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VASCO Data Security International, Inc. (NASDAQ:VDSI)

Q1 2009 Earnings Call

April 23, 2009 10:00 AM ET

Executives

T. Kendall "Ken" Hunt - Chairman and Chief Executive Officer

Jan Valcke - President and Chief Operating Officer

Clifford K. Bown - Executive Vice President and Chief Financial Officer

Analysts

Brian Freed - Morgan Keegan

Daniel Ives - Friedman Billings Ramsey

Fred Zeigel - Soleil Securities

Joe Maxa - Dougherty & Company

Scott Zeller - Needham & Company

Rob Owens - Pacific Crest

Katherine Egbert - Jefferies & Company

Brain Freed

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the VASCO Data Security, Inc. Q1 2009 Conference Call. During the presentation, all participants will be in a listen-only mode. Afterwards, we will conduct a question-and-answer session. (Operator Instructions)

I would now like to turn the conference over to your host today Mr. Kendall Hunt, Founder, Chairman and CEO. Please go ahead, sir.

T. Kendall "Ken" Hunt

Thank you, operator. My apologies for starting the conference call two minutes late, we had some connectivity problems.

Good morning, everyone. For those who are listening in from Europe good afternoon, and from Asia good evening. My name is Ken Hunt, and I am the Chairman, Founder and CEO of VASCO Data Security International, Inc.

On the call with me today are Jan Valcke, our President and Chief Operating Officer; and Cliff Bown our EVP and Chief Financial Officer.

Before we begin the conference call, I need to brief all of you on forward-looking statements. Statements made in this conference call that relate to future plans, events or performances are forward-looking statements, and these statement containing words such as beliefs, anticipate, plans, expects, and similar words is forward-looking and these statements involve risks and uncertainties and are based on current expectations.

Consequently actual results could differ materially from the expectations expressed in these forward-looking statements. I direct your attention to the company's filings with the U.S. Securities and Exchange Commission for discussion of such risks and uncertainties in this regard.

Today, we're going to review the results for the first quarter of 2009. As always, we will host a question-and-answer session after the conclusion of managements' prepared remarks. If possible, I'd like to budget one hour total for this conference call. You can limit your questions to one or two would be appreciated.

As expected the first quarter of 2009, was very challenging. But also as expected we were able to remain profitable, while continuing to make substantial investments in new products and increasing our focus on marketing events, which has resulted in significant number of new customers.

In Q1, revenues were 23.2 million, a decrease of 20% over first quarter of 2008. Q1 2009 was also our 25th consecutive positive quarter in terms of operating income and operating cash flow.

Our gross profit for the quarter was 72% of revenue and our operating was 20% of revenue.

During the quarter, we sold an additional 357 new accounts, including 51 new banks and 306 new enterprise security customers. This compares to Q4, 2008 in which we sold 37 new banks and 318 new enterprise security customers, a positive trend for 2009.

Compared to the first quarter a year ago, we sold 591 new accounts including 71 banks and 520 enterprise security customers. We now have approximately 8500 customers, including 1250 banks in more than 100 countries.

As we stated last quarter, VASCO's focus for 2009 is profitability. When the impact of the financial crisis and the global recession became clear, management took decisive action in order safeguard shareholder value.

We initially added a cost containment program to insure that we minimize the real growth in our expenses, while staying focused on the most important areas for our future. We are reporting a 16% decrease in operating expenses for the first quarter of 2009, over the first quarter of 2008, which reflects the benefit from our cost containment programs, beneficial changes in currency rates and the reversal of reserves for long-term incentives where it is not likely that our targets will be achieved. Cliff will discuss these items in more detail in his comments.

The company also decided to focus its efforts on its more mature markets in EMEA, South-East Asia and on the swiftly growing economies of the so called BRIC countries Brazil, Russia, India and China. During my visits to India and Brazil in Q1, I was impressed by the positive attitude, professionalism and vision of our customers and partners in those countries.

VASCO has not been immune from the economic situation. Few companies have done. Nevertheless with our strong fundamentals, including a healthy cash position, no debt and 25 consecutive profitable quarters, we believe that we are prepared to weather the storm. We are also ready to take advantage of any business opportunities that might arise during these challenging times. Despite these challenging times, we see some encouraging signs in the future.

In our traditional markets, we see that the number of new banking customers started to pickup during Q1. We believe that this trend will continue. Our enterprise security revenue remains fairly steady giving us our successful business mix of large orders with small margins, and banking, and smaller orders with higher margins in enterprise security.

We also seized some new markets emerging. At the end of Q1, we announced that the customers of video game company Square Enix were able to secure their amateurs with VASCO's DIGIPASS and VACMAN.

With Square Enix game Final Fantasy XI and the earlier announced World of Worldcraft game by Blizzard Entertainment, VASCO is proud to state that two of most popular internet gaming companies use VASCO'S strong indication to secure many of their gamers accounts.

You're probably asking what VASCO will do to maintain the company's success during the remainder of 2009. Our plan is pretty straight forward. We will keep working hard to make sure that the company does not only weather the storm, but emerges even stronger once the economy picks up. Therefore, we must keep our cost containment program in place without jeopardizing the company's flexibility, and ability to act quickly when opportunities arise.

