Intuit (INTU $44) is the leading provider of software for personal finances (Quicken), small business accounting (QuickBooks), and tax preparation (TurboTax and ProSeries). In 2004, the company entered a period of slower growth, ending a five-year run of 18% annually compounded revenue growth and 30% earnings per share growth. Alarmed at this development, each segment of the company has scrambled to analyze its market opportunities and develop new products. Using the homegrown concept of “Customer-Driven Invention,” employees were asked to go back to the roots of the company. Intuit has grown rapidly by solving big problems of personal and small business accounting and tax preparation. Company engineers and marketing people interface with customers to find ways of solving important customer problems. By developing more products that inexpensively and simply solve problems, management expects to gradually bring revenue growth back into the low teens. The sizes of the markets that Intuit addresses are large, so new product flow should indeed rekindle growth.
The company’s research and development effort has resulted in six new products, described below.
Intuit’s Consumer Tax segment has developed TurboTax SKI (Simple and Know It). It targets consumers with simple tax returns, a potential market of 41 million taxpayers using a pen or pencil to prepare a 1040EZ or 1040A, instead of a computer and tax software.
The QuickBooks segment grew revenues in the low teens in fiscal 2004, which was particularly disappointing. The weakest point in the division was a decline in the sales of QuickBooks Pro upgrades. To offset this decline, division management went looking for a portion of the small business market it was not reaching, and a new product was the result. Simple Start was designed for the 2.5 million new businesses started each year in the U.S. and the 9 million small business owners who still rely on pencil and paper or Excel spreadsheets. These people often do not know how to perform small business accounting and do not have time to learn. Priced under $100, Simple Start gives them a very quick and easy-to-use way to improve the accuracy of their business record keeping. It requires only 3 steps to set up the business, tracks customer purchases and payments, and generates the data needed for tax preparation.
QuickBooks POS is a point of sale system, which packages QuickBooks POS software with a cash drawer, LCD display, bar code reader, and credit card reader for a fraction of what small retail stores pay value-added retailers for equivalent equipment and capabilities. The system automatically integrates with the QuickBooks software that the potential customer is typically already using. There are 2 million small retailers in the U.S. spending billions annually on POS systems. A 10% penetration of this market would have a dramatic impact on Intuit.
Enhanced Payroll is a payroll automation program that for $299 per year provides automatic updates for withholding, workers compensation tracking, and net-to-gross calculations for small businesses using QuickBooks for payroll.
ProSeries Basic and ProSeries Express are two new products for the tax preparation professional. Basic addresses the smaller tax preparer not wanting to pay for a more robust product. This is a $70 million market. Express targets the storefront rapid refund market, which is a new $130 million market for Intuit.
The fiscal year ending in July 2005 is expected to be a transition year, as new products reinvigorate maturing product lines. Management is guiding revenue growth to the range of 6% – 9%, and earnings per share growth of 15 – 20%, from fiscal 2004’s pro forma $1.67 to about $1.95 in 2005. $2.20 would not be a surprise in fiscal 2006. Free cash flow production has grown at an annually compounded rate averaging 30% over the past five years. The business is an exceptional producer of cash, because minimal capital investment is required to grow revenues and earnings. Including cash reserves of over $5.00 per share, intrinsic value is estimated at about $40.
VeriSign (VRSN 31) is a direct beneficiary of the continual migration of our lives and businesses towards digital communications. It owns a database engine, appropriately named Atlas, which currently accommodates over 14 billion transactions per day, and has the capacity to handle 200 billion per day. Atlas has 13 operating sites worldwide and 3 standby sites, 3-millisecond response time, and 100% availability – it has never gone down, despite cyber-terrorist attempts to overload the Internet. This engine, operating invisibly in the background of the world’s data network, enables Web site owners, telephone companies, businesses engaging in e-commerce, and individuals to make Internet and cellular phone connections. Atlas is indispensable for Internet connections. Every time we query a .com or .net website, we have traveled digitally through Atlas. By making a tiny amount of money on each of these transactions, VeriSign will generate about $170 million in free cash flow this year (about 70 cents per share), possibly growing over the next five years to $500 million ($1.70 per share.)
VeriSign has two divisions, Communications Services and Internet Services. Communications Services produced 43% of revenues in 2003 while Internet Services produced 57%. Communications Services addresses a $16 billion market. Calls on a cell phone require a computer somewhere to interpret digital instructions and make a network connection. VeriSign’s SS7 network is the largest in the world, each day processing 350 million phone calls, 2.7 billion transactions, and 1 million short messages through its connections to over 1000 carriers. VeriSign manages 50% of all U.S. cellular roaming traffic, services number portability, offers “do not call” compliance, and operates a toll-free number database. It handles billing and payment for over 6 million cell phone subscribers. The recent acquisition of Jamba! adds content, handset testing, and conversion to VeriSign’s European business.
Internet Services addresses an $8 billion market. It currently handles 10 billion Internet queries per day, a number that at least doubles annually. It maintains the .com and .net databases, currently consisting of 36 million names, up 26% from 2003. When you type a “URL” into your Internet browser program, such as ebay.com, you have actually asked to be connected to a numerical address. Through the database, VeriSign translates all .com and .net analog inquiries into the numerical address, and then guides your connection to that address. It provides the payment infrastructure for 30% of all North American e-commerce. VeriSign also sells security certificates to authenticate digital identities and make e-business secure. 447,000 certificates were outstanding on September 30, 2004, up 20% from a year ago.
A potentially large future business for VeriSign is RFID, Radio Frequency Identification tags. Virtually any product can be given an electronic tag, which assigns the product a unique identification number, similar to an Internet URL. This enables the stages of the product’s life, from manufacture to final sale, to be tracked just by typing its RFID number into an Internet browser. The RFID can also serve as an anti-theft tag. The U.S. FDA will soon require all drugs to carry such an electronic label of manufacturing and distribution history, in an effort to counter drug counterfeiting and smuggling.
Financially speaking, these businesses have high fixed costs, so revenue growth causes profit margins to expand and earnings to rise faster than revenues. As one of the few “dot.com’s” that made it, VeriSign has had spectacular growth. The company has settled into a stable business identity with solid growth prospects. Cash earnings last year were $.53 per share, and pro-forma consensus estimates for 2004, 2005, and 2006 are $.68, $.85, and $.98, respectively. The company had $600 million in cash and negligible debt on September 30, 2004. Long-term earnings growth is expected to be about 20% per year, supporting an intrinsic value estimate in the mid-20’s. Risks pertain primarily to future growth of the Internet, the strength of the telecommunications economy, and demand for digital connections on cell phones and the Internet. The .com and .net registry business is regulated by ICANN, a quasi-government regulator, and, in particular, the .net registry is up for bidding next year. The company has a track record of overpaying for acquisitions. Because of the high profit leverage inherent in high fixed cost businesses, earnings and cash flow could be a lot better or a lot worse than projected.
VeriSign has a unique position in supplying the secure digital infrastructure indispensable for the operation of an increasingly information-based society. Profitability improves rapidly with revenue growth, and a sizable cash horde enhances financial flexibility.
Steven L. Ré, CFA November 16, 2004
The above is for information purposes only and is not to be construed as a recommendation to purchase or sell securities. The above information is from sources deemed reliable but is not guaranteed. It should not be assumed that investments in any of the above-mentioned securities will be profitable, and past performance is not a guarantee of future results. Earnings projections often miss, and markets sometimes go down. The employees and families of Quality Growth Management, Inc. may own the above-mentioned securities in their own accounts, and may trade them at any time without notice.