Diebold Incorporated's CEO Discusses Q3 2012 Results - Earnings Call Transcript

| About: Diebold Nixdorf (DBD)
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Diebold Incorporated (NYSE:DBD) Q3 2012 Earnings Call October 25, 2012 10:00 AM ET


John Kristoff - VP & Chief Communications Officer

Tom Swidarski - President & CEO

Brad Richardson - EVP & CFO


Kartik Mehta - Northcoast Research

Gil Luria - Wedbush Securities

Matt Summerville - KeyBanc

Roman Leal - Goldman Sachs

Paul Coster - JPMorgan

Michael Kim - Imperial

Zahid Siddique - Gabelli & Company


Good day everyone. Welcome to Diebold Incorporated Third Quarter Financial Results Conference Call. Today's call is being recorded. At this time, for opening remarks and introductions, I would like to turn the call over to the Vice President and Chief Communications Officer, Mr. John Kristoff. Please go ahead, sir.

John Kristoff

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

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

Before we discuss our results, as with past calls, it's important to note that we are restructuring non-routine expenses in our financials. We believe that excluding these items gives an indication of the company's baseline operational performance.

As a result, many of the remarks this morning will be focused on non-GAAP financial information. For a reconciliation of our GAAP to non-GAAP numbers, please refer to the supplemental material at the end of the presentation. In addition, all results of operations reported today, including prior periods exclude discontinued operation.

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

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

Tom Swidarski

Thank you, John. Good morning everyone. While our business in the third quarter was sound from a topline perspective, we experienced a number of unique challenges relative to profitability. First, we had a forecasting issue in our North American operation that caused us to overestimate our profitability going into the quarter. Our business in North America remains robust as we turned in 9% revenue growth during the quarter; however, a shift in mix significantly impacted profit margin on several sub-segments of the business.

Second, North American service margins were adversely affected by lower than expected build work and continued investments in our integrated services platform, software and productivity tools. Finally, a couple of very large financial self service projects with government banks in Brazil have been pushed out in 2013. Brad and I will address each of these factors in more detail in our comments this morning.

As a result of the revenue mix shift in North America and project delays in Brazil, as previously announced, we have reduced our earnings expectations for the full year. Despite these mixed shift and timing issues, we remain confident in the fundamentals of our global financial self service business which we anticipate to grow at 8% to 9% this year or 12% to 13% on a constant currency basis. While product margins are under continued pressure, we expect our service margins to return to the positive sequential trajectory in the fourth quarter.

Also I am encouraged by our security business performance during the quarter which grew nearly 8%. Security is the key strategic growth initiative for our company and we are beginning to gain increased traction in this space. As a result, we've tightened our full-year security revenue guidance within a higher end of our prior outlook and remain confident in our ability to execute on the many opportunities on our horizon for Diebold and deliver profitable growth led by our services capabilities, both in the near-term and beyond.

Now lets look at our regional performance. In North America, revenue grew approximately 9% with growth across the financial self service and security businesses. Though orders for products and service decreased slightly up a strong comparable to the prior year when we experienced a double-digit increase in orders. However, order entry was in line sequentially with the first and second quarters on a dollar basis. As I mentioned earlier, we had a greater than expected drop in profitability based on customer mix shift taking place on the heels of the upgrade cycle and the regional bank space related to ADA and PCI compliant.

To put this impact in perspective, in a given year, a 10 percentage point mix shift from regionals to nationals translates to about a $10 million drop in operating profit and an impact of approximately $0.10 in earnings per share. Likewise, when we saw a shift in the opposite direction in the first quarter, it resulted in dramatically higher profitability for the company. However, this shift towards the national account segment should not be interpreted as the weakness in the market.

Demand remained strong for deposit automation where at this stage by the national account segment which carries lower margin. Yet, it's important to note that regional bank self service revenue has grown 94% on a year-to-date basis and grew again during the third quarter, but at a significantly lower rate than the growth we experienced at the national account level.

Our integrated services front; we continue focus on building our infrastructure and extending our competitive advantage in the market. The integration of the Toronto-Dominion business, the largest such outsourcing deal in the industry continues to progress. We're on schedule to begin transitioning their machine and we’ll have more than 500 ATMs or about 10% of their total base on our systems in the fourth quarter. In addition, TD has decided to replace all its competitive terminals with [0.5 GB] units.

Also during the quarter our integrated services competencies enabled us to replace the ATM hardware of our primary in a number of regional account, Prudent Capital Bank and Midland State Bank. This exemplifies the added value we bring to our customers and helping them manage their retail delivery aspects of their operations.

To support this transition and further develop our IT capabilities in the services space, during the quarter we teams up with Verizon to open state-of-the-art datacenters located in their Terremark Centers in Texas and Virginia. This integrated advanced datacenter capability which leverages Verizon’s reach, reliability and global scope will increase our performance. This is one of the key investments we have made in our integrated services operation.

Reflective of the recent trends we are seeing in the regional bank space the total value of contracts we signed for IS in North America during the quarter was below the prior year period. However, we still expect to reach $300 million in total contract value this year. I am also encouraged by the growing services portion of our IS contract which now stands at approximately 70% of total contract value. This is important given the recurring nature of these services as well as the fact that many of these services are incremental for our traditional offerings. We will continue to focus intently on drawing this segment of our business.

Looking to 2013 and beyond, we are focused on bringing new solutions and innovations to the market. We recently introduced several such innovations at this year’s BAI Retail Delivery Conference. In the mobile innovation space, we displayed various transactional and authentication technologies. We also showcased our remote deposit capture application which delivers efficiency to check processing and improve customer service by allowing consumers to transform photos of check into digital deposit. In addition, we exhibited our cashless person-to-person payment capability, which enables consumers to make electronic payments to other consumers for businesses via mobile devices. These software-led services are clinical component of our future growth in IS.

