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VDSI > SEC Filings for VDSI > Form 10-Q on 2-Aug-2013All Recent SEC Filings

Show all filings for VASCO DATA SECURITY INTERNATIONAL INC

Form 10-Q for VASCO DATA SECURITY INTERNATIONAL INC


2-Aug-2013

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, as amended and Section 27A of the Securities Act of 1933, as amended concerning, among other things, our expectations regarding the prospects of, and developments and business strategies for, VASCO and our operations, including the development and marketing of certain new products and services and the anticipated future growth in certain markets in which we currently market and sell our products and services or anticipate selling and marketing our products or services 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" 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, 2012 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

The following discussion is based upon our consolidated results of operations for the quarters and six months ended June 30, 2013 and 2012 (percentages in the discussion, except for returns on average net cash balances, are rounded to the closest full percentage point) and should be read in conjunction with our consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q.

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 DIGIPASSES 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") or MYDIGIPASS.COM ("MDPC") or together ("DPS/MDPC") as described below.

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 can not only increase the security associated with accessing the business process, thereby reducing the losses from unauthorized access, but also, in many cases, can reduce the cost of the process itself by automating activities that were previously performed manually.


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We offer our products either through: (a) a product sales and licensing model; or (b) through our services platform, which includes both our DPS product offering, which was first made available in the fourth quarter of 2010, and our MDPC product offering, which was introduced in April 2012. DPS/MDPC is our cloud-based authentication platform. Our product license and sales model is expected to be used in situations where the application owner wants to control all of the critical aspects of the authentication process. We expect that our services platform will be used by: (a) companies lacking technical resources or expertise to implement a full authentication process or preferring to focus their primary attention on other aspects of their business rather than on the authentication process or (b) consumers that are aware of the dangers posed by identity theft.

By using our DPS authentication platform, business 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 using DPS to include B2B applications and B2E applications (e.g., employees of companies logging into third party applications operated in the cloud). We believe that corporations or application service providers will pay us a fee based on either the number of users accessing their application through our platform or the number of authentication clicks consumed by their users when accessing their application.

By using our MDPC platform, consumers using B2C applications will have convenient access to those applications with increased security. We expect that we will earn commissions from various vendors for purchases made by consumers using our platform.

While there were minimal revenues generated from the services platform to date, we expect that DPS/MDPC will start making a contribution in 2014. We believe that DPS/MDPC has the potential for significant future growth as it will make two-factor authentication more affordable and readily available to users and application markets.

Comparison of Results for the Three and Six Months Ended June 30, 2013 and 2012

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 using our product sales and licensing model will grow at a significant rate as the use of the internet increases and the awareness of the risks of using the internet become more prevalent among application owners. We also believe that a market will develop for our cloud-based service offering and grow at a significant rate as business owners and consumers become more aware of the risks involved in conducting business over the internet. 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 currently 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.

There continues to be significant global economic uncertainty, including Europe, our most important market. While it appears that circumstances that led to the sovereign debt crisis abated in 2012, many significant economic issues have not been addressed fully. As a result, we expect that Europe will continue to face difficult economic conditions in 2013. We believe that the current economic conditions in Europe may limit our growth opportunities in the Enterprise and Application Security market, but do not expect that the economic conditions will have a significant impact on the Banking market. Should the sovereign debt issue escalate, especially to the point that a country defaults on its debt or the European Union, or Euro Monetary Union, either 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.

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

1. 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 contain 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/MDPC, 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.


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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 any other network, including other VASCO networks, and similarly, is not connected to the internet. 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 environment, we believe a cyber incident could have a material impact on our future business. We also believe that these products may be more susceptible to cyber attacks than our traditional products since it involves 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 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.

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. These 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. Earnings flowing to the U.S. company are expected to be taxed at a rate of 35% to 40%, while earnings flowing to the Swiss company are expected to be taxed at a rate ranging from 8% to 12%.

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 tax rates in each of the countries in which it is earned. The statutory tax rate for the primary foreign tax jurisdictions ranges from 8% to 35%.

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 an expense by the U.S. and Swiss subsidiaries that own the IP 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 changes in exchange rates related to the currencies in the service provider subsidiaries, or

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

For items 1 and 2 above, there is a direct impact in the opposite direction on earnings of the U.S. and Swiss entities. Any change from item 3 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).

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 pretax income of the contracting subsidiaries providing services is reasonably assured while the pretax income of the U.S. and Swiss subsidiaries varies directly with our overall success in the market.

For 2013, we expect that our tax rate will be lower than in 2012 as growth in earnings of the Swiss company are expected to exceed the growth in earnings of the U.S. company, in part due to the fact that the final buy-in payments related to the original purchase of the IP were completed in 2012 (i.e., taxable income will decrease in the higher tax rate jurisdictions and increase in the lower tax rate jurisdictions as the Swiss and U.S. subsidiaries no longer make payments to the higher rate foreign countries related to the original purchase of the IP). The actual tax rate for 2013, however, will be determined based on the geographic location of earnings in 2013.


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Currency Fluctuations: In the second quarter of 2013 and 2012 approximately 92% and 94%, respectively, of our revenue was generated outside the United States. For the six months ended June 30, 2013 and 2012 approximately 92% and 93%, respectively, of our revenue was generated outside of the U.S.

