William Nettles - VP for Corporate Development and IR
Doug Bergeron - CEO
Bob Dykes - CFO
Andrew Jeffrey - SunTrust Robinson Humphrey
Gil Luria - Wedbush Morgan Securities
VeriFone Holdings Inc. (PAY) F2Q09 (Qtr End 04/30/09) Earnings Call June 2, 2009 4:30 PM ET
Good day, ladies and gentlemen, and welcome to the Second Quarter 2009 VeriFone Earnings Call. My name is Stacey and I will be your conference moderator for today. (Operator Instructions).
I would now like to turn the presentation over to your host for today’s call, Mr. William Nettles, Vice President for Corporate Development and IR. Please proceed.
Good afternoon and welcome to the VeriFone earnings conference call for the second fiscal quarter of 2009. Today's call is being webcast and a recording will be available on our website until June 9, 2009.
With me today is Doug Bergeron, CEO and Bob Dykes, CFO.
First, for the legalities. I want to remind everyone that VeriFone desires to take advantage of the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. Certain forward-looking statements in this conference call including management's view as to future events and financial performance are subject to various factors that could cause actual results to differ materially from those expressed or implied by such forward-looking statements.
For a description of these factors, I refer you to our filings with the SEC. Any forward-looking statements speak only as of today and VeriFone is under no obligation to update these statements to reflect future events or circumstances.
In addition, today's call will cover certain non-GAAP financial measures on both the historic and forecast basis. Our management uses these measures to evaluate our operating performance and to compare our results with those for prior periods as well as to other peer companies. These non-GAAP measures are not substitutes for disclosures made in accordance with GAAP. Reconciliations of these measures to the most comparable GAAP measures are presented in our earnings release, which is available on our website at verifone.com.
During this presentation, your line will be in a listen-only mode. At the conclusion of today's presentation, there will be a question-and-answer session. Instructions on how to signal for a question will be given by the moderator at that time.
Now, I would like to turn the call over to Doug Bergeron, CEO of VeriFone.
Thanks, William, and good afternoon, everyone. The second quarter non-GAAP earnings were $0.17 per share, compared to $0.19 in the second quarter of 2008 and $0.17 in the first quarter of 2009. The key accomplishment for the quarter centered on the mission which we shared with you on our March conference call to fortify our balance sheet.
We generated a record $62 million of cash flow from operations in the quarter, resulting from solid cash earnings on significantly reduced operating expenses and a major reduction in inventory. Some of this cash was used to retire $33.5 million of our convertible debentures at $0.59 on the dollar and still we managed to increase cash-on-hand by over $46 million.
Our revenue in the second quarter of 2009 was $202 million, versus $233 million in the second quarter of 2008, a 14% decline. Compared to the prior quarter, revenue declined 6%. We believe it is still too early to predict when VeriFone's revenue will rebound, but we do believe we may have seen a bottoming in some of the international markets where VeriFone’s business is heavily dependent.
Today, during the review of VeriFone’s revenue performance, I will comment on some of the indicators we are watching for, as we gauge the likelihood of recovery in some of our key businesses.
In North America, year-over-year revenue declined $70 million or 17% compared to the second quarter of 2008. The year-over-year comparison this quarter as well as last quarter is clouded by a substantial amount of US financial group revenue which shifted between the first and second quarters of 2008.
We believe a more relevant measure of performance is North America’s first half 2009 revenue, compared to first half of 2008. By this measure, revenue was flat. On a sequential quarterly basis, North America declined 1%.
Our second quarter 2009 results in North America follow a pattern we have seen in recent quarters. The US financial group with its focus on small merchant end users had a tough quarter, with revenue basically unchanged from first quarter levels.
Canada, subject to many of the same market forces as our US financial group had its lowest revenue in many quarters.
The multi-lane retail group posted very nice results, growing revenue 16% sequentially and 25% on a year-over-year basis. Our petroleum group remained in a holding pattern, as petroleum operators pushed our plan for PCI compliance at the gas pump due to recently relaxed enforcement plans by VISA.
