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Diebold, Inc. (NYSE:DBD)

Q4 2008 Earnings Call

February 04, 2009 10:00 AM ET

Executives

John D. Kristoff - Vice President, Chief Communications Officer

Thomas W. Swidarski - President and Chief Executive Officer

Kevin J. Krakora - Executive Vice President and Chief Financial Officer

Analysts

Matt Summerville - KeyBanc Capital Markets

Gil Luria - Wedbush Morgan Securities Inc.

Reik Read - Robert W. Baird & Co.

John Healy - FTN Capital Markets

Operator

Good day everyone and welcome to Diebold Incorporated's Fourth Quarter Year-End Finance Results Conference Call. Today's call is being recorded. At this time for opening remarks and introductions, I would like to turn the call over to the Vice President and Chief Communications Officer, Mr. John Kristoff. Please go ahead sir.

John D. Kristoff

Thank you Bill.

Good morning everyone and thank you for joining us for Diebold's fourth quarter and 2008 year-end conference call. Joining me today are Tom Swidarski, President and CEO and Kevin Krakora, Executive Vice President and CFO.

Just a few notes before we get started. We've adopted a slightly different format for our earnings releases and conference calls moving forward. In addition to the earnings release, we've provided a supplementary presentation on the investor page of our website. Tom and Kevin will be walking through this presentation as part of their opening comments today. And we encourage you to follow along and hope you find value in this new enhanced format.

We've included non-GAAP financial measures throughout our presentation this morning. Specifically, I refer you to slide 30 through 42 which provide our rationale for the use of non-GAAP measures as well as complete GAAP to non-GAAP reconciliations. Also, a replay of this conference call will be available later today from our website.

And finally as a reminder, some of the comments today maybe considered forward-looking statements, internal and/or external factors could significantly impact actual results and as a precaution, we refer you to the more detailed risk factors that have previously been filed with the SEC.

And now with opening remarks, I'll turn it over to Tom.

Thomas W. Swidarski

Thanks John. Good morning everyone.

2008 presented a unique set of challenges for Diebold, while I am very satisfied with the results we have achieved. I'm sure the most pressing question on everyone's mind is 2009. As you can see in our release, our outlook for 2009 has wider range than we typically provide. These is a reflection of the historic uncertainty that exist in the global economic market today, particularly in the financial industry.

Both Kevin and I will provide more detail on our assumptions for 2009 as we progress through this morning's call. But before we do that, let me first comment on 2008.

We achieved some remarkable results during the year. Despite operating in a tumultuous environment while remaining focused on the priorities we've established in 2006. Thanks to the stellar efforts of our associates worldwide, we accomplished much during the course of the year. Specifically, we ended the year with a strong balance sheet and cash flow. Liquidity was a key focus for us through 2008 and continues to be a key asset as we enter 2009.

We established a leadership position in China, also Opteva ATM were exclusively deployed by the Bank of China during the Beijing Olympics. We grew our presence in key emerging markets, Brazil, Russia, India and China. In United States, we continue to gain market acceptance with our integrated services portfolio. And for the second consecutive year were named as one of the world's top 100 outsourcing service providers by the International Association of Outsourcing Professionals, ranking well ahead of our nearest industry competitor.

We increased shipments of deposit automation solutions by nearly 50% from 2007. We expanded our solutions set with the launch of our bulk check deposit capability, we also introduced an innovative new bulk-cash acceptor, which we've rolled out later this year. We gained traction in the government security space. A new multi-year contract with United States Postal Service is a prime example. And, we made a number of significant operational improvements in 2008.

As shown on slide 5, in November we met our goal to eliminate $100 million in cost from our cost structure. We initiated a computed wide effort to find smarter ways of doing business that would simultaneously reduce cost and prove the quality of our product and services, and increase customer satisfaction. Associates who worked on these initiatives, did a tremendous job of thinking in more innovative ways. They did more than just squeeze cost out of the old process, they identified best practices that were new to Diebold and implemented them successfully. As a result of the success of this initiative, in 2008, we expanded the effort to eliminate an additional $100 million of cost out of the company by the end of 2011.

Key to this next 100 million, we expanded our relationship with Menlo, our logistics partner in the supply chain area. They assisted us in reducing our finished goods warehousing footprint from 89 company operated facilities, down to three Menlo operated logistic centers. One of these centers located in Greensboro in North Carolina, is a flexible delayed product configurations facility serving markets in North America and Latin America. This helps us improve lead times to our customers while reducing costs.

We also improved our manufacturing footprint. We now have 85% of our Opteva production in low cost geographies. By increasing in low cost geographies, we are also manufacturing our ATM products closer to our key customers and growth regions in Asia and Eastern Europe.

In addition, we consolidated our security manufacturing facility in Ohio, with an existing facility in North Carolina. To further streamline our operations, we expanded our vendor managed inventory system, also we continue to leverage our relationship with Aviva, implementing best practices in direct and indirect procurement processes.

Finally, our relationship with key suppliers have matured to the point where they are now on slight actively collaborating with our engineering and design teams on new product development initiatives.

Additionally, we have continued to eliminate waste and improve productivity through our global service operations. Service remains a key strategic focus for me, as we further differentiate ourselves from our competitors. The improvements we've made have enabled us to reduce response time and improve overall up time.

Through all these strategic initiatives, we not only delivered significantly improved profitability for our shareholders, we're also improving our already strong customer loyalty ratings, which rose an additional 20% year-over-year.

Another key strategy for Diebold has been expanding our recurring services business. In 2008, total contract value for our integrated services and outsourcing business grew more than $55 million in United States alone. Clearly, financial institutions are moving quickly to reduce their cost structure and focus on their core business of retail banking. This creates more opportunities for us to expand our integrated services business. This recurring revenue stream when combined with our traditional recurring maintenance contracts, represents more than half of our total revenue.

