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

Q2 2008 Earnings Call Transcript

July 24, 2008 10:00 am ET

Executives

Kendall Hunt – Chairman and CEO

Jan Valcke – President and COO

Cliff Bown – EVP and CFO

Analysts

Daniel Ives – FBR

Robert Breza – RBC Capital Markets

Jonathan Ruykhaver – ThinkPanmure

Brian Freed – Morgan Keegan

Nick Andrewes – Lazard Capital Markets

Sean Jackson – Avondale Partners

Ed Ching – B. Riley & Co.

Andrew Abrams – Avian Securities

Fred Ziegel – Soleil Securities

Scott Zeller – Needham & Co.

Operator

Good morning and welcome to the VASCO Data Security International Inc. Second Quarter 2008 Earnings Conference Call. It is now my pleasure to introduce your host T. Kendall Hunt, Founder, Chairman and CEO. Sir, you may begin.

Kendall Hunt

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

Before we begin the conference call, I need to brief all of you on forward-looking statements. Statements made in this conference call that relate to future plans, events or performances are forward-looking statements. Any statement containing words such as “believes,” “anticipates,” “plans,” “expects,” and similar words is forward-looking, and these statements involve risks and uncertainties, and are based on current expectations.

Consequently, actual results could differ materially from the expectations expressed in these forward-looking statements. I direct your attention to the company’s filings with the U.S. Securities and Exchange Commission for a discussion of such risks and uncertainties in this regard.

Today, we are going to review the results for the second quarter of 2008. As always, we will host a question-and-answer session after the conclusion of management’s prepared remarks. If possible, I’d like to budget one hour total for this conference call. If you can limit your questions to one or two, it would be appreciated.

First I’d like to address revenue for second quarter of 2008. Revenues for the second quarter were $35.4 million, an increase of 9% over second quarter of 2007. It was also our 22nd consecutive positive quarter in terms of operating income. Our gross profit for the quarter was 72% of revenue and our operating income was 25.5% of revenue.

There were several points worthy of note in the second quarter. First and most apparent is the fact that the reported revenues were the best in the company’s history. Second, our deferred revenues increased approximately $1.5 million during the quarter. The majority of that increase reflects revenues for additional product that we shipped in the second quarter where the revenue will be realized over the life of the contract with our customer.

Third is the fact that we experienced strong order intake or bookings much of which occurred in May and June. As you know, the hardware components of our authentication offerings are often custom manufactured incorporating our customer’s corporate color and logo. This means that they are not sitting on a shelf waiting to be delivered. However, with VASCO’s very flexible and capable manufacturing partners, we were able to respond quickly to the surge of orders and will be recording a major portion of these revenues in July of the current quarter.

New accounts sold in the second quarter continued at a very high level. During the quarter, we sold an additional 516 new accounts, including 79 new banks and 437 new enterprise security customers. This compares to the year earlier quarter in which we sold 113 new banks and 518 new enterprise security customers. We now have approximately 1,150 banks and 6,500 enterprise security customers in more than a 100 countries. In addition to banking, our customers include corporations, Internet companies and federal, state and local governments.

Some of the highlights for Q2 2008 include Banco Itau in Brazil chose VASCO to secure more than 1.6 million end users with VACMAN Controller and Digipass GO3. Independent Bankers' Bank in the U.S. chose VASCO to secure its online banking with VACMAN Controller and Digipass GO6. Mizuho Bank at Japan, Intesa, Sanpaolo, Italy and Banco Itau Brazil, received VASCO's Market Vision Award.

We launched our retail store to offer VASCO products directly to end-users. We announced Digipass for SonicWall SSL-VPN to secure EMEA corporations. VASCO opens its subsidiary in Mumbai, India. VASCO expanded its U.S. Channel Partner Program. And last VASCO was ranked 5th in Fortune Small Business Top 100 and 14th in BusinessWeek's Hot Growth Companies top 50. VASCO is gaining more recognition as a leader in the strong authentication area as evidenced by the BusinessWeek and Fortune rankings.

Currently VASCO’s image is that of a leading provider of one time password authentication to the financial sector. This is gratifying but not necessarily accurate. We are also making significant progress across a wide variety of online and Internet based transactions and applications, and it’s not just for securing financial transactions. It is security patient medical records, it is securing citizens government ids, it is securing student records. It is securing Internet gamers’ valuable characters. We can talk more about this in the Q&A session.

We are establishing and expanding our brand with our full option all terrain authentication strategy. VASCO combines all of its authentication product solutions and services on one and unique platform, VACMAN Controller. Our server family consists of VACMAN Controller, Identikey for the companies that want a full authentication server, and aXs GUARD as an authentication appliance for smaller corporations who want plug and play authentication.

We are seeing a growing interest in our other authentication functionalities such as e-signatures. Globally man in the middle attacks are on the rise. E-signatures are a perfect tool to counter man in the middle security threats. Currently we have several million end users utilizing our e-signature technology. We expect that this trend will continue and even accelerate even in the United States. With over 6,500 global customer references we are well established in the enterprise security sector. The market and our competitors will be seeing a lot more of VASCO in this area.

As a conclusion, we can state that VASCO offers the broadest range of strong authentication solutions in the sector for every application and for any company or institution. Our business outlook and performance remains strong on a global scale.

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

Jan Valcke

Thank you, Ken.

