Last week, I wrote, "Either Register.com (Nasdaq: RCOM) is dramatically undervalued, or one of the bruises on this apple goes much deeper than the surface." Mea culpa; there's definitely more rot in this apple than I originally recognized. I just hadn't dug deep enough.
Thanks to excellent emails from many of you last week, I was able to track down several additional issues weighing on Register.com's stock price. Whereas before I considered the company's positive free cash flow a sure thing, I now realize there's a chance Register.com could lose money in the coming year.
Here's a rundown of three major issues that warn of possible further deterioration in Register.com's business:
1. Intense price competition
The most obvious challenge to Register.com's business is the industry's cutthroat pricing. Domain name discounters such as GoDaddy.com charge only $8 to $10 per year, or approximately one-fourth the price of Register.com's $35 per year list price. Price competition is a big reason behind Register.com's lagging renewal rates and declining gross margins.
Recognize, however, that while these bargain-basement domain providers are stealing market share, they may not be stealing any of the industry's profit share. It's hard to say whether the discounters are actually turning a profit. If they are, it's probably not much.
To Register.com's credit, it hung onto its 3.4 million domain names under management between Q1 and Q2 of this year. Also, management noted on its Q2 conference call that net transfers (domain name transfers in from competitors minus transfers out) for the quarter were "slightly positive."
2. High credit card chargebacks
Most of Register.com's business is billed to customers' credit cards. This is great for Register.com, in that it allows the company to collect immediate payment at the time of sale. But there is one problem, and it's a biggie: At the time of transaction, it doesn't have the actual card in hand, nor does it obtain the cardholder's signature. Therefore, it is liable for fraudulent and disputed credit card transactions.
This is especially problematic when it comes to billing for renewals. Until recently, it would automatically bill domain name renewals to a customer's card unless that customer specifically "opted out" of the renewal. But instead of opting out, most customers that no longer want their domain simply call up their credit card company and dispute the charge.
The mounting number of disputed charges is putting Register.com at risk of losing its credit card transaction privileges. In the "risk factors" section of the company's most recent 10-Q, management made the following disclosure:
� we have been, and continue to be, assessed significant financial penalties from one credit card association and have been informed that if we do not reduce our rate of chargebacks and refunds to a level acceptable to it in the near future, we may lose our ability to accept payment through credit cards issued by the association. Another credit card association has notified us that the monthly financial penalties will increase significantly every month if our chargeback and refund ratios are not reduced below its acceptable level.
In Register.com's dire effort to reduce chargebacks, the company has been implementing an "opt in" form of renewal with some of its customers. As you might imagine, sending an email to customers asking for explicit permission to renew results in a much lower renewal rate than under the automatically billed "opt out" program. This is a major reason renewal rates have been declining.
Management currently expects renewal rates for the remainder of the year to range between 45% and 50%. Given the constraints of the "opt in" form of renewal, I think the market would be happy if Register.com could simply deliver on this promise.
3. Collections risk
On the Q2 conference call, management mentioned it's facing some "slow paying" customers in its enterprise channel. As we just discussed, most of its customers pay by credit card. But there are also corporations who contract for its services and pay by traditional invoiced billing. The slowness of these customers to pay their bills is pretty significant. Over the past year, accounts receivable more than tripled, going from $5.3 million to $16.3 million -- which is an especially strong increase considering that over the same period, revenues declined. Ouch.
This issue doesn't have nearly the foreboding implications of the first two, but it's still another sign of a deeply struggling business. If it isn't able to collect on these payments in the next quarter or two, it may have to bite the bullet and write off some of those receivables. If nothing else, the dramatic increase in receivables puts into question the quality of some of its revenues.
Valuation
So what does all of this say about Register.com's current valuation? With the stock hovering around $4.20, that's close to a 7% discount to net cash per share of $4.51. While I no longer believe the stock has value of $9.07, as I posited in last week's article, I do think the stock has already discounted the risks laid out above.
That said, even with the known risks discounted, there's still a lot of execution risk involved. Register.com is a "show me" story. The company has repeatedly disappointed investors, and management has shown no confidence in its stock by taking action to repurchase shares.
Over the next several quarters, it will need to prove its ability to generate positive free cash flow, maintain its 3.4 million domain names, and not let gross margins fall below 65%. If it achieves all of this, I would think the stock could attain a value of its cash per share plus a small multiple to its free cash flow. But given everything I now know, I wouldn't want to buy this stock unless it fell to an even steeper discount to its net cash. I might also reconsider the stock's potential if the CEO stopped selling stock and/or the company announced a stock repurchase.
Finally, I walk away from this Register.com experience with a new level of understanding of the saying, "If it looks too good to be true, it probably is." Stocks do occasionally become ridiculously cheap, but such situations demand all the greater due diligence in order to make certain that surface bruises aren't indicative of a significantly rotten apple.
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.
