A Telephone Book Monopoly

This is a write-up on a company that literally hides in plain sight.  It is a great company with modest upside potential and fairly limited long-term downside.  It’s not a home run, but it is a sleep well at night sort of idea.  It is often ignored because of its simplicity and lack of long-term growth options.  

Verisign (VRSN) is a global provider of domain registry services, which means that they operate as a sort of telephone book of the internet for any .com and .net addresses (including a few other domain names).  Users pay an annual fee for the right to “park” their website at a specific address, for example, Amazon.com.  This fee is paid to VRSN.  

The ability to operate this “telephone book” is granted to VRSN through a contractual relationship with ICANN (Internet Corporation for Assigned Names and Numbers), the nonprofit agency that “coordinates” the internet.  ICANN is currently overseen by the NTIA, National Telecommunications and Information Administration, a division of the Department of Commerce.  

Despite the use of the word monopoly with regards to VRSN’s business, it is not an actual monopoly since users have the ability to park their websites at addresses other than .com and .net.  For example, the second biggest registry service (.biz) is operated by NSR (another public company).  Additionally, ICANN has recently auctioned off the rights to numerous other suffixes, including .web (this auction was won indirectly by VRSN), .store, .attorney, .auto, and really almost any other suffix you could name.  (A more complete list can be found here).

It is potentially to hard too overstate how great a business this is.  Since 2010, VRSN has focused its entire efforts on its registry services unit. Prior to 2010, VRSN was a conglomerate of disparate internet-related businesses.  Given the shift in 2010 and focus on its one unit since then, we will look at the financials since 2011.  

If you think about the business, the marginal cost of adding another domain name to the registry is very, very low.  Therefore, the operating leverage has dramatically benefitted the company as it has pared down its efforts to focus on this one unit.  

2015 2014 2013 2012 2011
Gross Profit Margins 81.80% 81.35% 80.62% 80.81% 78.60%
Operating Margins 57.20% 55.90% 54.73% 52.35% 42.67%
Capex as % of Sales 3.84% 3.89% 6.80% 6.07% 24.96%
Free Cash Flow as % of Sales 57.60% 55.50% 53.24% 55.47% 18.56%

Given the capital light nature of their operations, Verisign has been able to use almost all of its cash flow to repurchase stock and pay a one-time dividend in 2011 (since 2011, the company has focused solely on share buybacks.

Share Buybacks 2015 2014 2013 2012 2011
Operating Cash Flow 606 564 528 457 329
Share Repurchases and Dividends in $ 643 883 1036 326 1013
Diluted Share Count 133 141 156 164 167

These margins and focus on share buybacks, along with lack of capital intensive business make Verisign a truly excellent business.  One downside to these margins is the risk of competition or backlash from ICANN that Verisign’s profits are too high.  One potential opportunity for Verisign in the future is to be purchased by a conglomerate like Berkshire Hathaway.  Under the Berkshire umbrella, the profit margins would be hidden and Buffett or his successors would be able to allocate the future cash flow to their highest and best use (interestingly, Berkshire currently owns about 12% of VRSN).   

There are 5 bear cases:

  1. Contract Renewal
  2. Pricing
  3. Transition Process
  4. New TLDs
  5. Not Cheap

Contract Renewal

The current .COM registry agreement between Verisign and ICANN will expire on 11/30/2018, however, as part of the transition away from NTIA’s involvement in ICANN, VRSN is extending this agreement until 2024.  This process should be done within two months as the transition is set to occur on 10/1/16.  However, even with the amendment and extension, the key focus on this contract and its renewal should be on the presumptive renewal right contained within the contract. The presumptive right of renewal in layman’s terms is the right for the contract renewal to continue in perpetuity unless VRSN “screws” it up.  In other words, as long as VRSN doesn’t mess up the telephone book and direct people going to amazon.com to walmart.com, VRSN’s right to operate the registry is perpetual.  A presumptive right of renewal means that the contract will not be re-bid at the end of the contract, but the parties may seek to extend the terms beyond the renewal date.  I have included the relevant contract language below.  

“This Agreement shall be renewed upon the expiration of the term set forth in Section 4.1 above and each later term, unless the following has occurred : (i) following notice of breach to Registry Operator in accordance with Section 6.1 and failure to cure such breach within the time period prescribed in Section 6.1, an arbitrator or court has determined that Registry Operator has been in fundamental and material breach of Registry Operator’s obligations set forth in Sections 3.1(a), (b), (d) or €; Section 5.2 or Section 7.3 and (ii) following the final decision of such arbitrator or court, Registry Operator has failed to comply within ten days with the decision of the arbitrator or court, or within such other time period as may be prescribed by the arbitrator or court.”

