TMCnet News
VERIFONE SYSTEMS, INC. - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) This section and other parts of this Quarterly Report on Form 10-Q contain forward-looking statements that involve risks and uncertainties. In some cases, forward-looking statements can be identified by words such as "anticipates," "expects," "believes," "intends," "potential," "continues," "plans," "predicts," and similar terms. Such forward-looking statements are based on current expectations, estimates, and projections about our industry, and management's beliefs and assumptions, and do not reflect the potential impact of any mergers, acquisitions, or other business combinations or divestitures, that have not been completed. Forward-looking statements are not guarantees of future performance and our actual results may differ significantly from the results discussed in the forward-looking statements. Our statements regarding future performance also incorporate our estimates, projections and assumptions concerning the performance of recently acquired businesses, including Hypercom, which we acquired on August 4, 2011, as described in Note 16. Subsequent Event in the Notes to Condensed Consolidated Financial Statements of this report on Form 10-Q, including assumptions about the prospects for the acquired businesses' products and markets, the ability to retain customer relationships and key employees, successful integration of key technologies or operations, and the potential for unexpected liabilities. In addition, as we integrate these businesses into our operations, our understanding of the financial and operational performance of the acquired businesses may change. Factors that might cause such differences include, but are not limited to, those discussed in Part I, Item 1A Risk Factors in our 2010 Annual Report on Form 10-K and in Part II, Item 1A of this Quarterly Report on Form 10-Q. The following discussion should be read in conjunction with our consolidated financial statements and related notes included in our 2010 Annual Report on Form 10-K and the Condensed Consolidated Financial Statements and Notes thereto included in Part I, Item I of this Quarterly Report on Form 10-Q. Unless required by law, we expressly disclaim any obligation to update publicly any forward-looking statements, whether as result of new information, future events, or otherwise. When we use the terms "VeriFone," "we," "us," and "our" in this item, we mean VeriFone Systems, Inc., a Delaware corporation, and its consolidated subsidiaries. Overview We are a global leader in secure electronic payment solutions. We provide expertise, solutions, and services that add value to the point of sale with merchant-operated, consumer-facing, and self-service payment systems for the financial, retail, hospitality, petroleum, government, transportation, and healthcare vertical markets. We are one of the largest providers of electronic payment systems worldwide. We believe that we benefit from a number of competitive advantages gained through our 30-year history of success in our industry. These advantages include our globally trusted brand name, large installed base, significant involvement in the development of industry standards, security infrastructure, global operating scale, customizable platforms, and investment in research and development. We believe that these advantages position us well to capitalize on the continuing global shift toward electronic payment transactions. Our industry's growth continues to be driven by the long-term shift toward electronic payment transactions and away from cash and checks in addition to changes in security standards that require more advanced electronic payment systems. Internationally, growth rates have generally been higher than in the United States because of the relatively lower penetration rates of electronic payment transactions in many countries as well as governmental efforts to modernize economies and to encourage electronic payments as a means of improving collection of value-added tax ("VAT") and sales tax. Recently, additional factors have driven growth, including the shift from dial up to internet protocol ("IP"), developments in wireless communications, personal identification number ("PIN") based debit transactions and advances in computing technology that enable vertical solutions and non-payment applications to reside at the point of sale ("POS"). Most recently, widely publicized breaches of systems that handle consumer card details have spurred widespread interest in more secure payment systems and "end-to-end" encryption technology. Security has continued to be a driving factor in our business as our customers endeavor to meet escalating governmental requirements directed toward the prevention of identity theft as well as operating safeguards imposed by the credit and debit card associations, which include Visa International ("Visa"), MasterCard Worldwide ("MasterCard"), American Express, Discover Financial Services, and JCB Co., Ltd. In September 2006, these card associations established the Payment Card Industry Security Standards Council ("PCI SSC") to oversee and unify industry standards in the areas of debit and credit card data security. Standards include Payment Card Industry PIN Transaction Security for pin entry devices, PCI-DSS for enterprise data security and PA-DSS for payment application data security. We are a leader in providing systems and software solutions that meet these standards. Timing of our revenue recognition may cause our revenue to vary from quarter to quarter. Specifically, revenues recognized in some of our fiscal quarters can be back-end weighted when we receive sales orders and deliver a higher proportion of our System Solutions toward the end of such fiscal quarters. This back-end weighting of orders may adversely affect our results of operations in a 26-------------------------------------------------------------------------------- Table of Contents number of ways and could negatively impact revenues and profits. First, the product mix of orders may not align with manufacturing forecasts, which could result in a shortage of the components needed for production. Second, existing manufacturing capacity may not be sufficient to deliver a high volume of orders in a concentrated time at quarter-end. Third, back-end weighted demand could negatively impact gross margins through higher labor, delivery and other manufacturing and distribution costs. If, on the other hand, we were to seek to manage