Description

Summary

WEB is a company in transition, but farther along than the market is giving it credit for. WEB runs a high-quality business from the perspective of subscription-based web services, carrying excellent cash flow, visibility, and low capital intensity. WEB has been in transition as of late, going from a focus on domain names and site building tools - where others have quickly taken a bigger lead (GDDY, WIX) - to a greater focus on value-added online services for SMBs, spanning web presence and digital marketing. While the early stages of the transition have been rough - from being chewed up and spit out in the domain/site-building biz in 2014 - to an optically rocky start with their Yodle acquisition in late 2015.

Nevertheless, WEB turned the corner in early 2017 and both the market and the sell-side haven’t taken notice or acknowledged it. With y/y rev growth returning in 4Q17 and significant runway to drive up margins materially, I view WEB as possessing >50% upside from here, based on substantial FCF growth and (hopefully) an improvement on its dirt-cheap multiple (9x FCF), particularly given the gap relative to peers (EIGI, GDDY) sitting in the mid/high teens.

Finally, there is further upside to the story than what is just presented here, with an LBO possible (likely?) at some point in the next few years, as well as no buybacks or reduction in interest expense considered in my estimates, despite the high likelihood of both.

Company Description

Web.com (WEB) provides domain name registration, website building, and digital marketing services, largely to SMBs. Though WEB offers a broad variety of services, it’s probably best to think about the company’s offerings in the following buckets:

1. Domains - WEB is one of many domain name registrars; if you want to get a website, you can buy the domain from WEB. A lot of guys do this, GDDY being the Big Kahuna here. This is a totally commoditized business with low ARPU BUT very low churn (how often does anyone change domain name providers?). Retention in this business is ~99%
2. Site building - this itself can be divided into 2 sub-categories:
1. Do-It-Yourself (DIY) - tools to help domain buyers build their sites. This is also totally commoditized, and with high churn to boot, given the numerous players and options available here, including many free options. Notable players here (other than GDDY) are WIX and SquareSpace
2. Do-It-For-Me (DIFM) - outsourced site-building, thus more of a service than a product; Think of it as Joe Plumber, who can barely turn on a computer, paying for WEB to build and maintain his website. This is far less commoditized and falls within WEB’s value added services (VAS) category (see more below). It’s notable that GDDY has been trying to acquire its way into DIFM, most recently with the acq of Main Street Hub for $125M a few weeks ago.
3. Digital Marketing Tools - this runs the gamut of somewhat table-stakes services (SEO/SEM, contact services, social media management) to more differentiated, high-ARPU products (lead-generation, vertical-specific CRM/marketing tools, franchise marketing management being the primary ones). These are high(er) churn (relative to domains), but significantly higher ARPU (in the hundreds, potentially thousands per month, vs. domains and site building in the single or low double digits per month), exhibit better growth (vs. domains and DIY site building, which are effectively fully penetrated), and have minimal competition from one-stop-shop perspective (i.e. fairly fractured field).

The weakest area here is DIY, which has been in steep decline. Generally speaking, WEB views its business through the lens of valued-added services (VAS) and non-VAS, which is now roughly 60/40 split VAS/non-VAS. The VAS business are the key focus and more-or-less comprise the digital marketing products and DIFM.

WEB’s business is fully subscription-based, mostly on monthly payment terms, which means a few things: 1) great cash generation profile - negative CCC - which allows for more leverage at better rates than most (regularly levered >3x net; gets great debt terms anyway); WEB’s peers are set up similarly; 2) excellent visibility; 3) gradual shifts in the business, given ratable recognition of new subs, so very rarely, if ever, is there a sudden spike or drop in results in a given quarter, which leads to...4) both sequential and y/y comparisons are important and valid; seasonality doesn’t really exist to a meaningful degree, so consistent sequential growth or declines in any meaningful metric can (and should) be read into.

Background / Recent History / Where the Opportunity Comes From

Back in 2014, WEB had hit it’s all-time share price high >$35 before the wheels started to come off. WEB’s business back then was primarily domains and DIY tools, which comprised >70% of rev. The domain market became largely penetrated and the DIY space became commoditized, creating a need for scale in domains and a race to the bottom (from a price POV) in DIY. With the market turning against them, WEB had a series of earnings misses and/or guide-downs, compounded by sell-siders turning against the name, sending shares into the teens.

In response, WEB management decided to focus on non-commoditized services and started re-apportioning out investment dollars toward higher-ROI opportunities, hence the focus on VAS. In order to scale the VAS side of the business, WEB bought a private company (who had previously filed for IPO, but never went) called Yodle in Feb 2016. The acq of Yodle supercharged WEB’s VAS game, pushing it to >50% of rev.

