VeriSign (NASDAQ: VRSN) has been called the “toll road” of the internet many times. This is because services provided are crucial to the internet functioning properly. VeriSign is a leading provider in domain names ending in .com or .net. The company is basically a directory for the internet, pointing users to the correct web pages.

How does VeriSign exactly make money?

VeriSign is the wholesaler for internet domain names ending in .com or .net to domain name registrars like GoDaddy (NYSE: GDDY) and many others. It’s basically a monopoly that has no competition. The company, in 2016, collected fees on 142.2 million domain names, 126.9 million were from .com and 15.3 million were from .net endings. Currently, VeriSign collects $7.85 per year for each .com domain name and $8.20 for each .net domain name.

The oversight body over VeriSign is ICANN (Internet Corporation of Assigned Names and Numbers), which is a non-profit organization whose mission is to keep the internet secure, stable and usable. VeriSign has an exclusive agreement with them, which was recently extended until November 30, 2024. Here is how ICANN explains what VeriSign’s role is on the internet:

A domain name itself comprises two elements: before and after “the dot”. The part to the right of the dot, such as “com”, “net”, “org” and so on, is known as a “top-level domain” or TLD. One company in each case (called a registry), is in charge of all domains ending with that particular TLD and has access to a full list of domains directly under that name, as well as the IP addresses with which those names are associated. The part before the dot is the domain name that you register and which is then used to provide online systems such as websites, email and so on. These domains are sold by a large number of “registrars”, free to charge whatever they wish, although in each case they pay a set per-domain fee to the particular registry under whose name the domain is being registered.

VeriSign is a registry that supports the .com and .net TLD.

Competitive Position

With no competition, VeriSign offers a very predictable cash generating business that should grow steady over time. The DOC (Department of Commerce) still has control over pricing being charged to registrars even though ICANN is the oversight organization. Currently, VeriSign can’t raise prices on the .com domain names. Even without price increases on the .com domain names, VeriSign should see 1-2% growth annually, with management eating away at its shares through its stock repurchase program.

Management, in the past few years, also have focused on operating margins. With VeriSign having no pricing competition in the .com or .net domain name space, margins shouldn’t erode. Management knows this, and if they can’t raise prices to expand margins, the next best thing is to cut cost. Operating margins have expanded to 60% in 2016.

Source: Gurufocus.com

Creating Value

VeriSign has a very simple business model that will keep generating large amounts of cash. It would be nice if this capital could be reinvested to produce high returns on capital, but that’s not management’s plan, and I think they are correct in staying focused on their business at hand. With slow organic growth and management squeezing out every last drop of operating margins, this should provide sufficient returns for shareholders. Every incremental dollar of revenue almost drops to the bottom line.

With a large cash generating business and nowhere to invest the cash, management has been allocating capital towards stock repurchases. This has been a huge value driver, and I believe it will be the same going forward. I’ve modeled three different scenarios for free cash flow growth between 5-7%, and what the stock repurchase capacity would look like over the next 5 years. I have taken into account the annual capital expenditures, which is reducing the amount of cash used for stock repurchases.

With 5-7% free cash flow growth, management should be able to reduce the shares outstanding by 25-28% over the next 5 years. This will significantly enhance the intrinsic value per share. These buybacks and with minimal cash flow growth should generate 8-10% returns, which doesn’t factor in higher multiples than 15x cash flow. It currently sells for around 18x cash flow.

Conclusion

VeriSign is a great business selling at a reasonable price. Would I like to buy the company at a better price, yes, but with the monopolistic position in the market, small organic growth, and share buybacks, the company sells at a reasonable price. This analysis doesn’t provide any price increases in the .com fee structure, which I think could occur in the next few years. This would have a significant impact on generating increased cash flow. Two of the attributes that are attractive about the company is the cheaper the share price is the more shares they can retire; and the company should still be able to perform well in a bad economic environment.

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Disclosure: I am/we are long VRSN.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article is intended to provide information to interested parties. As I have no knowledge of individual investor circumstances, goals and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks mentioned.



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