Seeking Alpha
Profile| Send Message| ()  

All investors want to make money and one of the best ways to pick a company is to find those that have a significant moat or competitive advantage to help them. However, what's even better than a moat is a blazing wall of fire in the form of a monopoly on the business in question. Most broad monopolies that people can name are either illegal (and thus risky - think AT&T before it was broken up), or legal but not open to investment (OPEC or the NFL and MLB). (Note: the most common monopoly of course is utilities, but these are not broadly supported by the entire country, being confined to one geographic region as a rule of thumb.)

However, there is one stock out there with a legal monopoly protected by the US government and a broad business that is not susceptible to a local economic downturn in any given area of the country; VeriSign (VRSN).

VeriSign is in the business of providing Internet infrastructure services. Basically, it runs the behind the scenes business for the .com, .net, .edu, .gov, and .org domain names. Anytime anyone anywhere in the world buys or renews a .com, .org, .net, .gov, or .edu domain name, VeriSign gets a cut of the action. The company is the only one that is allowed to do this business under a multi-year contract with the ICANN (Internet Corporation for Assigned Names and Numbers), a quasi-governmental entity.

The firm most recently renewed their contract with ICANN for an additional 6 years this past December. Under the contract, VeriSign continues to provide the infrastructure support for all major US domain names, however it is no longer allowed to unilaterally increase the price of this support for .com domain names. In the future, the firm must get approval from the Department of Commerce before increasing its prices. Thus this deal is both the firm's greatest asset and its greatest risk as I will discuss momentarily.

VRSN was once a dotcom startup, but in the last ten years it has morphed into a firm that generates significant cash and has a very strong financial profile as the table below shows.

2012

2011

2010

OCF/Share

$2.24

$1.16

$0.77

EPS

$1.91

$0.83

$0.39

Revenue in Mil.

874

772

681

Net Income in Mil.

312

139

70

Cash in Mil.

1,556

1,346

2,061

Total Assets in Mil.

2,062

1,856

2,444

Total Debt in Mil.

695

659

653

P/E Ratio Low

17

33

54

P/E Ratio High

26

46

95

Share Price High

$32.81

$27.00

$21.21

Share Price Low

$50.15

$37.73

$37.18

The table reveals that VRSN has changed from a growth story to a value story in the last few years. At one time investors were willing to give the company a sky-high multiple in excess of 50 even though the firm earned very little. Over time the firm has grown into that valuation even as the stock price has risen strongly. In fact, VeriSign has become a very profitable company in the last few years with significant cash flow and cash on the books. Given VRSN's 150 million shares outstanding, this cash balance equates to about $5.75 per share in cash net of debt. This gives the company a ttm P/E of about 21 after accounting for cash given the recent stock price of around $46 per share. Analysts don't appear to think the company is done growing profits yet with consensus fiscal year projected profits of $2.30, $2,48, and $2.64 per share for FY 2013, 2014, and 2015 respectively.

Thus given this projected growth by analysts, a P/E of 21 net of cash on the books does not seem excessive. In particular, the company is protected from competition for at least the next 6 years because of its ICANN contract. Further the company has been increasing its operating margins in the last few quarters from less than 50% in 2011 ago to 59.6% in the most recent quarter. Analysts and the company both believe that figure can at least remain stable and probably go higher as the firm works to wring costs out of its system.

Currently VeriSign doesn't pay a regular dividend, preferring to return capital to shareholders through stock buybacks instead. This may be getting ready to change though. In the last few years, the company has paid out a special dividend of about $3 a share each December, and analysts at S&P think with the new ICANN contract signed, the company may be ready to begin a regular dividend later this year. This could be a powerful catalyst for the stock as I will discuss in a few minutes.

VeriSign is not without risks though as the chart below shows.

(click to enlarge)

VeriSign suffered sharp price falls in November and December as investors fretted over the critical ICANN contract negotiations with the Department of Commerce. These negotiations will undoubtedly be an issue again in 6 years when the company has to renew their deal with the DoC, but in the meantime, this risk is not an issue. Beyond this, there are two important risks that the company faces moving forward.

First, the company's ability to increase its prices on .com domain names (by far the most popular) is now severely limited. The company can only increase its pricing if the Department of Commerce agrees, which the DoC is unlikely to do unless VRSN can show a material increase in costs related to stability or security threats. Thus future increases in revenues from .com domain names are limited by the increase in the number of domains in existence. Investors took this as a bad sign, but I believe it may actually help the firm in the long run.

With VeriSign's pricing power now limited, the company has an even greater incentive to increase profits by focusing on costs. Too often monopolistic and oligopolistic firms rely solely on increasing revenue to increase firm profits rather than trying to rein in costs and improve operations. With revenues tied down, VeriSign should continue striving to increase its operating margins, and its capacity to do so has surprised analysts in recent quarters.

Further, while the firm's revenue increases are limited, they are by no means non-existent. The firm still has good prospects thanks to increased use of .net and .org domain names where the company retains more pricing power (for example, the company can hike .net domain name fees by 10% annually until 2017). Further growth in the number of domain names internationally should continue to help the company improve revenues while it remains protected for at least the next 6 years from any competition at all.

The second risk the company faces is also a potential catalyst for the stock. It comes from the possibilities and risks surrounding the adoption of additional global top level domains (gTLDs). ICANN is planning to add additional domains names along the lines of .book, .shop, .home, etc . Basically the problem is that the Internet is running out of good website names under the classic .com domain framework. As a result, ICANN is looking at setting up new gTLDs under which new websites can be set up. This has the potential to either be a huge catalyst for the stock if a large number of new domains are bought, or a big let-down if no one ends up using the new gTLDs. Right now, there appears to be strong interest in the new gTLDs based on news reports, but investors will have to wait a year or so to see how things start to play out.

