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

Q2 2010 Earnings Call

July 27, 2010 10:00 a.m. ET

Executives

T. Kendall Hunt - CEO

Jan Valcke - President & COO

Cliff Bown - EVP & CFO

Analysts

Brian Freed - Morgan Keegan

Joe Maxa - Dougherty & Co

Andrew Abrams - Avian Securities

Scott Zeller - Needham & Company

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the VASCO Data Security International Inc. Q2 Earnings 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 T. Kendall Hunt, Founder, Chairman, and CEO. Please go ahead, sir.

T. Kendall Hunt

Thank you, operator. Good morning, everyone for those listening in from Europe, good afternoon and from Asia, good evening. My name is Ken Hunt and I'm 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. Any statement containing words such as believes, anticipates, 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 a discussion of such risks and uncertainties in this regard.

Today, we are going to review the results for the second quarter of 2010. As always, we will host a question-and-answer session after the conclusion of management's prepared remarks. If possible, I would like to budget one hour total for this conference call. If you can limit your questions to one or two, it would be appreciated.

Revenues for Q2 were $24.7 million, an increase of approximately 1% compared to the second quarter of 2009. Q2 2010 was our 30th consecutive positive quarter in terms of operating income. Our gross profit for the quarter was 70% of revenue, and our operating income was 6% of revenue.

Our business mix between banking which provides higher volume, more margin and non-banking which provides lower volume higher margin resulted in continuing healthy gross margin of 70% for the first six months of 2010. during the quarter, we sold an additional 480 new accounts including 56 new banks, and 424 new enterprise and application security customers.

This compares to the second quarter a year ago, in which we sold 350 new accounts including 44 banks and 306 enterprise security customers. We now have almost 10,000 customers including approximately 1500 banks in more than 100 countries. Although management considers the number of new customers as an indicator of the momentum of our business, and effectiveness of our distribution channel, the number of new customers is not indicative of future revenue.

During the second quarter of 2010, our cash and our working capital remain relatively constant as compared with our balances at the end of the first quarter. At June 30, 2010 our net cash balance was approximately $76 million and we had approximately $84 million of working capital. The strong cash balance gives us the flexibility to invest in our growth now that the economy seems to be improving. Over the past several quarters, we've seen a number of positive trends in our business.

VASCO's non-banking business is growing steadily. For the first two quarters of 2010, our enterprise security business grew 6%, compared to the first two quarters of 2009. Non-banking revenue was 33% in Q2 and 30% of the first six months of 2010. This compares to 32% in Q2 a year ago and 29% for the first six months of 2009. Although our banking business is recovering more slowly than anticipated the longer-term still looks bright and visibility is improving.

The RFPs that we have described to you in past calls are indeed materializing in the firm orders. Our order intake was up significantly in Q2, this is contributing to a growing backlog which will give us the visibility that we have been missing for a while. We do believe that banking market is recovering and will lead us to strong growth in 2011. The competitive landscape ahs changed dramatically, but some of our historic competitors have been acquired by private equity firms of larger corporations.

Others have shifted their attention to activities outside of VASCO's traditional markets. This is bringing growing business opportunities for VASCO particularly in the enterprise security market. Our improved product range including the IDENTIKEY Server allows us to approach markets prospects and applications that were previously out of reach. We have realized many competitive wins and replacements with our new product portfolio.

Our DIGIPASS as a service strategy looks very promising. We believe that our services offering will prove to be an important additional source of revenue and income in the longer term. Historically VASCO is not a company that likes to hide. We have always tried to under promise and over deliver. We are doing our very best to continue that tradition. Although we expect the recovery of our traditional banking market will happen, results might continue to be lumpy in the short term. This is driven not only by the timing of our customers purchasing decisions but also by manufacturing challenges such as scarcity of parts due to a general ramp up by the recovering electronics industry.

We continue to believe that VASCO's long-term future is looking very positive despite the short term situation. Be patient we will deliver. At this time I would like to introduce Jan Valcke, VASCO's President and Chief Operating Officer. Jan?

Jan Valcke

Thank you, Ken. Ladies and gentlemen as Ken noted the second quarter of 2010 was VASCO's target profitable quarter. Despite the impact of the slow recovery of the banking market, our continued success is due to the hard work and effort of VASCO's employees. In an environment that is still difficult with slowly improving short term visibility we are seeing several encouraging signs. In our traditional stronghold, the financial sector we see that the number of RFPs and others is growing worldwide. However, the short term growth in the EMEA region is slower than we anticipated.