Now let’s discuss the major North America businesses in more detail, starting with the US financial group. This business continues to be impacted by low merchant activation levels. We are seeing two trends develop however, one negative and one positive.
The first development is what I have characterized previously as the rice and beans purchasing behavior of our customers. We are seeing a movement from premium wireless solutions towards landline solutions, and within landline solutions, a movement from fully-featured to single-application solutions. These shifts are negative for us, as they have compressed revenue and margin somewhat this year.
The second development, which is very positive, is a flight to quality. During these bad economic times, customers increasingly view VeriFone as a strongest and most dependable survivor and supplier, and we have gained market share here as a result of this.
We think that the US financial business maybe approaching the bottom, based on signs of stabilization in US consumer spending and the rebalancing of inventory levels in our distribution channels. A change to a more optimistic outlook will depend on future readings of two indicators.
The first, which we have no control over, and frankly are not in a position to predict, is an improved small business lending environment, which is essential to business expansion. The second indicator, which we believe will be a positive factor in 2010, is the increasing interest and plans for North American acquirers to implement high-value security capabilities at the point-of-sale, which requires much more advanced functionality than is available rice and beans world.
Moving on now to our multi-lane group; we enjoyed a number of successes this quarter, reinforcing our leadership position. We have not been materially impacted by IT CapEx reductions at tier-one retailers, as PCI compliance is currently the number one priority of CIOs. In the tier-two retailer space, we do see evidence of certain customers delaying purchases due to weakening financial positions. But so far, this has not been significant enough to have a material adverse effect on our overall result.
Rounding out our North America review is our petroleum group. We had expected to start a modest ramp of secure pay pump solutions revenue this quarter, but lost the momentum with the Visa announcement to postpone enforcement of penalties for non-compliance until 2012. We do hope in the coming quarters to announce some major customers, but do not expect a meaningful revenue contribution in this area until 2010.
Internationally, revenue declined 11%, compared to the second quarter of 2008 and 9% compared to the previous quarter. On a year-over-year basis, Europe decreased 16%, Asia 15%, and Latin America 1%. Compared to the prior quarter, Europe declined 4%, Latin America decreased 7%, and Asia was down 31%.
This quarter Europe had the weakest performance compared to internal expectations. Our results were influenced by some harsh actions taken by certain customers, and in one instance, the government authority in response to a period of record economic contraction.
Let me give you few examples. In Russia, the government announced an import tax of 20% on our products, making an already difficult pricing environment even more untenable.
In Continental Europe, we were informed by one of our largest customers that the annual forecast would be paired back by 50%. In the UK, we saw some retailers starting financial hardship in obtaining waivers to delay PCI compliance programs.
Though the overall European revenue performance didn’t meet our expectations, we did see signs of progress. In Italy, a country where we have a de minimis market share. We sold our first turnkey petro solution and obtained initial orders from three new customers.
In the UK, we continue to add major banking customers and are winning we believe an increasing share of the retail business. In Russia, the two largest banks have announced plans to restart purchasing, albeit at a muted level compared to prior years.
Latin America declined slightly on a sequential basis, as Brazil was flat as compared to the first quarter, Mexico had excellent growth and Venezuela's results were insignificant.
In Brazil, our vertical non-processor customer base has been hit hard by the recession. Many of these business models depend in large part on transaction charges related to declining sales of pre-paid cell phone usage.
In addition, the tightening of credit availability has constricted our vertical customers' ability to reach new retail locations. This situation now seems to be improving.
In the past several weeks, we have read about the flow of capital back into Brazil, an increasing consumer confidence. If this is sustained, we see the vertical non-processor business returning to some health some time in 2010.
Mexico had its best quarter in several quarters due to a major deal with BBVA for the deployment of over 25,000 wireless units. We see this quarter's revenue performance is not repeatable, given the reduced deployment plans at many of our banking customers.
