Verisign, Inc (NASDAQ:VRSN)
Q2 2008 Earnings Call
August 6, 2008 5:00 pm ET
Ken Bond - Vice President of Investor Relations
Jim Bidzos - Executive Chairman, Interim President and Chief Executive Officer
Brian Robins - Acting Chief Financial Officer
Sterling Auty - JPMorgan
Phil Winslow - Credit Suisse
Sarah Friar - Goldman Sachs
Todd Raker - Deutsche Bank
Walter Pritchard - Cowen & Company
Rob Sanderson - American Technology
Israel Hernandez - Lehman Brothers
Manish Hemrajani - Oppenheimer
Garrett Becker - Merrill Lynch
Katherine Egbert - Jefferies
Fred Ziegel - Soleil Securities
Good day and welcome to this VeriSign, Incorporated Second Quarter 2008 Earnings Conference Call. Today’s call is being recorded. At this time, for opening remarks, I would like to turn the call over to Mr. Ken Bond. Please go ahead, sir.
Ken Bond - Vice President of Investor Relations
Thank you Robby. Good afternoon everyone, and thank you for joining us for VeriSign’s second quarter 2008 earnings conference call. I am Ken Bond, Vice President of Investor Relations, and I am here today with Jim Bidzos, Executive Chairman and Interim President and CEO of VeriSign and Brian Robins, our acting Chief Financial Officer.
A replay of this call will be available beginning at 5 PM Pacific Time via telephone at 888-203-1112 or 719-457-0820 for international callers and will be available through August 12. The pass code for both numbers is 9794237. The press release and financial information discussed on today’s conference call are available on the Investor Relations website at investor.verisign.com. The Q2 2008 press release is available on FirstCall, Market Wire, as well as the VeriSign Investor Relations website. For those of you joining us via webcast, we also invite you to view the slide presentation, which accompanies today’s conference call. These same slides will be available for download from our website 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 discuss in detail in 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.
Additionally, financial results in today’s press release and matters we will be discussing today include non-GAAP measures used by VeriSign. Our non-GAAP income statement and a description of items excluded in our non-GAAP financial information is located on the VeriSign Investor Relations website. Also let me quickly mention that we expect to file our 10-Q no later than next Monday.
As an early reminder, our Analyst Day originally scheduled for September has been moved to November 12 in New York City at the Western Hotel near Times Square.
In a moment, Jim and Brian will provide some prepared remarks and afterwards, we will open up the call to your questions. Unauthorized recording of this conference call is not permitted. We anticipate the call will end before 3 PM Pacific Time.
And with that, I would like to turn the call over to Jim.
Jim Bidzos - Executive Chairman, Interim President and Chief Executive Officer
Thanks Ken. In this call, I would like to start with comments on key announcements we made during the quarter, followed by a review of our business and operating results for Q2. From there, I would like to touch on some areas that we believe are of particular interest to investors based on conversations we’ve had with shareholders including how we are managing the business overall and an update on our divestiture activities.
Brian will then discuss the financial results for the second quarter and provide limited guidance before we move to the Q&A portion of the call. As we announced in early July, we made a management change and I assumed the role of President and CEO on an interim basis in addition to being named Executive Chairman.
Subsequent to that announcement, we spoke with a number of shareholders and analysts, and I would like to share with you some insights from those discussions. Most important is that our strategy has not changed. We remain focused on protecting and growing our core businesses, executing on the sale of non-core businesses, and rightsizing our business once the divestitures are complete.
As we look to grow the core, we will continue to invest in those opportunities where we expect to see solid returns on a risk adjusted basis. Let’s be clear that these modest investments do not signal the return of an M&A growth-oriented strategy, nor do they signal any significant change to the improvements in operating margin that we expect to see.
We’ve also made very good strides in addressing our capital structure but we are not done and we believe the capital structure changes will remain an area where we can further unlock shareholder value.
Q2 was a solid quarter driven primarily by our core franchises of Naming and SSL. We reported core revenue of 233 million, which was at the high-end of our 228 to 233 million guidance.
Additionally, businesses we intend to divest performed better than expected again making for a solid quarter all around and I would like to thank all of our employees for their focus and continued commitment to VeriSign.
The non-GAAP operating margin for our core businesses during the second quarter was 34.2%. We are pleased with this result as it puts us in a very good position to achieve our Q4 exit rate target of 35% or higher. Non-GAAP earnings per share for the core businesses was $0.25, $0.02 ahead of consensus estimates due to strong revenue growth and lower than expected operating expenses.
As announced in February, we entered into an accelerated share repurchase agreement to repurchase $600 million of shares. The ASR agreement was completed in July when we received an additional 1.4 million shares over and above the 15.1 million shares we received in Q1.
Also in July, following completion of the ASR, we repurchased 3.5 million shares. These shares as well as the incremental 1.4 million shares received as part of the ASR completion will be reflected in the Q3 share count which Brian will discuss later.
This week, the Board of Directors approved an increase to the total amount authorized for share repurchases. As of this week, we now have $1 billion authorized and available for share repurchases. Since recommencing share repurchases last year, we’ve reduced the common shares outstanding by more than 28% over the last four quarters.