Ladies and gentlemen, we continue to be pleased with the performance of VASCO in the area of products, markets and certainly its skilled and motivated people. Based upon more and more Internet based applications, and the inherent risk of fraud, we are seeing some important evolutions in the use of VASCO’s products and solutions. As Ken said, all over the world, the threat of man in the middle attacks is growing. Man in the middle are lurking in the Internet and trying to hijack your transaction. This fraud scheme jeopardizes the entire e-banking and e-commerce sector. VASCO offers the solution to this arm, the man in the middle, with its e-signatures.

Globally we see that the interest in our soft and hardware e-signature solutions is growing quickly, both with existing and new customers. Our server family VACMAN, IDENTIKEY and aXs GUARD give us the kind of reach we never had before. From now on, any company from the smallest SME to the largest multinational can use the full array of VASCO authentication solutions. Our server approach works, and we see the traction for our new server models, both in the direct business and in the channel. We keep investing strongly in the success of our software product range. As you know, software sales contribute substantially to our margin. We see some very encouraging signs from different application driven niches.

Our markets are evolving positively. Our banking market is doing well on a worldwide scale. Our push into enterprise security is proving to be successful, creating high value and recurrent revenue. This has a very positive influence on our business mix, hence our high gross margins this quarter.

In addition, we see very encouraging signs in the number of geographical markets in the e-gaming, e-government, e-health and e-education verticals. The fact that we keep expanding our worldwide presence with offices and people, allow us to grab such opportunities directly. We have detected some important global market trends, which will allow us to sustain our growth in the longer term. The first one, going mobile. On the client side, the revolution in the mobile world is continuing. PDAs and smart phones get more and more processing power. Mobile Internet connections are becoming faster. This leads to the birth of new expectations. User expect to be able to connect wherever they are. This also leads to new applications, such as mobile banking, mobile gaming, mobile commerce, et cetera, et cetera. With a strong software authentication offering at the client slide, VASCO is well positioned to benefit from this evolution.

Number two, the infrastructure, the secure infrastructure. Evermore, people are accessing the Internet and its application via unsecured open devices such as public PCs, digital TV, mobile phones and much more. These tools are very vulnerable to outside threats and fraud schemes. As a result, the application and infrastructure providers are obliged to harness their system in order to protect their heavy investments in this new business channel. Again, VASCO with its mature and market leading server offering is well positioned to benefit from this evolution.

Number three, the virtual life. This success of so-called virtual life programs is growing everyday. People invest incredible high amounts of time, energy and money in order to nurture their avatar and raise it properly. In a number of cases, avatars get kidnapped or stolen. Users can buy their avatars back by paying ransoms, or they have to start all over again. Such emerging fraud cases can damage the entire virtual life industry. Luckily, a number of visionary companies are aware of this danger and have already acted. With its vast experience and cutting edge authentication solution, VASCO is well positioned to benefit from this evolution.

(inaudible) in solutions, markets and infrastructure will allow VASCO to speed up its evolution towards software and outsourcers service companies. With regards to the people, the most important asset of every company and certainly of VASCO, we can say that our efforts are successful. Our Seal Academy is gaining momentum, training VASCO people, partners and third parties. This way we expand our global network of VASCO certified specialists, and we are strengthening our ability to take advantage of every business opportunity wherever it may appear. Also we keep investing in the development of our managers and employees in order to be able to let company evolve to the next stage in its existence.

Finally, I told you in the past that we need more people to fuel our growth. It is a pleasure to tell you that we are on track with our goal plans in that field. Thank you.

Kendall Hunt

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

Cliff Bown

Thanks, Ken, and welcome to everyone on the call.

As noted earlier by Ken, revenues for the second quarter of 2008 were $35.4 million, an increase of $3 million or 9% over the second quarter of 2007. For the first six months, revenues were $64.3 million, an increase of $5.5 million or 9% over the comparable period in 2007. The increase in revenue for the second quarter and the first six months reflected modest increases from the banking market and significant increases in the enterprise security market.

Revenues from the banking market for both the second quarter and first six months of 2008 increased 3% from the same period in 2007. Revenues for the second quarter and first six months of 2008 increased 51% and 49% respectively from the enterprise security market. It should also be noted that the comparison of revenues was positively impacted by the weaker U.S. dollar in 2008.

We estimate that revenues in second quarter and first six months of 2008 were approximately $2 million and $4 million higher respectively than they would have been had the exchange rates in 2008 been the same as in 2007. In both periods, revenues were approximately 6% higher than they would have been had the exchange rates in 2008 been the same as in 2007.

The percentage of revenue coming from enterprise security market has increased substantially in 2008 when compared to 2007. The distribution of our revenue in the second quarter of 2008 between our two primary markets was approximately 83% from banking and 17% from enterprise security. This compares to 88% from banking and 12% from enterprise security in Q2 of 2007. For the first six months of 2008, 82 % of our revenue was from banking and 18 % was from enterprise security and compares to 87% from banking and 13% from enterprise security for the first six months of 2007.

Our revenues continue to come predominantly from outside the United States. The geographic distribution of our revenue in the second quarter was approximately 69% from Europe, 5% from the United States, 7% from Asia and the remaining 19% coming from other countries. The geographic distribution of our revenue for the first six months of 2008 was approximately 68% from Europe, 7% from the U.S., 9% from Asia with the remaining 16% from other countries.

