Diebold's CEO Discusses Q3 2011 Results - Earnings Call Transcript

| About: Diebold Inc. (DBD)

Diebold Inc. (NYSE:DBD)

Q3 2011 Earnings Call

October 27, 2011 10:00 AM ET

Executives

John Kristoff – VP and Chief Communications Officer

Thomas Swidarski – President and CEO

Bradley Richardson – EVP and CFO

Analysts

Kartik Mehta – Northcoast Research

Matt Summerville – KeyBanc

Gil Luria – Wedbush Securities

Roman Leal – Goldman Sachs

Zahid Siddique – Gabelli & Company

Paul Coster – JP Morgan

Operator

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

Thanks, Dana. Good morning, everyone, 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 Web site. 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 results as with past calls it’s important to note that we have restructuring, non-routine expenses, non-routine income and impairment charges in our results. 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 to 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 Web site. 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 please refer to the more detailed risk factors that have previously been filed with the SEC.

Now with the opening remarks I’ll turn it over to Tom.

Thomas Swidarski

Thanks, John. Good morning, everyone. Thanks for joining our call today. Once again we delivered sound performance during the past quarter showing significant improvement in our profit margins, particularly in our Services business and are delivering on our commitments to generate the majority of our earnings in the back half of the year. We continue to effectively reduce our cost structure and drive improvements in our operations while focusing on more profitable business opportunities globally.

In addition North America continued to perform exceptionally well with high demand for our financial self-service solutions. Given our market improvement of profitability and the continued strength in our North American business we have increased confidence in our earnings outlook for the remainder of the year. As such we are raising our full year EPS guidance to $2.15 to $2.25 per share.

Total revenue for the third quarter decreased as we continue to be selective in the markets in deals we pursue, particularly in EMEA. The security business for bank branches in the United States remains challenged. However we have clearly improved our profitability through our continued focus on developing strategic relationships with customers and differentiating ourselves through high valued services. In turn we expect a strong fourth quarter with year-over-year increases in orders, revenue, margin and EPS. Our solid third quarter results combined with an expected strong fourth quarter provide us with momentum as we look to 2012.

During the quarter we had several key announcements regarding new innovations that help build the foundation to deliver even more value to our customers over the next several years. In August we unveiled a prototype of the world’s first virtualized ATM at VMworld. This is a very influential event hosted by VMware, the industry leader in Cloud computing and virtualization technologies and is attended by thousands of global IT professionals and decision makers worldwide.

Developed in collaboration, the virtual ATM prototype removed onboard computer from the terminal, assigning each machine in a fleet to centralize computing resource. The result is now at a consolidation ensuring resources through our self-service network, but also across delivery channels. This opens the door to more effective channel orchestration. In short, virtualization will lead a lower total cost of ownership and increase ATM uptime. The virtualization concept has not only generated a significant amount of media coverage, but more importantly it has spawned a number of thought leadership discussions with strategic customers around the world.

Virtualization represents an important milestone on Diebold’s roadmap, deleveraging cloud computing technology in the financial space, and will fundamentally change the way solutions are deployed in the marketplace. This technology is game-changer for our industry.

Also in August we announced the Opteva Flex Performance Series. The most robust of service terminal we’ve ever offered, it combines traditional deposit automation capabilities including bulk cash and check-accepted with full currency recycling, the first in our industry. It can be configured with a separate cash dispenser and recycling module all in one ATM. This makes it well-suited for deposit automation intense market such as Latin America, Asia and EMEA, and as the North American market for deposit automation continues to evolve, the Flex series puts us in a very strong competitive position. We dramatically improved reliability and flexibility of these terminals, enabled financial institutions to transform the way they mage cash at the ATM, including efficiencies, decreasing cost and minimizing the administrative burden.

All the customer feedback on Flex has been extremely positive particularly in our key growth markets. In September I attended a customer event in Turkey in which the Flex series grew intense customer interest. We also conducted customer events in Mexico and elsewhere in the world where Flex created a great deal of conversations. So we are very encouraged by the level of response we are seeing in the marketplace.

In services we continue to innovate by growing our integrated services offerings. We introduced the concept of integrated services, more than five years ago. Since then it has grown exponentially and is changing the way financial institutions think about the retail banking operations. In the U.S. for example, the banking landscape assisted dramatically over the past two years. This has created a level of operational complexity that is driving more financial institutions to consider an outsourcing approach.

Integrated Services enables them to meet regulatory requirements and offer the customers our latest technology. This environment has resulted in another record quarter for Integrated Services business. In the United States the company signed new IS contracts during the quarter valued at nearly $19 million, an increase of more than 200% over the prior-year period.

On the security front we believe there is equal, if not greater potential for an integrated services approach. The necessary technology to tie together physical and logical security systems has grown very complex and is creating a compelling case for an outsourcing model similar to what we built in our ATM business. We’re adapting to this need by building an industry leading IF offering which we plan to launch in early 2012. We have very strong capabilities internally that we are leveraging to build a comprehensive portfolio of services.