From a branch automation perspective, our Concierge Video Services technology was very popular with customers at this show. This brings video technology to the ATM to visually connect bank personnel with the consumer to resolve problems, answers questions or fulfill marketing opportunities. Unlike competitive offerings, our Concierge Video Service can be added to existing ATMs eliminating the need to invest any dedicated terminal. This solution was developed in partnership with CO-OP Financial Services, which had more than 3500 credit union members, 30 million card holders and 4,700 shared branch and locations. We have planned several private installations for this technology in the fourth quarter, and are very excited about its potential moving forward.

These sorts of innovations combined with advances in cloud based services, 4G network capable ATM and our Opteva and Flex series all introduced during the past year, places us at the leading edge of technology in our industry.

Looking at the security business, revenue grew at 8% during the quarter; while our total orders grew at a similar rate. As soon as (inaudible) joined the company, he has been working to realign the organization, build the sales team, invest in software and services platform and grow the pipeline of opportunities. I am encouraged that these efforts are beginning to have an impact, as we generated double digit gains in both revenue and orders in electronic securities during quarter. We are also shifting our strategy in terms of where we are focusing our efforts within electronic security, with greater emphasis on growing recurring services within the financial space, and less emphasis on one-off enterprise implementation projects.

These recurring services will provide us with a more stable stream of revenue moving forward. Though we are comfortable with where we are regarding our strategy and improves execution and security and renewed confidence in our ability to deliver growth in 2012. Therefore we have tightened our revenue growth projection within the high end of the prior range and expect to deliver 3% to 4% revenue growth for the full year.

Now looking at Asia Pacific; revenue was 2% lower in the period but up 4% on a constant currency basis. As service growth was offset by lower product volume. Service growth in the region was primarily driven by China where we saw solid growth in maintenance contract, managed services and sales of consumables. The decrease in product volume was mainly attributable to timing of business in India and Southeast Asia partially offset by the growth in China. Total product and service orders increased well into the double-digit range, driven primarily by growth in China and India.

In China we are seeing consistent demand in tier one banks and we are making notable inroads with the tier 2 and 3 regional banks. The demand we are seeing is not only for our traditional ATM, but for our high end cash recycling solutions. In India the government began initiative for the state run banks to nearly double the number of ATMs over the next few years by outsourcing to private company. We opted not to bid on any of the deals as a primary deployer given the risk in significant upfront capital required with unknown returns.

However we are currently pursuing opportunities to provide hardware and maintenance services to the various companies acting as primary deployers. We've already won a number of such contracts and we are well positioned to capture as much as 30% of the installed base of the total project. We anticipate the business resulting from the splurge of activity in India will be diluted from a product margin perspective. However the services aspect of the business is appealing given the good service margins and recurring revenue inherent in these agreements we are making. This strongly supports the managed services strategy in India without taking on the risk and capital investment required as a primary deployer.

So I feel good about what we are doing in Asia not only from the level of activity we are seeing but in the type of business we are doing and how it fits within our strategy of growing services globally. In Brazil in Latin America revenue decreased 15% or 2% on a constant currency basis due to the decline in year-over-year elections revenue in Brazil. The decrease in elections revenue also resulted in substantially lower product gross margin. Double digit revenue growth in Latin America was more than offset by the decline in Brazil due to the timing of projects and the impact of the Real. Orders in Latin America and Brazil grew in the low single digit range.

In Brazil several factors led to the delays in a couple of very large government bank bids for ATM replacements. These include the government bank worker strike, shifting priorities of internal projects in the bank and finally a general slowdown in government activity leading up to the elections which took place earlier this month. While these delays were a primary contributor to our reduced outlook for the year, we expect a strong year in our Brazilian operations in 2013.

We are confident in our market position, technology and services capabilities in Brazil which positions us well for 2013 and beyond. In Latin America outside of Brazil we continue to experience double digit growth in revenue and orders throughout the region. I am encouraged that a portion of that growth is being driven by new integrated services contract. During the quarter we signed several significant contracts including the one with a multi national Spanish bank in Peru, several others in Columbia and elsewhere within the region.

As we look to the fourth quarter and beyond we expect to continue to deliver strong growth from these emerging markets. Looking at EMEA, revenue declined approximately 4% but was up 6% on constant currency basis. Orders experience strong double-digit growth as we continue, as we saw continuing momentum in the [product] automation and recycling driven by our Opteva Flex series of ATM. Business was especially strong in South Africa and Saudi Arabia. Also one of our recent wins in Europe was the direct results of our growing software and service competences in EMEA. We delivered XFS base, customized software solution with nearly 100 advance Opteva units with cash recycling and coin deposit capability.

All these significant orders are positioning EMEA well for the fourth quarter and provide a solid backlog for 2013. And we're still on track to achieve modest profit for the full-year in the region.

Brad is going to provide more specifics on the balance sheet but I want to take a few moments to discuss our strategy in terms of cash used. You are aware of our increased investments in IT and services infrastructure, shared services and new product and application development to reduce cost, increase our competitiveness and help generate organic growth. In addition to these ongoing investments, we're placing greater focus around developing a more robust M&A pipeline. To that end, we recently announced strategic acquisitions in two key growth areas, logical security and services. In September, we expanded our security expertise with the acquisition of GAS Technology.

GAS is the leading Brazilian internet banking, online payment and mobile banking security company that services most of the country’s leading financial institution and protects nearly 70% of the internet banking transaction in Brazil. We are confident that GAS will be a meaningful addition to Diebold as we expand our logical security expertise. Earlier this year we announced the acquisition of Altus, an industry leading multi-vendor service provider in Turkey. Altus provide IT services to the financial sector through 32 service centers doubling approximately 80 cities in Turkey with a team of more than 150 professionals.

