Diebold, Inc. (NYSE:DBD) Q2 2016 Results Earnings Conference Call July 28, 2016 8:30 AM ET
Stephen Virostek - Vice President, Investor Relations
Andy Mattes - President and Chief Executive Officer
Christopher Chapman - Senior Vice President and Chief Financial Officer
Gil Luria - Wedbush Securities.
Matt Summerville - Alembic Global Advisors
Arun Seshadri - Credit Suisse
Joan Tong - Sidoti & Company
Kartik Mehta - Northcoast Research
Justin Bergner - Gabelli & Company
Saliq Khan - Imperial Capital
Umesh Bhandary - Jefferies & Company
Good day, everyone. Welcome to the Diebold, Incorporated Second Quarter 2016 Financial Results Conference Call. At this time for opening remarks and introductions, I would like to turn the call over to the Vice President, Investor Relations, Steve Virostek. Please go ahead, sir.
Thank you, Leanne and good morning everyone. Welcome to Diebold’s second quarter earnings call for 2016. Joining me today on the call are Andy Mattes, President and CEO; and Chris Chapman, Senior Vice President and Chief Financial Officer.
During this webcast, we will refer to slides, which are available on the Investor Relations page of diebold.com. A discussion is being recorded and a replay of the webcast will be made available on the website later today.
Our comments will focus on results from continuing operations unless otherwise noted. For slide number two of the presentation you can see our discussion will include certain non-GAAP financial measures, which we believe are a helpful indicator for measuring the company’s baseline performance. We have provided a reconciliation of these metrics to the respective and most directly comparable GAAP metrics in our supplemental materials.
Slide three contains a reminder that there is certain comments today may be characterized as forward-looking statements. There are a number of factors that could cause our actual results to differ materially from these statements. You may find additional information on these factors in the company’s SEC filings. Please keep in mind that forward-looking statements discussed today are current as of today, and that subsequent events may render certain information out of date.
The purpose of slide four today is to bring to your attention the Company’s Form S-4 registration statement and offer document, which we have filed in connection with Diebold’s offer to acquire all ordinary shares of Wincor Nixdorf. These documents are available for your review on the diebold.com website.
And now, I’d like to hand the call over to Andy. Andy, you are facing a summer cold today.
Yes, just in time. Thanks, Steve. Good morning and thanks to everyone for joining us today. We delivered solid second quarter results, highlighted by continued services revenue growth, improved profit margins and strong orders led by activities in the Americas.
These results are a good springboard for the second half of 2016. Looking at the activity by region, Asia Pacific continues to be almost challenging region due primarily to the Chinese governments by [ph] local not mandate on IT product. To a lesser extent, top line results were also affected by slower decision making in India as financial institutions digest the recent changes to government regulations.
Excluding the effects of currency, total revenue decreased 18% in the region and FSS orders declined more than 20%. To re-establish sales in China, we are preparing to launch our joint venture with Inspur, an $8 billion IT services company. The joint venture has received national approvals and we continue to work through local approvals while we are also preparing to transfer manufacturing and other assets to a lower cost location.
In Europe, the Middle East and Africa our account focussed strategy continues to drive good performance. Total revenue increased 4% in constant currency led by strong services growth from installation activity in Europe. This is the sixth consecutive quarter of constant currency revenue growth for the region.
We have delivered growth and increased our operating profit margin from 13.3% to 15.2% year-on-year. Orders decreased more than 20% in constant currency during the quarter due to a challenging comparison with the prior year and the timing of a few large deals which slipped out of the quarter.
Overall, the market environment in EMEA remains favourable for our industry as banks continue to automate their branches and improve their operating efficiencies. For example, in Italy we won a competitive bid at Banca di Asti to provide advanced feature, in-lobby ATMs along with a three year service contract.
Moving to North America, FSS orders increased more than 20% in constant currency due to strong activity on both sides of the border. For example, we signed a 5-year contract with the Canadian Credit Union Association to advance branch automation with 1200 ATMs supporting software and maintenance services.
What we like about this order is that it demonstrates the relevance of branch transformation for financial institutions of all different sizes. In addition, we booked an order with a top three bank in the U.S. to deploy more than 3000 of Diebold’s next generation ATM as this customer seeks greater operational efficiency through automation.
These wins add to our growing product backlog which improves our visibility on the second half. In Latin America, FSS orders increased more than 50% in constant currency, primarily driven by wins at three large accounts in Brazil for more than 4,500 ATM. The largest contributor was Banco do Brasil, the largest financial institution in Latin America which ordered more than 3500 terminals equipped with our latest biometric security readers and new field [ph] communications.