Thus, the strategy became to keep milking the low-churn high-FCF domain business by running what they have and selectively investing (e.g., in Latin America), but otherwise moving investment dollars out of the area. Put another way, don’t spend money on trying to replace the 1% churn - the ROI is too low and the market is too competitive. Same deal on the DIY business, though DIY is far less stable. Rather, investment dollars would be targeted at the VAS category, where there is less big-fish competition and higher-ARPU / higher-ROI opportunity. While the churn in VAS is significantly higher than domains, the ARPU and growth more than offset that factor.  

The problem was that the Yodle acq got off to a less than awesome start. Long story short, WEB and Yodle had some overlapping products and technologies, so WEB mgmt paused investments in the products that would be discontinued or meaningfully altered (primarily the lead-generation and related digital marketing services) until the go-forward product portfolio was ready for prime time (why put money into something that’s going to be canned). The result was several quarters of poor financials and metrics following the Yodle acq.

This was all telegraphed by mgmt (i.e. that spending would be pulled back for a few qtrs, subs would decline and churn would rise), with mgmt being fairly consistent in its messaging that the product portfolio would be figured out by end of 2016, 1Q17 thus being the trough, and continued improvement through 2017 and beyond. Nevertheless, the market wasn’t forgiving, though somewhat understandably so - from a 30,000 ft view, it looked like a company that was the odd man out in the domain business made an acq to jumpstart an alternative strategy but fumbled the snap.

The key is that - true to mgmt’s word - the tide has turned. As predicted, the business troughed in 1Q17, with most metrics (all save subs/churn) improving since Q1. In terms of subs and churn, those numbers will stabilize but won’t turn positive for a while given the mix shift toward higher churn services and the lack of investment in retaining churned customers from non-VAS products. Yet, WEB is basically still at the same level that it was after they reported 1Q17 earnings. Sell-siders are running out of excuses to keep shares neutral-rated and Q4 earnings (being reported tonight) will see rev return to y/y growth.

Thesis / Investment Positives

1. Turnaround has already begun
   1. As per mgmt’s original projection, following the release of the new Leads by Web combined lead-gen product in 4Q16, ARPU and rev troughed in 1Q17 and inflected in 2Q17 on q/q basis
   2. Q4 guidance implies return to y/y growth, coming from the right areas
      1. Premium Services (where lead-gen is reported) expected to continue accelerating
      2. Retail revs (where domains and DIY site-building are reported) have stabilized over the last several quarters
   3. At recent public appearances, mgmt specifically called out improvements in Premium Services retention and sales productivity
   4. Mgmt. expects return to MSD+ growth near-term (Street at ~+4% in 2018/2019)
2. Better business profile vs. pre-Yodle
   1. WEB long-term rev growth target is MSD-HSD
   2. This is a mix of the domains running flattish, DIY declining HSD, and VAS growing HSD/LDD
   3. VAS mix continues to grow, creating a nice acceleration of revenue over several quarters / years
3. Large margin expansion opportunity
   1. No meaningful opex increases needed/expected for a while
      1. Re-ramp of S&M investments has already been going on as part of re-allocations, vs. net new spend
      2. Mgmt has noted further sales productivity potential on the current headcount (i.e. more sales per salesperson)
      3. WEB expects future sales investments to be layered-in incrementally (i.e. no upfront opex spike)
      4. R&D and G&A are also expected to remain stable for foreseeable future
   2. Better structural margins in VAS
      1. Legacy Yodle GM% >70% vs. legacy WEB GM% in mid-to-high 60s
      2. VAS products are not structurally more cost intensive than non-VAS
      3. ARPU inflection and Premium Services growth indicate improving mix
   3. Results in >300 bps of margin expansion opportunity
      1. As VAS scales and opex remains flattish, WEB should exceed pre-Yodle EBITDA% of 28-29%, vs. 25.5% today
      2. Street currently modeling <100bps of improvement for 2018
4. Dirt cheap valuation
   1. Growing sub-based SW biz, growing MSD, with EBITDA% >25% minimal capital intensity and excellent returns on capital
   2. WEB trading at 9x FCF (11% FCF yield) on the equity / 11x FCF (9% FCF yield) to EV on 2017 estimates
   3. As far as comps go, the closest 2 - GDDY and EIGI - trade in the mid-to-high teens as a multiple of FCF
5. Shareholder-friendly capital allocation
   1. WEB generates a bunch of cash, which it uses for 2 things
      1. Debt reduction
      2. Buybacks
   2. Given mgmt’s comfort with leverage, WEB can (and has) get aggressive on buybacks when opportunity strikes
   3. Otherwise, WEB will use the cash to reduce debt
   4. Roughly 90% of FCF since 1Q16 has been used on either buybacks or debt reduction

