There are few legal monopolies.
One commonly cited example in the public markets is Sirius XM (Nasdaq: SIRI). Sure, Sirius is the only satellite operator in the market, but radio listeners have alternatives -- including the likes of local broadcast radio. Even other common monopolies have alternatives, such as the U.S. Postal Service, where you can opt to use FedEx (NYSE: FDX) or UPS (NYSE: UPS). However, is there any market in which customers don't have a choice?
But what if there were a legal monopoly that embodied "customer captivity"? Imagine a company that has agreements that give it unrivaled power. And imagine that this same company operates in the fastest-growing industry in the world -- the Internet.
That company is VeriSign (Nasdaq: VRSN), which has a virtual monopoly on Internet domains.
This company has a high level of customer captivity, meaning that its customers rely heavily on its services and cannot get said services elsewhere. VeriSign offers domain name registry services. What this means is that VeriSign operates the authoritative directory of dot-com, dot-net, dot-cc, dot-tv and dot-name domains.
The company saw a sizable pullback in late 2012, after the Internet Corporation for Assigned Names and Numbers (ICANN) approved its agreement as the primary registry for dot-com domains but disallowed the company's request for pricing increases. So dot-com domain fees will remain flat through 2018. The market initially took this as bad news but soon realized that VeriSign still has a monopoly on the domain registry industry. VRSN is now back on an upward trend.
Again, the real beauty with VeriSign is that it has agreements that make it the exclusive register of dot-com, dot-net and dot-name domains. The agreement ensures VeriSign's recurring revenue stream, and although the dot-com domain fees are fixed, VeriSign can boost dot-net fees by 10% annually through mid-2017. Just last quarter, the company increased its domain fee by $0.56 to $6.18 for its dot-net domain names, which will go into effect in February 2014.
Although the company doesn't pay a dividend, it does have a robust share buyback plan.
Going into the third quarter, VeriSign had around $1 billion remaining under its buyback program. With its robust cash-flow generation, there's no reason the company can't continue snatching up shares. Over the past 12 months, VeriSign managed to generate almost $520 million in free cash flow. That's nearly $3.80 in free cash flow per share, or nearly 7% free cash flow yield.
VeriSign's impressive cash hoard of more than $2 billion helps protect on the downside, but 85% of it is held overseas. However, VeriSign is looking get that cash to shareholders. One option is for the company to take advantage of low rates and increase its borrowing, using its overseas cash as collateral. (This is essentially what activist investor Carl Icahn is pushing Apple (Nasdaq: AAPL) to do with its massive pile of cash.) Given the complications of repatriating cash, VeriSign has promised to put a plan to shareholders by year end.
Risks to Consider: One of the biggest risks is that the level of growth for dot-com and dot-net domain names could hit a level of saturation, meaning growth would begin to slow. There's also the continued weakness in Europe, where the company gets around 15% of revenues from Europe, the Middle East and Africa. Another potential risk is that the company is unable to repatriate its overseas cash hoard in such a way that's advantageous to shareholders.
Action to Take --> Buy VeriSign with upside to $78, which is 45% above current trading levels. That's a price-to-earnings (P/E) ratio of 30 on 2014 earnings estimates, which compares favorably to VRSN's five-year average P/E of 40 and the industry P/E of 33. The risk/reward trade-off for VeriSign is appealing, as given its monopolistic stranglehold on the domain registry business and large cash balance, the downside appears limited.