Diebold Nixdorf, Incorporated
Q2 2015 Earnings Call Transcript

Published: 30 Jul 2015

[Operator:]

Good day, everyone, and welcome to the Diebold, Incorporated's Second Quarter 2015 Financial Results Conference Call. At this time, for opening remarks and introductions, I would like to turn the conference over to Vice President of Investor Relations, Mr. Steve Virostek. Please go ahead, sir.

[Stephen A. Virostek:]

Thank you, Anthony, and thanks to everyone who is joining us today over the phone and on the Web for Diebold's second quarter earnings call. Joining me today are Andy Mattes, President and CEO; and Chris Chapman, Senior Vice President and Chief Financial Officer. Just a few notes before we get started. In addition to our earnings release, we've posted presentation slides on the IR page of diebold.com. We will reference this presentation during today's comments and we encourage you to follow along. Right now, I am on slide two. I'd like to remind our listeners that consistent with the company's prior practice, we exclude restructuring charges and certain non-routine expenses from our non-GAAP financial metrics. We believe that excluding these items provides a helpful indicator of the company's baselines performance, as well as many of our remarks today will focus on the non-GAAP financial information. So for a reconciliation of GAAP to non-GAAP, please refer to the supplemental materials at the end of the presentation. Moving to the next slide number three, I'd like to remind our listeners that some of our comments may be considered forward-looking statements and our actual performance may deviate from these statements. They are subject to risks and uncertainties. Please refer to our detailed discussion of risk factors on file with the Securities and Exchange Commission. A replay of this webcast will be available later today. Please keep in mind that the information discussed is only current as of today and subsequent events may render the information in this webcast out of date. And now, I'd like to hand the call over to Andy.

[Andreas Walter Mattes:]

Thanks, Steve. Good morning and welcome to all participants who joined our webcast today. In the second quarter, we hit the ball down the middle of the stairway with results that were in line with our expectations. We delivered solid revenue growth in our core businesses. FSS revenue increased by 5% as reported and 13% in constant currency. Security revenue increased by 7% as reported and 8% in constant currency. Strong double-digit order growth in EMEA where we are increasing our market share helped the company generate modest total order growth in constant currency. Excluding China and Brazil, where market specific headwinds are weighing on our results, orders were up solidly. We expanded our gross margin by 10 basis points on a GAAP basis and 50 basis points on a non-GAAP (3

[Christopher A. Chapman:]

Thanks, Andy, and good morning, everyone. I will start off by walking through our second quarter financial performance and then provide an update on our 2015 outlook. Starting on slide 11, in the second quarter, total revenue as reported was flat to prior year. In constant currency, however, total revenue increased approximately 8%. Focusing on our core business, FSS and security grew 5% as reported or approximately 12% in constant currency. This growth in our core business more than offset the decline in Brazil other business, which had significant activity in the second quarter of 2014. North America had solid constant currency growth of approximately 14%, driven by strong activity in both the FSS and electronic security business. Additionally, Latin America, excluding Brazil other, had growth of more than 30% in constant currency, with our strong order activity over the last several quarters driving the revenue growth. Finally, EMEA grew 8% in constant currency for the quarter, while Asia Pacific was down 6%, adjusted for currency. As you can see on our slides, currency continues to have a significant impact on our 2015 results. In the quarter, currency headwinds negatively impacted total revenue by approximately 8%. As we move to slide 12, financial self-service revenue increased approximately 5% as reported. On a constant currency basis, FSS revenue grew 13% with three of our four regions reporting growth in the quarter versus the prior year period. Revenue in Asia Pacific declined in the quarter by 8% in constant currency, primarily due to declines in China where the government has implemented an initiative to shift a significant percentage of technology related purchases from foreign providers to local suppliers. North America grew in the high-teens in constant currency, primarily due to large national account projects. On a constant currency basis, EMEA increased approximately 8% as we continue to gain share by executing our account-focused strategy in the region. In Latin America, we had nearly 40% growth adjusting for currency, driven by the strong activity we previously highlighted. Total security revenue, on slide 13, increased approximately 7% or 8% in constant currency. Electronic security revenue increased approximately 12% or 15% in constant currency, with a 2% decline in our physical security business. Electronic security represented approximately two-thirds of our total security revenue in the quarter. Our electronic security growth has continued to outpace the market growth rates as our investments in people and technology are paying off. Looking at slide 14, Brazil other declined approximately $36 million versus prior year with minimal activity reported during the period. On slide 15, total gross margin improved 50 basis points to 26% on a non-GAAP basis. This improvement was driven by 100 basis point expansion in service gross margin to 31.8%. We're pleased with the continued service gross margin improvement over the past several quarters, which resulted from our global service transformation efforts and improved mix of higher margin services. Product gross margin slightly decreased by 20 basis points to 18.5%, primarily the result of geographic mix and higher volume of national account business in North America. Moving on to slide 16, total operating expense was 20.1% of revenue compared with 19.3% in the prior year period, reflecting a $6.5 million increase for the quarter. The increase was due to higher foundational reinvestment tied to our transformation. Consistent with our prior outlook, we expect our pace of reinvestments to begin to ramp down towards the end of the year. In addition, the recent acquisitions of Phoenix and Cryptera were not in our prior year results. Turning to slide 17, we have realized $63 million in net cost savings since the program's beginning. We had reinvestments in the first half of 2015 of $12 million and expect approximately $20 million in reinvestments for the full year. As we have discussed on previous calls, the vast majority of our reinvestments are hitting in operating expense, while approximately two-thirds of the savings come through in the gross profit line. For the year, we're on track to realize $40 million in gross savings, which after investments will result in additional $20 million in net program savings. Turning to slide 18, non-GAAP operating profit decreased approximately 6%, but was flat on a constant currency basis from the prior year. Our operating margin decreased 40 basis points (22

