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VDSI > SEC Filings for VDSI > Form 10-Q on 2-Nov-2012All Recent SEC Filings

Show all filings for VASCO DATA SECURITY INTERNATIONAL INC | Request a Trial to NEW EDGAR Online Pro

Form 10-Q for VASCO DATA SECURITY INTERNATIONAL INC


2-Nov-2012

Quarterly Report


Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (in thousands, except headcount, ratios, time periods and percents)

Unless otherwise noted, references in this Quarterly Report on Form 10-Q to "VASCO," "company," "we," "our," and "us" refer to VASCO Data Security International, Inc. and its subsidiaries.

Cautionary Note Regarding Forward-Looking Statements

This Quarterly Report on Form 10-Q, including Management's Discussion and Analysis of Financial Condition and Results of Operations and Quantitative and Qualitative Disclosures About Market Risk, contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934 and
Section 27A of the Securities Act of 1933 concerning, among other things, the prospects of, and developments and business strategies for, VASCO and our operations, including the development and marketing of certain new products and the anticipated future growth in certain markets in which we currently market and sell our products or anticipate selling and marketing our products in the future. These forward-looking statements (1) are identified by use of terms and phrases such as "expect", "believe", "will", "anticipate", "emerging", "intend", "plan", "could", "may", "estimate", "should", "objective", "goal", "possible", "potential", "projected" and similar words and expressions, but such words and phrases are not the exclusive means of identifying them, and (2) are subject to risks and uncertainties and represent our present expectations or beliefs concerning future events. VASCO cautions that the forward-looking statements are qualified by important factors that could cause actual results to differ materially from those in the forward-looking statements. These risks, uncertainties and other factors have been described in greater detail in our Annual Report on Form 10-K for the year ended December 31, 2011 and include, but are not limited to, (a) risks of general market conditions, including currency fluctuations and the uncertainties resulting from turmoil in world economic and financial markets, (b) risks inherent to the computer and network security industry, including rapidly changing technology, evolving industry standards, increasingly sophisticated hacking attempts, increasing numbers of patent infringement claims, changes in customer requirements, price competitive bidding, and changing government regulations, and (c) risks specific to VASCO, including, demand for our products and services, competition from more established firms and others, pressures on price levels and our historical dependence on relatively few products, certain suppliers and certain key customers. Thus, the results that we actually achieve may differ materially from any anticipated results included in, or implied by these statements. Except for our ongoing obligations to disclose material information as required by the U.S. federal securities laws, we do not have any obligations or intention to release publicly any revisions to any forward-looking statements to reflect events or circumstances in the future or to reflect the occurrence of unanticipated events.

General

We design, develop, market and support open standards-based hardware and software security systems that manage and secure access to information assets. We also design, develop, market and support patented strong user authentication products and services for e-business and e-commerce. Our products enable secure financial transactions to be made over private enterprise networks and public networks, such as the Internet. Our strong user authentication is delivered via our hardware and software DIGIPASS security products (collectively DIGIPASSES), many of which incorporate an electronic and digital signature capability, which further protects the integrity of electronic transactions and data transmissions. Some of our DIGIPASSES are compliant with the Europay MasterCard Visa (EMV) standard and are compatible with MasterCard's and VISA's Chip Authentication Program (CAP). Some of our DIGIPASS units comply with the Initiative for Open Authentication (OATH). As evidenced by our current customer base, most of our products are purchased by companies and, depending on the business application, are distributed to either their employees or their customers. Those customers may be other businesses or, as an example in the case of Internet banking, our customer banks' corporate and retail customers. In future years, we expect that our customers will increasingly use our cloud-based service offering, DIGIPASS as a Service ("DPS") as described below.


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We offer our products either through a product sales and licensing model or through our DPS product offering, which was first made available in the fourth quarter of 2010. DPS is our cloud-based authentication platform. By using our authentication platform, customers can deploy two-factor authentication more quickly, incur less upfront costs and be able to use strong authentication when logging onto a larger number of Internet sites and applications. We expect those applications to include business-to-business applications, business to employee applications (e.g., employees of companies logging into third party applications operated in the cloud), and business to consumer applications. While there were minimal revenues generated from this product in 2011, and we expect that the contribution of DPS will still be limited in 2012, we believe that DPS has the potential for significant future growth as it will make two-factor authentication more affordable and readily available to users and application markets.

