The toll road of the internet

We love stable, boring, monopolistic businesses

Verisign is a regulated monopoly with 68% Operating Margin and 50% NOI Margin. This very high quality business had sat on our 5AM Capital Global Listed Equity Fund watchlist for a long time. We remained patient - waiting for an entry point for our Fund which we found in July last year. Since then, this 'boring under the radar business' is up 33% - helping to contribute to our Fund's 19% annualised performance. 

Imagine you're sitting at your computer and you type in a web address, like  5amcapital.com.au (VIEW LINK) or livewiremarkets.com.au , into your browser. You hit enter, and within seconds, the website loads. This seamless experience is made possible by a complex system working behind the scenes, and Verisign plays a crucial role in this process.

The internet relies on the Domain Name System (DNS) to translate human-friendly domain names (like 5amcapital.com.au IP addresses (like 192.0.2.1) that computers use to identify each other on the network. Enter Verisign (NASDAQ:VRSN). Verisign operates the authoritative DNS servers for the .com and .net top-level domains (TLDs).

Every second, Verisign handles millions of domain names and their corresponding internet addresses. Verisign also provides root zone management, DNS (Domain Name System) services, and security services to protect the internet's critical infrastructure. This basically means the company is in charge of making sure the Internet is working properly. These are essential services that are crucial to the functioning of the internet.

As such, we like to think of Verisign as the operator of a toll road. Every time you drive on this road (visit a website), Verisign ensures the road is well-maintained, free of obstacles, and that you reach your destination smoothly. They collect a small fee (domain registration and renewal fees) for this service, which funds the maintenance and security of the road (internet infrastructure). 

The company makes money mainly by collecting ~$9 per year for each domain name that is registered, and they manage around ~165 million domain names. The margin on this recurring revenue is extraordinarily high, and there is very minimal need for cash in this business. 

The high margin recurring revenue and the low capital requirements lead to stable and predictable free cash flow, which the company uses almost exclusively to buy back stock. Last year their revenue was $1.49 billion, of which $1.0 billion was profit, or about 67%, a fraction most companies can only dream of.

Transport Toll Road v Digital Toll Road

Toll roads are nice, simple businesses and an easy way to build an analogy for Verisign. 

We don't, however, currently hold any toll roads in our 5AM Global Equity Fund. In fact, we are quite bearish on several transport toll roads. The large margin improvements that toll road operators achieved through the implementation of electronic tolling are no longer tailwinds. Traditional toll roads now have few levers within their control. They can't control the number of cars (and we are cautious regarding developed markets commuter outlook and they will continue to be exposed to economic cycles, work-from-home trends, urban congestion and public transport policies) and can't control the toll pricing. 

Toll roads are often priced to perfection, making it challenging to find a margin of safety when considering a cautious long-term outlook.

This is however not the case for Verisign. Companies won't turn off their domain renewal when the economy contracts. 

Digital presence is a necessity and Verisign benefits from structural internet usage. 

Competition & The Relationship with ICANN:

You might ask, who do they compete with?

The company is essentially a monopoly given their exclusive rights over the .com and .net top level domains (TLDs). These rights are granted by ICANN (Internet Corporation for Assigned Names and Numbers), the organization responsible for coordinating the internet’s naming system.

To understand Verisign's unique position in the internet infrastructure landscape, it's essential to delve into the history of both Verisign and ICANN, and how their exclusive contract came to be.

Verisign was founded in 1995, during the early days of the internet. Initially, the company focused on providing digital security certificates, which are crucial for encrypting online communications and ensuring secure transactions. Over time, Verisign expanded its services to include domain name registry operations, which would become its core business.

The Internet Corporation for Assigned Names and Numbers (ICANN) was established in 1998 as a nonprofit public benefit corporation. Its mission is to help ensure a stable, secure, and unified global internet. ICANN coordinates the unique identifiers (like domain names and IP addresses) that allow computers to find each other on the internet. Before ICANN, these functions were managed by various entities under the oversight of the U.S. government.

When ICANN was formed, it took over the responsibility of managing the domain name system (DNS) from the U.S. government. At that time, Verisign was already operating the .com and .net domain name registries. Recognizing Verisign's expertise and the critical nature of its services, ICANN granted Verisign an exclusive contract to continue managing these top-level domains (TLDs).

But it gets better. This contract was not just a simple agreement; it included a right of renewal. This means that as long as Verisign continues to meet its contractual obligations and maintain the stability and security of the DNS, it can renew its contract without facing competition. This right of renewal has been a cornerstone of Verisign's business, providing long-term stability and predictability in cashflows.

Recent Contract Renewals

Despite the exclusive right of renewal, Verisign share price performance was very muted leading into this year’s dot com contract renewal. Between the 11^th of Dec 2023 and 2^nd of May 2024 the VRSN share price was down 21% leading into the .com renewal date.

Verisign's contracts for the .net and .com domains have been renewed multiple times and interestingly, each time, the market has been cautious leading into renewal. However, after running the ruler over the exclusive right of renewal, modelling out the expected cashflows and the value on offer, we gained the conviction to initiate a small position in Verisign on the 17^th of July at around $179 USD/share.

The complexity to the renewal was that even though the renewal was virtually guaranteed, the price was not. Verisign has a cooperative agreement with NTIA, which, until 2018, set a cap on the price for .com. In 2018, it was amended with a formula that allowed Verisign to raise the price by 7% per year in four years out of six. The wholesale price was $7.85, so now, after four increases, it’s $10.26. This is the price that registrars pay for renewals; initial registrations can be, and usually are, discounted, and each registrar can mark the price up or down as much as they want.