[Operator:]

Thank you. Today's question-and-answer session will be conducted electronically. Our first question comes from Gil Luria with Wedbush Securities.

[Gil B. Luria:]

Yes. Thanks for taking my question. Good morning. Wanted to talk about some of the regions you mentioned. So, China, this has been an issue that seems to have been getting worse. Do you expect that business to just go away over time, that the Chinese banks will eventually all (29

[Andreas Walter Mattes:]

Morning, Gil. It's Andy. You're correct. China has basically moved the goalpost. If you take a look at what has happened over, let's say, the last 20 years, in the beginning it was okay to operate in China as a wholly-owned foreign entity, then multinational companies were okay, and today, you got to be more Chinese to do business in China. Now, the task for all tech companies, including ourselves is to come up with a strategy of how we comply with that approach towards being more Chinese, while at the same time making sure we adhere to U.S. business practices and make sure adhere to the processes and controls that we've implemented in our company. So this is – it's a big to do. It's not a trivial situation. It's something that we are working on a lot and we think we'll going to come up with a really good answer, but not something you want to rush into.

[Gil B. Luria:]

And then, Brazil, it seems like the level of activity there is tied to the political situation. Is it now at a point where you're at a base line maintenance level of activity or could we see even more declines there as with continued political uncertainty?

[Andreas Walter Mattes:]

Well, Gil, to your point, like in all countries, our sizeable installed base and our big service business always provides a floor to our revenue in any geography. That also holds true in Brazil. We would expect that we're somewhere at a base line. And if you take a look at the country, while it is going through rough times at the moment as an economy, the long-term perspective for the company is still very positive and in the long run Brazil will turn back into a growth opportunity.

[Gil B. Luria:]

Great. And then finally, on Europe, you talked about unfavorable mix driving the operating profit down there. What's the mix shift more specifically there that – and is it something that's just based on the tough comps or specific to the quarter?

[Christopher A. Chapman:]

Yeah, it's just really based on the tough comps. Again, it was just a mix of some customer projects that we had last year that had fairly nice margins and then, year-over-year, we got a little bit different mix of the overall business than we did in previous year. That's the big driver.

[Gil B. Luria:]

Got it. Thank you very much.

[Operator:]

Our next question comes from Joe Radigan with KeyBanc.

[Joe K. Radigan:]

Hi. Good morning, guys. First, on product gross margin, I believe you cited geographic mix as one the primary reasons for the product gross margin decline, but North America was up 13%, which is your most profitable region. Is it really just a function of the mix between customers within North America or is there – are you seeing increased pricing pressure or is there something else going on there?

