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Executives

Kendall Hunt - Chairman and Chief Executive Officer

Jan Valcke - President and Chief Operating Officer

Clifford Bown - Executive Vice President and Chief Financial Officer

Jochem Binst - Director of Corporate Communications

Analysts

Brian Freed - Wunderlich Securities

Joe Maxa - Dougherty & Co.

Frederick Ziegel - Topeka Capital Markets

Scott Zeller - Needham & Co.

Brian Freed - Wunderlich Securities

VASCO Data Security International, Inc. (VDSI) Q2 2012 Earnings Conference Call July 26, 2012 10:00 AM ET

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the VASCO Data Security International Inc. Q2 2012 Earnings Conference Call. During the presentation, all participants will be in a listen-only mode. Afterwards, we will conduct a question-and-answer session. (Operator Instructions).

I would now like to turn the conference over to T. Kendall Hunt, Chairman, Founder, and CEO.

Please go ahead, sir.

Kendall Hunt

Thank you, operator. Good morning, everyone, for those listening in from Europe, good afternoon and from Asia, good evening. My name is Ken Hunt and I am Chairman, Founder, and CEO of VASCO Data Security International, Inc. On the call with me today are Jan Valcke, our President and Chief Operating Officer; and Cliff Bown, our EVP and Chief Financial Officer.

Before we begin the conference call, I would like Jochem Binst, VASCO’s Director of Corporate Communications to brief all of you on forward-looking statements.

Jochem Binst

Thank you Ken. Ladies and gentlemen, statements made in this conference call that relate to future plans, events or performances are forward-looking statements. Any statement containing words such as believes, anticipates, plans, expects and similar words is forward-looking. And these statements involve risks and uncertainties and are based on current expectations. Consequently, actual results could differ materially from the expectations expressed in these forward-looking statements. I direct your attention to the company's filings with the U.S. Securities and Exchange Commission for a discussion of such risks and uncertainties in this regard.

At this time I will turn the call back over to Ken.

Kendall Hunt

Thank you Jochem.

Today, we are going to review the results for second quarter of 2012. As always, we will host a question-and-answer session after the conclusion of management's prepared remarks. If possible, I would like to budget one hour total for this conference call. If you can limit your questions to one or two, it would be appreciated.

Overall, we are very satisfied with our Q2 performance. Q2 revenues were $46.6 million, an increase of approximately 11% compared to the second quarter of 2011. Q2 2012 was our 38th consecutive positive quarter in terms of operating income.

Our gross profit for the quarter was approximately 63% of revenue, an improvement of 2 percentage points over the second quarter of 2011. Our operating income continuing operations was approximately 19% of revenue per quarter, an improvement of almost 10 percentage points over the second quarter of 2011.

At June 30, 2012 out net cash balance was $85.1 million, an increase of $648,000 over our balance at December 31, 2011. And we had a $118 million in working capital. The strong cash position and strong balance sheet is an important tool to support VASCO’s future growth. As I mentioned during previous calls, we have two important priorities in 2012. 1) To fortify and enhance the strong position in our core business. 2) To develop our services business.

The result of our core business continues to be very positive. We have demonstrated with our performance in Q2 that somewhat lower results in Q1 2002 were temporary caused by the historical lumpiness of our banking business and manufacturing weakness due to the Chinese New Year, which reduced our available manufacturing days for the quarter.

Our enterprise and applications security business continues to show steady growth. Thanks to previous years investments and people and products. We have not seen any slowing down of our core business. To the contrary, our cumulative order intake through the first six months of 2012 has been substantially stronger than the same period last year. And in fact the strongest first six months in the company’s history.

We started the year with a backlog that was lower the last years. At the end of Q2, we have closed that gap completely and are well underway to reach our 2012 guidance objectives. In the first half of 2012, it does not appear that the sovereign debt issue in the Eurozone has been significant impediment for VASCO’s business.

Our banking business in Europe in still going strong, we have also received orders from banks in countries where the sovereign debt issue seems to be the most severe. A motivating factor for banks to many parts of the world is the fact that internet banking is a very low cost and profitable application.