We believe in the long-term viability of the global economic system, we believe that the worldwide economy will eventually turn to the positive and we will be ready to take advantage of it when it does. We will continue to focus on our most productive markets, be selective in making new investments and maintain our focus on containing our cost and as a result expect to be profitable throughout 2009.

At this time, I like to introduce Jan Valcke, VASCO's President and Chief Operating Officer. Jan.

Jan Valcke

Thank you, Ken. Ladies and gentlemen, Q1 was a challenging quarter due to the recession and the financial crisis. Nevertheless, we are proud that the first quarter was a profitable quarter for VASCO. This means that our business model and our business mix is robust enough to keep the company profitable even in times of recession. As a result, we will maintain our cost containment program without going to a stage of cost cutting.

As you remember, we invested heavily in people during 2008. All those new people are fully integrated in our company now. The combination of experienced veterans and new recruits will allow us to take advantage of any opportunity within our areas of focus. It also allows our company to be ready for the future when the markets pickup again.

Our investment in 2008 and continued investment in 2009, in products and solutions is also helping us a lot this year. Thanks to the strengthening of our hardware and software products, and the introduction of our new PKI products. We're able to maintain a very high gross margin.

Our extended product range also allow us to enter market that we were not able to address before.

In our markets, we see some important trends. Our existing banking customers are emptying their stock of DIGIPASS authentication products. Due to the effects of financial crisis, they order new products in a conservative way. This means that we receive more but smaller orders from our customers instead of one or two big orders a year, as one of the case in the past.

We are convinced that this part of market will gain new momentum in the mid-term. We have seen an increase of number of new banks in the first quarter of 2009 compared to Q4 2008. This is mainly due to the high number of low budget, yet high value marketing actions we organized worldwide. We will continue this pace and this formula in the future on the global scale.

In enterprise security, we have experienced a status quarter with regards to new customers. We have noticed that large employment in enterprise security will delay probably due to the recession. Thanks to our business mix, this fact doesn't really hurt us.

In addition, we are seeing the emergence of new applications security verticals such as gaming. As mentioned by Ken earlier, we announced another customer in that niche, the Japan based company Square Enix.

In conclusion, we believe that the investments we have made in people and public have positioned as well during the period of economic uncertainty, and are the key factors in helping us remain profitable.

Despite the change in buying patterns of our existing customers, which is contributing to the current decline in revenues. We are continuing to see strong interest in our products. We believe that we cannot only remain profitable during this difficult period, but also take advantage of opportunities that present themselves. As a result, we expect to strengthen our leadership position in the authentication market. Thank you.

T. Kendall "Ken" Hunt

Thank you, Jan. At this time, I'd like to introduce Cliff Bown, Vasco's EVP and Chief Financial Officer. Cliff?

Clifford K. Bown

Thank you, Ken, and welcome everyone on the call. As stated by Ken, revenues for the first quarter of 2009 were $23.2 million, a decrease of $5.8 million or 20% from the first quarter of 2008. The decrease in revenue for the first quarter reflected a decrease of 25% from the banking market, partially offset by a 1% increase from the enterprise security market.

The comparison of revenues in Q1 2009 to Q1 2008 was negatively impacted by stronger the U.S. dollar in 2009.

We estimate that revenues would have been $1.9 million or 8% higher than reported at the exchange rates in the first quarter of 2009 been the same as in the first quarter of 2008.

The distribution of our revenue in the first quarter of 2009 between our two primary markets was approximately 75% from the banking market and 25% from enterprise security.

In the first quarter of 2008 approximately 80% came from the banking market and 20% came from the enterprise security market. The geographic distribution of our revenue in the first quarter of 2009 was approximately 71% from Europe, 5% from the United States, 12% from Asia, and the remaining 12% from other countries.

For the first quarter of 2008, 67% of the revenue was from Europe, 8% was from the United States, 11% from Asia and 14% from other countries.

Gross profit as a percentage of revenue for the first quarter 2009 was approximately 72% and compares to 69% for the first quarter of 2008. The increase in gross profit as a percentage of revenues primarily attributed or related to the higher percentage of our revenue that came from the enterprise security market and lower non-product related costs. Both of which were partially by the effect of currency.

By non-hardware revenues was approximately 20% of total revenue in both the first quarter of 2009 and the 2008. As mentioned earlier, revenue from our enterprise security market which generally has margins that are 25 to 30 percentage point higher than in the banking market was 25% of our total revenue in Q1 2009, compared to 20% in Q1 of 2008.

Operating expenses for the first quarter of 2009 were $12 million, a decrease of $2.2 million or 16% from the first quarter of 2008. Operating expenses for the first quarter of 2009, reflected a reversal were approximately $2 million of accruals that had been established in prior years for the long-term and stock (ph) based compensation plans, but is no longer likely that the performance targets will be met.

The reversal of the accruals was partially offset by $307,000 of expense related to awards made in 2009 and prior years under some of our equity incentive plans.