Our proven ability to execute on our strategic initiatives, combined with our recurring service revenue stream, positions Diebold to continue to deliver sustainable long-term value.

Now, to review our performance in the business segment, I'll begin with financial self-service in the Americas which is slide number ten. In the financial self-service market, demand for our solutions remained relatively stable. Working at the Americas, activity in the national accounts United States remained solid during the quarter. This was driven by continued steady deployment of the deposit automation technology.

Diebold remains well positioned with the National Bank segment. In fact, of the top five U.S. bank ATM deployers, which represent approximately 55,000 ATMs, Diebold has more than 50% share of their installed base. Demand in the regional accounts in the United States, however continued to weaken during the quarter. These banks remain conservative with capital deployment in this recessionary environment.

In Brazil and Latin America, the demand environment remained strong. We continue to maintain a strong leadership position in Brazil. In 2008, we were awarded every major order, including two of the largest ATM orders in history, with Banco de Brasil and Kasha. Our exceptional service organization and large integrated service business in that region enabled us to maintain our competitive advantage moving forward.

In EMEA, while revenue was down from the quarter and year, our profits in the region improved substantially. Our strategy there remains to aggressively focus on growth regions in Eastern Europe. We have, however, seen some weakening recently, particularly in Russia where oil prices have fallen and credit is tightened. In Western Europe, our strategy remains to selectively pursue profitable business. As part of this strategy, we've made great strides in rightsizing our infrastructure and realigning our distribution model in certain countries.

For example, we adopted a different distribution model in Germany and closed our direct German operations. We believe that by taking this approach, in Europe we can establish a profitable, sustainable business on a more manageable scale.

Turning to Asia-Pacific. Revenue decreased significantly in the fourth quarter. As previously discussed, this was a result of a large order in China, which revenued in the third quarter rather than the fourth. For the full year however, sales in Asia-Pacific were up nearly 20%, with particularly robust growth in China, where we continue to expand our leadership position. We've also made progress growing our service business in the region. For example China, India and Thailand collectively grew their service businesses more than 25% during the year.

In addition, by focusing on growing our integrated services business, our operation in India has transformed from several years of operating losses into a profit center in 2008.

The recurring (ph) revenue during the quarter was down 13% and down 5% for the full year. This business remains U.S. centric with high exposure to banking.

Top-line growth continues to be adversely affected by reduced construction of new bank branches. In addition we've experienced delays in some large customer projects due to recent consolidation. This has particularly impacted our physical security and facility business. Similarly, the environment for retail security was also weak as major retailers scaled back spending given the difficult economy.

We've made great strides in the government space in terms of building credibility. This culminated in the major contract with United States Postal Service that was awarded to Diebold late last year. Diebold is one of only a few security integrators with the service infrastructure and technological expertise to undertake such an extensive project, and design and deliver an IP... an integrated IP video security solution. This agreement helped establish Diebold as a credible player in the government space, which is important as we pursue other large opportunities for 2009.

We made similar progress in the commercial security business, where we continued to experience solid growth in the business-to-business segment. These successes underscore how we've elevated our presence and our security integration capabilities beyond the financial services into new markets.

As we move forward, we intend to build on this success. We are for example, in the early phase of introducing an energy management solutions that could control and monitor heating, ventilation, air conditioning and lightning for our customers. This is another value-added service which can help relieve our customers of the everyday challenges they face in managing their facilities, while also reducing their cost and increasing environmental efficiency.

Despite the recent revenue challenges facing our security business, we've managed to improve our profitability. We've accomplished this through cost reduction initiatives, concentrating sales efforts on high value; high margin opportunities and reevaluating unprofitable segments.

For example, our retail security business was able to realize higher margins despite reduced revenue in 2008.

In the case of our EMEA based enterprise security operations, we were not able to achieve an acceptable level of profitability, and therefore recently made the decision to close those operations entirely.

In summary, when looking at our total business, we made many strides throughout the course of the year. However the global economic downturn which began to accelerate during the fourth quarter, clearly affected the market in which we operate. Looking ahead the global economy will almost certainly remain extremely challenging throughout 2009.

In particular, the financial industry is under pressure to decrease cost and gain efficiency in this climate. As a result, we see long-term opportunities to further assist our customers in transforming their businesses. However, the near-term outlook here remains very uncertain. Given this uncertainty and the volatility that currently exist in the financial industry, we're taking a number of additional short-term cost saving actions. These actions include deferral of executive merit pay increases, a substantial reduction in the company's 2009 for 1K match (ph), a significant reduction in advertising expenses and a company wide initiative to reduce travel.

Finally, in 2008, we reduced our global workforce by approximately 800 positions or 5%. As 2009 progresses, we will continue to evaluate headcount level and take additional actions, if necessary. While we are obliviously concerned about the negative global economic environment we are facing, Diebold is in a unique position to deliver value.

The solutions we provide enable customers to reduce cost and improve efficiency. Additionally, more than half of our revenue comes from services, much of which is recurring in nature. Finally, we've put in place the infrastructure, culture and processes, to drive continuous improvements across our business. As we move forward, we'll continue to enhance, diversify our offerings, realize synergies where sensible, and make prudent and financial business decisions.

To conclude, I'm proud of the significant progress we've made during the past year to improve profitability, and enhance our competitive position while facing a multitude of challenges. As we look ahead, 2009 is the 150th anniversary of Diebold. We posses many strengths refined during our 150 years in business. Our people, our brand, our strong balance sheet and liquidity, and more importantly our ability to deliver innovative solutions to our costumers. All of these attributes will help guide us through the tough environment all businesses will be facing in 2009.

I'd like to express my thanks to all the Diebold associates and today my appreciation for the terrific job that you do every single day. With that I'll now turn the call over to Kevin.

Kevin J. Krakora

Thanks Tom, and good morning everyone.

