VeriSign, Inc. (VRSN) Q3 2014 Earnings Report, Transcript and Summary

Good day everyone. Welcome to the VeriSign's Third Quarter 2014 Earnings Call. Today's conference is being recorded and any unauthorized recording of this call is not permitted. At this time, I would like to turn the conference over to Mr. David Atchley, Senior Director of Investor Relations and Corporate Treasurer. Please go ahead, sir.

Thank you operator and good afternoon everyone. Welcome to VeriSign's Third Quarter 2014 Earnings Call. With me are Jim Bidzos, Executive Chairman, President and CEO; and George Kilguss, Senior Vice President and CFO; and Pat Kane, Senior Vice President, Naming and Directory Services. This call and our presentation are being webcast from the Investor Relations section of our website, www.verisigninc.com. There you will also find our third quarter 2014 earnings release. At the end of this call, the presentation will be available on that site, and within a few hours, the replay of that call -- of the call will be posted. Financial results in our earnings release are unaudited, and our remarks include forward-looking statements that are subject to the risks and uncertainties that we've discussed 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 risk factors that could cause actual results to differ materially from those contained in the forward-looking statements. VeriSign retains its longstanding policy not to comment on financial performance or guidance during the quarter unless it is done through a public disclosure. The financial results in today's call and the matters we will be discussing today include GAAP and non-GAAP measures used by VeriSign. GAAP to non-GAAP reconciliation information is appended to our earnings release and slide presentation, as applicable, each of which can be found on the Investor Relations section of our website. In a moment, Jim and George will provide some prepared remarks and afterward we will open up the call for your questions. Unauthorized recording of this call is not permitted. With that, I would like to turn the call over to Jim.

Thanks, David. Good afternoon everyone. Our third quarter results were in line with our objectives of offering security and stability to our customers while generating profitable growth and providing long-term value to our shareholders. We reported revenue of $255 million, which was 4.7% higher year-over-year, and delivered strong financial performance, including $150 million in free cash flow. The base of .com and .net active registered domain names ended the quarter at 130 million. Our balance sheet remains strong with $1.5 billion in cash, cash equivalents and marketable securities at the end of the quarter. Our strategic framework to protect, grow and manage the business continues to serve us well as we see operational and financial benefits from our focus and discipline. As a part of managing our business, during the third quarter, we continued our share repurchase program by repurchasing 4.2 million shares for $226 million. At the end of the third quarter, $833 million remained available and authorized under the current share repurchase program, which has no expiration. We continually evaluate the overall cash and investing needs of the business and consider the best uses for our cash, including potential share repurchases. Before I get into the third quarter results, I want to provide a few updates since our last earnings call. As you recall, VeriSign began to engage in a negotiating and contracting process with ICANN on our remaining 13 new gTLD applications, which primarily consists of transliterations of .com and .net, earlier this year. We have been in discussions with ICANN during this contracting period and have requested certain modifications to the registry agreements that would govern these new top level domains. As we have not yet reached a final agreement, ICANN has granted an extension of time until December 30, 2014 to execute the new agreements…

Thanks, Jim and good afternoon everyone. During the third quarter, we generated revenue of $255 million, up 4.7% year-over-year, and delivered GAAP operating income of $139 million, up 5.1% from $133 million in the third quarter of 2013. The GAAP operating margin in the quarter came to 54.7%, compared to 54.5% in the same quarter a year ago. GAAP net income totaled $95 million compared to $81 million a year earlier, which produced diluted GAAP earnings per share of $0.69 in the third quarter this year compared to $0.53 for the third quarter last year. As of September 30, 2014, the company maintained total assets of $2.2 billion. These assets included $1.5 billion of cash, cash equivalents and marketable securities of which, $599 million were held domestically with the remainder held internationally. Liabilities totaled $3 billion at the end of the quarter. I'll now review some of our key third quarter operating metrics, which are: revenue, deferred revenue, non-GAAP operating margin, non-GAAP EPS, operating cash flow and free cash flow. I will then discuss our 2014 full year guidance. As mentioned, revenue totaled $255 million for the third quarter. 61% of our revenue was derived from customers in the U.S., and 39% was from international customers. Deferred revenue at quarter end totaled $893 million, a $37 million increase from year end 2013. Third quarter non-GAAP operating expense, which excludes $15 million of stock-based compensation, totaled $101 million compared with $98 million in the second quarter of 2014 and $100 million in the same quarter a year ago. Non-GAAP operating margin for the third quarter expanded to 60.6% compared to 58.8% in the same quarter of 2013. Non-GAAP net income for the third quarter was $97 million, resulting in non-GAAP diluted earnings per share of $0.70 compared to $0.59 in the…

