On Friday, The US Commerce department approved an amended agreement between VeriSign (NASDAQ:VRSN) and ICANN for the operation of .com registry until 2018. The stock price of the company dropped by about 15% after the news. The amendment has removed the provision for permitted price hikes of up to 7% for any four of the six year time period. Otherwise, the new contract is essentially the same as the one agreed upon with ICANN in June 2012.
The restriction on price hikes is expected to limit the revenue growth over the coming period while chipping away on the gross margins simultaneously. The renewed contract does away with the fixed fee the company paid to ICANN and replaces it with a variable fee, which will also negatively impact margins. The two factors have led us to revise our earlier estimate for VeriSign down to $38. The revision is about 10% above the current market price of $34 as we expect a new substantial revenue stream to open up post ICANN’s introduction of several new gTLDs next year. The infrastructure services for several of these new domains is expected to be provided by VeriSign. 
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Revenue growth to slow
.com domains constitute close to ~90% of the .com/.net domain name mix currently governed by VeriSign. The restriction on price hikes will result in the .com domain price staying steady at $7.85 until November 2018. With the agreement for .net domain registry permitting price hikes of up to 10% per year  and the growth of .net domain names (~9%) slightly outpacing that of .com domain names (~6%),  we now estimate the growth of the combined fee to slow down to 2% annually and reach $8 by 2019. This resulted in a 10% decline to our previous estimate of $50 for the stock.
On a positive note, the agreement does provide an opportunity for price hikes if the company is able to show that a cost based price hike is necessary to maintain the security and stability of the Internet. However the price hikes must be signed off by the Commerce Department before implementation, a process we expect to be cumbersome and time consuming. In a highly unlikely scenario, the pricing restrictions may also be removed altogether if the company demonstrates to the Commerce Department’s satisfaction that market conditions no longer warrant such restrictions.
Gross margins to decline
A secondary impact of the restriction on price hikes will be on the gross margins of the company. The margins had increased steadily as the company exercised all the permitted price hikes under the contract, which ended this 30th November. We expect the margins to decline steadily over the forecast period even as the company tries to maintain them at current levels by cutting down on its costs.
Currently the company maintains considerable overcapacity and redundancy in its DNS system to mitigate the risk of the .com domain malfunctioning. We expect the company to review and restructure security systems for .com domain in order to maintain its margins over the coming years. However with performance in terms of constant availability of DNS systems being the primary criteria under the registry agreement, we don’t expect the company to resort to drastic cost cuts.
Another threat to the company’s margins comes from the fee it pays to ICANN for each registered domain name. As per the old agreement, the company used to pay $4.5 million as a quarterly lump sum fee regardless of the number of domain names registered. However, as per the proposed agreement the company will be paying up-to $0.25 per year for any .com registered, renewed or transferred domain. At the current levels it could translate to an additional annual expense of $10 million from the .com domains alone.
New gTLDs to pressure .com’s market share
ICANN is overseeing an expansion of the gTLD universe with an aim of adding 300-1000 new gTLDs every year. We expect the new gTLDs to negatively impact .com/.net market share of overall domain names. VeriSign has applied for 14 of these new TLDs. However, the process for the introduction of these new gTLDs is expected to take time and we don’t see a major adverse impact in the near term.
We have a revised $38 Trefis price estimate for VeriSign.Notes:
- VeriSign is backend for 220 new TLD applicants and applies for 14 itself, Domain Name Wire, April 2012 [↩]
- ICANN Approves The Renewal Of .Net Contract With VeriSign, The Domains, June 2011 [↩]
- VeriSign Management Discusses Q3 2012 Results – Earnings Call Transcript, Seeking Alpha, October 2012 [↩]