The cost bases internet banking is very low since banks can eliminate much of their investments in Bricks Mortar and related staff. With VASCO banks can offer their customers security combined with convenience. This is very appealing to many banks and their customers. We also had excellent results from our Asia Pacific operations driven by strong growth and banking in the government sector. Cliff will give you a little more information on our revenue per region.

During Q2, we officially launched MYDIGIPASS.COM and started to address the market with our hosted consumer authentication platform, which provides convenient and secure login services to various web applications. Currently, we have over 200 websites testing, integrating and are using MYDIGIPASS.COM. I believe that this is an impressive number considering the fact that we launched the platform in April of this year. Going forward, we will take numerous actions to make MYDIGIPASS.COM even more attractive for end users and websites including localized and translated versions of the portal, new options functionalities and more.

In 2012, we will concentrate on building a critical mass of MYDIGIPASS.COM enabled websites and activated end users. We believe that we will generate the first meaningful revenue for our services offering in 2013. We also expect that we will start providing additional metrics regarding the ramp up of our services business, as a part of our third quarter reporting process.

At this time I would like to introduce you Jan Valcke, VASCO’s President and Chief Operating officer. Ian.

Jan Valcke

Thank you Ken. Ladies and gentlemen, the second quarter of 2012 was a very good quarter. Results are good and the order intakes stay strong. As you know our traditional business relies on the business mix of 1) The financial market giving us high volume deals with lower margins and 2) The enterprise security and application security market bringing the smaller deals with higher margins.

In Q2, our banking business was strong and our enterprise and application security business delivered another quarter of steady growth. However, our overall gross margin were under some pressure due to our continuous success in banking which produces good revenue, but lower gross margin.

As we have described before our banking business often consist of large deals. The timing of these deals within a quarter defines whether the revenue can be a recognized in that quarter. This produced somewhat lumpy results quarter to quarter, that we have to live with currently. We believe however, that VASCO’s banking business is strong and has a lot of growth potential long term. This is combined with our enterprise and application security business which is normally smaller deals, but higher gross margin. This creates a stream of orders that brings us steady long-term growth. Our good performance in our traditional business allows us to invest in our growth. This includes the launch of new products and the development and marketing of our service business model.

On April 23rd, we officially launched MYDIGIPASS.COM. We went to market immediately with a three step approach. 1) We aim at earlier doctors in the online B2B field. 2) We use our market knowledge and the references built up in the first step to address local market leaders in the B2B and the paying B2C sectors. 3) We aim at global market leading B2C internet companies and ASP’s.

Our current stages is that 1) We having a first batch of earlier doctors using MYDIGIPASS.COM. 2) We are filling our pipeline with the local market leaders in B2B and paying B2C and 3) we are talking to a number of Global Tier One companies about the implementation of MYDIGIPASS.COM. We keep strengthening our service offering.

Over the last couple of managed months, we strengthened the compatibility of MYDIGIPASS.COM with some of the world’s leading e-commerce platforms such as Magento. We also enhanced the reach of our dormant DIGIPASS by announcing that Intel has implemented DIGIPASS into Ultrabook. In the future, we will keep adding to our MYDIGIPASS.COM offering, starting in the third quarter.

In the second quarter of 2012 also brought us the launch of some fine new products, such as the new version of IDENTIKEY appliance and in strengthening of our PKI product line, with a new release of CertiID Suite and DIGIPASS KEY 202. We do not plan on hiring substantial new start in the short term.

We invested strongly in people during the last couple of years. And our goal is now to make this people successful, now that they are up to speed. Thank you.

T. Kendall Hunt

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

Clifford Bown

Thanks Ken and welcome to everyone on the call. As an overall comment to the discussion today, please note that the numbers being referenced today for the second quarter and first six months of 2011 have been restated to reflect the results of DigiNotar, which was declared bankrupt in the third quarter of 2011, as a discontinued operation.

As noted earlier by Ken, revenues for the second quarter of 2012 were $46.6 million, an increase of $4.5 million or 11% from the second quarter 2011. For the first six month’s revenues were $78.9 million, an increase of $0.7 million or 1% from the comparable period in 2011.