Our target market is any business process that uses some form of electronic interface, particularly the Internet, where the owner of that process is at risk if unauthorized users can gain access to its process and either obtain proprietary information or execute transactions that are not authorized. Our products not only increase the security associated with accessing the business process, thereby reducing the losses from unauthorized access, but also, in many cases, reduce the cost of the process itself by automating activities that were previously performed manually.

Comparison of Results for the Three and Nine months ended September 30, 2012 and 2011

Industry Growth: We do not believe that there are any accurate measurements of the total industry's size or the industry's growth rate. We believe, however, that the industry will grow at a significant rate as the use of the Internet increases and the awareness of the risks of using the Internet grow among applications owners and consumers. We expect that growth will be driven by new government regulations, growing awareness of the impact of identity theft, and the growth in commerce that is transacted electronically. The issues driving the growth are global issues and the rate of adoption in each country is a function of that country's culture, the competitive position of businesses operating in that country, the country's overall economic conditions and the degree to which businesses and consumers within the country use technology.

Economic Conditions: Our revenue may vary significantly with changes in the economic conditions in the countries in which we sell products. With our current concentration of revenue in Europe and specifically in the banking/finance vertical market, significant changes in the economic outlook for the European banking market may have a significant effect on our revenue.

We acknowledge that there is significant economic uncertainty in Western Europe today regarding the sovereign debt issue. If the sovereign debt issue escalates to the point that major countries default on their debt and either the European Union, or Euro Monetary Union, disbands or is re-formulated, we expect that the resulting economic difficulties would have a major negative impact on the global economy, not just the economies of Western Europe, and our business.

We do not believe, however, that the uncertainty surrounding the sovereign debt issue had a measureable negative impact on our business in the third quarter or first nine months of 2012 and we do not expect that it will significantly reduce our business opportunities for the remainder of 2012.

Revenue from our Europe, Middle East and Africa ("EMEA") region, which accounted for 53% and 61% of our consolidated revenues for the third quarter and first nine months of 2012, respectively, decreased 31% and 19% when compared to the third quarter and first nine months of 2011. We believe that the reduction in revenues in the third quarter and first nine months of 2012 compared to the same periods of 2011 was not due to a change in the economic environment, but primarily reflected the timing of when orders are received and goods are shipped and the strengthening of the U.S. Dollar compared to the Euro.


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On a global basis, we entered 2012 with a lower backlog of orders than in 2011. In addition, while our intake of new customer orders in the third quarter was lower than in the third quarter of 2011, our order intake for the first nine months of 2012 has been stronger than in the same period in 2011.

Cybersecurity: Our use of technology is increasing and is critical in three areas of our company:

1. The use of software and information systems that we use to help us run our business more efficiently and cost effectively;

2. The products we have traditionally sold and continue to sell to our customers for integration into their software applications contains technology that incorporates the use of secret numbers and encryption technology; and

3. New products and services that we are introducing to the market, such as DPS, are focused on processing information through our servers (or in the cloud from our customers' perspective).

We believe that the risks and consequences of potential incidents in each of the above areas are different.

In the case of the information systems we use to help us run our business, we believe that an incident could disrupt our ability to take orders or deliver product to our customers, but such a delay in these activities would not have a material impact on our overall results. To minimize this risk, we actively use various forms of security and monitor the use of our systems regularly to detect potential incidents as soon as possible.

In the case of products that we have traditionally sold, we believe that the risk of a potential cyber incident is minimal. We offer our customers the ability to either create the secret numbers themselves or have us create the numbers on their behalf. When asked to create the numbers, we do so in a secure environment with limited physical access and store the numbers on a system that is not connected to our network, and similarly, is not connected to the Internet. Were such an incident to occur, our business could be subject to significant disruption and we could suffer significant monetary losses and significant reputational harm.