the fulfillment of back-end weighted orders through holding increased inventory levels, we would risk higher inventory obsolescence charges if our sales fall short of our expectations. Because our revenue recognition depends on timing of product shipments, decisions we make about product shipments, particularly toward the end of a fiscal quarter, may impact our reported revenues. The timing of product shipments may depend on a number of factors, including price discussions with our customers, operating costs, including costs of air shipments if required, the delivery date requested by customers and our operating capacity to fill orders and ship products, as well as our own long and short-term business planning. These factors may affect timing of shipment and consequently revenues recognized for a particular period. We operate in two business segments: North America and International. We define North America as the United States and Canada, and International as all other countries from which we derive revenues. Net revenues and operating income (loss) of each business segment reflect net revenues generated within the segment, supply chain standard inventory cost of System Solutions net revenues, actual cost of Services net revenues, and expenses that directly benefit only that segment, including distribution center costs, royalty and warranty expense. Corporate net revenues and operating income (loss) primarily consists of amortization of purchased intangible assets, step-down in deferred revenue, impairment, stock-based compensation, acquisition related and restructuring costs and other Corporate charges, including inventory obsolescence and scrap, rework, specific warranty provisions, non-standard freight and over-and-under absorption of materials management overhead and personnel costs. Since these costs are generally incurred on a company-wide basis, it is impractical to allocate them to either the North America or International segments. We experienced revenue growth in certain developed and emerging countries. In developed countries, we experienced revenue growth driven mainly by customers upgrading and replacing their systems to address best-practice security in more stable economic conditions. We experienced revenue growth in emerging countries primarily due to growing demand as a result of improvements in overall macroeconomic conditions. We expect demand to continue to grow in the remainder of fiscal year 2011, with particular strength in emerging economies and certain North American vertical businesses. Additionally, demand in North America benefited from the integration of our taxi media solutions business and we are expanding that business into other geographies, beginning with the recent launch of our taxi card payment and digital media solutions in the United Kingdom. We continue to devote research and development ("R&D") resources to address the market needs of both emerging and developed economies. On June 30, 2011, we completed our acquisition of DEC, a South Africa-based electronic payments solutions provider of secure payment technologies, services and solutions at the point of sale for Sub-Saharan Africa and the Indian Ocean Islands. See Note 14. Business Acquisitions to Notes to Condensed Consolidated Financial Statements included in this report on Form 10-Q. The results of operations for DEC have been included in our condensed consolidated financial statements from the date of acquisition. On August 4, 2011, we completed our acquisition of Hypercom, a provider of electronic payment solutions and value-added services at the point of transaction, by means of a merger of one of our wholly-owned subsidiaries with and into Hypercom such that Hypercom became a wholly-owned subsidiary of VeriFone following the merger. In connection with the merger we issued 14,462,628 shares of VeriFone common stock, par value $0.01 per share in exchange for all the outstanding common stock of Hypercom, and options to acquire Hypercom common stock were converted into options exercisable for approximately 814,638 shares of VeriFone common stock. Immediately prior to the merger, Hypercom divested its U.S., United Kingdom ("U.K.") and Spain businesses to independent third parties. As part of closing, Hypercom paid off its' outstanding long term debt, totaling approximately $69 million, with cash provided by VeriFone. Critical Accounting Policies and Estimates Management's discussion and analysis of financial condition and results of operations is based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. On an ongoing basis, we evaluate our critical accounting policies and estimates, including those related to revenue recognition, inventory valuation, allowance for doubtful accounts, warranty reserves, contingencies and litigation, income taxes, accounting for goodwill and long-lived assets, stock-based compensation, business combinations and restructuring. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. 27-------------------------------------------------------------------------------- Table of Contents There were no significant changes to our critical accounting policies during the nine months ended July 31, 2011. For information about critical accounting policies, see Note 1. Principles of Consolidation and Summary of Significant Accounting Policies and Critical Accounting Policies and Estimates in our Annual Report on Form 10-K for the fiscal year ended October 31, 2010. Results of Operations Net Revenues We generate net revenues through the sale of our electronic payment systems and solutions that enable electronic payment transactions, which we identify as System Solutions, as well as, warranty and support services, field deployment, advertising and transaction fees in our taxi media solutions business, installation and upgrade services, and customer-specific application development, which we identify as Services. Net revenues, which include System Solutions and Services, are summarized in the following table (in thousands, except percentages): Three Months Ended July 31, Nine Months Ended July 31, Net % Net % 2011 2010 Change Change 2011 2010 Change Change System Solutions $ 253,659 $ 213,091 $ 40,568 19.0 % $ 714,700 $ 600,653 $ 114,047 19.0 % Services 63,292 48,364 14,928 30.9 % 178,462 124,914 53,548 42.9 % Total $ 316,951 $ 261,455 $ 55,496 21.2 % $ 893,162 $ 725,567 $ 167,595 23.1 % System Solutions Revenues Three Months Ended July 31, Nine Months Ended July 31, Net % Net % 2011 2010 Change Change 2011 2010 Change