Description

Verisign has been written up on VIC previously and has been a business that we have evaluated for sometime. The reason we are bringing this back up to the surface is the stock price is at a ~3 year low. While some of this is likely to do increased interest rates, we still feel that at a 3.7% free cash flow yield and a reasonable growth path warrants initiating a position in a company that is high quality from a qualitative and quantitative standpoint. The .com registry agreement is the primary risk here, but we do not see it as an all or nothing situation if the contract was not renewed under the presumptive right of renewal. That being said, we are confident that the company will be able to keep the contract long term and see growth from price increases. 

Background

• Founded in 1995 by Jim Bidzos (the current CEO/Chairman) and is headquartered in Reston, VA. They have a market cap of ~$20 B and are a part of the S&P 500.
• Jim Bidzos is the founder/CEO and became chairman in 2009. Previously he helped build RSA security, which established an early standard for authentication and encryption. George Kilguss became CFO in 2012 before which he served as CFO for several different technology/internet companies.
• Annual executive compensation bonuses are based on equally weighted revenue and operating margin targets. Longer-term awards are based on an operating income CAGR and stock price performance relative to the S&P 500.
• Inside ownership is 1.28% with all executives owning less than 1% of the total company. The largest holder of all investors is Berkshire Hathaway at 12%.
• Analyst coverage is low with 2 firms covering the company, Morningstar and Robert W. Baird Co.

How do they make money?

Verisign is essentially a regulated monopoly that has been granted exclusive permission to register websites under the “.com” and “.net” domain names along with a variety of others. The company is granted exclusive permission to do this by ICANN, which regulates the internet, under a 6-year reoccurring contract in conjunction with an agreement with the U.S. Department of Commerce. This contract includes a presumptive right of renewal clause that allows Verisign to automatically renew its exclusive contract as long as the obligations under the previous contract were upheld. They have provided uninterrupted service, their primary obligation, for over 25 years. The service that they provide is website access through a database using DNS servers which connect web address queries with the server that houses the data and functionality of the website. As a part of their process, they implement security and firewall measures throughout their infrastructure to make sure accessibility and accuracy are maintained.

Verisign is a global company as many companies use the “.com” and “.net” registry domains. Verisign provides the conversion of website names into 100 different native languages. They list their revenue by geography, but this is based on the registrar and not necessarily the end customer. For example, someone from England could use a U.S.-based registrar to create their website and the revenue would be listed as "U.S.".

Over the years, ICANN has added several different domains (website endings) that are available for use. Despite this, the ".com" domain continues to have a dominant market share and is seen as the most trusted and recognized domain.

Currently, Verisign charges $8.39 per year for a new or renewal of a “.com” domain name and $9.02 for a “.net” domain. For each domain registration, they pay $0.25 per year to ICANN. Renewal rates are typically near 75%.

Individual customers, called registrants, contract directly with registrars or their resellers, and the registrars in turn register the domain name with a registry operator such as Verisign. Verisign has one large customer that accounts for 33% of revenue annually. It seems reasonable to believe that this customer is GoDaddy since they are the market leader in domain registrations. At times, domain resellers will register domain names in the hopes of reselling the domain at a higher price.

Verisign operates 2 of the world's 13 internet root servers and is the only institution to operate more than 1. The other operators are government organizations, non-profit regulators, and universities. These root servers provide a crucial part of the website access process. While it is unclear how much, if any, money Verisign makes from the operation of the root servers and related processes alongside ICANN, it does show how Verisign is deeply integrated with several organizations and a very important cog in the wheel of basic internet operations.

Competition

The most direct competition Verisign faces is from other registrars that operate other domains. These companies include Donuts (a U.S.-based registry operator of generic domains), Radix (an Indian registry operator), and PIR (a U.S. non-profit registry operator focused on the “.org” domain). ICANN could decide to put the “.com” or “.net” domain rights up for bid (likely only if Verisign did not perform their obligations), and they would have to compete against these companies. Otherwise, competition with these companies comes in the form of interest in the ".com" domain versus other domains for which these companies are the registrar. In 2005, the “.net” domain was put up for bid after the completion of Verisign’s first contract from 2001 – 2005. Verisign won the bid against at least 5 other bidders. Companies like Microsoft and Sun Systems supported Verisign’s bid because of their consistent record of execution. With the winning of the “.net” bid in 2005, presumptive renewal rights were added to the “.net” contract to encourage investment with the certainty of the contract. The contract for Verisign to be the registry operator for “.net” has been renewed ever since.   