Venezuela, which has historically been our third largest market in the Latin American region, registered sales at a level, which is approximately 25% of the 2008 run rate. We are hopeful that the recent increase in the price of oil will stabilize the political situation and allow commerce to transpire at more normal levels.
The Asia decline was largely expected, as major tenders in China previously scheduled in our second quarter, were deferred into the third quarter.
In India, we expected to do some business with financial customers, but the devaluation of the rupee made it difficult for VeriFone and our customers to agree on acceptable pricing.
Australia was a bright spot where we commenced shipments to equip a fleet of 20,000 taxis with VeriFone payment solutions. We expect Asia to improve sequentially in Q3.
In summary, with the exception of North American tier-one retailers, who are proclaiming PCI compliance as their highest priority technology investment, our customers throughout the world continue to adjust to the new economic realities.
In the third quarter, we’ll see the return of some customers who recently suspended purchasing activities, but expect for the foreseeable future a very conservative buying profile.
This concludes my comments on revenue. And I’ll now turn it over to Bob to discuss P&L, the balance sheet and talk the guidance.
Thanks, Doug. As Doug discussed revenue in detail, I will start with non-GAAP gross margin. Our non-GAAP gross margin for the second quarter was 33.8%, a slight decline as compared to our first quarter 2009 margin of 35.2%.
The purchasing behavior, which swung product mix towards less profitable low-end systems that Doug mentioned earlier, was effective in both North America and Europe. Partially offsetting this were cost reduction redesign savings and a pickup of approximately a 100 basis points in provision for inventory reserves as compared to the first quarter.
On the subject of inventory reserves, I will remind you that last quarter we booked an $11.8 million charge. This quarter, we again took a substantial provision of $9.6 million. Our second quarter charge addresses a changing profile of certain product with demand not only dropped off significantly recently, but it's unlikely to snap back when the economy rebounds.
Our operating expenses declined another $5.8 million this quarter. We realized the full quarter benefit of the reductions that occurred in December of 2008, along with stringent discretionary expense controls and an approximate $1.4 million favorable currency impact.
R&D declined $2.3 million or 14%. Sales and marketing declined $1.5 million or 9%. G&A declined $2.1 million or 12%.
For the time being, we aren't planning on any significant changes to the underlying operating expense structure, so currency fluctuations will be the primary driver of volatility in third quarter.
Net other expense was $4 million in the second quarter, as compared to $4.4 million in the prior quarter, reflecting the lower interest on our LIBOR-based senior debt, partially offset by the reduced interest income on our cash balances.
On a GAAP basis, second quarter 2009 earnings per share were $0.22, compared to a loss of $0.21on the second quarter of 2008.
I would like to bring to your attention three of the items included in our GAAP results, but excluded from our non-GAAP reporting. First, we booked a $13.1 million gain from the purchase of 33.5 million of VeriFone convertible debt. In addition, we recorded gains of $2.7 million, pertaining to a true-up of the first quarter goodwill impairment estimate, and $2.2 million for favorable settlement regarding warranty claim for an acquired product.
Now moving to the balance sheet, let's review DSOs, inventory and debt covenants. Our DSO increased by 8 days to 77 days this quarter. In large part, the result of back-end loaded revenue. We had a lower shipmen month in February, and this gave us less opportunity to collect receivables in April.
Our delinquency metrics have been holding steady so far throughout the recession, with the one exception being the 3.4 million Venezuelan receivable where settlement is pending approval from CADIVI, the government, which controls the release of US dollars.
Inventory at a $106 million has now declined $63 million from the October 2008 peak. This reduction was the product of close coordination and great team work by our supply chain and sales groups throughout the last two quarters. In the third quarter, we expect our inventory to be flat to slightly down. Debt covenant requirements were comfortably achieved and metrics improved sequentially.