In the first quarter of 2008, we'd recorded to $670,000 of expense related to awards under the equity incentive plans.

The comparison of operating expenses in Q1 2009 to Q1 2008 was also positively impacted by the stronger U.S. dollar in 2009. We estimate that expenses were $1.4 million or 11% lower than they would have been had the exchange rates in the first quarter of 2009 then the same as in the first quarter of 2008.

Operating expenses decreased $898,000 or 12% in sales and marketing. 247,000 or 9% in Research & Development, and $912,000 or 26% in general and administrative when compared to the first quarter of 2008.

The majority of the decrease in sales and marketing areas related to the adjustment of the long-term incentive plan accruals.

Expenses in the first quarter of 2009, including the benefit of currency, related to sales, tax and marketing programs were comparable to the first quarter of 2008. Expenses related to the recently opened sales offices, primarily in Brazil, Japan and India were $312,000 or 155% higher in the first quarter of 2009, than they were in the first quarter of 2008.

Similar to the change in sales and marketing expense, the decrease in Research & Development in Q1 2009 compared to Q1 2008, was primarily related to the adjustment of the long-term incentive plan accruals.

Expenses in the first quarter of 2009 again including the benefit of currency related to R&D staff were approximately 7% higher than in the first quarter of 2008.

The decrease in general and administrative expenses reflected the benefit of the adjustment in the long-term and same plan accruals, as well as lower recruiting costs, purchase services expenses and professional fees.

Expenses in the first quarter of 2009 including the benefit of the currency related to the G&A staff were approximately 12% higher than in the first quarter of 2008.

As previously noted by Ken and Jan, our expenses reflect the benefits of our cost containment programs. We have continued to maintain the investment we made in prior years in the infrastructure needed to support our future growth and realized expense reductions in other areas. Overall the benefit of the change in currency rates has been more than offset by the full year affect of increases in head count in 2008.

Operating income for the first quarter of 2009 was $4.7 million, a decrease of $1.1 million or 19% from the first quarter of 2008. Operating income as a percentage of revenue or operating margin was 20% for both first quarter 2009 and 2008.

The company have reported income tax expense of 1.2 million for the first quarter of 2009, compared to 1.5 million for the first quarter of 2008. Effective rate was 25% for the first quarter of 2009, compared to 23% as reported for the first quarter of 2008. The effective rates for both periods reflect our estimate of our full year tax rate at the end of each respected period.

The increase in the tax rate is primarily attributable to the reduction in pre-tax profits. And our current structure or effective tax rate will be very sensitive to the level of pre-tax income. Pre-tax income increases, we expect the effective rate to decline and as pre-tax income decreases the effective rate more increase.

Earnings before taxes, interest depreciation, amortization, EBITDA or operating cash flow if you will was $5.3 million for the first quarter of 2009 and is 24% lower than the $7 million reported from the first quarter of 2008.

The makeup of our workforce as of March 31, 2009 was 309 people worldwide with approximately 165 in sales, marketing and customer support, 96 in Research & Development and 48 in general and administrative. The average head count for the first quarter of 2009 was 66% or 27% higher than the average head count in the first quarter of 2008.

Turning for a moment to the balance sheet, our net cash balance and working capital both decreased normally from December 31, 2008. During the first quarter of 2009, our cash balance decreased by $385,000 for less than 1% to $57.3 million from $57.7 million at December 31, 2008.

Our working capital has increased $678,000 also less from 1% to 75.3 million from 75.9 million at December 31, 2008. We had debt outstanding at either March 31, 2009 or December 31, 2008.

Finally, our day sales outstanding and accounts receivable increased from 79 days at December 31, 2008 to 84 days at March 31, 2009. The increase of DSO is primarily relates to the lower level of average daily sales in the first quarter of 2009 compared to the first quarter of 2008.

Thank you for your attention, I'd like to now turn the meeting back to Ken.

T. Kendall "Ken" Hunt

Thank you, Cliff. Summing up, we expect to be profitable in 2009 through focus and execution. We will continue to invest in our marketing activities, our people and our infrastructure while containing our costs.

In light of the continued uncertainty in the market, Vasco will continue to temporarily discontinue providing annual guidance.

At this time, we will open up the call for your questions. Operator?

Question-and-Answer Session

Operator

Thank you. (Operator Instructions). Our first question comes from the line of Brian Freed, Morgan Keegan.

Brian Freed - Morgan Keegan

Good morning. Thanks for taking my question. Really I have two of them. First, on the reversal kind of back to the envelope, it was $0.04 to $0.05 incremental over the quarter depending on what tax rate. Is that calculation consistent and what does that imply for your kind of go forward operating expenses is more like the $14 million quarter run rate rationale?

And then secondly, with respect to some market share, EMC reported this morning, RSA was actually up about 5% year-over-year. Can you kind of comment about what your seeing in the market? Do you feel like you're losing share versus RSA or do you think it's a make shift within the market, just kind of give me a color there?

T. Kendall "Ken" Hunt

Thank you, Brian. I'll have Cliff answer the first question and Jan you address the second question about market share competition.

