Diebold CEO Discusses Q3 2010 Results - Earnings Call Transport

| About: Diebold Inc. (DBD)

Diebold, Inc. (NYSE:DBD)

Q3 2010 Earnings Call

October 28, 2010 10:00 a.m. ET


John Kristoff – VP and Chief Communications Officer

Tom Swidarski – President and CEO

Brad Richardson – EVP and CFO


Kartik Mehta – Northcoast Research

Reik Read – Robert W. Baird & Company, Inc.

Matt Summerville – KeyBanc Capital Markets

Paul Coster – JP Morgan

Gil Luria – Wedbush Morgan Securities, Inc.


Please standby. We’re about to begin. Good day, everyone and welcome to the Diebold Incorporated Third Quarter Financial Results Conference Call. Today’s call is being recorded.

At this time, for opening remarks and introductions, I would like to turn the call over to the Vice President and Chief Communications Officer, Mr. John Kristoff. Please go ahead, sir.

John Kristoff

Thank you, Sarah. Good morning and thank you for joining us for Diebold’s third quarter conference call. Joining me today are Tom Swidarski, President and CEO; and Brad Richardson, Executive Vice President and CFO.

Just a few notes before we get started. In addition, to the earnings release, we’ve provided a supplementary presentation on the Investor page of our website. Tom and Brad will be walking through this presentation as part of their comments today, and we encourage you to follow along.

Before we discuss our third quarter results, as on past calls, it’s important to note that we have restructuring, impairment and non-routine income and expense in our financials. We believe that excluding these items gives an indication of the company’s baseline operational performance. As a result, many of the remarks this morning will focus on non-GAAP financial information.

For a reconciliation of our GAAP and non-GAAP numbers, please refer to the supplemental material at the end of the presentation. In addition, all results of operations reported today including prior periods exclude discontinued operations.

Finally, a replay of this conference call will be available later today from our website. And as a reminder, some of the comments today may be considered forward-looking statements. Internal and/or external factors could significantly impact actual results. As a precaution, we refer you to the more detailed risk factors that have previously been filed with the SEC.

And now, with opening remarks, I’ll turn the call over to Tom.

Tom Swidarski

Thanks, John, good morning, everyone. I’m very pleased with the solid third quarter operating results we announced this morning, and proud of the continue efforts of our associates around the world. We remain very focused on, and it’s been a clear leadership in service and integrated services, to drive increase recurring revenue across our global markets.

Certainly the Brazil election business had a large positive impact on our results and we’re very proud of the work we’ve accomplished in that area. However, it’s important to note that our core business in Brazil, as well as some of our other key geographies performed extremely well as we delivered meaningful topline growth, and significant improvement in earnings.

In addition, a more positive global product mix, particularly in the United States, resulted in notably higher product gross margins during the quarter. Our service margin continues to improve as we leverage our footprint, improve productivity, and add higher value demand and services to our mix of offerings. Our net deposition improved by more than 35 million from September 30, 2009. I’d expect we’ll continue to gain ground on the working capital improvements throughout the remainder of the year.

I’m also encouraged by the double-digit increase in global orders. Each geographic region delivered order growth during the period, which affirms our prior assessment that industry is slowly beginning to recover. In addition, there is strong order growth for financial self-service in the U.S. regional bank space.

We remain confident in our outlook for the remainder of the year, and as a result, have tightened our earnings guidance near the top end of our prior range. We are seeing increased momentum in many of the key areas we serve. For example, we recently received a large cash recycling order from one of the largest banks in Italy. This contract includes three years of maintenance services. It also reflects our ability to face highly competitive pressure in a cash recycling market place.

In Turkey, we received a large order for VocaBank, one of the leading banks in Turkey. We’re providing 575 customized [inaudible] ATM, enabled with cash deposit, coin transaction, and bill payments through customized software. Turkey is one of the world’s fastest growing markets for ATM deployments, and we are confident in our competitive position there, due to our recent investment in a direct operation within a country.

Also during the quarter we announced Navy Army Federal credit union chose Diebold implement mobile banking. By deploying our mobile bank solution, Nav, Army becomes the first credit union in its Texas region with a robust mobile program, improving its ability to compete with larger banks offering mobile services. Diebold’s providing this capability through a multiyear managed services contract, allowing the credit unions to reduce operating cost, generate revenue, and help integrate their delivery channels.

Additionally during the quarter, we passed important third-party audits to verify our continuous compliance with [inaudible] and PCI standards for ATMs security which is a major concern in our industry. While many other ATM providers perform these audits internally, we feel that having third-party audits provide absolute conformation of our compliance with these critical industry standards.

Finally, we recently complete a security infrastructure upgrade at the North America headquarters of Christie’s Auction House in New York City. This upgrade enables the auction house to centralize its security operations, reduce risk, and improve event response times across multiple sites.

Now, let’s look at our performance during the quarter in the geographies regions. In North America, revenue grew 7% during the quarter while orders grew 9%. The momentum we discussed on our second quarter call continued into the third quarter. We’ve experienced strong revenue and order growth in both the regional and national bank segments. Deposit automation shipments in the regional segment grew significantly during the quarter as credit unions and banks alike deployed deposit automation solutions.