The increase in revenue in the second quarter reflected a 10% increase in the revenues from the banking market and a 17% increase in revenues from the enterprise and application security market. For the six months ended June 30, 2012 the increase reflected a 23% increase from the enterprise and security application market, partially offset by a 3% decrease in revenues from the banking market.

It also should be noted that the comparison of revenues was impacted by changes in exchange rates of the Euro and the Australian dollar to the U.S. dollar. We estimate that revenues were $1.7 million lower for the second quarter and $1.9 million lower for the first six months of 2012, than they would have been had the exchange rates in 2012 been the same as in 2011.

The mix of revenues for the second quarter 2012 was 83% from the banking market and 17% from the enterprise and application security market. The mix of revenues for the six months ended June 30, 2012 was 81% from the banking market and 19% from the enterprise and application security market. For both, the second quarter and for six months of 2011 84% of our revenue came from the banking market and 16% of our revenue came from the enterprise and application security market.

The geographic distribution of our revenue for the first six months of 2012 was approximately 64% from Europe, 7% from the United States, 19% from Asia and the remaining 9% from other countries. Through the first six months of 2011, approximately 74% of our revenue came from Europe, 6% from the United States, 6% from Asia and the remaining 13% was from other countries. We believe that the change in mix of revenues by region does not reflect any significant change in the economic environment of any given market, but rather reflects the businesses based on specific projects undertaken by our customers in specific time periods.

As discussed previously, the majority of our revenues are sustainable and repeatable by nature rather than recurring. Our gross profit margins improved 2% to 3% points in 2012 over 2011. Our gross profit margins are 63% and 65% of revenue for the second quarter in first six months of 2012 respectively compared to 61% and 62% of revenue for the comparable periods in 2011.

The increase in gross profit is percentage of revenue for the second quarter of 2012 compared to 2011 primarily reflects an increase in revenues from the enterprise and application security market as a percentage of total revenue, a decrease in the percentage of our total revenue that came from sales of card readers. And a decrease in non-product cost associated with the customization and expedited delivery of products, which were partially offset by a decrease in the gross profit margin from the application security market as a result of an increase in quantity of hardware products sold and a decrease in the gross profit margin due to the negative impact on revenue and gross profit of changes in foreign currency rates.

In addition to the factors impacting the comparison of the second quarter of 2012 to 2011, the gross profit margin for the first six months of 2012 compared to 2011 also reflects an increase in non-hardware revenues as a percentage of total revenue.

As noted earlier revenues from our enterprise and applications security market which generally has margins that are 20 to 30 percentage points higher than the banking market, where 17% and 19% of our total revenue for the second quarter and first six months of 2012 respectively, compared to 16% for both the second quarter and first six months of 2011. Card readers which can have a lower gross profit margin that is approximately 10 to 20 percentage points lower than other hardware related margins due to competitive pricing pressures, where 13% of our revenue for both the second quarter and first six months of 2012 respectively, compared to 27% and 22% for the second quarter and first six months of 2011 respectively.

The decline in gross profit margin on revenues from the enterprise and application security market for the second quarter and first six months of 2012, compared to 2011 reflected an increase in the quantity of hardware products sold. The reduction in the gross profit margin related to the larger orders is consistent with our approach to pricing, which is to offer lower average selling prices per unit per large volume purchase orders. Now, on hardware revenue, which can have a gross profit margin that is approximately 20 to 30 percentage points higher than hardware related revenue, depending on the model and the quantity of the hardware units sold was 20% and 24% of our revenue for the quarter and first six months of 2012 respectively compared to approximately 20% and 21% of total revenue for the second quarter and first six months of 2011, respectively.

As noted on previous conference calls majority of our inventory purchases already dominated in U.S. dollars. Also as previously noted our sales were denominated in various currencies, including the Euro and Australian dollar. As the U.S. dollar has strengthened when compared to the Euro and Australian dollar in the same periods in the prior year, revenue from sales made in Euros and Australian dollars decreased as measured in U.S dollars without a corresponding change in cost to goods sold.

