Description

Recommendation: Long Rightside Group (NAME)

Key Insights

• Recent results depressed by costs for new gTLDs

  • EBITDA margins have fallen from high teens to break-even, primarily because of expenses associated with new gTLDs.

• Market appears to have overlooked the Back-end Registry business

  • Exclusive agreement to operate back-end registry for Donuts Inc.

  • Donuts Inc. is the largest owner of new gTLDs and has already sold >1.1mm domain names

• High visibility to accelerating revenue growth

  • Deferred Revenue up 14% vs. 0.3% YTD revenue growth

• Additional revenue will be at much higher margins

  • Direct margins on registration for new gTLDs ~33% vs. 11% for .com domains

  • Direct margins on Owned & Operated gTLDs ~90%

Thesis

I recommend an investment in recently spun-off Rightside Group, Ltd. (Ticker: NAME) as a way to capitalize on the release of new generic Top Level Domains (“gTLDs “) with limited downside risk due to the company’s $3.16 per share in net cash (~38% of market cap) and stable, profitable legacy registrar business.

I believe the opportunity is available because of limited analyst coverage (one analyst), a small market cap ($155mm), and results that are depressed by expenses associated with a new business segment that has only recently begun to generate revenues.

I expect the stock to re-price as more investors become aware of the opportunity, consolidated results consistently and meaningfully improve from the recognition of very high margin revenues, and the focus of capital allocation shifts from new gTLDs towards returning capital to shareholders.

Background

Pre-Spinoff & Spinoff Details

NAME was spun-off from Demand Media, Inc. (DMD) this summer. Since IPO’ing in January 2011, shares in pre-spin DMD (inclusive of the shares of NAME received) have been a terrible investment, largely because DMD’s largest contributor to revenues and profits, eHow, faced significant headwinds as Google changed their search algorithm in ways that were unfavorable to eHow.¹ As such, it’s understandable that investors initially view NAME skeptically.

However, I think I think linking legacy problems at eHow to the prospects of NAME misses the fact that NAME is at a particularly interesting cross-over point. For several years NAME has invested in new gTLDs at the expense of margins and other investment alternatives without receiving any credit for the investment-like nature of the expenses since the new gTLDs were not even available, let alone ramped and being recognized as revenue.

Note: NAME was spun-off from DMD and began trading separately on August 1, 2014. Adjusted for DMD’s 1:5 reverse-split (post distribution), the distribution ratio was 1:1.

Overview of Domain Name Value Chain

Historically, the domain services industry was split between registries, registrars, and customers seeking domain names. For domain names registered with the .com and .net registries, Verisign receives a fee from third-party registrars per annual registration that is fixed pursuant to agreements with ICANN. Third-party registrars were split between retail (primarily GoDaddy and Rightside’s Name.com) and wholesale (primarily Rightside’s eNom). Registrars act as a distributor between the registry and individuals/businesses seeking to purchase domain names. While retail registrars distribute domain names to individuals and small businesses, wholesale registrars distribute to resellers (e.g., Namecheap and Google). Finally, companies offer consumers the chance to purchase domain names that have expired (e.g., customer did not pay the annual renewal fee) in the aftermarket.

Due to agreements with ICANN and the Dept. of Commerce, Verisign is restricted from owning more than 15% of any registrar. However, the same restrictions do not apply to other competitors in the industry. Rightside, as the world’s largest wholesale registrar, and the 2^nd largest registrar overall, has the opportunity to become the largest vertically integrated player in the domain name industry with the introduction of its new gTLDs.

The slides below, excerpted from NAME’s IR presentation, provide a good overview of the domain name value chain.

Components of Value

Net Cash

Registrar (Name.com & eNom)

Overview

NAME’s registrar business sells domains via both retail (Name.com) and wholesale channels (eNom). Name.com is essentially a miniature GoDaddy, and eNom is similar, but the product is white-labeled by distribution partners who do not have registrar licenses and thus only handle marketing. Each of these distribution channels generate two types of revenues – Domain Name Services and Aftermarket & Other.

Domain Name Services earns revenue from registration fees charged to domain name purchasers like ValueInvestorsClub.com and others. NAME receives approximately $9 per domain per year, but NAME must remit $8 of this amount to the registry owner (Verisign, ticker: VRSN in the case of “.com”) and ICANN (an international non-profit organization that oversees the internet). NAME then sells higher margin add-ons to the customer.

Aftermarket & Other revenues are generated from advertising placed on domain names owned by Rightside or a customer seeking to monetize their traffic (subject to revenue sharing agreements). Aftermarket & Other also includes revenues from the sale of owned domains.

NAME’s Form 10 indicates the company’s legacy registrar business has grown revenues at a CAGR of approximately 10% over the last three years. However, NAME’s adjusted EBITDA (co definition) has slipped from $31.4mm in 2011 on revenues of $160.5mm (19.6% EBITDA margins) to just $8.0mm of adjusted EBITDA on revenues of $185.2mm in 2013 (see table below for more details).

What happened to cause lower margins for NAME?