Change International $ 169,906 $ 121,450 $ 48,456 39.9 % $ 454,227 $ 354,544 $ 99,683 28.1 % North America 83,753 91,641 (7,888 ) -8.6 % 260,473 246,109 14,364 5.8 % Total $ 253,659 $ 213,091 $ 40,568 19.0 % $ 714,700 $ 600,653 $ 114,047 19.0 % System Solutions net revenues for the three and nine months ended July 31, 2011 increased $40.6 million or 19.0%, and $114.0 million or 19.0%, respectively, compared to the same periods in fiscal year 2010. For the three months ended July 31, 2011 and 2010, System Solutions net revenues comprised 80.0% and 81.5% of total net revenues, respectively. For the nine months ended July 31, 2011 and 2010, System Solutions net revenues comprised 80.0% and 82.8% of total net revenues, respectively. The lower proportion of System Solutions net revenues in fiscal year 2011 compared to fiscal year 2010 reflects the impact of our taxi media business transition from primarily a System Solutions business model to more of a services model and the inclusion of Services revenues from that taxi media solutions business for the entire nine months ended July 31, 2011. In addition, growth in Petroleum Services revenues and in International Services revenues across the world also contributed to the shift from System Solutions to Services revenues. International System Solutions Net Revenues System Solutions revenue in Europe, the Middle East and Africa ("EMEA") increased $29.6 million, or 55.6%, for the three months ended July 31, 2011 compared to the three months ended July 31, 2010, primarily due to a $15.1 million contribution from the Gemalto business acquired in December 2010, as well as a $6.4 million increase in Northern Europe, the Middle East and Africa driven by increased demand. The increased demand was due to a number of factors, including a combination of improved economic conditions in the U.K. relative to the same period in fiscal year 2010, efforts by our U.K. customers to address Payment Card Industry PIN Transaction Security ("PCI-PTS") 3.0 compliance requirements, and increased demand in Nordic countries. In addition, we experienced a $5.1 million increase in Continental Europe primarily attributable to improved economic conditions in Russia relative to the same period in fiscal year 2010 and a $3.1 million increase in Southeast Europe mainly as a result of strong performance of our new Vx Evolution products and improved economic conditions relative to the same period in fiscal year 2010. 28-------------------------------------------------------------------------------- Table of Contents Asia's System Solutions net revenues increased $8.6 million, or 41.1%, for the three months ended July 31, 2011 compared to the three months ended July 31, 2010. The growth in Asia was widespread across the region, with a $2.9 million increase in India associated with a terminal deployment cycle which began in the second quarter of fiscal year 2011 by financial institutions, a $2.5 million increase in China mainly related to transportation and social welfare projects, a $1.8 million increase in other southeast Asia countries primarily attributable to the addition of a new distributor in the Philippines and sales of payment systems to the largest taxi fleet operator in Singapore and a $0.9 million contribution from the Gemalto business acquired in December 2010. Latin America's System Solutions net revenues increased $10.3 million, or 21.7% for the three months ended July 31, 2011 compared to the three months ended July 31, 2010, primarily as a result of increased demand throughout the region including increased demand for the recently introduced Vx Evolution products with the exception of Brazil where System Solutions revenue remained relatively unchanged compared to the same period in fiscal year 2010. System Solutions revenue in EMEA increased $60.7 million, or 35.7%, for the nine months ended July 31, 2011 compared to the nine months ended July 31, 2010, primarily due to a $31.1 million contribution from the Gemalto business. In addition, we saw a $12.7 million increase in Continental Europe as a result of improved economic conditions in Russia relative to the same period in fiscal year 2010 and increased customer spending at the end of the 2010 calendar year, and an $8.8 million increase in Southeast Europe due to strong demand as a result of our recent Vx Evolution product launches and overall improved economic conditions, and an $8.4 million increase in Northern Europe, the Middle East and Africa driven by increased demand. Latin America's System Solutions net revenues increased $22.9 million, or 18.1% for the nine months ended July 31, 2011 compared to the nine months ended July 31, 2010, primarily as a result of increased demand throughout the region including increased demand for the recently introduced the Vx Evolution products. Asia's System Solutions net revenues increased $16.1 million, or 27.7%, for the nine months ended July 31, 2011 compared to the nine months ended July 31, 2010. The growth in Asia was primarily attributable to a $6.1 million increase in Australia and New Zealand mainly due to compliance driven terminal upgrades, a $4.7 million contribution from the Gemalto business and a $5.4 million increase in India associated with a terminal deployment cycle begun in the second quarter of fiscal year 2011 by financial institutions. North America System Solutions Net Revenues North America System Solutions net revenues decreased $7.9 million, or 8.6% for the three months ended July 31, 2011 compared to the three months ended July 31, 2010. This decrease included a $12.4 million decrease in net revenues from our Petroleum business due to the non-recurrence of revenues from our Petroleum customers' efforts to address the July 2010 PCI-PED compliance deadlines during the three months ended July 31, 2010, a $7.3 million decrease in net revenues from Vertical Solutions due to the timing of our multi-lane retail and vertical market customers choosing to upgrade their systems and a $4.3 million decrease in our taxi media System Solutions revenues attributable to the impact of the transition of our taxi media solutions System Solutions business model to a services model. These decreases were partially offset by a $16.0 million increase in our North American Financial business, which sells payment systems to small and medium-sized businesses through ISOs and payment processors, and benefited from a reduction in inventory levels in the channel which spurred renewed demand from these resellers. North America