While 2008 certainly presented a unique set of challenges for us, I'm very pleased with the solid performance that we achieved throughout the year. In the full year 2008, we achieved significant improvement in profitability and earnings per share and delivered exceptionally strong cash-flow.

I feel these improvements confirm that the company's leadership team and highly engaged work force are focused on the right operating and financial initiatives to reach our long-term financial goals.

Before we review the financial information, it's important to note that we have a significant amount of restructuring charges, non-routine expenses and impairment charges in our financial results. We believe that excluding these items, provides an indication of the company's baseline performance. As a result many of my remarks will include non-financial information.

Let's now turn to our financial results. First I'd like to refer you to slide 16, which focuses on the fourth quarter and full year revenue highlights. Total revenue decreased by 57 million or 6% in the fourth quarter which included a negative currency impact of 5%. For the full year 2008, revenue increased 223 million or 8% which included a net positive currency impact of 2%.

Looking at our financials self-service business on slide 17, revenue decreased by 34 million or 5% in fourth quarter. The reason for this decrease was reduced revenue quarter-over-quarter in China. As we have communicated in prior quarters our typical seasonality was affected by purchases in China which came in earlier 2008 rather than being concentrated into fourth quarter.

If we were to exclude the impact of China, total financial self-service revenue in the fourth quarter would have increased 1%. For the year, financial self service revenue grew a 169 million or 8%, as we had particularly strong growth in both Brazil and Asia Pacific.

Now, turning to slide 18. Our fourth quarter security revenue decreased by 31 million or 13%. A majority of this decrease occurred in the banking segment which saw declines in new branch construction and delays in facility renovations. For the full year, security revenue decreased 37 million or 5%. Again the weakness in the banking segment accounted for much of the year-over-year decrease. In addition, we experienced reduced spending by our major customers in the retail market.

However, our government and commercial security businesses, in total, were up slightly for the full year. Finally, election systems revenue grew by 91 million for the year, with more than two thirds of this increase coming from election systems revenue in Brazil.

Turning next to non-GAAP total gross margins, I'm pleased to refer you to slide 19. The fourth quarter 2008 gross margin was 24.5%, down slightly from the 24.6% in Q4 2007. Product gross margins in the Q4 2008 was 24.6%, a decline of 1.1 percentage points from Q4 2007. This decrease was due to a premier election's inventory write down of $13 million in the fourth quarter of 2008 and $4 million write down in the fourth quarter 2007.

However service gross margins in the fourth quarter of 2008 improved by 0.9 percentage points moving from 23.5% in Q4, '07 to 24.4% in Q4, '08. This improvement was primarily due to productivity and efficiency gains realized in North America and EMEA.

Full year 2008 gross margin was 25.9%, an improvement of 1.8 percentage points. In that time product gross margins improved by 0.7 percentage points, moving from 27% to 27.7% in 2008. The highly profitable Brazilian voting business was a major factor in driving this improvement. Excluding this business, product gross margins in 2008 would have been 27.1%, just slightly higher than the prior year.

Benefits realized from our cost savings plans was partially offset by unfavorable sales-mix within North America, higher commodity costs and price erosion in certain international markets.

Full year service margins improved dramatically, moving from 21.3% in '07 to 24.1% in '08. This improvement reflects savings from our cost reduction initiatives, productivity and efficiency gains and improved product quality. These gains came despite significant year-over-year increases in fuel costs and represent an improvement well in excess, the 22% target we established for service margins back in 2006.

Moving on to non-GAAP operating expense. As highlighted on slide 20, the Q4 2008 operating expense as a percent of revenue was 17.8% compared with 16.1% in the comparable period of 2007. Operating expenses in the fourth quarter increased by 4.3 million or 3% from the prior period. While we control the absolute dollar spend in operating expense, drop in revenue quarter-over-quarter drove the increase in operating expense as a percent of revenue.

Full year 2008 operating expense as a percent of revenue was 17.4%, an improvement of 0.5 percentage points from 2007. Operating expenses in 2008 increased by 24 million or 5% compared with 2007. This increase was partially a result of the impact from currency exchange and higher legal expenses. In addition, the full year 2007 included the $10.1 million recovery of a previously reserved Premiere Election's receivables.

Finally, higher accruals for a performance pay and additional cost of living increases were more than offset by savings from our cost reduction initiatives.

Now if you would please refer to slide 21. Non-GAAP operating profit margins in the fourth quarter 2008 was 6.8% compared to 8.5% in fourth quarter of 2007. This decrease was due to unfavorable leveraging of operating expenses as a percent of revenue.

Operating profit margin for the full year 2008 was 8.4%, compared to 6.2% in 2007. As we indicated earlier, 2008 financial results benefited from highly profitable Brazilian voting business. Excluding this business, the operating profit margin in 2008 would have been 7.8%, a 1.6 percentage point improvement over the prior year. This improvement in operating profit margin was the result of higher gross margins, especially in our service business coupled with the positive leveraging of our operating expenses.

Turning to the EPS reconciliation slide, non-GAAP EPS from continuing operations in the fourth quarter 2008 was $0.40 per share compared to the $0.67 per share in fourth quarter 2007. Full year EPS from continuing operations was $2.69 per share compared to $1.70 per share for the full year 2007, an improvement of 58%.

In earnings per share from continuing operations for both the fourth quarter and the full year of 2008, benefited from a lower effective tax rate. The effective tax rate in 2008 on income from continuing operations on a non-GAAP basis, was approximately 22% compared to approximately 28% on a similar non-GAAP earnings in 2007.

In the fourth quarter 2008, the company closed its EMEA based security operations. Given the materiality of this business, the company was required to separately categorize all the financial results from these operations on its P&O as a single-line item titled, loss from discontinued operations net of tax. This loss was 13 million in 2008, compared to 5.4 million in 2007, including the 2008 loss was a non-cash asset impairment charge of $16.7 million.