Nevertheless we expect that the bulk of new volume purchase agreements and large orders in the financial sector that have come from EMEA. These RFPs are coming from both existing customers and new prospects. Enterprise security is enjoying solid global ground; our growing and mature partner network is a tremendous asset in the growing success of enterprise security. Also in non-traditional B2C and B2B application VASCO is interesting and preparing for future growth.

We are also inventing in our recently announced DIGIPASS as a service business model. Currently we are targeting various leading application service providers to make their enterprise products DIGIPASS ready. We believe that DIGIPASS as a service will be instrumental in VASCO's future success.

Thanks to this positive business mix, we are able maintain our gross margin at a solid 70%. With regards to the products a lot of work has been done during the second quarter. We have invested strongly in the DIGIPASS as a service back end platform.

In addition we have made our server offerings more robust allowing us to compete in areas where we weren't able to compete before. As Ken already mentioned, this is bringing us new competitive business wins, previously out of our reach. We also continue to invest in our wide variety of hard and softer DIGIPASS family of client authenticators. We believe that we have the strongest product family in the world.

People are VASCO's most important asset. We continue our invest in new hires, particularly in sales and R&D. Additional bandwidth is needed for the further development of our DIGIPASS as a service offering and for our growing success in our traditional business.

As a conclusion ladies and gentlemen, we believe the recovery of our business is happening. We see new deals, new RFPs and new volume purchase agreements. However what we can't control is the exact timing of when this recovery will be demonstrated by return to more aggressive growth. Our best protection is sometimes in the fourth quarter or early 2011.

As I described earlier, the mission we have right now is to combine short term and long term objectives. As a profitable debt free company we are able to invest in our long term growth without hurting the business. We continue to be positive about VASCO's future success. Thank you.

T. Kendall Hunt

Thank you Jan. At this time I would like to introduce Cliff Bown, VASCO"S EVP and Chief Financial Officer. Cliff?

Cliff Bown

Thanks Ken and welcome to everyone on the call. As noted earlier by Ken, revenues for the second quarter of 2010 were $24.7 million, an increase of $284,000 or 1% from the second quarter of 2009. For the first six months revenues were $48.7 million, an increase of $1 million or 2% from the comparable period in 2009.

The increase in revenue for the second quarter and first six months was primarily related to an increase in revenues from the Enterprise and Application Security market. Revenues from the Enterprise and Application Security market increased 6% for both the second quarter and first six months of 2010 respectively when compared to the same periods in 2009.

Revenues from the Banking market decreased 1% for the second quarter and increased 1% for the first six months of 2010 when compared to the same periods in 2009. It should be noted that the comparison of revenues was impacted by changes in exchange rates of the euro and Australian dollar to the U.S. dollar.

We estimate that revenues in the second quarter were $365,000 lower for the second quarter and $459,000 higher for the first six months of 2010 than they would have been had the exchange rates in 2010 been the same as in 2009.

The percentage of revenue coming from the enterprise and application security market has increased by one percentage point for both the second quarter and first six months of 2010 when compared to 2009. Revenues from the enterprise and application security market were 33% of total revenue in the second quarter, and 30% of total revenue for the first six months of 2010.

With the weakness in the European markets, the percentage of revenue coming from Europe has declined in 2010, compared to the same periods in 2009. The geographic distribution of our revenue in the second quarter was approximately 66% from Europe, 11% from the United States, 10% from Asia and the remaining 13% from other countries.

For the second quarter of 2009, approximately 70% of our revenue was from Europe, 6% from the U.S., 9% from Asia and the remaining 15% was from other countries. The distribution for revenue, of revenue for the first six months ended June 30 of each 2010 and 2009, were similar to the percentage of revenues for the second quarter of each year.

Gross profit as a percentage of revenue for both the second quarter and first six months of 2010 was approximately 70%. In 2009, gross profit as a percentage of revenue was 68% in the second quarter, and 70% for the first six months, ended June 30. The increase in gross profit as a percentage of revenue for the second quarter of 2010 compared to 2009 primarily reflects the favorable change in the mix of products sold and the benefit of our enterprise and our application security revenues increasing as a percentage of total revenue.

The mix of products sold in the second quarter in first six months of 2010 reflected an increase in non-hardware revenue as a percentage of total revenue and a decrease in card readers sold as a percentage of total revenue when compared to the same periods in 2009. Our non-hardware revenues were 27% and 26% of total revenue for the quarter in six months ended 2010, respectively and compares to 24% and 22% of total revenue for the quarter in first six months of 2009.