Moving now to business metrics for the second quarter, I would like to talk a bit about our core businesses starting with Naming. Our Naming business continues to show good growth as the adjusted zone for registered names in dot-com and dot-net totaled 87.3 million names at the end of the quarter compared with 84.4 million names last quarter, a sequential increase of 3% and an increase of 20% year-over-year.
Historically, the second quarter is seasonally weaker for adjusted zone growth and the net increase of 2.9 million names this quarter reflects that normal seasonality for traditional naming customers. As discussed in the past, our Naming business includes domains registered by registrars who operate in many industry segments. Traditional names represent 91% of the adjusted zone, while names registered for the purpose of online advertising represents 9%.
This quarter’s net increase reflects some weakness among a few online advertising customers largely resulting from changes in Google Smart pricing program with Adsense, especially with regard to less valued Adsense words. Additionally, industry litigation around the use of certain domains in online advertising discussed in Q4 is affecting the space as well.
A percentage of new name registrations represented by online advertising was 8.5% this quarter, down from a historical high of 12% in Q2 of last year. We believe that the new policy implemented by ICANN in July with regard to the five day grace period will cost some lower valued names to not be registered. However, a healthy portion of online advertising Naming customers are not solely reliant on the five-day grace period.
Registrars with bifurcated models using their own tools or the daily analyzer tool we make available to all registrars continue to have active and healthy portfolios. Over the remainder of this year, we are internally forecasting a slowing of growth related to names registered and renewed for the purpose of online advertising. However we are also forecasting increased traditional name growth from international markets, especially those markets we’ve targeted with distributor and end-user domain campaign. To be clear the challenges being discussed today have been limited to our online advertising business.
In total, we processed 7.5 million new domain name registrations during the quarter compared with 7.1 million names last year. The underlying growth drivers are consistent with prior quarters as we saw a solid growth in both US and international regions. While we continue to see solid growth domestically, we also continue to develop our international opportunities, regions that we see as showing significant growth potential for both dot.com and dot.net overtime.
We also saw continued growth from most customer segments including traditional corporate, SMB and consumer. This growth reflects unit growth and the entrance of new registrars in key customer segments and growing international markets.
The renewal rate for Q1 was 74% consistent with Q4. Renewal rates are not determinable until 45 days after the end of the quarter. As a result, we report renewal rates on a one quarter lag. As a reminder, we announced in March that effective October 1st, registry fees for dot-com and dot-net names will increase by 7% and 10% respectively to $6.86 and $4.23 per year, which at these prices we believe continues to be an outstanding value.
Finally, our internet infrastructure continues to operate at ever increasing levels and recently we saw peak loads of over 48 billion DNS requests per day as our systems again demonstrated VeriSign’s capability of being able to operate global networks at this scale and reliability remains unparalleled due in large part to our continued investment in infrastructure such as project Titan. And my thanks to all the employees who work in our tech operations’ facilities that keep uptime record for us.
In summary, no one else, no one has operated a global network infrastructure of this nature, at this volume level or with 100% uptime over the last 10 years, even as we remain the most attacked global network on the planet
Moving to our security services, our second core franchise, SSL saw the install base for the quarter increase to 1,056,000 certificates compared with 1,024,000 last quarter and 923,000 in the same quarter last year. We are very pleased as this growth represents 3% sequential growth and 14% year-over-year growth in the base. The Q2 annualized average unit revenue or AUR for the install base of VeriSign, GeoTrust and Thawte branded certificates was $258 this quarter, down from $261 last quarter and up from $256 the same quarter last year.
The sequential decline in AUR was the result of continued shifts in product mix as GeoTrust continues to grow faster than the overall portfolio. Looking forward, order shifts and product mix coupled with international expansion could result in further AUR decline; however continued strong growth in the number of certificates leave our revenue expectations for low double-digit growth intact.
While still a small portion of our SSL business, we continue to be pleased with the results of our extended validation or EV certificates, as nearly 6000 internet domains have gone green with EV. Q2 demand for EV certificates continued to be strong as we more than doubled the units sold a year ago. We are seeing a growing stream of customers including Banc of America, Aetna, Buy.com, General Electric, Money Bank and JP Morgan Chase amongst others go green with EV.
A necessary foundation to displaying the green bar and ramping our EV business, our EV-capable browser, such as Microsoft, Internet Explorer 7, Firefox 3, and Opera 9.5. Currently, EV-capable browsers represent just over 50% of the market and as this continues to grow, this should only help further the growth of EV certificates. We also continue to work with customers to document the benefits they are seeing with EV certificates including higher click-through rates and lower abandonment rates has got customers recognize the green bar and the VeriSign seal which is now seen approximately 150 million times a day.
In summary, we are pleased with progress in this business as we remain the #1 provider of EV certificates with market share of 75% and growing as measured by a third party research firm.
Coming into 2008, we set aggressive goals for our EV Certificate orders and while we are pleased with all the positive signs, this quarter we started seeing some effects of the economic slowdown. EV adoption within large scale customers was less than what we had hoped for and we could see the order acceleration we expected for later this year being pushed out.