Turning next to cash... net cash flow on slide 23, I was extremely pleased with our fourth quarter and full year cash flow performance. Free cash flow improved by 90.5 million or 87%, moving from 103 million in Q4, 2007 to 194 million in Q4, 2008. And we define free cash-flow as net cash from operating activities less capital expenditures.

Full-year 2008 free cash-flow was 223 million, more than double the 107 million in 2007. This represents a record level of free cash flow and was realized despite significant cash payments for restructuring and non-routine expenses in 2008.

Looking at the next two slides on working capital metrics. Days sales outstanding or DSO improved by 6 days moving from 51 days at December 31, 2007, down to 45 days at December 31, 2008. DSO of 45 days is exceptional, especially when you compare it to our recent history when the company's DSO was routinely higher than 60 days.

The improvements realized over the last two years reflect globally coordinated efforts across a number of departments and divisions within the company to streamline and shorten our total order to cash process.

Inventory turns improved from 4.2 turns at December 31, 2007, to 4.4 turns at December 31, 2008. I'm disappointed with the lack of significant progress with our inventory turns, we anticipate greater improvement moving forward with the completion of our global plant realignment and the warehouse consolidation effort.

Turning next to liquidity and net debt. Net debt at December 31, 2008, was 254 million, a decrease of 70 million from a year ago, our net debt to capital ratio was 21% at December 31, 2008, compared to 23% at December 31 2007. Given the current uncertainty in the credit markets, and the heightened importance of liquidity, I'm pleased that we are able maintain such strong balance sheet. The significant reduction in the equity market values has created both earnings and cash-flow pressure on many company sponsored pension plans. As a result, I'd like to spend a brief minute reviewing the status of our pension plans.

As highlighted in slide 27, the positive news is that our pension plans will not significantly affect either our profitability or our cash flow in 2009. After completing a review of our... with our actuaries, we have determined that our 2009 pension expense will be approximately $6 million, that compares with 3.3 million of net expense in 2008 and 8.2 million in 2007. In addition, we anticipate cash contributions of 12 to 14 million in 2009, compared with contributions of 6.8 million in '08 and 11.3 million in '07.

Turning to our full year outlook for 2009. As Tom mentioned in his remarks, we expect 2009 to be an extremely challenging year, we're facing a difficult market environment which we expect will continue to disproportionately affect spending in our profitable regional banking segment. We've also encountered currency headwinds, especially from a weaken Riyal and Euro.

And finally, we have difficult revenue and profit comparisons without the repeating Brazilian election systems business. As a consequence, we expect full year revenue to decline 2 to 10% with currency headwinds of nearly 5%. Our expectation is that financial self-service revenue will decline 1 to 7%, while we expect security revenue to be in the range of negative 8% to positive 3%.

Finally, we expect election systems revenue of 70 to 80 million with no anticipated elections revenue from Brazil and the lottery systems revenue of 5 to $10 million. We expect our full year 2009 GAAP EPS to be in the range of $2.07 to $2.36 per share.

Restructuring charges and non-routine expenses are expected to be nominal and in total of the range between $0.03 or $0.04. Excluding these items, non-GAAP EPS is expected to be in a range of $2.10 to $2.40 per share. Within this guidance, we have several moving parts and assumptions as I highlighted on slide 29.

As I mentioned previously, a profitable Brazilian elections business in 2008 did not repeat in 2009. This represents a negative impact $0.30 per share. We are expecting an effective tax of approximately 28% which is significantly higher than 2008 due primarily to expect the changes in the geographic mix of income. This higher tax rate will negatively affect EPS in 2009 by $0.13 on the lower range and $0.16 on a higher range.

Given current exchange rates, and the recent strength of the Dollar against the Euro and the Riyal in particular, we anticipate a negative EPS impact of approximately $0.13 year-over-year. We expect additional benefits in 2009 from our cost savings initiatives, depending on volume we anticipate a positive EPS impact of approximately $0.34 to $0.43 per share from these savings.

Also, we anticipate continued adverse revenue mix shift particularly within North America, where we have recently seen a more significant shift in demand from our higher margin regional accounts to the lower margin national accounts. Our guidance assumes this trend will intensify in 2009. We believe the impact from this shift in revenue could negatively affect earnings by $0.26 to $0.39 per share.

Finally, it's important to note that, included in the other line is the net positive impact from the premier elections inventory write down in 2008 that does not repeat in 2009.

As I mentioned earlier, our full year operating margin, excluding the profitable Brazilian elections revenue would have been 7.8%. Our 2009 EPS guidance implies on lower revenue and operating margin flat to slightly up from this 2 to 7.8% level.

We believe we can achieve these operating results despite lower revenue levels, unfavorable business mix and the headwinds in currency exchange rates. Key to achieving these results will be continued execution of our cost savings initiatives. In addition as Tom stated in his remarks, and as listed on slide 14, we're taking a number of short-term cost saving actions given this extraordinary economic environment.

In conclusion, while it's impossible to plan for every contingency that may occur in this climate, I can assure you that we will continue to act swiftly and decisively. We will continue to focus our reducing cost, improving our business and delivering innovative solutions to our costumers. This gives me confidence that we can continue to outpace our competitors in this period of uncertainty.

Now I'll turn the call back to John.

John D. Kristoff

Thank you Bill.

Thanks, Kevin. Bill we're for our first question, if you would go ahead please.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions). And we'll take our first question from Mark... excuse me, Matt Summerville with KeyBanc.

Matt Summerville - KeyBanc Capital Markets

Just wondering if you could, Tom, kind of walk through what your regional expectations are either including or excluding currency, however you want to talk about it, for the ATM businesses that are embedded in your I think, minus 7% to minus 1% kind of revenue number?