Gross profit as a percentage of revenue for the second quarter and first six months of 2008 was approximately 72% and 71% respectively. Both were significantly higher than the 64% and 65% reported for the second quarter and first six months of 2007 respectively. The increase in gross profit as a percentage of revenue for 2008 compared to 2007 primarily reflects the fact that higher percentage of our revenue are coming from the enterprise security market as previously noted and the fact that our non-hardware revenues continue to grow as a percentage of total revenue. Our non-hardware revenues were approximately23% of total revenue for the first six months of 2008 and compares to 14% of total revenue for the first six months of 2007. Both of these items are consistent with the business strategy outlined by Ken and Jan.

In addition, the strengthening of euro compared to the U.S. dollar also contributed to the improvement in our gross margins as a percentage of revenue. We estimate that the strengthening of the euro increased our gross margin percentage by approximately 1.7 percentage points in the quarter and 1.9 percentage points for the first six months.

Operating expenses for the second quarter of 2008 were $16.4 million, an increase of 5.1 million or 46% from the second quarter of 2007. Operating expenses for the first six months of 2008 were $30.5 million, an increase of $8.7 million or 40% from the same period of 2007. Operating expenses for the second quarter and first six months of 2008 included $803,000 and $1.5 million respectively related to stock-based incentive plans. Stock based incentive plan expenses in the second quarter and first six months of 2007 were $462,000 and $905,000 respectively.

It should be noted that the comparison of operating expenses in 2008 to 2007 was negatively impacted by the weaker U.S. dollar in 2008. We estimate that expenses were $1.7 million, or 12% higher for the quarter and $2 million or 11% higher for the first six months than they would have been had the exchange rates in 2008 been the same as in 2007.

For the second quarter, operating expenses increased by $2.4 million or 36% in sales and marketing, $890,000 or 43% in research and development, and $2 million or 88% in general and administrative, when compared to the second quarter of 2007. The majority of the increase in sales and marketing area were related to the company’s increased investment in sales staff and the cost associated with opening the offices in Brazil and Japan. The increase in research and development was primarily attributable to increased compensation expenses, and the increase in general and administrative expenses primarily reflected increased compensation expenses, professional fees, travel expenses, recruiting costs and increases in our provisions for uncollectable accounts.

For the first six months of 2008, operating expenses increased by $4 million or 31% in sales and marketing, $1.7 million or 41% in research and development, and $3.1 million or 67% in general and administrative when compared to the same periods in 2007. With the exception of the increase in our provision for uncollectable accounts, the reasons for the increasing expense for the first six months are generally the same as for the second quarter.

Operating income for the second quarter of 2008 was $9 million, a decrease of $404,000 or 4% from the $9.5 million reported in the second quarter of 2007. For the first six months, operating income was $14.9 million in 2008, a decrease of $1.4 million or 9% from the $16.3 million reported in 2007. Operating income as a percent of revenue or operating margin was 25.5% for the second quarter and 23.1% for the first six months of 2008. In 2007, our operating margins were 29.1% for the quarter and 27.7% for the first six months. The decrease in operating margin is attributable to our planned and previously discussed increase in our investment in our infrastructure that is needed to support future growth.

The company recorded income tax expense of 1.8 million for the second quarter and 3.3 million for the first six months of 2008. The effective tax rate was 20% for the second quarter and 21% for the first six months of 2008. For 2007, the company reported income tax expense of 2.7 million for the second quarter and 4.6 million for the first six months. The effective tax rate reported in 2007 was 28% for both the second quarter and six months period ended June 30. The effective tax rates for both 2008 and 2007 reflect our estimate of our full year tax rate at the end of the second quarter in each year. The reduction in tax rate is primarily attributable to the benefits expected from our new structure related to the company’s ownership of its intellectual property.

Earnings before interest, taxes, depreciation and amortization, EBITDA, or operating cash flow, if you will, was $9.9 million in the second quarter and $16.9 million for the first six months of 2008. EBITDA was $311,000 or 3% lower in the second quarter and $844,000 or 5% lower than in the first six months of 2007.

The make up of our workforce as of June 30, 2008 was 270 people worldwide with 147 in sales, marketing and customer support positions, 83 in research and development, and 40 in general and administrative categories. The average headcount for the second quarter of 2008 was 54 persons or 26% higher than the average headcount for the second quarter of 2007. The average headcount for the first six months of the year 2008 was 55 persons or 28% higher than the average headcount for same period in 2007.

We continue to maintain strong next cash and working capital balances during the second quarter of 2008. As of June 30, 2008, our net cash balance which is defined as total cash less bank borrowing was $42.1 million, a decrease of $5 million or 12% from 47.8 million at March 31, 2008, and an increase of $3.2 million or 8% from 38.8 million at December 31, 2007. As of June 30, 2008, our working capital balance was $66.9 million, an increase of $7.9 million or 13% from $59 million at March 31, 2008, and an increase of $14.4 million or 28% from $52.4 million at December 31, 2007. We had no debt outstanding during the quarter.

During the quarter, our days outstanding and accounts receivable increased to 83 days as of June 30, 2008, from 67 days at March 31, 2008, and from 76 days at December 31, 2007. The increase in DSO was primarily related to the timing of when sales were made in the quarter.

I would now like to turn the meeting back to Ken.

Kendall Hunt

Thank you, Cliff.

