Dueling Fools
Master of Your Domain?
April 28, 1999

Network Solutions Bear's Den
by Paul Larson ([email protected])

The excitement over Internet stocks has pushed all the equities remotely related to the Web or electronic commerce towards the moon. Some of these stocks deserve their premium valuations because the expected growth in their businesses is nothing less than explosive. Unfortunately, Network Solutions is in the basket of stocks that, in my opinion, does not have a fundamental operating model that comes anywhere near justifying its current lofty price. Simply said, the company is a one-trick pony whose monopoly is about to come to a close. In fact, it looks like Network Solutions is a disaster waiting to happen.

I'm sure David has gone over what Network Solutions does and why they have benefited from the Internet revolution. While looking at the company's results may have been an excellent proxy for looking at the growth of the Internet in the past, it will no longer be the case in the future. And we're talking near future, Fools.

I think the bearish argument can be summarized in three words -- Competition, Competition, Competition. The company as it operates today is essentially the lone supplier to a large government contract. In other words, it has a monopoly. When you register a domain name, you must pay Network Solutions $35 a year for the right to the online real estate. However, the Network Solutions monopoly is about to hit a reinforced brick wall.

Just last week it was announced that five companies will be able to start selling domain names from now through June 24. During this test period, the five companies, including America Online and France Telecom, will be able to register names themselves while paying Network Solutions a $9 per name per year fee. Every name that goes through AOL or any of the others will mean roughly a quarter the revenue to Network Solutions than before. That doesn't exactly bring visions of supreme pricing power to this Fool. Rather, the company is dependent on Uncle Sam and other regulators to set its prices, and those parties have a stated intent to reduce prices as much as possible.

Later this summer the flood gates really open. Another 29 competitors are due to enter the domain name arena in what will surely drive prices down even further. Not only will Network Solutions have to start sharing the revenue pie, but the company will also probably be forced to reduce its $35 fee to compete with others. Increased competition means not just having customers diverted to rivals, but also reduced prices and margins across the board.

While some may point to the $9 access fee Network's rivals have to pay to access the company's database, there's no guarantee that those prices won't drop even further after the trial period ends in June. And in a year or two from now, the price to enter a name in the database may fall to a fraction of today's rate.

The motivation of the government and the Internet Corporation for Assigned Names and Numbers (ICANN) should be painfully clear. They want competition and reduced prices, which is exactly the opposite of what Network needs to sustain its revenue and cash flow growth. Plus, there's absolutely no guarantee that the government will not yank Network's primary duties for administering the domain name database altogether down the road. Some have argued that some kind of independent and non-profit organization should be responsible for managing such an important function, and those arguments certainly have merit.

Let's now look at the company's valuation. As of this writing, the company trades at roughly 200x trailing earnings. Obviously, this is quite a premium valuation, especially for a company that is about to see one of its cornerstones -- its monopoly -- crumble to dust over the next few months.

The company is expected to earn $0.61 per share in the coming year, which if achieved would put the company at "only" 140 or so times earnings. If Network was able to maintain its 100% annual growth these valuations might not appear so loony. However, it should be painfully obvious that the increased competition in the short term is going to be a severe drag on Network's growth going forward. Plus, when you throw in the longer-term uncertainty about who exactly will be maintaining the core database in the coming years, the valuation looks simply ridiculous.

If Network Solutions were involved in other lines of businesses having the Internet naming monopoly come to a close may not be such a catastrophe. But with roughly 90% of the company's cash flow coming from this one business alone, Network desperately needs its monopoly to continue to sustain growth. Plus, with Network's pricing power being actively kicked out from underneath the company, the stock looks like it is headed the same direction as the costs for registering a name on the Internet -- down.

Next: The Bull Responds