[Christopher A. Chapman:]

No. With regards to your last point, I'm not seeing increasing price pressure in North America. The big thing within North America that you hit upon there, higher portion of national, regional account activity down, and there's a big disparity in the margins between (33

[Joe K. Radigan:]

Okay. And then, Andy, on the decision to eliminate the COO position, I guess, why now? Is it just that your comfort level around the new leadership that you've brought in? Is it where your – the progress you've made on the transformation effort? Just maybe a little background on the timing of that decision.

[Andreas Walter Mattes:]

Sure. Look, these are always tough decisions to make. But as a company, we've been putting a lot of effort in taking out management layers, streamlining the organization, hiring great talent as close to the customer as possible. And when you do that, we've done that – we started doing that in the middle management ranges at the beginning of our turnaround. At some point in time, you also have to do it at the top of the organization. At the end, it will also increase our decision-making processes and it'll make us a little bit more customer-centric in our approach going forward. Why now? Well, we are right at the turning point between a crawl phase that we've pretty much concluded. We've put our processes in control. We have our systems. We feel very comfortable that the cost containment thought process is becoming part of the general DNA of the company. And then, we're opening a new chapter on the walk side of the house, where we're going more into a services-led, software-enabled business, which will ultimately require a slightly different. And if we want to add gross (35

[Joe K. Radigan:]

Okay, great. Thank you.

[Operator:]

Our next question comes from Matt Lipton with Autonomous Research.

[Matt Lipton:]

Hi. Good morning, everybody. Just wanted to talk about the services gross margin first, lots of new activity on managed service agreement and multi-vendor deals. Can you talk about relative to the company average of 32% versus gross margin? How additive these deals can be or what happened?

[Andreas Walter Mattes:]

First of all, we only do deals that at the end of the day are accretive to the company. So we're very – and all these large deals, you want to choose very wisely, because everyone of them is going to be a long-term engagement of the company with a customer. It's also a long-term partnership that you're entering into. From a cost point of view, services, anywhere you look at the world, is the utilization game. So we're making certain that we have a invent once, reuse often model. So, for instance, take the managed services agreement – the multi-vendor services agreement that we had in the U.S., we had major win in Q1 with BBVA Compass. And that's pretty much an East Coast-centric type of customer. So as we were expanding our multi-vendor services activities, we made sure we're looking for geographies where we can reuse the people that we're training on other people's gear and get again good leverage out of those workforces. So you want to be very smart about how you do it. There is always a little bit of a ramp-up in that business, but we're very confident and we see that as a big growth path for the company going forward.

[Matt Lipton:]

Got it. I guess, real quick, Chris, on OpEx with Phoenix in the numbers a bit this quarter. Was that a noticeable inorganic help to the services margin – gross margin? (37

[Christopher A. Chapman:]

No, it's not large enough to swing the numbers. Again, the Phoenix activity is accretive and it will continue to be accretive, both on the gross margin side. For the full year, as we indicated last time, it's probably going to be a little more neutral to earnings with all the integration costs and everything else from that perspective, but it's not large enough to move the needle significantly at this time, but we'll continue to improve it over the quarters to come.

[Matt Lipton:]

Got it. And then, shifting gears, just wanted to talk about Australia very quick. It's not a market that I know very well or I've ever heard anyone in the ATM business talk about, but I saw that you did sign up a new multi-vendor deal there which potentially gives you a better foothold in that country. Is it also an underserved market similar to kind of the experience you had in UK in Spain, where you might be able to go in and take share with a product and services footprint? Thanks.

[Andreas Walter Mattes:]

Australia is a very unique market. It's also always a test market for the Asian players on just about any technology. The thing to highlight is our win in Australia is a software win. So, at Westpac, we – there's not a single Diebold machine in the account. They had multiple software vendors. They were a Phoenix legacy account to a certain degree and they also had a big chunk of software from one of our main competitors and some other stuff. And the customer wanted to standardize, have one platform, one user approach, one common look and feel, and they chose the best product they could find and it was Phoenix. So we're very excited. If anything, it's a good indication that the vendor-independent approach that we have with the software is applicable and it's applicable in geographies and in accounts where we have not even been in before, so it – and largest TAM that we have as a company. And we're extremely encouraged that we were able to grow a legacy Phoenix account into something really big under the new combined company.

[Operator:]

Our next question comes from Matt Summerville with Alembic Global Advisors.