Turkey is one of the largest ATM markets in the world growing at more than [15%]. Altus provided us with the service infrastructure necessary to capture on the opportunities in this market. As I think about our acquisition strategy, we intend to step up on our activity in the coming quarters and focus on security and services opportunities in our existing markets. We have a very strong financial and strategic criteria for acquisitions and a rigorous process from opportunity to integration. As we put a high focus on growing our business both organically and acquisitively, we had to reprioritize where we invest our capital resources. After analyze our near and long term growth priorities it’s become clear that investing more than $100 million in a new headquarters facility is not the right priority for the business at this time. Therefore as we announced earlier this morning, we are indefinitely suspending our plans in that regard and do not plan to pursue new construction options for the global headquarter facility even in Ohio or elsewhere.

To address the competitive pressures in our global markets and allow the kind of continued investments necessary to grow business, we have a number of initiatives underway to address our long-term cost position. Brad will get into these efforts in more detail during his comments, but we are sharply focused on keeping our cost under control and taking the right steps to gain more efficiencies throughout our operations.

So to wrap up my comments this morning, while we are frustrated by the various challenges we encountered during the quarter, we are confident in our long term strategy and continue to execute against that strategy. Investments we are making today to enhance the solutions we deliver to the market reduce our long-term cost structure and expand our services infrastructure will bring value for years to come. The global financial self service market is growing in key geographies and we are encouraged by what we are seeing given the growth of our international order book and in security business it’s beginning to show extremely encouraging signs of progress. We also continue generate very strong cash flow and are confident in our ability to continue that trend moving forward.

With the investments we are making in the business and the acquisition strategy we are following, I am certain that we’ll successfully execute on our growth plan and deliver superior returns to our shareholders. With that I will turn the call over to Brad.

Brad Richardson

Thanks Tom, and good morning everyone. Before I get into our quarterly financial results and outlook for the remainder of the year. I would like to provide some insight into the preliminary third quarter results we have reported last week, which were well below our expectation.

As Tom, mentioned we missed our internal projections for the quarter, largely due to customer’s mix issues within our highly profitable North American regional business. In addition we experienced an adverse impact due to lower billed work service volume and additional cost associated with the investment in our integrated services platform.

And we have good visibility into our backlog and the related scheduling, we were not to as sharp around accurately projecting the timing and margin associated with specific installations during the quarter, which is turn adversely impacted margin. We realized there will always be timing issues in terms of what period revenue is recognized, but we need to do a much better job forecasting our service cost and the margins associated with our scheduled backlog.

We are addressing our processes to improve our forecasting efforts and execution moving forward. Looking at our third quarter results, we reported non-GAAP EPS of $0.39 per share compared to $0.69 in the prior year. There were a number of factors which lead to deteriorating growth margins and higher operating expense during the quarter. As a result we have lowered our full year non-GAAP EPS guidance to $2.25 to $2.30 from the prior range of $2.50 to $2.60. I will walk you through these factors in greater detail in a few moments.

Our revenue outlook however remains largely intact as our core markets which while cyclical remains sound. We did experience two large bank customer delays in Brazil which impacted our top line assumptions for the full year. Thus, we tightened our full year revenue outlook to growth of approximately 6% at the low end of our prior range. Despite these delays in Brazil, we still intend to grow our financial self-service revenue 8% to 9% or on a constant currency basis 12% to 13%.

This is notable considering the current global economic environment and competitive pressures in our industry. Our strong balance sheet anticipated free cash flow supports our continued growth in key areas such as software, services and electronic security. For example as Tom mentioned, we recently made two strategic acquisitions, GAS in Brazil and Altus in Turkey, both of which are highly synergistic and accretive to the growth of the company.

Acquisitions such as these enable us to build upon the organic growth we are generating. As we think about our capital allocation strategy, we are focused on driving the long-term growth of the business and return on capital employed at 15%.

Investments that support these strategies take precedence. To this end, we recently made a necessary decision to end the pursuit of our new world headquarters facility.

Now to review our financial results, turning to slide 16, total revenue was $710 million, flat from the third quarter of 2011 including a negative currency impact of approximately 6%. The third quarter revenue was driven by strong performance in both our financial self-service and security businesses in North America offset by the $21 million decline in election revenues in Brazil. For the quarter, service revenue increased more than 3% while product revenue declined 4%.

Looking at our financial sell service business on slide 17, third quarter revenue was $531 million, an increase of 1% due to national account activity in North America as well as continued strength in Latin America excluding Brazil where we enjoy a strong leadership position. Service revenue grew approximately 2%.

The security business on slide 18 took a positive turn this quarter with revenue of $154 million, an increase of approximately 8%. And our electronic security business grew 14% in the quarter. This gives further credence to our execution of the software led services strategy in our electronic security business. This is the third consecutive quarter of sequential order growth which builds our confidence in the long-term growth prospects for our electronic security business.

As a result of our increased confidence, we tightened our full year security revenue guidance at the top end of our previous range to grow 3% to 4%. Turning to slide 19, total gross margin for the quarter decreased 3.1 percentage points from 2011 with an equal decline in both product and service.

We experienced pressure on product gross margin during the quarter due primarily to the tough comparison we had within the high margin Brazil election business. Product gross margins were also impacted by an unfavorable customer mix in North America and EMEA.

Turning to service gross margin as Tom noted, there was lower volume of [break] six service revenue in the quarter within our North American business. We also continue to invest in our integrated services platform, software and productivity tools.

Finally, we experienced the mix issue in relationship to more low margin installation revenue versus higher margin build work in contract maintenance revenue. The higher installation revenue was the result of the increased product revenue in the quarter.