Now I would like to share some comments on the progress of our identify and authentication services business. Within IAS, the strength continues with VIP and one-time password programs as we have now distributed more than 1.9 million credentials and we continue to be pleased with the strong uptake of credentials by consumers and we expect to see this adoption continue to ramp. We believe that IAS has the potential to form a third core franchise for the company over the next few years.
This quarter we also announced that VeriSign was selected by Microsoft as an OpenID provider for users of HealthVault(NYSE:TM), a free service that enables consumers to store and manage their health information online. In working with Microsoft on HealthVault(TM), we are able to combine the convenience of OpenID single sign-on with second factor authentication under the VeriSin VIP program.
I would now like to comment on some areas that we believe are of interest to investors based on discussions we’ve had over the last month since the management change. After announcing our strategy to focus on core businesses, we organized our management team using a divided focus approach and have been pleased that as a company we remain focused on continuing to protect and grow our core businesses.
We have also been able to maintain operating continuity for those businesses being divested which again performed above plan. In addition to managing the businesses day-to-day and executing on plan, we are also investing for growth in next generation products and services which fit our D&A ground global scale and trust. These investments are what I would describe as marginal with little to no effect on our operating margin expectations for continued improvement.
Moving now to an update on our divestiture efforts, this is the primary area where we are feeling the effects of the economic downturn, as it has become clear over the last few weeks that the sale process will take longer and be more complicated than we originally anticipated.
We’ve expected and have seen a normal removal of potential buyers as we work our way through the sales process, but a longer timeframe for completing the divestitures is reflective of the broader economic environment. As market conditions have worsened, buyers are taking more conservative postures, making it difficult to bring deals to closure, and it has become apparent that the approaches to deals we believe would work at the beginning of the sales process will not work today.
As recently as late July, we were in very advanced discussions with potential buyers for two of our largest businesses, but these discussions have now been suspended. As an example, one of the divestitures we expected to announce during Q2 was delayed by a very late-stage requirement calling for audited carve-out financial statements, even though the potential buyer had initially agreed no audit would be required. In addition, we could not reach an agreement regarding certain key closing conditions. As another example, the other divestiture stalled because the potential buyer decided the environment and timing are not right for them.
As a result, we’re adapting to the weaker economic environment and we’ve already begun the process of ensuring that we have audited carve-out financial statements for each of the larger divest business units. We have already completed the audit process for one of these businesses and are aggressively working to complete the process for the other two businesses as soon as practical.
While recent events would suggest it will now take longer than our original expectation to complete the divestiture plan, our commitment to sell these and other non-core businesses has not changed. And as recently as this week, the Board reaffirmed its commitment to the divestiture strategy. We fully expect that these businesses will be sold.
As Brian will discuss later, our disciplined management of non-core businesses again led to better than expected operating performance. The importance of executing on planned divestments in an expedient manner remains a top priority. But we remind ourselves that while these events are important, the key to unlocking shareholder value will be driven by what happens in our core businesses, more so than the timing or sales proceeds of non-core businesses.
As we’ve said before, 2008 is going to be a very interesting year with a lot of moving parts, but the end result that VeriSign will be smaller and a much better positioned company for the future is unchanged.
I’d now like to turn the call over to Brian for a walkthrough of our financial results for the second quarter as well as guidance. Brian?
Brian Robins - Acting Chief Financial Officer
Thanks, Jim, and thanks to everyone for joining us this afternoon. Before looking at the second quarter, let me mention that we expect to file our 10-Q no later than next Monday. Also, I’d like to provide an update on the financial reporting of the businesses we intend to divest and their placement into discontinued operations.
As we have said previously, in order for a business to qualify for discontinued operations, it must first meet several criteria, including management having the sufficient authority to sell the business, the business being available for immediate sale, an active program to sell the business having been fully initiated, and its sale being probable within one year. Further, we must conclude there is no significant continuing evolvement in the operations of the business once it is sold.
This quarter, we placed the Communications Services business into discontinued operations. Of the businesses being divested, Communications is the largest and most valuable. Discontinued Operations now includes two of the three largest businesses, Communications and Enterprise Security. The other two businesses currently included in discontinued operations are Communications Consulting and International Clearing.
The Digital Brand Management Services and Content Delivery Network Services were sold during the second quarter. The historical results of DBMS are reported in discontinued operations. However, because of our equity ownership in Kontiki, the results of this business will remain in continuing operations.
The businesses not yet qualified for discontinued operations are messaging, prepaid billing, real-time publishing and postpaid billing. Let me briefly talk about each of these now.
Messaging is the third of the three large businesses we are divesting. We began marketing efforts in late May with feedback in early July, showing interest in both parts and the whole of the messaging business. Based on the sales process and the accounting standards, we intend to place messaging into discontinued operations in the third quarter.
During the second quarter, we settled litigation matters relating to our prepaid business have decided the best course of actions to wind down that business. We’ve already notified our customers as well as effective employees and the business will remain in continuing operations until it’s completely shut down sometime during the first half of 2009.