Summing up, we are pleased with progress we saw in the business in Q2. Not only did we report a record level of revenues for the quarter, but we also increased our deferred revenues and saw a strong order flow throughout the quarter. The current order flow reinforces our belief that our growth rates over 2007 will accelerate in the second half of the year. We are however reducing our revenue guidance for two primary reasons, one is to more fully consider the impact of our business strategies where a larger portion of our business activity relates to recurring software revenue which may be deferred and recognized in future periods.

The second is to reflect a more conservative outlook for the full year given the uncertainty of the world economies. Therefore, we now project that our full year revenue will grow from 15 to 25% over full year 2007. We expect gross margins to be in the range of 60 to 68% of revenue. And lastly we expect that full year 2008 operating income would be in the range of 20 to 25% of revenue.

This guidance reflects the company’s strategy to continue its aggressive growth by investing in its people and the infrastructure necessarily for longer-term profitability. It also reflects our evolution to a more software centric company with a focus on recurring revenues and in some cases the recording of deferred revenue over multiple years.

Ladies and gentlemen, thank you for your attendance today. I look forward to your participation in the next earnings conference call. At this time, I’d like to open the floor to questions.

Question-and-Answer Session

Operator

Thank you. (Operator instructions) Our first question is coming Daniel Ives with FBR. Please go ahead.

Daniel Ives – FBR

Hey, guys. It feels good to say congrats in the quarter. Just a few questions, so first, can you may be speak to big deals? I mean, you don’t give a backlog number, but how should we thing about the orders, specific deals that are in backlog that are going to be maybe hidden revenue over the next few quarters? Can you just explain about the composition of big deals versus small deals?

Kendall Hunt

Daniel, as the company grows, we are less reliant on the bigger deals than we have been in the past. It wasn’t that long ago that our top 10 customers represented 80% our total revenue for the year. A couple of years ago, the top 10 customers would represent over, just over half. And that percentage continues to go down. Last year, as you may recall, for the first time we didn’t have a single 10% customer. So, I think what you are seeing is just a general growth in the business without a huge reliance on any particular big deal. Jan, you have anything you’d like to add to that?

Jan Valcke

No.

Kendall Hunt

Okay, all right.

Daniel Ives – FBR

Okay. Now, if I think back to the last few quarters, you had a few disappointing quarters (inaudible) now you have a solid quarter, healthy outlook, what’s changed? Because I remember the last call you said that you see things that we don’t, and it is proven it right by the strong quarter. What’s happened in the business over the last three months that I’d sat may be changed or firmed up strong deal for – is it one thing, is it a confluence of things, is it longer deals signatures and you guys have kind of structured the business around them now, can you maybe just give some clarity around that?

Kendall Hunt

Yeah, in the first quarter earnings conference call, Jan and I and Cliff talked about a change in the business from the point of view of authorization or deal approval from the customer’s point of view. It made the sell cycle a little longer, but I think we are probably through that, or getting close to through that. But I don’t see anything unusual with the quarter we just announced. It is just an indication of a strong steady growth of our business, and I think you can expect that going forward. I think that third quarter will be very strong because of the strong order inflow and deals and booking that we did in May and June. You can expect a very strong third quarter.

Daniel Ives – FBR

Okay. Then (inaudible) just a final question, since you don’t give the backlog number anymore, just maybe if you could anecdotally talk about it? When we think about backlog going into say the rest of the year, okay, second half, versus let’s say last year, going into the second half, is the visibility that you on backlog similar, better than it was a year ago, just so we could understand that, because you don’t give that backlog number, just for the rest of the year?

Kendall Hunt

So, the question is, is the backlog, any better, any worse, any different than this time last year. I don’t think so. I think that the backlog always consists of deals that come to us with firm purchase orders. They come in every month, they are typically scheduled for shipments over three or four shipments over the course of 12 months. None of that has changed, really.

Daniel Ives – FBR

Okay, I will just sneak in one last question –

Kendall Hunt

Daniel, could you let somebody else and that’s your fourth question (inaudible).

Daniel Ives – FBR

Actually tax rate, mention it, thanks.

Kendall Hunt

Thanks very much, Dan.

Operator

Thank you. Our next question is coming from Robert Breza with RBC Capital Markets. Please go ahead, sir.

Robert Breza – RBC Capital Markets

Hi, thanks for taking my question. Cliff, maybe one quick question for you is, as we look at the enterprise business, you talked in prior conference calls that the enterprise business tends to be higher price points, can you talk about the enterprise business relative to the bank business as it relates to gross margin, do you see typically better gross margins on the enterprise side than you do the bank side as the banks tend to purchase more volumes, any color there would be helpful. Thanks.

Kendall Hunt

Well, as you recall, Rob, the enterprise security markets are probably 20 basis points better in terms of gross margin than the banking business. We do offer price discounts for large volumes, those large volumes generally do come through banks. So, we have a very wide range of margins when we look at the banking business. But the enterprise security business on the other hand is generally smaller quantities. So, we generally see operating or gross margins on enterprise security 85% and higher, whereas the banking business on very large deals may be in the mid 50s, smaller deals in the banks may be in the mid 60s in terms of gross margin.

Robert Breza – RBC Capital Markets

Great, that’s helpful. I will jump back in the queue.

Operator

Thank you. Our next question is coming from Jonathan Ruykhaver with ThinkPanmure. Please go ahead.

Jonathan Ruykhaver – ThinkPanmure

Hi, guys.

Kendall Hunt

Hi, Jonathan.