As noted earlier the impact of changes in currency rates are estimated to have decreased revenue and gross margin by approximately $1.7 million and $1.9 million for the second quarter and first six months of 2012 respectively. Had the currency rates in 2012 been equal to 2011, the gross profit margin would have been approximately $1.3% points higher for the quarter and 0.8% points higher for the six months ended June 30 of 2012.

On a consolidated basis our operating expenses for the quarter and six months ended June 30, 2012 were $20.5 million and $40.1 million respectively. A decrease of $1.2 million or 6% from the second quarter of 2011 and an increase of 0.1 million for the six months ended June 30, 2012.

The decrease in consolidated operating expenses for the second quarter of 2012 compared to the second quarter of 2011was primarily related to the benefit of the change incurred in exchange rates, partially offset by a 2% increase in average headcount and an increase in stock-based incentive plan costs.

Consolidated operating expenses for the first six months of 2012 compared to the same period in 2011 were essentially flat, as the benefit from the change in the currency rates were offset by a 3% increase in average headcount and an increase in stock-based incentive plan costs. We estimate that our operating expenses were $1.5 million and $1.8 million lower in the second quarter and first six months of 2012, respectively, than in the comparable periods of 2011 due to the changes in currency exchange rates.

Operating expenses for the second quarter and first six months of 2012 included $1.2 million and $2.2 million of expenses related to stock-based incentive plan costs, respectively, compared to $0.8 million and $1.3 million of stock-based incentive plan costs for the second quarter and first six months of 2011, respectively.

Operating income for the second quarter of 2012 was $9 million, an increase of $4.9 million, or 122% from the $4.1 million reported for the second quarter of 2011. For the first six months, operating income was $11.2 million in 2012, an increase of $3 million, or 36% from the $8.2 million reported in 2011. Operating income as a percentage of revenue or operating margin was 19% for the second quarter and 14% for the first six months of 2012. In 2011, our operating margins were 10% for the quarter and 11% for the first six months.

We have reported income tax expense of $2 million for the second quarter and $2.5 million for the first six months of 2012. The effective tax rate was 21% for both the second quarter and first six months of 2012. For 2011, the company reported income tax expense of $1.2 million for the second quarter and $2.1 million for the first six months. The effective tax rate reported in 2011 was 26% for the second quarter and 23% for the six-month period ended June 30. The increase in tax expense for the second quarter and first six months was attributable to higher pre-tax income, partially offset by lower effective tax rate. The effective rates for both 2012 and 2011 reflect our estimate of the full year tax rate at the end of the second quarter in each period. The change in tax rate reflects a number of differences including but not limited to our estimates of full year pre-tax income at the end of the second quarter for each year, as well as the geographic distribution of where the income would be earned.

Under our current structure, our effective rate will be very sensitive to level of pre-tax income. As pre-tax income increases, we expect the effective rate to decline and as pre-tax income decreases the effective rate will increase.

The makeup of our workforce at June 30, 2012 was 367 people worldwide, with 170 in sales, marketing, and customer support, 142 in research and development, and 55 in general and administrative. The average headcount for the second quarter of 2012 was 8 persons or 2% higher than the average headcount for the second quarter of 2011. The average headcount for the first six months of 2012 was 10 persons, or 3% higher than the average headcount for the same period in 2011.

Our balance sheet continues to show strong cash and working capital balances throughout the second quarter of 2012. Our net cash balance was $85.1 million at June 30, 2012, a decrease of $8.3 million, or 9% from $93.4 million at March 31, 2012, and an increase of $0.6 million or 1% from the $84.5 million at December 31, 2011. The decrease in cash from March 31, 2012 was attributable to the strengthening of the US dollar to the euro and most all other currencies in other countries in which we operate, and an increase in other key elements of working capital. At June 30, 2012, we had working capital of $118 million, an increase of $5.3 million, or 5% from $112.7 million at March 31, 2012, and an increase of $9.4 million, or 9% from $108.6 million reported at December 31, 2011. The increase in working capital for the quarter and six months ended June 30, 2012 was primarily related to cash flow from our operations.

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

Kendall Hunt

Thank you, Cliff. We are pleased with the results of Q2 and we are optimistic about the remainder of the year. Both our quarter intake and backlog are up over last year at this time. The fundamentals do look good.