In addition, in the second quarter of 2013 and 2012 approximately 82% and 80%, respectively, of our operating expenses were incurred outside the United States. For the six months ended June 30, 2013 and 2012 approximately 81% and 79%, respectively, of our operating expenses were incurred outside of the U.S. As a result, changes in currency exchange rates, especially from 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 on operating income, we attempt to denominate an amount of 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. If the amount our revenue in Europe denominated in Euros continues as it is now or declines, we do not expect that we will be able to balance fully the exposures of currency exchange rates on revenue and operating expenses.

The U.S. Dollar to Euro exchange rate was essentially unchanged for the quarter and six months ended June 30, 2013, respectively, compared to the same periods in 2012. In addition, the U.S. Dollar strengthened approximately 1% against the Australian Dollar for the quarter and six months ended June 30, 2013, respectively, compared to the same periods in 2012. As a result, the changes in exchanges rates did not have a significant impact on either revenues or operating expenses for the quarter or six months ended June 30, 2013.

The financial position and the results of operations of most of our foreign subsidiaries, with the exception of our subsidiaries in Switzerland and Singapore, are 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. Revenues and expenses are translated at average exchange rates prevailing during the period. Translation adjustments arising from differences in exchange rates generated other comprehensive loss of $8 in the second quarter of 2013 and $2,267 for the first six months of 2013. Translation adjustments arising from differences in exchange rates generated other comprehensive loss of $4,066 in the second quarter of 2012 and $1,980 for the first six months of 2012. These amounts are included as a separate component of stockholders' equity. The functional currency for our subsidiaries in Switzerland and Singapore is the U.S. Dollar.

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 were $0 and $91 in the second quarter and first six months of 2013, respectively, compared to losses of $49 and gains of $46 in the second quarter and first six months of 2012, respectively.

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 Rim; and 4) Other Countries, including Australia, Latin America and India. The breakdown of revenue in each of our major geographic areas was as follows:


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                                                        United           Asia           Other
                                          EMEA          States         Pacific        Countries         Total
Three months ended June 30:
Revenue:
2013                                   $   24,460      $   2,904      $    6,670      $    3,226      $   37,260
2012                                       31,367          2,914           8,815           3,546          46,642
Percent of Total:
2013                                           65 %            8 %            18 %             9 %           100 %
2012                                           67 %            6 %            19 %             8 %           100 %
Six months ended June 30:
Revenue:
2013                                   $   46,478      $   5,930      $   11,356      $    8,862      $   72,626
2012                                       50,744          5,840          15,367           6,949          78,900
Percent of Total:
2013                                           64 %            8 %            16 %            12 %           100 %
2012                                           64 %            7 %            20 %             9 %           100 %

Total revenue in the second quarter of 2013 decreased $9,382, or 20%, from the second quarter of 2012. The decrease was primarily attributable to a 21% decrease in revenues from the Banking market and an 18% decrease in revenues from the Enterprise and Application Security market. For the first six months of 2013, total revenue decreased $6,274 or 8% from the first six months of 2012. The decrease was primarily attributable to a 5% decrease in revenues from the Banking market and a 19% decrease in revenues from the Enterprise and Application security market.

Revenue generated in EMEA during the second quarter of 2013 was $6,907, or 22%, lower than the second quarter of 2012. For the first six months, revenue generated in EMEA was $4,266, or 8% lower than the first six months of 2012. The decrease in revenues in both the second quarter and first six months of 2013 compared to the same periods in 2012 reflected a decrease in revenues from both the Banking and the Enterprise and Application Security markets.

Revenue generated in the United States for both the second quarter and first six months of 2013 was largely unchanged from the second quarter and first six months of 2012. Revenues for both the second quarter and first six months of 2013 compared to both periods in 2012 reflected an increase in revenues from the Banking market offset by a decline in revenue from the Enterprise and Application Security market. 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 second quarter of 2013 was $2,145, or 24%, lower than the second quarter of 2012. For the first six months of 2013 revenue was $4,011, or 26% lower than the first six months of 2012. The decrease in revenues reflected a decline in revenue from both the banking and the enterprise and application security markets in both periods.

Revenue generated from Other Countries during the second quarter of 2013 was $320, or 9%, lower than the second quarter of 2012. For the first six months of 2013 revenue was $1,913, or 28% higher than the first six months of 2012. The decrease in revenues from Other Countries in the second quarter of 2013 compared to 2012 was primarily due to a decrease in revenues from both the Banking and the Enterprise and Application Security markets in Australia. The increase in revenues from Other Countries for the first six months of 2013 compared to 2012 was primarily due to an increase in revenues from the Banking markets in Australia, India and South America partially offset by a decrease in revenues from the Enterprise and Application Security markets in Australia and India. 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.


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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 June 30:
      Revenue:
      2013                          $   30,827      $        6,433      $   37,260
      2012                              38,836               7,806          46,642
      Percent of Total:
      2013                                  83 %                17 %           100 %
      2012                                  83 %                17 %           100 %
      Six months ended June 30:
      Revenue:
      2013                          $   60,267      $       12,359      $   72,626
      2012                              63,576              15,324          78,900
      Percent of Total:
      2013                                  83 %                17 %           100 %
      2012                                  81 %                19 %           100 %

Revenue in the second quarter of 2013 from the Banking market decreased $8,009, or 21%, from the second quarter of 2012 and revenue from the Enterprise and Application Security market decreased $1,373, or 18%, in the same period. Revenue for the first six months of 2013 from the Banking market decreased $3,309, or 5%, compared to the first six months of 2012, while revenue from the . . .

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