System Solutions net revenues increased $14.4 million, or 5.8%, for the nine months ended July 31, 2011 compared to the nine months ended July 31, 2010 was primarily attributable to a $19.8 million increase in Vertical Solutions due to the timing of our multi-lane retail and vertical market customers upgrading their systems and a $26.7 million increase in net revenues from our North American Financial business, which sells payment systems to small and medium-sized businesses through ISOs and payment processors, and benefited from a reduction in inventory levels in the channel that spurred renewed demand from these resellers. These increases were partially offset by a $19.9 million decrease in our Petroleum business driven by the completion of our Petroleum customers' efforts to address the July 2010 PCI-PED compliance deadlines, and an $11.9 million decrease in our taxi media solutions revenues attributable to the impact of the transition of our taxi media solutions System Solutions business model to a services model. Outlook for System Solutions Net Revenues Over the last several quarters, economic conditions in some parts of the world have shown signs of improvement, favorably impacting global demand for our products. We are unable to predict whether these signs of continued improvements will be sustained. Moreover, many economies that have experienced economic improvements since the global recession in 2008, including the U.S., continue to experience some volatility and challenges in achieving sustained economic growth. Any sustained economic weakness or deterioration in economic conditions, particularly if persistent, would adversely affect our business, operating results, and financial 29 -------------------------------------------------------------------------------- Table of Contents condition. We expect our International revenues to grow with the addition of the Hypercom business, which is almost entirely outside of North America. We expect the North American System Solutions PCI-PED compliance related growth in our Vertical Markets (which include multi-lane retail, hospitality, retail banking, transit, government and healthcare) and Financial businesses to be moderate, while new technologies like NFC, smartphone enabled payment technologies at the point of sale and security should fuel incremental demand. Demand from our North American Petroleum customers is expected to increase in fiscal year 2012 as the Petroleum market continues to adopt new more secure payment devices for gasoline dispensers, which improve security against breaches and media capabilities at gasoline dispensers. Services Revenues Three Months Ended July 31, Nine Months Ended July 31, Net % Net % 2011 2010 Change Change 2011 2010 Change Change North America $ 38,082 $ 31,569 $ 6,513 20.6 % $ 110,467 $ 72,925 $ 37,542 51.5 % International 25,412 16,794 8,618 51.3 % 68,701 52,260 16,441 31.5 % Corporate (202 ) 1 (203 ) nm (706 ) (271 ) (435 ) nm Total $ 63,292 $ 48,364 $ 14,928 30.9 % $ 178,462 $ 124,914 $ 53,548 42.9 % nm - not meaningful Services net revenues increased $14.9 million, or 30.9%, and $53.5 million, or 42.9%, for the three and nine months ended July 31, 2011, respectively, compared to the same periods in fiscal year 2010. International Services Net Revenues International Services Net Revenues increased $8.6 million, or 51.3%, for the three months ended July 31, 2011 compared to the three months ended July 31, 2010 primarily due to a $2.1 million contribution from the Gemalto business, a $1.6 million increase in Brazil mainly due to increased repair and rental businesses and a $1.1 million increase in Israel. International Services Net Revenues increased $16.4 million, or 31.5%, for the nine months ended July 31, 2011 compared to the nine months ended July 31, 2010 primarily due to a $5.1 million contribution from the Gemalto channel, a $3.4 million increase in Israel, a $2.5 million increase in Brazil due to increased repair and rental business, a $2.0 million increase in Mexico due to higher sales volume, a $1.9 million contribution from ABS in Italy acquired in September 2010 and $1.5 million increase in Northern Europe, the Middle East and Africa. North America Services Net Revenues For the three months ended July 31, 2011, our North America Services Revenues increased $6.5 million, or 20.6%, primarily due to a $3.5 million increase in our taxi media solutions business compared to the same period in fiscal year 2010, reflecting the impact of our transition from a System Solutions business model to a services model, and a $1.5 million increase in Petroleum Services mainly due to our software maintenance programs. For the nine months ended July 31, 2011, our North America Services Revenues increased $37.5 million, or 51.5%, primarily due to $22.4 million of revenue growth in our taxi media solutions business compared to the nine months ended July 31, 2010, of which $9.3 million was due to the impact of our transition from a System Solutions business model to a services model. The remainder of the increase in taxi media solutions Services revenues was attributable to the inclusion of revenues from our taxi media solutions business for the full nine months ended July 31, 2011, resulting from the Clear Channel Tax Media ("CCTM") acquisition which closed on December 31, 2009 and continued expansion of that business. We also experienced other revenue growth of $15.1 million, including $7.6 million in Petroleum Services mainly due to our software maintenance programs, a $2.7 million contribution from the WAY Systems business acquired on August 31, 2010, a $1.7 million increase in system deployment projects at large vertical customers and a $1.6 million increase from our PAYware Connect gateway. Outlook for Services Net Revenues We expect Services revenues in North America to be driven by continued growth in Petroleum software maintenance programs for the remainder of fiscal year 2011, continued growth in our taxi media solutions business and system deployment projects. Internationally, our new London taxi business' planned ramp up over the next few quarters is expected to increase credit card transactions and advertising revenues. In addition, we expect incremental services revenues as a result of the DEC acquisition. 