Revenues from card readers were 13% and 14% of our revenue for the second quarter and first six months of 2010 respectively, compared to 22% and 18% respectively for the comparable periods in 2009. As noted on previous calls, our card reader product line has lower margins due to competitive pricing pressures.

Operating expenses for the second quarter of 2010 were $15.9 million, an increase of $500,000 or 3% from the second quarter of 2009. And operating expenses for the first six months of 2010 were $31.8 million, an increase of $4.5 million or 16% from the same period in 2009.

Operating expenses for the second quarter in first six months of 2010 included $626,000 and $1.2 million respectively, of expense related to stock-based incentive plan. Operating expenses related to stock-based incentive plans for 2010 were $200,000 and $2.4 million higher than the comparable periods in 2009.

For the first six months of 2009, operating expenses reflected a benefit of $2 million, related to the reversal of approvals for long- term, performance-based incentive awards, where it was determined that that targeted performance would not be achieved.

It should also be noted that the comparison of operating expenses in the second quarter of 2010 versus 2009 was positively impacted by the stronger U.S. dollar in 2010. We estimate that expenses were $332,000 lower than they would have been, had the exchange rates in 2010 been the same as 2009.

And for the six month June 30, operating expenses were negatively impacted by a weaker U.S. dollar which increased operating expenses by $488,000. For the second quarter including the benefit of currency, operating expenses decreased $306,000 or 4% in sales and marketing, increased $310,000 or 10% in research and development and increased by $498,000 or 12% in general and administrative when compared to the second quarter of 2009.

The decreased in sales and marketing expense primarily reflected the benefit of the change in exchange rates, the increase in research and development expense primarily reflected increased compensation expenses and increase purchase services. The increase in general and administrative expense primarily reflected higher professional fees, purchase services and recruiting expenses.

For the first six months of 2010, including the afore-mentioned negative impact of change in currency rates, operating expenses increased by 564,000 or 4% in sales and marketing, $1.1 million or 21% in research and development and $2.8 million or 42% in general and administrative when compared to the same period in 2009.

Adjacent to the recent noted for the changes in the second quarter, the increase in expense reflected the benefit from the reduction and stock-based incentive plan, compensation expense recorded in the first six months of 2009 as previously mentioned, and an increase in our provision for uncollectible accounts receivable.

Operating income for the second quarter of 2010 was $1.6 million, an increase of $224,000 or 17% from the $1.4 million reported in the second quarter of 2009. For the first six months, operating income was $2.3 million in 2010, a decrease of $3.8 million or 62% from the $6.1 million reported in 2009.

Operating income as a percentage of revenue, our operating margin was 6% in the second quarter and 5% for the six months of 2010 and in 2009; our operating margins were 6% for the quarter and 13% for the first six months.

The Company reported income tax expenses $696,000 for the second quarter and $978,000 for the first six months of 2010. The effective tax rate was 39% for the second quarter and 37% for the first six months of 2010. For 2009, the company reported income tax expenses $681,000 from the second quarter, and $1.8 million for the first six months.

The effective tax rate reported in 2009 was 25% for both the second quarter, and the six month period ended June 30. The effective rates for both 2010 and 2009 reflect our estimates of our full-year tax rate at the end of the second quarter in each period.

The increase in tax rate is primarily attributable to the reduction in pre-tax profits. In addition, the rate for the second quarter of 2010 included the benefit of $287,000 of discrete items, related to adjustment of prior year's tax provisions. Under our current structure, our effective rate will be very sensitive to the level of pre-tax income.

As pre-tax income increases, we expect the effective rates to decline, as pre-tax income decreases, the effective rate will increase. Earnings before interest, taxes, depreciation and amortization, EBITDA or operating cash flow if you will was $2.2 million for the second quarter and $3.8 million for the first six months of 2010.

EBITDA was $987,000 or 31% lower in the second quarter, and $4.8 million or 56% lower in the first six months of 2010. The makeup of our workforce at June 30, 2010 was 323 people worldwide with 168 in sales, marketing, and customer support, 101 in research and development and 54 in general and administrative.

The average headcount for the second quarter of 2010 was 12 persons or 4% higher than the average headcount for the second quarter of 2009. The average headcount for the first six months of 2010 was 3 persons, or 1% higher than the average headcount for the same period in 2009.

Finally, our balance sheet continues to show strong cash and working capital balances throughout the second quarter of 2010. As of June 30, 2010 our net cash balance, which is defined as total cash plus bank borrowings was $76 million, a decrease of $127,000 dollars or less than 1% than from the 76.1 million at March 31, 2010 and an increase of $8.4 million or 12% from $67.6 million at December 31, 2009.