We expect to begin marketing the real-time publishing business this quarter and we continue to evaluate strategic alternatives for the postpaid billing business. While we are hopeful that we will substantially complete the largest transactions this year, our recent experiences including the macroeconomic environment lead us to believe that some of the divestitures will close in 2009, as Jim alluded to earlier.
Lastly, despite the macroeconomic challenges, we are pleased by the operational progress we have made with the variables we can control as we execute on our strategy and move toward our in-state organization.
As discussed in our last earnings call, and as Jim mentioned earlier, we have adopted a divide-and-focus approach to run the business. We continue to see the benefits of running core and non-core business as standalone operations, and this focus is reflected in our current financial results.
We have taken a number of steps in the first half of 2008 to drive focus, transparency of results, and ownership in the non-core businesses. For each business, we have monthly operating review meetings, cross-functional integrated capital meetings, have substantially completed the in-state org design and have lowered the number of overall people by having dedicated product teams. We’re very happy with our progress to-date.
Moving now to a more detailed discussion of results for our core business, Q2 was another solid quarter. Revenue of our core business came in at the high-end of our guidance at 233 million, up 4% sequentially and up 21% year-over-year. The growth was driven again by the continued strength of our core businesses.
Turning to operating margins, as we continue to execute our strategy, we are seeing operating leverage is reflected in non-GAAP core operating margins of 34.2% for the quarter. This represents the significant incremental improvement of nearly 400 basis points. These results reflect focused and disciplined expense management around labor and corporate overhead, and they also reflect approximately 100 basis points of improvement due to the deferral of depreciation as our Delaware data center is coming on line in Q3.
Non-GAAP cost of revenue and operating expense for the core business were 153 million, down 2 million from last quarter, primarily due to lower labor expenses from both regular and contingent workforces.
Below the operating income line, we incurred a non-GAAP loss of approximately 7 million as the interest expense related to our convertible bonds more than offset the interest income.
We continue to expect that other income will be negative over the remainder of this year due to lower interest income. We continue to carry less cash in our balance sheet as we have aggressively repurchased shares over the last year.
Non-GAAP core net income for the second quarter was 50 million, an increase of 14% over the prior quarter resulting in non-GAAP earnings per share of $0.25, $0.02 above our internal plan due to solid revenue results and disciplined expense management. The diluted share count used in EPS calculations was 203 million shares, down from approximately 210 million shares last quarter.
Moving on to cash flow and balance sheet items. Operating cash flow for the quarter was strong, $169 million. There were multiple drivers for the strong operating cash flow this quarter, including continued strength in the core business.
Our primary businesses of Naming and SSL have very favorable characteristics of receiving cash payments well before revenue has been fully recognized. Over time, we expect we will increase our comments around cash flow measures in discussing our financial performance in addition to the current financial measures.
Capital expenditures for the quarter were 34 million. Last month, we brought on line a new data center in Delaware. This data center is a state-of-the-art and now provides the company with two fully hardened data centers with geographic diversity, while still maintaining real-time data replication between the two facilities.
Our ability to consistently generate solid operating cash flows resulted in our maintaining a strong balance sheet with ending cash, equivalents and restricted cash of over $669 million, up nearly $137 million from last quarter. In addition to the strong operating cash flow mentioned earlier, we also received nearly 50 million in sales proceeds from the sale of real estate. Lastly on cash, we paid off the $140 million balance on the line of credit this quarter.
Net DSO for the second quarter was 41 days, consistent with last quarter. Deferred revenue ended the quarter at $780 million, up 19 million or 3% from last quarter. The growth in deferred revenue stemming from core services continued to be strong as we saw year-over-year growth of 17%.
We ended the quarter with approximately [1,300] employees, down 250 from last quarter largely due to completed divestitures and planned head count reductions. Head count will continue to decline through the second half of the year with the sales of non-core businesses and further reductions in shared services head count.
Moving now to guidance. This quarter we will again provide guidance for our core businesses, which are Naming, SSL and IAS. We also include VeriSign Japan in our core numbers given its focus on SSL and IAS services.
For Q3, we expect revenue for the core businesses will be in the range of 236 to $241 million, reflecting year-over-year growth of 16 to 19%, leaving us in a very good position to meet our annual guidance calling for full year growth of 18 to 20%.
We expect the Q3 non-GAAP operating margin will be similar to this quarter’s 34.2%, give or take a percent. Offsetting the expected continuing improvements in operating margin is the inclusion of depreciation expense not incurred last quarter. Likewise, lease expenses associated with real estate previously owned will impact operating margins.
Looking forward, even with likely delays in some of the divestitures, we continue to expect that we will exit 2008 with non-GAAP operating margins of 35% or higher as operating margins will benefit from the actions we have taken in our divide-and-focus approach. We also expect to aggregate of items below the operating income line will be similar to this quarter’s results due to continued expectations that interest income will be lower this year on both lower cash balances and interest rates.
Finally, before considering the effect of our convertible debt offering, we now expect that the fully diluted share count will be approximately 198 million shares. The convert could add another 3 to 5 million shares.
In summary, we are very pleased with our business execution in the second quarter, particularly as it relates to revenue growth from the core businesses as well as non-GAAP operating margin expansion. We remain focused on executing our strategy as we clearly see this as a key to further unlocking shareholder value longer term.