Thomas Swidarski

Okay. Matt, I'll start with that and then Kevin you can chime in (ph) as we go through. Certainly, the regional bank space, the area that we have the most scrutiny on and we saw some significant shift as we entered into the November, December timeframe of last year. So, throughout the course of 2008, we saw order entry that was fairly strong and then we saw a change in that occur really towards the end of last year which has given us kind of uncertainty in that space which has caused us to really try and make some prudent decisions here. So, in the... in the ranges that we've set up, we have in the regional banks space and basically that's North America, we are projecting to be at the high-end down in the low double-digit range. And then at the high... I'm sorry, at the low-end we would be down at 25 plus range for the regional accounts in the U.S.

Matt Summerville - KeyBanc Capital Markets

And then can you sort of walkthrough what your thought processes with, I'll just call them the big banks here domestically?

Thomas Swidarski

Yeah with the big banks, it's interesting that's almost on the other side that we saw a continued strengthening in the U.S. throughout the course of the year. We come into the year with strong visibility and good market position there and have good confidence in terms of not only where we stand, but in terms of the continued rollout of the deposit automation which is the big driver for the major players there.

Certainly, of the impact of the acquisitions that are occurring, that impact, the timings of some of these decisions with the National City, in PLC environment. But all in all, we have very good visibility, good strength there. And one of the other common fact on the regional side that we've seen as, as you get into some of these players and again as acquisitions take place there, we've seen a few orders move to the right as acquisitions have taken place and they are postponing those. We've seen the FDIC come in on a couple of occasions and delay some existing decisions. So, really what we're seeing the bulk of the impact of the uncertainty is the regional space, we feel very good about the clarity and visibility and strength of the national players.

Matt Summerville - KeyBanc Capital Markets

Great. Then can you kind of walkthrough the other regions as well?

Thomas Swidarski

Certainly. Let me just finish maybe the Americas, with Brazil and Latin America, very good position, feel very strong in terms of some good order entry really throughout 2008 and feel good in terms of those markets heading into 2009. Certainly, the economic downturn may have some impact on certain regions there, but we feel very strong with the backlog and our position in those spaces that we feel... we will fair very well.

If I move to Europe, certainly Europe continues to be from a revenue standpoint, a challenge for us, especially because of the competitive position in Western Europe, but we've really focused on profitability, and improving profitability in Western Europe as well as a good competitive position in Eastern Europe, and feel like we've made some good strides there. Thus we took some actions in 2008 to strengthen profitability there, to put us in better stead. But from a revenue standpoint, it will impact us in terms not having the same level of revenue but much better profitability, and being selective where we go.

So, Europe again is... we are number three player when you look at all of Europe combined and that's the area that we will have the greatest challenges in going forward. And you got an economic environment there that's challenging as well. So, I am pretty cautious relative to the European region.

Asia, I feel very strong about, feel very good in terms of what we've accomplished in China over the last several years, and this year was just an absolute banner year. But we've made some great progress throughout the rest of the region as well. I mentioned that our services business grew 25% really as a result of China, Thailand and India. India, we are seeing a lot better profitability delivered as a result of the focus on integrated services. So, I feel like we are... the ship is definitely strong in that region and we've got some good visibility to major markets there and feel like we're well positioned.

So, if I would summarize Matt, I'd say the two areas of greatest concern as we look out in the market, would be the regional bank space in the U.S. and the EMEA region.

Matt Summerville - KeyBanc Capital Markets

Okay. And then, just a couple of other questions. Kevin, do you have the split between how much of the restructuring charge, was in product gross margin versus service gross margin?

Kevin Krakora

I do. And if you give me a minute, I can locate that real quickly for you.

Matt Summerville - KeyBanc Capital Markets

Okay. And then, I guess I will ask another question, while you are looking. Tom, you've highlighted I think it was Tom, in your prepared remarks around some of the other things you are looking to do from a cost standpoint near-term. Outside of the 800 people that you've reduced in terms of headcount. Are there material savings in some of those other things you are talking about, whether it be compensation, whether it be reducing travel, can you quantify that in some way?

Thomas Swidarski

I don't have that right in front of me, Matt. But I would say probably in the range of 5 to 10 million, ballpark, I mean I could go back, we could find a better number, but I think that's kind of what I recall. So, for us that's material.

Matt Summerville - KeyBanc Capital Markets

And then how much of the 800 people... or the headcount reduction, how much savings from that did you realize in '08 and then how much is left therefore to be realized in '09?

Thomas Swidarski

Yeah, I would say the vast majority of the realization of that will be '09. I don't know if it will be 25% in '08 kind of range, but I am guessing along those lines.

Matt Summerville - KeyBanc Capital Markets

Okay. And then just one last question, and then maybe Kevin has that data point or I'll just back in the queue. With regards to free cash flow, obviously you had an excellent 2008 in terms of the cash generation. What are your thoughts on what you can do in 2009, whether a similar number given the absence to cash restructuring some of this non-routine stuff could in fact still be in the cards for Diebold? In that context, what are your CapEx plans? And then have you thought... are you thinking anything differently especially with stock down today, about share repurchase?

Kevin Krakora

Let me answer that, Matt. Before I give the information about restructuring, we have about 42 million of restructuring expense in 2008, 25.6 million of that was at the... in the product... in the gross margin line and 15.9 million of that was in the Op expense line.

And to your questions on cash-flow, obviously, we were again exceptionally pleased with the performance that we had in '08, while we didn't provide specific guidance for '09, our expectations are that we're going to have strong cash flow in 2009. One of the things that drove our good cash flow in '08 was remarkable improvement in DSO, getting that down for the 45 day range. Again our expectations as we go into '09 is that, we are kind of getting a point where any improvements there can really be slight. We are looking inventory turns as an opportunity for continued improvement from a cash flow perspective in '09. So, those two things we have to comfort (ph).

