VeriFone Holdings, Inc. F4Q08 (Qtr End 10/31/08) Earnings Call Transcript

VeriFone Holdings, Inc. (PAY)

F4Q08 Earnings Call

December 16, 2008 4:30 pm ET

Executives

William Nettles - Director of Corporate Development and IR

Douglas G. Bergeron - Chief Executive Officer

Robert Dykes - Chief Financial Officer

Analysts

Andrew Jeffrey - SunTrust

Tien-Tsin Huang – JP Morgan

Gil Luria - Wedbush Morgan Securities

Wayne Johnson - Raymond James

Presentation

Operator

Good day, ladies and gentlemen, and welcome to the VeriFone fourth quarter fiscal year 2008 conference call. My name is Christa and I'll be your operator for today. (Operator Instructions) I would now like to turn the call over to Mr. William Nettles, Vice President of Corporate Development and Investor Relations.

William Nettles

Good afternoon and welcome to the VeriFone financial results conference call for the fourth quarter of 2008. Today's call is being webcast and a recording will be available on our website until December 23, 2008.

With me today is Doug Bergeron, CEO, and Bob Dykes, CFO.

First for the legalities. I want to remind everyone that VeriFone desires to take advantage of the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. Certain forward-looking statements in this conference call, including management's view as to future events and financial performance, are subject to various factors that could cause actual results to differ materially from those expressed or implied by such forward-looking statements. For a description of these factors, I refer you to our filings with the SEC. Any forward-looking statements speak only as of today and VeriFone is under no obligation to update these statements to reflect future events or circumstances.

In addition, today's call will cover certain non-GAAP financial measures on both an historic and forecast basis. Our management uses these measures to evaluate our operating performance and to compare our results with those for prior periods as well as to other peer companies. These non-GAAP measures are not substitutes for disclosures made in accordance with GAAP. Reconciliations of these measures to the most comparable GAAP measures are presented in our earnings release, which is available on our website at www.verifone.com.

During this presentation, your line will be in a listen-only mode. At the conclusion of today's presentation, there will be a question-and-answer session. Instructions on how to signal for a question will be given by the moderator at that time.

Now I would like to turn the call over to Doug Bergeron, CEO of VeriFone.

Douglas G. Bergeron

Good afternoon everyone. I would like to take the time we have today to review the current state of VeriFone’s various business segments, and more importantly, what we see going forward in this obviously very challenging environment.

First, a brief recap of our financial results announced earlier today. Our fourth quarter GAAP net revenue and non-GAAP earnings per share were within the range we communicated to you on November 20, 2008. GAAP net revenue was $245.0 million, an increase of 3%, as compared to $238.0 million in the fourth quarter of the prior year, and non-GAAP earnings per share was $0.19, an increase of 36%.

Later in the call, Bob will discuss in detail our financial results, including the write-down of goodwill and intangible assets, the tax provision, and the impact that these items have on our GAAP results.

Let me first now proceed with our business review, beginning with our North American market, which experienced a 16% decline in net revenue as compared to the prior year. In the U.S. financial segment, that market which serves processors and ISOs, we supply small businesses. We don’t have much new to report. By all measure, we have a very strong market share lead in this segment but clearly this market is heavily dependent on the rate of new store openings, which is down significantly from previous years.

New stores and restaurants are simply not being opened and shopping centers and strip malls are not successfully replacing stores that close their doors in this recession.

Our multi-lane segment, which directly serves large, national chain retailers, is doing much better, though also challenged by a very soft retail economy and by a number of national retailers recently announcing mass store closings. This market continues to demonstrate a strong interest in enterprise-wide systems upgrades for PCI compliance and other security-related benefits. We won a number of major national chain deals in the quarter and believe we are winning a vast majority of large orders.

The most promising development since we last spoke is the secure pump retrofit opportunity in our petroleum business. In connection with the July 2010 card association mandate that all card transactions at pumps must be protected with advanced triple DES encryption technology, one of our major petroleum customers announced a program to provide financial incentives for its gas station operators who upgrade their pumps to achieve compliance.

Operators who have become compliant will receive a temporary price-per-gallon reduction from the petroleum company, to fund the pump retrofits. In addition, gas station operators will receive an additional financial incentive by achieving compliance prior to June 2009.

Let me now take a few minutes to speak about our international business results and outlook. International net revenue grew 20%, with Latin America growing at 46%, Asia at 13%, and Europe at 8%. As we mentioned in our last call, emerging markets experienced extreme exchange rate volatility in the latter part of October and contributed to our revenue and gross margin shortfall.