In fact we earned the 2011 Online Trust Alliance Leadership Award for Excellence in Security Practices. This award acknowledges us for rigorous testing and validation of critical security technologies, solutions and services and data and information security. This type of third party recognition provides early validation of our strong IS capabilities in the security area. These and other recent innovations demonstrate that Diebold continues the lead in our industry and build a robust technology pipeline to support a broad portfolio of services as we move forward.

Now let’s take a closer look at our performance on a regional basis. In North America total revenue during the quarter increased 4% while overall product and service orders grew about 11% in the region. We’re looking at just product orders for financial self-service in the region. We saw an increase around 85%. In fact U.S. Regional bank product orders and financial self-service once again increased well in excess of 100% and the expected revenue is beginning to materialize as we approach the end of the year. Customer demand continues to be driven by regulatory acquirements and deposit automation.

In fact during the quarter our shipment for deposit automation in North America increased nearly 50%. Deposit automation shipments in the regional bank segment increased more than 200% during the quarter and are up 150% year-to-date. This demonstrates that the market recognized Diebold as the fastest, most reliable deposit automation technology in the industry. Our superior technology, coupled with our best in class service organization and strong customer relationships enable us to maintain and grow our market leading position in the United States.

In summary we remain very optimistic regarding the state of the North American financial self-service market and are strong competitive position. As our large backlog in North America converts to revenue in the fourth quarter, we expect another strong quarter in terms of operating profit. The region remains our most important and profitable market. As such North America will serve as a primary catalyst for earnings growth for the remainder of the year and into 2012.

Looking at our Security business revenue decreased 6% during the quarter. Our orders fell 9%. These results are reflective of the continued distress nature of the physical security market for bank branches in the United States. We expect this segment will remain weak well into 2012. You will recall in my comments during our second quarter call that we made some significant changes in our U.S. financial sales organization to grow the Security business. We’ve moved some of our top enterprise security systems experts over to the financial group, especially to focus solely on security sales to financial institutions. And we are already seeing some more results of our refocused efforts as our security sales pipeline in the financial space doubled during the past quarter.

This progress is encouraging and we believe we now have the right strategy and infrastructure in place to more successfully pursue opportunities in this space. It’s important to note, however, that the sales cycle on the security side is dramatically longer than on the ATM side of the business. As such, we don’t anticipate return of the Euro and Europe’s growth in orders or revenue in the security space until the second-half of 2012.

Now moving to EMEA, revenue dropped 11% as the company continues to concentrate its sales efforts and fewer markets with higher profit opportunities. Orders for products and services were down 31% in the period, and a difficult comparison to third quarter 2010 in which orders grew 53%. During the quarter we continued to make operational progress in EMEA, once again, significantly reducing our losses in the region to about $2 million. We are now projecting profitability there in the fourth quarter.

On a macro level, we’ve begun to see weakening demand in certain less European markets, such as Spain and Italy while demand remains relatively strong in some of the emerging markets, such as South Africa and Turkey. Given the ongoing improvements of our operations and our growing confidence, we can now achieve modes profitability in the region for the full year 2012 despite some of the weakening macro economic trends.

In Latin America including Brazil, revenue declined during the quarter by about 30% while orders fell 12%. Excluding election systems and lottery sales, orders were essentially flat. As I previously mentioned, we have lowered our revenue expectations in Brazil for the remainder of the year. This reflects the recent strengthening of the dollar against the business – the Brazilian reality, and the timing of a couple, potentially, large orders that slipped into the fourth quarter and will not revenue until 2012. We continue to feel very, very confident with our market-leading position in Brazil.

Moving forward we have an opportunity to grow our share even further as one of the large banks in the country opens up its purchases to a broad base of suppliers for the very first time, moving to the rest of Latin America, the market remains very dynamic. During the quarter we sizeable business in Venezuela, Peru and Chili, also services growth in the region has been particularly strong.

Now moving on to Asia Pacific, revenue increased 48%. However excluding an accounting adjustment in the prior-year period revenue increased 17%. Orders for products and services declined 9% as a large order in China slipped into the fourth quarter. However, we received this order in October which positions us for a strong fourth quarter order entry.

Third quarter revenue growth in the region was driven primarily by our Integrated Services business, particularly in India where we now monitor 40% of the ATMs in the country. I’m very encouraged with this growth as it reflects our strategy to grow services aggressively in Asia and protect our profitability. This enabled us to differentiate ourselves from the local hardware manufacturers that are driving down product pricing throughout the region.

In regard to the massive flooding in Thailand over the past week, I wish to send my thoughts and sympathies to our associates who have been impacted by this disaster. We have a very dedicated team of 500 people in Thailand and my heart goes out to them and their families. From a business perspective we have mitigated any immediate impact on our supply chain, though the situation is still evolving.

Given our performance in key markets and the increased profitability in our business, we feel very confident with our earnings guidance for 2011. As we look toward 2012 there are some items to consider in terms of planning and financial assumptions. Overall we expect modest, top line growth driven primarily by the Americas. However we anticipate a drop in both revenue and/or remains associated with the Brazilian Election business. In addition we anticipate higher pension expense. On the plus side, we expect modest profitability EMEA for the full year and demand and profitability remain strong in North America. As I said earlier, we expect to see growth in the Security business in the second half of 2012. Finally we anticipate similar overall seasonality in revenue and earnings to what we had in 2011.

