Description

A FRESH LOOK AT REGISTER.COM. At first glance, RCOM doesn’t seem to offer much potential upside at its current price; the business is barely profitable and has yet to deliver on management’s past promises of profit growth. However, a comparison of the company’s cost structure to that of key competitors reveals that there is much room for cost cutting -- to the point, in fact, that the business could potentially generate significantly greater annual free cash flow, perhaps even more than $1/share. More importantly, as suggested by last year’s $120-million tender offer and the related appointment of a value-conscious activist investor to the board, the company appears to be taking steps to unlock shareholder value, and is in the midst of a restructuring program, the stated goal of which is to improve cost efficiency. Finally, with nearly $4/share in cash & liquid investments, downside appears to be limited.

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With 3.1 million Internet domains under management, Register.com generates average annual revenues of a bit more than $32 per domain, but spends roughly the same amount every year to service each domain, begging the question: Does it really cost $32 a year to keep each domain’s database server entries up-to-date? Where does all the money go? What are they spending roughly $100 million on every year?

According to Register.com’s most recent 10-K and 10-Q filings, the $32 figure is spent more or less as follows: cost of revenues is about $10 per domain, consisting of the $6 annual registry fee all registrars must pay to registries like Network Solutions, and $4 in largely unspecified costs; technology expenditures are $5 per domain; general & administrative expenses, $6 per domain; and sales & marketing accounts for most of the rest of the company's expenditures.

How does this compare with the figures of competitors of similar size? Register.com’s three largest competitors are Network Solutions, Tucows Inc., and Go Daddy Group, Inc. Together with Register.com, these companies manage more than half of all registered domains worldwide. Since Network Solutions, in addition to being a registrar, also runs the .com and .net registries (a different business), I compared Register.com only to Tucows (http://www.tucows.com) and Go Daddy (http://www.godaddy.com).

Tucows is publicly traded (TCOW.OB), and virtually all its revenues are generated by the domain registration business, making the comparison fairly straightforward. Annual revenue per domain is $10, reflecting the relative lack of brand recognition and a lower-quality customer base. But more to the point, cost of revenues is only $6 per domain, roughly equal to the $6 annual registry fee; technology expenditures are only $1 per domain; and general & administrative expenses, only $1 per domain. Sales & marketing expenses, also much lower on a per-domain basis, account for most of the remaining expenditures. As of March 2004, Tucows managed approximately 4.1 million domains -- comparable to Register.com --and was modestly profitable.

Go Daddy is privately held, but key financial and operational data about the company is available from several sources, including Deloitte & Touche’s “Technology Fast 500” list for 2003 (http://www.public.deloitte.com/fast500) (Go Daddy is #92), Registrar Stats (http://www.registrarstats.com), Dun & Bradstreet, and the company’s website. According to these sources, Go Daddy’s annual revenues are about $8 per domain—consistent with the company’s advertisements for registrations at $7.95 to $8.95 per year. The cost of revenues is at least $6 per domain (for the annual registry fee), leaving at most $2 per domain for technology, general & administrative, and sales & marketing expenditures. As of May 2004, Go Daddy managed an estimated 3.9 million domains -- comparable to Register.com -- and, according to management, was profitable.

In short, two of Register.com’s three largest competitors are running operations of similar size but with a cost of revenues, technology expenditures, and general & administrative expenses that are, respectively, roughly 40%, 80-85%, and 80-85% lower per domain. This disparity is so large that it can’t be explained away by business-model or client-mix differences. The inescapable conclusion is that Register.com’s cost structure is bloated.

The risk to Register.com of mass customer defections to low-cost providers appears to be low. Research shows that the vast majority of customers who actually use their domains (as opposed to domain speculators and warehouses) overwhelmingly prefer brand-name registrars -- i.e., Network Solutions and Register.com. (See, for example, http://cyber.law.harvard.edu/people/edelman/registrar-choice/2003.) This dynamic is unlikely to change soon. For example, Register.com’s market share among Fortune 1000 customers actually has been increasing, from an estimated 9% in 2002 to 12% in 2003. As common sense would suggest, customers who use their domains seem reluctant to risk going with a lesser-known registrar just to save a couple of dollars a month -- it’s not worth the trouble.

The opportunity to reduce costs and increase profits at Register.com appears to be significant. Were the company to bring its costs down to levels similar to those of its competitors, free cash flow could increase significantly, perhaps to more than $25 million per year, equivalent to roughly $1/share.

Management appears to have realized this -- probably with a bit of help from one James Mitarotonda, the investor who pushed for the tender offer and negotiated for himself a seat on the board of directors last year. The company is in the midst of a restructuring, the primary goal of which is to improve cost efficiency. Given the bloated cost structure, this restructuring has a good chance of being at least modestly successful.

However, the restructuring efforts won’t produce immediate results. As recent SEC filings state, the company has hired personnel to develop new systems even as it continues to maintain older systems with other personnel, leading to double staffing (and inflated costs) in the interim. However, once the new systems are up and running, it would be reasonable to expect costs to decrease.

In summary, this situation offers significant potential upside (if the restructuring program is even only modestly successful), and limited downside (thanks to a sizeable amount of excess cash & investments on the balance sheet) -- not a bad combination.

Catalyst

Completion of restructuring program
Launch of new information systems
Headcount and other expense reductions