We also reported at that time that customers remained motivated to continue their deployment plans for the next year and also noted it was too early to tell how much the increased local currency prices of dollar-based VeriFone solutions would impact roll out plans.

Over the last few weeks we have become somewhat more pessimistic as we read news reports of the weakening macroeconomic fundamentals in emerging market countries, especially those that are dependent on external financing, or rely on oil exports as a major revenue source, such as Russian, Venezuela, and Mexico, all strong VeriFone markets.

We are guardedly optimistic about Asia as China has the internal resources to implement significant stimulus programs and influence economic activity. However, last week we saw worse than expected trade data out of China, which will ultimately be unfavorable to employment, consumer spending, and I suspect systems deployments.

Our approach in these emerging markets in the last few weeks has been to re-evaluate the payback period on some of our growth initiatives and slow down or defer operating expense investments accordingly.

In Western Europe some of our banking customers have been directly impacted by balance sheet issues and all have been impacted by the recessionary environment in Europe.

However, we continue to develop relationships with continental European customers desiring second sources following the merger of Ingenico and Sagem as a counter balance to the overall sluggishness in that market place.

Before turning the call over to Bob, please allow me to give you some updates on VeriFone’s ongoing efforts to prepare and insulate our company for what is clearly going to be a very challenging 2009.

First, we believe cash is king in this environment. We are not extending credit to customers unless we have certainty of quick repayment. In previous cycles we have all witnessed the situation where challenging revenue environments led to aggressive credit terms by suppliers. This is not being, nor will it be the case at VeriFone.

Customers and countries with new economic or geopolitical risks are now being handled on a letter-of-credit basis. We are not offering flexible payment terms to ISOs who can’t get credit from their own banking sources and we think this is a very dangerous game for competitors to play.

We are focused aggressively on reducing inventory and raising cash and we are only building new inventory on a strict P.O. basis.

We have reduced operating expenses by approximately $3.0 million per quarter since the end of the year. The most of that impact will not be felt in Q1 due to notice and severance timing issues. We are aggressively renegotiating any component price, shipment costs, or services cost we can in order to boost our gross margins.

We are continuing to evaluate each of our CM relationships and we will switch suppliers if we feel we are not getting the most aggressive deals available.

And finally, we are now holding firm on pricing in all markets and in fact, increasing prices in Brazil, Turkey, the U.K. and in several other markets. Pricing discipline has become a key and important component of our business mantra in this difficult economy.

Now, I will turn it over to Bob Dyke for details on our financials.

Robert Dykes

This quarter we had a significant write-off of goodwill and intangible assets as a result of continued weakness of our company’s overall equity value as reflected in the stock price during October and potentially weaker future macroeconomic environment.

This write-off, along with an estimated GAAP tax provision of $61.0 million, is the major contributor to our preliminary GAAP earnings per share loss of $4.30. We have reduced the carrying value of intangibles, other than goodwill, by $30.0 million under FAS 144 and we have reduced the carrying value of goodwill by $256.0 million under FAS 142. It should be noted that the Securities and Exchange Commission filing rules allow the goodwill impairment to be filed as a preliminary figure to be trued up in the subsequent quarter and that this impairment and our GAAP tax provision, along with related balance sheet accounts, should be considered preliminary.

Our GAAP statements of operations, balance sheet, and cash flows are also preliminary and will be updated in our annual report filing, Form 10-K.

In addition, it should be noted that this impairment charge was taken only in one geographic area where the total goodwill was $334.0 million and was basically powered on our low-teen stock price during the fourth quarter. We have another $251.0 million of goodwill in another geographic area that was not impaired in 2008 but the declines in our stock price during the first quarter of 2009 are likely to result in impairments to goodwill in these other geographic areas during Q1 that may be in the same order of magnitude as the impairment we took in Q4.

Now I would like to discuss our operating results. As Doug discussed revenue in some detail, I will move next to non-GAAP gross margins, which came in at 34.7%, a decline as compared to 37.6% in the third quarter of 2008, which had the benefit from non-recurring credit. These margins reflect a favorable sequential domestic mix, an unfavorable sequential wireless/non-wireless mix. Specifically in the fourth quarter wireless as a percentage of worldwide sales was 24% as compared with 30% in the third quarter as the recession had disproportionately affected restaurants.

We did have a few non-recurring items in our reported non-GAAP gross margin this quarter, caused by an exchange rate volatility and the unexpected revenue shortfall which contributed to a 100 basis point decline.