Clifford Bown

Brian related to the impact of earnings per share. We computed the adjustment for the first quarter to be about $5.5 a share. So you're in the right ballpark with the numbers that you were looking at. Given the sensitivity of our tax rate as those moneys came back to the income, our tax rate moved down. So there is a netting effect of the two pieces.

In terms of the long-term run rate, you should take that add it back to the expense base in -- I really can't comment on whether $14 million is, but if you took the 12 million, we just reported in the quarter added 2 million back, it would be at least at that level.

Brian Freed - Morgan Keegan

Yeah. Would you address the question about market share competition?

Jan Valcke

Sure. Thank you. First of all, as we compare ourselves to RSA, there are some differences of course in our business. In the banking market, the banking market we mean here e-Banking application or security for e-Banking application, we don't see so much RSA as a competitor. And secondly, in the enterprise security where you of course we have heavily completion with RSA. We see also that there is not so much a decrease in our business. Of course I cannot compare to the total number of RSA. RSA is doing all the things and only authentication.

But again in the enterprise security, it is a quite stable business, it is really in the banking business that we have suffered in the first quarter, that's mainly due to customers, the banking customers who are in fact reducing their inventory and only placing orders for short earnings.

Brian Freed - Morgan Keegan

Okay. And as a follow-up to that, you guys didn't seem to see the downturn on the banking side as fast as some others, I think that's primarily due to your Internet exposure, based on that you think you'll probably be a little bit slower to recover or do you think the recovery will probably be consistent with the U.S. bank?

T. Kendall "Ken" Hunt

I'll address that, I think that what we've noticed is a different buying pattern, buyer, it's a conservative buying pattern instead of giving us, a large bank giving us a purchase order for 12 time, where they might be for call offs or assumption. [Technical Difficulty] They're buying pattern, now is to use up the inventory of physical DIGIPASS hat they might have, and order -- smaller orders, perhaps enough supply for one quarter.

Around the world, we haven't seen the kinds of write-offs and problems, that we've seen here in the United States, and perhaps London but that still are the UK, it still doesn't mean that the banks aren't kind of emotionally caught up by what's happening elsewhere in the world, and thus, even though they are continuing to move forward on their banking, online banking initiatives certainly their 0buying patterns have changed, I have just described.

I'd say generally speaking, we are optimistic about what we see in the market trends in the market [Technical Difficulty] is up quarter-over-quarter. So I describe our tone is generally optimistic about the banking community. Jan, if anything you want like to add to that?

Jan Valcke

I would like only to say that I do agree that we cannot compare the U.S. banking market. We cannot compare but with the rest of the world.

Brian Freed - Morgan Keegan

Okay, thanks.

T. Kendall "Ken" Hunt

Thank you.

Operator

Our next question comes from the line of Daniel Ives with FBR.

Daniel Ives - Friedman Billings Ramsey

On backlog I mean, I know you don't give that number bookings. Did that kind of need internal expectation. How is that trend this quarter-over-quarter?

T. Kendall "Ken" Hunt

Backlog?

Clifford Bown

Well, backlog as we've described it in the past has always been what is under firm -- under a firm purchase order. And certainly that number has changed. I don't know that it's one way or the other net our expectations. It is what it is and the backlog is smaller relatively speaking because of what I described a few minutes ago, the buying patterns of the banks, the larger banks particularly instead of ordering 12 months worth of goods and then taking sub shipments in one quarter, they are ordering smaller orders. So, indeed because of that when we look at firm PO's or firm backlog, the backlog is smaller.

Daniel Ives - Friedman Billings Ramsey

So, you had customer this quarter go back -- go up, we want to kind of tone it down we want last, I mean is that trend that you've seeing this quarter or maybe decline, you're relative to what you've seen?

T. Kendall "Ken" Hunt

Well I'd say it s just its kind of a consisting pattern over last quarter or two, where the buying pattern has changed. I'm sure you've read like I have that generally speaking inventories in most businesses are down. And that's the trend in the banking business, they're using up more their inventory of physical DIGIPASS tokens before they order more, and when they do order instead of giving us a 12 month PO they give us what is equivalent to three months PO. It does not mean that their programs, their applications have stopped it's just a different buying pattern, Daniel.

Daniel Ives - Friedman Billings Ramsey

Okay. That's it. Thank guys.

T. Kendall "Ken" Hunt

Sure.

Operator

Our next question comes from the line of Fred Zeigel with Soleil Securities.

Fred Zeigel - Soleil Securities

Hi, guys.

T. Kendall "Ken" Hunt

Hi, Fred.

Fred Zeigel - Soleil Securities

As a follow-on to that, what's the gross margin implication of the banks going to smaller more frequent ordering? On the one hand, I would think you're able probably price it higher and or otherwise less of a discount. On the other hand you've got probably a less efficient manufacturing schedule, so when you sort of wash all that together, what's the gross margin effect?

T. Kendall "Ken" Hunt

Well at a macro level Fred. Obviously the consolidated gross margin is going to be affected more by the mix of the growth rate in enterprise security versus banking.