As of June 30, 2010, our capital balance was $83.7 million, a decrease of $2.6 million or 3% from $86.3 million at March 31, 2010 and a decrease of $3.9 million, or 4% from $87.6 million at December 31, 2009. We had no debt outstanding during the quarter.

Our day sales outstanding and accounts receivable decreased from 71 days as of June 30th, 2010 from (inaudible) days at March 31, 2010 and from 88 days at December 31, 2009.

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

T. Kendall Hunt

Thank you Cliff, as we described early in the call today 2010 is turning out to be more challenging than we had anticipated. However, the fundamentals of our business are strong with an increased number of new accounts compared to 2009, a growing enterprise in application security business at 33% of revenues for Q2 and 30% of revenues for the first six months of 2010. Increased RFP activity resulting in a growing number of volume purchase orders and significant order intake for Q2 considering the data points that we have available at this time; I'm modifying guidance for the rest of the year.

First, we expect that full-year 2010 revenue will grow from 5% to 10% over full-year 2009. This is a change from our previous guidance of 15% to 20% revenue growth. Second, we are maintaining the full-year 2010 operating income as expected to be in a range between 5to 10% of revenue.

This guidance reflects the company's strategy to continue its aggressive growth by investing in its people, our newly announced DIGIPASS as a service and the infrastructure necessary for long-term profitability. It also reflects our continued evolution to a more software centric company with a focus on recurring revenues.

This concludes our presentations today, and we will now open the call for questions. As I mentioned earlier as a courtesy to others on the call, I would appreciate it if you would limit your questions to an initial question plus a follow-up. If you have additional questions please get back into the queue. Operator?

Question-and-Answer-session

Operator

(Operator Instructions). And our first question comes from the line of Brian Freed with Morgan Keegan. Please proceed.

Brian Freed - Morgan Keegan

Good morning, real quick. As you look at your forecast going forward, it looks like you expect growth to accelerate to and or into the double digit growth after and the lackluster growth for the first half of the year. Can you give us a little color what gives you the confidence that you will indeed see that acceleration, and also maybe some color around how the timeline of progression RFP to revenue occurs?

T. Kendall Hunt

Sure. The banking business has historically had a pattern of a request for information that's what a bank does. They send out a general request for information for a great number of security vendors to present what they think will work. They typically would send out I don't know 20, 30, 50 invitations. They boil that down to between four and six finalist, and then they have a more formal request for proposal with specific requirement, and so the banks can take quite a long time from the point where they conceptualize and justify an online banking applications where they go through the RFI, and then the RFP etcetera. RFPs once they are distributed typically the decision is made within I don't know 60 to 90 days. Jan can certainly add his color after I finish my response, but it's probably between 60 and 90 days to make a decision, and then they, they do a pilot with the chosen vendor that pilot might make, it might take 90 days with the subset of the audience up there rolling out. And then historically the rollout could take two or three years.

So, what we've been pointing out over the last couple of conference calls is we've seen the RFP volume grow dramatically, and now what we're seeing is those RFPs come to conclusion and they are turning into orders for VASCO then these are the volume purchase agreements that we talk about, and therefore, certain number of units, licenses or DIGIPASS, it's for software and because the banks are dealing in some cases with very large audiences. It takes two years maybe longer to roll these things out. So, what we've seen in the second quarter is kind of a combination of some of these RFPs turning into large orders, and that's what we're describing as order intake in the second quarter.

Order intake is simply that. It's an order, and the schedule is again over a year, two years to roll out the product to the customers. Jan, do you have any additional comments on that?

Jan Valcke

Well, maybe just a small comment about production. It's a short-term problem that we have today about the short base in components that there is with our -- in the Chinese market. The boom of the economy creates also the shortage and that is something where we are suffering on the left and the right a little bit, but this is only for short-term deliveries.

T. Kendall Hunt

Yeah. I might mention the component is nothing exotic. One of the problem areas is the little screen that goes on our devices, and they are in short demand and we are managing that. Short-supply I should say and we are managing that.

Brian Freed - Morgan Keegan

Okay so in summary you see the RFP volume is really the basis for your accelerated growth in the second half.

T. Kendall Hunt

Yes Brian and the conversion of the RFPs to actual orders and once we get those that becomes backlog and wasn't that long ago we were able to communicate to the market our backlog into a quarter that's coming back and we are seeing backlogs for our quarters and we are starting to measure it internally and we are seeing backlog out over 12 months, we are working with that.

So, it is getting to be more predictable than it's been over the last 12 to 18 months.