To summarize, I continue to feel extremely confident in the direction we’re headed. We’re delivering on the expectations we established throughout the year to generate the majority of our profit in the third and fourth quarters. Our efforts to improve all aspects of our operations and continually deliver value added services are showing up positively from a profitability perspective. Customer intimacy is fundamental to Diebold’s growth everywhere we compete around the globe. We have proven time and time again that our core intellectual capital enables us to lead the industry in terms of innovation. With our Flex series we continue to lead in the area of deposit automation. We were the first to introduce the concept of integrated services, and now we’re the forefront of virtualization in Cloud computing in the financial self-service space.

Diebold associates in the frontline are leveraging their thorough understanding of the market and our current perspective customers to help drive business and build value for our shareholders. Their expertise and commitment gives me great confidence that we’re on the right track to a successful future.

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

Bradley Richardson

Thanks, Tom, and good morning, everyone. Before we review the financial results I will comment briefly on our profitability during the quarter, our progress regarding our restructuring efforts in EMEA and our share repurchase program. To reinforce Tom’s comments, we have significant improvement in margin performance this quarter. This is proof that our business strategies are beginning to take hold, especially in our Services business where we have seen consistent improvement over the past several years. We achieved this improvement despite lower revenue during the quarter from Brazil elections, EMEA and our Security business. Overall we expect to continue our improved profitability momentum into the fourth quarter which positions us well as we look to 2012.

We continue to execute on our restructuring efforts in EMEA. During the quarter we once again significant reduced our losses in the region which amounted to about $2 million. As I mentioned in our last call, we’ve identified $8 million in cost reductions for 2011 and we are on track to hit that target. Given our progress on restructuring and our core country focus, we fully expect to turn a profit in EMEA in the fourth quarter. I’m encouraged by the results we’ve generated to date and absent any further setbacks in the banking industry, I’m more confident we are in a position to achieve modest profitability in EMEA for the full year 2012. This expands our opportunity for consolidated year-over-year earnings growth.

Also during the quarter we were active in our share repurchase program. Given the weakness in our share price earlier in the quarter and our growing confidence in the company’s future outlook, we felt it was prudent to step up our share repurchase efforts. We’ve consistently maintained that we would be opportunistic in our approach, and during the quarter we repurchased 1.7 million shares at an average cost of $27.55 per share, leaving just 700,000 shares on the current board authorization. We intend to continue to be opportunistic in our share repurchase program for the remainder of the year.

Now to review our financial results for the quarter let’s turn to Slide 17. Total revenue declined 5.2% with 3% positive impact from currency. Product revenue declined 13.8% while service revenue increased 3.2%. As I already mentioned, the decrease in product revenue is primarily the result of a $43 million decline in elections and lottery revenue in Brazil from the third quarter of 2010. The order picture outside of North America in the third quarter appears weak due to timing in various areas, particularly China and Brazil.

However we expect fourth quarter worldwide orders in our Financial Self-service and Security businesses to be up significantly with year-over-year growth in virtually every region of the world. This sets us up nicely as we build momentum for 2012. Looking at our financial Self-Service business on Slide 18, third quarter revenue increased 2.6%, growth was primarily the result of strength in North America driven by regional banks’ adoption of deposit automation solutions and addressing regulatory requirements.

In the Security business, on Slide 19, third quarter revenue declined 6.3%. The market for bank branch security equipment continues to negatively impact our overall revenue. Within the financial industry where we have significant brand equity, we continue to focus on growing our Enterprise Security business as well laying the groundwork for Integrated Services. As Tom indicated in his comments, we’ve seen a significant increase in our sales opportunity pipeline and we anticipate returning this business to top line growth in the second half of 2012.

Looking at Slide 20, the total gross margins at the third quarter was up 1.4 percentage points. Product margin increased due to a more favorable customer and geographic mix particularly in the Americas and EMEA. The service margin grew mainly from continued productivity improvements and cost savings initiatives during the quarter.

Moving now to non-GAAP operating expense, as highlighted on Slide 21, third quarter operating expense as a percentage of revenue was 19.1%, up 100 basis points from the prior period on lower revenue. On a dollar basis however, operating expenses decreased from the prior-year period. We expect that trend to continue in the fourth quarter despite an increase in R&D investments as we continue to focus on tight cost control. For the full year we expect operating expense to be around 19% of revenue.

Now, turning to Slide 22, the non-GAAP operating margin in the third quarter was 8.2% representing our highest quarterly operating margin in nearly three years. As Tom noted, these results clearly show our commitment to reducing our cost structure, while focusing on more profitable business opportunities globally. We expect fourth quarter operating margins to exceed 8% which will result in a full year operating margin of around 7%.