We would now like to open the call for your questions. Operator?
Thank you. The question-and-answer session will be conducted electronically. [Operator Instructions]. And we’ll go first to Sterling Auty with JPMorgan.
Yeah, thanks. Hi, guys. So, on the divestiture timing, I just wanted to be clear, do you expect to get any of the big three divestitures done in ’08 or do you think maybe you are going to have to break up the big three into smaller pieces?
We would like to – of the large divestitures we hope that we get some completed this year.
Okay. And then, as you look at on all three of the big divestitures, are there still strategic buyers that are interested or are you at a point where it’s mainly just financial buyers?
No, there are still strategic buyers at the table, and in the case of one of the large businesses, we have completed financials and we have a strategic buyer that we are in discussion with. So there is – it is certainly possible that we could still achieve some of the goals we have set for ourselves in ’08, but we are prepared for it to take longer.
Okay. And then last question, you mentioned kind of what you’ve done with the pacing impact in your own interim model you being a little bit more conservative, but can you quantify that to a certain extent, does the kind of 8% in the mix from online advertisers does that go to 5, 4, how far down does it go?
Can you repeat the question?
Yeah. So I am wondering, you mentioned in your prepared remarks that in your internal forecasting that you’ve taken into account the impact from the new ICANN rules on online advertising and pacing and that you kind of assumed a smaller amount of online advertiser names. I am just kind of curious how small do you think that can get in the mix in terms of the percentage?
Got it. So, traditionally Sterling it’s been 8 to 10% of our adjustive zone and then on a new registrations on a quarterly basis it’s been in a range of -- well last year we had a historical high of 12 or at about 8.5%. We do think that it could come down a little from the 8.5% this quarter. We kind of have to wait and see though. To be really honest with you, there is a number of things that are going on here, the Google changes that Jim made reference to earlier, and then as well the ICANN policy change that took effect on July 1. We did see some initial effects in the early part of the month of July, but subsequently since then in the weeks following, we’ve seen it appears to be almost a near recovery of that. So, we are still kind of working our way through to kind of understand what the impact on these changes is going to be.
Alright, thank you.
Next question please?
We’ll go next to Phil Winslow with Credit Suisse.
Hi guys. I just want to follow up on the domain name front. You talked about sort of a deceleration there as far as expectations go, so bit of a drop off obviously year-over-year this quarter. What do you think is the appropriate sort of growth of this year, but also when you do put your long-term thinking cap on for just the dot-com and dot-net basis?
Phil I apologize. I think we are having a hard time hearing here trying to make sure we get the gist of the question right before responding.
Yeah, it was just the -- what do you expect for growth as far as the second half in dot-com and dot-net in the base and then what is the appropriate long-term growth rate there from a unit perspective not dollar?
Okay. So, in this quarter we saw a net increase of 2.9 million names. Over the last number of quarters, we’ve seen growth rates more in the range of say 3 to 4 million on a quarterly basis, so clearly we are seeing some effect here as a result of the changes we talked about earlier. I think that the results that you saw this quarter are probably indicative of what we might see in the next quarter and then at Q4 we will have to take that one as they come.
And then just finally on the SSL certificate side, also just maybe get a sense of the growth in that base there?
The overall growth in SSL that we talked about in the past is we are looking for revenue growth in the low double-digit range, so in the 10 to 12% kind of range and that is indicative of the AUR trends that we talked about earlier, where we do think that due to product mix, there is a potential for the AUR to come down a little bit just due to product mix shift. So what’s that’s telling you essentially is that the unit growth would be higher than the revenue growth.
Great. Thanks, guys.
Thank you. We’ll go next to Sarah Friar with Goldman Sachs.
Hey guys. This is Fred Grieb for Sarah Friar. One quick question on the EV certs. You said you were thinking the uptick was going to push out a bit, should we be thinking middle of 2009 for that now, just kind of wondering when I should be ticking up my ASP for that business?
I think it’s difficult to say exactly when. I mean the two factors that we can see that might be influencing this are; one that we were both quite frankly, we have minimal if any control over. #1 is the general economic conditions. I think there are some people who especially in the larger enterprises who may not be buying as many EV certs for their particular use as they may have. That could change if they start to see success which we believe they are with the certificates that they do deploy. And, the other issue there is the browser base that’s capable of supporting them. So, the trend there is likely to be good, but it’s difficult to say exactly when it’s going to happen. Could be this year, might be past the end of the year.
Okay. And then, one follow-up on the margins. Basically because you guys are kind of taking a little bit more of a growth stance, about how much of the margin expansion once we get to the 35% range do you think is going to come from revenue growth, fixed cost base and how much is going to come from additional cost cutting?
It’s going to be a combination of both. This quarter we had a great quarter of 34.2%. We expect next quarter to be roughly about the same. There is a couple of things that are going to happen in the third quarter that did not happen in the second quarter such as we have an ICANN increase, the Delaware data center is coming on, so we have additional depreciation, also we have the leased expense related to the building sale. So, we are committed to exiting the year at 35% or higher and on a go forward basis it's going to be a mix between the revenue growth and additional savings of the shared services.
