Diebold Nixdorf, Incorporated
Q3 2014 Earnings Call Transcript

Published: 30 Oct 2014

[Operator:]

Good day, everyone. Welcome to Diebold Incorporated's Third Quarter 2014 Financial Results Conference Call. 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, Kim. Good morning, and thank you for joining us today for Diebold's third quarter conference call. Joining me today are Andy Mattes, President and CEO and Chris Chapman, Senior 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. Andy and Chris 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 of past calls, it's important to note that we are excluding certain restructuring charges and non-routine expenses from our non-GAAP 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 focus on non-GAAP financial information. For a reconciliation of our GAAP to non-GAAP numbers, please refer to the supplemental material at the end of the presentation. In addition, all results of operations reported today, including prior periods, exclude discontinued operations. Also 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. A replay of this conference call will be available later today from our website. For those listening to the replay, please keep in mind that the information discussed is only current as of October 30, 2014, and subsequent events may render the information in the replay out of date. Finally, I did want to quickly announce that we will be holding our Analyst Day in New York on December 10. We will be providing additional details around our Diebold 2.0 turnaround program as well as our outlook for 2015. Please feel free to reach out to our Investor Relations team for more information. And now with opening remarks, I'll turn the call over to Andy.

[Andy Mattes:]

Thanks, John. Good morning, everyone and thank you for joining the call today as we discuss our results for the third quarter. As usual there are several items I will be covering today

[Chris Chapman:]

