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VeriSign (NASDAQ:VRSN)

Q3 2010 Earnings Call

October 28, 2010 5:00 pm ET

Executives

Mark McLaughlin - Chief Executive Officer, President and Director

Brian Robins - Chief Financial Officer, Principal Accounting Officer and Executive Vice President

Nancy Fazioli - Investor Relations

Analysts

Ignatius Njoku

Sterling Auty - JP Morgan Chase & Co

Daniel Cummins - ThinkEquity LLC

Edward Maguire - Credit Agricole Securities (NYSE:USA) Inc.

Walter Pritchard - Citigroup Inc

Chloe Wayne

Rob Owens - Pacific Crest Securities, Inc.

Craig Nankervis - First Analysis Securities Corporation

Sarah Friar - Goldman Sachs Group Inc.

Todd Raker - Deutsche Bank AG

Operator

Good day, and welcome to the Third Quarter 2010 Earnings Call. [Operator Instructions] At this time, I'd like to turn the conference over to Ms. Nancy Fazioli. Please go ahead.

Nancy Fazioli

Thank you, operator. Good afternoon, everyone, and thank you for joining us for VeriSign Third Quarter 2010 Earnings Conference Call. I'm Nancy Fazioli, Director of Investor Relations, and I'm here today with Mark McLaughlin, President and CEO; and Brian Robins, Executive Vice President and CFO.

Please note that this call and accompanying slide presentation are being webcast through our investor relations website located at investor.verisign.com. Please refer to our website for important information, including the Q3 2010 earnings press release. A replay of this call will be available on our website within a few hours. Today's slide presentation will also be available for download after the call.

Financial results in today's press release are unaudited, and the matters we will be discussing today include forward-looking statements, and as such, are subject to the risks and uncertainties that we discussed in detail on our documents filed with the SEC, specifically the most recent report on Forms 10-K and 10-Q and any applicable amendments, which identify important risk factors that could cause actual results to differ materially from those contained in the forward-looking statements. I would like to remind you that in light of Regulation FD, VeriSign retains its long-standing policy to not comment on financial performance or guidance during the quarter unless it is done through a public disclosure.

The financial results in today's press release and the matters we will be discussing today include non-GAAP measures used by VeriSign. GAAP to non-GAAP reconciliation information is appended to our press release and slide presentation, both of which can be found on our investor relations website. In a moment, Mark and Brian will provide some prepared remarks, and afterwards, we will open up the call for your questions. Unauthorized recording of this conference call is not permitted

With that, I would like to turn the call over to Mark. Mark?

Mark McLaughlin

Thanks, Nancy. Good afternoon, everyone. We're pleased with the performance of the business this quarter. We continue to see strength in the Internet trends that drive our business. Also, the team's ongoing operational discipline and execution leading up to and following the close of the sale of Authentication Services is helping to drive positive results. There is still a lot of work to be done as we transition the Authentication business. We're very focused on a smooth transition, which is on track, in which we expect to be largely completed in the mid-2011 time frame. I'll now cover the highlights of our financial results from the third quarter.

Revenue in the third quarter for a Naming Services was $172 million, representing an 11% year-over-year increase. Naming Services is comprised of Registry Services and Network Intelligence and Availability or NIA services. Non-GAAP earnings per share was $0.27 compared to $0.16 in Q3 2009. Non-GAAP operating margin was 43.1% compared to 33.7% in Q3 2009.

During the quarter, we utilized $146 million of cash to repurchase 5.1 million shares, leaving us with repurchased authorization of approximately $1.4 billion. In August, we received $1.28 billion in proceeds from the sale of the authentication business, which brings our cash balance at the end of the third quarter to $2.55 billion, approximately 65% of which is held domestically.

Operationally, in Naming Services, the base of registered names in .com and .net this quarter totaled 103.5 million names at the end of September, a 9% increase year-over-year. $2 million net names were added domain name base this quarter.