Fred Zeigel - Soleil Securities

Right.

T. Kendall "Ken" Hunt

I think your question is more within the banking market, are we seeing higher margins within banks. And I think our answer on that would be to the extent that the change in ordering is coming from our very large banks that have made generally large purchases in the past and their volume purchase agreements. They're already at a level where they're continuing to receive the benefit of the lower price from those higher volumes.

At the current time, we're not looking to change any of these existent contracts that we have with them, to go back and reprice those. For those that are coming in on purchase orders however those don't have the benefit of those larger volume purchase arrangements, those would be at higher prices

Fred Zeigel - Soleil Securities

Can you say roughly of the banking revenues. What percent might come from your, I guess traditionally 5 or 10 largest customers?

Clifford Bown

Well when we talk about the top ten customers in any given quarter, there are a few distributors in those numbers. But the top ten customers that are producing revenue today those percentages continue to decline in the first quarter of 2008, our top ten contributed 47% of our revenue as the top ten in the first quarter of this year was 43% of our revenue. In that top ten, there were couples that are distributors that serve the enterprise security market.

Fred Zeigel - Soleil Securities

Okay. And a quick question for Jan, what are you seeing in terms of the mobile authentication market?

Jan Valcke

We see that in fact of course the mobile authentication or let say the mobile, telephone, Blackberries and so on are of course perfect platforms to install authentication on it.

It is of course technically speaking and let say more deployment speaking, that's a right word, deployment speaking there are some problems today due to rash deployments. You can imagine if you have a, let say a million of customers you want to see, and today the only technology that is really available is downloading applets, java applets on that mobile telephone.

And that is of course a bottleneck in deployment. So we see a interest, but we don't see that as the ultimate authentication platform today. It's rather a mixed, what do I mean that is, they go with traditional DIGIPASSs and one of the traditional DIGIPASSs that they are using is a java applet on mobile platform and the latest choice to the customer. That is the today situation, of course technology evolves, that at least goes further on. And that mobile platform will be more and more popular to do also authentication.

T. Kendall "Ken" Hunt

I might add that, our attitude as you know is one of trying to provide the customer, our customer what they want to use or what they perceive is the best product used we have over 50 products, all delivered on the same platform back main controllers. So I guess to some degree you could describe us as agnostic in terms of product that a customer chooses. Our goal is to be there and be their best partner and to provide, what they want and that's why we have so many different product choices, hardware, software combinations.

Fred Zeigel - Soleil Securities

Thanks.

T. Kendall "Ken" Hunt

Sure.

Operator

Our next question comes from the line of Joe Maxa of Dougherty & Company.

Joe Maxa - Dougherty & Company

Thank you. Jen, just looking at the backlog, coming down and the orders being smaller. Is it reasonable to assume that Q2 could be lower than Q1. I know you're not giving the guidance, but I just want to get a flavor maybe.

T. Kendall "Ken" Hunt

Well, when we say that the orders are coming down, please understand that I think the pace of business is still positive. The nature of the orders or the consumption is still positive, I don't think that the banks are consuming any less but before I said, the banks like many industries are using up their inventory down to a level that in the past they didn't do.

And so the orders are coming in chunks instead of our commitment for a year. So I guess I can cautiously say no, I don't see a decline in the business overall in a macro level.

Clifford Bown

Joe, this is Cliff. Also from our seasonality or trend point of view historically that Q1 has been depressed for a number of reasons. Q2 has been much stronger quarter. All of that comparison in Q1 you've got the back that were coming after holidays, you get the Chinese new year where production is shutdown. So there is a number of issues where people are starting up in the year. There is issues with us being able to produce as much product as we could possibly ship during Q1. So our history has been that Q2 is stronger than Q1 for many of those reasons.

Joe Maxa - Dougherty & Company

Okay. That's helpful. Is the margin, do you think with your change in product mix, is that sustainable in that 70% range?

Clifford Bown

Well, it's always a mix the business as we planned from all hardware revenue, in other words selling the hard tokens, the DIGIPASS hard tokens six or seven years ago and now that mix is more like 75% hard revenue, and 25% or so non-hardware revenue.

The natural trend because we're selling software and we're selling non-hardware services and things like that. Trends would be not only to sustain but perhaps even grow or increase. But it all boils down to a mix of businesses. We sell more enterprise, customers. We're selling those in smaller quantities with very, very high gross margins. And we've reported in the past when we saw the card readers in great quantities, those have a negative impact on our gross margin. There are still good gross margins, but it's a trend down instead up.

I'd said generally speaking our direction is to continue to increase the non-hardware revenue and in many cases opportunities that in the past we didn't have and that's going to have a positive impact on the gross margin.

Joe Maxa - Dougherty & Company

Okay. The gaming vertical, do you include that in the enterprise security space?

T. Kendall "Ken" Hunt

We do.

Joe Maxa - Dougherty & Company

Okay. So if that seems volumes would we assume -- would that more of a gross margins similar to your banking gross margins?