We are seeing similar trends in the national account space as more banks outside the nation’s top three are beginning to convert their ATM networks to include deposit automation capability. Excluding the top three banks, total U.S. shipments of deposit automation terminals and modules, more than doubled during the period. The television ads many of us have seen from Bank of America and Chase, confirm that the profile for deposit automation is also increasing.

Diebold has the unique solution to put us in a superior competitive position with those customers who have yet to deploy deposit automation. Our technology offers unparalleled flexibility, including bulk note, bulk check, single note, single check, or any combination at a variety of competitive price points. And the results our customers are measuring on reliability uptime and other key customer metrics validate our technical performance advantages. Our separate check and note module design also enables parallel processing for faster transaction times, superior performance and reliability compared to a single module design. No other competitor offers this level of flexibility and reliability.

Our competitive advantage in this area positions us well, not only in North America, but in all the international markets we serve. In fact, during the quarter about half the full function ATMs we shipped globally, were equipped with deposit automation capabilities.

In addition, we have the largest most responsive and experienced direct service organization in the industry. And through our integrated services business model, we offer complete outsourcing solutions. This provides smaller financial institutions an avenue to quickly convert their ATM fleets for deposit automation without a large capital outlay.

I’m very pleased with the continue traction and recurring services revenue we have gained in the outsourcing space. The total value of integrated services contract will secure and 2010 will surpass 100 million and represent a growth of 50% from 2009.

Another catalyst for growth, moving forward, is compliance with industry and regulatory requirements. For example, new requirements related to the American’s with Disability Act will be saved during 2011 and become mandatory on March 15, 2012. In addition, they’re revolving PCI standards for security that will affect ATMs moving forward.

Again, we had a very strong performance in North America self-service during the quarter and feel very good about our strong order growth. We anticipate demand in this region will continue to grow.

Now, let’s look at our security business. Our expectation in the financial space remains tepid, especially as it relates to bank branch construction in North America. However, we continue to see encouraging signs within our emerging enterprise security business. Growth in the non-branch base contributed to overall order growth of 13% during the quarter.

In addition to the work we’re doing with Christie’s Auction House that I mentioned earlier, we were awarded other significant projects during the quarter. For instance, we won a key project related to security, the World Trade Center site, namely, Tower 4 and the entire transportation hub beneath the World Trade Center, which is one of the major critical infrastructure security project in a country right now. These projects represent approximately 30 million in future revenue from this single site.

Project wins such as these are not only important from a financial prospective, but help establish our reputation as a leader in this space. In addition to enterprise, we’re growing other key elements of our security offerings in markets outside the financial industry. During the quarter we teamed with McKinney, a mechanical contracting and system integration firm. We’ll provide advanced monitoring services to McKinney’s customer base across the United States.

As a new member or our Advanced Dealer Program, McKinney will leverage Diebold advanced monitoring solution to help its customers reduce cost, enhance security, and increase operational efficiencies. Looking ahead, we’re increasingly confident that enterprise security and other strategic initiatives will help us generate sustainable growth in North America.

Now, moving on to Asia-Pacific, as we have maintained throughout the year, we anticipate the region to be more back-end loaded in the fourth quarter. In addition, we recorded an out of period accounting adjustment in China, related to our remediation effort that Brad will discuss in more detail on his comments. It’s important to note that this adjustment significantly contributed to the negative year-over-year revenue in comparison in the region.

Orders however, grew 5%, and we anticipate a very strong fourth quarter in terms of orders and of revenue. I recently visited the region, and I am encouraged that we’re in a strong position to take advantage of the enormous opportunity presented by the Asia-Pacific market.

In Thailand, demand for Deposit Automation Solutions is growing, particularly the area of cash recycling. We’re in a position to maintain our strong market leadership with our Opteva cash recycling terminal which are secure, reliable, and cost efficient deposit automation capabilities.

While visiting Beijing, I had the opportunity to meet with the leaders of several banks, including China Construction Bank, China Postal Savings Bank, and Beijing Rural Commercial Banks. Those conversations underscored the importance of our continued investment to accelerate our development of hardware, software, and services that address the unique requirements of the Chinese market.

Our organization in China has established strong partnerships with these major players. Due to China’s importance in this global business and a tremendous opportunity in the region, my vision is to create the same world-class competency in the China as with both North America and Brazil.

In EMEA,we experienced considerable growth in orders and revenue in the third quarter. However, this is compared to a very weak prior year. While I’m not content with our competitive position in the region, we continue to have success in certain areas. In addition to the recent successes I mentioned before in Turkey and Italy, we’re also having a strong year in Spain, France, and parts of Africa.

In Russia, as you know, our operations experienced a setback in light of our recent voluntary FCA disclosure. Since Russia is a priority market for us, we decided to change our business model to a Diebold direct approach. As part of the strategy we’re investing in our direct operations to enhance our internal professional and maintenance services resources.

This strategic initiative will strengthen our position in Russia, complement our existing operation, and will also allows business more effectively in the highly competitive markets in the region. However, due to these factors, we don’t expect Russia to be a major contributor again until 2012.

EMEA remains the most difficult region in terms of our ability to compete profitably. While we feel good about the progress we’re seeing in some of the areas of the region, much work remains for us in EMEA to achieve the strong competitive position we have in other markets around the world.