During the third quarter, we processed 7.5 million new registrations, which is a 7% increase year-over-year. The 2010 Q2 renewal rate was 73.2%, up from 72.1% in Q1 2010. While renewal rates are not fully measurable until 45 days at the end of the quarter, we believe that the renewal rate for Q3 2010 will be approximately 73%. For that domain name additions, we expect the Q4 net names added to the base to be between 1.7 million and 2 million names.

Q4 has a larger expiring name than in the third quarter and an increased number of first-time renewing names and expiring name base. In addition, in some previous years in the fourth quarter, we have seen some registrars doing year-end inventory reviews, resulting in some deletions at the very end of the year. While we review accounts on a regular basis, it is possible that there could be some deletions resulting from this kind of activity. It would not appear in our regular account reviews.

On the infrastructure front, the growth of the Internet, that is positive for our business, will continue to put increased demands on our infrastructure. In the third quarter, we processed an average $66 billion DNS queries per day, up from $63 billion queries on average per day last quarter. Also last quarter, I highlighted exciting developments with the implementation of DNSSEC [indiscernible] and a forthcoming implementation in the .net zone later this year and the .com zone next year. This is one of the most significant security enhancements for the DNS ever, and we are proud of our leadership role there. As we continue to show leadership for the next digital decade, we will plan to continuously invest in our infrastructure to enhance our readiness for any future DNS requirements.

Finally, as I know it is an area of interest for investors, we will continue to update you with regard to public developments and the case filed by the Coalition for ICANN Transparency or CFIT against VeriSign. In August, we regressed at the case management conference with the District Court to begin the process to resolve this matter through summary disposition or trial. That conference was held on Friday, October 22, and the court established a timeline for the litigation, including among other things, adopting the parties for post schedule for summary judgment on certain threshold issues with a hearing set for March 2011. And for final summary judgment, with the hearing set in October 2011, the court also set the trial date for December 5, 2011. Beyond the procedural updates, given that this is an ongoing litigation, we will not be commenting further other than to reiterate that we continue to feel confident about the case, and we'll defend our position vigorously.

With that, I'll turn the call over to Brian.

Brian Robins

Thanks, Mark, and thanks to everyone for joining us today. Mark gave you the highlights for the quarter, so I'd like to just dive into the key financial metrics that we're focused on for the year, revenue, deferred revenue, non-GAAP operating margin, non-GAAP EPS growth and free cash flow. As we noted, revenue for Naming Services was $172 million, up 3% from the prior quarter and up 11% year-over-year. From a continuing operations perspective, we are still on track to wind down the final non-core business, Content Portal Services or CPS in Q4. The business contributed $364,000 in revenue during the quarter to bring continuing operations revenue to $173 million.

Deferred revenue for Naming Services ended the quarter at $654 million, an increase of $13 million or 2% from Q2, and up 13% from the same period in 2009. Non-GAAP operating expenses were approximately $98 million, down 2% quarter-over-quarter and down approximately 5% year-over-year. Non-GAAP operating margin was 43.1% in the third quarter compared to 40.5% in 2Q. As we noted last quarter, there are number of moving parts related to the transition of the Authentication Services business to Symantec. We expect to have those substantially completed by midyear 2011. But in the interim, we may see some variability in operating margins as we head toward the 45% range in the second quarter of 2011 as we discussed last quarter.

A quick comment on the Transition Services Agreement with Symantec. We still expect that bulk of the TSAs to be completed in mid-2011. Note that the income from the TSA hits other income line, and the reasonable estimate is still $5 million for the second half of 2010, as well as for the first half of 2011. Non-GAAP net income for the third quarter was $48 million, resulting in non-GAAP earnings per share of $0.27 compared to $0.24 in Q2 and $0.16 in the same period in 2009, a 69% increase from 3Q 2009.

We exited the third quarter with a diluted share count of 175 million shares. During the third quarter, we repurchased 5.1 million shares. Operating cash flow on a consolidated basis was negative $82 million in a 3Q, a one-time impact cash resulting from taxes related to the sale of Authentication Services.