T. Kendall "Ken" Hunt

Yeah that's a very good question. And you're absolutely right. They are -- the ideas to them to consume almost like a retail bank to consume large numbers and so when they're consuming or buying large numbers they get a lower price and that would materialize in lower gross margins. But we also have growth with the small and medium businesses through our growing reseller channel that has a positive impact on the gross margins.

Clifford Bown

Joe, on the gross margins issue if you go back and look at each quarter of last year, we had a range of 65% to 72 % that quarter we had 65% you may recall that we had a sizeable one-time write-off related to an investment in a project. And adjusted for that the margin in that quarter were closer to 68 to 69%. So we've got a history now of five consecutive quarters at 68 to 72% margins and as Ken mentioned, our strategies are such that we would expect those to continue.

Joe Maxa - Dougherty & Company

Okay, thank you very much.

Clifford Bown

You're welcome.

Operator

(Operator Instructions) Our next question comes from the line of Mark Doulstrow with Bluscent (ph).

Unidentified Analyst

Good morning. Thanks for your time. I'm afraid you're going to beat the gross margin question. I think basically from what you've said the majority of the gross margin increase was from the better enterprise mix, this must be a fuzzy math but I'm taking kind of a 500 basis points increase in the enterprise mix and saying that's 25 to 30% higher margin. So, a 150 or more basis points could be attributed to that and so that the lower non-production it seems like it's a relatively small impact?

T. Kendall "Ken" Hunt

Mark, that's correct. The non-production does also reflect different methods of shipment, whether it comes by sea versus air with our customers ordering smaller quantities generally they want things on a shorter frame basis, so we end up with more air, great package charges which are higher, other non-product related or customizations it moulds for the new product, it mould just for the quantities and so forth. So we have a number of those kinds of things, but on a macro level, your observation is correct

Unidentified Analyst

Great. And I think you've discussed this. With respect to the smaller, more frequent orders. Are you mostly referring to existing customers or is it also applied to new customer.

T. Kendall "Ken" Hunt

Well the biggest impacts are the existing customers. Customers that we've had as customers for a year, two years, five years, 10 years and their buying patterns have also changed.

Unidentified Analyst

All right. I don't know how exactly you'd be able to evaluate it. But do you get us any indication that the inventory levels are quite low at these customers because, I guess I think if orders are becoming smaller, if you had a whole bunch of inventory lying around, why would you even bother buying a couple of months of inventory. Has that told you anything about what the inventory levels are?

T. Kendall "Ken" Hunt

Jan, do you have any visibility into some of our banking customers and their levels of inventory and what the trend might be there?

Jan Valcke

Yes, we have financial (ph) visibility of the inventory of our customers. Well, we'd like to say first of all is, you need to understand it is the buying pattern that has changed. That means that we see at one hand a increase in orders, but for smaller quantities and a smaller quantities is for their immediate needs of those customers. So the right question is here, can VASCO really produce fast enough as this buying patterns are changing. So we have changed our working attitude there. We are forecasting very well, we are looking in those inventories and we will make sure that the customers or that the goods to the customers will be delivered on their desired time,

Unidentified Analyst

Thanks for your time.

T. Kendall "Ken" Hunt

Thanks Mark.

Operator

Our next question comes from the line of Scott Zeller with Needham & Company.

Scott Zeller - Needham & Company

Hi. I think retail there was a 10% customer in the quarter?

Clifford Bown

There were not, not in the first quarter of 2009, no 10% customers in the first quarter of 2008 either.

Scott Zeller - Needham & Company

Okay on the previous commentary on cost containment. Could you just clarify -- does that mean absolute number cost containment, or does that mean contained as percentage -- contained cost as a percentage of revenue?

Clifford Bown

I think within our context, Scott it basically means shifting the cost to where we have priorities and managing our third-party external cost. The point that I was trying to make in some of my prepared remarks was that we have increased substantially our investment in staff worldwide to put in place the infrastructure we need, to support our current level of activity and expected future growth. So the average head count increase was 27%.

So when you strip away the effects of currency, strip away the other things, our overall cost associated with people in sales and marketing, in R&D, in G&A have all increased. But what we've done is within those categories we have changed focus of some of the areas. So there have been terminations in areas where people were not productive, but additions in other areas that would be of more interest to VASCO.

We have also looked at all of our outside cost and we've had significant reductions and cost such as professional fees and purchase services and temporary agencies, and those kinds of things.

So we're really sort of tempering down not growing our overall staff, number at the end of 1231 or 310 number of total staff at the end of this quarter is 309, But there is been a mix within the areas. That to reflect changes where we think we can be more productive, more efficient, more effective.

Scott Zeller - Needham & Company

Okay. Is there a way you can just more definitively say that, that should be OpEx lines will trend up or down going forward?

Clifford Bown

I can't say with any absolute certainty because, with our operations being primarily overseas. Rest of those expenses are going vary with fluctuations in currency rates. In terms of our expectations of spending for incremental staff while cost containments in place. We don't expect to have any substantial increase in head count. There is basically a head count freeze in place across VASCO. If new position is to be hired, it has to be justified based on the new opportunity that is there.

So internally we don't believe that on a constant currency basis, that our operating expenses would changed substantially.

