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VeriSign Inc. (VRSN - Analyst Report) reported second-quarter 2013 earnings of 55 cents, which beat the Zacks Consensus Estimate by a couple of cents. Earnings (including stock-based compensation) increased 22.5% year over year but declined 4.6% sequentially.

Revenues

Revenues surged 11.8% year over year and 1.2% sequentially to $239.3 million, slightly ahead of the Zacks Consensus Estimate of $237.0 million. Approximately 60% of the revenues were from the U.S, while the remaining came from overseas. Both U.S. and international revenues increased 12.0% from the year-ago quarter.

VeriSign Registry Services added 1.22 million net new names compared with 1.99 million in the previous quarter. Active domain names in the zone for .com and .net increased 4.9% year over year to $124.3 million (.com 109.2 million and .net 15.1 million) in the quarter.

VeriSign processed 8.7 million new domain name registrations for .com and .net, slightly down from 8.9 million in the year-ago quarter and 8.8 million in the previous quarter.

VeriSign estimates renewal rate to be approximately 72.4% in the second quarter compared with 72.9% in the year-ago quarter. Exact renewal rate figures will be available post 45 days of the end of the quarter. In the first quarter of 2013, renewal rate was 73.2%.

During the quarter, VeriSign hiked fee for .net domain names from $5.62 to $6.18, effective from Feb 1, 2014, as per its agreement with Internet Corporation for Assigned Names and Numbers (ICANN).

Margins

As a percentage of revenues, operating expenses declined to 44.8% in the second quarter compared with 50.0% in the year-ago quarter but increased from 43.6% in the previous quarter.

A sharp decline in sales & marketing (S&M) as well as general & administrative (G&A) expenses, down 260 basis points (“bps”) and 210 bps, respectively, drove the year-over-year decline. Research & development (R&D) expense declined a modest 10 bps from the year-ago quarter.

The sequential rise in operating expense as a percentage of revenues was primarily due to a 20 bps expansion in G&A and a 200 bps upside in S&M, which offset a 60 bps decrease in R&D.

Operating margin was 55.2% in the quarter, compared with 50.0% in the year-ago quarter and 59.6% in the previous quarter. The year-over-year improvement was primarily due to lower operating expenses. However, sharp rise in operating expenses on a sequential basis negatively impacted operating margin.

Net income as percentage of revenues was 36.1% compared with 32.9% in the year-ago quarter and 37.9% in the previous quarter.

Balance Sheet & Cash Flow

Cash and cash equivalents (including marketable securities) were $2.00 billion (out of which $630.0 million was held in the U.S.) compared with $1.56 billion in the previous quarter. The significant rise in cash balance was primarily due to the issuance of 10-year $750.0 million senior unsecured notes in Apr 2013.

Operating cash flow was $147.0 million in the quarter, down from $150.6 million in the first quarter. Free cash flow was $132.0 million compared with $145.0 million in the previous quarter.

VeriSign repurchased approximately 7.1 million shares for $334.0 million in the quarter. The company’s board of directors approved an additional $519.0 million to buy back shares, which brings the total authorization to $1.0 billion.

Positive Guidance

VeriSign intends to focus more on developing new revenue streams in 2013. The company expects to add 1.0 to 1.4 million net new names in the .com and .net registry for the third quarter of 2013.

For full year 2013, VeriSign forecasts revenues in the range of $952.0 to $962.0 million (up from prior outlook of $945.0 to $960.0 million), which represents an annual growth rate of 9.0% to 10% (up from 8%). Non-GAAP gross margin is expected to be at least 80%, while operating margin is forecast to be between 58.0% and 59.0% (up from at least 57%).

Interest expense and non-operating income, net is expected to be within the range of $60.0–$62.0 million for fiscal 2013. Capital expenditure is expected in the range of $60.0 million to $80.0 million for fiscal 2013.

Our Take

We believe that the hike in.net fees will drive VeriSign’s top-line growth going forward. Additionally, growing generic top-level domain (“gTLD”) customer base, international expansion through IDNs (internationalized domain names) and strong growth in the Network Intelligence and Availability (“NIA”) services will further boost revenues and profitability.

However, negative impact of search engine adjustments on domain monetization and increasing marketing expenses related to the introduction of new gTLDs and IDNs remain the primary headwinds in the near term. Moreover, the ongoing cash repatriation issue remains a concern with respect to liquidity in the near term.

Although the recent debt issue improves liquidity, we believe that higher interest rates will hurt profitability in the near term. Additionally, significant competition from AT&T Inc. (T - Analyst Report), Verizon (VZ - Analyst Report) and Infoblox Inc. (BLOX) in the NIA segment remains a major concern.

Currently, VeriSign has a Zacks Rank #3 (Hold).

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