Below is an excerpt on VRSN from our Q2 2014 Partnership letter. While I don't get into specific financial analysis or valuation estimates, I shared this with my investors after discovering a tremendous amount of confusion around VRSN, its capabilities, and its current regulatory status.
Founded in 1995, VeriSign (NASDAQ:VRSN) was initially a "certificate authority" or issuer of "digital certificates,"1 but sold this part of their business in 2010 to focus on a far better line of business, one that would usually be described as a "monopoly." Of course, VRSN is far too prudent to use the m-word, and instead prefers "registry services" as the title for the line of business responsible for nearly all revenues and profits. But, as I detail below, "registry services" is really secret code for "the internet won't work without us, and we have contracts that ensure our ongoing monopolist opportunities will continue to fill our pockets."
Before delving into the details of VRSN's business and those contracts, it is important to understand something called top-level domains (TLDs). TLDs are the last part of every internet domain, examples of common TLDs would be .com, .net, .org, etc. Each time anyone - anywhere in the world - goes to a website of their choosing, they do so by typing a name (e.g., cnn, google, facebook, etc.) followed by a TLD (e.g., cnn.com, google.com, etc).2
In the digital world, VRSN is the "authoritative directory" of all .com domain names AND "the exclusive registry of domain names within the .com" generic top-level domain (gTLDs).3 As a registry, VRSN maintains "the master directory of all second-level domain names in these TLDs"4 (e.g., johndoe.com, example.com, facebook.com, etc). To fully comprehend the significance of these terms, consider the following examples:
- As the "authoritative directory" VRSN ensures that the web address "amazon.com" directs all internet traffic to the famed web retailer (instead of a page dedicated to the Amazon rain forest), or that "cnn.com" directs all internet traffic to a site filled with "breaking news" rather than the homepage for Charles Nicholas Nelson (i.e., someone, or something, with the initials of CNN). The technical name for this function is Internet Assigned Names Authority (IANA) and involves control of something - also controlled by VRSN - known as the "root zone." A full explanation of this responsibility is addressed a bit later in this letter, and will - of course - require several more acronyms.
- Better than a directory - even when it's an authoritative directory - is an "exclusive registry." Exclusive registry simply means that every .com (or any other TLD for which VRSN is the exclusive registry) must - without exception - always pay VRSN when they 1) first register a domain and 2) when the domain is renewed every year thereafter. While consumers are free to buy and keep their domains at any registrar of their choice,5 no domain for which VRSN is the "exclusive registry" is issued or renewed without first paying VRSN and its humble shareholders.
Only Sure Things Are Death, Taxes . . . and Domain Registration Fees
It is VRSN's role as the exclusive registry for .com that is by far the largest contributor to revenues and profits. Fortunately, there are only a few factors to consider when thinking about the .com registry and any potential impact this may have on VRSN's success going forward:
- Active Domains: VRSN makes money when either new .com domains are issued or old .com domains are renewed. As of YE 2013, VRSN reported a total of 127.2 million active .com and .net domains,6 representing a 5% improvement from the year before.7 While the active domain counts does seem to ebb and flow based on trends outside of VRSN's control (e.g., economic condition, registrar promotions, etc.), growth in active domains over the last five years has ranged from 5-9%, and better than 70% of all .com and .net domains are renewed each year.
- Continuity, Exclusivity, and Profitability of .com Registry Agreement: In 2000, VRSN acquired the core registry functions that would form the basis for VRSN's registry services division.8The .com Registry Agreement (Agreement) is a periodically renewed contract between VRSN, ICANN, and the United States Department of Commerce. The last iteration of the Agreement was signed on November 29, 2012 and provides the following key points:
- VRSN will remain the exclusive registry operator for domain names in the .com TLD through November 30, 2018.
- The price of a .com domain name shall not exceed $7.85 for the term of the Agreement.9
- Just in case the other terms weren't favorable enough, VRSN and their lawyers have seemingly managed to effectuate this Agreement into perpetuity with the following legalese: "The 2012 .com Registry Agreement provides that it shall be renewed for later terms unless it has been finally determined by an arbitrator or court that the Company has failed to cure a fundamental and material breach of certain provisions of the 2012 .com Registry Agreement and, following the decision of such arbitrator or court, the Company10 fails to comply with such decision." Thus, VRSN's exclusive monopoly on .com registration will remain in place unless 1) a court or arbitrator rules that VRSN has defaulted on their part of the Agreement; AND 2) despite said ruling, VRSN still fails to take steps necessary to fix their default! Maybe John Rockefeller was on to something when he said "competition is a sin."
The Less Favored Children
It is worth noting that VRSN does provide the registry for a variety of other TLDs including .net, .name, .tv, .cc, and others. But, for brevity's sake we will simply note that VRSN's other registry operations are generally based on terms even more favorable (especially in terms of pricing) than those found in their .com Registry Agreement.
Additionally, ICANN is in the early stages of introducing a whole slew of new gTLDs possibilities including such "blockbusters" as .today, .ninja, .company, and .tips!11 While much has been made of this new "land-rush" of domains, .ninja hardly seems like a plausible threat to the long establish standard of .com or any of the alternatives already available. Nonetheless, it is always good to be prepared. Accordingly, should any of the new gTLDs prove more popular than anyone expected, VRSN stands to benefit as applicants for approximately 200 of these new gTLDs are already in contract with VRSN to provide back-end registry services.