[Matt Summerville:]

Morning. Couple of question. First, can you talk about how we should think about those sequential cadence in both product and service margins, second half of the year versus the first half? And then, it sounds to me like there's a lull going on in the small bank market in North America probably in this post Windows 7 sort of timeframe (40

[Christopher A. Chapman:]

Hi, Matt. This is Chris. I'll take the first half of that. With regards to second half margins, and we've talked about this in the past, I don't expect the service margins to always follow a nice linear path. The third quarter, typically, we have some underutilization in a couple of the markets, especially a market like Europe, where you have a pretty big holiday schedule. So, typically the third quarter service margins, we would see those come down and this year would be no different and then ramp back up on a full year basis in the fourth quarter as we see a little more utilization. Product margins, expect to be fairly well in line with what you've seen on a year-to-date basis based on the mix of activity we currently see.

[Andreas Walter Mattes:]

And then with regard to – yes, go ahead.

[Matt Summerville:]

No, I was just going to repeat my second question. Sorry.

[Andreas Walter Mattes:]

No, we didn't forget you. So, with regard to North America, I think your observation is correct. The regional banks open the first strings (41

[Matt Summerville:]

One of the things that had been talked about in the past was, on these bigger managed service deals, and certainly there's lots of different things you've been talking about the last two quarters at least. I guess what – if you had to point to one or two things – and there was always statements like, that these are multi-year discussions, it sort of takes forever, like, why is the logjam just breaking now? Why are all these deals coming down Diebold's way all of a sudden? And I guess, what does the go forward funnel look like on these bigger transactions?

[Andreas Walter Mattes:]

Great question. Look, I've always said, pursuit on these deals is anywhere between 12 months and as much as 24 months. We started to go down that route as early as late 2013, when we talked about change in the trajectory of the company to being a services-led, software-enabled company. And if you basically add 18 months to the end of 2013, you're here and now. So it's actually a normal – that's a normal development of a sales funnel that has been building over the last one to two years. And looking forward, I'm encouraged about the level of conversations that we're having. And if you also recall, at some of the earlier calls, I said these big deals are like penguins off the iceberg. And let me take Spain as a great example here. If you recall, last year, our big services deal was Bankia, where we did the total implementation services for that bank for some 2,000 machines. And about a year later, there is a second Spanish bank that goes down the very same route, goes into a managed services agreement with us, with Banco Sabadell. And because they're all watching each other in the market, and if a model is innovative, if a model is attractive and shows positive result in the market, word gets around and your funnel increases. So we're very upbeat about the opportunities, but again, they will take their time and they're going to work themselves through the system.

[Matt Summerville:]

Great. Thanks, guys.

[Operator:]

Our next question comes from Saliq Khan with Imperial Capital.

[Saliq Jamil Khan:]

Great. Thank you. Hey, Andy, during the first quarter you had announced a deal with Walmart where Diebold had replaced a competitor. Could you give us an update on the relationship and the installation progress?

[Andreas Walter Mattes:]

Happy to. Relationship is good, and installation is going well. This – it's all tracking to plan. Now, keep in mind, Walmart – when Chris talks about timing, you've probably highlighted one of the biggest elements of that because, as you can imagine, the retailers will not let you do anything in their stores, as innovative as it may be, in the pre-holiday shopping season. So the majority of the rollout will actually be in the beginning of 2016.

[Saliq Jamil Khan:]

Got it. As you are looking at, particularly within securities, because you saw a pretty big uptick within electronic security revenues, what has been the factor in regards to you winning new electronic security contracts and retaining those clients? I guess, my question essentially is, what are these clients coming to you for, what's the big need that they need that Diebold's able to plug the hole in?