Moving on to non-GAAP operating expense, it’s highlighted on slide 20. In the third quarter, operating expense as a percent of revenue was up 40 basis points. This was primarily due to our increased investments in R&D to support future offering in the financial self-service and security segments. For the full year, we still expect our operating expense to be around 18.5% of revenue, as we leverage operating expense structure over greater volume in 2012 versus 2011.

Let me provide more detail on what we are doing from a cost structure perspective. On slide 21, we are taking a broad long-term view of our efforts. In order to offset ongoing competitive pressures in our global markets, we have a number of initiatives underway to address our cost position. As part of these efforts, we are realigning hardware and software development resources in global centers of excellence, geographically situated to best meet our R&D needs in key international regions. Building out our global IT and business service center in Hyderabad, India and aggressively implementing advanced service technologies and productivity improvement tools primarily in our large service organizations in North America and Brazil.

As a result of these and other strategic cost reduction initiatives, we are making a contentious decision to reduce our headcount by approximately 500 full time contract and open job position primarily in Brazil and North America.

Many have already taken place and the majority are expected to be complete in the next 30 days. While these are very difficult decisions, they are necessary to align our overall cost structure within the needs of the business. We are also continuing to execute on our smart business 300 cost savings initiative which is currently focused on areas of indirect end. In doing so, we are freeing up more resources that will allow us to make investments in growing the business.

We continue to be diligent in these cost control efforts in order to incrementally improve the long-term profitability of the company and we will expand and accelerate these initiatives as appropriate.

Now to slide 22, non-GAAP operating margin in the second quarter decreased to 4.7% from 8.2% in 2011. We now expect to have full year operating margin will be in the high 6% range. This is a setback to reaching our margin improvement target.

While we have driven marked improvements in EMEA, North America and the Latin America division, Brazil has been highly dilutive to our margin this year due to the cyclical nature of the FSS and voting businesses there.

Turning to the EPS reconciliation table on slide 23, non-GAAP EPS moved from $0.69 per share in the third quarter 2011 to $0.39 per share in the current quarter which I will elaborate more on in a moment. Our non-GAAP tax rate moved up considerably from 21.2% in 2011 to 30.6% in 2012. The 9.4 percentage point increase is attributable to non-recurring discrete items reducing the rates for the third quarter of 2011.

Greater income from regions with higher tax jurisdictions increased the effective rate for the current quarter. Our full year EPS guidance assumes a non-GAAP tax rate of around 27%.

Slide 24 provides some additional insights on the year-over-year decline in non-GAAP EPS. As shown, EPS declined by $0.30 in the third quarter 2012 versus the prior year. A large portion of the decline came from North America as a result of the stronger mix in national account revenue as well as the increased service investments we covered earlier.

Another significant impact came from the year-over-year decline in the Brazil voting and lottery businesses. Finally, the higher tax rate also contributed to lower EPS in the quarter.

Turning to slide 25, free cash flow decreased $41 million in the third quarter, while year-to-date free cash use improved $29 million. As such, our free cash flow is more balanced this year though we still anticipate a strong fourth quarter.

Our improvement in free cash use year-to-date coupled with continued enterprise initiatives continues to put us in a position to generate approximately a $170 million in free cash flow for the year.

Looking at slides 26 and 27, day sales outstanding increased by six days from the prior year to 54 due to geographic composition in receivables and timing of payments.

For the full year however we expect DSO to be in line with the prior year. Inventory turns improved during the quarter versus the prior year and while we are at the highest third quarter turn levels in several levels we have room to continue to improve inventory turns as we move forward.

Moving next to liquidity and net debt on slide 28, we finished the quarter in a net debt position of $151 million, a reduction of $81 million from the net debt position at September 30, 2011. Our strong balance sheet also puts us in a position to continue reserving the record for the light standing consecutive dividend increases in North America. In addition, during the past several years, we have returned a solid 3% to 4% dividend yield, reflecting the financial strength of our company and our steadfast commitment to our shareholders.

During the quarter, we did not repurchased any shares while we have roughly 2.4 million shares remaining on our repurchase authorization, our investment priorities at this point are our dividend, acquisition activity and reinvestment in the business.

In our full year outlook for 2012 as shown on slide 29, we expect revenue to increase approximately 6% in line with the lower end of our previous guidance range of 6% to 8% due to customer delays in Brazil. We are also lowering our full year guidance for financial self service revenue to grow 8% to 9% including the currency, again due to customer delays in Brazil.

Security revenue on the other hand has been tightened at the top end of the range to grow 3% to 4%. We are lowering our full year 2012 non-GAAP EPS guidance to be in the range of $2.25 to $2.30 from the prior guidance of $2.50 to $2.60. Again, our earnings guidance assumes a full year tax rate of around 27%.

Slide 30 gives further insight into the reasons behind our lower guidance for the year. The change in customer mix in North America, service investments and other items that I mentioned earlier represent a reduction of $0.17 to $0.20 per share in our outlook. The remainder of our reduced outlook is attributable to government bank delays in Brazil for financial self service deployment.

Turning to slide 31, I would like to outline some key considerations regarding our 2013 outlook. First a macroeconomic environment of slowing growth. Second, we anticipate modest topline growth with difficult comparisons in North America and revenue growth in Latin America and Brazil and the security business.

Next, we expect continued downward pressure on product margins especially considering the year-over-year mix shift in North America. However, we also expect improvements in service margins compared to 2012 as our investments in that space continue to take hold.

Finally, we expect higher healthcare and pension expense, however, we also expect benefit from the cost containment actions we are now taking. Net-net, we are positioning the company to drive operational improvement and grow earnings per share in 2013.