In Latin America and Brazil, business remains strong with orders up 9% and revenue excluding elections and lottery, also up 10% during the quarter. Outside of Brazil, several countries of Latin America are performing well. Mexico, Columbia, Venezuela, and Central America have been major contributors as we continue to maintain the leading market position throughout Latin America.

Regarding the recent elections in Brazil, I’m pleased to report that we manufactured and delivered on time, 195,000 voting terminals for the elections which took place October 3. During elections, more than 113 million people voted on our technology. The technical aspects of the elections was a success, with less than 1/10th of 1% of the precincts having to use manual ballots. The lowest number in the history of Brazil automated elections. This once again, demonstrates the significant depths of our knowledge and technical resource in Brazil. And my thanks and gratitude goes out to all our associates who helped make this project a success.

As you’re aware, the Brazilian government has an option to purchase an additional 55,000 machines under the current contract. Should they decide to exercise that option, the related revenue will be recognized in 2011.

Our outlook for the region in our financial self-service business remains positive as we’re seeing growing opportunities in the areas of deposit automation and ATM securities.

Our leading market positions throughout Latin America, particularly in Brazil, enables us to capitalize on these growth opportunities in the coming years.

In closing, I am pleased with the company’s overall financial performance and am encouraged by the signals of recovery in the market. As I mentioned earlier, our outlook in the year remains the same, and we have tightened our earnings guidance near the high end of our prior range. I’m confident we’ll have a strong finish to the year.

As we look toward 2011, there are some items to consider, in terms of planning and financial assumptions. We expect a significant drop in both revenue and earnings associated with the Brazil election business; in addition, we anticipate higher pension expense, continued legal consulting cost, and resuming our 401(k) match. So we’ll be working against some of these factors as we plan for 2011.

Moving forward, we’ll continue to work toward the vital goal of making Diebold the best in Class Company and generating maximum value for all our stakeholders. Our innovative approach, financial self-service security, and integrated services will provide breakthrough solution that way new business can generate ever greater customer loyalty. At the same time, we’ll maintain our focus on implementing an effective financial controls within our global processes.

Exceeding customer expectations, we’ll be critical in achieving our goals moving forward. And I’m certain that with the effort, the people of Diebold put into their roles on a daily basis, we’ll surpass our objectives.

With that, I’ll turn the call over to Brad.

Brad Richardson

Thanks, Tom, and good morning, everyone. There are a number of key topics I’ll discuss this morning. First, I’ll cover our revenue picture for the quarter and full year, then review our strong gross margin performance. I’ll address our free cash flow and balance sheet, and then detail our guidance assumption for the remainder of 2010. Finally, I’ll discuss our financial control environment including the out of period accounting adjustment we recorded in China related to our financial remediation efforts.

First, I’d like to refer to Slide 12 which shows order activity for the past three quarters. As Tom emphasized in his comments, we had very strong order growth during the third quarter. This slide shows the overall momentum building in our market as our customers are gaining confidence and are more willing to invest capital resources and self-service technology.

Earnings declined 13, total revenue was $749 million, up 16% from the third quarter of 2009, or 15% on a constant concurrency basis. For the quarter, product revenue increased 33% as we completed the large rollout of voting machines for Brazil ahead of the nation’s national election.

Excluding the impact from Brazil voting, product revenue grew 4% with growth in every geographic region except Asia-Pacific, which was negatively impacted by a $19 million out-of-period accounting adjustment, which I will address shortly, as well as timing of business.

As we have stated previously, we anticipate strong revenue in Asia-Pacific in the fourth quarter. Service revenue grew 3% during the third quarter driven by growth in North America and Asia-Pacific.

Looking at our financial self-service business on Slide 14, third quarter revenue was $511 million up 5% from the third quarter 2009. The decline in Asia-Pacific was more than offset by growth in each of the other geographic regions, particularly in North America and EMEA, where demand for deposit automation continues to increase.

In the security business, on Slide 15, third quarter revenue declined $5 million or 3% from the same period in the previous year. This decrease was due primarily to continue weakness in new bank branch construction, while the enterprise security business continued to expand.

The security business had a strong fourth quarter in 2009, and we expect that trend to continue this year. And further, we anticipate our overall security business will return to modest growth in 2011.

Looking at Slide 16, the total gross margin for the third quarter increased 2.1 percentage point from the third quarter 2009. The increase was primarily driven by improved product gross margin as well as continued improvement and profitability in our service operation.

The product gross margin for the quarter was up 3.2 percentage points due mainly to more favorable customer mix in North America, and overall geographic mix. In service, the gross margin grew 1.7 percentage points during the third quarter primarily due to continued improvement in product reliability and ongoing productivity.

For the full year we still expect a service gross margin to be around 26%.

Moving now to non-GAAP operating expense, as highlighted on Slide 17, in Q3 2010, operating expenses as a percentage of revenue decreased 2 percentage points from the comparable period in 2009.

Operating expense in the third quarter increased 17.9 million from the prior period. Although we expected increased selling expense on the higher revenue and investment in R&B we have been challenged by higher legal and compliance expense associated with our financial mediation efforts and FCPA review.

For the full year we expect operating expense as a percent of revenue to be in the low 18% range. Now, turning to Slide 18, the non-GAAP operating margin in the third quarter increased meaningfully to 7.5 percentage points from 5.1% in the third quarter 2009.

