It's been said that value investing is like shopping in the grocery bargain bin for damaged apples. A bruised apple that costs a quarter is a steal compared to a perfect apple that goes for a dollar. Unless, that is, the bruise on the surface is indicative of an apple that's rotten to the core. Whether you're shopping for bargains at the grocery store or in the stock market, the key is making sure what looks cheap isn't priced that way for good reason.
It's with this mindset that I recently began taking a closer look at Register.com (Nasdaq: RCOM). New York-based Register.com is the No. 2 player in the global market for Internet domain name registration (.com, .org, .net, etc.). This business was once monopolized by Network Solutions, which is now part of VeriSign (Nasdaq: VRSN). In June 1999, the U.S. Department of Commerce broke the monopoly and began authorizing additional accredited domain registrars. Register.com was the first such competitive registrar, which helped the company lock down its No. 2 position.
Regular readers will recall that Register.com was one of the stocks Rick Munarriz highlighted in July when he was seeing green -- as in companies with lots of cold, hard greenbacks in the bank. At the time of that article, Register.com was trading for $7.25, a slight premium to its net cash per share. Now, after an earnings report deemed poor, the stock is down to $4.38, an appetizing discount to its net cash per share of $4.51.
Most companies trading below cash value are priced that way because they're burning cash -- but not Register.com. The company has generated positive free cash flow each of the past seven quarters, as well as each of the past three years. This consistent free cash flow production is evidence of Register.com's cash-advantaged business. By selling multi-year domain registrations and renewals, Register.com receives upfront cash (booked as deferred revenue) for service agreements that will play out over several years. In that way, Register.com's actual cash flow far exceeds reported earnings.
Over the past year, Register.com generated $25.6 million in free cash flow on $109.9 million in revenue. That's a free cash flow margin of 23.3%. And this is no fluke. Register.com's free cash flow margins have been strongly positive each of the past three years:
1999 2000 2001 Free Cash Flow Margin 207.3% 26.6% 18.9%
And yet even with these kind of profit margins, the market is assigning a negative value to Register.com's business. With a stock price less than the company's net cash per share, the market is essentially saying that Register.com's future ability to generate free cash flow is strongly in doubt. Either Register.com is dramatically undervalued, or one of the bruises on this apple goes much deeper than the surface.
Register.com is priced so cheaply that my gut instinct is there simply must be something amiss. That's why I've been digging around the Register.com story looking for all the dirt I can find. Here's a comprehensive list of everything negative I've uncovered:
1) Declining revenue
In the most recent quarter, ended in June, revenue declined 10.1% to $26.97 million. This marks the third consecutive quarter of declining year-over-year revenue. It should be noted that while reported revenue is declining, the all-important deferred revenue component is growing. As of June, the deferred revenue account stood at $93.72 million, up from $89.63 million in March, and up from $77.38 million at the end of 2001.
2) Declining gross margins
Gross margins in the June quarter clocked in at 65.6%, down sharply from 71.2% in the year-ago quarter. Year-to-date, Register.com's gross margin is 66.7%, down from 70.1% for all of last year. This may be a sign of price wars among industry players. At the same time, these reduced gross margins haven't impeded Register.com's ability to turn an operating profit.
3) Drop in renewal rate
As of June 30, 2002, Register.com had approximately 3.4 million domain names under management. That's flat with the number reported in the first quarter of this year. But on a slightly negative note, the company reported that its renewal rate for paid registrations dropped in the second quarter to 49%, down from the mid-50% range in Q1. This drop brings the year-to-date renewal level to 52%.
4) Insider selling
According to Register.com's profile on Yahoo! Finance, insiders have sold 557,000 shares (6.1% of insider holdings) over the past six months. It's a bit disconcerting to see insiders selling any stock at such low valuations. But this level of selling hardly seems worrisome. Insiders still hold 21% of shares outstanding.
5) High stock option grants
Like many small, Internet-related companies, Register.com issues a ton of options. According to the company's most recent proxy statement, employee stock options granted in 2001 were a hefty 7.1% of diluted shares. Even for a small, developing company, I don't like to see options surpass 5% of shares outstanding.
That's it. The above list represents some important concerns; but even taken in whole, these concerns shouldn't, in my view, drive the stock's value below its net cash per share. The short interest on the stock is a low 1.4%, so it's not like there's a contingency of naysayers out there betting on Register.com's demise. And the analyst community isn't that negative on the stock -- the three analysts following Register.com all rate it a "hold." Register.com isn't hated; it's just neglected.
But as a value investor, how can you neglect a company that sells for less than its net cash when it's generating more cash every quarter? When a stock is this cheap, issues such as declining gross margins and high stock option grants are mere bruises on the apple. Even slicing off those bruised parts, there's still a lot of good fruit here.
Let's take a look at the valuation to see what kind of opportunity may be in store. The first component of value is the net cash per share. The numbers break down as follows: $70.99 million in cash and equivalents, plus $68.77 million in short-term investments, plus $71.62 million in marketable securities -- all minus notes payable of $9.12 million, and then divided by 44.835 million diluted shares outstanding. That equals $4.51 in net cash per share. To that we add the business value, which we'll base on a multiple to trailing annual free cash flow of $25.6 million, or $0.57 per share. Even on the most conservative basis, I think an 8x multiple is warranted, given the consistency with which Register.com generates cash. That's business value of $4.56.
Sum it up, and we have cash per share of $4.51 and business value of $4.56, for a total estimated intrinsic value of $9.07. That's better than a double in stock price from current levels.
How do you like 'dem apples?
By the way, if you're knowledgeable about Register.com, and you think I'm missing something here, please email me. Your feedback is always appreciated.
Matt Richey is a senior investment analyst for The Motley Fool. At the time of publication, he had no position in any of the companies mentioned in this article. Matt's personal portfolio is available for view in his profile. The Motley Fool is investors writing for investors.