Moving to slide 32, I would like to provide a brief update on our compliant initiatives. More than two years ago, we made a voluntary disclosure related to certain potential violations of the Foreign Corrupt Practices Act. This prompted an extensive internal investigation that has caused the company more than $20 million. The process has also been disruptive to our business, causing significant setbacks in certain markets such as Russia, Eastern Europe and China. This journey has been arduous, but today we have a much more robust compliance program, which gives us confidence that we're conducting our global business in a compliant manner.

Currently, we are in very active negotiations with the Department of Justice and the Securities and Exchange Commission working towards a resolution. While we cannot predict the timing or nature of any potential settlement at this point, we will continue to provide updates on key developments moving forward.

In continuing our commitment to transparency, during the quarter, one of our Brazilian subsidiaries was notified of attack assessment of approximately $130 million. This assessment primarily relates to allegation of prohibited importation of certain ATM component. We certainly take all matters related to this issue seriously. However, we disagree with the assessment and are vigorously defending our position. These type of tax audits in Brazil are not uncommon as many companies have experienced similar assessments. We're currently assessing the impact of this tax uncertainty. Due to the lengthy administrative and judicial processes, this issue will likely not be resolved for many years. We will continue to provide updates on this matter as necessary.

In closing, we are disappointed in the results we delivered during the quarter. We are addressing our internal processes to improvement our forecasting efforts and gaining more accurate view of the business moving forward. The fundamentals of our business remains sound. As I mentioned earlier, we expect our financial self service business to grow 12% to 13% on a constant currency basis. In addition, I am encouraged by the high single-digit growth we saw on our security business during the quarter and we remain on-track to deliver on our guidance that we set at the beginning of the year within this segment.

Moving forward, while we continue to encounter pressure from the product margin perspective, the investments we are making in service and IT infrastructure will enable us to continue to improve margins on the service side. The cost improvement steps we are taking are strategic and measured and are reflective of the investments we have been making to address our cost position.

We are continuing working to align our operations with the strategies and long-term target set within our financial framework. Our revised revenue guidance for 2012 still puts us above our long-term goal of 4% to 6% and we are making strong progress towards achieving our target of 15% sustained return on capital employed. Lastly, our solid balance sheet puts us in a position to capitalize on growth opportunity and deliver sustained shareholder value.

With that I will turn the call back to John.

John Kristoff

Thank you, Brad. Danna, we’ll take our first question now, please.

Question-and-Answer Session


Thank you. (Operator Instructions). And we will go first to Kartik Mehta with Northcoast Research.

Kartik Mehta - Northcoast Research

I wanted to ask you Brad and Tom I think you both mentioned that the opportunity to do some acquisitions and I wanted to get to your thoughts and may be what areas you’re going to focus on and if you believe based on evaluations you are seeing out there if these will be accretive to earnings or that would take a little bit longer to achieve?

Tom Swidarski

So Kartik I will start may be and frame up the areas that we are looking at. I would say there is probably four areas of focus; one what would be called traditional break fix maintenance type of services and certainly those types of acquisitions are easy to fold into any existing operation and we think those can be accretive very quickly.

The second type of acquisition will be in the security space that may include an acquisition on the technology side, it may include an acquisition relative to the services our capabilities, but security certainly is a top of mind issue for us and as we’ve generated and the momentum here, we think there is some opportunities we’re going to be evaluating in that space.

The third I would point to, have to do with the, what I would called gases into the services space. So technologies that we fold into the integrated services offering would be very appealing to us and sometimes these are smaller technology companies with a capability and this one happen to be around security on the internet banking space, but there is other one in that type of (inaudible) we would be looking and generally those would be smaller.

And then I would say the fourth would be in key geographies and we have identified six to 10 key geographies which really drive the businesses that were in a long-term and anything in those areas much like we did with Altus to give up the strength and capability to compete more effectively and the market we think is critical will be the fourth area that we focus on.

Kartik Mehta - Northcoast Research

Thanks, Tom. And then the question on Brazil. I think Brad, in our prepared remarks you talked about Brazil and obviously that’s having a year-over-year tough comparison from a margin standpoint and I am wondering from the orders you have seen and maybe just having a perspective of that geography, what percentage of the EBIT do you think you could get back in 2013 that you lost in 2012?

Brad Richardson

Certainly, as we showed on slide 30, I mean we estimated the impact of the government bank delays, somewhere in the neighborhood of $0.08 to $0.10 per share and we are watching the order activity very closely on the bank delays, but our assumption is that we would get that back in 2013. That was part of the 2013 consideration slide that we showed and again there's lots of puts and takes for 2013 but certainly we would expect that to come back in 2013.

Kartik Mehta - Northcoast Research

And then just a final question Brad, you maintained your cash flow guidance even though you took down EPS guidance, can you just talk about maybe what areas are helping you, so you are able to maintain your cash flow guidance that you have confidence you can get to 170 in 2012.

Brad Richardson

Certainly when we started the year we signaled about $150 million of free cash flow and as we've seen our performance this year continue to improve, we took it up to the 170. We probably have cut back a little bit on the capital investment side which will certainly help us achieve the 170. But if you look at the slides again I mean there's quite a bit of momentum on the receivables here in the fourth quarter like we normally have but also the inventory performance albeit it’s not where we wanted to be, its been performing better than where we were a year ago this time and so its those factors that give us confidence on the $170 million of free cash.


And we will go next to Gil Luria with Wedbush Securities.

Gil Luria - Wedbush Securities

I wanted to ask a couple of questions on the state of regional bank market and your business there, do you expect to be as we are now after we had the ADA spike earlier in the year, are we still up year-over-year in regional banks so third quarter over third quarter of last year so is that deposit automation upgrade cycle still happening for regional bank.

Brad Richardson

Yeah Gil if you would look at year-over-year just regional banks space and just self service we are up year-over-year. I think what we are seeing is the rates that were up is decelerating.