Scott Zeller - Needham & Company

And the last question is for Ken. If I remember correctly the news we had after the December quarter, I believe you said that buying behavior was changing at that point. Could you tell -- and I know we heard more about that today but could you refresh us on when you saw the buying behavior change or people were breaking up orders to smaller sizes. Did that begin in the December quarter or even earlier perhaps?

T. Kendall "Ken" Hunt

Well, we certainly saw a freeze of the orders and the -- I don't know late November or early December timeframe where there were orders that we had an indication we had PO's and the customers decided that they wanted to delay the delivery of those orders into 2009. Jan, did we see any indication of this new order pattern before that, in other words instead of the 12 month PO's a shorter PO or a smaller PO. Did we see any of that earlier than late in the fourth quarter of last year?

Jan Valcke

No. It was in the month of November that we saw.

Scott Zeller - Needham & Company

Okay. Thank you.

Operator

Our next question comes from the line of Rob Owens with Pacific Crest.

Rob Owens - Pacific Crest

Hi, guys. Give me a commentary around deal size compression, would we be surprised either next quarter throughout the remainder of the year to actually see some large deals or a 10% customer in the mix?

Clifford Bown

I'm not sure I understand the question, Rob. Are you saying that's going forward, is it possible that VASCO could have a 10% customer.

Rob Owens - Pacific Crest

Yeah, I know over the next couple quarters, would we be surprised to see a 10% customer reenter the mix? I'm just trying to get a sense of are there large deals out there or have a lot of those just been put on hold at this point?

T. Kendall "Ken" Hunt

Jan, the question is do we have any large opportunities where either a current customer or prospect where if that opportunity were to happen that would end up doing a 10% of our revenue for the quarter type of customer.

Jan Valcke

I'd say a very tough question, and pay that in the existing customer base. Again, we see a difference in this buying pattern and I do not expect to see on a quarterly base a 10% customer coming in that existing customer base. Its always possible, on the other hand, its always possible that in new business kind again new business you can see new banking business, but also as you understand also our business makes us changing more and more that in other markets or even in the banking markets that we see a 10%, -- is possible that we see a 10% customer coming in.

Now having said that, is that a 10 % customer on a yearly base or is it a 10 % customer on a quarterly base? I don't know. I believe that today with this buying pattern we would rather see that on a yearly base.

Rob Owens - Pacific Crest

Okay.

T. Kendall "Ken" Hunt

Also apart from the buying patter issue, I think VASCO has worked very hard to increase the number of customers in its customer base. We've worked very hard to diversify our business risk away from 10% customers. So based on the information I have, yes we're working on some large deals, what I ever expect those large deals to be 10% in the quarter, they maybe, but I think the probability going forward as VASCO continues to grow its customer base of any big customer hitting that level, especially on a consistent basis is getting less than in each quarter in each year.

Rob Owens - Pacific Crest

Great. And then -- I think you gave us some top 10 numbers, but can you just give us a some sense how deal sizes have worked on a year-over-year? How much compression you're actually seeing on an average basis?

Clifford Bown

I don't have any dated, to give you that's precise to that point, because each of our customers have different dynamic, as we've talked before we're still a small enough business, where each quarter will be lumpy and any statistics of that nature will very substantially period-to-period just based on which customer place orders in that period.

Rob Owens - Pacific Crest

Okay. Thanks.

Operator

Our next question comes from the line Brian Freed with Morgan, Keegan.

Brian Freed - Morgan Keegan

Hey guys, quick follow-up, can you give us just the head count number, it remind us the end of December and as well the end of March? And secondly you talked you've intimated a couple times of production issues, can you go into little more color which you're seeing on the production side?

Clifford Bown

Well, in terms of head count, let me give you, three data points --Brian, our head count at the end of Q1 2009 is 309 people. At the end of 2008, December 31, 2008 it was 310 people. But at the end of the first quarter of 2008, it was 248 people. So that's what we've made the investment as Jan pointed out in his prepared remarks about the substantial investment in hiring staff, we went from 248 to 309 people over the last 12 months.

Brian Freed - Morgan Keegan

Okay. Thanks

Operator

Operator: Our next question from the line of Kathy Egbert, Jefferies.

Katherine Egbert - Jefferies & Company

Did you want to finish answering another question?

T. Kendall "Ken" Hunt

Yeah Brian had a second question I think.

Katherine Egbert - Jefferies & Company

Yes. Do you want to answer it?

T. Kendall "Ken" Hunt

Well remind me again, what the question was. Carry on.

Katherine Egbert - Jefferies & Company

I am not sure how to get back in. The question I was going to ask was a -- numbers on new customers for banking and for enterprise and those numbers are pretty high. I'm just wondering how do you define a new customer and also what's the size of these orders, with these new customers put in and what's the churn rate, I'm just trying to get a sense because the number seem very high relative to your run rate of revenue? Thanks.

T. Kendall "Ken" Hunt

Jan, Would you like to define the customer?

Jan Valcke

Yeah, a new customer that's very easy, it's a customer that we have never send an invoice. So it's really new, new. That's the definition of a new customer.