1. Pricing for domains has not changed

Domain names under management have grown steadily (at least 1.0mm per year since 2009), and pricing has remained consistent since 2009, which indicates that Domain Name Services is not the cause of the margin decline. Further, NAME’s primary costs for Domain Name Services (fees paid to ICANN and Verisign) have not changed materially.

2. Mix shift has modestly impacted margins

First, NAME has seen a mix shift away from Aftermarket & Other revenues which are higher margin. However, a review of the movement in NAME’s margins and mix of revenues indicates the shift is unlikely to be the driver of the decline. For example, margins rose from 2010 to 2011 despite a small decline in the % of revenues that came from Aftermarket, indicating NAME is not completely dependent on Aftermarket to generate profits. Further, the decline in margins from 2011 to 2012 and 2012 to 2013 exceeded the change in mix. Since margins on Aftermarket revenues cannot be greater than 100%, there has to be something else going on.

3. NAME has incurred costs to prepare for new gTLDs

NAME has invested or made refundable deposits in the amount of $19.5 million associated with gTLD applications during the nine months ended September 30, 2014, and made total capital investments or made refundable deposits in the amount of $41.6 million associated with certain gTLD applications since 2012.

Furthermore, NAME incurred approximately $8.4 million of expenses related to the new gTLD Program for the year ended December 31, 2013, and $6.6 million for the nine months ended September 30, 2014, but sales of new gTLDs only began in 2014 (steadily ramping) and the revenue associated with sales of new gTLDs has largely been deferred.

Margins associated with new gTLDs are meaningfully higher

• Due to Verisign having an effective monopoly on the registry industry, price increases require approval from the Dept. of Commerce. On 1/15/12, Verisign increased registration fees for .com domain names by 7% to $7.85. This price is fixed for the duration of Verisign’s current registry agreement, which is through 11/30/18, except that prices may be raised up to 7% per year. Conversely, there are no restrictions placed on the pricing of new gTLDs, allowing the market to allocate higher prices to gTLDs deemed more valuable. This has been observed in the early rollout of new gTLDs, with some of the higher valued domain names selling for prices upward of $100k. The average price expected for new gTLDs has ranged from $25-$35 vs. ~$10-$13 typically paid for.com domain names. Considering the nosebleed contribution margins for providing registry services, the extra revenue flows almost entirely to the bottom line.

Estimated Value of Registrar

NAME’s legacy registrar business has historically been quite steady, in large part because of the low- to mid-70% annual renewal rates. Pricing has also been stable, with NAME achieving low-single digit revenue per domain price increases.

Registrar Valuation Scenarios

• Revenue

  • Domain Name Services

    • Conservative: Implies ~6% growth in 2015 despite 14% YTD increase in deferred revenue (~18.5% annualized).

    • Base Case: Implies deceleration of revenue growth to ~10% in 2015 (from ~13.5%) despite the higher rate implied by deferred revenue.

    • Aggressive: Implies ~15% revenue growth in 2015, a slight acceleration, but still below the annualized increase

  • Aftermarket & Other

    • Conservative: Assumes the current annualized run-rate going forward.

    • Base Case: Reversion to HSD growth since revenue has stabilized in recent quarters after NAME shed low-quality advertising revenue previously offered on its O&O websites.

    • Aggressive: Assumes the company can better monetize its aftermarket services through better understanding highly popular gTLDs through its registry business.

• EBITDA Margins

  • Conservative: 6% (excluding identified gTLD opex).

  • Base Case: 10% (excluding identified gTLD opex & slight reversion in mix).

  • Aggressive: 14% (excluding identified gTLD opex & reversion in mix shift towards historical levels).

• EBITDA Multiple:

  • Conservative: 5.5x (below historical levels and well below peers).

  • Base Case: 7x, (below peers which trade at ~8.5-9x).

  • Aggressive: 8.5x (in-line with peers).

O&O Registry (owned new gTLDs)

Overview

• Rightside currently owns 35 gTLDs, and has an interest in 38 additional gTLDs that are yet to be resolved (note: gTLDs with multiple bidders go to an auction process if the parties cannot agree on an outcome). Management expects to own ~40 gTLDs at the end of the process.

• Examples of domains sold to date are shown in the table below.

  • The company has bifurcated the gTLDs into classes such as professional, small business, pay per click, and consumer.

• The first gTLD was launched into general availability on 5/21/14, and six have been launched in the past two months. Rightside owns 11 gTLDs that have not been launched into general availability yet.

O&O Registry Valuation Scenarios

• Revenue

  • gTLDs owned

    • Conservative: 35 gTLDs currently owned by Rightside

    • Base Case: Mgmt. expects to own ~40 gTLDs at the end of the process.

    • Aggressive: Mgmt. expects to own ~40 gTLDs at the end of the process.

  • Domains per gTLD

    • Conservative: 25,000

    • Base Case: 50,000 (Rightside conducted significant market research to decide on the gTLDs it wanted to pursue).

    • Aggressive: 75,000 (.ROCKS and .NINJA have each sold > 20k domain names already).

    • Note: Little known gTLD .NAME has approximately 193k domains registered and “failed” .XXX has 109k.

