VeriSign's Slowing Growth Underlies Our $41 Valuation

Mar.13.13 | About: VeriSign, Inc. (VRSN)

Verisign (NASDAQ:VRSN) is primarily known as the authoritative registry for dot-com and dot-net generic top-level domains. It also operates a diverse array of network infrastructure, including two of the Internet's 13 root name servers and the back-end systems for the dot-gov, dot-jobs, and dot-edu top-level domains. The company's share price has risen almost 15% since Jan. 24, after the company reported steady revenue growth in 2012 and gross margins improved to almost 80%.

We believe that the market is being overly optimistic about Verisign's prospects. Its primary revenue growth driver for the past few years, the annual increase in the dot-com domain registration fee was fixed by the renewed agreement with ICANN (Internet Corporation for Assigned Names and Numbers). As a result, the company is now dependent upon the growth in the dot-com and dot-net domain name registrations and the annual hikes in dot-net domain names. The dot-com domain names have been losing market share to other gTLDs (generic Top-Level Domains) over the past couple of years, and new gTLDs are expected to be launched in the coming years. This will further increase the pressure on the revenues from dot-com domain registrations. Also, as the dot-net domain names constitute only 15% of the dot-com/dot-net domain mix, the impact of dot-net domain registrations on company-wide revenue growth is expected to be minimal. Limited revenue growth potential supports our $41 Trefis price estimate for VeriSign, which is 15% below the current market price.

Revenue Growth to Be Slow

The dot-com domains constitute close to ~90% of the dot-com/dot-net domain name mix, currently governed by VeriSign. The restriction on dot-com domain fee hikes under the new agreement will result in the dot-com domain price staying steady at $7.85 until November 2018. At the same time, the agreement for dot-net domain registry permits price hikes of up to 10% per year.

The growth of dot-net domain name registrations (~9%) has been slightly outpacing that of dot-com domain names (~6%), and we estimate the growth of the combined fee to slow down to 2% annually and reach about $8.50 by 2019. We estimate that the combined fee would have to increase to about $10 in the long term to support the current market price.

Gross Margins to Decline

As part of its contract with ICANN, VeriSign has to ensure 100% reliability of the dot-com/dot-net Domain Name Servers (DNS) for it to be eligible for contract renewal. To achieve this reliability, the company maintains layers of redundancy in its infrastructure to prevent an outage that can potentially render half of the Internet inaccessible. The permitted price hikes in the dot-com and dot-net domain registration fees over the past decade had helped VeriSign maintain gross margin levels in the 70%-80% range, while investing in infrastructure simultaneously. With the dot-com domain name registration fee fixed, we now expect its margins to decline to about 70% in the long term. This will happen as the company maintains redundancy in the underlying infrastructure to ensure reliability and hence its eligibility for a contract renewal.

Another threat to the company's margins comes from the fee it pays to ICANN for each registered dot-com domain name. As per the old agreement, the company paid $4.5 million as a quarterly lump sum fee, regardless of the number of domain names registered. However, as per the proposed agreement the company will be paying up to $0.25 per year for any dot-com registered, renewed or transferred domain. At the current levels it could translate to an additional annual expense of $10 million from the dot-com domains alone.

A restructuring of the infrastructure could, however, lead to the associated costs going down and margins not declining as expected. The fair value of VeriSign will increase to about $47, if the margins were to stay steady at current levels of 80% over the forecast period instead of declining.

New gTLDs to Pile Additional Pressure on Declining Dot-com's Market Share

The combined market share of dot-com/dot-net domains has been declining consistently over the past few years. This decline is a result of the growing popularity of country code domain names such as dot-uk, dot-in, dot-cn, and dot-de. Currently, ICANN is overseeing an expansion of the gTLD universe, with an aim of adding 300-1000 new gTLDs every year. We expect the new gTLDs to negatively impact dot-com/dot-net market share of overall domain names. VeriSign has applied for 14 of these new TLDs. However, the process for the introduction of these new gTLDs is expected to take time, and we don't see a major adverse impact in the near term.

We have a revised $41 Trefis price estimate for VeriSign, which is 15% below the current market price.

Disclosure: No positions.