Taking Stock: Security Company VeriSign Must Resolve Revenue Problems

In my recent conversations with IT managers, security remains a leading topic. And as most IT managers are all too aware, there are very few simple answers.

Normally, investors would like the prospects of Veri-Sign Inc. (VRSN--Nasdaq), a leading security software vendor and one of the chief players in public key infrastructure and domain-name registration. But as of Nov. 26, VeriSign's stock price was $40, the same price it was on Sept. 11. This, in spite of the large price gains made by other stocks in the security software segment--more than 40% since Sept. 11. Let's look at some problems that may have dampened VeriSign's prospects.

First, the company has both revenue-recognition and deferred-revenue issues. Revenue-recognition concerns raise the specter that investors may be overpaying for growth rates that are lower than reported. After reviewing VeriSign's most recent Securities and Exchange Commission filing, I realized the average investor would need a degree in forensic accounting just to understand the one-page explanation about recognition of revenue for domain-name renewals. I'm always suspicious when a company goes to such great lengths to muddy the waters.

A slowdown in deferred revenue and an order backlog also are early signs of trouble. Companies look to grow deferred revenue and backlog to maintain consistent future revenue growth rates. VeriSign's management has historically said deferred revenue growth rates would be in the 3% to 5% range. Its third quarter showed an increase of 2.6%, not a huge disappointment, but on the low side.

Second, VeriSign's receivables keep creeping up as measured by days that sales are outstanding. The number rose to 76 days, the fifth quarter in a row for the upward trend. Much of this may be explained by recent acquisitions and the fact that the customer mix is moving toward larger customers and their notorious slow-payment schedules. This may suggest that VeriSign's financial model isn't as profitable as it once was, given that customers are extending credit terms to their advantage.

Third, the company has been on a major acquisition binge during the last couple of years. Financial performance has become a moving target, and there's a lot of assimilation of new technologies and businesses. As I've mentioned many times, this doesn't come without substantial infrastructure cost and personnel turmoil. Although these acquisitions may be in the company's strategic interests, implementation doesn't always go as expected. In other words, business risk has risen along with the financial risk. VeriSign's recent registration that it may sell $750 million of new equity tells me that other acquisitions are likely to happen sooner rather than later.

With 210 million shares outstanding valued at $40 per share, the equity-market capitalization is a healthy $8.4 billion. Revenue this year is projected to be around $985 million, rising to $1.3 billion to $1.4 billion next year. Wall Street analyst estimates for the company's earnings this year and next center at 65 cents and $1.16, respectively. But the analysts' range for 2002 reaches from 85 cents to $1.30. Clearly, confidence in management forecasts varies greatly.

The best news is that VeriSign is still growing nicely and the operating leverage (expansion of profit margins) on its business model continues to grow. Operating profit margins are expected to rise to 18% to 20% from 14% to 16%. At $40, the 2002 price-to-earnings multiple is "only" 34.5 times. For a company growing at 30% to 40% a year, this may not seem unreasonable. However, growth rates may come down from their current lofty levels, given the trends in its business and a slow economy.

I don't mind paying a slight premium for this company, but I won't buy until the stock goes below $30. More important, until many of the company's specific problems are resolved, I feel more secure with my money on the sidelines, even though almost every sell-side investment firm has either a buy or a strong buy recommendation on the stock.

William Schaff is chief investment officer at Bay Isle Financial Corp., which manages the InformationWeek 100 Stock Index. Reach him at [email protected].

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