Gil Luria - Wedbush Securities

And then in terms of competitive wins and losses, can you help us with a comparable metric to the one that was mentioned by NCR a couple of weeks ago. In terms of banks that you haven't done business with over the last three years and you did business with this year so how many banks have you added this year that you haven't done business with over the last three years.

Tom Swidarski

Yeah, Gil, I think that number is about 700 this year I think it’s a little north of 700 and as you might expect a lot of those would be institutions that are small and as a result of ADA and PCI you know have to make an investment and those would be in that very smallest category in terms of the regional bank space. We have sub segments there, but overall I would say maybe even a more important indicator would be revenue growth year-over-year were up 94% there which to me looks at the broader breadth of kind of the capability of a lot of the regional that are a little bit bigger than a one or two kind of a ATM acquisitions. So we look at a number of those type of factors and kind of give us a sense of how we are turned in.

Gil Luria - Wedbush Securities

And then on the managed services business, you are ramping up TB which is by far the biggest customer you had today, and you, seem to be some incremental cost that your taking on. First question is how long is it going to take for you to add the required infrastructure and then the second part of that question is, once you ramp up to take on TB with their full phase of ATMs. Are you going to have to make that kind of investment every year to take on more customers or the investment you're making this year scalable for you to bring in other customer?

Tom Swidarski

So, I'll answer those pieces and then Brad you can chime in if need be. So first of all, one of the comments I think Brad and I both made was our service margin in the fourth quarter are going to return back to what we consider normal levels for us. As you saw the second and third were down. Part of that had to do with investments that we're making here, relative to the TB. So in essence, we have completed the vast majority of investments we're making here. So I don’t expect to have any impacts its had.

The second piece of that is because of the way we made those investments there are truly scalable. So we're leveraging, you know, as I mentioned, Terremark with Verizon in their partnership. We have our space within their facilities and can leverage their capabilities. So while it took us a while from an investment standpoint to get up to speeds for someone that size and scope and technical capabilities that TB needed. We're now at that level and we would not expect to have to make an incremental investment like we have as we put on any size accounts going forward.

The other piece of that is it will help us because we will begin move in once we have thrown a dominion up and running. We will begin moving all of the [IS] businesses that we're currently running on our system over there which would really allow us to again focus on cost and take some of that out and allow us to be much more efficient going forward.


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

Matt Summerville - KeyBanc

Couple of questions Tom, first one of your initial remarks was to get a forecasting issue in North America you overestimated profitability. I am a little lost just to actually how that happens in this (inaudible) age with the IT systems we have, so is that a human issue an IT issue is this lingering ERP stuff I mean really dig into how this happened.

Tom Swidarski

Bard you want to.

Brad Richardson

Yeah, Matt good morning and certainly with our IT systems we have very, very good visibility to the backlog, and we have got good visibility to backlog split between national and regional, and we have decent visibility as to when that backlog is actually going to be scheduled and installed. What we found this quarter though is our visibility to the margins within that backlog. We typically had been using more of kind of an average for the regional phase average for the national space and that typically has worked well for us and that the North American business has been very predictable, it didn’t work in this quarter and so we have taken additional steps in our forecasting process to really show the backlog, show it scheduled but then show the margins the actual specific installation margins on that backlog that’s the fix that we have made.

Matt Summerville – KeyBanc

Okay. And is that just a bigger picture about (inaudible) we are looking at kind of three years of flat EPS if we go back even six years or so ago revenues about where it is operating profit non-GAAP is about where it is I mean what do you guys do from here, you have gone through actually 200, and you have taken a lot of cost out. The margins just aren’t improving, what should give us confidence that the lights sort of get switched on and margins around that sustainable track to 10%?

Brad Richardson

Okay, matt. That's question that we have very focused on from our long term standpoint. Certainly when you go back that period of time, you look at what happened during the financial crisis, you look at how you come out on the other end. So the world is very different today then it was five or six years ago and we recognize that. The cost side equation is certainly one piece of that and as we’ve outlined today there are number of actions were taking there, there is a number of productivity tools, like (inaudible) resolve which helped on the service.

So while you think of smart business 100, you think of maybe infrastructure pieces, probably more important was on the productivity side. So as you can see this year our margins on the service side, this quarter we are down significantly compared to where they have been historically. We are expecting to end the year and exit say the fourth quarter closer to 28%.

And our expectation is to continue to grow those over the next several years, with the productivity tools I am talking about. The other piece of that is you mix in the [IS] efforts that we put in place. So the higher services capability from and again gap fits into the type of discussion for talking about. Those capabilities of providing Toronto-Dominion with endpoint security, we are providing with content distribution. The other thing outside the traditional hardware and software, it’s really the software services becomes the key ingredient for us and those are the capabilities we have been building and those margins are higher.

Certainly, if you look at the third element the product margin, the product margin is going to be under pressure and that why we put so much emphasis on building agnostic systems and tools on the back end which is very different then it work three, four, year ago and five years ago relative to being able to improve someone’s network regardless if it’s a Diebold device or someone else’s device. You know hardware agnostic services capabilities and that applies not just to the self-service business but the security side of the business. And that would be the last settlement that I would add.

At the security side of the business specifically electronic security gives us a lot of opportunities that we are now focused on and while we don't have a lot of track record during electronic security side put in perspective in the financial services segment here in the US where you have physical security and self-service business with over 50% market share and the electronic security side it’s single-digit, so 8% to 9% to 10%. We've got a lot of opportunity there because of lot of capability there but we've now oriented a lot of the organization in that regard. So that's the direction we are headed and while we have confidence that we are going to change the margin perspective going forward and beginning in 2013. We are not talking about wait till 2014 or 2015 but 2013 beginning to change that trajectory.

