The Highlights:
Verisign is a unique business with a government granted monopoly and near perpetual growth
The biggest factor in the valuation is the discount rate, with a close second being the terminal growth rate
I value the stock at $160, which is considerably less than the current market price of $208
Key Learning Point: Don't be whack and miscalculate your WACC
Imagine a company with a government granted monopoly to be the sole producer of a good that grows at 2% per year indefinitely and provides a 60% plus operating margin. This is essentially the operating environment for Verisign (VRSN). Verisign is a company that was founded during the dot-com bubble, which left quite a blemish on the company's balance sheet in the form of negative retained earnings. The company operates two of the internet's thirteen root nameservers and has a government granted monopoly to be the sole seller of ".com", ".net", and ."org" domain registries. Essentially, when you buy a new domain name through a registrar, such as GoDaddy, they are ultimately buying the domain from Verisign. The one drawback of having a government granted monopoly is that the government ultimately has control of the privilege and pricing. Below is a slide from the Company's 2019 full year results presentation.
At first this seems like it will be a fairly easy company to value. The revenue line is very stable and growing at roughly 2% per year. The costs barely fluctuate, so the company is able to provide 60% plus operating margins that grow larger every year. Then the dark truth starts to set in as you begin to question your spreadsheet. This is not your typical equity security and treating it like one will cause you much heartburn. The valuation ultimately hinges on one factor - the discount rate. This factor will be abnormal and it will cause you much grief as it did I. So how should one think about this company to become more comfortable with valuing it?
Spoilers: The company is an ultra low risk internet utility that has a perpetual 2% growth rate.
Verisign's business and equity act more like fixed income than actual equity. The government monopoly, the stable revenue growth, and the ever-increasing operating margins are akin to a quasi-government security with a coupon that grows at 5% annually. Instead of paying the coupon to shareholders in the form of a dividend, Verisign's preferred method of returning value to its shareholders is to repurchase its stock. Since 2009, shares issued and outstanding have decreased from 183 million to 117 million. This is roughly a 4% per year reduction in issued and outstanding shares.
Since 2009, Verisign's revenue and operating profit has more than doubled. Verisign saw double digit revenue growth from 2009 to 2013, but this has since slowed to the mid to low single digits. Operating profit has continued to increase due to Verisign's ability to keep operating costs constant while growing revenue. Verisign's operating costs were actually lower in 2019, than they were in 2009. This is a business that continues to show top-line growth, while costs remain flat and capital expenditures minimal. This setup provides the fuel to the engine that grows operating profit and free cash flow.
This security can be valued with a complex DCF model, but it is more suited to a much simpler model. The value I calculated equals $160 per share, which indicates that the stock is quite a bit overvalued based on its current market price. See my inputs below:
I estimated that revenue would grow perpetually by 2.5% per year. This matches management's 2020 revenue expectations and bakes a little bit of conservatism into the valuation. I increased the operating margin from 65% in 2020 to 70% in 2025 and for the terminal year as the company has a track record for holding costs constant. Based on management's projections and historical financials, I chose a middle of the road tax rate of 20%. Although Verisign has historically had an effective tax rate that is below this level, keeping it at 20% is a more conservative approach. OP stands for operating profit and OPAT stands for operating profit after tax. Finally, I backed out the inflationary growth of capital expenditures in excess of depreciation to arrive at the free cash flows (FCF).
Next, I discounted the FCFs by a 6% discount rate to arrive at the value of the firm. I backed out debt and a working capital adjustment to arrive at a value of $18.7 billion. Divide that by the numbers of shares outstanding, roughly 117 million, to get to the per share value of $160.
So let's discuss some of the key inputs for this model, primarily the discount rate. So, how does one come up with a discount rate for a company like this? That is a great question and I am not sure I have the precise answer. My personal preference when valuing a company is to spend more time on the components impacting cash flow and then assess the value of the company under a number of different discount rate scenarios. I don't pretend to have a crystal ball, but I hope to be in the ballpark. Verisign's cash flow inputs don't have much volatility and cannot easily be used as levers in our valuation. Also, the terminal growth rate is pretty solid and there is not much room for variation. Therefore, we are left with trying to figure out what kind of discount rate makes sense on a security like this.
When calculating a weighted average cost of capital (WACC), one must compare the different sources of capital in terms of their cost and their market value weighting. Verisign has less than 10% of its capital structure in the form of debt. The yield on that debt might also be considerably different than the stated coupon. For example, Verisign has stated coupons rates on its debt ranging from 3% to almost 6%, yet the market yield on many of the bonds fall around 2%. This 2% yield more accurately represents Verisign's actual cost to borrow. Assuming a 20% tax rate, the after-tax cost of debt is roughly 1.6%.
Now we come to the challenging part: the cost of equity. I don't have a good or easy answer on this one either. Duff and Phelps has the standard cost of equity equal to 8.5%, which is composed of a 2.5% risk-free rate and a 6% equity risk premium (ERP). I believe that the ERP for Verisign should be considerably lower than the average market security. I believe a government granted monopoly, the utility-like business model, and the tremendous financial operating stability of the company drives risk down significantly. From a CAPM perspective, Verisign's beta on many financial websites is below 1.0. Also, companies in the utility industry tend to have very low betas. Therefore, reducing the ERP seems like an appropriate procedure. Ultimately, I decided to reduce the ERP down to 4%. Therefore, the cost of equity is calculated at 6.5%.
If we utilize the company's current 90/10 equity to debt capital structure and the aforementioned costs of equity and debt, we arrive at a discount rate of roughly 6%. Gurufocus came up with a similar WACC. The capitalization rate of the terminal cash flow is calculated at 3.5%, which is the discount rate of 6% minus the terminal growth rate of 2.5%. Slightly changing the terminal growth rate or the discount rate can cause significant changes in the valuation.
In the following sensitivity table, I have calculated the per share value of Verisign under a number of different discount rates and terminal year operating margins.
Although the current stock price of Verisign at $208 per share is conceivable, the assumptions needed to justify that price would need to be too optimistic. Buying the stock today does not ensure an adequate margin of safety. Although it is unlikely, it is also conceivable that Verisign could one day lose its monopoly on the domain registry business. That would be a highly unlikely doomsday scenario for the stock, but it is not impossible. But, as long as internet domain names remain relevant and the government continues to grant Verisign its monopoly, then the stock price will most likely be sold at a premium. If the stock had a correction to the mid $100s, I think that might be an opportune time to make an entry. Otherwise, this security is best viewed from the sidelines.
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