Jonathan Ruykhaver – ThinkPanmure

Given the strength you see in both gross and operating margins, what is there in the business mix that causes you to guide below those levels that you reported in 2Q? Is it just the assumption around business activity on the retail banking side?

Kendall Hunt

Well, it’s I think in the press release and then in my comments, we’re cognizant that the world economy is difficult, and it’s probably less predictable than it’s been for quite some time. So, I’d say our actions in reducing our top line guidance is just an intelligent move towards a more conservative look.

Jonathan Ruykhaver – ThinkPanmure

I am referring more to the profitability on operating margin?

Kendall Hunt

Sorry. Cliff?

Cliff Bown

Yes. When it comes to the gross and operating margins, Jonathan, we are still seeing in our order flow large orders coming through in overall revenue volumes and it’s picking up in the second half is likely to come from some of those larger type deals. So, what we are reflecting in both gross margins and operating margins is, A, the potential that the revenue mix in future quarters will be more heavily weighted back toward banks.

Jonathan Ruykhaver – ThinkPanmure

Right, okay.

Cliff Bown

And when it comes to operating margins, where we are continuing to invest heavily in people and infrastructure to support future growth and therefore there too you might see a decline in operating margins as that investment continues.

Jonathan Ruykhaver – ThinkPanmure

Right, okay. And then just final question, in the corporate access market, can you comment on where the strength is coming from, and how are you winning? Is it price, or is there some product differentiation that might be helping in competitive situations?

Kendall Hunt

Jan, would you address that question.

Jan Valcke

Yeah. It is certainly our strategy that is working very well. I will repeat our strategy where we are doing large deployments toward banks. And then marketing wise we are saying to the banks those Digipasses that you have in your pocket that you are using to secure the transaction of your banks, well, they are coming from VASCO. And secondly, VASCO is doing more than just Digipass. So, that is the message that we are putting all the time in the market, and that means that we are increasing substantially our enterprise security sales.

Jonathan Ruykhaver – ThinkPanmure

Okay. So, the strategy is basically that the same as the strategy you used going into bank and retail market?

Jan Valcke

Yes, more vision, but the big difference there is also is and that has also to do with the visibility like comeback lots and so on is that we were running against limits with a number of people, maybe we did a very good job by increasing our head count and that will also profit the company in the future.

Jonathan Ruykhaver – ThinkPanmure

Okay, thanks.

Operator

Thank you. Our next question is coming from Katherine Egbert with Jefferies. Please go ahead.

Kendall Hunt

Hi, Katherine.

Operator

Katherine, your line is live.

I will take the next question in queue. Our next question is from Brian Freed with Morgan, Keegan. Please go ahead.

Brian Freed – Morgan Keegan

Hey guys, thanks for taking my call. A couple of quick questions, first on currency, you indicated that currency had a 6% positive impact on revenue, but a 12% negative impact on OpEx. Given that the euro moved about 14% versus the dollar year over year, I am just trying to figure out why it wasn’t a similar impact of revenue as it was to operating expenses. Could you bridge that for me?

Cliff Bown

All right. There is no easy answer to it, Brian, but the net come of it is that when we do a sale, even in Europe, we have the ability to do it in various currencies. So, some are in euros, some are in Swiss francs, some are in British pounds, whereas our operating expenses is more of a consistent base. The majority of our operating expenses are paid in the currencies of the country in which we operate. And today, our heaviest investment is still in the euro areas. So, you will get a different mix in terms of impact on percentages, because the mix of revenues and the denomination of those revenues is different than the mix of our OpEx and the denomination of what we pay those operating expenses in.

Brian Freed – Morgan Keegan

Okay. And secondly, your tax rate is lower this year, you talked about it briefly, but can you address what your full year tax rate is going to be, and if you see that as a sustainable level long term?

Cliff Bown

Well, under U.S. GAAP we are required each quarter to assess and estimate what our full year tax rate will be. So, the 21% that you see for the year to date second quarter is in fact our estimate of our full year tax rate at this time. Now that tax rate will have sensitivities to the mix of our business where the net profits result. As you know, we have operating losses in the United States, and to the extent that the U.S. continues to operate at a loss, that’ll have a negative effect on our tax rate because we are not able to tax benefit losses in the U.S. Contrary, on the other side of the coin, the higher our revenues, the higher our profits, if those increases are in the European region, with our new intellectual property ownership strategy, it is likely that those will have beneficial impacts on our tax rate, i.e. the tax rate will be lower because those earnings will be taxed at a lower rate. So, we have that continuing mix under U.S. GAAP. We always have to do our best estimate of our full year results, and the tax rate that comes from that is what you see in the quarterly reporting.

Brian Freed – Morgan Keegan

So, that would imply we should be modeling at 21% tax rate for the remainder of the year?

Cliff Bown

That’s our current best estimate of what the tax rate would be. As you saw last year, we did have an adjustment in the fourth quarter because the final mix of our results wasn’t what we had expected and it did result in a slight increase in the tax rate in Q4. We will continue to monitor and update that rate every quarter, but it has the possibility to go both directions depending upon where our earnings are realized.

Brian Freed – Morgan Keegan

Okay. And then my final question, could you quantify to some respect the level of carryover from the large deals that fell into July or continues into July?

Cliff Bown

Actually we can’t. We decided we would not identify the amount or the number of deals. The only thing that I am really comfortable with saying is that we had very strong bookings in the mid and later part of the quarter and that a large amount of that is going to be reflected in July and certainly the third quarter, and the third quarter is going to be very strong.

