Internet 2001: VeriSign, Exodus Dominate Services Sector

The Internet Services sector is an amalgam of more than 50 companies targeting widely varying markets and customers. Among them are providers of Web hosting services, domain registrars, Internet job sites, e-mail outsourcers, online educational and learning networks, etc.

Thus, it is a group that resists easy categorization.

However, two things can be said for certain about the Internet Services sector: 1) Every member company saw its stock lose ground this year, with all but two falling more than 50% in value; and 2) It will be thinned out considerably in the coming year as the more marginal firms – small-cappers serving niche markets – are squeezed out of existence.

Two of the companies that should be doing much of the squeezing are VeriSign and Exodus Communications , by far the largest players in the sector with market capitalizations of $15.9 billion and $9.5 billion, respectively. In third place is messaging infrastructure provider Critical Path, with a market cap of $2.3 billion.

VeriSign’s main business, until last summer, was digital certificate technology. When the company bought Network Solutions, though, it expanded its offerings far beyond e-commerce security. In fact, revenue from Network Solutions, the world’s leading domain registrar, is more than double what VRSN was pulling down for its digital authentication business.

Excluding costs associated with the Network Solutions purchase, VRSN posted a Q3 profit of 18 cents per share. I believe VeriSign is well-positioned in two major markets (digital certificates and basic ‘Net services) and should emerge as one of the few big Internet winners.

Nonetheless, I would stay away from VRSN shares right now because they are overvalued, trading at 52x trailing 12 months’ revenue of $305 million, which is far higher than most large Internet companies these days. The current share price is $80.44; I wouldn’t look at it until it drops at least below $50, which is where it was headed before bouncing off a closing price of $68.13 last Thursday.

Exodus Communications, meanwhile, continues to attract strong support from Wall Street analysts, despite continued losses dating back to 1995, most due to the Web hosting company’s heavy investment in Internet data centers.

The good news for Exodus is that it achieved positive cash flow from operations in the past two quarters. The bad news is that EXDS itself expects it will “continue to experience net losses on a quarterly and annual basis for the foreseeable future,” as company officials wrote in the Q3 report.

That’s not music to the ears of today’s Internet investors, who want to see profits now. Still, Exodus’ revenue growth and volume (240% and $230 million in Q3) are eye-catching and, to some, worth of an investment.

While I understand the attraction of betting on a company many think will be the dominant Web hosting and services provider in coming years, I prefer to focus on ‘Net firms that already have demonstrated profitability. Exodus isn’t quite there yet, but investors should pay attention to the next couple of quarterly reports to see which way the company is headed financially as the new year gets under way.