Fourth quarter non-GAAP operating expenses were $54.8 million, a slight decrease from the third quarter. We received some benefit from the strengthening dollar at the end of October, from the approximate $26.0 million quarterly run rate of local currency operating expenses.

Moving on now to the balance sheet, we are pleased with our DSO performance, which again was 65 days. Our long-term model continues to be in the low- to mid-70s. Ending inventory, however, was higher than planned, at $170.0 million. We see a need to rebalance inventory with demand and are targeting a reduction in 2009 to $140.0 million.

Our fourth quarter leverage ratio and fixed charge ratio are well in compliance. Note that our EBITDA in these calculations includes $42.0 million of restatement expenses over the last 12 months and the ratios will naturally improve next year as these amounts fall from the trailing four-quarter EBITDA calculation.

Our guidance for the first quarter is for revenue to be between $220.0 million and $230.0 million.

We are now expecting non-GAAP EPS to be between $0.15 and $0.19 per share. We are lowering the fiscal year 2009 revenue guidance to a range of $920.0 million to $1.0 billion. This compares to prior guidance of $950.0 million to $1.03 billion.

EPS should be in the range of $0.85 to $1.10. This compares to prior guidance of $0.95 to $1.20.

Cash flow from operating activity should be in the range of $82.0 million to $97.0 million, consistent with prior guidance as lower cash from net income is offset by reduced working capital requirements.

Now let me turn it over to Doug for some closing comments.

Douglas G. Bergeron

Without a doubt, these are extremely tough times and 2009 will be a challenge in many respects. To be candid, I believe our markets have weakened further since our last conference call. I do not yet see the light at the end of the tunnel and it could very well get worse before it gets better.

Thankfully, we have important and unwavering securities deadlines which will hold up our multi-lane and petroleum businesses. We still expect growth in the emerging markets, where our systems are needed for those new, electronic economies to develop.

From a competitive standpoint, in tough times the leader suffers the least and the small guy the most. We believe these are not times that banking customers experiment with a new provider or a smaller challenger. Although VeriFone’s growth will be dramatically lower in 2009 than our long-term expectations, I believe our competitors will actually experience meaningful revenue declines in 2009.

In summary, although uncertainty and turmoil may continue to impact global economy for some time, we are optimistic that we will come out of 2009 a leaner, stronger business positioned to enjoy the resumption of the good secular growth that the worldwide electron payments system industry provides.

Now we will open up the line for your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Andrew Jeffrey - SunTrust.

Andrew Jeffrey - SunTrust

Obviously the first quarter is a pretty challenging environment. It sounds like you haven’t seen much of anything change in the U.S. and it looks like Europe is a little bit weaker. And then you’ve got sort of the full year improving from the first quarter run rate. Can you give us a sense of the confidence in latter-year ramp up? Are there any specific assumptions you are making to make you feel a little more confident as we move out past the first quarter of the fiscal year?

Douglas G. Bergeron

We are confident, as I said, as we continue to see some growth in the emerging markets, and actually good growth in multi-lane and petroleum. The great unknown is will there be any recovery in North American financial, i.e. processors and ISOs, and in Europe, and in some of our more important emerging markets, like Russia and Venezuela, and Mexico, which are actually hurting quite measurably right now.

Our assumptions are it will be a challenging first half but we built into the revenue range an expectation of some improvement in some of our segments in the second half of the year. Clearly, if that does not happen and we stay where we are today, macroeconomically, or deteriorate, we will be at the low end of our range. If we get some improvement, we’ll be mid- to upper-end of our range.

But the range is wide because of the unprecedented lack of visibility we have in the overall future of the worldwide economy today.

Andrew Jeffrey - SunTrust

Is there anything we should be thinking about as affecting the gross margin here, as we move throw fiscal 2009. It looks like mix has gotten about as adverse as it’s likely to. I know on the last call you talked about some initiatives to reduce the cost of goods. Where were you in that process and how do you consider this 35% range as progressing?

Douglas G. Bergeron

We are on target with all of the research & development programs. They’re largely complete and now those component price reductions are working their way through the supply chain and we have already seen a little bit and we will see more throughout the year, unchanged from the expectations that we discussed last quarter, in the $30.0 million to $40.0 million range.

I think the three factors that are headwinds on gross margins are one of the only places in the world we see growth right now is the emerging markets. That will have a larger than previously planned impact on overall contribution, and they, as you know, have lower gross margins.