Thanks Andy and good morning everyone. I will start off by walking through our third quarter financial performance and then provide an update on our 2014 revenue earnings and free cash flow outlook, now to review our financial results. Turning to slide 15, total revenue for the quarter increased approximately 9% on the GAAP and constant currency basis. As a result of increased volume across all regions expect Latin America, which was down slightly due to a decline in the security business, as I noted in the second quarter call we expect our Brazil other business which consists of lottery, IT and election solutions to be a strong contributor for a revenue growth for the full year. As we move to slide 16, financial self-service revenue was up 5% on both a GAAP and constant currency basis with growth in Asia Pacific and EMEA partially offset by a decrease in Brazil. As we have noted EMEA continues to perform especially well posting solid revenue growth over the prior year. In Brazil, the decline was driven by lower volume due to timing based on customer delivery expectations. Total security revenue on slide 17 was up approximately 3% compared with the prior year period. Electronic security grew 14% driven by strong growth in North America offsetting this increase was a 12% decline in our physical security business. Looking at slide 18, Brazil other was up $34 million mostly driven by deliver on the large lottery order placed in 2013. On slide 19, gross margin for the quarter improved 1.3 percentage points to 26.2 %. This was driven by a solid improvement in service gross margin which increased 1.4 percentage points to 30.4%. This improvement reflects the continued benefits of our service transformation efforts across the globe. As I noted last quarter, some of our reinvestment are being charged to service cost of sales as we focused on improving our systems and expanding our infrastructure to support our growth and global service transformation efforts. Therefore, we expect our service gross margin to finish the year at approximately 30%. Product gross margin increased 1.9% percentage points to 21.2%. The increase was primarily the result of favorable geographic and products mix primarily its high in the U.S regional bank market EMEA and Latin America. Moving on to slide 20, total operating expenses was 19.5% of revenue compared with 18.1% in the prior year period, representing an increase of $22.6 million. During the third quarter, increased volume grew higher selling expense as well as investments we have made in sales and marketing. In addition, as Andy highlighted, we continue to make investments in our transformation such as IT, back office transformation and R&D as we work to bring a pipeline of new solutions to the market over the next several months. Turning the slide 21, year-to-date we’ve realized our plan $25 million in net savings. As we highlighted during our last call, our gross savings are relatively equally distributed over the quarters. However, the majority of our reinvestments impacted our P&L in the second half of the year. As you can see the increase in our third quarter operating expense reflect this impact bringing our year-to-date savings to $45 million in our year-to-date reinvestment to $20 million. Midterm these investments and innovation, IT infrastructure, back office transformation, service, sales and marketing will continue improve our internal controls and processes, reduce our costs and position us for growth. Turning to Slide 22, non-GAAP operating margin in the third quarter decreased 10 basis points to 6.7%. We’ve been able to fund our reinvestments this year through our improved operating performance and transformation efforts. Looking at operating profit by segment on Slide 23, all regions improved from third quarter of 2013. The growth in North America is directly related to increase volumes in the regional bank market and growth in the FSS service business. Asia Pacific benefitted from favorable country mix within the region. The increase in EMEA is a result of our prior restructuring efforts in the region coupled with strong growth from our targeted account strategy. And higher volume in Mexico drove the majority of the improvement in Latin America. The decrease in the corporate segment reflects the business reinvestments we’ve been highlighting on the call. EPS on a non-GAAP basis was $0.54 during the quarter. This excludes restructuring charges of $0.01 as well as non-routine expense of $0.03 related to legal, indemnification and professional fees. We’re also excluding a $0.01 tax benefit associated with our product foreign cash repatriation. Our third quarter non-GAAP effective tax rate was approximately 29%, which brings our year-to-date non-GAAP effective tax rate to 32.8%. Moving on to free cash flow on slide 25, our free cash flow results reflected $34 million free cash used which increased $31 million from the same period last year. This is a result of increased working capital needs as we’ve grown our business in the quarter and are building inventory to meet delivery commitments during the fourth quarter and the first quarter of 2015. Turning to slide 26, DSO increased 5 days over the prior year. Primarily as a result of strong revenue in September in geographic mix primarily associated with Asia Pacific. Looking at slide 27, inventory turns were down slightly at 4.4 turns as a result of higher finished goods inventory in transit to support near-term deliveries. Net debt on slide 28 for the period was $265 million, an approximate $80 million increase from the prior year period resulting in a net debt-to-capital ratio of 21%, an increase of six percentage points. And now I am going to take a moment to update you on a few additional items. First, our team has remediated our material weakness related to controls over Brazil indirect taxes and communication and is focused on remaining material weakness in India. The company is continuing to strengthen its control environment with investments in our systems, processes and people. Along those lines, we recently attracted and hire two new leaders in the finance organization. Henry Orphys has joined Diebold to lead our global tax function and Dave Kuhl to lead our global treasury activities. Henry comes to Diebold from KBR, where he served as Vice President of Tax and also spent his career in the tax organizations at several large global companies including Intel, where he spent more than a decade. Dave most recently served as Vice President of Finance at Ingersoll Rand and held treasury and finance leadership roles at American Standard, DuPont and Exxon. Both men have outstanding experience operating and complex multinational business environments. And we will leverage that experience as we grow the company. Finally, the company renewed its credit facility during the quarter which is now extended to August 2019. The facility has increased from $500 million to $520 million with no changes to debt covenants. Looking at our outlook on slide 29, as Andy mentioned earlier in the call, we’re increasing our revenue growth expectations for the year to approximately 7%. This is supported by our strong backlog which grew year-over-year by approximately 20%. Driving part of the increase in revenue guidance is activity in Brazil other, where we have received extensions to previous orders in early October for both lottery and IT related equipment. Given the short cycle time deliver on these orders, we took a position on the necessary inventory in the third quarter. We are narrowing our non-GAAP EPS guidance to a $1.70 to $1.80 inclusive of an increase on our full year non-GAAP tax rate assumption. As noted on the second quarter call, there was pressure on our non-GAAP effective tax rate and the year-to-date effective tax rate is now at 32.8%. Based on better visibility to our full year mix of income and discrete tax items, we now expect our full year non-GAAP effective tax rate to be approximately 32%. As a reminder, our full year earnings guidance includes the devaluation of the Venezuelan bolivar of approximately $0.12 and in additional $0.03 related to the divestiture of ERAS. We expect restructuring charges in non-routine expense to be $0.21 to $0.23 range, excluding the $0.19 gain on the sale of our ERAS subsidiary. We’re maintaining our free cash flow outlook for the year of $80 million to $100 million; this includes an approximate $25 million increase in our capital expenditure as we make strategic reinvestments in our business. Year-to-date, we have to consistently execute remaining in steadfast and our focus on continuous improvements to maintain and strengthen our control environment while operational reducing our costs and improving our working capital efficiencies. As you can see, the company is beginning to demonstrate tangible results from our turnaround effort. We have strategically ramped up the appropriately investments in the third quarter as we lay the foundation for long term profitable growth. With that I’ll open up the call for questions.

[Operator:]

Thank you. [Operator Instructions] We'll go to our first question from Gil Luria of Wedbush Securities.

[Gil Luria:]

Yes thanks for taking my question, if you wouldn’t going through the detail for Brazil other revenue and profit for this year and I know you are not going to provide 2015 guidance but how much of that do you expect to fall off next year. So we know how to properly model next year at least in that regard. That seems to be a very big factor.