The third is capital expenditures. What we said there and talked about spending just over 50 million in this year, we expect in 2009 to spend a little bit more than that, but probably in the range of call it 65 million to 70 million CapEx spend and some of that's going to be related to some IT investments that we continue to make in our business space. So, when you put all those spaces together, my expectation is that we are certainly going to well north of $100 million of free cash flow as we go into 2009.

With regards to your question on share repurchase, clearly at the price levels we are at, we think that we are undervalued and we'd love to be buying back shares. We continue to look at the environment though and what's happening with bank lending activity and liquidity and certainly in the near term we'll continue to look at that but would not be expecting to do any share repurchasing in the near-term environment until we see some change in the behavior of bank and bank lending.

Matt Summerville - KeyBanc Capital Markets

Great, thanks.

Operator

And we'll take our next question from Gil Luria at Wedbush.

Gil Luria - Wedbush Morgan Securities Inc.

Good morning.

Thomas Swidarski

Good morning Gil.

Gil Luria - Wedbush Morgan Securities Inc.

Wanted to dig a little deeper into the U.S. market. In the national banks, when you're talking about the top three or top five banks and their roll outs of deposit automation, are those all progressing still at the same rate and when do you expect those roll-outs to be complete?

Thomas Swidarski

Yeah. I would say of the top five banks, probably the top three are the ones really rolling out aggressively and we've seen them not back off. In some cases, we've seen kind of an acceleration in terms of their desire and demand. In terms of the paces at which they are installing, last year was a record year. I mentioned that we saw deposit automation modules and units up 50% from the 2007 level. And so we continue to see that kind of activity this year.

In terms of where they are at in their cycle, I would say that Banc of America is probably furthest along in that process and probably by the end of this year maybe coming towards the end of it. But Wells Fargo made the acquisition of Wachovia, Wachovia wasn't rolling out deposit automation. So that will issue in terms of how that will evolve, yet remains to be seen, because Wells hasn't either rolled it out in all of their footprint yet.

In Chase, I would say, of the three, the biggest players is just has begun the process in 2008 and again, these are multi-year, two, three year kind of roll-out plans and I would expect that we're going to get more visibility to that this year. So, I see these all continuing. The other big player like a U.S. bank or a P&C now, really haven't engaged in real heavy activity to this point, piloting various types of technology in various isolated instances. But I would they were on full fledge rollout. And then as you go down, the other major banks from there, you have, what I would call people doing small pilots but really not major rollouts as of right now.

Gil Luria - Wedbush Morgan Securities Inc.

And then on the regional banks, as you speak with these banks, is the discussion around the fact that they are distress and don't have capital budgets or around the fact that they are concerned about the overall economy, and even though they are doing fine, they rather not spend the capital right now?

Thomas Swidarski

I think it's the later, Gil. I think it's the fact that there is so much uncertainty out there. And kind of the environment is changing as they speak. They see... there's no reason to do something that could push back three months or six months wait, unless they are in the midst of something that it's absolutely critical.

So, certainly the regional business for us is still continuing along as the matter of the pace, as the matter of the kind of the movement to deposit automation. And as we sit now, there are certain institutions that have moved out down the deposit automation path. And we've got credit units, you've got small banks, you've got other regional banks that have moved down that path, and they'll continue to finish that. But a lot of the rest, I would call the vast majority are kind of in a wait-and-see mode.

And the conversations we're having with them, even the good conversations on integrated services, I mean we had a $15 million contract with a customer and two weeks later they get acquired by someone else, and so that whole thing comes into question and the timing of that comes in the question. So, you're seeing a lot of that uncertainty out there. And especially as we move into the integrated services space, we make great progress this year in the United States, I mean the total contract value was up by 55 million, 100 new customer kind of environment, which is great for the long-term. These are long process decisions that go high up the food chain there, because they're changing the way they operate and take cost out of their system, but it requires executive approval.

And I've just seen a lot of executives right now being very hesitant to pull the trigger on some these. But, again I think we're positioned well with that, we have got patience in that regard, because half of our revenue comes on the service side, we've made tremendous improvements relative to the service margin. So, we're willing to be very patient and work with them in this regard, because they got a lot of confidence in them, so we're going to continue to focus and grow our service margin and that's half of the revenue stream, but the product side, the visibility there in the regional bank space has been as cloudy as I have seen in 20 years.

Gil Luria - Wedbush Morgan Securities Inc.

Got it. So the range of outcomes that you discussed is low double-digit to down 25% for regional banks. How much were orders down in the fourth quarter in that segment?

Thomas Swidarski

They were...

Kevin Krakora

Double-digit.

Thomas Swidarski

Yeah they were down (ph) double-digit.

Kevin Krakora

Low double-digit.

Thomas Swidarski

Low double-digit.

Gil Luria - Wedbush Morgan Securities Inc.

Okay. So your... the worst case is severe worsening?

Thomas Swidarski

That is correct. That is correct.

Gil Luria - Wedbush Morgan Securities Inc.

Last question. The cost... the additional cost cutting measures that you mentioned, are those part of the 12 million in '08 and 35 million in '09, are those on top of those programs?

Kevin Krakora

Specific actions actually are slightly incremental. Yes, in that part of that cost initiative patterns (ph).

Gil Luria - Wedbush Morgan Securities Inc.

Got it. Thank you.

Operator

We will take our next question from Reik Read from Robert Baird and Company.

Reik Read - Robert W. Baird & Co.

Hi, good morning. Tom, could maybe give us a little bit more thought on China, with respect to how that might play out over the time period here in 2009, just given the post Olympics shift? And what's the impact here on near term profitability? I guess the assumption would be is that the near-term is going to be weaker than the back half for the year, and I would assume that, that would have an impact on early profitability in the year?

