Verisign: A Case Study of a Great Business

Verisign (“VRSN”):  The quarterly update from VRSN is so enjoyable.  It takes so little mental effort to realize that this is a great business.  Additionally, each quarter, you realize how much heavy lifting is being done for you by the great business. You can find the earnings release here.

VRSN provides a great example of what you should look for in a business. It’s like sitting down in a “Great Business Class” in your MBA program and opening up to Chapter 1 on the first day: Verisign.

The rarity of this business doesn’t mean that such examples never come along. Instead, the rarity is an indication of the patience required to wait for a business that is both understandable by you and a truly excellent business. Certain companies are probably great businesses, but I struggle to understand a wide variety of companies. Additionally, some fast food companies are easy for me to understand, but I don’t really consider them to be great businesses.  These two questions are personal to each investor. It is rare to find both characteristics in one business. The idea of waiting for these types of situations is something we need to emphasize more.

With VRSN specifically, I want to emphasize a few key points about why I think it is such an exceptional business and what to look for in other businesses.

VRSN’s management is not interested in Empire Building.” Management recognizes that they have a special asset. They have what you might call a “golden goose” in their registry business. If management would use the cash flow from the golden goose to go out and buy a regular dairy cow, they would immediately dilute the quality of their overall business. I can imagine the pitch, we are “creating a farm superstore”…but this just means that management wants to raise their profile and build an empire. The examples of companies diluting their great businesses with empire building acquisitions could fill multiple business school classes (Coke buying Columbia Pictures and GameStop’s acquisition of AT&T Mobility Stores come immediately to mind). It’s not an understatement to focus on how rare this characteristic is. Most corporations think they can take the incoming $1 of cash flow and turn it into $2 in a few years, but really it ends up becoming 50 cents.  It isn’t a bad thing if the only wise decision to allocate your capital back to your shareholders. See’s Candies comes to mind in this area. You do not see See’s competing in every grocery store aisle with Hershey’s. I am sure Buffett is fine with this result. Some businesses are only great at a certain size or in a very specific business niche or geography. For these businesses, growth is destructive and therefore the cash is better utilized elsewhere.  Few managers understand this because their incentives aren’t usually aligned (and by incentives, I usually mean, their pride and occasionally pay package structures). Who wants to be CEO of a great small company, when you can be CEO of a potentially great large company?

Competition: Competition is probably one of the biggest threats to shareholder value for any company.  The competitive threat from the current landscape of other businesses in addition to the future competitors that don’t even exist now provides a continual concern for shareholders in any company.  VRSN is one of the few examples I have ever found that has virtually no competition. The contractual agreement to be the registry for .com and .net provides VRSN a contractual monopoly for their business.  Buffett once talked about owning the “one toll bridge from Michigan to Canada” and how great a business that would be. These businesses are very rare and VRSN is such a business. The financial statements of VRSN would look dramatically different with sustained competition.

Operating Margins: Although this point is merely an accounting observation, it is quite instructive to see how great of a business VRSN is by looking at the dramatic increase in operating margins over the past 5 years. Operating margins increase as revenues increase faster than marginal or required fixed costs increase.  This is a very common idea in business, but VRSN is a great example of how the fixed costs of operating their business do not increase at the same level as their revenues increase, both because of new customers and through pricing power.  Without real pricing power due to contractual provisions, VRSN has still been able to increase operating margins because their fixed costs have not increased in line with their increased revenues. They have very little variable costs with each additional user, and their fixed cost base can most likely support many more customers than they are currently serving.  

VRSN provides the rare example of the proper equation for investment success. It should take very little time to understand that a business is both exceptional and within your circle of competence. The larger time requirement is in the patience to wait for such an idea and to wait for such an idea at the right price. Most people focus their efforts solely on the time to understand a business, which is natural because that is generally the only factor that they can control. The problem with this approach is that great businesses typically don’t take a significant amount of time to recognize. Instead, people convince themselves after hours of invested time that they have discovered an “off-the-beaten-path” great investment idea.

Although I believe VRSN is a great business, I do think valuation matters. At its current prices, I no longer believe VRSN will provide significant upside going forward. This could change in the future if something causes the valuation to decline significantly without affecting the actual business. VRSN will remain on my watch list and we will be patient for a better valuation.

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