Brian Freed - Morgan Keegan

And then my final follow-up on that is with respect to linearity. Do you expect to start linearity across the September and December quarters or just the component constraints due to more at the back end?

T. Kendall Hunt

Well are you talking about revenues per quarter?

Brian Freed - Morgan Keegan

Yeah.

T. Kendall Hunt

Well historically we have had some exceptions but historically if you look over the last, what if you look since 2003 is an example. Second quarter is strong, third quarter is typically seasonally down because of the holidays in Europe and we still do over 60% of our business in EMEA and then fourth quarter is very strong and then first quarter is even or down from the fourth quarter.

Historically, that's generally what we have seen, we did see a couple of differences in 2008 where in the third quarter of 2008 we had our biggest quarter ever almost $40 million in revenue but that was an exception.

Brian Freed - Morgan Keegan

Okay. Thanks.

T. Kendall Hunt

Sure.

Operator

Thank you. And our next question comes from the line of Joe Maxa with Dougherty & Co. Please proceed with your question.

Joe Maxa - Dougherty & Co

Thank you. So, on that seasonality question, can you give us a little indication of your thoughts on Q3 up or down sequentially?

T. Kendall Hunt

Well I think it will, I don't that I can say anything about third quarter specifically other than give you historic range and tell you what I have always already said is that we have very good order intake in the second quarter. But we are still challenged with predictability of the business because of not enough backlog to be able to predict quarters out. So, Joe unfortunately I can't say anything specific about third quarter.

Joe Maxa - Dougherty & Co

Okay I did want to ask if you could give us a geographic location of your new banking customers. I am just wondering if there is a shift over the last year or two or how big the ship maybe from primarily banks in Europe to outside of Europe.

T. Kendall Hunt

Yeah Jan, you can answer that question please.

Jan Valcke

So, if you look at RFPs and RFPs who already came in order and then you are talking most of the part of EMEA. So, banking EMEA will come again strong in our business.

Joe Maxa - Dougherty & Co

Okay so your newer backlog is mostly EMEA.

Jan Valcke

Well if you want, number one is EMEA, two is Asia, three is in the Pacific and four is the U.S. because in the U.S. there is not a lot of retail banking business or non-retail banking business.

Joe Maxa - Dougherty & Co

Okay all right, that's helpful. Thank you.

Operator

Thank you. (Operator Instructions). And our next question comes from the line of Andrew Abrams with Avian Securities. Please proceed with your question.

Andrew Abrams - Avian Securities

Hi, I wonder if you could just talk a little bit about the environment relative to where we were maybe two quarters ago at the customer level. Are you seeing, and this is more on the banking side than on the enterprise side, are you seeing customers start to facilitate long term programs or are we talking about kind of the, we know we got a program out there but we're going to do it in very small steps. Is anybody building up those steps or are we still in the kind of lets do it as slowly as we possibly can and make sure we're going in the right direction.

T. Kendall Hunt

Absolutely. We're seeing the banks plan longer term. Over the course of 2009 we did see the pattern that you describe which were smaller just in time kind of orders where we really had to respond quickly to meet the needs. The RFPs are bigger deals. They're bigger transactions. They're serious transactions and therefore delivery over 12 months or so.

Andrew Abrams - Avian Securities

So those should translate a little faster than what you had been seeing six months ago in terms of the way they play out?

T. Kendall Hunt

Yeah, many of the RFPs have reached their conclusion; the process that I described before which would be up to a year and a half, two years. RFI, RFP, its after negotiations et cetera. And so we would have seen a significant number of those RFPs turn into orders and that's why we're talking about the order intake in the second quarter as being relatively significant compared to the last year and a half. So yes.

Andrew Abrams - Avian Securities

Okay and lastly are we still in a relatively short delivery time schedule. I know you said there were some component shortages but they seem relatively short term. Are we still figuring as you get your orders; you can deliver in the same quarter?

T. Kendall Hunt

Well we figured out over the course of 2009 how to do that because whereas in the past we might need or ask for lets say four weeks or six weeks to turn an order around because our customers were managing their inventory and managing their budgets. They would ask us unreasonable turnaround times, two, three weeks and we figured out how to do that.

So we're seeing less of that. Jan if you have some more color on that, please chime up but….

Jan Valcke

The short, the black and white answer is that for the moment we are still delivering at short term and I'm talking now, now, now. But as mentioned before in this call, as we are getting more and more RFPs for large orders, those RFPs, we allot, some of those RFPs we have already in order. So we believe that visibility, in the next couple of months we'll come back to give you a better forecast. For the moment, yes. It is still working with short term deliveries.