In the case of our new products and services, which involve the active daily processing of the secret numbers on our servers or servers managed by others in a hosted or co-location environment, we believe a cyber incident could have a material impact on our future business. We believe these products may be more susceptible to cyber attacks than our traditional products since they involve the active processing of transactions using the secret numbers. While we do not have a significant amount of revenue from these products today, we believe that these products have the potential to provide substantial future growth. A cyber incident involving these products in the future could substantially impair our ability to grow the business in this area and we could suffer significant monetary and other losses and significant reputational harm.

To minimize the risk, we review our security procedures on a regular basis. Our reviews include the processes and software programs we are currently using as well as new forms of cyber incidents and new or updated software programs that may be available in the market that would help mitigate the risk of incidents. While we do not insure against cyber incidents today, we would likely review insurance policies related to our new product offering in the future. Overall, we expect the cost of securing our networks will increase in future periods, whether through increased staff, systems or insurance coverage.


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Income Taxes: Our effective tax rate reflects our global structure related to the ownership of our intellectual property ("IP"). All our IP is owned by two subsidiaries, one in the U.S. and one in Switzerland. Our two subsidiaries have entered into agreements with most of the other VASCO entities under which those other entities provide services to our U.S. and Swiss subsidiaries on either a percentage of revenue or on a cost plus basis or both. Under this structure, the earnings of our service provider subsidiaries are relatively constant. These service provider companies tend to be in jurisdictions with higher effective tax rates. Fluctuations in earnings tend to flow to the U.S. and Swiss companies.

We expect earnings flowing to the U.S. will be taxed at rates approximating the U.S. statutory tax rate, but with the majority of our revenues being generated outside of the U.S., our consolidated effective tax rate is strongly influenced by the effective tax rate of our foreign operations. Changes in the effective rate related to foreign operations reflect changes in the geographic mix of where the earnings are realized and the respective tax rates in each of the countries in which earnings are realized. The statutory tax rate for the primary foreign tax jurisdictions ranges from 8% to 34%. For 2012, we expect that total earnings in foreign countries where the IP is owned by our subsidiary in Switzerland will be taxed at a rate that is 10 to 15 percentage points lower than the U.S. rate. For years after 2012, we expect that the rate differential for foreign countries, when compared to the U.S. statutory rate, will increase as the buy-in payments related to the original purchase of the IP are completed (i.e., taxable income in the foreign countries will decrease in the higher tax rate jurisdictions and increase in the lower tax rate jurisdictions as the Swiss and U.S. companies no longer make payments to the higher rate foreign countries related to the original purchase of the IP).

The geographic mix of earnings of our foreign subsidiaries will primarily depend on the level of our service provider subsidiaries' pretax income, which is recorded as expense in the two entities that own our intellectual property (i.e., subsidiaries in the U.S. and Switzerland), and the benefit that is realized in Switzerland through the sales of product. The level of pretax income in our service provider subsidiaries is expected to vary based on:

1. the staff, programs and services offered on a yearly basis by the various subsidiaries as determined by management, or

2. the amount of the payments made by the U.S. and Swiss entities related to the purchase of the service providers' original IP (which payments are scheduled to cease at the end of 2012), or

3. the changes in exchange rates related to the currencies in the service provider subsidiaries, or

4. the amount of revenues that the service provider subsidiaries generate.

For items 1, 2 and 3 above, there is a direct impact in the opposite direction on earnings in the U.S. and Swiss entities. Any change from item 4 is generally expected to result in a larger change in income in the U.S. and Swiss entities in the direction of the change (increased revenues expected to result in increased margins/pretax profits and conversely decreased revenues expected to result in decreased margins/pretax profits) than the change in the service provider entities.

In addition to the provision of services, the intercompany agreements transfer the majority of the business risk to our U.S. and Swiss subsidiaries. As a result, the contracting subsidiaries' pretax income is reasonably assured while the pretax income of the U.S. and Swiss subsidiaries varies directly with our overall success in the market.

