Verisign: A Capital-light Compounder At A Lofty Price
Verisign is a company you rely on every day. Without Verisign, you wouldn't be reading this, or much else on the internet.
Business Model
Verisign maintains the authoritative address book for the internet. Like houses have street addresses, websites have IP addresses. And like the post office needs a street address, internet browsers need an IP address.
Verisign maintains a directory that stores domain names and their corresponding IP addresses. When you type Amazon.com into an internet browser, the browser has to look up the IP address in Verisign's directory before it knows where to take you. Verisign's domain name system (DNS) is a simple but mission-critical part of the internet, and by extension global commerce and communication.
Verisign makes money when an end user registers or renews a .com or .net domain, among others. End users buy a domain through registrars like GoDaddy or Google Domains. Those registrars are Verisign's customers.
Registrars currently pay Verisign $7.85 per .com. Verisign remits $0.25 of that to ICANN, their regulator. Registrars pay up front. They either maintain deposits with Verisign or provide an irrevocable letter of credit.
Verisign is a natural monopoly. Only a single directory exists so that there's only one place to update with changes. If multiple directories existed, discrepancies would emerge and chaos would ensue. The internet is too important for a risk like that.
ICANN is an international non-profit that oversees the internet's domain name system. The U.S. Department of Commerce has significant influence over it. ICANN contracts with Verisign to provide a domain name registry for .com and .net. The contracts specify performance obligations and the maximum price Verisign can charge registrars.
Win-Win-Win
The ICANN-Verisign contracts are generally favorable to ICANN, Verisign, and end-users.
ICANN and end users want a secure and stable internet. That’s easier said than done. ICANN incentivizes Verisign to invest by giving them a long, profitable contract. The 2018 .com contract runs through 2024 and carries the presumptive right of renewal. It allows Verisign to raise prices by up to 7% in each of the last four years of the contract. The final .com price increase will be in October 2024. The current .net contract allows Verisign to increase prices 10% annually through 2023.
If ICANN had to find someone else to manage the DNS, a mistake in the changeover could prove catastrophic and bring down the internet. ICANN would rather avoid that situation entirely. They want Verisign to succeed. That's why Verisign's contract is so favorable.
In 2005 ICANN put the .net contract out for bid. Verisign, the incumbent, won. Tech giants, including Microsoft and Sun Microsystems, supported Verisign's application because of their 100% uptime record. Verisign maintained 100% uptime for the .net registry for seven years, enabling trillions of page views and billions of emails. Can you imagine if every .com and .net domain went offline for even a day?
Verisign's contract gives them confidence in their future. It's easy to see that their investments in stability and security today will generate a high return over time.
End users, people who actually own .com domains, benefit from this arrangement too. A .com signals that a business is legitimate, trustworthy, and open for business. Today, a .com costs $7.85 per year and a .net costs $9.02. This is a minuscule cost for even the tiniest business. The value of a .com far outweighs its cost. The economic value of a stable and secure global DNS far outweighs Verisign's fees.
The only group that has raised an issue with ICANN are registrars like GoDaddy. In a sense, Verisign wholesales domains to registrars, who re-sell them to the public. Verisign’s fees are an expense they’d rather not pay.
Verisign’s prices aren’t prohibitively expensive to anyone. Although Verisign is incredibly profitable, .coms are still a bargain. The societal value of 100% internet uptime is almost incalculable. Verisign has a rare win-win-win business model that benefits all stakeholders and produces lots of cash.
Capital Allocation
Verisign's business model requires minimal incremental capital. Verisign operates hundreds of servers around the world and has 872 employees. They spend roughly 5% of revenue on research and development and 7% on sales and marketing. The rest of their costs are more or less fixed.
Today Verisign has 65% operating margins. Price increases and additional domain registrations should produce operating leverage in the years to come.
Verisign has the rare capacity to grow earnings faster than revenues and do it while returning virtually all profits to shareholders. It is a “capital-light compounder.” Legendary capital allocator Lou Simpson sits on the board and should ensure that capital allocation continues to be shareholder friendly.
Risks
Verisign’s most obvious risk is losing the .com contract. It’s unlikely, but theoretically possible. The mitigant is Verisign’s 100% uptime record. So long as Verisign doesn’t screw up, it’s hard to argue someone can do it better.
Unfortunately, this is an asymmetric risk skewed the wrong way. Verisign can’t be any better than perfect, but anything less than perfect could be disastrous. Like a turkey who is dutifully fed by a farmer day after day until Thanksgiving, Verisign’s financials will look rosy until they’re not.
While Verisign is highly likely to renew its contract with ICANN, it's unclear if they will win future price increases. The 2020 price increases are the first since 2012.
There's also risk to volumes. What if .com domains lose their cache? This is unlikely given a .com’s relative affordability versus its signaling power.
Valuation
Valuing a capital-light compounder is difficult because they are worth so much. Imagine if you had a savings account that yielded 3% but grew even if you spent the 3%. That’s what a capital-light compounder does.
To estimate Verisign’s future returns, we need to make some assumptions about the business’s key variables.
1. Pricing. It’s easy to assume that Verisign raises prices as much as possible through the end of their current contracts in 2023 and 2024. After that, it’s conservative to assume they renew their contracts but do not win further price increases.
2. Volumes. The total number of .coms and .nets has grown 4% in each of the last two years, mostly driven by .coms. To be conservative, let’s assume 2% annual growth in .coms and none in .nets.
3. Margins. Verisign should experience operating leverage. Let’s assume that all costs are fixed except sales and marketing (7% of sales) and research and development (5% of sales). At a 21% tax rate, incremental margins should be 70%.
Under these assumptions, Verisign’s bottom line will grow 10% annually for the next 5 years and 6% for the next 10. The growth rate slows between years 5 and 10 because we assumed no further price increases.
Verisign should be able to return nearly 100% of net income to shareholders while growing. Currently, Verisign trades at a lofty 37x net income, which works out to a 2.7% yield.
If we assume that Verisign continues to trade at this multiple, the stock will return about 13% for the next five years and 9% for the next 10 years.
My Take
These are not necessarily bad forward returns. There’s good line-of-sight for the next five years, and I think we made conservative assumptions for the subsequent five years. There’s upside to these assumptions if Verisign can raise prices further or if volumes grow faster.
But, will Verisign continue to trade at a 37x multiple? While it is not out of the question, I wouldn’t bet on it.
Verisign’s current multiple discounts its growth through 2024. What happens if its next contract doesn’t allow it to raise prices? Growth will slow and its multiple will contract accordingly.
How much lower could Verisign’s multiple go? It averaged 20x in 2014, which was in-line with the average market then. Verisign is an above-average business, so the average multiple is a reasonable downside scenario.
If Verisign trades at 20x after 5 years, its 5-year CAGR will fall from 13% to 1%. If it trades at 20x after 10 years, its 10-year CAGR will fall from 9% to 3%. And this assumes that the market still averages 20x then. What if interest rates rise and multiples contract?
The longer you own a stock, the closer your returns mirror the business’s. Changes in multiple have a muted effect the longer you hold. Nevertheless, I prefer to buy a business whose multiple is more likely to go up than down. Verisign doesn't clear this hurdle. I don't see a margin of safety in Verisign's current price. It is, however, an exceptional business and one I'll continue to watch.
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