[Chris Chapman:]

Gross margin Gil this is Chris, just to break down the major pieces of Brazil others so year to date the Brazil other is at approximately $175 million revenue, I expect that to be around $220 million on the full year the major pieces of that been around $100 million in lottery and $120 million in the IT related equipment. So it’s about a $40 million increase from where we were at on the last call. And so if you think about that, moving into 2015, I would expect that to fall off a little bit North of the $150 million we talked about before likely closer to $170 million fall off. But again I would know, and you can see it here in the third quarter as well that’s a little bit of a lumpy business going forward to model for 2015. I would expect that to be approximately $50 million if you are looking at the go forward estimates.

[Gil Luria:]

That comes in at a pretty high profitability level if I recall so that 15% and that’s about a $0.30 earning that we have this year that’s not going to come back next year. Is that right?

[Christopher Chapman:]

Both of those product lines are accreted equal I would say it’s somewhere between 10% to 15% and again you’ve got a lot of factors in terms of timing of when you purchase the inventory potential currency headwinds a kick in that but, I would say if you model little bit South of that closer to a 10% blended drop rate that’s probably a little more appropriate.

[Gil Luria:]

Got it. And then wanted to ask about new 5500 line you are saying first, new product line in the long time. What kind of advantages you start about lower total customer ownership for the customer. What kind of a financial advantages overtime that will it offer Diebold in terms of the cost of maintenance and then gross margin.

[Andy Mattes:]

Gil this is Andy. Good morning a few things that will make this a very important milestone for the company it’s actually the first time that we developed a product for the international market. In the past the company used a U.S and that adopted it to international needs. This time put it the other way around. So therefore it’s you towards the customers, it will help the customers to drive it lower total cost of ownership because we’ve taken all the Green ATM capabilities that we’ve already released with our India machine a few months back and now they are standard for the complete international market product line. If you are looking for the Diebold’s benefits just to put it for you in terms of complexity, the product probably has about 30% lower skew number count than its previous model. Now you think of course, you’ve got to wrap them out, you got to do make sure you get the volume you going to switch over factory but in the long run this will drive again the idea of efficiency productivity and then the last point is which is also a first for us we’ve put a lot of money on the R&D side into the service ability of the machine which will help us to continue to drive our services focus in the regions and which will also help us to generate the service margins in North of 30%.

[Operator:]

And we’ll move on to our next question from Kartik Mehta of Northcoast Research.

[Kartik Mehta:]

Hey good morning. Andy you talked about strength in North America and I think you said the regional bank market or maybe you said that Chris. I am wondering if this kind of a one-time strength or based on quarter do you think we’re filing to a point where you could see the regional bank market getting better.

[Andy Mattes:]

So this years has been good in the regional space and just sit back, if you think about our U.S business it’s really the tale of two different stories. Our national account business is still recovering from the loss of two of the largest banks in the U.S. that the company had experienced some years back. Our regional business however has been steadily regaining momentum, if you are looking for a magnitude, I’d say those on the orders and revenue side year-to-date were like double-digits in that business. And if I look at our pipeline, it is especially encouraging if I look at the new projects around branch transformation, innovative ideas, managed services a lot of interest in the regional space. So, we’re cautiously optimistic about that segment of the market.

[Kartik Mehta:]

And then Andy, EMEA had a very good quarter and if you look within EMEA is there a particular region that’s providing the strength or is it that all the regions are growing about the same for you?

[Andy Mattes:]

Let's go back, the biggest key to our restructuring in EMEA that we got out of the - we’re going to be everything for everybody in every country, we’re having a very clear major account focus and the good news here is that especially in the UK and Spain which have been able to win new accounts and we see business ramp up. While the markets like in South Africa where we always held a very strong position or in France our business continues to run at very high level.

[Kartik Mehta:]

Andy just lastly, I know you gave guidance about a year ago. Since then obviously some good things happen and something’s that you didn’t anticipate have happen. As you look back now heading into 2015, how do you feel about where Diebold is both from an operational standpoint and management talent standpoint to take you to the next level?