[Andreas Walter Mattes:]

In my mind, there's three elements to the answer. First, if you recall, we said 18 months ago that we're going to increase the amount of sales people that we add to this electronic securities team, and we were able to attract really good folks. We increased our workforce by roughly 40, 50 folks at the time. And that goes back to the old sales axiom that you sell more when you show up. So that is just working itself through the funnel. The activity has been building, and people are now closing deals. Second, our technology, especially around SecureStat, is such a unique opportunity. If you remember, SecureStat is pretty much a portal that enables you to switch your electronic security provider without having to upgrade or even forklift any of the equipment that you have in the building. So, if you guys in your company wanted us to monitor your offices, you could give us a call tomorrow. We'll put SecureStat on your server and we'll switch you over to our monitoring center. The minimum switching cost give customer a choice to go to a company – and now it's the third aspect of the sales approach. As you know, we only focus on large accounts, national or large regionals. And it's the same thing that we have on the FSS side in our targeted account strategy that we have in Europe. When you have a targeted account strategy, you do nothing but that type of business, nothing but that type of support, it shows up in the level of quality and the level of dedication and the level of service you give to a customer, and customers like it. So, you combine all three and then, if you want to sprinkle a little pixie dust on top of it, we've just done this teamwork with Eagle Eye, which is a really innovative cloud-centric video solution. We've got a very attractive value proposition in our ES business.

[Saliq Jamil Khan:]

No, we know the guys at Eagle Eye pretty well, and it's a pretty unique proposition that they have from a product and solution perspective. But the last question I had for you was, we kind of hinted upon this earlier in the conversation as well but, while much of what is going on in China is out of anyone's control, what are you doing right now to offset the decline in revenues from APAC?

[Andreas Walter Mattes:]

Well, the answer to this one is services and software. If you put China, it falls into two buckets. Decrease in our product revenue, and if you want to be even more specific, the bigger the bank, the larger the decline, because that's where the government, of course, is leaning on the most, but the offset is the service revenue within China, but also the service revenue within the region. And you can see – and I don't think it's by happenstance. We talked about the Phoenix win in Australia earlier. On previous calls, we talked about our very successful managed service business that we have in India and in Southeast Asia. It's not by happenstance that this – the market is going this way because the banks are really, all over Asia, trying to innovate their business models and we're very well positioned to take advantage of that. And if you balance all of that out, we think we can offset quite a lot of the China headwind, any given quarter, it might be a tough comp.

[Saliq Jamil Khan:]

Thank you, Andy. I appreciate it.

[Operator:]

Our next question comes from Meghna Ladha with Susquehanna.

[Meghna B. Ladha:]

Hi. Thanks for taking my question. Can you help us understand what specifically changed since last quarter that's leading you to raise your financial self-service guidance today?

[Andreas Walter Mattes:]

We won more deals.

[Meghna B. Ladha:]

Was that just primarily – like I said just globally, is it North America? I mean, I know that you saw a lot of market share gains in Europe, Middle East, Africa. Was it Europe that helped you increase your guidance today, or was it just globally or just winning more deals?

[Andreas Walter Mattes:]

Well, Meghna, the great thing is we see very positive momentum all around the globe. We've had great deals in Southeast Asia. We've got some great successes especially in the Middle East and Africa, and Western Europe right up there on the forefront. Let me just take the UK as an example. We talked about our account-centric approach. We were able to lever in a relationship that we have with one of the largest banks in the world, with HSBC, and used that as an entry into the UK and (52

[Meghna B. Ladha:]

That's great, Andy. Thank you so much for the color. Just a quick question on capital allocation. Are you still considering smaller digestible software type acquisitions or could there be possibility of a larger acquisition if the right opportunity presents itself?

[Andreas Walter Mattes:]

Meghna, this is the tech industry. Anything is possible. We have a very prudent approach to M&A. We will – we've said from the very beginning that wherever we think a buy versus make will help us to gain more IP or more market access sooner than if we were to do it home-grown that we would entertain it, assuming – and that's the big line that we draw in the sand, assuming the acquisition is accretive. And if you take a look at our tuck-ins that we've done with Cryptera and with Phoenix, they're both on a very good trajectory. We just did the one year review of Cryptera. It's actually ahead of the business case that we had at the time. So we're feeling very good. When and if the right opportunity presents itself and it meets all the hurdle rates that we're putting on to the company and our decision-making process, we do have the firepower to pull the trigger, but we're not rushing into anything.

[Meghna B. Ladha:]

Thank you so much.

[Operator:]

Our next question comes from Justin Bergner with Gabelli & Company.

[Justin Laurence Bergner:]

Good morning, Andy. Good morning, Chris.

[Andreas Walter Mattes:]

Morning, Justin.

[Christopher A. Chapman:]

Morning.