The total leverage ratio, which compares net debt-to-EBITDA, and should not exceed 3.5, was 1.0 in the second quarter. The fixed charge coverage ratio, which compares EBITDA less capital expenditures and cash taxes to interest on principal payments, and should not be less than 2.0, was 4.3 in the second quarter.
Both these ratios improved over the prior quarter. For the benefit of our investors, we have published details of the above compliance ratio calculations on the Investor Relations tab on our corporate website at www.verifone.com. You will also find a clean reconciliation for non-GAAP results there.
As we mentioned earlier, we repurchased $33.5 million of our convertible debt this quarter. We achieved an average price of around $0.59 on the dollar. The covenants of the credit agreement limit what we can spend on repurchases of convertible debt and given the run up in BOM prices after our transactions, we are not planning further repurchases at this time.
Our guidance for the third quarter is for revenue to be relatively flat to our second quarter results of $202 million. We expect non-GAAP earnings per share to be between $0.15 and $0.18. For the full year, we now expect revenue to be between $810 million and $830 million. Non-GAAP earnings per share is projected to be in the range of $0.65 to $0.70.
I will turn it over to Doug to conclude his remarks.
Thanks, Bob. One of the key indicators of relative success in a recession is how market share dynamics are playing out. We believe it's a leading indicator for how the world will look when markets return to normal. Fortunately, given that our main competitors are all public companies, it's a relatively straightforward calculation for us and our investors to make and follow.
Based on our analysis, in the first three months of calendar 2009, our two largest competitors on a pro-forma basis reflecting acquisitions, reported revenue declines of approximately 25% to 30% as measured in US dollars.
VeriFone's results for Q2 approximately the same period show decline of less than 15%. We believe that total available market revenue declined 22%.
As noted from our guidance, VeriFone does not see nor is counting on any rebound in our overall market in the near future. We have adjusted our cost basis to remain quite profitable during these challenging times and we will continue our goals of fortifying our balance sheet.
Curiously, both of our competitors have recently promised a revenue rebound in the near term. Now we are involved in every market worldwide with a broadest set of solutions, the strongest brand and the best sales organization. And frankly, we do not see nor are promising such an immediate rebound.
Now if our crystal ball is wrong, we will enjoy that upside. In either case, we will continue to strive to improve profitability and to increase market share worldwide.
Thank you for listening and we will now open it up for questions.
(Operator instructions). Your first question comes from the line of Tien-Tsin Huang with JPMorgan. Please proceed.
Hey, good evening, guys. It’s actually [Reggie] filling in for Tien-Tsin. I guess, first question on gross margins, I guess you guys talked about there is a shift towards lower margin product single application, fixed line products.
Just curious, can you talk a little bit about what the impact is from that shift? And then the follow-up on that question. I know you guys had a couple of initiatives on a gross margin line that you had planned for this year, just curious does the shift to these lower margin products changed the potential there?
So the mix shift is about 100 basis points or so. And as we noted, we got about $9.2 million charge there, so there is about 4.5 basis points that the margin was depressed in this quarter. And I have to say that we’re probably through most of the inventory reserve.
When I finished the first quarter, I said we might have some more in the second quarter. Now I can say that conceivably there could be some more in future quarters, but it will certainly be down from what we have expressed in the last two quarters, based on at least where we see the market today.
And going forward, the engineering changes that we have indicated could contribute around 500 basis points of improvement. I have previously indicated that will be rolling out quarter-by-quarter and we do expect to see improvement from that in the third and fourth quarter, so particularly fourth.
And into the first quarter of next quarter, I had indicated in the last quarter, it's probably, we had a shift from the fourth to the first quarter to get the full realization on that. So it's going to be multiple quarters that we things change. But the inventory reserves, we do expect to reduce the amount required there on the income statement basis next quarter and the subsequent quarters.