In addition to our ongoing efforts to reduce cost, increase productivity, and pursue profitable revenue growth, the margin also benefited from the Brazil election business which carries very little incremental operating expense.

Turning to the EPS reconciliation table on Slide 19, GAAP EPS from continuing operations in the third quarter was $0.66 per share, compared with $0.37 per share in the third quarter of 2009.

Excluding restructuring, impairment charges and non-routine income, our third quarter non-GAAP EPS was $0.70 per share compared with $0.39 per share in the third quarter of 2009. I would note our non-GAAP tax rate in the third quarter was 25.2% in the third quarter of 2009 our non-GAAP tax rate was 14.1%.

For 2010 we still expect a full year non-GAAP tax rate to be approximately 28%.

Looking at free cash flow on Slide 20, as a reminder, we defined free cash flow as net cash from operating activities, less capital expenditures. Free cash flow in the third quarter of 2010 was $56 million compared with free cash flow of $35 million in the third quarter of 2009. Given the normal back-end loaded nature of our cash flow, we’re still targeting free cash flow for the full year of roughly $150 million.

Looking at slide 21 and 22 on working capital metrics, we continue to focus on managing our working capital. Day sales outstanding increased by 1 day to 47 versus the prior year, attributable to growth of revenue and phasing a customer sales activity within the quarter.

Inventory turns declined by .1 turns during the quarter, and the decrease in the turns is due to an increase in inventory in support of a ramp-up in fourth quarter production. This was partially offset by the reduction in Brazil election system inventory.

By year-end, we do expect turns to exceed the levels we reached last year as we draw down inventory in support of the strong revenue expected in the fourth quarter.

Turning next to liquity and net debt on slide 23, the net debt on September 30, 2010 was 174.4 million, a decrease of 36.2 million from September 30, 2009. Our net debt capital ratio was 14% at September 30, 2010 compared to 17% at September 30, 2009.

The quarter end net debt levels represent an increase of 109.1 million from December 31, 2009. In regards to repurchasing our shares, we continue to take a measured approach in implementing our repurchase program. You’ll see that during the quarter we repurchased 126,000 of the company’s shares for a year-to-date total over 773,000 shares repurchased. There are 2.2 million shares remaining on our existing board authorization.

Now I’d like to address our financial control environment and remediation effort as shown on slide 24. As I covered in my remarks during the last quarter, we have been working for some time to remediate material weaknesses that resulted from the extensive internal accounting review which began in 2007. We still have two remaining material weaknesses, the first is related to income tax controlled deficiencies that resulted in errors requiring out of period adjustments in our 2009 tax provision. Our tax team has taken significant steps to improve our processes and we still anticipate this area will be fully remediated by the end of this year.

The other material weakness we’re working to remediated is in the area of accounting policy. As I pointed out, during the last call, to fully remediate this issue, we had to strengthen our control procedures related to the application of the revenue recognition policy, related to multiple element arrangements which involved contracts with bundled products and service components. This is a technically complex area which involves the complete review of contract to ascertain the proper time to recognize revenue associated with specific deliverable and there related cost.

The ongoing work in this area has resulted in the out of period accounting adjustment in China highlighted in todays earnings release. At this point, we don’t anticipate any further material adjustments to our financial statement as a result of our work in this area.

During the fourth quarter we will be focused on testing our control environment in our effort to fully remediate this material weakness by the end of this year. We will continue to communicate our progress to you and disclose any key updates in a timely manner.

Also, let me update you on where we stand with the FCP review. Last quarter we made a voluntary disclosure related to our subsidiary in Russia in which the company identified certain transactions and payments by the subsidiary that potentially implicates the books and records provision of the FCPA. While our assessment remains, the transaction and payments in question do not materially impact or alter our financial statement, we continue to conduct an internal review of our global FCPA compliance. We voluntarily self-reported our initial findings to the FCC and to the department of Justice. As a result, the company received a subpoena for documents from the FCC and a voluntary request for documents from the Department of Justice in connection with the FCCs investigation of the matter. This is a standard step in the FCPA related process that allows the FCC and the DOJ to gather information to conduct their review, and we fully expected and planned for this. We are cooperating with FCC and the DOJ, and due to the nature of these types of reviews, we cannot predict the length, [inaudible] or impact of any it will have on our results of operations.

Again, we view our approach in this process as a continuation of our commitment to transparency and full disclosure. As we address the challenges presented to us in the coming year, we will continue to embrace the highest principal of values in ethics in our relentless work in sustaining a sound financial control environment.

Turning to our full year outlook on slide 25, as Tom mentioned in his remarks, we are reaffirming our outlook and have tightened our earnings guidance near the top of our range, which includes the $0.05 negative impact of the out of period accounting adjustment. Implicit in this range is a gross margin decline of a couple of percentage points in the fourth quarter, primarily due to a higher mix of lower margin product revenue coming out of EMEA, and Asia/Pacific. As you can see, we have adjusted our revenue guidance to 4 to 5% growth from the prior 5 to 8% growth expectation, with the entire revision occurring in the financial result service line. This is largely the result of lower year-over-year growth in EMEA than what previously expected, as well as the out of period accounting adjustment in China.

So in summary, I am pleased with the progress we’ve made and rebuilding our profitability in our return on capital employed. We are encouraged by the momentum in orders as our key markets are emerging from the global recession. Liquidity remains strong, giving us the flexibility to reinvest in support of select growth opportunities, and we are effectively working through various processes to address our current material weaknesses, and FCPA compliance.