In addition to the robust product orders, we were awarded a two year service contract for more than 4000 ATMs with Brazil’s largest private financial institution. So after several challenging quarters in Brazil we are encouraged by the strong activity in this country, despite the economic and political challenges in this region, our customers are seeking new ways to improve service levels and reduce operating cost through branch transformation solution.
Further evidence of the success of our services strategy in this region is our recent multi vendor services within Colombia for 1200 ATMs. Looking at our global services business, we continue to grow by delivering on our multi vendor and managed services win. Services revenue grew 4% in constant currency inclusive of FSS services revenue growth of 5%. We continue to make progress towards our goal of shifting the mix of revenue to more services and software as we continue to execute on transforming Diebold to a more services led software enabled company.
In aggregate, the mix of services and software revenue has increased from 57% in 2013 to 66% during the quarter. Just as encouraging as our progress in becoming a more services led company is the growing market acceptance of our software offering. Ten new multi vendor software contracts during the quarter are evidence that we are gaining traction in the market. We are seeing continued success with regional banks in the U.S. we are looking towards the advanced capabilities from branch transformation as well as the ability to upsell new financial services to their customers.
Additionally, it is encouraging to see opportunities in new countries such as India where we have launched our first Phoenix software project. Since acquiring Phoenix last year we have added nearly 20 new logos and doubled our pipeline of opportunity.
Despite our top line being down in the quarter, our cost mitigation action boosted the company’s profit margins. We delivered a 20 basis point improvement to our non-GAAP operating margin and a 40 basis point improvement to our adjusted EBITDA margin when compared with the year ago quarter.
Looking at our outlook for 2016 we expect a much stronger second half to result in full year revenue being flat to down 2% as reported and flat to up 2% in constant currency. Our second half revenue projections are under pinned by a strong product backlog which increased by nearly 20% year-on-year.
Turning to our profitability metric, the results from our recent cost actions support our full year targets for adjusted EBITDA and non-GAAP EPS from continuing operations. Before closing and in the spirit of the Pro-Football Hall Of Fame activities which are kicking off here in Canton, I am pleased to report that we are nearing the goal line with our pending acquisition of Wincor Nixdorf.
On the regulatory front, we have received anti-trust clearances from all but one country, Poland that is required to close the transaction. Over the past few months, teams from both companies have been diligently developing integration plans and we are confident that we will hit the ground running. The excitement is definitely building as we prepare to double the size of our company.
We are eager to begin the integration of our two companies and together offer our customers the broadest solution set in the industry. And with that, I’ll turn the call over to Chris.
Thanks, Andy, and good morning, everyone. I will focus on our results from continuing operations unless otherwise noted. The impact of the divested North America electronic security business is included in the income from discontinued operations net of tax line.
Starting on slide 10, total revenue declined 10% as reported or 7% in constant currency for the second quarter. Currency headwinds impacted total revenue by approximately 3%. Excluding the impact of currency, growth in our services business in North America and EMEA was more than offset by lower hardware volume in emerging markets and North America.
Looking at constant currency, FSS revenue declined 11% while security revenue decreased $3 million or 4%. The decline in security was primarily related to lower volume in the Latin America electronics security business.
Brazil other revenue increased approximately $14 million year-on-year due to increased election system sales. Looking at regional segments in constant currency, EMEA revenue increased nearly 4% with double digit improvement in service revenue partially offset by a decrease in product revenue.
Asia-Pacific decreased 18% with continued market challenges in China and India. While Latin America decreased approximately 6% largely due to declines in the Brazil FSS business. North America decreased approximately 8% reflecting the cyclical nature of large project activity which was partially offset by strong growth in our services business.
Moving to slide 11, total gross margin was relatively flat in the quarter at 27%. Service margins increased 50 basis points to 34.4% primarily due to higher utilization rates to North America more than offsetting the headwind from declining product installations.
Product gross margin decreased 320 basis points to 15.3% which is primarily the result of our account changing business model in China as well as lower volume in North America that carries a higher margin.
Turning to slide 12, total operating expense decreased $14 million or 10 basis points as a percentage of revenue compared to the prior year period. The decrease is the result of our focus on cost reduction actions, lower reinvestment levels and variable selling expense.
On slide 13 our operating margin was 5.8% for the quarter reflecting a 20 basis point improvement year-over-year. Non-GAAP operating profit in the second quarter decreased approximately $2 million from prior year impacted by lower product revenue and product gross profit. This was mostly offset by improved performance in our services business and lower operating expenses.