30-------------------------------------------------------------------------------- Table of Contents Gross Profit The following table shows the gross profit for System Solutions and Services (in thousands, except percentages): Three Months Ended July 31, Nine Months Ended July 31, Amount Gross Profit Percentage Amount Gross Profit Percentage 2011 2010 2011 2010 2011 2010 2011 2010 System Solutions $ 103,038 $ 74,761 40.6 % 35.1 % $ 286,343 $ 216,225 40.1 % 36.0 % Services 28,574 20,734 45.1 % 42.9 % 79,345 50,386 44.5 % 40.3 % Total $ 131,612 $ 95,495 41.5 % 36.5 % $ 365,688 $ 266,611 40.9 % 36.7 % System Solutions Gross profit on System Solutions increased $28.3 million, or 37.8%, and $70.1 million, or 32.4%, for the three and nine months ended July 31, 2011, respectively, compared to the same periods in fiscal year 2010. For the three and nine months ended July 31, 2011, International and North American gross profit percentages both increased, while Corporate costs as a percentage of revenues for the three months and nine months ended July 31, 2011 increased compared to the same periods in fiscal year 2010. International System Solutions gross profit percentage increased during the three and nine months ended July 31, 2011 compared to the three and nine months ended July 31, 2010, primarily as a result of a favorable product mix impact due to increased sales of newer product solutions, which carry higher margins compared to certain previous generation solutions, and an improved geographic and customer mix within Asia relative to the same period in fiscal year 2010. North America System Solutions gross profit percentage increased during the three and nine months ended July 31, 2011 compared to the three and nine months ended July 31, 2010. We experienced favorable product mix and customer mix in our financial, petroleum and multi-lane retail solutions sold in North America relative to the same period in fiscal year 2010. Corporate costs of goods sold as a percentage of revenues increased for the three months ended July 31, 2011 compared to the three months ended July 31, 2010, mainly due to a $1.6 million increase in freight and duties, $0.5 million increase in the provision for excess obsolete inventory and scrap associated with business acquisitions and discontinued product lines and a $0.5 million increase in contract manufacturing costs. These increases were partially offset by a $2.0 million reduction in amortization of purchased intangible assets. Corporate costs of goods sold as a percentage of revenues increased for the nine months ended July 31, 2011 compared to the nine months ended July 31, 2010, mainly due to a $7.9 million increase in the provision for excess and obsolete inventory and scrap associated with business acquisitions and discontinued product lines and a $2.1 million increase in product specific warranty accruals. These increases were partially offset by a $3.7 million reduction in amortization of purchased intangible assets and a $1.2 decrease in accrued royalty as a result of a settlement agreement. Services Gross profit on Services increased $7.8 million, or 37.8%, and $29.0 million, or 57.5% for the three and nine months ended July 31, 2011 compared to the three and nine months ended July 31, 2010 largely attributable to increases in Services revenues as well as benefit from favorable mix of services. North America Services gross margin percentages increased during the three and nine months ended July 31, 2011 compared to the three and nine months ended July 31, 2010. For the three months ended July 31, 2011, this increase was driven by favorable product mix in our Petroleum Services business partially offset by lower gross margin in our taxi media solutions business. For the nine months ended July 31, 2011, the improved gross margin on the taxi media solutions and transactions in the first half of fiscal year 2011 and the inclusion of three full quarters of gross margin from our taxi media solutions business resulting from the CCTM acquisition which closed on December 31, 2009 also contributed to the margin percentage improvement. International Services gross margin percentages increased during the three and nine months ended July 31, 2011 compared to the same periods in fiscal year 2010, primarily driven by margin improvements in Brazil related to repair services and the rental business as well as growth in ATM transaction volume in Israel. These increases were partially offset by a decrease in Northern Europe, the Middle East and Africa associated with investments in our new London taxi business and a decrease in Asia due to unfavorable customer mix. 31-------------------------------------------------------------------------------- Table of Contents Research and Development Expenses Research and development ("R&D") expenses are summarized in the following table (in thousands, except percentages): Three Months Ended July 31, Nine Months Ended July 31, Net Percentage Net Percentage 2011 2010 Change Change 2011 2010 Change Change Research and development $ 27,457 $ 18,888 $ 8,569 45.4 % $ 74,501 $ 53,799 $ 20,702 38.5 % Percentage of net revenues 8.7 % 7.2 % 8.3 % 7.4 % R&D expenses for the three months ended July 31, 2011, including the impact of changes in currency exchange rates, increased $8.6 million, or 45.4%, compared to the three months ended July 31, 2010 primarily due to a $5.1 million increase in personnel costs as a result of the addition of new businesses and headcount increases associated with the launch of our Vx evolution initiative and PAYware Mobile solutions, a $0.9 million increase in facilities and operating supplies, and a $0.7 million increase in outside services. In addition, R&D expenses increased by $0.6 million due to a shift towards general application development projects which benefit broad groups of customers rather than customer specific projects, the costs of which are typically charged to cost of net revenues. Changes in foreign currency exchange rates resulted in a $0.9 million of the increase in R&D expenses during the three months ended July 31, 2011 compared to the three months ended July 31, 2010. R&D expenses for the nine months ended July 31, 2011, including the impact of changes in currency exchange rates, increased $20.7 million, or 38.5%, compared to the nine months ended July 31, 2010 primarily due to a $13.6 million increase in personnel expenses as a result of the addition of new businesses and headcount increases associated with the launch of Vx evolution and PAYware Mobile solutions, a $1.6 million increase in outside services, a $1.6 million increase in facilities and operating expenses, a $0.9 million increase in stock-based compensation and a $0.5 million increase in