This Undiscovered Monopoly Mints Money

If you're like me, you watch dozens of flicks a month, most of them served up through YouTube. But I'll pull down the occasional video or TV show through other sources, too. Netflix (Nasdaq: NFLX  ) , Hulu, Google, and many other media companies are changing the face of video, transforming the Web into a paradise for movie fans. We're all familiar with the big guns jockeying for position here, but I've found a company that set is to capitalize on the explosive growth in online content delivery.

What's more, it's got the backing of digital heavyweights such as Netflix, Microsoft, Cisco (Nasdaq: CSCO  ) , Hewlett-Packard, and most of the major Hollywood studios among more than 50 other firms behind its solution. This company is not competing directly against these big boys, so it can ride their success to its own gains.

A new star in the business
The company is called NeuStar (NYSE: NSR  ) , and is valued at just under a $2 billion, which places it just inside the typical threshold for small caps. NeuStar has consistent 20%+ net margins, virtually no debt, and nearly 20% of its market cap in cash. Yowza! In a minute, I'll get back to the big online opportunity, but I want to describe what the company does and why it's so profitable. Bear with me, because this otherwise-boring company is effectively a monopoly that mints money.

NeuStar maintains authoritative databases that allow its customers to successfully route phone calls in North America and to exchange critical info with other communication services. Telecom giants Sprint, AT&T, and Verizon, wireline carriers such as Frontier Communications (NYSE: FTR  ) , and emerging players, such as cable companies, have to use NeuStar's database to route almost all of their calls. NeuStar allows these telecoms to share critical operating data so that messages can successfully cross from one network to another. Its service is vital in locating end-users and establishing their identity, and in routing voice and data to the proper recipient.

If you've ever kept your mobile phone number but changed carriers, NeuStar was working behind the scenes to make sure you got your calls at the new provider. And if you've ever voted on a TV show, say for the winner of Dancing With the Stars, for example, it's NeuStar behind the curtain. The company is now pushing internationally, and has already developed a directory of more than 1 billion numbers.

The more devices that are out there, the more potential database entries that NeuStar can capture, and the more valuable its database. And it's not just phones, but rather any Web-connected device. Sales of mobile devices are set to explode, as everyone knows, but other gizmos, too, including laptops, Kindles, and potentially other non-typical devices such as cars and appliances.

The company receives contracts for many of its database services from an industry group that represents all telecom carriers in the U.S., and it has had no problems renewing the contracts. That's good, since the contracts totaled nearly 64% of revenue in 2009. The current contract expires in 2015.

By developing new services off its core business, NeuStar has built a company that becomes very profitable with only mild increases in sales. Over the last eight quarters, sales growth has averaged 4%, while net income has increased 21%. Even better, its capital requirements are low, and all investment needs can be easily met by operating cash flow. In fact, over the last three fiscal years, the company has pulled six times as much cash out of the business as it has invested.

The undiscovered opportunity
But here is the big opportunity that I mentioned at the top of this piece: NeuStar looks set to capitalize on the interoperability of the media devices that now dominate our lives.

The content industry has increasingly focused on protecting its copyrights while consumers have tried to maintain their access to purchased films and music across platforms. So the media industry formed a coalition and created Ultraviolet, a "digital locker" system that allows consumers to watch any movie they've purchased on any device anywhere, while protecting industry's ownership rights. Essentially, the rights to the content are stored online and then transferred to Ultraviolet-compatible equipment.

Ultraviolet is supported by Microsoft, Cisco, Netflix, Best Buy, Akamai (Nasdaq: AKAM  ) , Motorola (NYSE: MOT  ) , and Nokia (some 60 in total) as well as the major Hollywood studios, with the exception of Disney.

The big guns in this space have selected NeuStar exclusively to run the registry database that authenticates a consumer's ownership of a movie. The registry is built now, and Neustar is waiting on the industry to proceed. According to a conference call earlier this year, the company will be paid every time a movie is downloaded. Read that sentence again. NeuStar will take a tiny slice (very tiny, to be sure) of every download.

Now, this initiative does not include Disney, which is developing its own competing service, nor Apple (Nasdaq: AAPL  ) , which has its own digital rights setup. (They're both Steve Jobs-influenced companies, it's worth noting.) Not having Apple on board is a huge loss, for sure, but is the Class of Cupertino able to push its weight around enough to move the rest of the industry combined? Maybe, but NeuStar could still be a good investment even if Ultraviolet doesn't work out as expected. And there's a lot of alignment among the 60 partners to make Ultraviolet work.

Foolish takeaway
I like to have multiple good ways that an investment can work out well. While NeuStar is poised for success on its own, I think this stock could work out well in another way: as a buyout by private equity. Here's why it would be attractive to private equity:

  • Exposure to high-growth sector of mobile Internet devices.
  • Reliable cash flows and pristine balance sheet, which would allow a private-equity buyer to load up the company with debt for an immediate dividend payment.
  • Stock sits in an ideal price range for private-equity take-outs, even if a buyer were to pay a substantial premium.