Andrew Abrams - Avian Securities

And on the enterprise side, just kind of the same characterization, are you seeing a change in the enterprise side. I know in some companies that I talked to, they're still very cautious about placing extended large orders or large orders and are extending them out if they are large. Has that changed at all for you in the last quarter or two?

Jan Valcke

Yes. I believe that if you have followed our product line, our suite of product today is a very mature suite of products based on software with the large margins we have in that business. So basically today our suite of products is mature to compete with all our competitors. That is the change.

The second thing is, it's a bit different than in the banking business. The banking business is still a business where you go to new markets. So, the Enterprise security is certainly with these two big business, Remote Access and Enterprise Security in a much more mature market. So basically, I do agree with what you're saying. There is not so much a growth today in that market.

On the other hand, we are gaining more and more businesses against our largest competitors. We are turning also around companies that are working with the competitors, that are now working with VASCO.

So we still expect very good growth, not only from the market as such, but also from competitive deals that we are getting due to the fact that our business model is different and probably better than those of our competitors

Andrew Abrams - Avian Securities

And this would be kind of the RSA penetration that you talked about, last quarter or a quarter before where you were targeting kind of the lack of strength that RSA was showing once that acquisition was done. So, you would assume that your share against RSA or competitive large scale players has increased a bit over the last quarter or so?

Jan Valcke

Yeah. Our share is certainly becoming bigger. We have a larger part of the pie. But it's not only RSA. There is, like Ken mentioned in his exposés, there is also other competitors who have taken privately and so on. So we are becoming a very strong company in that field.

Andrew Abrams - Avian Securities

Got it. Great.

T. Kendall Hunt

Andrew, I also should mention that until recently we talked about banking business and non-banking business. Now we describe non-banking business as Enterprise and Application Security. And the Application Security market we count Gaming as a very big opportunity. And that opportunity continues to grow quarter-by-quarter. In fact, our two largest customers in the second quarter were gaming companies.

Andrew Abrams - Avian Securities

And if we look at the gaming companies –

T. Kendall Hunt

We're in the top ten.

Andrew Abrams - Avian Securities

If we look at the gaming company business, are you gaining share with your largest clients or are you're adding additional clients going forward?

T. Kendall Hunt

Well we're penetrating the existing banking -- the existing gaming companies that we've signed up over the last two years, one year and six months and we continue to sell new ones. Is that your question?

Andrew Abrams - Avian Securities

Yeah. I was looking for the increase in penetration at your already established customers. Is that continuing? Is there a point where it starts to level off or where you kind of saturate those customers, clients who are going to pay for something to protect themselves and then you get down to the kind of generic guys that wont?

T. Kendall Hunt

I don't think we're close to penetration or saturization as yet. The gaming companies are selling the product or getting the product drifting with some kind of a point reward to the gamers. The gamers if you went to the internet and you went to YouTube, and you type in Blizzard Authenticator, you can see some of our best sales people talking about with great enthusiasm their Blizzard Authenticator manufactured by VASCO -- they don't know that -- and how they like it so much and why everybody that's a gamer should have one.

Andrew Abrams - Avian Securities

Got you. Okay, well thank you very much.

T. Kendall Hunt

Sure.

Operator

Thank you. And our next question comes from the line of Scott Zeller with Needham & Company. Please proceed with your question.

T. Kendall Hunt

Hi Scott.

Scott Zeller - Needham & Company

Thanks. Can you hear me okay?

T. Kendall Hunt

Yes, hi Scott.

Scott Zeller - Needham & Company

Hi. Back to the commentary around the components, I understand from Jan's comments the short-term issue. But how does that impact the win rate for RFPs, because I believe some of your RFPs and revenue generation is very near-term, you're suggesting where you'd get a win and then a immediate big order. So can you please tell us sort of how component shortage might be affecting the RFPs and win rates?

T. Kendall Hunt

Well, the shortage of the lenses would be a short-term issue for a short-term order. The RFPs, as I had mentioned before, typically larger deals, larger transactions and delivery is over 12 to 24 months. So it wouldn't really impact an RFP very much other than the shorter term delivery requirement.

Scott Zeller - Needham & Company

Okay, and then --

T. Kendall Hunt

As we sell through the channel of course, we're selling in very small quantities; we're selling a VASCO branded DIGIPASS token and I don't know. Jan, do you have any other comments on that. I can't These really aren't impacted other than ones that are scheduled for the next quarter, this quarter.