No Good Deed Goes Unpunished
VRSN's role as "authoritative directory" - while fundamental to the daily functioning of the internet - involves a slightly complicated web of contracts and organizations: At the very foundation of the internet is a role called Internet Assigned Numbers Authority (IANA) which is the right and responsibility to assign names among domains.12Because the original architecture of the Internet was developed in the United States, this responsibility was initially managed by the US government. However, since the 1990s, the US government has offloaded much of the IANA responsibility to a non-profit group known as the Internet Corporation for Assigned Names and Numbers (ICANN). ICANN was essentially created for the purpose of being able to contract out the running of the IANA function - a power given to them (and periodically renewed since) by a contract from the National Telecommunications and Information Administration (NTIA).13 While ICANN manages the IANA function under contract to the NTIA, the actual work of maintaining the core list of gTLD domains and their operators is handled by something known as the "root zone." The technical work of maintaining the root zone is managed under a cooperative agreement between the US Department of Commerce14 and VRSN.
The reason the above detail is important to understand is that recent market pessimism for VRSN seems to indicate that most investors simply misunderstand - or are too lazy to even try - the dynamics of the non-registry part of VRSN's business. This became especially clear - and all the more important - given the government's recent noise-making:
- In March of 2014, mainly in response to pressure from revelations made by Edward Snowden about the National Security Agency and its spying activities, the NTIA announced that the US would relinquish federal government control over "the administration of the Internet." The government plans to relinquish this control by simply not entering into another contract when the current contract15 expires in 2015. Instead of renewing the contract with ICANN, the US government plans on simply surrendering the IANA function to ICANN going forward. Because nothing is ever clear or easy when it comes to government actions, ICANN will have to meet a list of currently ambiguous specifications, and our elected officials will need plenty of time to pontificate one way or the other. Thus, no one really knows when - or if - this change will actually happen.
- Nonetheless, investors spooked by these developments seem to be unaware of the following:
- The contract to manage the root zone is separate (i.e., 100% unrelated) from the contract with ICANN that stipulates VRSN's ongoing role as the exclusive registry of .com domains (officially known as the ".com Registry Agreement," unofficially known as the monopoly money printing machine).
- The role of managing the root zone - something ICANN may or may not renew post transition - is currently provided by VRSN for free "as a service to the internet and the world."
- Given the continued importance of a functioning and reliable internet to the global economy, we suspect ICANN is unlikely to make flippant changes to key parts of the underlying infrastructure - especially when such infrastructure is maintained for free and without problems . . .
Ultimately, an investment in VRSN is a bet on the future of the Internet, and VRSN's continued role as a stable and reliable provider of several core functionalities. Developments related to the NTIA's departure may provide some near-term turbulence, but we suspect any turbulence will largely be noise and misunderstandings. Either way, we are confident that VRSN's dominant position will remain intact, and may even rise stronger whenever the dust settles. At just 14 times earnings, we suspect manning the .com toll both may be significantly more promising and enduring than current market consensus seems to think.
1 Digital certificates serve as a trusted third party in cryptography to enable secure connections over the internet. For example, if two parties (i.e. you and me) are seeking to securely transact or communicate over the internet, a method is needed to verify each party is representing themselves truthfully. As a third party, trusted by both parties, a certificate authority serves as the verifier to each party that 1) both of us are who we say we are, and 2) the transaction is thus valid and secure.
2 If drawing an analogy to the physical world, the name might be the street address, while the TLD might be the state or country of such address. Either way, both the name and the TLD are necessary to avoid getting lost in both the physical and digital worlds.
3 From Wikipedia: "a gTLD is one of the categories of TLDs maintained by the Internet Assigned Numbers Authority." "The core group of generic TLDs consist of the .com, .info, .net, and .org domains."
4 While a much smaller part of their business, VRSN is no one-trick pony, it is also the exclusive registry and authoritative directory for .net, .cc, .tv, .name, .gov, .jobs, and .edu domain names.
5 Popular registrars include GoDaddy, Network Solutions, and eNom to name a few.
6 As of YE 2013, VRSN reported 112 million .com domains and 15.2 .net domains.
8 The operations for .com, .net, and the .org TLDs were acquired in VRSN's acquisition of Network Solutions. VRSN would later divest the retail part of Network Solutions (i.e. the domain name registrar), while retaining the wholesale domain name registry that is now their main line of business.
9 Except that VRSN will have "the right to increase the price of a .com domain name during the term . . . due to the imposition of any new Consensus Policy or documented extraordinary expense resulting from an attack or threat of attack on the Security or Stability of the Domain Name System (DNS) not to exceed 7% above the price in the prior year."
10 In both cases, Company is VRSN.
11 On June 13, 2012, ICANN announced it had received 1,930 applications for over 1,400 unique new gTLDs.
12 (amazon.com = online retailer, not a site about the rain forest).
13 The NTIA would actually "let out for bid" the contract for the management of the IANA function. However, the contract has historically been written in such a way that there was only one entity, ICANN, that could realistically win the contract.
14 of which the NTIA is a component.
15 between the NTIA and ICANN.
Disclosure: The author is long VRSN. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.