  • Revenue per domain

    • Conservative: $15

    • Base Case: $20 – Rightside’s IR presentation on 12/5/14 showed it expects to earn $20 for selling a .SOCIAL domain name through GoDaddy.

    • Aggressive: $20

• EBITDA Margins

  • Conservative: 80% (reflecting estimated marketing as well as G&A)

  • Base Case: 85% (minimal incremental)

  • Aggressive: 90% (Company reports direct margins of ~100%)

• EBITDA Multiple:

  • Conservative: 7x

  • Base Case: 8x – Likely conservative multiple as the registry segment will provide high margin revenue streams with ~70%-75% annual retention rates.

  • Aggressive: 9x

Back-end Registry Services

Overview

Rightside has not disclosed very little about the Back-end Registry Services agreement it has with Donuts, making it the least visible value driver. However, I believe it would be a mistake to overlook the value of NAME’s Back-end Registry platform.

Donuts was formed through ~$100mm venture capital funding to bid on new gTLDs. While Donuts had the capital to acquire gTLDs, it did not have the operational infrastructure necessary to provide registry services to registrars and end-consumers. As a result, Donuts signed an agreement for Rightside to provide all of its back-end registry services for an initial term of 5 years.

I believe the best analogy for NAME’s Back-end Registry Services business is the sub-segment of Neustar (ticker: NSR) that provided similar services to the .CO gTLD until Neustar bought the gTLD from Columbia in April 2014 (for ~5.5x gross revenues or 8.0x revenue, net of .CO was paying to NSR for services).

In conjunction with its announcement the acquisition, NSR disclosed that it had received $4 million of revenue from the service agreement, which was a subset (since it would be eliminated in consolidation) of the $21 million of revenue earned by .CO. In other words, NSR was receiving ~20% of the gross revenues for .CO for providing the back-end registry services.

Applying the ~20% to the pricing NAME used in its IR presentation on December 5, 2014 to the pricing example provided for a new gTLD ($20)implies NAME will receive ~$4 per domain sold by Donuts per year.

As of 12/8/14, Donuts has sold ~1.1mm domain names through 156 new gTLDs. The top 10 gTLDs have sold > 20k each, and the top 31 have sold > 10k each.

Back-end Registry Valuation Scenarios

• Revenue

  • gTLDs owned

    • Conservative: 156 currently

    • Base Case: 180 based on having an interest in 30-35 gTLDs in coordination with Rightside that are yet to be resolved as well as additional gTLDs Donuts applied for on its own.

    • Aggressive: 200

  • Domains per gTLD

    • Conservative: 20,000

    • Base Case: 40,000 based on already averaging > 7k per gTLD even though most have only been on the market for a few months.

    • Aggressive: 60,000

  • Revenue per domain

    • Conservative: $3 of the $20 fee paid to Donuts

    • Base Case: $5 based on a 25/75 split between Rightside and Donuts

    • Aggressive: $7 of the $20 fee paid to Donuts

• EBITDA Margins

  • Conservative: 75%

  • Base Case: 80% (Rightside expects direct margins to be ~95%-99% on registry services & other operating costs should be minimal beyond the required infrastructure is fully implemented.

  • Aggressive: 85%

• EBITDA Multiple:

  • Conservative: 6.5x

  • Base Case: 7.5x

  • Aggressive: 8.5x

Fixed Cost Structure for O&O Registry + Back-End Registry Not Reflected in EBITDA Margins

Insider Incentives

• PE owners w/ 39% interest (haven’t sold since DMD IPO).

  • Oak Investment Partners ~24% (4,487,062 shares)

  • Spectrum Equity Investors ~15% (2,770,540 shares)

• CEO:

  • 86,947 RSUs granted on 11/3/14 which vest over 16 quarters

  • Target bonus % of base salary increased from 65% to 85%

• Recent insider buying.

  • Director Robert Majteles purchased 12k shares @ $8 on 12/2/14

Risks

• Increased price competition among registrars for .com and other legacy gTLDs

• Further declines in Aftermarket & Other revenues

• Poor adoption of new gTLDs (O&O and Donuts)

Catalyst

Catalysts

• Recognition of revenue for gTLDs already sold (owned and Donuts)

  • Deferred Revenue on the balance sheet provides a high degree of visibility for future revenue.

• Rising consolidated margins

  • (Deferred Revenue – Deferred Costs) / Deferred Revenue shows higher embedded margins

• Increased analyst coverage

  • Currently only B. Riley covers NAME

• Increased free cash flow generation and potential return of capital

  • Carrying excess cash

  • Free cash flow greater than earnings (paid before revenue is recognized)

  • Improving earnings outlook

  • Once the “land grab” for new gTLDs is done, I would expect the company to evaluate capital allocation options, especially buybacks.

• Buyout Candidate (not a prediction)

  • NAME’s cash generation, depressed valuation, and stable business could appeal to private equity (including existing PE holders).

  • Donuts Inc. might want to buy-in the operator of its registry (and pick up a registrar in the process)

  • Web.com (WWWW) owns a registrar business and only has a very small interest in new gTLDs that they might want to increase.