travel. Additionally, R&D expenses increased by $1.6 million due to a shift towards general application development projects which benefit broad groups of customers rather than customer specific projects, the costs of which are typically charged to cost of net revenues. Changes in foreign currency exchange rates resulted in a $1.4 million of the increase in R&D expenses during the nine months ended July 31, 2011 compared to the nine months ended July 31, 2010. We expect R&D expenses, assuming a stable currency environment, to grow in absolute amounts for the remainder of fiscal year 2011, primarily as a result of our acquisition of Hypercom that will, among other things, increase our R&D activities globally to support a larger product portfolio and customer base. Sales and Marketing Expenses Sales and marketing expenses are summarized in the following table (in thousands, except percentages): Three Months Ended July 31, Nine Months Ended July 31, Net Percentage Net Percentage 2011 2010 Change Change 2011 2010 Change Change Sales and marketing $ 32,769 $ 24,145 $ 8,624 35.7 % $ 92,214 $ 67,035 $ 25,179 37.6 % Percentage of net revenues 10.3 % 9.2 % 10.3 % 9.2 % Sales and marketing expenses for the three months ended July 31, 2011, including the impact of changes in currency exchange rates, increased $8.6 million, or 35.7%, compared to the three months ended July 31, 2010. This increase was primarily due to the addition of new businesses and headcount increases to support higher demand as significant revenue growth occurred in most emerging markets and developed countries, and to support the launch of a number of new initiatives such as end-to-end encryption, PAYware Mobile solutions, PAYMEDIA, and the Vx Evolution transition. The increase in sales and marketing expenses primarily consisted of a $4.8 million increase in personnel expenses, a $1.1 million increase in stock-based compensation expense, a $1.1 million increase in advertising and marketing expense, and a $1.1 million increase in acquisition related charges. Changes in foreign currency exchange rates resulted in a $0.9 million of the increase in sales and marketing expenses during the three months ended July 31, 2011 compared to the three months ended July 31, 2010. Sales and marketing expenses for the nine months ended July 31, 2011, including the impact of changes in currency exchange rates, increased $25.2 million, or 37.6%, compared to the nine months ended July 31, 2010. This increase was primarily due to the addition of new businesses and headcount increases to support higher demand as significant revenue growth occurred in most emerging markets and developed countries, and to support the launch of a number of new initiatives such as end-to-end encryption, PAYware Mobile solutions, PAYMEDIA, and the Vx Evolution transition. The increase in sales and marketing expenses primarily consisted of a $14.5 million increase in personnel expenses, a $3.9 million increase in stock-based compensation expense, a $2.3 million increase in advertising and marketing expense, $1.7 million increase in facilities and operating expenses and $1.3 million 32-------------------------------------------------------------------------------- Table of Contents increase in travel expense. In addition, acquisition related charges increased by $1.3 million. Changes in foreign currency exchange rates resulted in a $1.2 million of the increase in sales and marketing expenses during the nine months ended July 31, 2011 compared to the nine months ended July 31, 2010. We expect sales and marketing expenses, assuming a stable currency environment, to grow in absolute amounts for the remainder of fiscal year 2011 as our business grows and due to the completion of our acquisition of Hypercom on August 4, 2011. General and Administrative Expenses General and administrative expenses are summarized in the following table (in thousands, except percentages): Three Months Ended July 31, Nine Months Ended July 31, Net Percentage Net Percentage 2011 2010 Change Change 2011 2010 Change Change General and administrative $ 28,657 $ 21,327 $ 7,330 34.4 % $ 79,716 $ 61,488 $ 18,228 29.6 % Percentage of net revenues 9.0 % 8.2 % 8.9 % 8.5 % General and administrative expenses for the three months ended July 31, 2011 increased $7.3 million, or 34.4%, compared to the three months ended July 31, 2010. This increase was primarily due to a $4.6 million increase in acquisition related charges mainly comprised of professional services fees, a $1.3 million increase in stock-based compensation expense, a $1.2 million increase in personnel primarily due to headcount increases and higher benefit costs resulting from the resumption of the discretionary employer match related to our 401(k) plan for our U.S. employees, and a $1.0 million increase in facility and operation expenses. These increases were partially offset by a $0.8 million decrease in outside services due to decrease in non-acquisition related tax and legal-related professional services. General and administrative expenses for the nine months ended July 31, 2011 increased $18.2 million, or 29.6%, compared to the nine months ended July 31, 2010. This increase was primarily due to a $9.9 million increase in acquisition related charges largely attributable to professional services fees, a $5.7 million increase in stock-based compensation expense, a $5.3 million increase in personnel expenses primarily due to headcount increases and higher benefit costs resulting from the resumption of the discretionary employer match related to our 401(k) plan for our U.S. employees, and a $0.9 million increase in facility and operation expenses. These increases were partially offset by a $4.6 million decrease in outside services. We expect general and administrative expenses, assuming a stable currency environment, to grow in absolute amounts for the remainder of fiscal year 2011 due to increased business operations from our acquisition of Hypercom, including for example additional legal and litigation expenses related to lawsuits that we assumed as part of the Hypercom acquisition. Amortization of Purchased Intangible Assets Amortization of purchased intangible assets decreased $1.6 million and $5.7 million in the three and nine months ended July 31, 2011, respectively, compared to the same periods in fiscal year 2010 primarily as a result of purchased intangible assets being fully amortized partially offset by amortization of new intangible assets from fiscal year 2011 acquisitions. We expect