We acknowledge this is a challenging process, however, we remain committed to elevating our financial control environment to best in class levels, and I remain personally committed to maintaining the highest levels of transparency and balance communication regarding our progress to all of our stakeholders.

I’ll now turn it back over to John.

John Kristoff

Thanks Brad. Sarah, we’d like to open it up for questions at this time.

Question-and-Answer Session


(Operator Instructions) Our first question will come from Kartik Mehta of Northcoast Research.

Kartik Mehta – Northcoast Research

Good morning, Tom. I wanted to ask you about the order growth you’re seeing in North America. I think in your prepared remarks you said you’re seeing more growth even from banks other than the top three and I’m wonder if you could provide more color? Are you starting to see strength from the regional and community banks as well, or just middle tier banks are who you’re really seeing the strength from?

Tom Swidarski

Kartik, I would say it’s a across the board. I think when you guys were in for the analyst day, we talked about how many different institutions, I think we were up to about 400 institutions that had already been engaged in deposit automation. We had about 30 or so that 25 plus the automation terminals and I think what is crystal clear now is that moment continues. We are seeing it at every level of engagement and fortunately with our location we’ve got a number of institutions we talk to on a daily basis coming through as well as with my – I was just down in Florida, which last year, for instance, was really particularly hit hard and I’m real pleased with the level of activity we’re seeing there this year, which I think is a good sign that a state like Florida, which was so hard hit in the economic crisis, we’re starting to see activity in those banks. And deposit automation, PCI compliance, and AVA types of issues along with the whole outsourcing integrated services piece seem to be the three or four biggest drivers of activity.

So in short, it’s across the board, not just the big banks.

Kartik Mehta – Northcoast Research

And on this security business piece it looks like orders have really improved. Could you provide a little more color on that? I’m assuming this is all outside of the financial institutions, but I wanted to make sure I understood where the business is really coming from.

Tom Swidarski

Yeah. I would say inside the financial institution first, you know, we’re still on the security front, it’s still a struggle. The bank branch build is not there and we don’t see that necessarily coming back to any levels. And as I’ve indicated in the past, there used to be about 4,000 or so branches built on an annual basis. This year that number might be 1,000 or 1,200. So you can see the dramatic impact that has on the physical and security that’s tied to the bank branch build.

Outside of that, we’ve seen growth really in all those sectors. The ones I was referring to were kind of high profile enterprise security types of situations and one of the ones that was the highest profile for enterprise companies really across the U.S. and there were companies outside the U.S. Bidding on this, all having to do with the World Trade Center. So as you know, there’s multiple towers going up there. We’ve secured the award for Tower 4. We’ve also been awarded for the transportation hub, which is through the Port Authority of New Jersey and New York, beneath that, which is the biggest transportation hub in the United States, you know, very complex, sophisticated, high-end systems and that alone, along with we do the perimeter, we have a security system on the perimeter of the World Trade Center right now. That one site alone is going to yield in the tune of 30-plus million in revenue in the next coming year.

So we’re seeing that kind of level of effort and we’re putting the resource behind the critical infrastructure and shifting it away from what our traditional business was. And the other thing I referenced was we have a very capable, as you have seen, infrastructure relative to the ability to monitor and respond. So we’re taking that infrastructure and white labeling it through other folks. And I use the example of McKinney’s today, whos is a contractor and an integrated services provider. They have customers out there that we would not normally touch. This gives them the opportunity to resell our services and for us to participate in that area and grow this in the future.

So it’s a very concerted effort outside the financial industry to grow on the security side with the capabilities we’ve developed from the financial services sector and we’re meeting with some pretty good success this year.

Kartik Mehta – Northcoast Research

And then, Brad, you gave some color on 2011, and I’m wondering, is the right way to think about 2011 is if you took the higher end of the guidance, just for sake of discussion at 2010, thinking about $0.30 for the Brazilian election business, really a core EPS number of 2010 would be somewhere around $1.80. You go off of that, obviously, then you’d have to take out some of the other expenses you talked about, like the higher pension expense, the 401(k) match. Would that be the right way to think about 2011?

Brad Richardson

That’s hard. I think that’s absolutely the right way to kind of frame up the launching point as we move into 2011.

Kartik Mehta – Northcoast Research

And then finally, Brad, the other income that increased in the quarter, I think you reported 8.2 million compared to like a negative 1.4 last year. Is there anything that would explain that increase?

Brad Richardson

Yeah, we do have in our kind of a breakout of that other incomes. That’s one of the increased disclosures that we put in. But I think a majority of that increase is coming from foreign currency gains and this is really a reflection of what’s happened to the strength of foreign currency relative to the U.S. dollar.

Kartik Mehta – Northcoast Research

Thank you very much. I appreciate it.

Brad Richardson



Our next question comes from Reik Read with Robert W. Baird.

Reik Read – Robert W. Baird

Hi. Good morning. Could you guys maybe talk about two catalysts it seems like there are in the North America market? The canceled FDIC fees and Tom, you brought it up in your remarks, the ADA now has a date out – to what extent are those actually having an impact that you can see in terms of improving order trends?