Management has predicted top-line growth of 11% in 2011. If that translated into 11% EBITDA growth, then the stock would carry an enterprise value about six times next year's EBITDA. That's not at all expensive for the stability of NeuStar's recurring revenue and the potential for upside on Ultraviolet. And it wouldn't be absurd to suspect that its capital-light model would fetch a multiple of 10 times EBITDA (especially in a buyout), positioning the stock for 35% gains from here and perhaps more. 

So those are the reasons I like NeuStar. What about you?

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Jim Royal, Ph.D., owns shares in Frontier Communications. Best Buy, Walt Disney, and Microsoft are Motley Fool Inside Value picks. Akamai is a Rule Breakers recommendation. Apple, Best Buy, Disney, and Netflix are Stock Advisor choices. The Fool has written calls (bull call spread) on Cisco. Motley Fool Options has recommended buying calls on Best Buy. Motley Fool Options has recommended a diagonal call position on Microsoft. The Fool owns shares of Apple, Best Buy, and Microsoft. 

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Read/Post Comments (10) | Recommend This Article (43)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 03, 2010, at 3:59 PM, FoolSolo wrote:

    I made a pitch on this stock yesterday and added it to my portfolio. Even if someone doesn't acquire the company, it is a growth stock on its own merits and a reasonably valued buy at that.

  • Report this Comment On December 03, 2010, at 4:38 PM, Emperor2 wrote:

    Apple ought to consider buying this company, adding Disney to the mix, and milking this cash cow forever.

  • Report this Comment On December 03, 2010, at 4:44 PM, TMFRoyal wrote:

    Hi, FoolSolo,

    NSR is growing revenue nicely and is not expensive at that. It has multiple ways to drive revenue, and the buyout possibility is just gravy. Its business model, reasonable valuation, and attractive balance sheet make it a nice candidate for a financial buyer. We'll see.

    Fool on!

    Jim

  • Report this Comment On December 04, 2010, at 11:36 AM, catoismymotor wrote:

    Jim,

    Let us imagine a future where NSR has not been bought, is still rockin' and rollin', lets say five years out. I imagine in that time more Indians, Brazilians and Chinese, in addition to the domestic market, will have the income to download movies as you described above. In these foreign markets would NSR still have a piece of the action?

    I have not had a chance to look into how much money NSR makes from each download in the domestic market, but if it is the same overseas markets I think I see a huge wave of money coming their way. I estimate in North America, Brazil, China and India there are 2.7 billion people. If the market increases by just 5% over the next five years that means there will be 135 million more customers in 2016 downloading movies.

    Thank you for the article. It is great food for thought.

    Cato

  • Report this Comment On December 06, 2010, at 11:14 AM, TMFRoyal wrote:

    Hi, Cato,

    I see no reason why NeuStar wouldn't have a piece of that action. It's already moving into a global database company to help route calls, and has a billion numbers. The company is essentially riding the coattails of these much bigger players, who have all the muscle anyway. So I would expect, to the extent that these huge companies have pull in other countries with the Ultraviolet initiative, NeuStar would be on board. Of course, there are issues with piracy, which are well known (in the US and abroad), and Apple is such a huge force because its products dominate the space (for reasons that I'll never understand but just have to accept.)

    Jim

  • Report this Comment On December 06, 2010, at 6:01 PM, kramsigenak wrote:

    TMFRoyal,

    You don't understand how Apple products rule this space?? Wow, that's an amazing comment... I'm practically speechless. With due respect, you better research this space more.

  • Report this Comment On December 06, 2010, at 7:24 PM, TMFRoyal wrote:

    Hi, kramsigenak,

    My comment is directed specifically to the ridiculous margins that Apple can pull out of its (fundamentally) commoditized products that lock you into the Apple universe. Is an Apple product so good that anyone should pay 40% or more for the privilege of having it and then being locked into Apple's DRM system? (Apparently, for many, the answer is yes...). For me, I'll never see the value in paying a premium for an Apple product when I can get a device that works to my level of needs for much cheaper. In a similar way, I don't get Starbucks or Chipotle, but I don't have to get them, in order to understand the mechanism by which they rock the world (Apple included).

    Jim

  • Report this Comment On December 10, 2010, at 12:24 PM, Borbality wrote:

    This is exciting stuff. Looking into it now.

  • Report this Comment On May 24, 2011, at 11:42 AM, airjohn wrote:

    anyone have any updates on neustar's progress with ultraviolet?......haven't heard anything about it in a while and i thought it was supposed to be released in the middle of this year.

  • Report this Comment On July 24, 2011, at 6:38 PM, InvestWhatWorks wrote:

    "Neustar Media this week (6/30) turned over the final version of the digital rights management system developed for the Digital Entertainment Content Ecosystem consortium, paving the way for a consumer launch of the group's UltraViolet cross-platform video service later in 2011."

    "The Digital Entertainment Content Ecosystem (DECE) LLC, an open, cross-industry consortium of more than 70 companies dedicated to facilitating the development and operation of UltraViolet™, today (7/13) announced the launch of its licensing program for content, technology and service providers. DECE continues to anticipate that, beginning this fall, consumers in the United States will be able to purchase select movies and TV shows with UltraViolet rights."

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