Brian Freed – Morgan Keegan

Okay. And so if I could slip one more in just related to that, typically you see some seasonality in Europe due to vacations, et cetera, should we assume better than normal seasonality for the September quarter in that case?

Kendall Hunt

Seasonality will continue to play a factor, Brian. But there is really two issues here, one is the current order flow that we have, that will contribute to the quarter’s results. That will be somewhat muted by new orders that may come in in the third quarter and those effects will still be there. So, the real question is, what the net result would be for the third quarter, we can’t say today. We are off to a great start because of the volume orders that came in at the end of the second quarter that will be in the third quarter but the third quarter’s orders will be affected by our normal seasonality.

Brian Freed – Morgan Keegan

All right, thanks.

Operator

Thank you. Our next question is coming from Nick Andrewes with Lazard Capital Markets. Please go ahead.

Nick Andrewes – Lazard Capital Markets

Good morning, guys. Congratulations on a good quarter.

Kendall Hunt

Thanks, Nick.

Nick Andrewes – Lazard Capital Markets

Can you guys just maybe quantify a little bit about the new – the bookings in the quarter versus sort of a year-over-year basis? Is it up on a year over year basis versus Q2 of last year, or do we see a lot of revenue sort of flow into the quarter from pre-existing customers?

Kendall Hunt

Jan, would you answer that question?

Jan Valcke

Yes. The booking are up significantly, but we need to – let’s say the order intake is quite strong like Cliff and Ken mentioned already, and it continues to be very good. At the other hand, I will also repeat here the message of Ken, saying that some of those orders can be put in the fourth revenue for several reasons. That’s part of our business model that we are putting in place. So, I would think that to strengthen here in fact is we didn’t mention it maybe too much today is but we cannot ignore that we are increasing a lot of our software sales, or let’s say over non-hardware business, and that is extremely important for the company and that reflects directly to our gross margin. So, the signs are in fact on all levels very good.

Nick Andrewes – Lazard Capital Markets

Great. Just sort of a follow up on, it sounded like you guys said that what you are seeing in backlog for the third quarter here is directionally up form what you had in 2Q or the previous quarters, is that correct?

Kendall Hunt

Nick, I don’t think we are going to comment on backlog or quantification of those kinds of things, and it does seem to be a recurring question from the group today, so we are not going to comment on quarter over quarter changes in backlog or those kinds of things. I think if you look at our full year guidance which is still for very strong revenue of 15 to 25 % and you compare it to the fact that our year to date is only 9%, that implies that we do expect that the impact of the stronger order flow that we have been talking about, the impact of our increased penetration in the enterprise security market will in fact accelerate in the second half of this year.

Nick Andrewes – Lazard Capital Markets

Okay. So, I guess, just a quick follow-up, should we see some seasonality, the same seasonality from the third quarter to the fourth quarter then as we’ve seen in the past with revenue growth heading into fourth quarter, is that what you guys are planning for, is that what your expectations are?

Kendall Hunt

Well, based upon history, I guess we can expect that the fourth quarter will be a strong quarter. It always typically has been. We’ve had some anomalies one way or the other in some years, but yes, we expect fourth quarter to be strong.

Nick Andrewes – Lazard Capital Markets

Okay, great. Thanks, guys.

Operator

Thank you. Our next question is coming from Sean Jackson with Avondale Partners. Please go ahead.

Sean Jackson – Avondale Partners

Hi, guys. Can you guys hear me okay?

Kendall Hunt

Yes, Sean. We can.

Sean Jackson – Avondale Partners

I want to again talk about the booking strength in May and June, what do you attribute that to? Is it something that deals that you’ve been working on for a while just became closed, or was there a change in the market dynamics that prompted companies to make decisions?

Kendall Hunt

Well, in the first quarter earnings call, we talked about being very optimistic about the rest of the year, and we had a very strong forecast that was maturing, and I think it is just a realization of that strong forecast that we saw 90 days ago that’s happening.

Sean Jackson – Avondale Partners

Okay. Is it fair to say that those strong bookings are leaning more toward the banking segment than the enterprise segment?

Kendall Hunt

Yes. I think that’s true, yes.

Sean Jackson – Avondale Partners

Okay. And one of the metrics that I might have missed on the prepared remarks was the non-hardware contribution. I think you said 23% for the six-month period, what was it for the second quarter?

Kendall Hunt

We didn’t have that in the prepared remarks, but the first quarter I think we announced 20%, the second quarter was 25% of revenue, the average over or the total for the six months was 23%.

Sean Jackson – Avondale Partners

Okay, great. Do you have the number of what it was in the second quarter of ’07 by any chance?

Kendall Hunt

14%.

Sean Jackson – Avondale Partners

All right. Thank you.

Kendall Hunt

Welcome.

Operator

Thank you. Our next question is coming from Ed Ching with B. Riley. Please go ahead.

Ed Ching – B. Riley & Co.

Good morning, guys.

Kendall Hunt

Hi, Ed.

Ed Ching – B. Riley & Co.

You guys talked about online gaming. I know recently you signed basically the market leader in MMORPG world as a customer for authenticating and securing avatars. Can you give us a little color on what you think this market opportunity is going to be? How do you see these rollouts going with this customer and are you talking to any other providers of online gaming right now?

Kendall Hunt

Jan, would you address that please?

