Stocks & Markets

Net Security Stocks: A Solid Corner of Tech


With more and more people using the Web for business transactions and routinely typing in their credit-card digits on various sites, rising concerns about identity theft and other cybercrimes have put companies that provide Internet security products in the catbird seat. While Symantec (SYMC) and McAfee (MFE) have hitched their wagons to Microsoft (MSFT), on hopes that the new Windows 7.0 operating system will drive sales of their security software, other companies' business models aren't tied to the fortunes of Redmond & Co. Like VeriSign (VRSN), for example. The Mountain View (Calif.) company collects $6.87 for every new dot-com Web site it registers and $4.24 for every dot-net address it assigns under an exclusive seven-year contract with the Internet Corporation for Assigned Names & Numbers, known as ICANN, a nonprofit oversight body that coordinates domain names for the U.S. Commerce Dept. SSL Profitability ConcernsAnalysts estimate the Web infrastructure and security outfit added about 1.4 million domain names in the third quarter, which would be a 27% increase over the preceding quarter and ahead of the company's forecast of 900,000 to 1.2 million additional registrations, according to Oppenheimer (OPY) analyst Shaul Eyal in an Oct. 22 research note. That bodes well for third-quarter earnings, which the company is scheduled to report on Nov. 5. As the global economy continues to recover, "international growth could again crank up and provide a kick-start to recovery" in domain name additions, Eyal said. While the company enjoys a virtual monopoly in the domain name business, there are still concerns about the profitability of one of its key businesses: security socket layer, or SSL, certificates, which merchants buy from the company in order to enable the encryption of sensitive information during online transactions and authenticate information about the certificate owner. While VeriSign has a 75% market share in these certificates, its average selling price has continued to decline over the past several quarters. The company attributes that to the recession, which has made cost-conscious customers favor cheaper, lower-quality certificates. The average selling price was $241 in the second quarter, vs. $253 in the third quarter of 2008. VeriSign is expected to report earnings of 32¢ a share on Nov. 5, vs. 25¢ a year earlier, on projected revenue of $258.8 million, compared with $239.7 million in the year-ago period, VeriSign's results will follow on the heels of disappointing news from another marquee name in computer security. After the stock market closed on Oct. 29, McAfee reported earnings of 62¢ a share, excluding nonrecurring items, ahead of analysts' forecast of 61¢, McAfee's revenue jumped over 18%, to $485 million, but fell short of analysts' $486.7 million forecast. The stock finished 4.3% lower on Oct. 30. Upgrading McAfee's RatingIn a research note on Oct. 30, analyst Joel Fishbein at Lazard Capital Markets (LAZ) said that McAfee continues to gain market share in both the enterprise and consumer security markets. McAfee's recurring revenue model and its insulation from the current spending downturn make it one of the best-positioned software companies. Fishbein reaffirmed a "buy" rating on the stock and a price target of $49. (Oppenheimer does and seeks to do business with the companies it covers in its research reports.) In a Sept. 25 note that upgraded McAfee to an "outperform" rating, FBR Capital Markets (FBR) said it expected the company's extensive distribution network to enable it to grab a bigger piece of the growing cybersecurity market in the coming years. After the close of trading on Oct. 28, Symantec reported a profit of 18¢ a share for its second fiscal quarter, up from 15¢ a year earlier. Excluding one-time items, the company earned 36¢ a share, down from 37¢ a year ago but more than the 33¢ adjusted consensus earnings estimate by analysts. Revenue of $1.47 billion was down from $1.52 billion a year ago but beat the consensus analysts' forecast of $1.43 billion. Various analysts raised their profit and revenue outlooks for fiscal 2010 and the shares closed nearly 12.8% higher on Oct. 29. A Slimmer VeriSignSymantec's and McAfee's revenues "are more subject to the whims of consumer spending and enterprise security spending," as well as to the rising popularity of MacIntosh computers, says Katherine Egbert, an analyst at Jefferies & Co. (JEF). The fact that both McAfee and Symantec