Neustar Is Trading at Historically Low Valuations

At GuruFocus we have model portfolios that are simulated and tracked on the website. Our four value strategy portfolios have all outperformed the S&P 500 since inception. While using the screens that determine the portfolios, NeuStar Inc. (NSR) was near the top of the list for two of them. The two screens are “Top 25 Undervalued Predictable Companies” and “Top 25 Historical Low P/S Ratio Companies.” Since inception in 2009 the Top 25 Undervalued Predictable Companies portfolio has outperformed the S&P 500 by 29.68 percent. The Top 25 Historical Low P/S Ratio Companies portfolio has outperformed the S&P 500 by 22.25 percent since its inception in 2010.

The Company

Neustar was an operating unit of Lockheed Martin and created to manage large data sets. In 1997 it won the contract to administer the North American Numbering Plan (NANP). It created a massive database in need of neutral steward to give telephone companies equal access to everybody’s phone number. To ensure neutrality, it was divested in 1999 and the new company was named NeuStar.

Today Neustar is a neutral and trusted provider of real-time information services and analytics, using authoritative, hard-to-replicate datasets and proprietary analytics to help clients promote and protect their businesses. The company has five primary services:

• Marketing – The service provides clients the ability to plan and execute marketing strategies and measure the effectiveness of advertising campaigns across multiple channels with advanced marketing analytics, custom segmentation and media optimization. Its main competitors include: comScore, Acxiom, Nielsen, Adobe Systems, DataLogix and BlueKai.
• Business Assurance – The service provides clients with website performance monitoring and load testing analysis to enhance their ability to measure and improve online performance, and promote competitive advantages and positive end-user experiences. Its main competitor is Keynote Systems for website performance monitoring. They do not face direct competition for user authentication and rights management services.
• Security – The service provides a suite of domain name systems built on a global directory platform. It plays a role in directing and managing the flow of internet traffic, resolving internet queries, and providing security protection against cyber attacks. Its main competitors are Akamai Technologies, VeriSign, and Open DNS.
• Data – The service manages large, complex data sets that enable clients to process decisions and transactions in real time. Its competitors are Synchronoss Technologies, Telecordia Technologies, and Syniverse Technologies.
• Data Registries – The suite of data registry services includes dynamic routing of call and text messages among all competing communications service providers in the United States and Canada, the provision of caller-name and related information to telephony providers, the management of authoritative domain-name registries and the administration of the U.S. common short code registry.

NeuStar is currently in a transition from being a telecommunications infrastructure company to a growth-oriented information services and analytics company. The company listed four goals in its latest annual report:

1. Achieve financial targets.
2. Further strategy to become a leading provider of commercial insights and analytics.
3. Continue to compete vigorously for the NPAC contract that begins in July 2015.
4. Continue to invest in our employees and platforms to drive growth and shareholder value.

Financial Statements

Neustar’s earnings have been growing at a rate of 16.9 percent for the past five years and 6.9 percent over the past year. Its revenue has been growing at a higher rate of 23.4 percent over the past five years and 12.90 percent over the past year. The faster growth in revenue shows that the company’s margins have been decreasing over time.

According to the latest quarterly report, the company has $386.5 million in cash, an increase from its previous years. The company had a negligible amount of long-term debt on its balance sheet until 2011 when Neustar purchased TARGUSinfo. TARGUSinfo was a real-time on-demand information and analytics company. The long-term debt now on the balance sheet is at $783.4 million. The debt-to-equity is at a high level of 1.35. While the debt levels are high, the interest coverage at 12.10 is more than high enough to manage the debt. The company also has an Altman Z-Score of 3.03 indicating safe levels of debt. Neustar has also been buying back shares. The number of shares outstanding has gone from 80.2 million to a current amount of 62.8 million over the past 10 years.

Free cash flow has been increasing at a rate of 20.4 percent over the past 10 years, 23.70 percent over five years. Free cash flow and cash flow from operations have had a small decrease over the past year. Operating expenses increased higher than usual driven by advertising and professional fees associated with The NPAC vendor selection process and costs for restructuring initiatives designed to improve efficiencies.

Risks

At this point the main risk is the NPAC services contract renewal. In the first quarter of 2014, NPAC services accounted for 51.7 percent of total revenues. The timeline published by the North American Portability Management LLC (NAPM) estimated that by May 6, 2014, the Federal Communications Commission (FCC) will select the Local Number Portability Administrator for the next term beginning July 2015. May 6 will be here soon, and it is possible that the deadline could be pushed back further. Neustar has been servicing the contract for over 16 years. The odds seem to be in their favor for winning the next contract, but there is still the risk that another company will be selected. The other risk is that the competitive bidding process could reduce the profitability of the program. A loss of the contract would be a severe loss to Neustar since half of its revenue comes from service. The company is currently in transition to reduce its dependence on NPAC services. In 2010 NPAC services accounted for 65 percent of revenue and now it is about half of the revenue.

Valuation

Neustar is trading at historically low values in many different measures such as price-to-earnings, price-to-book and price-to-sales. The stock closed at $29.72 on 4/21/2014.

Using the company’s five-year median valuations would value the stock in a range of $50.00 to $85.00. Neustar is not growing as fast as its five-year average, so it does not deserve a valuation at those high levels. For the past 10 years on average, the annual growth of earnings has matched the annual growth of revenue. Revenue has been growing at a faster rate than earnings over the past five-year and one-year periods. For 2013, revenue grew at a rate of 12.9 percent while earnings grew at 7.4 percent. At that rate, earnings will grow at 57 percent of what revenues will grow at. The decrease in margins might remain low due to the competitiveness of the NPAC services contract. In the meantime, Neustar is expanding its other services and will likely expand its margins after the first full year of the new contract that starts in July 2015.

Compared to many of Neustar’s competitors, it is still trading at the lowest P/E. The negative news and uncertainty is reflected in the stock price.

The question is whether the stock’s price has come down too far while adjusting for the new information. While the company’s margins are likely to remain low and not start expanding for a couple years, I think it deserves a higher P/E to account for the growth opportunities with Neustar’s initiative to expand its services and lower its dependence on NPAC services. At this time a P/E of 15 would put it at the value of the Peter Lynch Earnings Line. Neustar has only traded below the line once before in the past in August and September of 2011. A P/E of 15 would value the stock at $37.00, giving it a margin of safety of 20 percent.

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