Introduction
Verisign Inc. (VRSN, Financial) is a company which provides domain registry services and internet infrastructure.
It is one of the most-dated internet companies, as its services are at the base of the web research mechanisms.
"Old" internet companies are considered not very hot nowadays, as everyone is focused on cloud computing, cybersecurity, artificial intelligence and other trendy tech topics, but adding some of them, like Verisign, to our portfolio can provide stable cash flows, and maybe even unexpected growth.
For those not familiar with how internet searches and domain name systems work, here are some concepts. A Domain Name System (DNS) is a sort of phonebook for the internet. Just like we used to search the correspondence between a name and a number in the phonebook, a DNS looks for the correspondence between domain names, e.g., gurufocus.com and internet protocol addresses .
After the DNS has located the relevant IP address, the system can access the corresponding internet resource, which is basically the desired website content. This system has been created to simplify website searches, as for a human it is much easier to remember a domain name than a series of numbers.
When we register a domain name for our blog or website, we pay an annual fee to a service provider caalled a registrar. The registrar does not manage the domain directly, but checks with a registry to see if the name you chose for the domain is available. A registry is the wholesaler which manages one or more domain names (like .com or .org). When you pay for your registration, part of your fee goes from the registrar to the registry for the domain name registration.
Each time we type the name of our favorite website, the corresponding query involves different servers distributed all over the world provided by our internet provider, our registrar and the registry, in order to resolve and find the relevant IP address (the complete set of steps would be a bit difficult to explain here, but that's what basically happens).
Verisign is one of the few registry companies in the world and manages (among others) two of the most used top-level domains, specifically the .com and .net ones. At the end of 2020, there were around 366 million domain name registrations in world, and the .com and .net TLDs had a combined 165.2 million registrations, a whopping 45% of the total.
Business value drivers and risks
The above technical introduction was needed to better understand which are the key variables driving value for Verisign.
The business model is actually very simple: the company aims to manage DNS registrations and grow them way into the future, possibly by raising prices in the meanwhile. The 2 key variables are thus the number of registrations and the annual registry-level fee per registration.
Referring to the number of registrations, domain base names (the active plus already registered but not active yet domain names) are expected to increase between 2.5% to 4.5% from the end of 2020 to end of 2021.
Turning to prices, of course, because of its dominant market position, Verisign cannot freely raise registration fees. The process is overlooked by two regulators: the U.S. Department of Commerce and the Internet Corporation for Assigned Names and Numbers, so every registry license and price increase must be approved by the above-mentioned organizations.
The latest .com registry agreements provides that Verisign will be the sole registry operator for domain names in the .com TLD through Nov. 30, 2024. This agreement was reached after a long litigation and was intended as a win-win outcome for both Verisign and the regulators (what about the final users? I think they would have preferred a different outcome).
And here comes the catalyst: under the current agreement, "the Maximum Price of a .com domain name may be increased without further DOC approval by up to 7% in each of the final four years of each six-year period". Referring to the .net TLD, the corresponding Registry Agreeement provides that Verisign will be the sole registry operators through June 30, 2023.
Of course, this does not mean that Verisign will apply the price increases every single year, but, at least for 2021, the increase was already announced during the fourth-quarter results call. Indeed, the company announced that the annual registry-level wholesale fee for each new and renewal .com domain name registration will be increased from $7.85 to $8.39 (effective Sept. 1st, 2021). That's equivalent to about an additional $90 million in revenue in around one year.
Just to summarize, we have a company with a quasi-monopoly market position, no competition until 2023-24 and the possibility to increase prices without incurring any sanction. If this is not a moat, then I don't know what a moat is.
Of course, in theory, Verisign faces the risk of not seeing its DOC and ICANN agreements being renewed in a few years, but as these have been renewed since the mid-90s and the switching costs would be enormous, I see this scenario as quite improbable.
Financial situation
Verisign's balance sheet does not appear extremely strong at first sight. Cash and equivalents stand at slightly less than $1.2 billion, while debt amounts to around $1.8 billion. However, the balance could be easily covered by only one quarter of free cash flow, so the situation is much better than expected.
Turning to profitability, the company had at the end of 2020 a return on assets of 45.48% and a return on invested capital of 62.53% (the return on equity cannot be calculated as the common equity is currently negative). The high profitability marks can be easily explained by the fact that Verisign spends very little to sustain its business. Capital expenditures were, in fact, only 3.4% of total sales for 2020.
The free cash flow margin is also very high, as it is currently 54.29% and has always been greater than 50% in the last four years.
Revenue was up by around 3%, but the company has been continuously buying shares in the recent years, as we can see from the chart below.
Referring to valuation, GF assigns Verisign a fairly valued rating, while the discounted cash flow calculator reports a fair value of $297, providing a 32% margin of safety on the current market price.
Conclusions
Verisign is an internet domain registry services company, and the only provider of DNS services for the .com and .net top-level domains.
The company has a quasi-monopoly market position and agreements with the Department of Commerce and ICANN regulators, which will expire in 2023-24. They also have the option to increase prices for the .com domains by 7% annually for the next four years.
The slow revenue growth, depending on the number of new registration and renewals, could get a boost once the announced 2021 price increase starts to impact results. The constant share repurchase activity could also increase earnings per share growth.
Disclosure:
The author does not currently own shares of Verisign, but is considering initiating a small position in the coming weeks.
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