Domain Names Help Web.com To Get A Foot In The Door of SMBs
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Note: A previous version of this article misstated Web.com's pricing structure. The error has been corrected below.
Headquartered in Jacksonville, Florida and listed in 2005, Web.com Group (NASDAQ: WWWW) is a leading provider of internet services and online marketing solutions for small- and medium-sized businesses (SMBs). Web.com meets the needs of SMBs anywhere along their lifecycle by offering a full range of online services and support, including domain name registration, website design, search engine optimization, internet marketing and local sales leads, social media and mobile solutions, shopping cart software, eCommerce website design and call center services. Web.com completed its acquisition of 100% of the equity interests in Net Sol Parent LLC, a provider of global domain names, web hosting and online marketing services for a purchase price of $569.0 million consisting of $405.1 million in cash and the issuance of 18 million shares of Web.com common stock valued at $9.16 per share on Oct. 27, 2011.
Web.com has a recurring revenue base with high visibility. It currently derives 97% or more of its revenue from fees associated with subscription services, which are generally sold through web services, online marketing, eCommerce, and domain name registration offerings. Annual average monthly customer churn, which is calculated as customer cancellations in the quarter divided by the sum of the number of subscribers at the start of the quarter and the number of new subscribers added during the quarter divided by three months, fell from 3.6% in fiscal 2009 to 1.5% and 1.0% in fiscal 2011 and 2012 respectively. Customer churn for Web.com is likely to remain stable going forward with the aging of its customer base, as renewal rates tend to be higher for longer term customers.
Web.com has a large installed subscriber base, which provides for significant growth potential through cross-selling or upselling. Prior to the acquisition of both Register.com and Network Solutions, Web.com did not operate its own registrar. Web.com gained nearly 2 million domain name customers from a premier domain name registrar with the acquisition of Network Solutions and it is now one of the industry’s largest providers of domain names. A domain name purchased from Web.com typically costs less than $10 for the first year with their promotional pricing, but allows Web.com to get a foot in the door and introduce their wide range of other products to SMBs. One example is Web.com's eWorks! XL, a comprehensive website design and publishing package targeted at getting SMBs online, priced at $95 per month. Since the acquisition of Network Solutions in October 2011, Web.com increased its Average Revenue Per User (ARPU) for its 3 million subscriber base from $12.86 to $13.77.
There is growing acceptance among SMB owners that an effective internet presence is critical to their marketing efforts and also signs indicating that businesses are spending an increasing proportion of their marketing on online channels in place of traditional media. According to Web.com's 2011 10-K, approximately 44% of about 27 million SMBs had a website at the end of 2011. Web.com estimated that even among the 44% of SMBs that had a website, most were probably not effective at using the internet for marketing and business development. Web.com with its breadth and depth of proprietary products and services, is well-positioned to benefit from the secular trend of more brick & mortar businesses establishing an online presence and companies which are already online increasing their marketing budgets on new media.
Valuation and Financial Analysis
Web.com currently trades at a trailing twelve months price-to-sales ratio (P/S) of 2.1, trailing twelve months price-to-free cash flow (P/FCF) of 3.8. P/E and P/B ratios are not used in the valuation of Web.com, due to negative earnings and the large proportion of goodwill from acquisition respectively. Web.com has a dismal earnings track record with losses in five out of the past ten years and was only profitable in 2009 in the last five fiscal years. However, it generated positive free cash flow in every year since its listing in 2005. Web.com's gross margin fell from its 2008 peak of 64% to 56% in fiscal 2010. It has since recovered to achieve gross margin of 60% for fiscal 2012. Web.com's margins are expected to expand in future periods, as it reaps the benefits from the economies of scale as a result of its past acquisitions.
Web.com is highly geared with a gross debt-to-equity ratio of 428%. In October 2011, Web.com entered into debt financing arrangements totaling $800 million, of which $771 million of proceeds were used to pay off existing debt and to complete the acquisition of Network Solutions. As of Dec. 31, 2012, $701 million of the debt remained outstanding. On Feb. 12, 2013, Web.com announced that it planned to amend, increase and re-price its First Lien Credit Facility and use the proceeds of such increase to repay the remaining balance of its Second Lien Term Loan. It will seek improved terms on its First Lien Term Loan, which has a current interest rate of LIBOR plus 4.25%, with a LIBOR floor of 1.25%, and a balance of approximately $628 million at Dec. 31, 2012.
Since there are no direct listed companies comparable with Web.com, I have used business software and services companies: Adobe Systems (NASDAQ: ADBE), ValueClick (NASDAQ: VCLK), and Oracle (NYSE: ORCL) for peer comparisons. Adobe and Oracle sell business and enterprise software to companies; while ValueClick is a digital marketing services company. All four companies trade at 14-15 times trailing twelve month P/FCF; while Web.com is undervalued on a trailing twelve month P/S basis (2.1 times P/S) relative to the other three stocks. ValueClick, Adobe Systems and Oracle are valued by the market at 3.1, 4.4 and 4.4 times P/S respectively. However, all three of them are profitable with strong balance sheets. Adobe Systems and Oracle have net cash financial positions; while Valueclick's net gearing is only 10%.
Web.com's existing and target customers are SMBs, which are more likely to be adversely affected by economic downturns than larger and more established businesses. SMBs tend to behave more conservatively in light of a weak economic environment, and may choose to cut back on spending and resources to develop their online presences. The risk of business closure represents the greatest threat to lower than expected customer retention rates.
Web.com's ARPU growth is dependent on the successful retention and upselling of products to Network Solutions's acquired customer base, and its investments to drive growth. While Web.com was able to successfully increase ARPU from $15.39 in the four quarter of 2010 (post-acquisition of Register.com) to $17.38 in the fourth quarter of 2011, there is no guarantee that it can achieve the same level of success with Network Solution. Also, its new customer acquisition efforts through marketing activities such as the “Feet on the Street” direct sales initiative, a Direct Response Television campaign and a Tour Title sponsorship may or may not achieve the desired results.
Web.com is a proxy for the migration of SMBs online and is making efforts to reduce debt and lower effective interest rate, in addition to generating strong free cash flows to meet interest payments. Notwithstanding that it is cheaper relative to peers on a P/S basis; I will prefer to purchase Web.com when it shows signs of increased balance sheet strength and profitability.
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