Free cash flow was $47 million in Q3, given $155 million in excess tax benefits and $26 million in capital expenditures in the quarter. Year-to-date capital expenditures are running $69 million, which includes approximately $20 million in spend during the year related to Authentication Services. Eight to 10% of the new revenue run rate is still a reasonable way to think about CapEx going forward for the remaining business.

Just an additional note to clarify, the significant increase net of tax benefits, we would have paid cash taxes related to the sale of Authentication Services if not for net operating losses related to stock options. Due to the use of the stock option NOLs, the cash flow statement must reflect the classification of $155 million as the use of cash and cash from operations and the source of cash in the financing section of the cash flow statement. In the Appendix our slide presentation, that will be posted on the website following the call, we have a cash flow reconciliation that you may find helpful.

Moving on to guidance. At this point, we believe we are making good progress to achieve or exceed our full year guidance. Naming Services revenue growth for 2010 of approximately 10%. Non-GAAP gross margin in the 77% to 78% range. Q4 exit non-GAAP operating margin increased to 42% to 43% from previous guidance of 40% to 41%. Non-GAAP other loss, net is expected to be a $20 million for 2010. Our guidance is based on continued growth and increased operating efficiencies in our business.

I would like to express appreciation of our employees during this transitional time in the business. Their hard work has enabled us to keep the transition of divested businesses on track. I'm very proud of the operational discipline the team has shown over the past several quarters. Going forward, we believe that we will be able to scale the business to a smaller footprint while continuing to seek opportunities to grow.

Thanks for your time today. Operator, we're ready for the first question.

Question-and-Answer Session

Operator

[Operator Instructions] We'll now go to our first question from Todd Raker with Deutsche Bank.

Todd Raker - Deutsche Bank AG

First of all, can you just talk about the stock buyback? Anything that prevented you in the quarter from buying stock were you guys blacked out as a result of the Symantec transaction at all? Just trying to get a sense for what we should be thinking run rate? And then secondly, can you talk about potential pricing? I know you you're guiding for -- well, I won't call it conservative, but net adds down here in Q4 with the growth profile still seems pretty healthy on a unit basis. And what's the likelihood that we'll get the last price increase announced?

Mark McLaughlin

Todd, it's Mark. On the buyback side, we don't comment on any blackout periods we may be. So I really can't get into the details about that. All what we can do is report what we've done at the end of the quarter, in the quarter. So I really can't get anything further than that. And on the pricing side, also as you know we've taken three out of four of the deposit price increases, we couldn't comment whether we intend to take the fourth one or when either as well. So we do think about those, as we mentioned before, take a lot of things into account. So you look at those included the economy, how the business is doing, how the registrar is doing and some other factors. A lot of positives in a lot of those areas today, but we can't comment as to if or when we take the next price increase.

Todd Raker - Deutsche Bank AG

Mark, maybe you could help us out because .net auto renews, I think, June of next year. So what's the time frame if you wanted to take one more price increase across .net? Can you do it all the way up until June? Or is there some time frame when you have to do that?

Brian Robins

We could take the pricing. We could notice a price increase in .net right up to the end of the term of the contract. If you were within six months or you noticed inside that six-month notice period, then the increase would take effect post the renewal.

Operator

And for our next question from Rob Owens with Pacific Crest Securities.

Rob Owens - Pacific Crest Securities, Inc.

Was curious on the new names added this quarter. It's slowed sequentially, I think, it was the first, kind of single digit number you've seen in a while. And do you think this is a function of just tougher compares? Is this something you're seeing in the economy? Anything from a geography standpoint?

Mark McLaughlin

Rob, it's Mark. No, I think on the new units that came in to the -- we got two million net units which is about a strong shelling, and then on the new side, we have $7.5 million. If you look back on historical basis over the last few years, I think three year and a half average, on that means that quarter is about $7.3 million. So it's actually pretty strong showing for net units if you look backwards.