did fairly well in the third quarter "shows the resiliency of storage and security and the resiliency of consumer electronics," she says. Roughly 60% of McAfee's revenues come from business purchases, compared with 75% of Symantec's revenues. VeriSign has been remaking itself into a slimmer, more focused company. On Oct. 1, VeriSign sold its global security consulting business to AT&T (T)—its 12th divestiture in two years. A leaner VeriSign should be better able to focus on its core business and improve its operating margins, according to the Oct. 22 note from Oppenheimer's Eyal. The margin for fiscal 2009 should climb to 38.4%, up 4.8% from 2008, and continue to widen to 39.6% in 2010 and 40% in 2011, Eyal said in the note. The slide in average selling prices of its SSL certificates could end fairly soon if, as the economy continues to recover, customers start to choose the higher-priced VeriSign brand, especially extended validation certificates, said Shaul in the Oppenheimer note. Competitive Bidding LikelyVeriSign will continue to be under some pricing constraints until an antitrust lawsuit filed by a not-for-profit group called the Coaltion for ICANN Transparency, or CFIT, is resolved. The suit alleges that VeriSign won its exclusive contract with ICANN without competitive bidding from other domain name providers. In June, the Ninth Circuit Court of Appeals in Los Angeles reversed a district court ruling that CFIT hadn't successfully stated claims that VeriSign's contract award violated antitrust laws, VeriSign, which has denied the charges, filed for a re-hearing in the Court of Appeals in July. VeriSign has a right to raise prices on dot-com registrations by 6% to 7% twice during the remaining four years of the contract, but analysts say that wouldn't be politically acceptable until the CFIT lawsuit is resolved. That's in spite of the fact that the company would use most of the increase to add bandwidth, and file backup and storage capability needed to withstand the 50,000 attacks its route servers receive daily, says Egbert at Jefferies. Even though VeriSign's current contract has a pre-emptive provision that would automatically renew it for another term once it expires in 2012, there's likely to be competitive bidding for the contract. Still, VeriSign has little reason for worry given how few competitors have invested as much as it has to lay down infrastructure for the Internet over the past decade, says Eyal at Oppenheimer. Fewer Up-Front PaymentsFishbein at Lazard is encouraged by the fact that VeriSign will be holding an Analyst Day in November for the first time in 18 months. And given management changes such as the appointment of President Mark McLaughlin as chief executive officer in August, "it will be interesting to see what the strategy of the company will be," he says. With $1.3 billion in cash on its balance sheet, he wonders whether VeriSign will opt to buy back stock or look for other companies to acquire. Security is one of the best-positioned areas within technology for revenue growth. Spending on enterprise software is expected to grow at a compounded annual rate of 4.7% through 2013, significantly faster than spending on information technology as a whole, according to industry researcher Gartner (IT). Security infrastructure revenue will grow at an estimated 10.2% compounded rate per year from 2009 through 2013, according to Gartner. In an Oct. 26 research note on the software industry, Fishbein said he expects software spending to fall by 1.6% in 2009 but to outpace spending on information technology overall. Uncertainty about future earnings is making customers insist on "just-in-time" purchases, shorter contracts, and fewer up-front payments. While the U.S., Asia-Pacific, and emerging markets seem to have bottomed, the Middle East, Africa, and Europe—especially the U.K.—remain weak. Holding Up in the DownturnAmong customers' spending priorities are technologies that promise high return on investment and nondiscretionary products such as security and compliance software, said Fishbein. In general, software should stand up better in the current downturn than in the past due to companies' larger recurring revenue bases, tighter cost controls, stronger balance sheets, and higher cash flows. Valuations for the shares of these companies look more expensive, but are still below historical mean levels based on cash metrics.
Bogoslaw is a reporter for Bloomberg Businessweek's Finance channel.

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