Jan Valcke

Yes on the RFPs, which are larger deals, there is no impact. We can manage that. It's really on this short-term business. Sometimes need to shift to the end of the quarter, deliveries to the next quarter due to that shortage, that Resident Component market.

Chris Bown

Yes, it would -- Scott, it would probably be an existing customer that is still in the mode of a short-term turnaround and they would ask us to -- what's been all let's say, today we get an order and they would say we want you to ship before the end of the quarter.

Scott Zeller - Needham & Company

Okay, thank you very much.

Chris Bown

Sure.

Operator

Thank you. And our next question comes from the line Mark Premisy, Private Investor. Please proceed with your question.

[Mark Premisy] - Private Investor

Hi, Ken.

T. Kendall Hunt

Hi, [Mark].

[Mark Premisy] - Private Investor

My question is a couple of quarters ago there was a mention that 2010, VASCO might add as much as 20% of their workforce based on the demand of the RPFs and developers and that sort of thing. Can you give us some idea how that's going and if you still see a demand for the hires?

T. Kendall Hunt

Yeah, our strategy in hiring is to hire more sales people, more senior sales people, particularly in markets where we don't have a physical presence like Mexico City; like Buenos Aires, Argentina; like Santiago to Chile. And so what we want in those promising new markets, we want global people that were born there, understand the language, understand English of course, have contacts, have networks, etc. so a lot of our focus is on hiring sales people in new markets.

The other focus is beefing up our R&D staff so that we can deliver the products that we have talked about and we've scheduled, DIGIPASS as a service is very, very important to us, so we want to make sure that we are properly staffed to build out that product. Jan you have anything else to comment?

Jan Valcke

Well I think we are a different company on that perspective than a year ago and then two years ago, we have now a tremendous got HR team that is also already worldwide and they are doing a tremendous job by finding the professionals, really the people that we need to – this local people that we need to have.

[Mark Premisy] - Private Investor

One other question if I may, in the U.S. I guess two or three years ago, there was the FFIEC dictate that caused financial institutions here in the U.S. to shore up there security and I'm just curious, is there any type of events here in the U.S. that could drive a greater presence of VASCO in the U.S.

T. Kendall Hunt

Yes and I think what's happening is as there is more and more hacking, there is more and more man-in-the-middle attacks. The FFIEC really wasn't a directive, it was more of a suggestion, it was guidance and many of the banks on the retail side adopted your mother's maiden name "Security" and I think there are many opportunities on the retail side going forward to replace those weaker forms of security.

As far as current customers' world wide, let's say that the initial round of purchasing was for a simple product. A DIGIPASS one button product, like a DIGIPASS Go 3 or DIGIPASS Go 6 and it was meant to make it very easy for the customer to be able to use it. Over the last several years, man-in-the-middle attacks keep increasing. That's where a hacker intercepts instructions for lets say a wire transfer and changes those instructions so that the wire transfer is sent to that person's -- the hackers bank, his/her own bank and so we have products both hardware and software that are able to take part of the instructions, incorporate into the DIGIPASS hardware or software and generate a unique number called a signature.

That signature is included with the instructions sent to the bank, so if any hacker intercepts the instructions and changes any of the instructions, the bank on the other side will not be able to generate a matching signature and will deny the transaction. That means we have quiet a few opportunities to upgrade our current banks on the commercial side mainly here in United States with the product that has multiple functionality including this signature. So, it's a great upgrade opportunity for us, mainly because of the more aggressive man-in-the-middle attacks.

[Mark Premisy] - Private Investor

Do you have the people to cover those opportunities?

T. Kendall Hunt

Yes I think we do.

[Mark Premisy] - Private Investor

Okay.

T. Kendall Hunt

Sure.

[Mark Premisy] - Private Investor

All right, thank you.

T. Kendall Hunt

Thank you, [Mark].

Operator

Thank you. And our next question comes from the line of Brian Freed with Morgan Keegan. Please proceed with your question.

Brian Freed - Morgan Keegan

Hey guys. A couple of more housekeeping items I wanted to run by.

T. Kendall Hunt

Sure.

Brian Freed - Morgan Keegan

You mentioned purchase services had a impact higher operating expenses. Can you talk a little bit about the purchase services you're acquiring and how you tend to balance your internal headcount and internally delivered services that you're purchasing for third party?