Fred, it’s Ken. Just one thing I want to make sure that does not get lost here is that when we first set out with these targets of 35% or higher, it was based on an expectation of the completion and execution of the divestiture plan that which allowed us to take cost out even with some of those divestitures now pushing out we still will make those targets. I think that's important for folks to keep in mind.
And another point I would like to add as well is that, we plan to make those margin targets while still being able to make these marginal investments that we talked about in growing the core businesses. And so, we are able to do everything that we think represents good solid risk adjusted leveraged opportunities to add incremental revenue.
Great. Thanks a lot guys.
Thank you. We'll go next to Todd Raker with Deutsche Bank.
Hi, guys. I wonder if you can just talk a little bit more broadly in terms of what you’ve seen from a macro environment on the SSL business and the dot-com, dot-net business? And then, how exposed do you think you guys are to potential slowdown and especially if you can talk about kind of July trends, I know you said you saw a little bit of a snap back, but if you look at the traditional side of dot-com, did you see a deceleration in July that was separate and distinct from the online ad? Thanks.
I couldn't hear any of that.
Todd, we are having a problem on our side hearing. We got the first part. If I got it right, commentary around the macroeconomic environment and how that might be affecting SSL and the Naming business, is that fair?
Yes, and if you can speak, you had some commentary on the July trends in the net ads around the online advertising, could you comment to the traditional side, the 91% of the basis not impacted here by tasting and did you see any deceleration in July in that portion of the base?
No. The growth that we saw in Q2 and then the early signs of what we have seen here in Q3 on the traditional name side of the business continue to be strong. To kind of put some perspective on this, in Q2 for the traditional name we saw growth of 21% year-over-year. To kind of put that in perspective, last quarter it was 22% and then a year back it was 23%. So we've actually seen a very good holdup of the traditional naming business.
I think just to put that in some perspective, we’ve been developing a number of different charts here and as I study these and looked at the underlying data, what sort of -- makes an impression on me as I look at these is that we are actually looking at a curve that's a 12 or 13 year curve, essentially since the internet became the worldwide web in the early to mid 90s is when you saw obviously the growth of the web and domain names. And there are lots of different things that have happened that had some impact in the growth of names at that time. But if you are looking at a very very long-term curve, you would expect that by virtue of the absolute number of names that exists that the growth rate will start to slow. And if you take out, eventually you might even refer it to as sort of many bubbles like for example, these advertising names, you see that that curve is actually quite smooth over a long period of time. The market is very resilient. The people who make money selling domain names are very creative. We also have a number of different ways that we can manage that business and also a large number of opportunities to invest for growth and the international space is the best example that I can give you. So, when you put all that together, I think in general that curve is much smoother than the near term data measured in weeks or months or even quarters might suggest.
Thank you. We’ll go next to Walter Pritchard with Cowen & Company.
Hey, couple of questions, most of mine have been answered. I guess just on G&A expense, that ticked up a bit this quarter, we were expecting that that may tick down as you just continue to take some of the fixed cost out of the base, what was the reason there?
As we mentioned earlier in the prepared remarks that G&A also has some of the cost from the discontinued operations and so when you look at some of the cost ties in this sort of transitional period, it’s tough to look at G&A quarter-to-quarter, sales and marketing quarter-to-quarter, cost of revenue quarter-to-quarter, overall operating margin is what you should look at holistically by the business. As we get the businesses divested and get the shared services out, they will be much clear on a go-forward basis.
And can you just give us a sense of how much of the discontinued ops cost is still embedded in G&A? That sounds like the biggest category that that’s still being influenced by?
Yeah, we have -- it's a great question and as we go through our in-state organization in doing our planning, we currently try to assess that. There is roughly about $300 million of undefined cost in the business that support both core and non-core and so we are in the process as you currently expect every quarter going through the contracts, the network, the technology and the people and trying dedicate as possible to specific products.
Okay. And then just as it relates to the CEO search, I know maybe pretty early in the process and Jim we just -- many of us just met with you maybe in the last few weeks. But, any update on candidates there or that process in general?
Any update on …
Sorry, CEO search?
Yeah. So, basically I have over the last month during July, I have interviewed the number of search firms. We had a Board meeting this week and I believe we have selected one I would like to tell that myself and not do it on this call. So, the immediate progress report is the selection of the search firm to work with.
And then just last question on the EV, somebody ask similar to this but just as a clarification, it just seems like that most of the EV search have been sold into large customers and it seems like it’s still not a very big line item and you are talking at most a couple of thousand dollars. I am just wondering why you are seeing economic impact there, if you just elaborate a little bit more on that?
Yeah, economic impact that we are seeing is actually the largest enterprise customers and the financial institutions are going through a lot of turmoil right now and so really it’s more of a focused issues. You know, with the results are on track, the curve that we are talking about is getting pushed back a quarter, two quarters, but we are happy with the progress that we are making on that.
Yeah, don’t underestimate also how many certificates some of these large organization have. So, upgrading them all at once might actually be a number that’s significant enough for them to have their attention drawn to?
