Register.com RCOM
December 23, 2002 - 10:13pm EST by
dle413
2002 2003
Price: 4.70 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 174 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description

Register.com (RCOM)

The Company

Register.com is primarily a domain registration business for retail, wholesale and corporate customers – offering their services on a global basis. The company further provides domain management, email, web site development, and other services either directly or through partnerships.

A new and potentially valuable business to Register.com is its subsidiary, RegistryPro, which provides it with the right to be the registrar and a registry for the .pro TLD (Top Level Domain – i.e. .com, .net or in this case .pro.) .Pro will be dedicated to certified professionals such as lawyers, doctors and accountants.

In March 2002, the Company also acquired Virtual Internet plc, a leading provider of online intellectual property protection services based in the United Kingdom. The company charges $35 per year for retail customers in the U.S. and arranges lower fees with its corporate customers – typically around $25 per year. Internationally, the Company charges standard registration fees that can reach over $100 in some countries.

The domain registration business has two primary service providers – the Registrar, who provides the actual service required to register the domain name, and the Registry, the administrator that maintains the master list of registered names in a TLD.

Register.com separates itself from its competitors, such as VeriSign, Snapnames and others through a combination of high-level customer service, focus on customer satisfaction, and focus on higher quality customers – thus avoiding the typical churn of customer names that VeriSign now faces.

For a detailed background on the history and fundamentals of the industry, please get The Motley Fool Select - Vol. 2, No. 7 (July 2002) and written by Zeke Ashton, available at www.fool.com in the “Foolmart” section. Regrettably, it costs $10. I also suggest you download a free copy of the State of the Domain, which is put together by SnapNames, a Register.com competitor – available at www.sotd.info. This is published monthly.

Economic Fundamentals

Guidance had been to expect over $125mm in recognized revenues for 2002, but has since been guided down to $105 to 110mm – probably on the low end of that range. The company currently has 39,530,000 shares outstanding basic and a bit over 40mm at the current share price. Many of these shares are through out of the money options at this point. At the current share price of $4.70 (the stock price was up $.36 today or 8.5%), the market capitalization of the company is $188mm on a fully diluted basis. Currently, the company has $202mm in net cash. Thus, at $4.70 (and assuming no value for those options out of the money), the company is trading for less than its current cash position of $5.15 per share (– i.e the operating company, which threw off over $13mm in free cash flow in the first half of the year has been assigned negative value!

The company currently has $90.6mm in deferred revenue (“DR”) ranging from one month to over five years with that amount reflected in the company’s current cash position. This is up from about $89mm at the end of the first quarter and $77mm as of December 31, 2001. While DR increased about $12M in the first quarter, it only increased about $4.1mm in the second quarter and declined about $3mm in the third quarter – not a great trend, but up significantly nonetheless.

The company reported $10M in FCF in Q1 2002 on net revenues of $27.3mm, down about 10% from Q1 2001. The company then reported $3.9mm in FCF in Q2 2002 on net revenues of $27mm, also down about 10% from Q2 2001. Net income was $3.65mm for Q1, $846K for Q2 – the latter of which was low partly due to a 70% tax rate and higher R&D costs in preparation for the RegistryPro efforts. The company jumped to a slight loss in the third quarter of $1mm on a pro forma basis (a real pro-forma this time) on revenues of $25.5mm, but remained cash-flow positive by a nose - $300,000. Revenues are trending flat to down slightly. [Note that I am still not resolved on how to treat their cash flow vis-à-vis deferred revenue and invite all comments on how to treat that liability vs. cash on hand]

As to CapEx, the company expenses most R&D, which includes some CapEx, and real CapEx should approximate depreciation of about $4mm per year. That conservatively assumes that it is all maintenance CapEx, which it is not.

I figure that the company will eke out another quarter cash-flow positive – perhaps to the tune of about $1mm. This will be pro-forma as well as there will be certain costs associated with additional goodwill write-downs as well as severance and other downsizing-related costs. Under this assumption, the company, without accounting for its cash hoard, will be trading between 14 and 15X trailing operational cash flow. While this trailing cash flow may not be the best indicator, it gives some sense of earnings power of the company in a decent economic environment.

Company Specific Issues and Advantages
The Company has a great business model, which includes:
• highly visible revenues (due to prepayment of one or more years),
• recurring revenue – both through a repeated need of customers to have a URL as well as a high proclivity for each customer to renew through Register.com (it is difficult to switch),
• a leverage-able business model (through upselling of other services),
• minimal CapEx,
• up front payment through credit cards (for all non-corporate business), which gives the Company the equivalent of float, and
• growing corporate customer sales, which are much more stable.

Market – The Opportunity
The domain registration business is a necessary business for the Internet to function. Similar to receiving a phone number, the registrar is the only company in control of your domain name. It is a government-provided monopoly for the registrar and an oligopoly for the registries as a group. The industry had gross listings of almost 29M names excluding country code URL extensions (known as Top-Level-Domains or TLDs).

The main heavyweight in the industry is VeriSign, which is seeing negative growth, similar to AT&T after deregulation in the 1980’s. To date, there are 200M businesses, but only 15M have domain names. Further, each company may have more than one domain name – either due to different extensions and/or due to different brands that one company may own. There are also 6B people, many of whom have or will have personal domain names – similar to a phone number. In addition, there are currently 240 ccTLDs

The business also stands to gain from the sale of supplemental services, including email hosting, web site creation, URL rerouting, web hosting (through a partnership), advertising and other services that can bring a small business’ tab up from the typical $35 per year registration fee up to over $350 per annum. In January, VeriSign attempted to lower prices for retail customers to $28, but six weeks later raised their prices back to $35. Thus, I have no immediate concern about pricing for the retail market – nor does the Company.

