Disclaimer: The views expressed here are mine and may change without notice. Past performance is not indicative of future results. All investments carry risk, including financial loss. This analysis is for educational purposes only and does not constitute investment advice or recommendations of any kind. Conduct your own research and seek professional advice before investing. Please see important disclaimers here and here.
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"When several models combine, you get lollapalooza effects; this is when two, three, or four forces are all operating in the same direction." - Poor Charlie's Almanack
This post is a write-up on a company I highly admire, and I believe business schools should teach Verisign (VRSN). It is a near-perfect example of extraordinary business success when multiple mental models are all working in the same direction. I could figure at least eight mental models in the case of VRSN.
Mission-Critical Service with Low Cost to Customers
Unlike humans, computers only understand the combinations of zeros and ones (IP address). An example of IP address is 157.240.22.35. So, how computers understand the website names that you type on your browser? This is where Verisign comes in. It operates an "interpreter" database (registry business) that translates website name you’re seeking into an IP address, and returns the location of the website. This sounds simple, but this service is critical to the functioning of the internet. It is not easy to remember numbers. Just think about memorizing 10-digit numbers for your favorite websites like google.com, facebook.com, cnn.com, and so on. VRSN does that for you.
How much would you pay for an important service like this? Does a couple of hundred dollars sound reasonable? You and I pay at least that amount yearly for an internet connection. Well, VRSN only charges $7.85 per year! That is an unbelievably low price for such a mission-critical service.
Legal Monopoly/Exclusive Franchise
Since the beginning of the internet, and until now, we know .COM has attained a special status. It has become a brand. Usually, when a person or a new business thinks about establishing its web presence, using .COM after the website name is the first thought. Why? Because .COM is associated with an internet presence, trust, and reliability.
So, who maintains the internet infrastructure of .COM? Verisign! In fact, VRSN is the exclusive operator of .COM under agreement with the government (Department of Commerce), and a non-profit internet regulatory body called ICANN giving it monopoly-like status.
Cancer Surgery Formula
VRSN's current business was not always like it is in its current form. More than a decade ago, VRSN operated various businesses such as security, authentication, messaging, and billing in addition to its golden goose (registry) business. However, the company took adequate steps to divest lower quality businesses to focus on its highest returning registry business. That's rationality applied to business decisions.
Informational Scale Benefits
Verisign, in itself, has developed a strong brand name in the world of the internet. It is recognized as a symbol of trust. Basically, if I have to choose a registry operator between Verisign and some other (call it Abhay’s registry operations), I know that Verisign has an excellent reputation whereas I don’t know anything about Abhay’s registry business. Thus, I think Verisign enjoys an informational scale advantage.
First Mover Advantage
The .COM was the first domain to ever launch. In fact, the first registered website was symbolics.com in 1985. Thus, VRSN also enjoys operating a domain registry that took advantage of being the first.
High Switching Costs
We just learned about the critical nature of the Verisign’s services for the operation of the internet and VRSN's monopoly-like status from its regulatory contract. In practice, that contract could be awarded to another company for reasons such as low cost. However, the money paid for the contract is much smaller compared to potential damage from handing over the operations to an inexperienced player. In June, VRSN completed 23 years of 100% availability of the .COM domain. Nobody else has that experience. Thus, it will a high-risk endeavor to award this contract to another player. In fact, I would argue, VRSN’s moat grows every passing day!
Untapped Pricing Power
I mentioned above VRSN’s low cost to its customers. But, I think those costs are too low. Let me remind everyone again – VRSN just charges $7.85 per year for a domain name. Given the nature of its services and strong brand name, it certainly has the ability to raise prices further. Thus, VRSN was not allowed by its regulators to increase prices in the past years. However, with the recent contract change, VRSN can now raise prices.
Autocatalysis
This is a mental model from the chemistry field. Simply this means the product serves its own catalyst. As Verisign increases the price of its product, it doesn’t have to spend a dime. That means almost all the incremental revenue turns into profit. Companies like Disney have benefitted from this model in the past.
What is the result of the above models working together? A lollapalooza cash flow generation. VRSN converts more than 50% of its revenue into distributable cash. This is way higher than the tech stalwarts we talk about daily. In fact, VRSN’s high cash conversion puts it into a rare breed of companies.
Let me go into Verisign’s business economics in more detail. Given the critical nature of the service and low cost, VRSN customers pay them regularly, resulting in recurring and predictable topline. The working capital is negative because there are no inventories, and accounts receivables, and customer pays in advance. The fixed capital employed is minimal and is funded by customer’s advance payments. In effect, there is almost no capital employed in the business. Moreover, this is a fixed cost business, and management has done a great job in cost management. Thus the profit margin increased to 65% in 2019 from 57% in 2015. All of this results in a huge return on capital and great shareholders' value versus market index like S&P 500.
Verisign’s business has tailwinds that keep on growing its recurring revenue base. The world’s internet penetration is still 62%. As more internet users grow, so will networks, and commerce activity. Thus, VRSN has a substantial runaway for growth.
Verisign’s ability to raise prices will further boost sales. If you add the attractive economics of the business, VRSN can keep seeing its profit margin increase.
Verisign is also run by a trustworthy management team whose interests are aligned. CEO James Bidzos owns more than $180 million worth of stock with a salary of roughly $9 million suggesting strong alignment with shareholders. In addition, the management bonus is tied to profit growth and VRSN’s stock performance relative to the S&P 500 index. Lou Simpson, an accomplished investor, and capital allocator have been on the board since 2005 signifying Verisign is run for the shareholders.
So, what does management do with the huge cash that the business generates? They return all of it to shareholders, primarily via share repurchases. I can see why some investors can have a different view on capital allocation given VRSN’s high market valuation. At a minimum, I think management’s intention is not bad. They clearly know they have a golden goose that generates a huge return on capital, so why use the cash flow to buy something else?
Earnings (excluding working capital benefit) in 2019 amounted to $5.15 per share as compared to $2.82 in 2015. That is an annual growth of 16%, which came from growth in internet users, price increase for domains other than .COM, margin expansion, and share repurchases. Future earnings will likely continue to see those benefits, but Verisign should also get benefit from the newly signed agreement with ICANN that will allow it to raise prices.
At the present price of about forty times 2019 earnings, the market valuation doesn’t look attractive. However, from time to time Mr. Market does provide opportunities to acquire such high-quality businesses at reasonable prices. A moderate nature of such a phenomenon happened this year when VRSN’s market value declined 30% towards the end of March. Ultimately, I believe Verisign is uniquely positioned to take benefit as our lives become more digital.
In summary, Verisign fully meets my criteria of a great business: It is easy to understand; possesses excellent business economics; is run by outstanding people; and has a multitude of mental models working together.
Abhay Srivastava is the Founder and Managing Member of AS Investment Partners LLC, a value investing firm (www.asinvpartners.com).