Rob Owens - Pacific Crest Securities, Inc.

And then second, you guys filed a couple of patents recently. At least I think it was published that were patents filed. Just with regard to scoring and ranking of traffic into domain names, any comment there is that for future potential services you guys are looking at?

Mark McLaughlin

We do a lot of intellectual property work, Rob. So we have over 200 patents on file that have been issued or are being filed. So that's regular course of business for us to try to protect intellectual property that we develop, and we wouldn't get into specifics as to what we would do to commercialize unless we have already done so.

Operator

[Operator Instructions] We'll now go to our next question from Sterling Auty with JPMorgan.

Sterling Auty - JP Morgan Chase & Co

I was just wondering, is there any change in the sources for the new names? You talked about the momentum that's building. But is there any new factors that has helped driving name growth?

Mark McLaughlin

The big picture around this is that we continue to see good growth in the base itself and then we can peel back on the renewals. Those are going up nicely mostly because the previously renewed base is increasing. And then on the new units, the sources are continuing to be the same, strong international growth. And inside that growth, in the unit standpoint, the BRIC countries continued to deliver very nicely. So there's no dramatic shifts in the good trends we have been seeing.

Sterling Auty - JP Morgan Chase & Co

And then on the renewal rate, anything that we should think about in terms of the renewal rate as we enter from its seasonal factor both the third and fourth quarter and then longer-term into the 2011 time frame?

Mark McLaughlin

We had more expiring names this quarter than last quarter. So we always have to watch how many names are in the expiring base. So that doesn't impact the renewal rates. It impacts the math as a result of those things. And then on the mix, we will have slightly more expiring names, first time expiring names in the mix. So the combination of those things comes out awashed on the overall renewal rate. An expiring base is fairly steady as a percentage of the base, but we're not really expecting because the base is getting bigger. Does that make sense?

Operator

Next question comes from Walter Pritchard with the Citi.

Walter Pritchard - Citigroup Inc

I was just wondering, now that you guys have SSL closed, do you guys have any more clarity on the timing of transition expenses and how we should think about lumpiness in terms of margins going forward?

Brian Robins

Tim, this is Brian. As I mentioned in the prepared remarks, the Transition Services Agreement going to mid-2011, and the Transition Services Agreements are broken into things that can be taken out in the business such as staff that are doing billing and collections and international locations. But the majority of it is network services and infrastructure that we're providing that we'll keep post-transition. And so we expect mid-next year for that to be complete. And the lumpiness in the margins, you'll probably see for the next two quarters.

Walter Pritchard - Citigroup Inc

And then secondly on headcount, I think you guys are flat this quarter. Is that the number we should expect the company to be at going forward? Or you expect us to fill up over the next few quarters?

Mark McLaughlin

There's a couple of puts and takes on headcount, and so we're trying to manage the business to an overall margin profile and not necessarily to our obtain for a headcount profile. We're ramping down on the West Coast and ramping up on the East Coast. We have duplication for a period of time. And then also there's a number of headcount related to the CSAs. As those are [indiscernible], the headcount going down. Then we're also investing back into NIA network in our operability and availability. So there's some puts and takes. So the headcount for probably the next two to three quarters will be one quarter, it may go down, next quarter it may go up just because of the puts and takes related to the Transition Services Agreement.

Operator

Our next question comes from Phil Winslow with Credit Suisse.

Chloe Wayne

This is Chloe Wayne for Phil Winslow. Could you comment at all on your expectations for the managed DNS business in the near-term? And how should we think about the margin profile going forward as you continue to ramp it up? And just as a follow-up, when you look at competitors, like UltraDNS from NeuStar, what does managed DNS bring to the people?