Given the wide range of tax rates in the jurisdictions in which we operate, we expect that our tax rate will be volatile in 2012 and beyond. Our tax rate in any given period will be largely dependent on the geographic location of the earnings. We expect that our tax rate will be higher when the mix of earnings favors the territories in which our U.S. subsidiary owns the IP and similarly will be lower when the mix of earnings favors the territories in which our Swiss subsidiary owns the IP.


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Currency Fluctuations: In the third quarter 2012 and 2011, approximately 94% and 85%, respectively, of our revenue was generated outside the United States. For the nine months ended September 30, 2012 and 2011 approximately 93% and 91%, respectively, of our revenue was generated outside of the United States.

In addition, in the third quarter of 2012 and 2011, approximately 86% and 80%, respectively of our operating expenses were incurred outside the United States. For both the nine months ended September 30, 2012 and 2011, approximately 81% of our operating expenses were incurred outside of the United States.

Changes in currency exchange rates, especially the Euro to U.S. Dollar, can have a significant impact on revenue and expenses. In general, to minimize the net impact of currency fluctuations, we attempt to denominate our billings in a currency such that it would provide a hedge against the operating expenses being incurred in that currency. We expect that changes in currency rates may also impact our future results if we are unable to match amounts of revenue with our operating expenses in the same currency.

The U.S. Dollar strengthened by approximately 16% and 10% against the Euro for the quarter and nine months ended September 30, 2012, respectively, compared to the same periods in 2011. The U.S. Dollar also strengthened approximately 4% and 1% against the Australian Dollar for the quarter and first nine months ended September 30, 2012, respectively, as compared to the same periods in 2011. We estimate that the changes in the exchange rate of the U.S. Dollar to these two currencies in 2012 compared to 2011 resulted in a decrease in revenue and operating expenses of approximately $1,523 and $1,981, respectively, for the quarter ended September 30, 2012 and a decrease in revenue and operating expenses of approximately $3,374 and $3,748, respectively for the nine months ended September 30, 2012 compared to the same periods in 2011.

The financial position and results of operations of most of our foreign subsidiaries, with the exception of our subsidiaries in Switzerland and Singapore (in which the functional currency is the U.S. Dollar), are generally measured using the local currency as the functional currency. Accordingly, assets and liabilities are translated into U.S. Dollars using current exchange rates as of the balance sheet date. Translation adjustments arising from differences in exchange rates are included as a separate component of stockholders' equity. Revenue and expenses are translated at average exchange rates prevailing during the period. Gains and losses resulting from foreign currency transactions are included in the consolidated statements of operations in other non-operating income (expense). Foreign exchange transaction losses aggregating $304 and $259 in the third quarter and first nine months of 2012, respectively, compares to losses aggregating of $583 and $525 in the third quarter and first nine months of 2011, respectively.


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Revenue

Revenue by Geographic Regions: We classify our sales by customers' location in four geographic regions: 1) EMEA, which includes Europe, the Middle East and Africa; 2) the United States, which for our purposes includes sales in Canada;
3) Asia Pacific; and 4) Other Countries, including Australia, Latin America and Central Asia. The breakdown of revenue for the three and nine months ended September 30, 2012 and 2011 in each of our major geographic regions follows:

                                                       United         Asia           Other
                                          EMEA         States       Pacific        Countries         Total
Three months ended September 30:

Revenue:
2012                                    $ 19,160      $  2,272      $ 10,651      $     4,209      $  36,292
2011                                      27,640         6,167         3,406            4,172         41,385

Percent of Total:
2012                                          53 %           6 %          29 %             12 %          100 %
2011                                          67 %          15 %           8 %             10 %          100 %

Nine months ended September 30:

Revenue:
2012                                    $ 69,904      $  8,112      $ 26,018      $    11,158      $ 115,192
2011                                      85,849        11,095         8,455           14,155        119,554

Percent of Total:
2012                                          61 %           7 %          22 %             10 %          100 %
2011                                          72 %           9 %           7 %             12 %          100 %

Total revenue in the third quarter of 2012 decreased $5,093, or 12%, from third quarter of 2011. Including the impact of changes in currency exchange rates, the decrease was primarily attributable to an 11% decrease in revenues from the banking market and a 16% decrease in revenues from the enterprise and application security market. As noted above, for the quarter ended September 30, 2012, we estimate that the strengthening of the U.S. Dollar as compared to the Euro resulted in a decrease in revenue of $1,523.