Jan Valcke

Yes. I will start with your last question. It’s of course yes. We are the market leader in authentication and it is normal that we are talking with a lot of application solution providers, one being the e-gaming, and it is normal that we are talking with the whole market about it. It is the market of virtual life, it is extremely fast growing, this virtual life stuff I should say. We expect that it is – it will be for us a very glowing business today that I think you can find in the Internet there are already millions of millions of users. As you know, Blizzard, and we can announce that is one of our customers, and I think their game is Warcraft, I am not so specialist in that, but I think you cannot only see it in the U.S., you need to see it on a worldwide level, that is happening. So, yes, we expect that that will be an extremely important for VASCO in the future.

Ed Ching – B. Riley & Co.

Jan, can you comment what the market opportunity is, and give me a number on what your guys think it could be?

Jan Valcke

I can only give you a number out of my head out of the total number of users, and it is tens of million. That does not mean I don’t pay attention, that does not mean that all the users will meet even. they will have a need of having strong authentication. But that is a number and that number is increasing every day. It is only when a user is coming in a I should say in a phase where his kidnapping of his life, his ransom could sound that will be high, or where money involved that really we see the need for today that we see the need for strong authentication, but I cannot give you those numbers of how much as a percentage that is.

Kendall Hunt

I would like to add one more thing. The fact that this customer blizzard decided acquire from VASCO a custom designed product with a logo and with a custom designed face on a physical token demonstrates what I’ve been talking about for sometime although soft tokens have a place in what we do and what we sell. Many of the large banks and now you are seeing the internet based companies like the fact that they have a physical token that they can brand as a part of their service to always remind their customers of the safe attitude, the secure attitude they have towards protecting the identity and assets of their customers.

Ed Ching – B. Riley & Co.

Okay, great. And I think last quarter or fourth quarter you guys had three deals that were delayed, are those all closed now, those three large deals, or are some of them still open?

Kendall Hunt

Well, Ed, we won’t comment again on the specifics of those deals. I think when we said that they were delayed in 2007, we said that they would ship throughout 2008. So, we can’t quantify that specific amount for you. Some of those items have shipped I think probably some are still open to ship.

Ed Ching – B. Riley & Co.

Okay, great. Thanks guys.

Kendall Hunt

Thank you, Ed.

Operator

Thank you. Our next question is coming from Andrew Abrams with Avian Securities. Please go ahead.

Andrew Abrams – Avian Securities

Just characterization if you could, first on the software side, how much impact does the software part have on your lowering your revenue guidance for the full year. Since we are spreading out some of that as opposed to making an actual physical one time sale, does that show up in that deduction? And second, if you could characterize your U.S. business, you know just an attitudinal side from banks and the enterprise side?

Cliff Bown

Well, Andrew, let me talk about the first one, first part of your question, then Ken and Jan can talk about the second part, the U.S. business. But the fact that the accounting rules are fairly precise when it comes to revenue recognition especially for multiple element deals, the fact that we are bundling software and presenting it to our customers on a number of different basis plays a significant role in the reduction of the guidance.

When you look at this quarter for example we reported an overall increase in sales of 9% compared to 2007, but at the same time our deferred revenues increased over a million dollars, approximately $1.5 million, reflecting the fact that we had actual transaction that have we sold them on a basis similar to what we had in the past, that would have been reflected in, or some portion of that $1.5 million would have been reflected in current revenues.

So, as we do go forward, as we continue our strategy of delivering these multiple elements all under one contract, one umbrella, we have to pay very close attention to the accounting rules. When it is a bundled transaction and there are post contract support issues, maintenance support that are bundled in that, we cannot recognize any portion of that transaction upfront under revenue. We have to defer the entire transaction, the token, the software, the maintenance and support and recognize it over the life of that post contract support issue.

So, if it is a one year maintenance, we recognize it ratably over the 12 months, if it is a three year deal, we recognize it ratably over the 36 months. So, part of the reflection in our guidance is understating those better, especially as it relates to our evolving strategies on the software side, and it is a factor, albeit, we cannot quantify it specifically for you.

Kendall Hunt

Jan, would you address the second question, our progress in the United States?

Jan Valcke

All right. Thank you. The progress in the United States is mainly in what is called application solution security and in enterprise security; application security like online gaming, enterprise security remote access and network security. We are progressing there extremely fast in the market. And we are also hiring, or we have hired and we are putting integrating more and more people in our Boston team.

The second thing I would like to highlight in the U.S. is that we see that we as market leader that we are getting more and more recognized ourselves as market leader. And the software vendors, or all vendors in general, are recognizing VASCO as the dealer in authentication, and they want to do business, business that may be will not be reflected right away in sales but that will bring out in the next quarters, months, years, in fact, new bundled products to the market. That is a very successful program that our U.S. people are doing today.

If it comes to the banking, I need to say that corporate banking in the U.S. is business as usual, and that retail banking is nowhere. Well it comes one day retail banking in the U.S., I cannot imagine that the U.S. will still be behind of the rest of the world, if even you see that in Asian markets, even like China and things like that, that they are so fast growing in those new banking applications. But if you ask me today, at the end of June 2008, I need to report that retail banking business is quite slow in the U.S.

Andrew Abrams – Avian Securities

Great, thank you.

Operator

Thank you. Our next question is coming from Fred Ziegel of Soleil Securities. Please go ahead.

Fred Ziegel – Soleil Securities

Hi, everybody.

Kendall Hunt

Hi, Fred.