Mark McLaughlin

On a general manner, we look at the market opportunity there. We look at the overall market is about $900 million market that is expected to grow at about 15% on an annual CAGR for the next three to five years. So the market opportunity itself was attractive. When you get inside that market, it's fairly fragmented market as far as who the players are. So we believe that given the network we have and the experience we have on that network, we have a competitive advantage there plus some name brand repetition that will help us from a selling perspective. So we haven't any guidance as to the business itself. It's not material to date at this point. But we like the space itself, and we will be involved in this space and try to grow that business. Relative to other folks that market from a managed DNS standpoint, other players have a list of services or suite of services of which Managed DNS is one of them, and we have that offering as well. So the idea is to provide ultimately an end solution were DNS-related services that are internal and external DNS.

Operator

Our next question comes from Sarah Friar with Goldman Sachs.

Sarah Friar - Goldman Sachs Group Inc.

Mark, can you talk a little bit about some of the newer things like DNSSEC? What can that mean in terms of a revenue opportunity for next year in terms of how much you charge customers, what sort of penetration do you think that you'll get? And then some of the other things that ICANN is working on like the new IDNs and the new TLDs. How do you think about that revenue opportunity and potential impact to your core registries?

Mark McLaughlin

Sure, on the DNSSEC side, there's two aspects left for us. On the core naming business itself, DNSSEC is the cost it's not a revenue generator because we have to do work in order to implement DNSSEC. It's a good thing for the infrastructure for the world using infrastructure. On the flip side of potential revenue opportunity in our NIA business, things like IPv6, DNSSEC, they make the network in DNS more complicated. So there's an opportunity there to help manage that on an outsourced basis as folks say this is more complicated and we like somebody to help us out with that. So it's across added revenue opportunity for us, but they're different sides of the business. And on the IDN side, we expect the new ccTLD in which we consider the idea and versions of common net to fill out the application process mid-2011 and be granted sometime in 2012. So the time frame as far as market expectations, we think these are opportunities for us. We're trying to be a bit measured on that given two factors that we know and this is a rough analogy. The one thing we know is that the IDNs that during com net base today, the English IDNs. Meaning comps is still on English like calm in front of it. That's about 1 million names in the base today and our base and that. And then on the global basis come if you look at ccTLD, it will be some countries that would be the prime suspects, if you will, for as far as sales that are in cyrillic or some other languages that's not English. There's about 16 million, 17 million total ccTLD that turn those languages. So it's a little hard to be specific if this one is where to come in. But we try to use those sort of English [indiscernible].

Operator

Our next question is from Dan Cummins with ThinkEquity.

Daniel Cummins - ThinkEquity LLC

As you look out and I know I heard you say Managed DNS is very small and young for you. As you look out, can you talk about your expectations for the distribution model? Why wouldn't this be another wholesale opportunity to work through the big tech partners like Go Daddy into it, Symantec and in small medium business? And would you expect it will be a mix of wholesale and the direct retail relationships at the high-end?

Mark McLaughlin

Yes, Dan. I think the answer is yes to all that. You got the right idea there. This looks like a traditional sales model where you'd go to market from a small field team going to the high end and then you have an inside sales force against. Getting into mid-market and then you have channel partners at the lower end of the market. And that lower end of the market is where we put our national partners and registrars discussions about the disturbing all these services. But we intend to cover the gamut of the market through those distribution channels.

Operator

[Operator Instructions] We'll now go to our next question from Ed Maguire with CLSA.

Edward Maguire - Credit Agricole Securities (USA) Inc.

I wonder if you could just shed any light on your broader thoughts on potential uses of cash for M&A or the possibility of a special dividend before the end of this year?

Mark McLaughlin

In the past, as we've said, we continue to view it this way. From an M&A standpoint, while it's possible that we could do some smaller deals that would help us, from a product roadmap standpoint or a go to market perspective, if we were to do something like that, we would need a few requirements to this core business. It wouldn't be large in size, and it would look at that weight something on the roadmap or go to market. So clear on what we do that. So speak in terms of what we might do and what the likely to do is new industries and we'll likely do anything like that. So from the perspective of using cash farm an M&A standpoint.

Edward Maguire - Credit Agricole Securities (USA) Inc.