amortization of purchased intangible assets to increase for the balance of fiscal year 2011 primarily as a result of the Hypercom acquisition. Operating Income The following table sets forth operating income (loss) for our segments (in thousands): Three Months Ended July 31, Nine Months Ended July 31, Net Percentage Net Percentage 2011 2010 Change Change 2011 2010 Change Change Operating income (loss): International $ 53,699 $ 31,265 $ 22,434 71.8 % $ 143,460 $ 97,275 $ 46,185 47.5 % North America 45,820 40,115 5,705 14.2 % 135,821 102,161 33,660 32.9 % Corporate (58,770 ) (43,789 ) (14,981 ) nm (165,983 ) (126,788 ) (39,195 ) nm Total operating income $ 40,749 $ 27,591 $ 13,158 47.7 % $ 113,298 $ 72,648 $ 40,650 56.0 % (1) nm - not meaningful 33 -------------------------------------------------------------------------------- Table of Contents International For the three and nine months ended July 31, 2011, International operating income increased $22.4 million, or 71.8% and $46.2 million, or 47.5%, respectively, compared to the same periods in fiscal year 2010 primarily due to increases in gross margin partially offset by an increase in operating expenses. North America For the three and nine months ended July 31, 2011 North America operating income increased $5.7 million, or 14.2% and $33.7 million or 32.9%, compared to the three and nine months ended July 31, 2010, respectively, mainly due to an increase in gross margin partially offset by an increase in operating expenses. Corporate Corporate operating loss increased $15.0 million for the three months ended July 31, 2011 compared to the three months ended July 31, 2010, primarily due to a $5.8 million increase in acquisition, integration related professional services fees, a $4.5 million increase in personnel costs, a $2.9 million increase in stock-based compensation expense, a $1.6 million increase in freight and duties, a $1.0 million increase in facilities and operations costs, a $0.6 million increase in expensed software development costs due to a shift towards general application development projects which benefit broad groups of customers rather than customer specific projects. In addition, we also experienced a $0.6 million increase in advertising and marketing expense, and a $0.5 million increase in provision for excess and obsolete inventory and scrap. These increases were partially offset by a $4.0 million reduction in total amortization of purchased intangible assets and a $0.6 million decrease in outside services. Corporate operating loss increased $39.2 million for the nine months ended July 31, 2011 compared to the nine months ended July 31, 2010, primarily due to a $12.5 million increase in personnel costs, a $11.3 million increase in acquisition and integration related professional services fees, a $11.0 million increase in stock-based compensation expense, a $7.9 million increase in provision for excess and obsolete inventory and scrap associated with business acquisitions and discontinued product lines, a $2.1 million increase in product specific warranty expense, a $1.5 million increase in expensed software development costs due to a the above mentioned reason, a $1.2 million increase in advertising and marketing expenses and a $1.1 million increase in inventory cycle count adjustments. These increases were partially offset by a $9.8 million reduction in total amortization of purchased intangible assets, a $3.1 million increase in outside services and a $1.2 decrease in accrued royalty as a result of a settlement agreement. We will incur additional restructuring and restructuring-related charges in the future for additional employee severance and benefit arrangements, and facility-related activities as a result of acquisitions. However, we are still in the process of determining the amount of these additional charges. Interest Expense Interest expense increased $0.5 million and $1.1 million in the three and nine months ended July 31, 2011, respectively, compared to the three and nine months ended July 31, 2010 primarily attributable to the increase in non-cash interest on our Notes. Other Income (Expense), Net Other income (expense), net increased $4.7 million during the three months ended July 31, 2011 compared to the three months ended July 31, 2010 primarily attributable to a $4.6 million gain on convertible note call option settlement, a $1.2 million gain from adjustments to acquisition related balances, partially offset by a $1.3 million increase in net foreign exchange losses. Other income (expense), net increased $5.2 million during the nine months ended July 31, 2011 compared to the nine months ended July 31, 2010 primarily attributable to a $4.6 million gain on convertible notes call option settlement, a $2.0 million increase in gains from adjustments to acquisition related balances and a $1.8 million gain on our acquisition of the Gemalto POS Business which closed on December 31, 2010. These increases were partially offset by a $3.0 million increase in net foreign exchange losses and the non-recurrence of a $1.5 million gain resulting from the reversal of a sales tax accrual during the nine months ended July 31, 2010. Provision for Income Tax We recorded income tax provisions of $13.0 million and $13.7 million for the three and nine months ended July 31, 2011, respectively. We recorded income tax provisions of $3.4 million and $3.0 million for the three and nine months ended July 31, 2010. The effective tax rates for the three and nine months ended July 31, 2011 and 2010 are lower than the U.S. statutory tax rate due to earnings in countries where we are taxed at lower rates compared to the U.S. federal and state statutory rates, utilization of previously unbenefitted U.S. tax attributes and reversal of uncertain tax position liabilities as statutes of limitations expired. 