In the second quarter, non-GAAP adjusted EBITDA was $53.9 million or 9.3% of revenue compared with $57.5 million or 8.9% of revenue in the prior year. Looking at operating profit in the second quarter as reported by segment on slide 14, North America profitability benefited from the continued expansion of our services business and cost reduction actions as operating margin increased approximately 80 basis points year-over-year. The prior year comparisons include project activity related to a large Canadian FSS rollout and Window 7 upgrade activity.
Asia-Pacific operating profit decreased $8 million due to the structural change to the market in China and lower activity in India. In EMEA, profit grew $2 million as we have increased our service volume and expanded margins.
In Latin America, operating profit was up, driven by lower operating expense which reflects the benefits of the cost actions executed in Brazil as well as increased activity in Mexico. The global and corporate line reflected lower spend of $7 million or down 9% versus the prior year as a result of lower reinvestment levels and continued cost actions.
Turning to the EPS reconciliation on slide 15, I want to first note that the restructuring and non routine items as shown are based on gross amounts before tax reflecting the recent SEC interpretations of non-GAAP presentation. This also requires a single line for the tax EPS impact for restructuring and non routine items as a reconciling item in the table.
The non-GAAP EPS from continuing operations was $0.43 for the quarter. Non-GAAP EPS excludes non-routine expense of $1.01 which consists of $0.60 related to M&A costs, $0.05 of legal and professional fees and $0.36 primarily related to the mark-to-market impact of the company’s foreign currency contract associated with the Wincor Nixdorf acquisition.
Additionally, we incurred $0.08 of restructuring expense primarily tied to additional actions we have taken to North America and Brazil. The tax benefit for restructuring and non-routine items inclusive of allocation of discreet tax impacts was $0.33.
During the quarter, the non-GAAP effective tax rate from continuing operations came in at 17.6% and brings our year-to-date rate to 25.6%. Moving onto slide 16, our results reflect a $97 million free cash use from continuing operations for the second quarter which includes approximately $23 million of payments for acquisition related expenses.
Looking at the year-over-year variance in addition to the acquisition related expenses, the results largely follow are normal seasonal pattern which reflects an increased manufacturing and finished goods inventory to support second half backlog. Also, we have seen steady improvement in collections in North America as the quarter progressed.
Turning to slide 17, DSO increased 12 days to 70 days in the quarter versus the same period last year primarily due to higher accounts receivable balances in North America. Inventory turns decreased to 3.9 turns compared with 5 in the second quarter of 2015 reflecting an increase in service parts required for the growing North America service business.
Additionally, we had an increase of finished goods primarily to support installations in Latin America. Net debt shown on slide 18 was $128 million, a decrease of $157 million from year end 2015. The decrease in net debt is largely attributable to the proceeds from the divestiture of our North America Electronic Security business partially offset by a free cash use in the year.
Moving to slide 19, we introduced this slide last quarter and think it is worthwhile to revisit again. The new capital structure currently has a blended interest rate in the mid 5% range which is in line with our original expectations. Based on the strong interest and the debt offering we are able to upsize the euro portion of the Term B loan and reduce the high yield offering by $100 million. The high yield notes and Term B loans funded in the second quarter and are being held as restricted cash.
As we noted last quarter, there was approximately $20 million of additional interest expense in the second quarter tied to the deal financing which was excluded from our non-GAAP results. This will increase to $30 million in subsequent quarters.
Given a large euro [ph] denominated exposures related to the Wincor Nixdorf transaction the company executed a hedging strategy to limit our purchase price exposure. The original cost, the hedging contracts was approximately $60 million.
During the quarter, we sold our original foreign currency option contract and locked in a net gain of $42 million. We subsequently entered into a foreign currency forward contract which limits our purchase price exposure to approximately $15 million.
Lastly, as you saw with our announcement on July 19, we declared a third quarter cash dividend of $28.75 per common share. As previously disclosed, the company intends to reset the annual dividend to approximately one third of Diebold’s current level following the close of the Wincor transaction. This change will allow for greater flexibility to pay down debt and reinvest to support the long term growth of the business.
Moving to slide 20, we are maintaining our 2016 revenue and earnings guidance. We continue to expect full year revenue to be flat to down 2% as reported or flat to up 2% in constant currency. Adjusted EBITDA is expected to be in the range of $220 million to $235 million for the year with depreciation and amortization around $60 million and share based compensation about $20 million for the full year.