Tom Swidarski

Well, I think like I would bundle those under the category that ADA in and of itself probably is not a huge catalyst but when you combine that with PCI and you combine that with, do I need to make an upgrade or do I need to think about software, all the sudden it becomes a tipping point and that’s really how we positioned it.

With a lot of ADA issues you know, it’s a matter of banks mitigating risk because there may be not a penalty sitting there. But the fact that there’s a date there allows us an opportunity to have a meaningful discussion with banks and credit units on that front. And I view it as another one of the areas where it’s additional complexity banks have to deal with, plus it’s an outsourcing solution of taking that off the table for them and then focusing on what they do very nicely.

And especially run quite a few symposiums on compliance and regulatory change. And again, have very good dialogs relative to institutions. You know, I think the much bigger driver is associated really with kind of that information and improving their underlying operational efficiencies. And then as part of that, if we can get them compliant, it’s kind of the icing on the cake. I view it in that light.

Reik Read – Robert W. Baird

And the FDIC fees, is that helping with deposit automation that you can see, or no impact yet?

Tom Swidarski

I would say no impact yet. I think the overriding issue of, you know, I mentioned it, some of the banks that we talk to, you know, Bank of America has been running ads in a big way relative to deposit automation and you know, if you go to any of the industry events, you’ve heard from various institutions of all sizes that the implementation of these has gone even better than expected in terms of number of checks that they get by far, and then also cash as well. So the fact that they’re able to provide that kind of automation service to their customers as a reliability point mean that people looking at that in a serious way and it’s more than the train has left the station, it’s there are a lot of people out there gaining competitive advantage in the marketplace.

So I think that is the overwhelming issue that they’re dealing with.

Reik Read – Robert W. Baird

Okay. And then Brad, just a question on the gross margins. In your comments, I think you said that fourth quarter we see a decline really due to product mix. But if I do the math, it seems like what you’re guiding to in service gross margins, they would also have to come down by a good chunk sequentially and I just wanted to understand what may be causing that.

Brad Richardson

Yeah, I mean I think, you know, what’s implicit in the guidance is really the assumption that the, you know, service margins do stay relatively stable, you know, sequentially from third quarter to fourth quarter. But the product margins are going to come down meaningfully to pull the overall gross margin down a couple percentage points. And it’s really, really driven – driven by the fact that, you know, we’re seeing increased revenue coming out of the EMEA and Asia-Pacific which have lower overall product margins.

Reik Read – Robert W. Baird

But is there a reason that the service gross margin should come down?

Brad Richardson

I mean, we certainly see, for example, going from third quarter to fourth quarter, and then we have our annual merit increase so that puts a bit of pressure, but again, I think the overall driver of the gross margin is really on the product side.

Reik Read – Robert W. Baird

Okay. And then just – also on the operating expenses, you’d kind of alluded to it and I guess Kartik asked in his questions, just the extra expenses. It seems like a pension-401(k) will occur throughout 2011. What about the legal fees? How much are you talking about there, and when might those start to dissipate if you can forecast it at this point?

Brad Richardson

Well, you know, what I can – what I can say here is, you know, the legal compliance remediation type fees, you know, that we had in kind of the third quarter was in that kind of $3 million type range. So it’s meaningful, but you know, as we sit here and look at 2011, we’re not in the position really to kind of forecast out how long those will continue to run and it really, it’s a function of the extent of the overall FCPA review that’s ongoing. Which again, you know, we just can’t put a timeframe on that at this point.

Reik Read – Robert W. Baird

Great. Thank you, guys, for the comments.


Our next question comes from Matt Summerville with KeyBanc.

Matt Summerville – KeyBank Capital Markets

Good morning, Brad. To get back to the last point, could you, is there a way you can provide any additional color 2010 versus 2009, or 2009, how much more you’re spending on both remediation and FCPA combined? Is it 10 million more? Is it 15, is it 20? Can you give some sort of ballpark figure so we can actually put some numbers behind that?

Brad Richardson

Matt, I mean, your question was, again, if you just look at Q3 2010 versus Q3 2009, again, we had incremental expenditures in the area of, again, the FCPA compliance and the financial remediation of about $3 million.

Matt Summerville – KeyBank Capital Markets

Okay. So is it fair, Brad, to annualize that and call it 12 for the year ’10 versus the year ’09, or is it going to be something less than that? And I guess, you know, is it really too hard to see if that increases or decrease in 2011? I guess because I’d be more inclined to think it comes down if you get kind of – if you’re able to put to bed those last two issues from a remediation standpoint.

Brad Richardson

Matt, I don’t think you can annualize it because simply it did kind of spool up, if you will, at the end of the second quarter, you know, when we voluntarily self disclosed. So really, you can’t just kind of analyze and say that’s the total amount. So again, it really is dependent on how long this does run in 2011. I think you are right from the standpoint of a lot of the monies that we have been spending, you know, on the financial remediation, you know, at this point, you know, our projects and our work plan, we expect that – the two material weaknesses to be remediated by the end of this year. So the expenditures that we’ve had on that should – should taper off in 2011. And again, it’s – we can’t estimate at this point, you know, how long the FCPA expenditures will continue in 2011.