Revenue generated in EMEA during the third quarter of 2012 was $8,480, or 31%, lower than the third quarter of 2011. The decrease in revenues reflected a decrease in revenues from both the banking and enterprise and application security markets.

Revenue generated in the United States during the third quarter of 2012 was $3,895, or 63%, lower than the third quarter of 2011. The decrease in revenues reflected a decrease in revenues from both the banking market and from the enterprise and application security markets. The banking market in the United States uses our technology primarily for corporate banking applications and, as a result, is relatively small. Given the size of the market, our results may vary significantly period to period based on the size and timing of shipment of individual orders.

Revenue generated in the Asia Pacific region during the third quarter of 2012 was $7,245, or 213%, higher than the third quarter of 2011. The increase in revenues reflected growth in the banking partially offset by a decline in the enterprise and application security markets.

Revenue generated from Other Countries during the third quarter of 2012 was $37, or 1%, higher than the third quarter of 2011. We expect that revenues from Other Countries will be more volatile than from our other regions given their earlier stage of development of the authentication market in those countries. VASCO, however, plans to continue to invest in new markets based on our estimates of the each market's demand for strong user authentication.

Total revenue for the nine months ended September 30, 2012 decreased $4,362, or 4%, from the first nine months of 2011. Including the impact of changes in currency exchange rates, the decrease was primarily attributable to a 6% decrease in revenues from the banking market partially offset by an 8% increase in revenues from the enterprise and application security market. As noted above, for the nine months ended September 30, 2012, we estimate that the strengthening of the U.S. Dollar as compared to the Euro resulted in a decrease in revenue of $3,374.

Revenue for the nine months ended September 30, 2012 generated in EMEA decreased $15,945, or 19%, from the first nine months of 2011. Revenue from the banking market for the first


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nine months of 2012 was approximately 23% lower than in the same period of 2011 while revenues from the enterprise and application security market were comparable to the revenue for the first nine months of 2011.

Revenue for the nine months ended September 30, 2012 generated in the United States decreased $2,983, or 27%, from the first nine months of 2011. The decline in revenues from the U.S. for the first nine months of 2012 was primarily due to a decline in revenues from the banking market.

Revenue for the nine months ended September 30, 2012 from Asia Pacific increased $17,563, or 208%, from the first nine months of 2011. Revenues from Asia Pacific for the first nine months of 2012 reflected an increase in revenues from both the banking market and the enterprise and application security market.

Revenue for the nine months ended September 30, 2012 generated from Other Countries decreased $2,997, or 21%, from the first nine months of 2011. Revenues from Other Countries for the first nine months of 2012 primarily reflected a decrease in revenues from the Latin American banking market.

Revenue by Target Market: Revenue is generated currently from two primary markets, banking/finance (banking) and enterprise and application security, through the use of both direct and indirect sales channels. The enterprise and application security market includes products used by employees of corporations to secure their internal networks (i.e., enterprise security market) and business-to-business, business-to-consumer, e-commerce, e-government, e-gaming and other vertical applications (i.e., the application security market) that are not related to banking or finance. In addition, revenue from services-related activities, such as maintenance and support are included in the Enterprise and Application Security markets. Management currently views the enterprise and application security market as one market because the same products are sold through the same channels to both customer groups. Sales to the enterprise security and application market are generally for smaller quantities and higher prices than sales made to the banking market. The breakdown of revenue between the two primary markets was as follows:

                                                       Enterprise
                                                            &
                                                       Application
                                        Banking         Security           Total
      Three months ended September 30:

      Revenue:
      2012                              $ 29,592      $       6,700      $  36,292
      2011                                33,403              7,982         41,385

      Percent of Total:
      2012                                    82 %               18 %          100 %
      2011                                    81 %               19 %          100 %

      Nine months ended September 30:

      Revenue:
      2012                              $ 93,168      $      22,024      $ 115,192
      2011                                99,116             20,438        119,554

      Percent of Total:
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