Earnings per share on a non-GAAP basis is expected to be approximately $1.45 to $1.60 with an effective tax rate of approximately 28% for the full year. Based on analysis of the backlog the majority of installations will take place in the fourth quarter and therefore second half EBITDA and non-GAAP EPS should be roughly split 30% and 70% between the third and fourth quarters respectively. The continued stability in our services business combined with growth and product backlog puts us in a position to deliver on our full year expectations.
Finally, our free cash flow outlook remains around $150 million for the full year. This outlook is inclusive of our identified restructuring and non routine expenses but does not include the cash tax impact tied to the gain on the sale of our electronic security business or expenses related to the combination with Wincor such as the additional interest, legal and integration costs.
Before I open up the call for questions I'd like to highlight the timing of our financial reporting we will likely see in the third quarter. Assuming the Wincor Nixdorf transaction closes during the third quarter, I would expect to report our results in mid-November.
Wincor will be completing its fiscal year-end closed and we will be consolidating the results for partial quarter, which will include impacts of purchase accounting and conversion of IFRS to U.S. GAAP for example.
With that, I'll open the call for questions.
Thank you. [Operator Instructions]. And we'll take our first question from Gil Luria with Wedbush Securities.
Yes. Thank you. Results were in line and it sounds like that the results from Wincor were very good as well. What's your level of concerns about your competitor going to your customers and talking to them about, and uncertainty about the product path and one of the products being eliminated? Is it something since the deal has taken a few months to close? Is it something you think your customers are concerned about or sharing that concern with you?
Actually, Gill, our customers are extremely excited rather than coming to us with question of which portfolio to go forward with. They're coming to us with wishlist of hey, now that you're going to double the amount of engineers that you have and you have so much more R&D and innovation power, we would like you to do the following things for us.
So, we have quite a few conversations with customers, where say, look, we're really excited to sit down with you and watch you through the complete rest offering, all the services we got to offer and the portfolio enhancements going forward. So, if anything excitement is building within the company, but its also building on the customer base.
That's great. And then Brazil, it sounds like that's the first bit of good news we've gotten from Brazil in several quarters. It's been a multi-quarter deterioration. Are these deals and contracts and rollout that you're going to have just things that have been postpone for a long time or do you think the Brazilian market has finally stabilized and you can have a little bit better visibility going forward?
I think in general and I think you can see that even if you take a look at what's happening at the Brazilian index these days. The attitude in Brazil is starting to be a little bit more optimistic. It's probably a combination of both, Gill. Some of the contracts have long been in the making and they finally got over the finish line in Q2.
Other things are new, the one that we're really excited about is the fact that we're back with the largest private bank in Brazil with the service offering. And that's huge, because for a multitude of reasons we were locked out of that account for quite a few years. Now that they are free to decide their own destiny going forward. The first thing they did is they picked up the phone and call Diebold back in. So, we're really thrilled about that.
I want to say, I'm very, very, very cautiously optimistic that we will see Brazil not to be a drag as much as it used to be in the past. Especially if you take into consideration that Octavio [ph] and his team have done a really nice job and taken cost out. You recall Q1 was the first quarter where Brazil was not a burden to the P&L in a long time. Now Q2 is the first time we see them showing up with massive orders. So the future is starting to look a little brighter down there, but it's too early to call it a trend.
That's great. Thank you very much.
And we'll take our next question from Matt Summerville with Alembic Global Advisors.
Thanks. Good morning. Similar questions just on North America, I mean, is that your sense Andy, is just a one quarter phenomenon, just really the beginning of a longer term wave as we think about branch transformation. I guess at the end of the day my question is around sustainability of the path you saw in Q2? And then maybe if you can differentiate the big banks versus the small banks and provide color on that that would be helpful?
Matt, this goes back to what I was trying to say in the call a quarter ago. We see in the developed markets, we see an uptick on branch transformation, we see an uptick in more complex solutions, and we see everything turning into a project. And what you will see is you'll see quarters where the orders numbers will underwhelming and then you'll see quarters like this were a few of the projects happen to hit in the very same quarter and then look very exciting.
So, there's going to be peaks and valleys, but the underlying level of discussion, the level of embracing the technology is very encouraging. And if you take a look at what's happening in Canada, that to me is a very good bellwether because here's an economy that truly got impacted by what's happening to commodity pricing around the world. And the next logical things was that the financial institutions then say, you know what we – we got to get smarter in the way how we deliver services to our customer and we got to get to offer rational improvement, hence they were embracing new technology. Once you see the credit unions who are normally trail blazing on rolling out the technology to be one of the first to embraced branch transformation is extremely encouraging. So, I'm pretty constructive on North America going forward.