We experienced the first decline in wireless system sales as a percentage of overall revenue last quarter, largely due to restaurant softness in Western Europe and in North America. That probably will continue.

And clearly, in tough economic times, there is a propensity for price erosion. We are doing everything we can into our sales channels in terms of holding the line there.

We think the area that we’re at is certainly sustainable, we believe we have got a good road map to improve, but this is going to be a challenging environment, both in revenue and gross margins.

Andrew Jeffrey - SunTrust

At the current run rate or a little better revenues, can you deliver operating leverage? It sounds like you have some pretty good expense control initiatives rolling out, but should we assume that those are going to fall sort of directly into the bottom line here?

Douglas G. Bergeron

Yes. You have the numbers for last year. We are running at a significantly higher opex run rate that we believe we will be in by Q2 of this year. Both the result of our own re-engineering, if you will, or our work forced and cutting of some of the discretionary expenses that can be cut in these types of times.

And also, we have been benefitting, I don’t know what the future holds, from a stronger dollar recently, which leads to a better environment for non-dollar expenses, which are a major component of our overall expense structure.

Operator

Your next question comes from Tien-Tsin Huang – JP Morgan.

Tien-Tsin Huang – JP Morgan

Can you give us more detail on the outlook by region? Anything we should consider as we model out growth by sector that may be worth pointing out?

Douglas G. Bergeron

We are on flat growth in North America and 10% growth internationally, gets you the midpoint of our range. That flat growth in North America is a decline in revenue year-over-year in processor/ISOs offset by an improvement in multi-lane and petroleum and taxi. Internationally, that 10% is largely flat is Europe and 15% to 20% elsewhere.

Tien-Tsin Huang – JP Morgan

And it sounds like pricing on your side has been holding pretty firm. Just generally speaking, do you feel like pricing out there is going to be rational? Is there a risk of any sort of aggressive moves or irrational pricings from the competitors, going forward? How do you think about that?

Douglas G. Bergeron

I pray that’s not the case. I think all of the participants in the market recognize that these are challenging times and I hope that they look at their own balance sheets and realize that you can’t be in business unless you generate cash. That’s our philosophy.

Tien-Tsin Huang – JP Morgan

The emerging markets, and what you are seeing, any change in the trends, month-to-month. You highlighted Russia and some of the others, and China, etc., but have you noticed any other broader changes in terms of appetite for new terminals. I only ask this because there are a lot of things obviously going on in the credit side and that could influence card-issuance growth, and of course you have got capex concerns coming out from the retailers. But then you have very low penetration overseas so, anything that is interesting to note here in terms of nearer-term trends, from some of the regions?

Douglas G. Bergeron

It’s different in every market. Like I said, Western Europe is really tremendous sluggishness caused by the major banks on the acquiring side, RBS and HSBC, etc. having their own balance sheet issues. In Russia, and Eastern Europe, which has long been a very strong contributor to VeriFone’s growth, you have currency conversion issues and in fact, some solvency issues with some of the smaller banks. Things are stable in the Middle East and through South Africa. They appear to be stable in China, although we get worried about it from time to time when you read the paper, as I mentioned. The rest of Asia has not yet started to show a lot of concern to us.

The only other issue that I didn’t mention earlier is the much weaker Brazilian real, Mexican peso, Russian ruble, ultimately lead to an impairment of purchasing power. I mean, there are no local providers. It’s effectively one French company and VeriFone most of the time and maybe Hypercom from time to time, but it’s not like the devaluation of the local currency is causing a competitive issue, but it causes a reduction in purchasing power.

And you have some major acquirers or processors, I have to believe, who did not build into their local business models 30% or 40% less purchasing power for 2009 of dollar-based systems.

Tien-Tsin Huang – JP Morgan

The expenses, by line, R&D, sales & marketing, G&A, as we model that out sequentially, is this a good base to run off of or any adjustments we should consider, beyond the ones you called out from GAAP to non-GAAP.

Robert Dykes

No, I think if you use the non-GAAP numbers that are in our report there, you can just model those and as we said, we do have reductions from the number we just reported for the fourth quarter and we expect to see that coming through by the second fiscal quarter.

Operator

Your next question comes from Gil Luria - Wedbush Morgan Securities.

Gil Luria - Wedbush Morgan Securities

Your petroleum business, could you work out for us how big of a business that is of the overall, of the last fiscal year, and then how much was it down last fiscal year when gas prices were up and the convenience store and petroleum stations had a credit crisis of their own?