Thank you, George. During the third quarter, we furthered our work to protect, grow and manage the business. We continue to protect the business by providing over 17 continuous years of 100% availability of the .com DNS. This track record is due to the skill of our people and our specialized infrastructure. We drive profitable growth by strengthening and marketing our current service offerings. Also, we continue to invest in the development of new products and services. Finally, we've been managing the business effectively as demonstrated by our improved operating margins, improved tax position, and by the return of cash to shareholders through share repurchases during the third quarter. We remain committed to offering the security and stability that are at the core of our business and make VeriSign a company with an unparalleled DNS service record and a company committed to long-term value creation for our shareholders. We'll now take your questions. Operator, we're ready for the first question.

[Operator Instructions] And our first question comes from Gregg Moskowitz with Cowen and Company.

Jim, the net domain name activity improved actually very nicely in Q3 after a challenging first half in terms of the 1.15 million net adds. And I know some of this is seasonality, at least relative to Q2 anyway. But is there anything else in particular that you would attribute the rebound to?

I'll let George comment on that. I'll just say that I think we did forecast last quarter. We were quite clear that we believe that our data and our modeling showed that we would see a stabilization in Q3 and Q4. So I think first of all, our modeling systems are serving us well, as what we projected actually did occur. I will just comment as well that Q3 was a record for Q3 gross adds. So the business is strong. I think it's calm as a trusted brand. And I think that, that's primarily at the heart of it, but I'll let George add some comments as well.

Yes sure, Gregg. As Jim mentioned, the net adds came in at 1.15 in the quarter, which was at the high end of our guidance. And gross registrations were really the reason that we got to the high end. 8.7 million was clearly up sequentially in both year-over-year. As Jim mentioned, it was the highest Q3 on record. And in gross registrations, we have really seen China continue to be a growth engine for us. China performed very, very well internationally. We also actually saw one of our large U.S. registers -- registrars -- also refocus on customer acquisition and began using discounts to acquire domain names for their customers. And so we also saw some benefit here domestically as well.

Okay terrific. And then looking within the TLDs, so .net is obviously much smaller than .com, but the .net names in the base did decline again, albeit very slightly this quarter. And I really wanted to get a sense of how you view this going forward. Do you think that we'll continue to see this go a bit lower? Or do you think that .net will resume growth at some point going forward?

Yes, so look, .net zone growth has been relatively flat all year. We believe, like other gTLDs, .net is experiencing some headwinds from the launch of the new gTLD program that happened earlier this year, about February. That program, that new gTLD program, has accumulated about 2.8 million registrations so far this year. But -- so we are seeing some headwinds from that. As far as long-term, we'll give some views at our next call, but I think it really depends on how the market digests those new gTLDs. There's a number of them coming out. There is quite a bit of confusion in the marketplace, and I think it's having some effects on the industry as a total -- as a whole.

Okay, got it. And then just one last one, if I could, for Jim. Would love to hear an update on the patent portfolio and any potential new services.

Okay. We haven't provided any specific updates this quarter. We continue to invest and work on the development on a number of new initiatives and we are making progress on those. But no update on those and no specific news with respect to the patent program other than it's an active program. And, of course, we're very busy and active in filing patents for our innovative inventions here.

And our next question comes from Walter Pritchard with Citigroup.