Yeah, that’s the point I was going to hit that it’s not that we are seeing any kind of disappointment here Walter I mean, the 100% year-over-year growth. But as Jim kind of points out what you might expect enterprises might take larger volume of EV certificates, they are just slowing down a little bit on the adoption on EV. They are taking in total the same numbers certs, just a little bit less on the EV is kind of distract with other issues.
Great. Thanks a lot.
Thank you. [Operator Instructions]. We will go next to Rob Sanderson with American Technology.
Yeah, thank you and good afternoon. First, a question for Brian. For the third quarter you mentioned incremental depreciation expense and lease expense on properties you previously owned. Can you give us a sense of the magnitude of the total incremental that we should be thinking about for the third quarter?
Just in this category it’s about 4 to $6 million.
Terrific, thanks. And then, second question on the PPC online advertising customers, you said 8.5% of the base. How do you know what names are pay-per-click driven? Is it really best guess or do you somehow know with certainty what kind of customer type that registers what names?
One more time please.
Sure, the online advertising customers 8.5% of the base. How do you know what names are pay-per-click driven and is there some way that you know with certainty or is just a best guess estimate?
We have a proprietary index that we use in determination that basically we use consistently over time to measure what portion of the base is paper-click driven or online advertiser oriented. It's a consistent measure and approach that we use to determine that and so this quarter it's 8.5% it’s been as high as historical high, a little over 10% of the adjusted zone in total.
Okay, thank you gentlemen.
Thank you. We’ll go next to Israel Hernandez with Lehman Brothers.
Hey guys. You talked about rolling out the new services around the core DNS and SSL business, can you give us an update as to where we stand with those and how long before we start seeing some services out of VeriSign. We are talking about sometime 2009, 2010 what's the timeline there? Thanks.
Israel, look for those new services probably coming in the later part of this year. Some of these are actually out in beta data form already with customer. I think we are at those near stages where we are getting ready to go with them live. We are pretty close there. Next question please?
Thank you. We’ll go next to Manish Hemrajani with Oppenheimer.
Hi, guys. You mentioned that you had about 7.5 million new domain names in the quarter. Could you give out the number of renewals?
The renewal was little over 12 million.
Little over 12. On the SSL side, on the ASPs, could you give some color on the sequential decline in AURs. Is there more of a GeoTrust mix in play here?
That’s exactly. VeriSign was up, Thawte was flat quarter-to-quarter and within GeoTrust there is two brands rapid SSL. We made a concerted effort this quarter to actually go after the low end of the market and we are successful in that, so we had more units at less cost per unit which lowered AUR.
Got it. Thank you.
Thank you. We will go next to Garrett Becker with Merrill Lynch.
Hi, good afternoon. Excuse me, I think most of mine have been answered. But I was wondering, I know it’s a little bit early, but perhaps you could talk about some of the new initiatives that Icon has put forward in terms of opening up the global top level domains and just how you think that may impact your business going forward?
Sure. I am certainly talking about the GTLDs that they have announced that they will open up in the future. So, first of all, we think that’s good that creates a larger space, it creates more names, it’s good for the internet. The internet is good for us. In the short-term, we find it difficult to assess the negative, any negative impact. I would say it’s more neutral to positive. First of all, ICANN has announced that they will be publishing a process by which parties can apply for new GTLDs that looks like it will not be a direct and simple process, it will – your application will have to be accompanied by a seven figure application fee, a million dollars that comes along with it. So, after that happens at some point in time there will be new GTLDs that are available. So I am assuming that some people actually get into that business. I think that it’s probably a safe bet that not all of them will be entirely successful in it that may end up benefiting us. I believe there are people who will go into that business with the intention from the beginning of contracting VeriSign to provide that service on their behalf, so that could be good for us.
In terms of the domain names themselves, it’s hard to see any short-term negative impact. An example I would give you is if somebody acquired and begin operating dot-hotel and let’s say that marriott.hotel, I really don’t think anybody believes that they are going to abandon marriott.com because they did that or fail to revenue marriott.com because they bought marriott.hotel. So, again in the near-term, it seems neutral to positive from where we sit.
Okay, great, that’s helpful. And then just one small one, could you -- can you give us an update on maybe dotTV within the base how that’s been trending and any chance you can give us an update on the number?
Yeah, actually dotTV is doing pretty well, still fairly small numbers, its’ below a million names, but it is actually growing faster from a unit basis than the overall adjusted zone. The other thing I would add there is to keep in mind that the price put on dotTV is quite a bit higher than dot-net or dot-com name at the price over $20 per name. So, it’s moving along very nicely as well as we get better price points on it.
Great. Thanks, that’s all I have.
Thank you. We will go next to Katherine Egbert with Jefferies.
Hi, good afternoon. Can you just – again, you know, I am going to ask this Ken, your operating margin on a long-term basis, you had said a while ago would be above 35%. Can you tell us actually to where it might be in the out years?
This is Brian. We have reconfirmed today that we’ll exit the year at 35% or higher. This year is a bit tricky from an accounting standpoint. We are making good progress in setting up the in-state organization and bifurcating the costs between the discontinued business and the continued businesses. But at this point, I can’t give you any further information.