Fred Ziegel – Soleil Securities

When you started the year, the plan was 100% head count addition, I think we are up 30 through the first half. Is 100 still the number or with the somewhat modified revenue growth or the head count plan is modified as well?

Kendall Hunt

I think Fred the answer is 100 would be the target, we’ve not slowed down our hiring plans at all. As we mentioned in the first quarter call, we’ve hired dedicated resources to do the recruiting. The issue is that with turnover, market conditions being what they are, it is unlikely that we will achieve a net additional of 100. It will be below that for the full year, but that’s still the goal, and we haven’t backed off form a business point of view looking to retire those people.

Fred Ziegel – Soleil Securities

Okay. You always – you sold authentication solutions as a combination of token, software and maintenance, and we are still doing that, but what is changing in terms of the composition of the deals such that a lot of it now needs to be ratably recognized as opposed to upfront?

Kendall Hunt

Under the accounting literature, Fred, there is a term VSOE, we have to have vendor specific objective evidence as to the value of any of the items that have not yet been delivered. So, we can separate the delivered items and recognize those as revenue and defer only the undelivered element based on that VSOE. Historically, what we’ve done in most of our contracts is identify fairly specifically here is the cost of the tokens, here is the cost of the host system software, here is the maintenance and support, and when you renew maintenance and support, here is how you are going to renew it. So, over the history of the company, we have been able to downstate what the value of the maintenance is because we’ve been able to go back to those renewals and say here is exactly what the customers have paid for maintenance on a standalone basis, so that’s created the objective evidence.

As we go forward into our new model, some of the structures are per user per year kind of basis and that charge includes maintenance and support. Under accounting literature, if you have the license and the maintenance for the same terms, you are never able to demonstrate VSOE because the customer is always paying one fee and getting both products, right. So, you don’t have the ability to break out or demonstrate VSOE because he never pays for those undelivered element on a standalone basis.

Fred Ziegel – Soleil Securities

I got it, okay. And is that happening – are those kinds of deals more on the bank side or the enterprise side?

Kendall Hunt

I think we see them on both sides, because again our strategy is to give our customers the most flexibility in designing their systems the way they need it for their customers. So, as you know, we’ve got over 50 different types of products we can put in the hands of the consumers, and that allows with our host system software VACMAN Controller to use any of those different models simultaneously. So, they can make decisions on a person who doesn’t need a lot of security for one model all the way up to somebody who needs a lot of security and they use a different model. So, we are still customer driven, and the decision on how we bill it, how they use it, is still in large part driven by what they need. So, I can’t say it is just us, but it is a combination of both sides that will drive that.

Fred Ziegel – Soleil Securities

Last question, on the gaming side in Blizzard, specifically the last time I looked into it, I guess, a couple of days ago, they are and have been sold out for a while, where do you guys stand in terms of shipments to them?

Kendall Hunt

We – as you indicate, they did sell to their end customers the original order and additional order has been placed on VASCO to manufacture more.

Fred Ziegel – Soleil Securities

Okay, so work in process then?

Kendall Hunt

Yes.

Fred Ziegel – Soleil Securities

Okay, thank guys.

Kendall Hunt

Sure. Operator, we have time for one more call, one more question, I should say.

Operator

Not a problem, sir. Our last question is coming from Scott Zeller of Needham & Company. Please go ahead.

Scott Zeller – Needham & Co.

Thanks. Regarding the increase in DSO, it seems to point to backend loaded linearity, but with the commentary about improved visibility, can you just help us understand these two forces?

Cliff Bown

Your interpretation is correct and it is consistent with my comment that a large percentage of the deals happen in the last month of the quarter. Overall, in terms of linearity we have good visibility, but that doesn’t necessarily mean that the customers are wanting the product on an equal basis throughout the quarter. So, while we see what the orders are, we know when the customer wants the delivery. Our just in time philosophy requires us really to deliver when the customer wants it, so I don’t think the two necessarily go together. When we have the visibility, we know that generally we are going to have many of the shipments in the last month of the quarter and when you look at the variability and our DSO 83 days in this particular quarter, 67 days in the prior quarter, that itself is more reflection of how the transactions did occur during that specific quarter.

Scott Zeller – Needham & Co.

Okay. Can you tell us the size of the largest deal in the quarter?

Cliff Bown

We cannot tell you that. We can tell you that the quarter had two customers that were more than 10% of our revenue. On a year to date basis, we still have no customers that are more than 10%.

Scott Zeller – Needham & Co.

I am sorry, can you repeat that again?

Cliff Bown

On a year to date, June 30 ’08 basis, we have no single customer that represented 10% of our revenues. For the quarter, however, we had two customers that were 10% of our revenues or more. And consistent with our prior discussion, our business is a little bit lumpy. We do ship to the customers when the customers require based on their rollout structures, so in this particular quarter we had two customers that had heavy rollout schedule.

Scott Zeller – Needham & Co.

Thanks very much.

Kendall Hunt

All right. In conclusion, hopefully you’ve got the message that management expects a strong third quarter and a strong last six months of the year. We will assess where we are at the end of the third quarter and assess the position of our guidance at the time.

At this time, I want to thank everybody for participating in the call, and as always I want to thank VASCO people around the world for their hard efforts and their execution and everybody have a good afternoon.

Operator

Thank you. This does concludes today’s conference call, you may now disconnect.

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Source: VASCO Data Security International, Inc. Q2 2008 Earnings Call Transcript
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