T. Kendall Hunt

Well, within the purchase service category, Brian there is a couple of things that are going on. One within Europe, it's fairly common for the staff to work on contracts, so rather than being direct compensation it will be reflected as a purchase services item for us. We do include those people in our headcount statistics, but in terms of the line items that they show up and it's more purchase services. The other kinds of things that we're doing with purchase service is there is some contract R&D for moving the programs along more quickly than what we will be able to with just our internal resources, and within the general administrative areas as you may recall, we have implemented the enterprise resource planning system, ERP system over the course of the last year we actually went live in July of 2009. we are continuing to use that outside resource to refine and improve our efficiency with the ERP programs.

Brian Freed - Morgan Keegan

Okay back at the housekeeping question. Can you explain why the tax rate increases on lower income?

T. Kendall Hunt

In general, it's deals with our new structure, the structure we put in place in 2007. it seems like it was yesterday, but obviously it's been a couple of years ago. With that structure essentially removed, the ownership of all the intellectual property to Switzerland and the United States. With that, we entered into inter-company agreements with all the other VASCO entities and other countries around the world for them to be contractors to one of those two entities either the U.S. or the Swiss entity. So, in essence we've guaranteed a certain level of profit for all of our other operating subsidiaries and taken all of the business risk and the majority of the earnings into either of the United States or Switzerland. Within the United States, we have essentially a zero effective tax rate because we've got net operating loss carried forward that are fully reserved on our books. Within Switzerland because of the tax structure there, there is a very low marginal tax rate on our earnings that flow through Switzerland. So in essence what happens is since the profits of all of our subsidiaries is fixed in our higher tax rate jurisdictions, we got a base level of tax expense that won't change, unless our spending in those countries change because they are all basically on a cost plus type bases, and whatever the change is in earnings, it flows through to one of those low tax jurisdictions either to Switzerland or the United States. So, any declines in our pre-tax profit basically do not have a significant impact on our tax expense. The marginal tax rate for those changes in pre-tax are very small whether it's up or down so if our pre-tax earnings are declining our effective tax rate is going to go up fairly quickly. If our pre-tax income is increasing similarly the tax rate will come down pretty quickly.

Brian Freed - Morgan Keegan

Okay, thank you. And then my final is you've given us the number of channel relationship in terms of the distribution channel specifically. Can you give any color on those, the progress to those perhaps distribution as a percentage of revenue and then lastly can you talk about accountings for those distribution relationships, do you recognize on sell in or sell out?

T. Kendall Hunt

With regard to the percentage of revenue that comes from distribution relationships, we do not report that because that is not uncommon for a distributor in a country where we don't have a physical presence of introduce us to a bank but then our direct sales team actually interacts with that bank to close the deal.

So, in those cases it's not clear who should get credit for the distribution revenue and instead of doing that we focus on what the different markets are that are being addressed and our percentage of revenue i.e. banking or enterprise and application security.

And so the channel relationship number is not something that we do track internally or report. The second part of your question Brian it slipped my mind, what was the second?

Brian Freed - Morgan Keegan

Revenues through distribution, do you recognize that is sell in or sell out?

T. Kendall Hunt

Essentially all of those relationships are complete when we sell it to the distributor so we recognize it on sell in when all of the different terms for that particular arrangement have been met. We have a lot of different, what they call incoterms, shipping terms, some are exworks our facility, some are cost insurance freight to the country in which they operate, some are delivery duty paid. So, we have to clear through customs. Some are up on customer acceptance on the other end. So, we recognize that once all of those different shipping terms are met and we have fulfilled all of our obligation but we are not recording revenue based on that distributor's ability to resell and collect the revenues from their transaction.

Brian Freed - Morgan Keegan

Okay and then a final follow-up there. Given the component charges and that type of issue, if you have seen an material shift in your distributor's inventory?

T. Kendall Hunt

Well again the majority of them are sell through as we have moved to larger distributors Tech Data, Ingram Micro, etc., they may tend to carry some inventory but we don't have visibility of that but the majority of our distribution channel today is again an order give it to us on short turn around, we ship it, they move it through their system and aren't carrying large amounts of inventory.

Brian Freed - Morgan Keegan

Thank you.

Operator

Thank you. And Mr. Hunter no further questions at this time. I will turn the conference back over to you to continue with your presentation or closing remarks.

T. Kendall Hunt

All right operator thank you very much. Thanks everyone for attending today. Thanks for the good question, we appreciate your confidence and patience with the company and as always I want to thank the VASCO people around the world for their hard work, for their efforts and their loyalty to the company. Good morning.

Operator

Thank you. And ladies and gentlemen that concludes the conference call for today. We thank you for your participation and ask that you please disconnect your lines.

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Source: VASCO Data Security International, Inc. Q2 2010 Earnings Call Transcript
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