Thomas Swidarski

Yeah, Reik, you're absolutely right. It will have a dramatic impact. As I've mentioned a couple of times, certainly China was... we had very good success there in 2008. And in 2008 a lot of that occurred in the first and second quarter and some led over the third quarter, which meant the fourth quarter of last year, which typically was the biggest, was by far the smallest and least profitable for us. That's going to swing back to a much more normal type of environment. We still have, I think good visibility in China. We're making penetration into what I would call there, kind of their equivalent of the regional bank of the second or third of your bank. But the major banks there, certainly the movement is going to be to the latter half of the year.

Plus, I wouldn't expect in 2009 to hit the same levels we did in 2008, simply because the Olympics encouraged some spending. But over the long haul, again, China is just so big and so important for us long-term. So, for me its movement to the second half of the year versus the first half which makes a little difficult for comparison purposes. And second, our revenue will probably in China maybe down 5 to 10%.

Reik Read - Robert W. Baird & Co.

Okay. And then just going back to Europe, if I separate Eastern Europe and Western Europe, you guys talked about a little bit of incremental weakness in Eastern Europe, and I would assume that that's what you were kind of refereeing to before maybe as just guys are getting cautious with CapEx? And then in Western Europe, is it a combination of... it's a weak market and you are still walking away from business?

Kevin Krakora

Yeah, I would say in Western Europe, if I can start there first, I would say that it's a weak market, there is certainly opportunities in Western Europe. But it's a weak market with a lot more caution that we're seeing in that region. And again we are not the biggest player in that space. So, for us in many cases we are walking away because we're not competitive in some of the bids. But in Eastern Europe, it's a very different environment, in that we are in a very competitive position. We've got good presence in those markets, good service infrastructure that compete very nicely there. We've seen some cautions here in the fourth quarter. And we've got some visibility here, January and February shortly, in terms of what's happening in the beginning of this year. But we're seeing the same type of caution that we are experiencing in for instance the regional banks here in the U.S.

Reik Read - Robert W. Baird & Co.

And then you may have addressed this just a minute ago but I want to make sure I understand clearly. In the U.S with the acquisitions that are occurring, that is not slowing down the national banks as they kind of take a look at their branch infrastructure and maybe think about redeploying ATMs, I take what you are saying?

Thomas Swidarski

No. It has not slowed it down. What I was referring to, you got the three big banks... or the three largest banks from retail banking standpoint that have very aggressive plans. The fact that Wells purchased Wachovia, Wachovia was not a player in deposit automation means that the plans that they had are being evaluated by Wells. So, that whole area in terms of how they will move forward will kind of have a lot more visibility to this year. And then National City and P&C coming together, we're in a very good position with both of those institutions, but they have not been playing heavily in the deposit automation space as of yet.

Reik Read - Robert W. Baird & Co.

So you are saying, it is a good long term opportunity, and you're really not seeing any potential short term disruption?

Thomas Swidarski

That's correct.

Reik Read - Robert W. Baird & Co.

Okay. Great, thank you.

Operator

And our next question comes from John Healy, FTN Capital Markets.

John Healy - FTN Capital Markets

Good morning guys. I apologies if you might have touched on this, but I jumped on a few minutes late. But I wanted to ask a little bit about the consolidation that we've seen here in the U.S. amongst the banks. When you look at the consolidation you've seen, how would you rate yourself in terms of a market share standpoint, do you believe you are gaining share on the hardware and service sides, I mean, are you neutral or maybe have you lost share? And kind of your thoughts on what this might do to future pricing when you go to those customers for servicing and technology, in the future when the markets comes back? How do you think you are competitively positioned?

Thomas Swidarski

Okay. John let me take those two pieces. From a consolidation standpoint, certainly in the U.S. and we feel like there is no who can compete with us on the service side of the operation and we see that everyday playing out in the field. That doesn't mean that we are going to win every service opportunity, it doesn't mean we are going to win every opportunity, but we feel very good in terms of our competitive situation both with the largest banks, as well as the small banks throughout the U.S. So, in terms of, are we a net gain or I expect that we will be a net gain or as a result of that. But I think that's more of a result of the service infrastructure and the capabilities we bring to the market along with the technology versus there being consolidation taking place.

The second question though, the larger the bank and more volume, the more pressure there is on pricing, absolutely. Simply from the standpoint that as, the players get larger and strategic sourcing says, well we're doing 5,000 instead of 1,000 or 1,000 instead 500 or 500 instead of 20, you get pricing pressure there. And so for us that's why the comp actions become so important to be able to maintain the kind of margin environment. And for us the bell weather of margin is really is on the service side. Our ability to maintain that service margin. Because once you get the real estate, then the question is can you service it in a profitable manner. So, that's where we're going to have a lot of focus and that's why are focused so heavily on the services and the service space in terms of improving those margins.

John Healy - FTN Capital Markets

Okay. Now that's helpful. And I guess we stay with servicing business, and you just think about the consolidation that has taken place and maybe the consolidation that takes place in future. From a bank branch standpoint, how do you guys feel about, I guess the level of bank branches here in the U.S. and maybe the conversations you've had with your banking partners? If that number starts to decline, is it 5% or 7%, whatever it is over the next couple of years, how do you feel about keeping the margins in that business, and I mean how quickly can that business kind of scale up and scale down, I guess?

Thomas Swidarski

It can scale up and scale down very quickly in terms of that. But from overall trend standpoint, the number of physical locations that was the big question in 2000 and 2001, can you do banking or retail banking without physical locations and I think the market has spoken that, no, you need physical locations. And it could be a branch, it could be a different shape of a branch. But it seems that there is going to be... maybe the growth is only 1% or 0.5% a year, but there is still a 120,000 or 100,000 type of locations... physical locations out there, which need to be renovated, which need new capabilities. And even as we were taking before I mentioned and we demonstrated a little bit at the banking show, energy management capability in a small facility like that, well there is a 100,000 opportunities for us. We're already doing security monitoring, possibly in that location, we're already doing service there. Adding on those types of services in that facility is important to us.

