First Union Securities Inc. Covers VRSN
12/27/00 5:20:31 AM
VeriSign (VRSN–OTC)
VRSN: UPGRADING RATING TO 2-BUY
Stock Rating: 2
Prior Rating: 3
Price Target: $90
KEY POINTS
We are upgrading VeriSign to a 2-buy from a 3-hold based on the attractive risk/reward profile at current price levels.
We believe the company’s near-term growth prospects remain attractive, and that EPS estimates will continue moving higher as the company reaps incremental synergies from its merger with Network Solutions.
VeriSign has one of the more scalable businesses on the Internet, and we expect further margin improvement as the company leverages its extensive infrastructure of data center operations across a larger revenue base.
VeriSign continues to extend its lead in the PKI market versus its primary competitor, Entrust. VeriSign’s total PKI sales in 3Q’00 (including deferred revenue) were roughly 65% higher than Entrust, whereas both companies were roughly neck-and-neck only 12 months ago.
In addition, through its merger with Network Solutions, the company boasts tremendous free cash flow and hefty returns on investment.
The only major wrinkle is the lingering uncertainty regarding the regulatory fate of the company’s Registrar business. The stock could remain somewhat volatile until there is further clarity on this issue.
Our DCF model implies a current valuation of $90, representing roughly 13% upside from current levels.
DISCUSSION
HIGH LEVELS OF RECURRING REVENUE
Verisign has high levels of recurring revenue, providing significant visibility on future earnings. Almost 44% of our revenue estimate for the next 12 months is reflected in short-term deferred revenue. At the end of Q3’00, VeriSign had $491 million in deferred revenue, including over $423 million in short-term deferred.
In addition, we expect at least 14 million domain names to come up for renewal in 2001. This should result in a significant boost in deferred revenue, beginning in Q1 2001, although the exact magnitude of the increase in deferred revenue will depend on renewal rates and average subscription lengths. Currently, VRSN’s renewal rate is running at 77% but we have factored in more conservative renewal rates of roughly 68%-72% in 2001.
MULTIPLE LEVERAGE POINTS TO EXPAND MARGINS
We expect operating margins to continue to improve, given the inherent scalability of VeriSign’s outsourced security infrastructure and registry business. For example, VeriSign can achieve significant leverage by layering in additional customers and revenue growth with little incremental investment to its existing infrastructure. With respect to the registry business, Network Solutions has built a highly scalable architecture that is capable of supporting approximately 50 million domain names. The registry is an incredibly profitable business today with 70%-80% operating margins.
In addition, the company can achieve even greater leverage on its substantial marketing expenditures through significant cross-selling opportunities and overlap in marketing expenses. We believe that these synergies will enable VeriSign to drive incremental revenue growth with little additional marketing cost between the two companies.
WIDENING LEAD IN PKI MARKET OVER ENTRUST
VeriSign is extending its lead in the PKI market versus its primary competitor, Entrust. VeriSign’s total PKI sales in Q3’00 (including deferred revenue, but excluding our estimate for SecureIT) were roughly 63% higher than Entrust, whereas both companies were roughly neck-and-neck only 12 months ago.
For Q3’00, we estimate that total PKI revenue at VeriSign was $57.7 million, including deferred revenue but excluding our estimate for SecureIT revenue, versus Entrust, which reported PKI revenue of $35.1 million, including deferred revenue, but excluding the contribution from enCommerce (roughly $8.7mm in Q3’00). This compares to Q3’99, in which both companies were neck-and-neck with roughly $23-24 million in PKI revenue each.
We believe that the shifting momentum in VeriSign’s favor in part reflects that customers are choosing an outsourced PKI service rather than an in-house software-based solution. Customers are choosing an outsourced service because of (1) lower upfront investment expenditures and (2) shorter implementation cycles versus an in-house software solution, and (3) far easier administration and management.
In addition, a recent IDC report on the PKI market suggests that VeriSign's core PKI outsourced services market should experience far more robust growth than in-house PKI deployments (Entrust model). IDC forecasts that the overall market for PKI software and services should grow at 61% CAGR between 1999-2004, reaching $3.0 billion in 2004. However, IDC forecasts that the sub-segment for outsourced certificate authority services (VeriSign model) should grow at a blistering 80% CAGR, reaching $1.78 billion in 2004. By contrast, the market for in-house PKI software deployments (Entrust model) is expected to grow at a much slower 45% CAGR, reaching $1.22 billion in 2004.
Although the domain name registration business generates tremendous free cash flow and attractive margins, many investors have expressed concern over decelerating growth in new registrations. As a result, the valuation of that business has been accorded a much lower multiple than VeriSign’s much faster growth PKI business. In effect, VeriSign shares have been penalized because it no longer represents a pure play on Internet security; but rather a hybrid model.
The good news for investors is that because PKI is growing far more rapidly than domain name registrations, VeriSign’s PKI revenues should comprise 40% of total revenue by 2002 from only 27% today. Network Solutions (which consists of registrar, registry, and value-add/consulting) today comprises 73% of revenue, but should be only 60% of revenue by 2002, with the registrar actually comprising less than 32% from 47% of revenue today.
In 2001, we forecast that VRSN could achieve $1.34 in cash earnings per share based on our analysis below. On a cash EPS basis, we believe VeriSign is reasonably priced. Moreover, our DCF analysis yields a present value of $85-$90. For purposes of our analysis, we add back the $60 million of deferred revenue write-off at Network Solutions. In addition, critical to our analysis is the assumption regarding the increase in deferred revenue (change in net working capital). We believe growth in deferred revenue will pick up significantly in 2001 driven by a substantial increase in domain name registration renewals.
Additional Information Available Upon Request
First Union Securities, Inc. maintains a market in the common stock of VRSN.
This is for your information only and is not an offer to sell, or a solicitation of an offer to buy, the securities or instruments mentioned. Interested parties are advised to contact the entity they deal with, or the entity that has distributed this report to them. The information has been obtained or derived from sources believed by us to be reliable, but we do not represent that it is accurate or complete. Any opinions or estimates contained in this information constitute our judgement as of this date and are subject to change without notice. First Union Securities, Inc. (“FUSI”), or its affiliates may provide advice or may from time to time acquire, hold or sell a position in the securities mentioned herein. FUSI is a subsidiary of First Union Corporation and is a member of the NYSE, NASD and SIPC. Copyright © 2000 First Union Securities, Inc. FUSI is a separate and distinct entity from its affiliated banks and thrifts.SECURITIES: NOT FDIC-INSURED • NOT BANK-GUARANTEED • MAY LOSE VALUE |