Got it. And then just as a follow-up, more of a question around free cash flow. When you look at your networking capital, when I did the calculation quickly as a percent of revenue, its like approaching 30%, and you know, I don't know how to describe it, that just not a good number. So where Chris can you get that? How quickly and how do you hit your free cash flow guidance this year?
Matt, the first comment I would make when you do that calculation especially given the forward looking nature of the build and the inventory to drive the second half revenues you really have to look at that, that percentage of networking capital on an annualized revenue basis to get little bit feel. We typically run around 19% to 20%, that's the mark we should be at and then drive lower than that.
If you look at the second half and the path that we see to the overall cash flow generation, number one, its going to be based on the stronger second half earnings, obviously cash flow is always underpinned by your strong GAAP earnings. Number two, from an AR standpoint we see the balance going down into the 40 range from a DSO standpoint.
We have made progress in North America. We talked about the ramp and the overall getting the invoicing caught up that occurred in Q1 really peaked in March, April timeframe. And then we've seen that following with our collections where that ramp every subsequent month after that peak in the overall billing. So we see those collections coming back in and obviously that's going to be a critical piece to underpin the second half and in the last component that I've already hinted out there little bit, we're going to see the inventories that we build right now for a lot of this project activity is going to get worked out of the system as we're driving the stronger second half revenues.
Does that mean free cash flow in Q3 on the heels of of better collections is positive or do we still have to wait for that giant chunk to come in Q4?
Yes. I would caveat out this excluding for the interest expense and deal cost and the cash tax on the ES sale gain which some of that will come through in the third quarter. Those items we've been excluding from the overall projections obviously, but we are expecting to show a nice improvement in the third quarter over the second quarter.
Got it. Thank you, guys.
And we'll take our next question from Arun Seshadri with Credit Suisse.
Hi. Thanks for taking my questions. Could you update us in terms of standalone cost savings program? I think we saw a pretty nice year-over-year OpEx reduction in this quarter. Just wanted to understand was any of – is any of the $15 million targeted for 2016 part of it? And then any updates in terms of any additional cost saving possible on a standalone basis?
Yes. With regard to the overall Diebold 2.0 cost savings program, we had targeted an additional net savings this year of $15 million. We're clearly on track with that. You see that coming through the numbers. As we also talked about in the first quarter based on the slow start and were some of the volumes we're at. We've been taken additional cost actions which you also see those showing up in the op expense line, but also now when you look at the service margins we continue to see overall benefits there as we leverage our service operations globally and so that's the combination of the growth plus the continued efficiencies that we're trying to gain....
Got it. Thank you. And then as far as some of the comments you made in the prior quarter in the financial self-services side, you know, India being one of the region where decision making was continuing to take longer than expected. Any color in sort of how that's progressing right now?
If you take a look at what happened in India is the government get a little bit ahead of its skies. Release too many banking licenses and then people had to sort their way out, now that they had all these banks, what to do with them and how to turn them profitable. I think the country is working through it. We start activity on the pipeline front to increase. How soon that will manifest itself in actual decisions being taken, it's probably a little too early to predict.
Got it. Thank you. Last question from me. Just another follow-up on the free cash flow side of things. Did I hear you right that you think on a sort of adjusted basis the Q3 could be positive free cash flow? And then if you could also on the second quarter free cash flow number, I think you said $23 million of the sort of year-over-year compare was related to M&A fees. Was all of the balance in terms of the year-over-year compared with last year, all related to the inventory build?
Yes. The answer to the latter question first. If you look at the year-over-year change, you've got the inventory increase, it’s a big portion of it, and there still some pent-up cash flow sitting in the AR balance, that's primarily tied to North America. So those are the two big pieces that are driving little bit of the higher use year-over-year, it’s the inventory in the AR from what we've seen there.
With regards to the third quarter adjusting for the items that we've talked about, we are looking in a positive area of improvement quarter-on-quarter. Clearly you're going to driving that as hard as we can to maximize the performance as we go forward.
And we'll take our next question from Joan Tong with Sidoti & Company.
Good morning. I have a question regarding the conditions in EMEA. Can you just give us a brief overview in terms of what you're seeing there? Any impact, potential impact or your view on Brexit -- regarding Brexit in the Eurozone?