34 -------------------------------------------------------------------------------- Table of Contents As of July 31, 2011, we remain in a net deferred tax liability position. The realization of our deferred tax assets depends primarily on our ability to generate sufficient U.S. and foreign taxable income in future periods. We have determined that it is not more likely than not that the deferred tax assets in the United States and certain foreign jurisdictions will be realized. Therefore we continue to record a full valuation allowance against these assets as of July 31, 2011. The amount of deferred tax assets considered realizable may increase or decrease in subsequent quarters as we reevaluate the underlying basis for our estimates of future domestic and certain foreign taxable income. We have recorded our uncertain tax position liability as a long-term liability as we do not expect significant payments to occur over the next twelve months. The amount of unrecognized tax positions could be reduced upon closure of tax examinations or if the statute of limitations on certain tax filings expire without assessment from the tax authorities. We believe that it is reasonably possible that there could be a reduction in unrecognized tax benefits due to statute of limitation expirations in multiple tax jurisdictions during the next twelve months of approximately $1.0 million. Interest and penalties accrued on these uncertain tax positions will also be released upon the expiration of statutes of limitations. Liquidity and Capital Resources Nine Months Ended July 31, 2011 2010 Net cash provided by (used in): Operating activities $ 121,654 $ 101,988 Investing activities (19,294 ) (13,681 ) Financing activities 33,477 (11,391 ) Effect of exchange rate fluctuations on cash and cash equivalents 3,226 (1,450 ) Net increase in cash and cash equivalents $ 139,063 $ 75,466 Our primary liquidity and capital resource needs are to service our debt, finance working capital, and to make capital expenditures and investments. As of July 31, 2011, our primary sources of liquidity were cash and cash equivalents of $584.2 million as well as $25.0 million available to us under our revolving credit facility. Cash and cash equivalents included $292.3 million held by our foreign subsidiaries as of July 31, 2011 and if we decide to distribute or use such cash and cash equivalents outside those foreign jurisdictions, including a distribution to the United States, we may be subject to additional taxes or costs. The Notes, with remaining principal amount of $277.3 million, will be due and payable in cash in June 2012, unless repurchased earlier with cash, whether or not holders exercise their stock conversion option. We believe that we will have adequate cash available in the U.S. to meet this obligation, and we are also confident that we could refinance the obligation by raising new debt. Our future capital requirements may vary significantly from prior periods as well as from those currently planned. These requirements will depend on a number of factors, including operating factors such as our terms and payment experience with customers and investments we may make in product or market development, as well as timing and availability of financings. We have $217.5 million of borrowings outstanding under our Term B loan, which matures October 31, 2013. We may also in the future execute further voluntary repurchases of our Notes. Finally, our capital needs may be significantly affected by any acquisition we may make in the future because of any cash consideration in the purchase price, transaction costs and restructuring costs. Based upon our current level of operations, we believe that we have the financial resources to meet our business requirements for the next year, including capital expenditures, working capital requirements, future strategic investments, and to comply with our financial covenants. Operating Activities Net cash provided by operating activities was $121.7 million for the nine months ended July 31, 2011, up $20.0 million from the comparable period of the prior year primarily due to a $34.2 million increase in net income offset by $15.4 million growth in working capital. Cash provided by operations before changes in working capital amounted to $142.0 million for the nine months ended July 31, 2011 and consisted of $83.6 million of net income adjusted for $58.4 million of non-cash items consisting primarily of depreciation and amortization, stock-based compensation expense, and non-cash interest expense. Changes in working capital resulted in a $20.4 million decrease in cash and cash equivalents during the nine months ended July 31, 2011. The main drivers of this decrease were as follows: • A $62.9 million increase in accounts receivable primarily due to increased revenues and the timing of billings and collections for the first nine months of fiscal year 2011. 35 -------------------------------------------------------------------------------- Table of Contents • A $17.4 million increase in prepaid expenses and other assets primarily attributable to an increase in prepaid income taxes, unrealized gain on equity security investment, increases in rental assets and increases in net investment in sales type leases. Partially offset by: • A $33.9 million increase in accounts payable and accrued expense and other liabilities primarily due to the timing of purchases and payments. • An $8.3 million decrease in inventory due to timing of product purchases and shipments. • A $6.3 million increase in income taxes payable. • A $5.5 million increase in deferred revenues. Investing Activities Net cash used in investing activities was $19.3 million in the nine months ended July 31, 2011, up $5.6 million from the comparable period of the prior year primarily due to an $8.9 million increase in business acquisition offset by $5.0 million in equity investments in the nine months ended July 31, 2010 that did not recur in the current period. The main uses of cash were payments of $14.2 million for the Gemalto POS Business acquisition partially offset by $3.5 million cash received from the DEC acquisition, and $8.5 million for purchases of machinery and computer equipment. Financing Activities Net cash provided by financing activities was $33.5 million in the nine months ended July 31, 2011, up $44.9 million from the comparable period of the prior year due primarily to a $34.8 million increase in proceeds from stock option exercises and the $11.7 million acquisition of business-noncontrolling interest in April 2010 that did not recur, offset by $2.0 million more net repayments of our debt than in the nine months ended July 31, 2010. The financing activities consisted primarily consisting of $41.2 million of proceeds from the exercise of stock options under our employee equity incentive plans partially offset by $8.0 million of repayments of debt. Off-Balance Sheet Arrangements Our only off-balance sheet arrangements, as defined in Item 303(a)(4)(ii) of the SEC's Regulation S-K, consist of forward foreign currency agreements described under Quantitative and Qualitative Disclosures about Market Risk. See Part I, Item 3 of this quarterly report on Form 10-Q. |