As you look at opportunities to provide registry service, I would say when some of the new global TLDs come online, I know you talked about this as an opportunity. Have you done an analysis of what the business profile and margin profile of these types of services might -- how they might compare to your existing business?

Mark McLaughlin

There's two ways to look at that, both where we think are attractive. One is for a new TLD that we might want to go after ourselves and run outside of any marketing we have to do around that. From an operational standpoint, we have a lot of economy skills to add a new TLD on there. And secondly, if we were to back end registry provider for somebody else who have the TLD, we would still enjoy the network efficiencies we have by putting a new TLD on an existing structure. So from a margin perspective, would expect this is attractive for us.

Operator

And now for our last question from Craig Nankervis with First Analyst (sic) [First Analysis].

Craig Nankervis - First Analysis Securities Corporation

For you Mark, the guidance for Q4 net name ads is almost flat year-over-year at the midpoint. I guess I was a little surprised at that. Are there any factors on the negative side this year that's influencing your forecast versus your results a year ago?

Mark McLaughlin

There's a couple of things you're looking at there, Craig. One is when we looking at the expiry may be is relative to the third quarter, we have more expiring names in the third quarter than the fourth quarter. And then the second thing is we have slightly higher next mix in the third quarter and fourth quarter of names that are expired and up for renewal for the first time. As you may know, the first time renewal rate is substantially lower than the previously renewed.

Craig Nankervis - First Analysis Securities Corporation

I'm so more focused than that in Q3. But I'm not going to do that in Q4 last year versus what you're guiding for Q4 this year. And I'm trying to understand if there's any end of year dynamics that are different this year and end of year dynamics versus last year?

Mark McLaughlin

I think the dynamics is the same. We've seen a couple of times in the past like in the script that you might do the end of the year that might not be aware of, given an account review that would happen or not. But from a dynamic standpoint, it's the same.

Craig Nankervis - First Analysis Securities Corporation

Brian, sales and marketing was much lower than I expected, is $18 million on a non-GAAP basis. Is that sort of a baseline going forward?

Brian Robins

It will be. There's a couple of things in sales and marketing. In the second quarter, we had some one-time expenses. There was the campaign that Symantec took over into third quarter. So we didn't recognize that in the third quarter where we did in the second quarter. Also we had a one-time program related to the 25th anniversary of .com in the second quarter. So second quarter had a couple of one-time events. And as we won the things that we sold our business we took our enterprise sales force and the process of building that up. So you can expect it to be flattish to where it was now. It will gradually grow over time but with the percent of center revenue it will likely go down.

Operator

We'll now go to Katherine Egbert with Jefferies.

Ignatius Njoku

It's Ignatius in for Katharine. Can you talk about what you're seeing in the BRIC countries? Are you signing up more registrars?

Mark McLaughlin

Yes, the BRIC countries continue to perform well for us. If we get inside the base, about 60% of the base is domestic, and about 39% to 40% of it is international. And then if you get inside the 40% that's international, about 25% of that is, well, I'll call it, emerging, which is primarily BRIC. And if you feel that in one layer lower, then you find out the BRIC countries growth rate units is twice as high as what it might be more mature international countries. So the BRIC countries continue to perform well, but it's off a lower base. But we've seen really big growth there.

Operator

I will now turn the call back over to Ms. Nancy Fazioli. Please go ahead.

Nancy Fazioli

Thank you, operator. I'd like to remind you that Brian will be presenting at the Credit Suisse 2010 Annual Technology Conference on Tuesday, November 30, as well as at the Barclays Capital Technology Conference on December 8. And then Jamba! NIA Services will present at Lazad Capital Cloud Computing Investor Forum on December 9. The webcast registration details will be available on the investor relations website. Also Mark recently gave an interview on the Communicator segment of C-SPAN that can be viewed at cspan.org. Please call the Investor Relations department with any follow-up questions from the call. Thank you for your participation and continued support. This concludes our call. Thank you and good evening.

Operator

This does conclude today's conference call. Thank you for your participation.

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