Matt Summerville – KeyBank Capital Markets

Got you. And then Tom, can you maybe spend a minute talking about within the EMEA region, you mentioned in Russia you’re moving more towards a direct operation there versus your prior strategy, but it also seemed like you guys have backed off more broadly of your – with regards to your revenue guidance in that region for the year. You mentioned you’re not content with performance. I assume that includes areas outside of Russia.

More broadly, what are you doing going forward in EMEA from a strategic standpoint to improve your performance there?

Tom Swidarski

Matt, I would say that Russia is a, you know, certainly a critical market, but it’s not the only one that impacts our guidance from a revenue standpoint. You are correct that between the China adjustment and really the EMEA, revenue is really what’s impacted, you know, changing the revenue guidance.

The thing that kind of is apparent there is we, you know, worked hard in the EMEA region is as we dealt with, you know, we have – Russia wasn’t the only place we have distributors. We have distributors throughout really Eastern Europe and other parts of Europe as well. But if I can concentrate on Easter Europe, really as we went through and began the FCPA investigation, we also are taking a look at how we deal with distributors in each of that region. That is really impacted their performance and in some cases we’ve severed relationships with distributors. So we’re in the process now much like we did in Turkey, of setting up an operation but in Turkey’s case, we’d been planning for it in an organized manner. We were ready to go. At the beginning of the year we had done our work to get there. And these cases, we’ve cut off really revenue sources immediately as we begin to build out a direct operation including our service operation.

So in Russia’s case, because of the size and the importance of it, it’s going to take a while and we do have revenue there, but we need, you know, we have outsourced a lot of the – even the service revenue we go through a distributor.

So now we’re building that service operation. We’re building that operational expertise, we’re putting the right type of sales organizations in place. So Russia is going to take some time for us to get there, and along with various parts of Eastern Europe. That’s been the area of really the biggest impact and the change over the last, you know, really 120 days as a result of this.

So you know, we’re working hard to put a priority focus on select countries there and do the same thing we’ve done in Turkey, which is get ourselves direct into the regions that we need to be and controlling really our – not only the way we go to market, but all the issues that, you know, arise from an FCPA kind of investigation; having more control of those operations and especially the critical countries.

Matt Summerville – KeyBank Capital Markets

Okay, Tom. Just one more final one if I can. You mentioned you were over in Asia pretty recently and you provided a little bit of color there. As we move into 2011, you know, this year you’ve talked about Asia being more back-end loaded, particular China in the fourth quarter, I get that. How are you thinking about 2011? Is that going to be back-end loaded as well based on these sort of preliminary discussions maybe you’re having with some of your big customers there?

Tom Swidarski

Yeah. Based on the – and because of the recent visit, I can say pretty confidently – I spoke to – I mention a couple on the call, but I spoke to many others while we were there and doing our operational review. 2011 will be a lot like 2010, which is much more back-end loaded. This year happens to be fourth quarter heavy, you know, but I would say definitely back-end loaded, could be third and fourth, or some could slip into the fourth and 2011 as well. But that’s the correct way to think about it.

Matt Summerville – KeyBank Capital Markets

Thanks, Tom.


(Operator Instructions) Our next question some from Paul Coster with JP Morgan

Paul Coster – JP Morgan

Yeah, thanks. Just on Asia for a second, so back-end loaded next year. Do you see the gross margins in that region improving? How do they compare to the corporate average?

Tom Swidarski

I would say the gross margins on the product side, and you have to separate product from service because we have various service operations there in different countries who have very strong, or maybe I would say accretive to the whole corporation service margin.

On the product side, I’d say generally speaking, and again, you’ve got to look at each country, but you would say they would be dilutive to the overall corporate averages from a product standpoint. That has a lot to do with how many competitors you find in some of the big countries there, but I would say dilutive overall. It’s – and then the other piece of that is, it’s the technology matters as well. If it’s deposit automation, the margins might be a little higher than just a typical cash dispensing type of thing. But overall they would be dilutive.

Paul Coster – JP Morgan

You mentioned that you have competence in China. What does that actually mean?

Tom Swidarski

Yeah, so what that means is today, you know, we probably have about 1,000 people in China, which includes the service operation. We have two factories there. We have engineering capabilities. When I compare that to where we’re at in Brazil, where we have 3,200 people, we have, you know, 200 software expects sitting in Brazil, you know, we have a – we don’t have anywhere near that kind of competency in China. And as these big banks start to want the level of sophistication that we’ve been able to drive into North America and into China, I need professional services that are much richer and deeper than they are today. I need hardware engineering that’s specific to that region, much like we have in Brazil that allow us to do customization and things for the major players there to help differentiate ourselves.

So we’re going to continue to invest in China in a significant way as we move forward, and not just for China, for those other emerging countries over there as they grow. So for instance, an Indonesia and a Vietnam, you know, we won’t have that same type of enormous infrastructure in each of those countries, they’re going to depend upon China. But we can’t have China dependent upon the United States or Brazil because we can’t move quick enough and we can’t be responsive enough to the market, and they have unique market needs.

So I want to have more capability there, so we – as we’ve put the factory there, we shipped a lot of the supply chain over in that direction, we’ve build engineering capably there. We just have to continue to grow our competencies across the board including integrated services and service competencies there. So while we’re in a – what I would call a good competitive position today, there are too many competitors that are knocking at the door in China not for us to be aggressive in terms of that being such a key global market for us. So that was the implication . It was to say we’re going to continue to invest in there with technical resources like we have at our disposal in the United States and Brazil, which would differentiate it from just any other market.