Matt Summerville - KeyBanc

Thank you and then just one last quick one, it sounds like you guys have essentially tabled the idea of buying back stock even at $30 in favor of going out and acquiring stuff. Can you just flush that out with me in terms of how you are thinking about that and why you have chosen to go that path?

Tom Swidarski

I think what we are seeing in the marketplace is evidenced by the till that we recent completed, there are some pretty attractive assets out there and some of that can be very accretive to us relatively quickly and while they may not be large in size, they give us some competitive capabilities to compete. So the one in Turkey certainly, Turkey is a market that we've entered, we are not a one or two player, we are a three player there adding a service operation with a kind of breadth and scope that they have allows us to participate in the market that's growing 15% a year or so. We see that as being a very strategic acquisition right within the core of what we do. Likewise, we are looking at United States relative to those types of operations and in other key markets around the world. So I would view this as good investment in our key business which allows to accelerate growth and achieve the kind of margin performance that we are looking to achieve through some accretive acquisition. Brad, anything you would add?

Brad Richardson

No. I think that covers it.


And we will go next to Julio Quinteros with Goldman Sachs.

Roman Leal - Goldman Sachs

Hi, it’s actually Roman for Julio. First I guess it’s a follow-up to Matt’s first question, when you look at North America and you look at the order growth that you've seen in nationals versus regionals. I guess nothing surprised you on the pace of order growth. It was more on the margin there, but with the visibility you have in the recent quarters and the time lag that it takes from that orders to convert into revenue, what do you think the revenue impact in terms of nationals versus regional is for the next two quarters, should we expect this mission to continue for the first half of 2013 or beyond?

Tom Swidarski

Yeah, I would say that that mixed shift will absolutely continue to shift more toward national less toward regional as we go through 2013. The big fast upgrade cycle relative to ADA PCI which drove a lot of business in the regional really has come to an end. Now we are back to more of a regular paced replacement and deposit automation being the big driver in regionals but as you get to the smaller regionals, they are less and less equipped to get to deposit automation as fast as the mid-tier regionals all the way up to the nationals. So, we see the mix continuing to move in that direction for sure.

Roman Leal - Goldman Sachs

And is there any change in the magnitude of that mix over the last few quarters and what sort of delta between order growth in nationals and regionals?

Tom Swidarski

Yeah, I don't know if I have a percent I can quote right now but certainly it's significant in terms of what it is. We probably get back to what the actual mix kind of change. I don’t have that.

Brad Richardson

The order activity certainly on that.

Roman Leal - Goldman Sachs

Okay, and then one last one. And in Brazil and I know that the cost reductions there, the headcount reductions there is probably very consistent of what you are doing corporate wide but given that you expect Brazil to bounce back. I am just a little confused. Are you timing for a potential slowdown in that region or again is this just a more consistent with what you are doing across the board? Thanks.

Tom Swidarski

We're not expecting a slowdown at all. I think in Brad’s comment just see in the slide, we really expect Brazil to have a very solid 2013. This is more, in programs we put in place over the last six months, nine months to recognize the inevitability of the issues we're going to face on the products from a long-term systemic standpoint and making the necessary adjustments there. Secondly, as you move more in those services form of things, we need to improve from a productivity standpoint. So part of these are tools from productivity standpoint as you move to services and part of the reflection of the product environment that we see going on. So, these are necessary important steps for us to be a leaner, healthier organization going forward.

Brad Richardson

Roman, I would just kind of reinforce. I mean this is something we've been looking at and we've been working on but the government bank pushout, certainly this isn’t a result of that. We had a third-party in helping us really look at process in order to look at where we could drive productivity primarily in the corporate overhead of our Brazilian business. So this is not a reaction to kind of the quarter, this is reaction to the product pressures that Tom spoke too as well as quite frankly reacting to operating in a relatively high inflationary environment. We have to look at this.


And we will go next to Paul Coster with JPMorgan.

Paul Coster - JPMorgan

I get the point about how full [costing] was the perhaps a little bit defective in terms of anticipating the margin mix, but may be as to I misunderstood the prior conversation but I also got the impression that there was so a fairly significant change anyway in the mix between national, regional counts quite later on in the quarter. If there is any truth to that statement? Can you just about the linearity of the change there and what it might be suggesting why would for instance regionals be slowing down at this point in time?

Tom Swidarski

Yeah, Paul let me address that. A lot of that had to do with coming off the PCI ADA upgrade cycle. As we look out going forward in what we see kind of in the order book would suggest that it’s going to continue movement from the smallest banks that they were just buying an ATM to meet compliance and regulatory requirements to more of a deposit automation replacement product. When you look at that, you look at the top three banks then we look at the next four to 25, the banks four to 25 are moving aggressively and they are moving forward with deposit automation kind of capabilities.

The next set of regional banks, the next 1,000 is different than the last set which is probably the remaining 9,000. The next 1,000 we are seeing activity there but it’s slower than the tier above them and then the bottom group, the bottom 9,000 whatever we are seeing that it’s taking longer. So the amount of revenue may be pretty comparable, the amount out of activity may be just as high but again it’s really tilted toward the top 25 or maybe the top 100 and then the second tilt would be sort of the top 1,000 and below that we are seeing much lower and they are taking longer. So that would be kind of consistent with your question.

Paul Coster - JPMorgan

And can you, I mean, what do you think the underlying reason for that difference would be?

Tom Swidarski

Yeah, so the difference is pretty simple for a lot of these folks. Number one is that the complexity moving in deposit automation requires a backend capability whether it’s the processing or the in-house capability and for a lot of folks that becomes a big obstacle or big stumbling block which is why we are trying to get them an integrated service. I mean, that's really we are integrated services oriented and we talked about integrated services this quarter. We said really year-over-year we are down but actually the number of customers is above because lot of it’s oriented towards this, just a number of slices down in the number of revenue associated with those price goes down.