Our view was that further price caps on the dot com agreement would be unfair and unlikely given Verisign’s relationship with ICANN. Additionally, the wholesale price for a .com domain is comparable to other top-level domains, similar to what PIR charges for .org, and generally less than the fees for newer TLDs like .biz or .review. Even if the wholesale price of .com were halved to $5 per year, it would hardly impact anyone except domain speculators. When setting up a website, costs for hosting, site design, and other services far outweigh the domain name fee. A reduction in the annual combined price from $120 to $115 is negligible. You could argue that VeriSign's pricing is unfair, and you wouldn't be mistaken. However, the impact of this unfairness is relatively minor compared to other parts of the website hosting ecosystem.

What happened?

As expected, the dot com contract renewal, finalized on November 27, 2024, did go through once again with no major changes to the conditions (allowing a price increase of 7% in 4 of the next 6 years). Since the announcement, Verisign’s share price has risen by approximately 30% to $240 USD/share. The .net contract had already been renewed on June 27, 2023, extending Verisign's management of the .net registry until June 30, 2029. This renewal allows Verisign to increase wholesale prices by up to 10% annually.

The market’s initial panic was unnecessary. Verisign’s impeccable track record and the critical nature of its services made it highly unlikely that ICANN would choose to replace them as they would have had to argue that Verisign had breached it operational duties (which was not the case). The company’s consistent performance in maintaining the stability and security of the internet’s infrastructure ensures that it retains the right to renew the exclusive contract every 6 years.

Essentially, with this pricing power baked in, revenue growth will compound at approximately 5% over the next 6 years. The maths on high margins means that this translates to net profit growth of approximately 7% per annum. This is because the fixed costs are spread over a larger revenue base, enhancing profitability. If net profit continues to grow at 7% annually and the company continues using the majority of free cash flow to buy back shares, the business will be doing around $1.15bn of free cash flow with around 86 million shares outstanding by 2030. This means intrinsic value per share is compounding at around 10% annually. We’re happy to buy a monopolistic long-term 10% FCF/share compounder at a PE of 20x as these assets normally will go for much steeper prices (i.e. physical toll roads).

Risks

It almost sounds too good to be true, so we’ve asked ourselves, what’s the catch? There’s two key elements to this thesis that we are monitoring going forward. Firstly, while pricing power is baked in, the other side of the equation, domain volumes are not.

But the internet is now 'mature'. Growth in domain name volumes, which pre 2000 was growing 50%+ per annum have started to plateau in recent years, to very low single digits. We incorporate plateauing into our forecast. 

As the internet has matured, the explosive growth in the number of registered .com and .net domains has naturally slowed. In the early days of the internet, there was a rush to secure domain names, driven by the novelty and the burgeoning potential of online presence. However, as the market has matured, most desirable domain names have already been registered, leading to a deceleration in new registrations. This trend reflects the broader stabilization of the internet as a critical infrastructure, where the initial rapid expansion phase has given way to a more measured, sustainable growth pattern.

We don’t mind this. Despite this slowdown, it's unlikely that the number of registered .com and .net domains will contract completely. These domains remain highly valuable due to their widespread recognition and trust. Businesses and individuals continue to prefer .com and .net domains for their credibility and familiarity. While the growth rate may align more closely with broader economic indicators like GDP, the overall number of domains is expected to maintain a steady, albeit slower, increase. This is partly because new businesses and ventures will continue to emerge, requiring domain names, and existing entities will maintain their online presence.

In the long term, the growth of .com and .net domains will likely mirror the general economic environment. As global GDP grows, so too will the demand for online presence, albeit at a pace that reflects the maturity of the market. The internet's role as a fundamental component of modern business and communication ensures that domain registrations will continue to be relevant in our view. However, the days of double-digit growth rates are likely behind us, replaced by a more predictable and stable growth trajectory.

The other risk is the use of new TLDs instead of the market expected norms of .com and .net. 

We consider this a relatively low risk for valuation impact, but it is one nonetheless. When the internet started, there were just a handful of TLD’s (.com was, and still is, the most popular by far). But in recent years, ICANN has begun auctioning off the rights to countless other TLD’s, which is being viewed by some as a risk to Verisign’s dominance on a key piece of “internet real estate”. In other words, if you start an AI company, you might choose BlueSoftware.AI instead of BlueSoftware.com. If you’re a CPA, you might choose JohnsCPApractice.cpa instead of JohnsCPApractice.com. This will be on the fringes - adding to the plateauing of the .com and .net

Conclusion

Unless Verisign was to fail in its duties (a possibility but an unlikely one), we think this monopoly will continue to be a profitable one. The government feels things are working well (Verisign has always performed—i.e. kept the internet “on”), and our read is that the contract will likely continue to be extended without any major changes.

Thus, in July 2024 when we initiated Verisign for our fund, we had come to the conclusion that although the valuation isn't a slam dunk we expect a moderate 9-10% p.a. return in the base case and more (11%+) in the bull case over the next decade. The business is very high quality, and has many "5AM like" attributes (clear monopoly, high margins, founder-led, boring business, etc).

A collection of these lower risk monopoly businesses, purchased at a fair price, ultimately provides the chance for our Fund to generate a return above our benchmark. So far, the 5AM Capital Global Equity Fund has compounded returns for clients at 19% p.a.

Although unexciting, we love businesses like Verisign - a high quality, very high margin, monopoly with regulated 'toll' increases. We will continue to search for them and invest when we feel we can enter at a fair price. 

Thanks for reading.

Sam Chipkin (CIO) & Tom Perfrement (Investment Manager)