Paul Coster – JP Morgan

Okay. Just switching to the security business a second, what percentage of that business now originates in enterprise and other emerging applications? And you’re obviously seeking to go to market and partnership with distributors and so what is that going to do to margins for that segment?

Brad Richardson

Okay. In the, you’re breaking it down, I mean, generally speaking, it’s about 3/4s financial and then 25% outside financials. I mean, that’s really what we’ve been tracking at. So the piece outside the financials is really where we’re seeing the order growth and the activity.

We do not use – let me separate the conversation from EMEA, then the conversation from security. In EMEA we use distributors, which really front end us. Here in the United States, relative to security, it’s really Diebold. It’s Diebold out in front of all this.

We talked about white labeling that, is really just our back-end infrastructure that somebody else can sell, you know, the infrastructure so they don’t have to build it themselves. So it’s very different than having a distributor kind of model. So you know, in the United States, these big contracts that we’re running today at the world trade center, that’s Diebold people going out with Diebold installation and Diebold technology and that’s really the approach we’re using in the United States where we have the kind of infrastructure, the brand awareness and the competencies to do that and move us forward.

The piece of, hey somebody needs a call center, or somebody needs a monitoring capability that we’ve already built, I’m willing to sell that at a white label to someone else, but it’s Diebold running, operated and owned.

Paul Coster – JP Morgan

Okay. Thank you.

Brad Richardson

You’re welcome.


Our next question comes from Gil Luria with Wedbush Securities.

Gil Luria – Wedbush Securities

Thank you. Good morning. I first wanted to ask about order trends. If you put up, I think it’s Slide 12, that shows the trend within the year, can you tell us how year-to-date orders compare with the year-to-date last year. And then also I’ll extend that to say how year-to-date orders compare with how they were in some of the better years, ’06, ’07, ’08. Are we starting to get back to the same levels or are we still far lower than those levels?

Tom Swidarski

From the – let me make sure I got the two questions right. The first one was orders year to day?

Gil Luria – Wedbush Securities

Yeah. So let me lump that into one question. How do orders year to date compare with orders in the first three quarters last year and the couple years before that?

Tom Swidarski

Okay. So year-to-date orders are up and as you would compare that say to previous years, I would say the momentum is building, Gil. It’s certainly not back in 2005, 2006 kind of levels of orders, but I think if you saw, what slide is that? Slide 12, you can kind of get a sense of this building and we see that momentum continuing and especially if you look at like some of the key markets like the United States, we’re liking the underlying activity that we’re seeing there, October appears to kind of gotten off to a good start as well. So it feels like the fourth quarter from order standpoint on that is going to be strong. We’re seeing the same thing in Asia. I think across the board we’re feeling very good about orders and seeing the level of activity beginning to increase, you know, which is hopeful. There’s a big difference between activity and getting the orders as we said in the past, and there’s a difference between orders and revenue for us. But you know, the momentum that we talked about in the second quarter is absolutely continuing and October kind of just strengthens that from where we were.

Gil Luria – Wedbush Securities

Got it. And then my second question is about Brazil elections and lottery. The election has been over for more than three weeks now. First, we wanted to see 55 options that they had. Have they communicated anything to you about the likelihood that they’ll exercise that option next, will there be next year? Will they – is there any likelihood that they’ll buy more than that?

And then even for the fourth quarter, you still have a $10 million range, which is usually more than can be accounted for by lottery. So can you help us tighten that range for the fourth quarter?

Tom Swidarski

Yeah. So the – I guess the two aspects of that is one, just so everyone on the call recognizes that while the major election took place, they have all the runoff elections that are taking place right now. So while it may not get the visibility, there’s just as much activity going on now and it gets even a little more complicated for them because you’ve got these run-off activities that take place around each of the spaces as well as international levels. So the level of conversation we’ve had with them at this point is pretty minimal because their focus still is on running these elections. So in terms of why that revenue, or why that gap is still 10 million because you’ve got two issues there. One is, part of the voting, you know, as they do these other ones, you do get sporadic orders that come in. And again, since they are running elections in different regions now, have the ability to order, we will see some variability there. The second thing is with lottery, the same thing happens. You know, we know we have some lottery that we’re fulfilling in the fourth quarter, but also as you get towards the end of the year, you’re never quite sure if they’re going to accelerate that or not. So we still have variability on both of those.

And regarding 2011 or the other 55,000, the way I view that is the better we perform like we did on the first one, the more likely that is, but we really haven’t had any conformation with any direct comments at this point with the team in Brazil and their election officials. And they were very clear to use, we’ve got to run these elections they’ve got to right and we’ll have that conversation.

But I think by the end of the year we’re going to have an indication because the elections will be over. We’ve got the meeting scheduled for the middle of December and I think we’ll, from there, have a pretty solid sense of that 55,000.

Gil Luria – Wedbush Securities

Very good. Thank you.


And that was our final question. A this time I’d like to turn the conference over to Mr. John Kristoff for any closing remarks.

John Kristoff

Thank you, Sarah. And I’d just like to thank everyone for joining us today on the call, and as always, if you have a follow up question, please contact me directly. Thanks again.


This doesn conclude today’s conference. Thank you for your participation.

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