Turning to the EPS reconciliation table on Slide 23, non-GAAP EPS moved from $0.73 per share in the third quarter of 2010 to $0.69 per share in the current quarter. Our non-GAAP tax rate moved from 25.2% in the prior period to 21.2% in the current quarter. This is due to a favorable outcome from an IRS audit which resulted in a discrete item that lowered our tax expense. As a result, we now expect our full year tax rate to be approximately 26%.

Turning to Slide 24, free cash flow for the quarter was $30 million compared with free cash flow of $57.5 million in the third quarter of 2010. The decrease in free cash flow is primarily the result of a significant increase in inventory in support of our forecasted fourth quarter revenue. As we look at the full year we anticipate normal seasonality with strong free cash flow in the fourth quarter. For the full year I still anticipate we will generate around $150 million in free cash flow supported by stronger earnings, inventory draw downs and a normal pattern of accelerated collection towards the end of the year.

Looking at Slide 25 and 26 the day sales outstanding increased from the prior year period by one day. Inventory turns decreased from the third quarter of 2010 again as we accommodate the substantial revenue we expect to deliver in the fourth quarter. Working capital remains a top priority and we anticipate seeing normal, seasonal improvements in the fourth quarter.

Turning next to liquidity and net debt on Slide 27, net debt was $232.2 million, an increase of $57.8 million from September 30, 2010. The increase in net debt during the third quarter was primarily the result of our share repurchases. Our net debt to capital ratio was 22% at September 30, 2011, compared with 14% in the prior period. We expect to generate the majority of our cash flow during the fourth quarter and anticipate the net debt at year end of approximately $50 million. This is an impressive leverage position considering that it concludes during the calendar year around $75 million in dividend payments and over $100 million in share repurchases.

In terms of the outlook for 2011 on Slide 28, we are revising our revenue outlook to reflect lower financial self-service revenue expectations in Europe and Brazil. This reflects the recent strengthening of the U.S. dollar as well as the timing of some orders which have pushed revenue into 2012. We now expect total revenue to be essentially flat with financial self-service revenue increasing 2% to 4% and security revenue unchanged from our previous guidance which is flat to down 3%. Given our improved margins, increased confidence in the fourth quarter and a lower tax rate we are raising our full year non-GAAP EPS guidance to be in the range of $2.15 to $2.25 per share.

As we move into 2012 I am confident in our ability to deliver solid results with our backlog and orders providing a sound foundation for growth. With that in mind, as Tom indicated in his remarks, we have provided some considerations as you start to think about modeling 2012. One additional point to consider regarding top line growth is that we continue to be disciplined in the type of business we pursue in order to drive return on capital employed to 15% in pursuit of building long-term shareholder value. As a result we have consistently demonstrated our willingness to trade revenue growth for profitability.

To conclude, I am encouraged at the direction we are heading. This is supported by extensive strategic work we’ve done related to our business in EMEA, our security operations and our global financial Self-service business. In addition the operational strength we have developed are effectively driven execution on our cost savings initiatives. Our restructuring efforts in Europe are providing a solid foundation for the region moving forward, and our processes for financial controls are sound. These factors coupled with our financial strength provide me with a tremendous sense of confidence as we look to capitalize and execute on the core strategies that we have put in place.

With that I’ll turn it back to John.

John Kristoff

Thanks, Brad. Dana, we’d like to take our first question at this time.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) We’ll take our first question from Kartik Mehta with Northcoast Research.

Kartik Mehta – Northcoast Research

Morning. Tom, as you look at the North American market now, specifically the U.S. market and the orders you’re seeing in the regional banks and maybe some of the conversations you’ve had with your customers, any sense of how long you think that upgrade cycle could last?

Thomas Swidarski

Kartik, let me put it in two frameworks. One would be in terms of what’s happening from the compliance standpoint. Obviously there’s a lot of activity that’s tied to compliance that they have some deadlines here in the first and second quarter of next year, and so I think that’s been a big driver. But as you can see for us it’s been four consecutive quarters now from a regional bank’s base of seeing product orders up well in excess of 100%. The comp will get more difficult in the fourth quarter, but we still see a very strong fourth quarter ahead of us.

The other piece of that I’d look at in terms of deposit automation which I think is another key driver underneath that. The way I’ve been framing that up is if you look at the big banks in top 25 versus the smaller banks and credit unions we’re seeing heavy activity with credit unions and small banks. The top banks you’d say maybe are 40% of the way or 50% of the way in terms of completing this rollout when you look at the total opportunity there. I think with the credit unions and the smaller community banks we’re probably only 20%, 25% of the way there.

I think deposit automation for me is a much longer turn. People are going to get themselves equipped relative to compliance immediately. But the issue on deposit automation and integrated services, both of those I see underlying strength for quite a period of time.

Kartik Mehta – Northcoast Research

Then Tom, as you look at EMEA what are you anticipating for a loss out of the region for 2011 now? It seems like you were ahead of plan on your restructuring and that might have been the result that the orders were less than expected out of EMEA. I was just wondering if you could update us on where you on in terms of restructuring and what you expect for a total loss out of the region.