Now, guidance. We are reaffirming the guidance that we gave you during the last conference call. Revenue for 2012 is expected to be $175 million or more, and operating income as a percentage of revenue excluding the amortization of purchased intangible assets for full year 2012 is projected to be in the range of 13% to 16%.

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

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from the line of Brian Freed from Wunderlich Securities. Please go ahead.

Brian Freed - Wunderlich Securities

Good morning and good quarter.

Kendall Hunt

Thanks, Brian.

Brian Freed - Wunderlich Securities

My first question really comes around your guidance and your confidence. As I look at the effective currency on your business, it looks to me like you are fighting something in the range of 4% to 6% headwind versus the point in time when you gave the initial guidance for better than $175 million. So, in effect on a constant currency basis it’s an increased level of guidance. Do you feel that that’s fully supported by the order intake you have seen in the first six months?

Kendall Hunt

Yes, we do.

Brian Freed - Wunderlich Securities

Okay, great.

Operator

Thank you. Our next question comes from the line of Joe Maxa from Dougherty & Co. Please go ahead.

Joe Maxa - Dougherty & Co.

Thank you, and congrats on a nice quarter.

Kendall Hunt

Thanks, Joe.

Joe Maxa - Dougherty & Co.

Also I wanted to talk a little bit about the back half of the year. Obviously a strong pipeline, as you mentioned, the questions I have are, are there large deals in this pipeline such as the HSBC in that range that could happen during this year or next year?

Kendall Hunt

We have large deals every year. HSBC as an individual multi-month transaction was very large. So we don’t have anything quite that large but we do always have quite a few larger deals that occur during the year. We are experiencing a lot of RFP activity for deliveries in ’13, so we are in pretty good shape for a good year in 2012 and good activity in these RFPs for going into 2013.

Joe Maxa - Dougherty & Co.

I see. Should we think about the seasonality, typical seasonality in the back half, consistent with what you would expect, or what you have seen in prior years?

Kendall Hunt

Yes, I would believe so. Second quarter is typically a strong quarter following a typically down first quarter compared to the fourth quarter, third quarter is typically weaker because of holidays in Europe, and so I think you can expect the same thing.

Joe Maxa - Dougherty & Co.

Right. And just real -- last question from me. On the gross margin front, given where you are guiding or reiterating your up margin guidance for the full-year and then reflecting the strength that you had in Q2, should we be thinking at gross margins at 63% are really the kind of the best you are going to see as we go through the year?

Clifford Bown

Joe, that will continue to depend on the mix of the orders that come in. So depending on the size of the banking orders and then the relative mix of banking orders to enterprise security orders, the percentage of gross margin will vary every quarter. So we can’t say 63% is it, but we are targeting still in the mid 60% range overall as all of those different components come together. There are just too many variables to pin one number down. Currency, if it continues to go in the direction it has and the euro appears to continue to weaken that will also have downward pressure on our gross margin as a percent of revenue.

Joe Maxa - Dougherty & Co.

Right. Okay, very good. Thank you.

Operator

(Operator Instructions) Our next question comes from the line of Fred Ziegel from Topeka Capital Markets. Please go ahead.

Frederick Ziegel - Topeka Capital Markets

Hi everybody.

Kendall Hunt

Hi, Fred.

Frederick Ziegel - Topeka Capital Markets

Can you give us some framework or idea as to how much of an investment is going into the services initiative which obviously if we start to see some revenues gets alleviated next year? Can you put some framework around that?

Kendall Hunt

We are not publishing anything in that regard, Fred. Where you would see the majority of the increase in investments going to be in the R&D lines of our reports. When we publish our MD&A to the 10-Q, you will see that the headcount this year compared to last year and really when you go back a little bit, it’s shown heavy growth in the R&D function, in terms of headcount. We have also reallocated the staff within the R&D function to work on services. So, in addition to the incremental we have reallocated. Suffice it to say, it’s several million dollars of investment in terms of annual costs. If we were to have great success with the service line then it will be a very small percentage of the revenues that it is generating. If we don’t realize that success we can down size the R&D to some degree, but it won’t be dollar for dollar of any number that we are allocating to it today, some of those resources would then be reallocated back into the core business.

