The Most Profitable Play in Telecom

The Telecommunications Act of 1996 mandated the need for disparate telecom networks to be able to communicate with each other. It also prescribed the need for number portability, which allowed consumers and businesses to keep their phone numbers even if they switched to another telecom provider or network.

The designers of the act could not have imagined how popular it has become for an individual to keep his or her phone number or that communications networks would transcend the wired and wireless spectrums to include the World Wide Web.

Neustar (NYSE: NSR) was specifically founded in 1998 to address the new industry needs that stemmed from the 1996 telecom act. The business was originally owned by defense giant Lockheed Martin (NYSE: LMT), but was acquired and developed until a public offering was made in June of 2005.

Neustar is effectively the industry’s clearinghouse, in that its networks help ensure interoperability across wire line and wireless networks. This even includes online communication through the Internet. The company also operates and maintains a directory for all area codes and seven-digit phone numbers in North America to facilitate portability. Other services include facilitating calls between competing provider networks and managing domain names including the “.biz” and “.us” suffixes on the Web, which explains its homepage address of

The way the company explains it, Neustar is the reason that providers can create new phone numbers, a caller from a Sprint (NYSE: S) network can seamlessly connect with a friend on the Verizon (NYSE: VZ) network. It also helps ensure that domain names are secure on the Internet and provides other online security verification measures.

#-ad_banner-#Neustar’s traditional telecom businesses are slower growing, but highly profitable. Better yet, contracts bind customers to Neustar, which provides a pretty high level of sales visibility. The Internet-related operations will be the main sales drivers going forward and have appeal, given online traffic is growing at about +40% per year and shows few signs of slowing down.

Growth has been impressive since Neustar’s IPO. Annual sales have expanded nearly +24% in the past five years, while net income has grown at more than +17% each year during this period. Profitability has grown steadily as operating margins have reached almost 35% during the past year. Net margins now exceed 20%, which means that $0.20 of every dollar in sales falls directly to the bottom line.

Other financial metrics are equally impressive. Returns on invested capital have exceeded 20% during the past couple of years. More than $342 million in cash on hand eclipses the $10 million in debt on the balance sheet, and leads to a net cash position of about $4.35 per diluted share.

Action to Take —> A highly profitable and growing business makes Neustar stand out in an industry that must spend billions of dollars maintaining and constantly upgrading telecom networks to keep up with ever-increasing wireless and Internet data needs. This lessens the investment appeal of other telecom constituents, such as those mentioned above and AT&T (NYSE: T), but makes Neustar’s model even more appealing.

Neustar generated about $2 in free cash flow last year. This excess capital has been building up as cash on the balance sheet and could be returned to shareholders in the form of a potential dividend a some point. Management did announce a $300 million share repurchase program that will serve to lower shares outstanding and boost per share earnings.

The firm’s price-to-free-cash-flow multiple of just over 12 is also appealing from a valuation perspective, as are the prospects for future growth along with the rapidly growing need for communications bandwidth. Management has targeted annual revenue growth of +10% and similar profit growth levels. A share price in the low $20 range would represent a potentially appealing entry point for the stock.