Most of the company’s competitors are either seeing declines in business, such as VeriSign or simply do not compete for the same customers. While there are many small players who offer deep discount URL registration, Register.com does not see them as a major threat to their retail or especially their corporate business.

Recently, the Company’s corporate business grew to about 21% of their total business from 17% last quarter or under $20M per year (it grew over 75% from 2000 to 2001). Management believes that this business could reach $500M over the next 10 years.

Example Corporate Customers
Picture the following two examples:
• Pharmaceutical Client: The company must have the URL for each drug name in most of the standard business and country extensions. This means that a single drug brand may be registered in 20 or more countries, providing over $600 per year. But picture a pharmaceutical customer with 10 drugs under development in all phases. First, a drug company will register up to 40 different URLs for potential drug names during phase I, and narrow it down to say 10 URLs by phase II and say 4 names by phase III. If on average, a drug company has 5 in phase I, 3 in phase II and 2 in phase III; further, let’s assume that they keep that registration in only 10 TLDs. That would mean that at a given time, the company is paying Register.com $59,500 (or 2,380 *$25 (discounted price from $35)).
• Major Consumer Products Company: Let’s assume that a company has 500 brands that they must keep registered in 20 different TLDs to cover business TLDs as well as country TLDs. At a price of $25 per brand per TLD, that would mean $250,000 per year. The Company has told me that they have multiple customers that pay that to them. Register.com told me that they have one client that pays them over $700,000 per year, and their corporate sales staff is now 25 people strong.

Marketing and Company position
The company continues to grow its retail business through advertising, word of mouth and marketing agreements. The major focus is on the global partner network, which is the Company’s wholesales business (TerraLycos and others), and on the corporate business, which is growing in leaps and bounds.

Important business statistics:
1. Names under management (yr. end 2001): 3.3M
2. New and Transferred Registrations: 340,000
3. Renewals: 350,000
4. Names under management (Q1 end 2002): 3.4M (~600K came up, 360K renewed)
5. 2002 YTD paid renewal rate: 52% (company expects about 45 to 50% for rest of year)
6. Percent of new registrations: 10% (constant over Q1)

Competitive Landscape

Company Name Verisign Register.com Tucows (discount)
Number of domains <10M 3.4M 3.2M
Deferred Revenue $588M (includes all biz.) $93M $23M
Cash & Equivalents $306M $211M 6.2M
CFFO* $20M $5M (est.) <$1M
* CFFO is a quarterly number.

Competitive Advantages
The Company has several competitive advantages. They are as follows:
1. A great name in Register.com
2. A higher quality list of customers
3. A very strong balance sheet with no debt and $202M in net cash. Much stronger than all competition save VeriSign.
4. Technology expertise that is second to none in the industry.
5. The best customer service in the industry
6. Weak competition – VeriSign, despite its strengths has poor customer service and is generally disliked by corporate customers.
7. Multiple sales channels and a strong and growing sales force.
8. The .pro business opportunity.
9. Discipline in the way the Company uses and stores cash.

Management
The management team is led by Richard Forman. I have known Richard for over 6 years and believe that he has a high degree of integrity. While he is not “Wall-Street-Slick,” I view that as a good thing. He does know the following: how to preserve cash, how not to blow cash, how to make intelligent acquisitions and how build a business conservatively. I have not met the rest of the management team, but think that at some point, it may need to be expanded as too much of the company resides in Mr. Forman. Particularly, I would want to see a CFO who really understands how to allocate capital – something I have not been able to build a feel for as the new CFO has not had a chance to prove his might yet. The problem now resides in management’s credibility after blowing the 2nd and 3rd quarters with little to no warning.

Risks
1. The company does not buy back shares.
2. Business is deteriorating, but still cash flow positive. It clearly has deteriorated from the first quarter where there was tremendous growth in NI, renewals as well as deferred revenue – all of which were down in Q2. If the company cannot rebound, it may start to bleed cash.
3. Management misallocates capital – partly through not buying back shares.
4. And let me conclude that the biggest risk is none other than: the company does not buy back shares!

Conclusion
Ultimately, I don’t believe that this company will triple in the next year. This is a slow growth company in a good industry that provides tremendous recurring revenue and great visibility through prepayment. A general business recovery and a share buyback could boost EPS and FCF/share dramatically, but I am not sure that management will push the share buyback dramatically, even at distressed prices. The reshuffling of the board and a recent win of a big corporate contract with Nestle are hopefully indicative of the company turning the corner on all levels.

Catalyst

1. Buyback of stock. The company currently has a small buyback registered for about 1M shares. This must grow dramatically now that the price has taken a dive to below cash.
2. The .pro registry business could add significant growth.
3. The corporate business could explode on the upside.
4. Acquisitions of other companies.
5. An acquisition of the company by a company such as Microsoft or another company serving the business community.
6. Restructuring and cost cutting should improve already positive cash flow.
7. Any strength in the general economy and business conditions should not only induce a spate of registrations of new URL's for small and medium sized businesses, but should also provide a fertile environment for the roll-out of numerous new products for major companies, including consumer products and pharmaceutical companies - each of which have their own URLs.
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