Frederick Ziegel - Topeka Capital Markets

Okay, thanks. I know this is going a little hard because enterprise business comes in kind of on a deadly flow basis, but would you expect the mix, I guess really to tie to Joe’s question, would you expect the mix over the next couple of quarters to tilt in what direction, for banks or toward enterprise?

Kendall Hunt

Well, for several years we have had the strategy of building up our enterprise and application business because it’s smaller deals, much higher margins to complement our higher revenue lower margin banking business and that strategy continues. We have focus on that Fred and everybody. In fact for the last year-and-a-half we have had a particular group of people we call direct touch where they are actually calling on the medium and larger sized enterprise opportunities to do that, and we are starting to see good traction. So, generally speaking, we would expect in our core business and that’s banking, enterprise, and application, we would expect the enterprise and application business would grow and become a larger portion of the overall core business, DIGIPASS as a Service, MyDIGIPASS.COM that’s totally new business.

Frederick Ziegel - Topeka Capital Markets

Alright. Is there much difference in gross margins between enterprise and application security? Those two buckets?

Kendall Hunt

No, I don’t think so.

Frederick Ziegel - Topeka Capital Markets

Okay. Alright, thanks.

Kendall Hunt

You are welcome.

Operator

Thank you. Our next question comes from the line of Scott Zeller from Needham & Co. Please go ahead.

Scott Zeller - Needham & Co.

Thank you. Could you give us, Ken, a range of expectations for ’13 on what you think the services business could turn into? Even just high level thoughts about your expectations for how material it could be as part of your business. Are we thinking low single-digits of revenue? Just any thoughts at all would be helpful to us.

Kendall Hunt

Yes, I would say that if you send me down what you have I would say that we would be very disappointed if the services business was at least 10% or more of our overall business and grow from there.

Scott Zeller - Needham & Co.

Okay. I may have missed it earlier, Cliff, but the percentage of revenue from non-hardware? I think you usually disclose that.

Clifford Bown

Yes, I did, it was in my prepared remarks. Let me just reference back here real quick to make sure I give you the right number. Non-hardware this year was Q2 20%, year-to-date 24%. Q2 of last year was 20% and year-to-date six months was 21%. So a 3 percentage point increase on a six-month basis.

Scott Zeller - Needham & Co.

Okay, thank you very much.

Operator

Thank you. And we do have a follow-up question from the line of Brian Freed from Wunderlich Securities. Please go ahead.

Brian Freed - Wunderlich Securities

Hi, Ken. When you look back across the quarter there has been a number of very high profile password hacks with LinkedIn, and Yahoo, and others. Can you talk about what impact if any this is having in terms of customer engagement or potential customer engagement, either for your traditional products, or DIGIPASS as a Service?

Kendall Hunt

Yes. Jan, would you like to address that please?

Jan Valcke

Yes, it’s a trend that we see the last years about identify theft. It’s coming also more and more in the media where they are alerting the consumer so that they can protect themselves. I think that business wise, of course, that’s excellent for us, certainly that the media is reporting that and basically that has been the base of the let’s say the business mobile that we have created a couple of years ago around DIGIPASS as a Service, with the front end MyDIGIPASS.COM to answer those needs from the consumer that wants to protect themselves if they are doing transactions. So, yes, this is good for future oriented business for us.

Brian Freed - Wunderlich Securities

And had there been any specific interactions with any of the large internet vendors or the folks who have actually seen password hacks in their systems as a result?

Kendall Hunt

Brian, I don’t think we can name anybody specifically, but you can rest assure that the sales organization is calling on the smaller, medium, and larger tier-1 as Jan mentioned in his prepared remarks, large tier-1 companies. We can’t report on any progress there but there are certainly targets.

Brian Freed - Wunderlich Securities

Great. Thank you.

Operator

Thank you. There are no further questions at this time.

Kendall Hunt

Alright. Thanks very much for joining us this morning. We appreciate it. As always, I want to personally thank all the best of people around the world for their efforts, their hard work and positive attitude. Everybody have a nice day.

Operator

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

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