That's great question, Joan. As you know the Brexit decision was a few days prior to the end of the quarter, so the quarter is clearly not impacted by any of this. So far we don't see any impact on our solution portfolio as much on sometimes we regret it. It's not an imposed by decision type of thing. And whenever a market gets under additional pressures as I pointed out earlier in Canada then people look for new ways to improve their bottom line, to improve their services and to even offload some of the activities that they have.
So, we see Europe as a fertile hunting grounds going forward and it might indicate a little shift from the product to the services side, but that's still too early to call, but from a level of interest its all very, very at in.
Okay. Thank you. And then questions regarding regional bank, Andy, is most of the activities you are seeing right now in North America, it's more like on the big national bank side. And if I were look at the regional bank upgrade cycle, is there – it was upgrade cycle in the past. And what's your view like in terms of like you know they are being – they will being more active going forward?
Now you got to be country-specific, Canada the regionals are very active, so we see that. And it shows up in our order book. In the U.S. it’s still more tilted towards the large accounts, but we see interest starting to take up on the regional front and you can see it with the software wins that the regionals that the credit unions are really taking a look at how we can provide new services to the community. And I'm extremely encouraged with the multi-vendor software deals that we were able to place this quarter. And many of them were actually with credit unions. So, relatively small institutions who want to make sure that they include innovative technology into their offerings going forward.
Okay. I'm just wondering because last time it seems like they had a major upgrades cycle, it was back in 2010 and you would think that every six, seven years they're going to start like you know looking into new technology, new product, so we are pretty much around the corner. Is it the right way to think about it or we are still probably a year or two years like before these activities pick up. Thanks for color anyway. So, just want to get a sense in terms of the timing?
I would agree with you that we're a lot closer to it than we were a few years back. When it's really going to happen, the Jury is out, the rate discussion will have some impact on it as you know we are on the opposite side of the rate discussion for our customers. If interest rates goes up our customers have a wider spread that usually a good when it comes to additional investment.
So, whether it’s a year out, whether its 18 months out, whether its 24 month out, I think it’s a little too early to call. But I agree with your underlying thesis that we're approaching a point in time, we're in regional upgrade cycle ought to come back into the picture.
Thank you for the answer. And then finally is on the JV, you said that you closed the JV. You are now preparing to launch it. And are you still looking at the timing like in terms of having some sort of business impact and offering impact its more going to be more like a 2017 event?
I assume you're talking China.
Yes. Exactly, China JV.
Joan, I've long given up to predict cycles of government agencies when certain things will get improved. The big milestone in China was the markdown [ph] approval that's in the [Indiscernible] but also as you very well know, market prices in China have gotten extremely competitive. So, we want to make sure together with our friends [Indiscernible] that the JV has a very positive launch. So, we're working very hard in ways to reduce the cost of our products and our solution which includes relocating the factory from Shanghai to one of the new government related zones and there local approvals required and we just going to work our way through them. I would hope we'll get them done sooner rather than later, but that's not for us to influence.
Okay. All right. Thank you for the answers.
And we'll take our next question from Kartik Mehta with Northcoast Research.
Hey, good morning. Chris, I was hoping that you could maybe provide a little bit more thoughts on second half in terms of EPS cadence. I know the quarters are little bit hard to predict now, because they were large orders that you and Andy have spoken about. So, any type of color you could give on what you anticipate through the second half would be helpful?
Yes. As we outlined we're looking at from an EBITDA and ESP standpoint for the second half basically a 30/70 split between Q3 and Q4 as the project activity starts to ramp up. I think two other key items to know that we have talked about historically obviously you get a little bit of below in Europe in summer time and so that typically impact the third quarter performance. And we've also already highlight multiple times here the impact that China is having, so clearly the overall performance in Asia when you look year on year is going to be down.
And if you look at where the current performance is at you know its little more of an indication of what you would expect for Asia in Q3 as well. So those are two areas that would be a bit of a long third quarter.
Andy, speaking of China and JV obviously Wincor has a JV. They've talked about, you have one. Thoughts on how you could manage both – or you allow to keep both or you allow to walk away from one. Thoughts on potentially having two JVs once you combined?
Kartik as you very well know I'm not at liberty to publicly talk about any of the Wincor activity. That's going to be an area that we will give more clarity on after we've consulted related companies.
And once you combined with Wincor do you think there will be greater predictability in quarters right now obviously orders can fluctuate and as you've said you have some peaks and valleys. Do you anticipate that changing with Wincor or just because it is industry, do you think that the predictability will stay it difficult?