T. Kendall "Ken" Hunt

And new customer can be a very small order Katherine or it could be a large order. If it sold through a reseller channel, and the reseller selling to a customer in Sydney or in Mumbai or wherever, when they sell a DIGIPASS pack in whatever quantity, that is a new customers, if they are first time user, first time invoice user.

Katherine Egbert - Jefferies & Company

Okay. Maybe I'm trying to just, lifetime value of the customer, if they start out small I mean in presumably many of these are pilots. Do they just kind of drop out after the pilot or do they go on stay customers, what's the churn rate?

T. Kendall "Ken" Hunt

Jan, Can you address that?

Jan Valcke

Sure. Again in new customers we need to make of course a difference between banks and what we call enterprise security customers. So in the banks again this orders can be small. It can be either one say it pilot that they can be starting with a test, public test, normally they start with test customers. And afterwards they go in larger deployments.

So to answer your question, when they started, they take us some of the answer is definitely yes there. In the enterprise security, the same thing except that it could be an order for 200 people company and the order everything at once. And then there is besides maintenance and shipment into and some privilege to do not so much follow-up business or it can be pilots that have a substantial increase in new business afterwards.

In enterprise security you could make the difference which between network security really. That's a vertical where the secure remote access, they secured to network and once we call applications security, application security means you really the business of a company transactions with their customers. There we see of course a substantial increase substantial increase after the pilots like for instance in gaming.

Katherine Egbert - Jefferies & Company

Okay. Thanks Jan

Operator

(Operator Instructions). We have a follow up question from the line of Joe Maxa with Dougherty & Company.

Joe Maxa - Dougherty & Company

Hi. Can you just little quick on the M&A activity you talked about potentials of, I guess you suggested you might do, do this opportunity was attractive, are you talking small acquisitions or would you be looking for larger ones?

T. Kendall "Ken" Hunt

Historically, we've always been interested in smaller acquisitions where there is a technology that our customer base has told us, that they would be interested in and again with our strategy of having many different products and solutions all delivered on back main controller.

When we on that one unique platform, when we feel that there is a good opportunity with the new product or technology, what we do is we do a make versus buy. We have a couple of business development people that do nothing are mainly they are looking at small companies around the world that have come up with a product concept, got funding, assembled an R&D team, built the product and start selling it in their respective country.

So if we can match that product, that new technology with our customer base that's what we want to do. And so it's a make versus buy. If we can buy a company, we call that a technology tuck-in. We acquire the company, simulate the people into our organization and put the product into our channels, into our banking channel and our reseller channel.

So, we are always interested in that kind of transaction, it's typically a smaller transaction, but cash transaction its typically accretive fairly quickly and we're opportunist. We're always looking for smaller acquisitions like that.

We have shied away from larger acquisitions, we just feel like the larger acquisitions are more treacherous and riskier, that doesn't mean that we wouldn't do a larger transaction, but it has not been our strategy in the past and probably not our strategy in the future.

Joe Maxa - Dougherty & Company

Okay. Thank you very much.

T. Kendall "Ken" Hunt

Sure.

Operator

We have a follow-up question from the line of Brian Freed with Morgan Keegan.

Brian Freed - Morgan Keegan

That second part of my question. You made a couple references to some production issues, can you give a little more clarity on then and have your results whatever they are?

T. Kendall "Ken" Hunt

Well the production issues are I think really more of a timing issue. Every year in the first quarter there is Chinese New Year. All the factories literally shutdown and all the employees go back to their homes for a two week holiday or vacation. And so we have the issues every single year, the challenge every single year of scheduling the manufacturing to meet the needs of the orders that we've received. So, that's mainly the issue, its nothing new, it's something that we face every year.

The other issue is because the banks primarily are waiting till the last moment and using up the inventory that they have, the other part of the pattern is that the banks wait till the last moment and give us an order and then are asking for fairly short turnaround delivery time. And so that's a challenge, and we're trying to work through that.

So instead of giving us, I don't know six weeks, they want the delivery in four weeks, or eight weeks they want the delivery in four week. So, it is something we've recognized and it something that we planned for. Is there any other issue Jan that you can think of in terms of...?

Jan Valcke

Well particularly this year, the Chinese manufactures one of the way they reducing their cost is giving a longer holiday, to their labor forces. The second thing is the Chinese holiday, the Chinese vacation is the timing of that is very important for us. If it comes in January it is less problematic, than it comes in February. So there is not a fixed date in Chinese New Year, so its a little bit different. And this year towards in several way.

Brain Freed

Okay. Thanks

T. Kendall "Ken" Hunt

All right, operator we have time for one more question.

Operator

At this time, there are no further questions. I want to give the call back to you.

T. Kendall "Ken" Hunt

All right, very good. At this time, we will conclude the call. I want to thank everybody for attending today and I look forward to your participation in the Q2 2009 conference call. And as always, I want to thank the VASCO people around the world for their hard work and diligence, and we will talk to you in about 90 days. Goodbye everybody.

Operator

And that concludes today's conference call. You may now disconnect.

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