Notably, the addition of these gTLDs could also allow VeriSign to get around the .com price increase restrictions if it can show that the addition of these gTLDs changed market conditions such that the restrictions are no longer necessary . This is a real possibility towards the end of 2014 assuming that the new gTLDs take off.

Speaking of catalysts, VeriSign has a number of others that may work in its favor to push its share price higher. The firm has been reporting good earnings of late and persistently increasing its operating margin, so that stock may move higher around any of its upcoming earnings releases.

In addition, the firm looks likely to announce a regular dividend or expanded share buyback program in the next few months. The firm is sitting on a mountain of cash with limited places to invest it, and in April, VRSN announced plans to sell $600 million of secured debt without specifying the purpose of this debt. Given that the company has roughly a billion dollars of net cash on the books, and a market cap of only $7 billion, the only reason for the firm to be taking on another $600 million in debt is if it plans to begin a very large buyback program. Virtually any other investment could be done with cash on hand already, and any debt related to an acquisition would most likely be issued contingent on the acquisition being completed. Thus with the combined proceeds of the debt offering and the net cash on hand, VRSN could potentially buy back in excess of 20% of all outstanding shares at current prices. If the firm announces a change in capital structure, either dividend or buy back, along these lines, the stock could easily rocket past its 52-week high to the mid 50's (in line with a forward P/E of 25 for example).

A forward P/E of 25 is a conservative estimate based on the average of the low P/E for 2011 and 2012, while a more aggressive multiple might be as much as 36 (the average high P/E for 2011 and 2012). Given 2012 earnings of $2.24, a conservative P/E of 25 leads to a stock price of $56, while a more aggressive P/E of 36 leads to a stock price of $80.64. With VRSN trading around $46 right now, the $56 price implies a 21.7% upside.

A P/E of 25 compares favorably with technology peers like Akamai (AKAM), Rackspace (RAX), and VMware (VMW) as the chart below shows. Like VeriSign, all of these firms are high growth companies and each of them has suffered one or more growth scares in the last 4-8 months leading to significant price declines. Yet all of them trade at P/Es considerably in excess of VeriSign's.

As of FYE 2012VRSNAKAMRAXVMWVRSN (at P/E of 25)Peer Avg
ttm P/E Ratio20.436.599.554.825.063.6
2 Yr Avg. Sales Growth14.1%17.1%33.8%30.6%14.1%27.2%
2 Yr Avg. Profit Growth194.0%12.2%57.1%51.0%194.0%40.1%
Price/Sales7.35.48.08.98.97.4
Price/EBITDA12.414.824.835.215.225.0

Multiple expansion for VeriSign would be far greater if the firm realizes significant promise on the back of the new gTLDs. While the new gTLDs will introduce some very limited competition for VRSN, this competition is unlikely to seriously threaten the company, and the gTLDs should actually help the firm. First, if the new gTLDs can be used by VRSN as a reason to get past the DoC's price hike restrictions on .com names, then the VRSN can go back to annual 7% price hikes. Moreover, even if the new domains cannot be used in this way, they will likely lead to millions of new domain registrations for VeriSign. In fact more than 200 of the new gTLDs have already announced they will use VeriSign to run their registries.

VeriSign has been an active participant in the discussion surrounding the issues with the new gTLDs, suggesting that the firm is certainly not resting on its laurels are far as its current dominance of the Internet goes. The risk for VeriSign in this process is that large numbers of websites could begin choosing to use alternative gTLDs beyond the traditional .com, .org, and .net. However, even under this scenario, as long as websites continue to use their existing .com web addresses, VeriSign would not see revenue declines. This issue is apparently a minor enough concern such that Warren Buffett's Berkshire Hathaway took a 5%+ stake in the firm earlier this year.

Thus the risk and reward under the new gTLDs relates to the number of additional web addresses created. Based on research from VeriSign, if the new gTLDs follow the average 3 year growth patterns and number of initial registrations of other gTLDs like .uk, .cn, .ru, etc, the total addition to VeriSign's book of web address could be on the order of 6 million sites with 20-25% growth annually thereafter. This would translate into roughly an additional $30-50 million in revenue for VeriSign, and just as importantly, would restore some of the growth luster the firm lost after the completion of the DoC contract last year. VeriSign's impressive book of patents could help in the effort to capture significant additional revenue by monetizing its patent portfolio through litigation with any of its nascent competitors in other countries.

Finally, as the world increases its use of mobile devices to access the Internet, VRSN could stand to benefit. To the extent that mobile traffic drives increased web use, this should also lead to larger numbers of web domains, which would benefit VeriSign. In particular, the addition of further domain name registrations to capture traffic under the most common gTLDs is a significant boon to the company. As the use of smartphones and mobile web traffic continues to grow, this should be a moderate tailwind for the firm.

In summary, VeriSign is a unique stock in that it offers investors the chance to own a broad monopoly on a critical piece of today's business environment. While a few years ago the stock was trading at a fairly rich P/E today it appears to be a more reasonable value. The firm does face some risks in the form of the contract renewal with the DoC in 6 years, the restrictions on price increases on .com domain names, and the upcoming addition of new global top level domain names, but these risks also present significant opportunities for the stock to move higher. Further, if the firm implements a large buy back, or regular dividend as it appears poised to do, this could easily push the stock significantly higher.

Source: Buy This Undervalued Growth Stock To Own A Legal Monopoly