Just one follow-up [Reggie] as it relates to a product planning and product roadmap. VeriFone has made its hay over the last decade by a very complex product portfolio that addresses first to market the needs to pay at the table, pay at the pump, wireless solutions, unattended solutions, gateways, etcetera. And it's many of those high-end solutions that have been hit the hardest during this economic slowdown. When normal times return, we will be the beneficiary of that shift in mix to our sweet spot in our product profile.
Okay. So just I guess to be clear there. When the inventory reserves kind of roll off and these engineering initiatives kind of kick in, I mean we should see some pretty good margin expansion on the product solution side, all right, by the end of the year?
As I said, and maybe into the first quarter before you see the full benefit of it, but we certainly do think that we are going to get some improvements quarter-by-quarter now as we move through not only the engineering changes. As I said, I think that we have got most of the inventory reserves that we need on board now and as the economy recovers certainly into next year.
Sounds good. Question on, I guess, currency. The dollar has weakened a bit against a lot of the emerging market currencies recently. Just curious how you guys are positioned kind of your pricing, is there any potential exposure there that made revenues fall shorter or have you seen an increase in demand because the products are slightly cheaper if you could talk a little about what you are seeing there? That would be helpful.
So the currency weakening is a positive for our revenue, because there are certain countries such as the UK where our contracts are drawn up in pounds. And although when the currency strengthens, we do make adjustments to that. There was some stickiness. So the rapid drop of the US dollar over the last couple of months is a positive for us in the UK and the number of other currencies, particularly in Europe where we are mainly locally priced.
So I would say, it's a positive on revenue. Of course, it’s a negative on our expenses because over half of our expenses are international as well. So there is going to be an increase in expenses as well.
Let's remember though that in the VeriFone strong hold of North America or United States, Eastern Europe, Latin America, and Asia, predominately transactions are done in US dollars or in currencies highly pegged at US dollar and is precisely in Europe where we have historically been weak that we would have dollar exposure. So the overall effect of the movements is most related to Europe where we're probably less relevant than in other markets.
Okay, thanks. I will hop back in the queue.
Your next question comes from the line of Andrew Jeffrey with SunTrust. Please proceed.
Andrew Jeffrey - SunTrust Robinson Humphrey
Hi, good afternoon, guys. I want to just follow up a little bit on [Reggie’s] question with regard to gross margin. It sounds like your inventory charges are largely behind. You said the trends are good. Is there some reason that either your service gross margin would come down. I noticed it's up this quarter. At the same time, that product gross margin is rising, especially given the abatement of write-offs.
Or is there some reason that expenses would rise sequentially from the second quarter level and even in nascent revenue recovery. I am just trying to get a sense of why we wouldn't see a pretty meaningful sequential uptake in non-GAAP operating margin, given some of the ins and outs you have discussed?
Well, services do have more local currency content in them, even in places where the services priced in dollars. You have to hire people to provide those services. So to the extent that the US dollar continues its decline even against non-G8 currencies, I think that would be harmful to operating expenses.
I think, Bob said though in his remarks, if you are looking for material swings, Q3 to Q2 on OpEx, you probably won't find them. Could there be a little swing upward based on FX in the declining dollar, yes. But I think nothing to change the underlying foundation of your model.
Andrew Jeffrey - SunTrust Robinson Humphrey
Okay. So in some regards, then, you've considered neither the benefits of a weakening dollar, nor the possibility of significant or gross margin improvement in some of your guidance. It sounds like a lot of conservatism.
At such point that, we do see a sustained revenue recovery, whatever that looks like. Doug, do you think you are operating at a level of SG&A and R&D, that would be baseline or does that start to grow again? How much in terms of just inefficiencies have you taken out of the business versus how much have you cut back to reflect the tough demand environment?
Well, we’ve toned down some of the two or three year projects. We haven’t marked all of them, but we have toned back because we had to run the business over the last year with the expectations that the world is different place for a while. We still have the largest industry R&D spent.
I would say we’re more likely to add R&D dollars going forward than take R&D dollars away, X any currency swings. These are times to invest in new products and to gain better market positioning.