Yeah, just a little directional Katherine, no numbers here of course. But the comments that we made today said that we believe we are going to make 35% or higher by the exit of this year and that is with some pushing out some of the divestitures. As Brian talked to you many times in the past, the cost come out relating to those divestiture that would give you directionally that, those numbers wouldn’t continue to increase in the next year as well.
Okay. That’s helpful. And then, last one, can you just remind us of what it takes to put something into discontinued operation, meaning is there a timeframe that the divestiture had to take place in order to come or qualified for desktop?
Yeah, well, there is two different things that you got do. One is you got to qualify for being held for sale and then one that meets that criteria, you got to – meet an additional criteria to put in discontinued operation. There is one-time requirement and the time requirement is that it has the sale that’s probable within one year. Also, you have to have an active program to sell the product, that so it has to be available for immediate sale and you have to have authority from the board to sell that asset. And so, once those were met, you can’t have any continuing influence in the operations of the business. So those are the five criteria to qualify for held for sale and then discontinued operations.
Yeah, Katherine this is Jim. If I can just comment on your first question about where our margins might go in the future, I think it’s helpful to just step back and sort of see the big picture, I mean one of the things that this quarter does in my opinion is that it confirms that we are -- to us that we are on the right strategy. If you look at the financial performances of the core businesses, if you look at the revenue, if you look at the margins, and you consider that we are going slower on the divestitures that we planned. We really think that’s due primarily to the larger economic conditionis that prevail right now. And you consider that we are able to make the marginal investments for revenue growth where ever we feel we need to and we start to consider that the N state company, which we should arrive at with clean financials hopefully by the end of 2009 where we will have the divestitures done. We will have those other costs taken out. We will have start to seeing -- we will start seeing the benefits of the marginal investments that we are making in new revenue opportunities. I think, we are convinced, if you sort of project and imagine that scenario, I think you can see why we think this is the right strategy.
Okay. That’s fair. Thanks Jim.
Thank you. [Operating Instructions]. We will go next to Fred Ziegel with Soleil Securities.
Hi, guys. I guess a question for Jim surrounding this DNS vulnerability has – is that having any impact on anything and where does that stand in terms of….?
I am sorry, we can’t hear you. You got to speak up.
Fred, I am sorry, we can’t get a word. But I don’t know if you are on a speaker phone, if you can get closer maybe or…
Can you hear me now?
Okay. So question was around DNS and the vulnerability and is that having any impact since it’s been discovered and secondly where are we in kind of cleaning that problem up?
Yeah. Certainly talking about DNS caching, that’s well understood problem. There a well developed available fixed for it. The only surprise which actually isn’t a surprise for people in this business is the slow rate in which people are actually applying the patch?
Yeah. Only thing I would add to that to Fred is that, the applicability of that particular problem is to what they call recursive server. And it’s really important understand that our DNS network is based on authoritative servers. And so, hence this is not even anything that would affect us, therefore DNS cache poisoning issue, but it does affect a number of recursive servers out there. Typically, those types of servers are on enterprise environments where they do it for speed of operations of their internal networks. But externally as it release to our networks, zero vulnerability to this problem.
Thank you. And we have one final question. We will take that question from Sterling Auty with JPMorgan.
Thanks. On the gross margin front, gross margins obviously had a nice improvement in the quarter. Can you going to a little bit more detail, is that revenue makes, is that headcount, what is the kind of keys to see specifically the improvement in gross margin?
Yeah. We don’t report gross margin. Gross margin for the quarter is approximately 79%. I think the operating margins are more complete meaningful measure. Once we complete, the divestitures and we get the discontinued costs out, you’ll be able to see the operating margins from a trend perspective. The increase in operating margin you saw was really twofold: one, it was increase in revenue from the prior quarter coupled with the tax that we had. Headcount attrition, we are able to take out from additional shared services and the divide and focus strategy that we alluded to during the script. We are really starting to see a lot of benefits from that. And so, we are doing things much more efficient. There is greater transparency and accountability and those results are paying-off.
All right. Thank you.
I think and also just worth mentioning that the parts of our business that we can control. The management team is doing an excellent job of controlling those costs, managing the business and obviously bringing in the revenue where we can. We haven’t had success with the divestitures that we’d hope for, but there are many, many parts of the business where we exercised direct control and careful management, I think I was being a bit modest. We have done a very good job there I believe.
All right. Thank you.
Thank you. And with no further questions, I would like to turn the program back over to Mr. Bond for any additional closing comments.
Thank you, Robby. We anticipate that our next quarterly conference call, which will reflect our third quarter 2008 results will be held on Thursday, November 6, at 2 p.m. Pacific Time. Final confirmation of this date will be provided the first business day after the close of the quarter on October 1. I would also like to remind you that in light of Regulation FD, VeriSign plans to retain its longstanding policy to not comment on its financial guidance during the quarter, unless it does so through a public disclosure. Please call the Investor Relations Department with any follow-up questions on this call. Thank you for your participation and your continued support. This concludes our call. Thank you all and good evening.
That does conclude the conference. You may disconnect your lines at this time.
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