This is Ken Wong for Walter. On -- you mentioned some traction with your partners on gTLDs running their back-end registries. Can you give us a sense, now that you've got a few of those under your belt, how customers are going about kind of paying for that product line? Is it a fixed cost? Are you guys getting some piece of the transactional element? Help us understand how that revenue model starts to flow through.

This is Pat Kane. Depending upon the type of TLD it is, it varies. And so if it's a brand customer, it certainly is a flat fee that we do because it's small numbers of registrations. But if it's going to be a more widely distributed customer, they tend to be more minimum payments and then per-domain fees on top of that.

Got you. So far, these early days, it's more of the flat fee variety since it's mostly the brands, right?

Well, we've only had 5 go in, so far, that are active. And since most of the ones that we have remaining are brands, we'll see most of those come online in 2015.

Got you. And then Jim, you mentioned that you guys had reached out to ICANN to modify your contracts for the transliterations of .com/.net. Kind of what exactly are you trying to get changed? And then how does that potentially impact how you go to market with those particular domains?

Well, I don't think there's actually time to go into the very specifics. We are in what's -- this is essentially a contract negotiation, so we are in that negotiating phase with ICANN for our IDN applications. And just to -- in addition to what Pat said, I want to say that any brands, essentially, were allowed an extension -- to seek an extension to June 29th -- or was it July 29th?

July.

July 29, 2015. That includes our .verisign brand and, of course, that would include the brands that we're providing the back-end services for. In the case of our own non-brand IDN applications, ICANN allows up to a 9-month extension, depending on your request and the circumstances. So without going into the details of our negotiation, we were given an extension beyond the September deadline until December 30th of this year. So we have basically a little over a couple of months to complete the negotiating phase that we're in with ICANN. I think I would say that this is a contract negotiation. This is what ICANN's Board envisioned when they authorized the form of agreement and the negotiating period, so we're engaged in the process. I just don't think I can, or it doesn't make sense, and I really can't go into all of those details. But the new date is December 30th of this year.

Got you. Okay. So look for something potentially Q1 timeframe. And I guess last thing for George, I note the G&A expense kind of ticked up a bit in Q3 and overall, I think you guys take care [ph] of the margins. Just wondering if anything we should think about there.

In the G&A, nothing really jumps out to me, Ken. I mean, on a GAAP basis, we did see our stock-based compensation go up a little bit quarter-over-quarter and that's primarily because we have our annual director grants hit us in Q3. And we also use variable accounting for a portion of our performance stock units. And as the stock price is up a little over $6 in the quarter, our stock-based compensation increased a little bit as a result of that. But as far as core expenses, I mean, there were a few movements between the line items, but as I mentioned last quarter, I think you should expect that as we continue to actively manage the business.

And from JPMorgan, we'll go next to Sterling Auty. Sterling P. Auty - JP Morgan Chase & Co, Research Division: I wanted to revisit, you made the comment of headwinds that gTLDs have made on the .net base. Is there any concern that you'll see enough headwinds in .com that the .com could get to the point where it's flat or declining like .net is?

This is Jim. I think when George said that .net was seeing some headwinds from the confusion associated with new gTLDs, I think generally, .net may be more susceptible to that confusion that swirls around new gTLDs. We're talking about hundreds that have already been delegated into the zone and hundreds more coming. So I think there's some consumer and business confusion associated with all of those. There are many plurals and I think .net is maybe more susceptible to that aspect of the new gTLD program. As I mentioned earlier, .com is going to be celebrating its 30th year in 2015 next year. .com is and is also -- .com also enjoys the longest track record of uninterrupted DNS service, 100% uptime in excess of 17 years now. So I think .com is just a strong brand and strong -- and for that reason, it's a trusted brand. And strong, trusted brands always do well. So I think that's the slight differentiation I would point out between .com and .net, that I think .net is more likely to be -- to fall into that category of different or, in this case, new gTLDs, and possibly be more susceptible to issues surrounding the confusion, which I'm afraid may -- it's going to continue. I mean, we're seeing hundreds of more new gTLDs coming and they're coming at the rate of many every single week. So there -- that confusion is likely to get worse.