Well, look, our industry is not going to change just because we will combined with Wincor, nevertheless there is a benefit in a larger number and usually when you take a look at North America and Europe and if you were to draw the curves they don't swing in unison, usually they kind of offset each other, so that will help.
What would definitely help is if you keep in mind that will be roughly $3 billion in services. And you get the amount of recurring revenue its going to go up. The currency hedging between dollars and euro you would assume is probably going to balance itself out a little bit more, because everything that you do especially in the service side and the hedges itself. So, I would expect it to be a little less volatile on the numbers, but the market is what the market is.
And then just one last question Chris. Past you've had some issues with ERP and that impacting free cash flow. As you stand today most of the billing issues behind your or are all the billing issues behind you, or is there still things that you need to work out to get the ERP system working as efficiently as you would like?
No. The bugs and kinks in the system, we work through those in Q1. As I noted we really peak on catching up on the service billings in that March, April time frame and now is just the matter of just working through the collections process. Obviously, when you have aged invoices and you have the size of the backlog that we build up in those, it takes a little more time to work through with our customers. We have been doing that. We're not seen higher write-off activity or bad debt and it just takes a little bit more to work through those with our customers which is what we've been doing and seeing the progress.
Perfect. Thanks, Chris. I appreciate it.
And we'll take our next question from Justin Bergner with Gabelli & Company.
Good morning, Justin.
Hi. First question is just on the merger, could you take us through again it came pretty quickly in terms of the hedging gains in the quarter and just any other updates that you can provide on the Wincor transaction as we move towards the targeted summer close?
Yes. Let me start off now, I'll let Andy talk about the timing of the close here. Specific to the hedging strategy, when we entered into the agreements back in 2015, we had a very large portion of the overall transaction not understanding the full amount that we're going to have in terms of share is tendered. And having a basic understanding but not a full understanding of the full euro exposure, and so at that point we entered into a hedging strategy that was essentially hedging 100% of the overall tender offer.
As we move forward and we saw the results of the tender offer, we saw where the euro was at, we were able to update and move forward with our hedging strategy, we locked in a gain, and that gain year to-date or like the date on that original contract we've outlined. And so we ran that piece through and then we entered into a forward contract and then lock in any remaining exposures that we have.
And so, if you look at the net $15 million that we've talked about you have the gain that we've locked in and then you have the cost of the forward contract and the movement that you have in the ultimate euro that are lock in the ultimate purchase price of the overall transaction that we have.
And from the timing point of view, Justin, we're pretty optimistic that we'll stick to the timeline that we've outlined from the very beginning. We're down to one country approval which is a condition for the close which is Poland. The good news is we had to go through 11 countries, 10 out of 11 we got now in the [Indiscernible] and not a single one of them that we get any onerous or painful stipulations from the regulatory authorities, but these countries go to their own processes and it’s a process whether its for a small number or whether its for a big numbers, it just got to work your way through.
We're pretty sure that Poland is going to be any difference than the previous 10. So we don't expect any major hiccups. And as soon as we've got the Polish clearance we will then take the next step and go to closing.
Okay, great. Just a quick clarification. How large is the gain and is that effectively increase your cash line?
The gain was realized, that was approximately $50 million and so that is locked in. So if you look at it from an overall cash flow that is a realized gain than you have the mark-to-market impact on the current forward that is not realized, obviously that's going to move up until the point that we then finalize that forward contract. We're at the closing of the deal and so that benefit would run through the overall cash flow not operating but the overall cash flow of the company.
Okay. So, that's why your GAAP EPS not affected. Further revise guidance I guess the hedging income didn't go up?
Yes. You have multiple pieces moving there, so you have the gain portion coming through and then you have the mark-to-market impact. A portion of that gain was also from an income statement standpoint was recognized as it was re-measured at the end of 2015. You have a portion of the gain that was in 2016 and you have a portion it was in 2015 that gets to the full contract, the date, amount that was ultimately recognized.
Got it. Thanks for that clarity. One more big picture question, it looks like your service revenue on the financial side has run close to 5% in each of the first and second quarter. Are you expecting that year-on-year growth to pick up in the second half as you hopefully reach your constant currency financial service target or is it all going to be from the product side delivering in the second half versus the first half?
Well, if you take a look service there's always three elements to service. There's Break-Fix, there's the Managed Services and there's the Installation Fees. So I would expect Break-Fix and Managed Services to continue on the trajectory that they're on which is steadily improving. And needless to say the more products we install you would also see an uptick on the installation side of the services house.