Douglas G. Bergeron

Historically it has been about 12% to 13% of our total business. It’s almost all U.S. and Canada, 95% North American. Last year, as you properly pointed out, it was 8% or 9% of the total revenue because of the reasons you mentioned. I would hope this year it returns to a more normalized 12% or 13% of revenue, $85.0 million to $90.0 million type of range.

Gil Luria - Wedbush Morgan Securities

Bob, could you take us through the calculation of the fixed charge covenant? What are the individual pieces for that calculation for fiscal year 2008?

Robert Dykes

Well, we actually report that to just to our folks that are the bond holders. But it’s important that when you’re doing that, that we only talk about the senior credit facility. But it’s basically you take EBITDA for the last four quarters, assuming the stock comp are non-cash, non-recurring items and less capital expenditures and the cash tax payments, and you divide it by the fixed charges, which is an interest expense, excluding the convert less interest expense, and net of interest income. And then any scheduled debt amortization you put on that as well, which is pretty small. And it has to be greater than two and we are substantially higher than that.

Operator

Your next question comes from Wayne Johnson - Raymond James.

Wayne Johnson - Raymond James

The guidance that you provided, what are your FX assumptions for 2009.

Robert Dykes

We’re not making specific FX assumptions. We basically have in our model [inaudible] today.

Wayne Johnson - Raymond James

So it’s constant currency, would that be fair?

Robert Dykes

Yes, I would say that’s fair.

Wayne Johnson - Raymond James

Well that may have worked in your favor here.

Robert Dykes

I would also point out that in lots of places we actually sell in U.S. dollars and even technically when we sell in local currency, we negotiate in U.S. dollars.

Wayne Johnson - Raymond James

I understand. And thank you for that clarification. On the pricing side, what do you think is driving the firmness, how you have been able to establish a firmer pricing base in what is arguably a very weak demand cycle here, and can you just talk a little bit about geographies where you feel that there are opportunities to improve pricing? You have already mentioned some where the pricing has gone up. If you could provide some comments on that it would be helpful.

Robert Dykes

Doug will probably give you more details but I will start by pointing out that in most markets there are only two competitors, which makes for a reasonably stable environment and often it’s a different two competitors but generally it’s two competitors and it creates a lot of the stability.

Douglas G. Bergeron

The first control mechanism is internal. You just say no. Politely, of course. And in an environment like this, where I don’t think you are rewarded for chasing the last dollar in revenue anyway, we are less than ever interested in the last dollar of revenue at a substandard gross margin.

We have continued to tweak our compensation plans for our direct employees around gross margin versus revenue. We have less control over our indirect channels but we are firm negotiators with them.

At the end of the day all we can do is hold the line. We are participants in a market, we don’t make the market and we have been vocal and I think firm with our intentions and we will continue that.

Wayne Johnson - Raymond James

And how would you characterize the pricing environment in the U.S. and Western Europe?

Douglas G. Bergeron

I don’t think it has changed much. The exchange rate volatility serves as a bit of a fog layer for all of us, both here and at our competitors, because when exchange rate move around 20% in a quarter and all of our expenses and COGS are in different currencies, it is very difficult to keep a real time handle on where your gross margins are and what your actual discounts are. But in a status quo environment you just hold the fort. I think the pricing environment really, as I said earlier, hasn’t changed much, or really at all, in the last six or nine months.

Wayne Johnson - Raymond James

On the petroleum side, that sounds like good news compared to what had been bad news in prior quarters. Is this catch up from the petroleum companies? What do you think is driving that improved performance?

Douglas G. Bergeron

The initiative we announced was with one petroleum company, announcing this effective subsidization of secure pump pay systems with wholesale price discounts to the retailers. The better quarter, last quarter was perhaps a bit of a catch up. I can’t imagine that the lower gas prices have bubbled their way into improved capital spending yet but if you talk to the folks at Visa and Master Card, and we do, gas station retail is one of the few bright spots in retail these days. So hopefully we will have a good 2009.

Wayne Johnson - Raymond James

Do you see Ingenico more or less in the U.S. than a year ago or has there been any change in the competitive landscape?

Douglas G. Bergeron

No, we see them in many multi-lane deals and despite a little bit of flurry mid-last year regarding an interest in the financial retail group, we haven’t seen, to be honest, any traction there so far.

Operator

At this time there are no further questions.

Douglas G. Bergeron

Thank you everyone. Hopefully we relayed the message today that we’ve got our heads down and we are preparing for the worst and hopefully we will all get through this a better company.

Operator

This concludes today’s conference call.

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