So that's why integrated services for us is so important. It continues to move there. But I would basically say they got regulatory issues they are facing, they have a compliance issue they are facing and then they have backend operational processing issues that are facing. Thus it’s a longer slow move whereas when you move up to the biggest banks and you are talking about whether it would be a 100 or 300 or 500 or for 2,000 ATMs, the benefits are pretty powerful and have the skill set and the competencies to integrate and move those. And they are expecting and are getting the kind of result that generate continue to rollout.


And we will go next to Michael Kim with Imperial.

Michael Kim - Imperial

Just turning to electronic security. Can you talk a little bit about some of the gross drivers in the quarter? Was it primarily in the finance vertical is there some initial extension to additional verticals and also any commentary on the mix?

Brad Richardson

Yeah, I would say that from the electronic securities front it really was almost across the board at this point. We are putting more emphasis back on the financial side, but we still have a lot of piece of business that extends beyond financial with electronic security. So I would say as we are building this organization out our expectations are electronic security will continue to grow, physical security in this quarter was relatively flat. So you saw the growth of electronic security evident itself. When physical security was down 10% or 20% then you mapped any of the growth on the electronic side.

So we put resources against it, we think we've the right programs in place and the technical capabilities that we are putting in place and so our goal is to drive electronic security from a recurring revenue standpoint which is different than some of the projects we've done in the past which would be the one time bigger installations or implementations and you get the product revenue but you don't get the ongoing recurring revenue and I would say that's the biggest difference for is to focus on a recurring revenue stream and while its relatively small now again we expect this to grow over time and that’s where we are putting our emphasis and focus and our number one segment is going to be the financial segment.

Michael Kim - Imperial

And is most of the recurring revenue driven by IS or other monitoring type revenue.

Brad Richardson

It would be a combination of those two. IS and monitoring.

Michael Kim - Imperial

And what was the progress on any visibility on IS adoption at this point.

Brad Richardson

Yeah, I'm not sure I have, I mean we've had a couple of pretty good examples of mid sized contract the $1 million to $2 million range with banks that have adopted IAS really for us to take over some of the infrastructure for their security within those organizations all the way up to some larger ones where they are going to be outsourcing and we are going to take over entire monitoring for them. So we are seeing a nice wide range, but again we are starting out, the base is small and it will take some time to grow it and again you are looking a lot of these, these are monthly recurring revenue businesses so you need to get a pretty big base for that monthly revenue and the margins associated with that are going to make the kind of impact for a while. But we absolutely feel good about kind of the pace and direction we are on. We feel good about the ability that as we focused on it, to see the kind of early results that we are seeing.


And we will take our final question from Zahid Siddique with Gabelli & Company.

Zahid Siddique - Gabelli & Company

Couple of quick questions, one, one of your competitors for the past several quarters has been commenting about gaining share in North America and ATM market, I wanted to check with you to see if you have been losing any share in North America over the past several quarters.

Brad Richardson

I think a couple of things there, one is I would point that the simple answer is no, we probably feel like we are the one taking the share. When you look at our growth rate, overall on a constant currency basis for the year in self service its going to be 12% to 13%. I've not seen any competitor anywhere in the world talking at that level on a constant currency basis and that's number one. If I look at North America I would look at the key components of North America, the regional banks base were up 94%, I think the question earlier was indicating that some of our competitors are up 50% or somewhere in that range so I mean I look at that and say that we clearly are doing well in that regard and then I would look at the other aspects of a number of accounts and some of the things like that where we feel like again we have a bigger share, we are growing faster and have taken more accounts.

So I'm not sure how I can conclude anything that we are either holding or taking a little bit of share but again on quarter-to-quarter basis, I don't think that’s as important as saying, what are the fundamentals of business, or what are we doing long-term systemically and that’s really we get into the integrated services in the service side of the business which we think, again is our key differentiator and that’s why the customer accounts and the product is important to us. It's really for the services and the add-on recurring revenue of service. So I feel good about where we are at from a share standpoint. I certainly don’t feel good about where we are at, what we perform relative to margin standpoint.

Zahid Siddique - Gabelli & Company

But regards to the Brazil tax assessment that you highlighted, if you take that and I guess, also the SEPA and if you go back a few years, you had revenue recognition issue. Why do these issues keep on pumping up in one shape or other? Is there something fundamentally wrong somewhere?

Brad Richardson

I think they are very, very different issues. And certainly as I mentioned in my prepared remarks, you look at the investment we've made in the compliance area in order to really strengthen our global compliance and give ourselves confidence that in the areas, for example, like SEPA that we feel confident that we got the controls in place to ensure that we operate in (inaudible) of the laws. I would point you to certainly in Brazil that the tax assessment that we got and again we take this very seriously but I think you can look at Brazil and look at many multi-nationals and getting tax assessment is not uncommon. Again, we take this one very seriously but it's not uncommon to get a tax assessment. So I think the issues that we’ve had they are not directly correlated. We've invested very heavily in our compliance activity as well as our control activity.

Zahid Siddique - Gabelli & Company

And then last question for security, you are guiding for full year for revenues to be up 3% to 4%. I think that implies the Q4 would be up may be 11% or 12% is that a fair assumption?

Tom Swidarski

I think that’s pretty accurate.

Zahid Siddique - Gabelli & Company

And how much is electronic security within the security business?

Tom Swidarski

It’s generally about half. So again it depends on whether physical security is flat or down a little as to kind of how it shakes out, but generally from an overall revenue standpoint physical and electronic today are about 50-50 of the total security picture.


I wanted to turn the call back to you for any additional or closing remark.

Tom Swidarski

Thank you, Danna. Well thank you everyone for joining us this morning and as always if you have follow-up questions, please feel free to contact myself or Nick Codispoti directly after the call. Thanks.


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

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