Downgrading VeriSign to a Hold

VeriSign (VRSN - Analyst Report) reported revenue of $223 million, up 23% year-over-year [y/y]. Stronger-than-expected EBIT margins of 30.3% were mitigated by higher net interest expense (lower rates, less cash). Second quarter 2008 guidance called for revenue of $228-$233 million compared to consensus of $228 million. Management expects EBIT margins to rise modestly, and net interest expense to be a slightly higher. We estimate Q2:FY08 EPS of $0.22, compared to consensus of $0.24.

The domain name business (approx. 60% of the core) posted 22% y/y growth in units, and benefited from a blended 8% price increase enacted October 2007, suggesting revenue growth of about 30% y/y. Unit growth y/y of the domain name business has moderated over the past five quarters by 28%, 27%, 25%, 24%, and 22%, respectively. Concerns were raised that regulators and/or Google (GOOG - Analyst Report)-initiated actions could reduce the number of "parked domains" (8-10% of names). Concerns surrounding this issue will likely persist.

In the past year, VeriSign has replaced its CEO and CFO (both internal), completed the restatement of its financials following its stock options investigation, completed a $1.25 billion convertible debt offering repurchased $1.15 billion worth of stock off the open market, and embarked on the strategic review of its product portfolio. While early, we are encouraged by the thoughtful and transparent nature of the process.

VeriSign is trading at 38.7 times our reduced 2008 earnings estimate of $0.98 per share. As the Internet spreads to mobile devices, we see VeriSign tapping this growth market with an array of value-added services. Moreover, we believe the company has substantial growth opportunities in the areas of intelligent supply chains, real-time publishing, and interactive television.

However, we are skeptical that the company, given its assertion that it will divest its remaining non-core businesses by year-end, will be able to follow through. We have reduced our target price slightly to $36. This is derived by applying a target P/E multiple of 36.7x to our 2008 EPS estimate, which we think is justified given the company's current consolidation process.
 
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