The other aspect you have is the transformation of the branch into more of a sales environment, more technology, less people kind of thing. So, I am not as much worried about the number of locations whether it's going to decrease 1% or grow 1%, it seems fairly stable. For me it's a matter of adding capability and service to take costs out for the bank or a bank like facility and allow us to do more of the servicing for that, and we're seeing momentum there, it's just the timing of that, it takes a little bit longer to accomplish that kind of contract versus selling someone a product. But again, I think we are pretty patient there, because we see the ability of driving service and the capability there as being very sticky, very long-term and good margin for us.

John Healy - FTN Capital Markets

Thank you guys.

Operator

Now we'll take a follow up question from Matt Summerville, KeyBanc.

Matt Summerville - KeyBanc Capital Markets

Tom, can you talk about, again, just going back to your revenue guidance, down eight, I think to plus three for security, what has to happen in '09 for that security business to grow?

Thomas Swidarski

Well, two things. First of all, in our space that we have four pieces of the business, on the security side, you've got retail, you have government, you've, what we call commercial and then you have financial. And if I can take those quickly Matt, into those four segments that might help shed better light on this. First of all on the retail side, we just see retail being very weak and we don't see much opportunity for too much growth in the retail space this year. So, we have that already factored as down and possibly double-digit range. And I think that's just a realistic expectation.

On the government side, we see government actually growing, and we don't see any reason why it's not going to grow given the contracts we have, and given the other opportunities we have in the government space. We feel very good about government, feel very good about commercial which is high-end kind of enterprise wide government capabilities within kind of commercial environment, and think of high rise facilities and all of the security that goes there. So, we see that growing.

So, the big area for us and still 80% of our revenue comes in the financial sector. And when you look at the financial sector you got two pieces, you have electronic security and you have physical security. The electronic security; we see is being still very solid with a lot of opportunities. The physical and facility part of our security business is going to be down, the question is, how much? And so, that really is the biggest wild card, that is the most profitable piece of our security business, but it's also the biggest piece as we stand today. While there are not going to be a lot of new bank branch openings, both of that (ph) say fixed deposit boxes, all of the aspects that go into the physical barrier kind of products is going to be down.

So we have got... I don't have the numbers right in front me, but down double-digits and it could be down 30%. So, I mean we are looking as that is the one space within security that really pulls the whole thing down, but certainly for us the diversification in the government and the commercial high-end enterprise types of system are going to offset that. I don't think they can offset that amount this year.

Matt Summerville - KeyBanc Capital Markets

Okay. And, so that business could be down 30, is that the type of thing that would be embedded in the guidance you have?

Thomas Swidarski

Yes.

Matt Summerville - KeyBanc Capital Markets

Okay.

Thomas Swidarski

That's right.

Matt Summerville - KeyBanc Capital Markets

Two more things, just real quick. Tom, I don't think you mentioned early on anything about how, in the context of the business performing at the level it is now, and when you look out to next couple of years, how do you think about the margin goals that you've shared with us before?

Thomas Swidarski

Okay. I feel basically in the... excuse me, in the margin goals we set, we had 7% set for I think 2008 that we far exceeded. Our expectations for getting to the 9% and the 10% were based on modest revenue growth. I think we are calling modest, 5 to 7% growth which historically seemed very modest and very reasonable, given kind of the environment we had seen historically. That's changed coming into this year. If for instance, we would have seen 6 to 8% growth. We would expect to hit the margin target we had out there and get pretty close to the 9 and 10% along that path. I mean there is certainly a lot of other factors going in, but we still feel very confident in our ability to get there. I think because of uncertainty and cloudiness to the market, we're trying to put a prudent range out there that we think make sense. We could certainly going to get a lot more visibility as we go through the year, but given the conversations we've had, and the uncertainty we have out there, we think this is the right place for us to be right now and we'll adjust that accordingly as we get more visibility. But the lack of visibility into our most profitable piece of business coming into the year, gives us some concern as to what's realistic.

Matt Summerville - KeyBanc Capital Markets

Sure and that's certainly understandable. And then just my last question back to the regional banks here in the U.S. is there any historical experience you can draw on? Or I guess, at what point or how long can these banks defer delay making these investments in order to stay competitive given how fast in some instances, some of the top banks here in the country are moving?

Thomas Swidarski

Matt I am... I was in banking before I join Diebold. And then Diebold for 12 years, I can't point to at anytime in my association with the financial industry where I haven't seen anything like this nor do I have kind of that basis to say, well boy, it's going to turn at this point. And even when I talk to lot of the banks, they're saying, they are in uncharted waters.

So, we're trying to deal with this. Certainly they are impacted and the environment is just very cloudy. And I have not got the ability to really provide anything more specific at this time. I mean I think the first quarter will be very telling for us in terms of when we take at look at order entry and revenue actually is coming in to give us some better sense on how that's going to flow through over the course of the year. But as many bankers that I've talked to and we have come visit, I've just got... I mean they have just cautioned me on every turn and at such I think that that's affected our ranges here.

Matt Summerville - KeyBanc Capital Markets

Great, thanks a lot.

Kevin Krakora

Matt, this is Kevin. One last thing, I think you asked restructuring, I may have misunderstood it. The restructuring numbers for product were 16 million in the year and service was 9.6 million. So that's part of the 25 (inaudible) that impacted the cost of sales line.

Matt Summerville - KeyBanc Capital Markets

Thanks Kevin.

Kevin Krakora

Okay.

Operator: And Mr. Kristoff, I'd like to turn the conference back over to you for any additional or closing remarks.

John Kristoff

Thank you, Bill.

I'd just like to thank everyone for joining us today. And as always, for additional questions or comments, please don't hesitate to reach out to me directly. Thanks again.

Operator

And again that does conclude today's conference call. We do thank you for your participation. You may disconnect at this time.

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Source: Diebold Q4 2008 Earnings Call Transcript
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