Variant Perception / Bear Case

1. Declining business in a highly competitive market
   1. This is a stale view - WEB has already pivoted meaningfully toward VAS and isn’t actively investing to keep pace in domains and DIY w/ GDDY, EIGI, WIX, etc. 
2. Subscriber metrics continue to deteriorate
   1. ARPU is improving, while sub adds / churn will keep getting worse due to mix shift to higher churn revs
   2. As long as ARPU and total rev keeps growing, hard to argue with mgmt’s logic of sacrificing low-churn / low-ARPU subs for high-churn / high-ARPU subs
3. High leverage
   1. “High” is relative - WEB’s business model more than supports it
   2. The rating agencies and lenders agree (low yielding debt)
   3. WEB’s peers are constructed similarly

Risks

1. Competition in VAS getting more intense
   1. In particular, GDDY is increasingly copying WEB’s moves in terms of moving into more value added services
2. Steeper run-off of domains/DIY
   1. If this falls apart - though not the focus of WEB’s strategy - it will certainly hurt financial metrics
3. Macro risk
   1. WEB is dependent on marketing dollars spent by SMBs
   2. A weak ad market - particularly among SMBs - will disproportionately hurt WEB
   3. Ad market is usually tied to general GDP and economic confidence

Estimates/Valuation

My methodology of choice is P/FCF - WEB stopped reporting a non-GAAP EPS number because its basically FCF anyway and FCF is the most important metric. Plus as a sub-based business, its the most optimal to use anyway (though I think FCF/share is always most important, generally speaking).

I have ~$3.40 in 2018 and $3.67 in 2019 (see calc below).

Note - taxes are a bit tricky; right now WEB is enjoying NOLs that limit cash taxes to single-digit millions. NOLs start to roll-off following 2018, but mgmt expects the remaining NOL balance to reduce taxes by $70M annually through 2021. Plus, given new tax legislation, I just throw another $5M of taxes on to 2019 from 2018, but that’s really just a random round number; it could very likely be $5-10M total.

• 2018
  • Rev = $794M (+5% y/y)
  • 70% GM%
  • $340M cash opex
  • = EBITDA of $215M
  • $16M in interest
  • $8M in taxes
  • $25M in capex
  • = FCF of $166M
  • 49M dil. Shs
  • = $3.39 / share
• 2019
  • Rev = $834M (+5% y/y)
  • 70% GM%
  • $350M cash opex
  • = EBITDA of $234M
  • $16M in interest
  • $13M in taxes
  • $25M in capex
  • = FCF of $180M
  • 49M dil. Shs
  • = $3.67 / share

Using 10x FCF seems fairly conservative, though GDDY and WIX trade in the teens. Using 10x, that gets to a mid-$30s target, or >50% upside from here. If the multiple were to materially expand and enter GDDY territory, upside could be into the $40s and $50s, making this a double-plus. All that said, I don’t want to rely too much on multiple expansion.

Thinking of it another way, I am getting to nearly 30% FCF growth y/y and at <9x FCF, WEB should get at least a little bit of multiple lift with strong performance / execution.

Catalysts

1. Primarily earnings - the primary aspects of the thesis are that rev turns positive on y/y basis and accelerates, while margins improve materially and sub metrics stabilize and improve
2. Sell-side upgrades - 9 guys cover the name, of which 4 are neutral (Barcap, JPM, Citi, and DB) and none of them have good excuses why. I expect them to start upgrading the stock over the course of 2018, which will help boost shares

Accelerators

1. More buybacks - certainly on the table and likely, though not modeled in to my numbers
2. Debt reduction - also not modeled into my numbers; there is a $259M convert coming due in August that mgmt has a lot of favorable options for re-financing. As I said, my numbers assume interest expense stays where it is now
3. LBO - WEB has been rumored to be considering a sale to PE in the past and shoe certainly fits (this business is made for private equity); CEO has implied in the past that they are certainly open to selling, but they want to get the value out of the turnaround

Catalyst

Primarily earnings - the primary aspects of the thesis are that rev turns positive on y/y basis and accelerates, while margins improve materially and sub metrics stabilize and improve

Sell-side upgrades - 9 guys cover the name, of which 4 are neutral (Barcap, JPM, Citi, and DB) and none of them have good excuses why. I expect them to start upgrading the stock over the course of 2018, which will help boost shares