Thomas Swidarski

Sure. Certainly all of the reasons for us, we continue to work the hardest there in terms of making sure that we’ve got clear and good understanding because of our performance in the past. As you’ve seen throughout the year we’ve been able to reduce our losses. My expectation would be that the fourth quarter yields some type of modest profitability, maybe $2 million or the $5 million range. In essence we think about that in terms of 2012. Depending on where the fourth quarter comes in that’s about probably a $0.10 or so pickup for us in 2012 as we think about getting to breakeven point for the full year in 2012.

We’re seeing positive signs. We need to see more of them. We need to string more performance together in EMEA because of our position there. But we think we’re on the right track. I think that’s kind of the dimension I would think about it in.

Kartik Mehta – Northcoast Research

Then just one last question, Tom, on Brazilian elections. You mentioned in your slide that you expect a drop in revenue and earnings. I’m wondering. Is the drop in revenue earners mean that it’ll go to zero? Or are you expecting some revenue in earnings out of Brazil in 2012? Any way to kind of give an idea in a range?

Thomas Swidarski

Yes. I think we’ll have a much better answer for you on the next call because we’re in the process right now of finalizing production right now. It’s going exceedingly well. They are in the process and have notified potential suppliers that they are going out to a bid process again. Probably in the late November/December timeframe we’d have some better insight. We’re modeling in. It doesn’t go to zero. We’re thinking about half of what it was this year. Again I think we’ll have a much better perspective on this on the next call.

Kartik Mehta – Northcoast Research

Thank you very much. Appreciate it, Tom.

Operator

And we’ll take our next question from Matt Summerville with KeyBanc.

Matt Summerville – KeyBanc

Morning. A couple of questions. First, as we think about either sequentially or year-over-year, however it’s easier to talk about, the improvement you’ve seen in both gross profit on the product and services side, is there any way to sort of frame how much of that is being driven by cost takeout versus mixed improvement versus maybe input costs going against you?

Thomas Swidarski

I’m not sure. I’ll look to Brad. I’m not sure I’d have a solid answer to break out that definitely right here, Matt.

Bradley Richardson

Maybe the way I would respond – and again I think you can see that for the full year roughly our product margins are going to be in the 25% range, service margins 27%. I would think of the product margin certainly we have ongoing costs but that’s driven by mix where the service is certainly where you’re seeing the continued drive of cost-cost savings, Matt.

Matt Summerville – KeyBanc

Then with regards to the comment on Europe making money in the fourth quarter, I’m just trying to clarify. Is that really a change in how you were forecasting the business? Or is that more a reflection of seasonality there? I’m trying to gauge what I guess has evolved over the last 90 days that makes you comfortable committing to that I guess.

Thomas Swidarski

Yes. I would say, first of all, seasonality always plays a big role in our business overall in EMEA more so than anywhere else just because of the way the EMEA market is for us. Second of all I would say it has firmed up. For us, we’re not talking about a major slaying, but we’re talking about really more confidence. We were talking about trying to get a run rate of profitability or a run rate of zero to 0.02 and we think we’re going to do a little bit beyond that. I’d say it’s firming up, and then also it’s just timing as well. You saw in the third quarter, revenue was down. Some of that has to do with just some delayed installations that now move into the fourth quarter. It’s going to assist our fourth quarter, but really doesn’t change our overall premise there.

Matt Summerville – KeyBanc

Then just lastly, if you look at the backlog that you guys have been building up in this small bank market how much visibility with that customer base if you look at just where your backlog is today do you have into 2012 at this point? I guess what I’m trying to get a feel for is how much of those 100% plus order numbers that you’ve had for the last year, how much of that is revenue at this point?

Thomas Swidarski

I would say we still have quite a ways to go relative to the revenue side of the equation, unlike maybe the larger banks where you’re mapping out 6, 9, 12 months with a lot of the credit unions and smaller banks. It takes a little bit longer to revenue because you’ve got to work through maybe a processor or a third party to help assist in that regard. It takes a little bit longer, thus I think we’ve got quite a ways to go from a revenue standpoint. Again, as I indicated, we’re expecting a very strong fourth quarter relative to this same space again.

Matt Summerville – KeyBanc

Thank you.

Thomas Swidarski

You’re welcome.

Operator

And we’ll go next to Gil Luria with Wedbush Securities.

Gil Luria – Wedbush Securities

Good morning. I wanted to follow-up on that. The U.S. ATM business is the most important business. It has your highest margins. What revenue growth rates do we have for that business, not just on the regional side? That entire U.S. ATM business, what growth rates do we have now? Is the fact that you’re selling a lot of these smaller banks to move services deals, integrated services deals mean that that growth rate can carry on into next year?

Thomas Swidarski

Gil, it was a little bit hard hearing. I don’t know if that’s the phone or the connection. I think the essence of what you’re asking about is maybe the underlying strength of North America and the growth rates going forward.

Gil Luria – Wedbush Securities

Yes. The growth rates for U.S. ATM. What are those revenue growth rates for U.S. ATM right now? Can those carry into next year based on the ramp of the Integrated Services business?