We have a next generation platform that is going to be capable of running both the Vx and NURIT platforms. That’s going to be an expensive proposition to complete. We’re already well in our way of doing that, but the final results of that will be some great R&D synergies across the organization.
So, we’re continuing to spend. It was the key to our success earlier this decade and given our relatively good position vis-à-vis our competitors on that front, I think it's time not to let up.
Andrew Jeffrey - SunTrust Robinson Humphrey
Okay. And then finally, there was some chatter about possibly some litigation resolution or wells notice resolution. I didn’t know that that anything that this could be substantiated but could you comment on any of those updates?
No, we’ll announce things when things are in a position to be announced. At this point, you could access the same Lexis-Nexis reports or legal reports that we do.
(Operator Instructions). Your next question comes from the line of Gil Luria with Wedbush. Please proceed.
Gil Luria - Wedbush Morgan Securities
Good afternoon. You talked a little bit about the inventory reduction. It's a pretty substantial reduction from the fourth quarter. Could you tell us a little bit more about what that involve?
Well, we've been working on and I mentioned in our first quarter that it's a major focus of us to continue to drive down our inventories to operate more efficiently. So the operations people work very closely with our sales organizations to only add inventory and only make purchases from contract manufactures as the products.
We do have manufacturers in Israel as well, but only to build products as we could really see demand for them. So much less contingency buys than in the past, and we used that to really drive the inventory out. Also, we work with our sales folks to sell products that are beyond the shelf for a while, but we only needed to be moved. So, sales force and the operations folks did a great job to really focus on driving that inventory down.
Gil Luria - Wedbush Morgan Securities
Got it. Now in most years you have a ramp in inventory towards your fiscal fourth quarter, should we still expect that pattern to happen again this year that that fourth quarter you will have at least some ramp up as you prepare for the late year demand?
No, we think we can operate on this manner, continue to try to make it lower, but we are sort of guiding flat from here for now, but we think we can operate this way.
Gil Luria - Wedbush Morgan Securities
Got it. And the inventory that you've written down over the last couple of quarters, now obviously this is product that you have on hand and you've written it because you've written it down because of how you perceive demand to be. If you were to sell that product going for just in terms of the accounting of this, if you were to sell that probably going forward that would be at very high margins, is that right?
Well, some of the product has been written off and what we'll be scrapping and shipping out. In fact some product was literally shipped out to the junkyard. So some of them it is heading in that direction. The other inventory we obviously have written it down to what we think is an appropriate reserve against that inventory. And so our expectation right now is that inventory won't sell. So I wouldn’t look for upside against that at the moment because our expectation is that won't sell and that’s why we took the reserve.
As you can imagine in today’s environment, every accounting entry gets 9 or 10 look, so I would not view this as a place for free upside in the future. We have just taken these reserves, because we are operating in a different world of demand than when this inventory was originally procured and the expectations are different.
Gil Luria - Wedbush Morgan Securities
Got it. And last question. One of your competitors, one of the sources that they think there will be recovery in the second half is, is the German e-health market. Have you assigned any contracts with the German government to sell terminals there? I know you are certified there a few months ago, but do you have any business coming from that?
Yes, we have a small amount of business. I could tell you this is a very nascent project. We expect very little upside over the next six months industry upside. We think it’s a good idea. But when you get governments and civil service involved, I think the expectation should be as we have suggested across our markets that things that you think will happen in the next six months will probably happen in the next 18 months.
You can see our press release on that this year from us.
At this time, I would like to turn the call back over to Mr. Doug Bergeron, CEO for closing remarks.
Well, thanks, everyone. The philosophy that management has embraced over the last six months and that we are going to continue until this storm passes is one around working capital management and cash generation and we're not searching the world for every last dollar of revenue. What we are trying to do is, make sure that we have the strongest possible company, best market share and the best market position when this is all over. So thanks for your time today.
We thank you for your participation in today's conference. This does conclude your presentation. You may now disconnect and have a great day.
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