And Sterling, I would just like add, I mean, .net was 15.1 million names in the zone versus 15.2 million names. I mean, it's been relatively flat. And so I actually think .net has held up pretty well over the year with all these new names coming on, bringing new names confusion. So I don't view .net's performance as anything negative. I just think it hasn't maybe grown as much or it's been a little flattish just because of the comments Jim was talking about, about the name confusion.

Yes. Again, .com is a strong brand for the reason of trust, security and stability. I would just point out again that this was the largest net new add -- sorry, largest gross adds in Q3 on record. And this is -- now, we're almost a year into the launch of hundreds of new gTLDs. I think that just points out what the security and stability of .com and the trusted brand of .com represent. Sterling P. Auty - JP Morgan Chase & Co, Research Division: Got you, got you. And now, looking at the guidance that you gave for name additions for the fourth quarter, how much of that is expectation of continued good gross additions on the top versus improved renewal rates? And maybe a comment on how you see the quarter has started. I think it's probably a little bit slower than last year, but obviously, we're at a different point this year, I think, in terms of cycle.

Yes, Sterling. So I mean, we guided 0.7 million to 1.2 million net registrations for the quarter. You did mention that we're out to a little bit of a slow pace in the month of October, but what you have to keep in mind or what I would like to let you know is that there was a -- there's a national Chinese holiday called National Day, which happens the 1st week of October. So as China becomes a larger part of our domain name business, it tends to impact seasonally a little bit more in the months when these holidays occur. So that happened for 7 days in the first month of October and slowed additions a little bit during that time. So we'll see what the zone does. You and I will see it as it's printed on the website. But if you even took where we were today and annualized it, you'd come to the low end of guidance even with that holiday in there. So we feel pretty comfortable with the range that we've articulated there. Sterling P. Auty - JP Morgan Chase & Co, Research Division: Got you. Last -- [indiscernible]

Sorry, if I could just add something, this is Jim. I think another thing to consider with respect to the renewal rate, which you mentioned as well, is that at 72%, which I described in my opening remarks, the renewal rate has ranged between 70% and 74% for the last 5 years. And so we're dead center in the middle of that range. Sterling P. Auty - JP Morgan Chase & Co, Research Division: No. All right, that made sense. Last question is, maybe I didn't really hear a lot of color on the non-naming business, so the other areas. Any particular comments that you could give in terms of how it performed in the quarter? Any changes in outlook?

There's no update -- there's no news that we're actually delivering this quarter other than to say that we're -- if you're referring specifically to the NIA business, we're pleased with the development there, but of course, we're not calling that out separately. And we are aggressively pursuing a number of initiatives in which we are making progress, but there's just no update this quarter.

[Operator Instructions] And we'll go next to Fred Ziegel with Topeka Capital Markets.

As I understand it, ICANN for their fiscal '15 budget was originally using something in excess of 30 million new gTLDs. That number, apparently, is now 15 million and most people think that number is way too high. So does that all tie back to confusion, contracting? Are people deciding to just move back to .com? Or what dynamics are at work in that?

Fred, this is Pat. What I would start off with, as far as the projections go, you're probably best off asking ICANN or better yet, maybe the registrars that actually sell the domains as to what they're thinking. But as Jim mentioned earlier, it's quite possible, and we believe, and we've -- and I've certainly seen written many times that there is additional confusion in the space, whether you have singles, plurals, who's going to buy what in terms of the different areas, what the communities look like, et cetera, and what still has to come out. So I think that there is some confusion. And I think, as Jim pointed out, with all these domains, the TLD that roll out every week, you'll see more and more confusion, I believe.

And that does conclude today's question-and-answer session. Mr. Atchley, I'll turn the call back to you, sir.

Thank you, operator. Please call the Investor Relations Department with any follow-up questions from this call. Thank you for your participation. This concludes our call. Have a good evening.