[Andy Mattes:]

As I said in my conclusion, we’re a company in transformation, we’re not transformed. We’ve done a lot of foundational work for the company; we’re getting closer to the end of the crawl space of our turnaround program, we’re starting to eye-walk [ph] and that switchover will come and with that earlier around the middle of next year. So, we feel very comfortable and confident with the progress that we’ve made year-to-date, we brought some great talent into the company, but by the same token we still have a lot of heavy lifting in front of us and we’re not probably back, quite contradictory and we got to make sure we continue on our path to execute every quarter and get things done to lay the foundation right for the company and with the solid foundation a lot of good things can happen in the mid to long-term.

[Operator:]

(Operator Instructions) and we’ll move on to our next question from Paul Coster of JP Morgan.

[Paul Coster:]

Yeah. Thanks very much for taking the questions. Andy first on branch transformation obviously it's very much focused on self-servicing side bricks and mortar environment. Have you seen any sort of adverse on CV and it's really not routinely available, are the banks really committed to the - so they still in sort of pilot phase, what was your assessment of the transition towards that technology?

[Andy Mattes:]

That’s a very fair question Paul. As the underlying driver is the banks are trying to reduce labor cost in their branches while remaining in the neighborhood making sure they can square that equation and doing all of that while keeping a very good customer service. So, the only way you kind of get there is to automation. So everybody wants to go there, everybody is trying to figure out how do I do is and most importantly if I use technology to do this, how do I differentiate my offering from the guy down the street. So, we’re seeing a lot of interest, a lot of momentum. But as I said earlier, this is not something that’s going to happen overnight, this is not a consumer product, this is an enterprise solution and it will roll out over the next 10, 12, 16 quarters and every one of those banks is going at their own pace, going at their own deployment rates for the year. But we see branch transformation to be a solid tailwind for our industry for the next two to three years to come.

[Paul Coster:]

Okay. Just switching to security some of the very impressive job of bringing on the electronic security platform, the physical security businesses is declining at a percentage is that an intentional acts, for instance are you raising sort of the bar on that business demanding a higher return on investment turning away business in the physical security space?

[Andy Mattes:]

The electronic security business, we are a system integrator, we are hardware agonistic and our focus is all around the solution all this is why the secured u is so important because you can connect to our services without having to do a forklift upgrade of our whatever equipment you may have installed we are focusing very much on the profitability of those orders we don’t grow our business for revenue sake. And the other things as we see a lot of growth in the commercial space so for instance this quarter we were able to land a very meaningful quarter with Sprint which again will drive the ball further down. Now the physical security side this is a business that is declining at a steady pace but it’s going to, the decline is probably going to flatten out as we go forward and it provides a solid base for solutions with the bank especially think around drive up solutions that type of stuff and we’re maintaining this business for as long as we can.

[Paul Coster:]

Okay last question on the electronic security side I believe you are still investment mode there when does that business send profitable. What you think in isolation the sort of operating when it’s reaching the charity?

[Andy Mattes:]

We haven’t disclosed bottom line numbers of that business. But I can assure you it’s already profitable today and more volume will make it even more attractive to our bottom line.

[Operator:]

And we’ll move on to our next question from Justin Bergner of Gabelli & Company.

[Justin Bergner:]

First question is regarding financial stock service revenue I mean as you think about the tail winds of bank branch transformation and headwinds of may be some windows seven upgrade revenue ceasing into next year. At what time do you think we’ll start to see acceleration in your financial soft services revenue or order profile?

[Andy Mattes:]

Short of given guidance for next year. Take a look at where the market is at that, probably most reputable market research Company in the space is RVR. They are predicting a 4% to 5% unit growth CAGR between 14 and 19, revenue it’s usually probably a point below that because unit count is driven very heavily by growth in the emerging market and our objective is clearly to continue to grow at least at market rate.

[Justin Bergner:]

Okay that’s helpful. My second question relates to free cash flow. It’s seems like the free cash flow outlook is being maintain but there might be some headwinds on the inventory side been offset by slightly lower CapEx I guess is that view correct and then second part of that question is it possible to quantify how much working capital been observed by the higher Brazil other revenue, than earlier anticipated?

[Andy Mattes:]

I’ll take the first part of that Justin and I may have to get back to you on the second part just to quantify that think about that a little bit, but your overall assumption is correct if you look at where we were at, growing company consumes capital and if you look at our performance in the third quarter from a free cash flow again we had a very strong end of the third quarter from a revenue standpoint and that means some of that revenue you are not going to necessarily collect on and so you going to have a higher receivable balance and as I noted as well. We’ve taken an inventory position on the Brazil other moving into the fourth quarter and so if you look at the activity that cycle repeats itself going into the end of the year. I could see it that we may end a little more on the lower end of our free cash flow range but overall I feel very happy with our underlying working capital metrics in that performance and you can match change in what were happening, in our free cash flow is really just driven by the demand and the business and to your last part of that question that’s probably about if you look at the Brazil other as we head into the fourth quarter the total impact of that probably close to 30 million approximately as what we’re carry into that and so again the timing of that revenue and moving that inventory will dictate some of that final free cash flow performance for us.