[Justin Laurence Bergner:]

Wanted to address a couple of things. Starting with share gains, you called out that you're taking share in EMEA and I think you cited 20% growth versus a flat market. If you maybe could sort of quantify or just remind us the magnitude of the share gains in EMEA and to what extent are you gaining share in other regions?

[Andreas Walter Mattes:]

So, Justin, in 2014, it was roughly 20% if you take RBR as your baseline. Also, if you to take a look at our numbers, both orders and revenues were up around 20%.

[Justin Laurence Bergner:]

Yeah.

[Andreas Walter Mattes:]

So very consistent between unit and revenue. And again, this is all centered around targeted accounts, especially in the UK, Spain, France, some of the other countries there. And we talked about Asia-Pac, where we're gaining market, especially in the avian markets, in India, and we're also back in the large account business in North America. I mean, the reason why we're so excited about the one big services win is because the customer pretty much had a five-year hiatus in terms of procurement from Diebold and we got back out of that. We're back in the game. So, if you take a look at where we're scoring, we're winning more large deals than we've done in a long time. And that's very encouraging.

[Justin Laurence Bergner:]

Great. It certainly seems like you are. With respect to service, the multi-vendor service agreements that you noted were signed this quarter, are those part of your order book in the second quarter? And is it possible to give us any idea as to sort of the magnitude of these agreements, like annual dollars for Diebold?

[Andreas Walter Mattes:]

Great question, Justin. So, first of all, unless we have already started work, these would not be part in our Q2 numbers. Now, if there's a product element to it, that would be part of the orders number, because when you look at orders, we have product orders and we have total orders, so product orders would show up. In the total orders number, you would only have the service revenue as it's performed. All of these deals are in their infancy when it comes to the implementation. So there's upside for the service revenue as you look into 2016. If you're trying to get a ballpark, the TCV number that we're looking at, so total contract value, and these are anywhere between three- to five-year deals. If we take a look at the year-to-date number, we're well north of the $150 million marker of deals that we've signed year-to-date and we expect this number to continue to go up before the end of the year.

[Justin Laurence Bergner:]

Great. When you say – just to clarify. When you say you're well north of $150 million signed year-to-date, what metric are you referring to?

[Andreas Walter Mattes:]

That's TCV. So, very simple, let's say, you do a five year deal with $5 million service revenue per annum, that would be $25 million TCV. And it will show up over the course of the next five years at a clip rate of $5 million, which is also when you look at the model, Justin, these things, service deals never create a spike in the model. They are very steady increases because rev rec is per month, per quarter of service performed you cannot recognize revenue anytime sooner, but the good news is, it really builds a groundswell that will give you long-term uplift on your services numbers for 2016, 2017 and beyond.

[Justin Laurence Bergner:]

Okay, great. Two quick questions, if I may. Can you remind us how large China is within APAC? And do you expect to maintain a lot of the service business notwithstanding the changes that are occurring in China or is that still to be determined?

[Andreas Walter Mattes:]

Let me start with the service thing. Same answer that I gave earlier on Brazil. Service provides the floor to our activity in the country. And Chris, you want to size it up?

[Christopher A. Chapman:]

Yeah. If you looked at total size of China, it's roughly 40%, 45% of the total Asia Pacific activity from a top line standpoint that we see today.

[Justin Laurence Bergner:]

Okay, great. And then finally, the restructuring was upsized a bit in your annual guidance. Could you clarify that?

[Christopher A. Chapman:]

Yeah. It's a couple of items. Number one, we've talked about the situations in China and Brazil. And we're not sitting back admiring the problem. We continue to take cost out and look at our cost actions to get us in the right place in 2016 as well. That's one aspect of it. And then the other piece of that really is we have some high cost restructuring activities that are out there as well. And so that's also driving the spike. If you look at our total call-out items, major change was the restructuring item. Total SEC legal fees stayed the same at approximately $0.12 to $0.13 that we said in the first quarter and that seems to be on track. So the biggest change was the restructuring.

[Justin Laurence Bergner:]

Great. Thank so much.

[Operator:]

It appears we have no further questions in the queue at this time. I would like to turn the conference back over to Mr. Virostek for any additional closing remarks.

[Stephen A. Virostek:]

Great. I want to thank everybody for joining us today. The replay webcast will be available later today. We appreciate your interest. Thank you very much.

[Operator:]

That does conclude today's conference. Thank you for your participation.