And as you also know every hour that we can build a service technician translates into margin – being margin accretive. So higher utilization is usually a good thing for a service workforce, so we're very encouraged on the services front, but the important thing is we're very encouraged and that what you see in the first half that the recurring monthly revenue is trending up, its consistently trending and that's a clear result of the managed services and the multi-vendor service contract strategy that we've embraced the wins that we had last year and of course the wins that we also getting this year.
Okay, great. And then should we expect some sort of sequential pressure on gross margin as product becomes a larger part of the mix versus service in the second half?
Yes. As you bring forward in the third quarter for example, you have little bit of that higher hardware revenue, you would have a little bit of dilution impact in the overall total gross margins, but our continued performance in the service and improvements in the service margins help to offset some of that and lot of that comes down just to the mix of revenue we have as well. As North America and Latin America we run a little bit higher volumes there, helps out more Asia, obviously that single digit type of margins and it improves a bit.
Okay, great. Thanks for taking my questions.
And we'll take our next question from Saliq Khan with Imperial Capital.
Hi, Andy. Hi, Chris.
Hi, Saliq Khan.
Guys, I think, the vast majority of my questions have been answered, but I have two real quick ones. First one is Chris given the lower reinvestment risk or reinvestment rate that you talked about earlier, it does improve your overall operating metrics in near term, but does that impact your competitive position, your ability to improve your tech-enabled solutions?
Now a lot of the reinvestment we have were foundational items that we have talked about, our IT systems and also updating and moving to a new hardware line which we hadn’t upgraded in a long time, a lot of that work has largely gone forward. We have those solutions out in the market and so we are not trying to be penny wise pound foolish here and hurting the long term business. We are really taking out some of the investments that were foundational items that we did before and we are trying to be very measured as we look at the combination in front of us as well.
Let me just add to that. For the last two years we’ve been talking about a total curve on the reinvestments. We had to do some stuff that were neglected for a long period of time, we invested the money. I’m actually very encouraged to see that it’s always easy to throttle forward on the spend side and we are very encouraged to see that the throttling back part of it is working just as well as the throttling forward and the organization truly understood the concept that we’ve put forward and I am very proud of the team that we were able to accomplish this just as we had predicted.
Just one more question on my end, which is with the slower branch transformation decision making that’s going on in the developed markets and that could potentially impact your overall visibility. What are you doing right now to help them prove this process as compared to your competitors?
We are out there selling. I mean we are having tons; we are having tons of conversation. It’s not a question of visibility. We got a lot of visibility. It’s a question of timing. Any time you have a large project, I cannot even begin to tell you how many times in my sales career I thought I’m close to closing a deal and then it took another 8 weeks to get it into the end zone. You just never know, some of these things get down faster than you anticipate and some of them might run into a pothole and it takes a little longer. That’s the only piece that you cannot predict. The activity level overall if I take a look the branch transformation was two years ago and where branch transformation is today, it’s just night and day.
Thank you guys.
And we’ll take our last question from Umesh Bhandary with Jefferies & Company.
Hi guys thank you for taking my questions. Just quickly I mean overall when you are sort of talking about Chinese competition, is that mostly limited to China or is that really spreading to your other geographies, I mean particularly why should we not worry about you know them sort of you know coming into the European markets in the same way that happened in the telecom hardware business. Maybe if you can provide some perspective on that?
Umesh that is a great question. So let me take it in three steps here. Primarily, that’s a China issue for China. But you are absolutely correct, there is the usual fears of -- instance where the Chinese companies go into usually -- some were in Asia, you also will start seeing them show up probably in Africa. But the biggest differentiator is when you ask yourself why aren’t they not in Europe or why they are not in the U.S. It’s just service.
And if you think this thing through when you automate a branch with all your cash, with all your mundane [ph] functionality, when all your customer interaction on the usual day to day stuff fits on a machine the very last thing that you can afford is this machine to be down. And we both have seen the movie on the telecom side usually far eastern players woefully under appreciate the importance of service and quite honestly in many cases also the importance of software which is why we did the transaction with Wincor because we are saying bolstering our service business.
We are going to be the largest service provider in our industry in a few weeks here, that makes a very important differentiating factor and it gives us a very defendable position going forward.
Great. Thank you very much. That’s all I got.
Okay, I want to thank everybody for joining us on today’s second quarter earnings call. If you have follow up questions, please reach out to us at Investor Relations.
And that does conclude today’s conference. Thank you for your participation.
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