Indirectly Verisign faces competition from internet technologies such as apps and online marketplaces. When you use the WSJ app, it does not require a “.com” registration. When retailers use Amazon to sell their goods, they do not need their own website. Several internet-based technologies could lessen the need for website registrations (metaverse?). This competition is tied to the relevancy of the ".com" domain and the potential for technological obsolescence. Technological obsolescence feels like a much longer-term risk, if at all, since companies would likely use new technology and a ".com" in tandem, just as most apps also have a “.com”. 

The Contract

The contract that allows Verisign a monopoly on “.com” and “.net” registrations is awarded by ICANN. The most recent contract for “.com” was renewed in October of 2018 and will expire in November 2024 (a 6-year term). In November of 2024, the contract will be automatically renewed due to a “presumptive” right of renewal clause unless Verisign did not perform the obligations of the contract over the previous term. There is a secondary contract with the Department of Commerce (DOC) that primarily governs the maximum allowed price and price increases for a “.com” registration, which has essentially the same term as the ICANN contract and automatically renews unless 120-day notice of non-renewal is given. The most recent ".net" renewal occurred in July of 2017 and carries a 6-year term that expires July 1, 2023. The terms of the ".net" contract are very similar to that of the ".com" contract but allow for higher annual price increases.

Growth

Verisign has not made any acquisitions for 15+ years. They may be somewhat restricted from making acquisitions due to their monopoly nature. This may impede some growth, but makes financials cleaner.

Growth comes from two sources. Price increases and increases in the number of domains registered, be it “.com”, “.net”, others, or new domains. The growth rate of “.com” domain registrations has been consistently in the low single digits for some time. Verisign won the bid to be the registry for the ".web" domain, but the contract has been disputed by competitors and has not been officially released, though seems likely to be released soon.

In 2018, Verisign and the Department of Commerce entered into an amendment that includes the ability for Verisign to increase prices on a “.com” registry. The amendment states that a maximum price increase of 7% is allowed in each of the final four years of each six-year agreement beginning October 26, 2018. A 7% price increase in the final 4 out of 6 years translates to a CAGR of 4% over the 6-year contract period. This new agreement comes after the previous contract disallowed annual price increases in the previous agreement. The agreement for the “.net” registry is similar to that of the “.com” registry agreement, but Verisign is allowed to increase prices by 10% per year for the “.net” domain in the final 4 years of the contract period ending July 1, 2023.

Verisign's reason for requesting the need to increase prices is driven by examples of increasing costs, the need for continued investment, and/or competition. Competition from new domains that had not existed in the past was a primary reason cited for why they were permitted to increase prices in their last contract. The most recent agreement that allows them to increase “.com” prices also requires them to continue to increase security and increase collaboration with ICANN to continue improving the registry system.

Financial Strength

Financial strength is very solid. They often keep substantial cash on the balance sheet and generate significant and consistent free cash flow.

·         Verisign has debt of $1,787 M and cash of $997 M.

o    All debt is “true” debt. Verisign has no leases.

·         Debt is comprised of several public fixed rate notes and $200 million line of credit. DDIS is accurate.

o    Moody’s rates their public debt BBB- and S&P has a rating of BBB.

o    Strengths listed are: high profitability, reoccurring revenue, market leadership, and good liquidity.

o    Negatives listed are: 100% deployment of free cash flow, limited size and scale, and market maturity.

·         The revolver credit agreement has one covenant.

o    Leverage must be maintained below 4x.

o    Current leverage: 1.9x

§  Net leverage is currently 0.8x, which is the highest it has been in 10 years.

·         Verisign does not pay a dividend, but typically allocates ~100% of its free cash flow to share repurchases. Over the past several years they have repurchased 3% of their shares annually.

o    Annual free cash flow of ~$700-750 essentially covers all of their net debt balance.

Risks

·         They lose the “.com” and “.net” registration agreements because they have operational issues. Or they lose or are limited in their ability to raise prices which would reduce growth.

·         Inflation. Costs could increase more than they are allowed to raise prices. Verisign does not necessarily have pricing power, they essentially have pricing permission - similar to a utility, but with fewer mechanisms for recouping costs.

·         The relevancy of “.com” and other domain names is lessened because of alternative ways of accessing content on the Internet.

Valuation

We value this business using a few different models. One being a perpetuity model with 5% growth and a 9% discount rate and year 1 free cash flow per share of $7.50. The growth rate is a combination of continued price increases under their current contract, share repurchases, and low domain growth. We handicap the aggregation of these growth rates to be conservative that these all come together on a year to year basis. 

The stock currently trades an an EV/EBITDA just below 20 versus a 5 year average of 25. We view the quality of the his business warranting a long term EV/EBITDA of 20x or more providing upside or at least a base from here from a multiple perspective. Operating leverage may continue to build for this company though inflation could negatively impact margins in the shorter term. 

Catalyst

Continued price increases

A return to their 5 year average EV/EBITDA