Thomas Swidarski

Yes. Let me answer the back half first. Really the growth rates in terms of carrying into 2012, absolutely. With the kind of backlog that we’re talking about and where we’ve been and where we’re going we think we’re going to be in very good position there. I would say when you look at it specifically in terms of regional banks and community banks and credit unions, the half of the universe that you would call outside of the top 25, those growth rates have been the 10% to 15% range. I would expect that we would continue to see that from a revenue standpoint as we go forward. Then the second half of the year we would expect in North America specifically to start seeing some pickup and growth on the security side as well.

Gil Luria – Wedbush Securities

Then on Brazil, in terms of the business that’s available there, NCR announced that they have the Bradesco business. Are there other large banks that have activity there that you think you could have some wins at the end of this year going into next year?

Thomas Swidarski

Absolutely. Let me clarify Bradesco first of all. Fortunately for us they certainly have an agreement with NCR, but much like they did this year, they ordered several thousand units from Diebold as well as some other non-ATM-like devices. My expectation will be that we’ll continue to do business with Bradesco. It certainly wouldn’t be the level that we have in the past since we probably have maybe 25,000 or 30,000 ATMs in that environment.

The second thing is, in our relationship with Bradesco we didn’t get the service parts of that contract. They have their own internal service arrangement. I look at that very differently than I do some of the other banks where we’re not only talking about the technology and doing services, but we’re also doing the critical piece of service. We see pretty good opportunities here in the fourth quarter for us that we think we’re in very good position with relative to the Brazilian market. We have traditionally done business with all seven or eight major players in the market. I expect that to continue. I would expect the waiting to be different going forward in terms of which banks and the size of those orders, but we think the fourth quarter can be pretty good to us from an order entry standpoint in Brazil.

Gil Luria – Wedbush Securities

That’s great. Thank you.

Operator

We’ll take our next question from Julio Quinteros with Goldman Sachs.

Roman Leal – Goldman Sachs

Hi. This is actually Roman Leal in for Julio. First on the European market, can you give a little bit more color on the state of, I think you called out Spain and Italy. I may be mistaken but I think those are the two countries you called out. Any more color on the market there? Is this broad-based weakness or just more competition?

Thomas Swidarski

I use those two as an example. I think the macro issues are the big overriding issues in EMEA that we are facing and the banks and the uncertainty of what’s happened there and the financial institutional structure there, and all the issues that they’re facing is really the big driven there. Unlike where we see the United States people have moved on to understand kind of the actions they’re taking there. We still see capital being maybe tied up a little more than it had been. But by the same token you’ve seen the improvement we’ve made relative to the type of activities that we have there, and also the improvement in terms of revenue that’s more profitable for us.

As you look at our mix around the world, we have much lower exposure in EMEA than we would in the United States, so as such as the United States moves we’re going to move a lot more reflective of that. EMEA, I still think there’s some time to work through all of the issues that they have there. As I mentioned, we’ve seen some strength in maybe some of the emerging markets, but the mature markets we still think it’s going to be a while before we really understand what the picture is and their movement to automation. While we have some success there, it’s smaller for us. The most important success we have there is improvement profitability picture and that’s how we’re looking at it.

Roman Leal – Goldman Sachs

Got it. I completely understand that it’s a smaller business there. In terms of the suspend trends, is it just that the fact that deposit automation are the major drivers here in North America and just not in Europe? Or is this more of a CapEx situation there?

Thomas Swidarski

No. The same drivers are there as in the U.S. As a matter of fact, in some areas they’re much further ahead in terms of automation. This is more of a CapEx thing. I think again, for us, you’ll see the fourth quarter we’d expect revenue and orders to be up in the fourth quarter. Again, some of that has to do with timing. For me it’s much more the macro issues that are being addressed there. We feel very good about refocusing back on select countries where we think we could make a difference and do it in a profitable manner. That’s really our focus in EMEA.

Roman Leal – Goldman Sachs

Okay. Then one last question on the Security business. What gives you the increased visibility or confidence that that business model is going to show some positive growth in the second half of next year?

Thomas Swidarski

I think a couple of things there. First of all, you split the business and say physical security versus electronic security. When we report those externally you see them as one number and you see security going down. In reality the electronic security has been relatively flat. It may be not up a tick for the full year, whereas you’re going to see physical security is actually down. When we separate those two we’ve got confidence of what’s happening there.

The second thing is, as you’ve seen, we’ve been able to do some pretty impressive things outside the financial industry. We talked about the results we’ve had in the World Trade Center and the World Trade Center transportation hub, and some of the most sophisticated buildings around the world that we have some expertise in. We’ve taken those same capabilities and oriented them back now to the financial sector. As such, when I talked about our pipeline growing, our pipeline with financial institutions, we’re not taking our enterprise security and our logical security skill sets to the financial space. I think we’re meeting with very good conversations and I think very good success.

While it may take longer for some of that to turn into actual orders in revenue and that’s why we’re talking about the second half of next year, based on the conversations and the opportunities that I personally have been involved with, I know the capabilities we have and the interest level back through our sweet spot which is the financial institutions. We feel very confident what we can do there going forward in 2012.