[Operator:]

[Operator Instruction]. And we’ll move on to our next question from Matthew Lipton of Autonomous Research.

[Matthew Lipton:]

Hey guys good morning. A quick question we’re talking about branch earlier transformation earlier and I think it’s pretty obvious that regional banks are still dealing with their real space footprint. So the orders that you’re seeing, like conversations are starting to have - at the high end the in branch kiosk your branch performance series or is it more standard remote positive cash rate yen is maybe with the [indiscernible] account there services and how the software really fits into the conversation is it - the new agilest platform of the card or to looking elsewhere for software and which looking at you on the product side right now?

[Andy Mattes:]

As probably yes to all three of your questions, because there is every one of those regional banks has a different starting point. The good news is we’re getting questions on all three elements. The first question is the color replacement and the additional functionality that you can put on the machine, which lands themselves more to the higher end of the product portfolio. You have some of the regionals that have not embrace deposit yet. So that is going and the agilest software as well as the service offering that we have out there, especially in that space, are very attractive. Just think about it we’ve got 22,000 machines under management in North America alone, if you take a look the next largest bank network would be Bank of America, I think they have roughly 16,000 out there. So, the fact of the matter that we can offer economies of scale to a smaller financial institutions that are at par with the bug guy with a very attractive value proposition and we see many branch transformation conversations started form that angle as well.

[Matthew Lipton:]

So still very much in the conversation they are trying to - people just putting it all different products not necessarily gravitating the one solution go ahead?

[Andy Mattes:]

The market is so early stage even give a definition out there by the resource guys what all is in branch transformation or not, some people define it more loosely than others. So, we’re actually very much looking forward to the research guys defining swim lanes and once those are out, we can then start reporting our success in our progress along those swim lane. But until then it's a fussy picture.

[Matthew Lipton:]

Got it. And then Chris, you didn’t talk about FX at all in the call, I am just curious to the 7% given the visibility you have into the business mix from the orders in the fourth quarter. How much of an FX headwind given where currency is moved in September is contemplated in that guidance in the fourth quarter? Thanks.

[Chris Chapman:]

There is a small amount of a currency headwind, I would say in terms of when we finalize our forecast we did factor in some of the recent movements in the rate, but again you’ve seen a little bit more of a pressure specifically in the Brazilian - specifically on the Brazilian real. Overall, when I look at our business from an overall currency standpoint, I feel very good about having a nice large global service presence which helps to insulate us from some of those currency movements giving, we’ve got the revenue and in our cost of line in the same currency. So, overall right now I would say to the guidance small amount of pressure, we’ve had about 25 year-to-date mainly in the FSS base and that’s almost all been between Brazil and India and so those are the major movements we’ve seen so far.

[Operator:]

And that conclude today’s question-and-answer session. At this time I would like to turn the conference back over to Mr. John Kristoff.

[John Kristoff:]

Actually I think we have one more question it looks like Kim.

[Operator:]

We will take this question from Meghna Ladha of Susquehanna International Group.

[Meghna Ladha:]

Thank you. Thanks for taking my question. Chris for the gross margin it did improved quite a bit sequentially, how much of it was related to Brazil? And directionally how should we think about both the product and services gross margin as we leave 2014?

[Chris Chapman:]

Yeah, if you look at the product gross margin first in the quarter that was really driven by the regional bank space in North America along with Europe and Latin America, so there is not a lot of Brazil other impact in that when you look at only year-over-year basis. If you think about our product gross margins on a full year, I would model that as approximately 19% given where we’re at, on the service side I did outline a little bit on the call, year-to-date I think were right at the 30% mark and I expect the full year to end right at that same level.

[Meghna Ladha:]

Thank you.

[Operator:]

And now I would like to turn the conference back over to Mr. John Kristoff.

[John Kristoff:]

Thanks Kim and thank you everyone for joining us on the call this morning. As always if you have follow-up questions please contact me directly and thanks again for joining us.

[Operator:]

And that does conclude today’s conference. Thank you so much for your participation.