It is important to note here that all new TLD agreements contain a similar presumptive renewal right.  In other words, this decision to grant a presumptive right of renewal was not a mistake by ICANN, but instead a conscious decision by ICANN because it encourages the registry to build out the infrastructure necessary to support and maintain this contractual right.  As long as VRSN continues to perform under this contract, this contract will not be “put out to bid.”

Pricing

Although I don’t believe VRSN needs to increase prices to make this investment work, the power to raise prices is certainly an attractive upside.  The .com pricing has been set since 2012.  However, VRSN does have the ability petition ICANN to raise prices if it can show that .com doesn’t dominate the market.  Given the proliferation of TLDs and the pricing increases taken by other gTLDs, notably .biz and .info, it now appears that .com is under-pricing its offerings.  I believe after the amendment/extension of the .COM agreement, VRSN may turn its focus to attempting to show cause that it is now underpricing its offering given the proliferation of others gTLDs and their respective prices.  Although Amendment 32 of the Cooperative Agreement would still require VRSN to gain approval for any price increases from the DOJ, it is more than likely that VRSN will at least attempt to make its case for raising the cap on its pricing (see here for Amendment 32).  However, I do not believe any pricing increase is necessary to make this investment work.

Transition

This step is what I believe has caused the most recent sell-off.  The NTIA is transitioning its oversight of the internet to complete autonomy under ICANN.  However, in the past few weeks, Ted Cruz and Mike Lee have asked the DOJ to investigate this contractual relationship (this is in addition to their call for the Congress to delay the transition of ICANN’s autonomy).  However, the real issue the Senators have is that they do not want ICANN to be completely independent of US oversight and this is another opportunity for them to throw a wrench in the process.  I do not believe this tactic will work.  The NTIA sent a letter to ICANN on August 16 (subsequent to the Cruz/Lee letter) indicating that the process is on track and set to proceed as planned with the full transition occurring on 10/1/2016.  The two catalysts therefore are the complete transition set to occur on 10/1 and the amendment to the .COM registry agreement, which should occur sometime before that date.  

New TLDs will diminish value of .COM

ICANN has auctioned off hundreds of new TLDs (see above for list). This is potentially the most valid argument, in my opinion.  However, the facts have yet to bear this out.  The new TLDs have had almost no impact on the growth or prevalence of .COM. Given the minor cost of registering a .com address, I believe that most people will end up securing multiple addresses to protect their business interest, but still seek out .COM as their primary address given its prevalence in the mind share of the general public.   

Furthermore, VRSN is also looking to grow in this area, but selectively.  VRSN has secured the rights to be the registry for the new .WEB gTLD.  VRSN paid approximately $130m for this right.  

Not Cheap

This is the other good bear thesis.  Although I don’t fully agree with some large bulls that this company is severely undervalued, I am willing to entertain the idea that there is a discount to fair value in a well-managed business.  

Some back of the envelope calculations are as follows:

Diluted Shares including converts: 130.6m

Senior Debt: 1.24B

Convert Debt: 1.25B (cash amount required for buyback under “Treasury Method”)

Cash: 1.9B

Enterprise Value: 10.4B ($75 share price)

Cash flow since VRSN has been in its current structure has been 538m, 579m, 601m and 651m.  Since this isn’t a cyclical business and the growth in free cash flow is mainly tied to VRSN becoming a more focused operation, I don’t see the need to discount or average these past 4 years of cash flow.  I estimate about 50m in ongoing maintenance capex, which gives me about 575m (adjusting for working cap changes) in  free cash flow generation per year going forward assuming no growth.  Adding back 110m in interest expense, a rough EV/FCF valuation is approximately 15.2 (10.4B/685m [575 fcf + 110 interest expense]).  This gives you a rough idea on the valuation.  This isn’t screaming cheap, but given the continued free cash flow generation and the “fog” around the contract extension/amendment, I believe this should trade closer to 18-20x free cash flow.  At 19x, you are looking at a $100 share price, assuming no pricing increases or further growth in volume.  

Over the next year, I see 3 things happening:

  1. Transition contract and amendment extension
  2. Request for pricing increase on .COM registrations
  3. Consistent capital allocation and continued free cash flow profile.  

This investment idea is too simple and lacks the shine of a growth stock.  I think that is why VRSN occasionally offers a boring, but solid investment.

Matt Brice

Verisign: The Golden Yardstick

Suzuki Violin is a method for teaching violin. There is a set of books that contain numerous songs that the children learn

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