Roman Leal – Goldman Sachs

Thank you.

Thomas Swidarski

You’re welcome.

Operator

And we’ll go next to Zahid Siddique with Gabelli & Company.

Zahid Siddique – Gabelli & Company

Hi. How are you?

Thomas Swidarski

Good.

Zahid Siddique – Gabelli & Company

A couple of questions. The first one is on pensions. I know you talked about higher pension expenses in 2012. If you could give us some color around that.

Bradley Richardson

Yes, Zahid. Let me just start off with a reminder of our pension situation. Our qualified plan, we were roughly underfunded about $50 million as we finished out 2010. We have a pretty strong funding situation of the plan. What is driving the potential increase in the pension expense is the change in the discount rate which has raised the overall present value, if you will, of the benefit obligations. This year we saw kind of a $5 million increase again driven by lower discount rates. I think for next year $5 million is probably a good placeholder.

Zahid Siddique – Gabelli & Company

What is the discount rate for 2012 versus 2011 versus 2010?

Bradley Richardson

I would rather not get into the details of what it is, but just in aggregate it’s been going down by about a percent per year the last couple of years.

Zahid Siddique – Gabelli & Company

Okay. Great. Any updates on the SCPA progress?

Bradley Richardson

Yes. What we’ve been reporting to you is basically that we plan to kind of wrap up our internal review towards the end of this year. We’re on track to do that. Then our plans are to sit down with the SEC and Department of Justice and try to resolve this matter. I can’t predict obviously at this point how that process will work. We’re on track to complete our internal review as we previously disclosed.

Zahid Siddique – Gabelli & Company

That is by the end of this year in general?

Bradley Richardson

The internal review by the end of this year. Correct.

Zahid Siddique – Gabelli & Company

Okay. Then you don’t have a sense of when the full review will conclude? Sometime maybe in 2012?

Bradley Richardson

Again, our review will be done, but again, we have to sit down and obviously discuss this with the SEC and the Department of Justice. Again, I just can’t predict at this point how that process will unfold, but I suspect it will obviously spill into 2012.

Zahid Siddique – Gabelli & Company

Sure. My last question is on the margin. I noted the gross margin improved in a sizeable manner in the quarter. Looking out into the next several quarters is that something that you believe would be sustainable?

Bradley Richardson

Certainly what I would say is we continue to show nice progression if you will on our service margins. We would expect service margins to continue to improve. At the same time, as you know, although our product margins have been strong that’s really being driven by mix. There’s going to continue to be price pressure globally on our product margin. I wouldn’t say that we’re going to continue to see significant improvement in the product margin side of the business.

Zahid Siddique – Gabelli & Company

Thank you.

Operator

(Operator Instructions) We’ll go next to Paul Coster with JP Morgan.

Paul Coster – JP Morgan

Thank you. I think most of my questions have been answered. However integrated services as it applies to securities, can you just explain to us what this is and what it does in terms of revenue model and visibility in time?

Thomas Swidarski

Yes. It would be comparable to what we’re doing on the ATM side. Let me kind of reflect on that first and then I can take you to the security piece because it might be easier to understand. If people have been dealing with, again we introduced these concepts four or five years ago. In Brazil we actually introduced them 10 years ago. In essence people outsourcing their ATM network to us, which includes governance. It includes audit. It includes running the ATM itself, processing transactions, routing transactions. It includes software, downloading software and the whole bit. In essence we take over the operational side of running the business for them.

When you think of the Security business think of the same thing. Today we already do quite a bit of monitoring for banks. Most of that monitoring we’ve been doing is associated with a retail bank branch. You take that same concept and realize that security now is moving like the ATM business has been in terms of everything is networked. Everything is connected and everything is IP based. Now we’re going back to institutions and really looking at – many institutions today still do their own monitoring. They run their own networks. That could be just burglary. That could be fire and burglary. That could be energy. Over those tracks of the monitoring, whether it be events and also the video aspects of that, we’re now looking at handling all of that for institutions.

We have several institutions that have an increased appetite of us to do that as they face cost structural issues as a result of what banking is undergoing here in the U.S. You can pick up the paper every day and people are talking about them focusing back on our core business. What can they do? There are pieces of their operation that we can actually take off their hands. We don’t have to run their whole security operation. It’s really the technical IP pieces. It generally starts from a bank branch network, but then you start thinking about their operation centers. How do they handle that?

And so, we have now been able to leverage what we have done with big facilities like the World Trade Center and building on that capacity and doing the same thing for a large complex building as well as many diverse facilities that a bank would have. In essence they’d be turning those capabilities over to us, and we see a big appetite for this much like we did five years ago when we introduced that concept in the U.S. It took several years on the ATM side to get the traction, but now we’ve moved quite a few of our people that are security experts into the financial space, calling on financial institutions along this line.

And again as I mentioned, our pipeline has improved dramatically as a result of this. Thus we know there’s really a market for it, and the competencies that we’ve developed both on the ATM side as well as what we were doing previously in terms of the security infrastructure is there. If people come to Canton when we have customers to visit we take them up to a center where we monitor things 24 hours a day, seven days a week, and just adding onto that is going to be what we do on the security side of the business.

Paul Coster – JP Morgan

Does it change the revenue model at all?

Thomas Swidarski

Yes. In essence what it does is most of these contracts end up being multiyear contracts. What it ends up being is relative to being a run rate for a two or three year period that we have operational kind of contracts for. It becomes much more steady services rather than a onetime product sale. It helps the Service business grow and services grow. Second of all, it helps in terms of margins and the consistency and quality of earnings.

Paul Coster – JP Morgan

Lastly, just to be clear here, you earlier said that the physical security market is down. Is it intentionally excluding that from scope?

Thomas Swidarski

No. This would say this basic premise is going to apply across the board. It’s just our opportunity is really going to be the electronic IP base kinds of things, not necessarily on the physical side of things, but again, if the physical side of branch building and that activity every picks up we’ll be in a good position to take advantage of it. Really the growth that we’re going to see is really going to be on the IP electronic security side in the financial space.

Paul Coster – JP Morgan

Okay. Thank you.

Operator

And we’ll go next to Matt Summerville with KeyBanc.

Matt Summerville – KeyBanc

Just a couple of quick follow-ups. First I want to talk a little bit more about free cash flow. In order for you guys to get to $150 million you need about $250 million in free cash in the fourth quarter. Just looking at Slide 24 you’ve never really been quite that strong. I guess, Brad, can you help sort of define or maybe put in buckets how you bill to that 250 number and I guess what your degree of confidence is there?

Bradley Richardson

Yes. I can just help you maybe, Matt, with the math, how about 240. I know you were trying to be big picture, but every dollar is going to count here. I think you point out obviously this is steep hill to climb. Let me say a couple of things. One is, in the fourth quarter again in that 240 we are working on a modest size tax refund that we expect to come in. That’s going to provide support for the 240 number. I would also say that we’ve spent 2011 looking very, very hard at our underlying processes, specifically for example here in North America working on our annual maintenance billing process. We think we’ve done a lot of improvement in that. Again, we think that will provide a year-over-year improvement in our overall collections. That’s just an example of process work that we have going on, and it’s going on globally to really help us meet this target.

Matt Summerville – KeyBanc

Then, Brad, maybe just a follow-up on the inventory side of things. Given the timing on the Brazilian elections and some of these other orders coming through, would you say inventory is going to be the biggest kind of component of that? Or would these other items that you just highlighted with me?

Bradley Richardson

No. I think the inventory you can see from our cash flow in the quarter we built nearly $50 million of inventory which again will be drawn down heavily in the fourth quarter. Again, I think it’s a combination of again the process work on our collection, tax refund, the underlying earnings and then obviously the significant draw down in our inventory.

Matt Summerville – KeyBanc

Then as we think about 2012 is there any sort of framework you can throw out there, Brad, as a placeholder for what we should be thinking in terms of an effective tax rate? I guess, as you guys are talking to the board, would you anticipate reloading that share repurchase for 2012?

Bradley Richardson

Yes. I think the effective tax rate, again this year we had guided the 28%. We took it down again, as I mentioned, in terms of the settlement of the past audit. But I think the 28% is a good placeholder, and in particular because we will be driving more earnings out of our North American business here in the near-term which has a higher effective tax rate. I still think the 28% that we’ve been using is a good, long-term proxy.

As it relates to our share repurchase program again, we’ve got 700,000 shares left on that. This is something that we review with our board on a quarterly basis and would be looking to do that after we’ve completed the year. We understand how our cash generation has come out, and we also understand what kind of our acquisition pipeline looks like. We have good capacity here, and we’re wanting to make sure we maintain capacity to continue to be able to invest in the business. That’ll be an early 2012 discussion with the board.

Thomas Swidarski

I think the other thing, Matt, in that regard is when you think of how we’re thinking about it, first of all is we’ve got a lot of opportunities we’ve talked about in terms of innovation here. Reinvesting in the business from an R&D standpoint and marketing standpoint becomes very high priority for us as we go forward, and again want to keep changing the game. We’re talking about adding services as we build these infrastructures. I can see us continuing to invest heavily on that front. Certainly we’re committed to the dividend, the M&A activity as well. We’re going to look at it holistically. Certainly it’s been an important part of our plan this year. It’ll probably play a role going forward. I want to make sure we look at it holistically.

Matt Summerville – KeyBanc

Thanks, guys.

Operator

And with no further questions in the queue I’d like to turn the call back over to Mr. Kristoff for any additional or closing remarks.

John Kristoff

Thanks, Dana, and thank you everyone for joining us this morning. Just one additional note before we sign off here. I wanted to mention that the Diebold Investment Community and Industry Analyst Conference has been scheduled for February 22 and 23 in New York City. Save-the-date announcements will be going out in early November with more details, but I just wanted to put that date out for you here this morning.

Thanks again for joining us. As always, if you have follow-up calls please don’t hesitate to reach out to us directly.

Operator

Again, that does conclude today’s presentation. We thank you for your participation.

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