OneSpan Inc (OSPN) 2006 Q3 法說會逐字稿

Good morning, my name is Eduardo and I will be your conference operator today. At this time I would like to welcome everyone to the Third Quarter 2006 VASCO Data Security International Inc. conference call.

[OPERATOR INSTRUCTIONS].

It is now my pleasure to turn the floor over to your host T. Kendall Hunt, Chairman, Founder and CEO. Sir, you may begin your conference.

Thank you, Eduardo. Good morning everyone. For those listening in from Europe good afternoon, and from Asia good evening. We have continuing good news to discuss with you today. My name is Ken Hunt and I'm the Chairman, Founder and CEO of VASCO Data Security International Inc. On the call with me today are Jan Valcke, our President and Chief Operating Officer and Cliff Bown, our EVP and Chief Financial Officer. Before we begin the conference call I need to brief all of you on forward-looking statements.

Statements made in this conference call that relate to future plans, events or performances are forward-looking statements. Any statement containing such words as believes, anticipates, plans, expects and similar words is forward looking and these statements involve risks and uncertainties and are based on current expectations. Consequently actual results could differ materially from the expectations expressed in these forward-looking statements. I direct your attention to the company's filings with the Securities and Exchange Commission for a discussion of such risks and uncertainties in this regard.

Today we're going to review the results for third quarter 2006. As always we'll host a question-and-answer session after the conclusion of management's prepared remarks. If possible I'd like to budget one hour total for this conference call. If you can limit your questions to one or two it would be appreciated.

First I'd like to address revenue for third quarter 2006. It was $18.7 million, an increase of 41% over third quarter 2005 and our strongest quarter ever even surpassing our very strong second quarter of 2006. It was also our 15th consecutive positive quarter in terms of operating income and cash flow. For the third quarter of 2006 our gross margins were 68% of revenue and our operating margins were an outstanding 26.6% of revenue.

Our backlog or firm business for Q4 as of today is $21.5 million. Backlog is defined as orders already shipped between October 1st, 2006 and today plus firm purchase orders scheduled to ship before December 31st, 2006. The results of Q3 2006 and the strong backlog announced today confirm once again that our strategies are working worldwide.

New accounts continue to grow during the third quarter. During the quarter we sold an additional 381 new accounts including 58 new banks and 323 new enterprise security customers. Year-to-date we have sold 1,083 new accounts including 138 new banks and 945 new enterprise security customers. Comparatively for all of 2005 we produced 821 new accounts including 89 banks and 732 enterprise security customers.

We now have over 550 banks and approximately 3,300 enterprise security customers including corporations, federal, state and local governments as customers located in over 100 countries around the world. Most importantly we are making significant business progress in the United States. While our revenues in the third quarter in the US were less than in the second quarter the trend in new accounts that we experienced in Q2 2006 is continuing and even strengthening this quarter.

In fact, 29 of the 58 new banks in Q3 were signed here in the US. This success has definitely been fueled by the very strong banking industry directive issued on October 12th, 2005 here in the United States by the FFIEC an umbrella of group regulators that includes the FDIC. The FFIEC directive has raised the security awareness of US banks dramatically.

VASCO is reaping the benefits of this enhanced awareness and we believe that we can do even better in the United States' banking market. While many banks are making the right decision by opting for the proven stronger authentication solutions of long-standing security companies, others are deciding on a 'meets minimum' approach due to the stringent deadline.

We believe that these banks will realize in 2007 that the products they've installed do not offer a good user experience and user experience is key for every successful authentication project. In 2008 and 2009 we believe that these banks will reconsider and opt for a mature and proven solutions from established vendors replacing those installed in 2006 and 2007.

We are seeing many different types of new banks becoming VASCO customers. We have the big institutions whose names you all know but there are also the small community type of banks. We must not forget that even the smallest bank will have to be FFIEC compliant.

The large banks we tackle via direct sales. To reach the large number of smaller banks we've established tight and successful partnerships with leading bank solution providers such as Fiserv, [FUNTEC] and others. For the nine months ended September 30, 2006 our US revenues were up 63% from 2005 and are already 24% better than our full-year 2005 results in the US.

We must not forget that all our regions are doing great. Europe, our traditional strong-hold shows growth in both the banking and the enterprise security market and other important markets like Latin America and APAC are performing extremely well too. VASCO's sustainable, repeatable sales model -- all of you should know this one by now. I've been consistent with this message for 15 quarters, namely that VASCO has developed a sustainable, repeatable sales model mainly driven by our strong vertical market, banking and finance. Our bank customers launch multi-year projects that are supported by our strong authentication products. These projects are directed towards large corporate and consumer audiences and are rolled out over two to four years. Additionally we continue to add new banks every quarter that contribute an ever-growing number of new projects. This has created the layering or stacking effect that I often speak about and is driving our top-line revenue and guidance.

Of course VASCO does not only sell to banks. We use the same products we have developed for the banking markets and other sectors and with success. We are experiencing continuing success in the enterprise security market and are continuously reinforcing our product offerings for that sector. The recent acquisition of all-in-one Unified Threat Management vendor Able N.V. strengthens our offerings and our position in enterprise security.

Full Option All Terrain model, we introduced our all-terrain strategy in the first quarter of 2006 to further penetrate and protect our existing and growing customer base. We will expand our flexible platform VACMAN Controller to support a growing array of authentication products. Some of those products like our Digipass for Web which we announced in the first quarter will allow customers to implement a strong authentication solution as a complement to or as an alternative to deploying hardware authentication devices. With the addition of Digipass for Web VASCO will be able to serve and authenticate every audience that needs strong authentication from people buying a book online once a year to CFOs and companies transacting millions of dollars on a daily basis.

We will also be looking to acquire companies that can expand our authentication offerings and product development capabilities. We are seeing some significant interest in Digipass for Web. In fact we expect the first Digipass for Web customers in the US to sign up in the very short term. Our software Digipass are also doing well in general. Next to Digipass for Web we see a growing interest in Digipass for Java phone resulting in firm orders where our customers offer their clients a choice of a hardware Digipass or a software Digipass for a Java phone.

In Q3 2006 we sold and shipped a record 2.9 million Digipass units once again demonstrating the effectiveness of our strategies, focus and execution. Programmed to date approximately 28 million Digipass units have been sold and shipped. We expect that our unit sales will continue to accelerate as we develop new markets, identify new audiences for the company's products.

I believe that VASCO is living up to its reputation for focus and discipline. We focus on markets where we have a differentiated and unique platform. We don't spend money lavishly but focus on profitability for our shareholders. We don't acquire companies recklessly but use a disciplined, well-defined process that assures a fair price and an optimal and profitable outcome.

The acquisition of the UTM company, Able N.V. announced today, is a good example of this strategy. Able is a profitable company with great products and great people. The company has already integrated VACMAN Controller into their award-winning aXs GUARD product line. Able was primarily active in Benelux. We believe that we can quickly grow the sales of aXs GUARD in the short term by selling the product on a larger scale through VASCO's worldwide sales channel.

At this time I'd like to introduce Jan Valcke, VASCO's President and Chief Operating Officer. Jan, congratulations to you and your team on another fine quarter.

Thank you, Ken. Ladies and gentlemen, last quarter was instrumental in the development as VASCO as a full option all-terrain authentication company. With regards to the products we have now a major evolution. We broadened our product range without endangering our focus and the cohesion of our offerings. As an authentication company VASCO specializes in guaranteeing that only the right designated persons get access to a network.

By adding fraud detection and analyzer services VASCO broadens its range beyond the pure authentication. Very recently VASCO announced that it acquired the Belgium UTM appliance vendor Able N.V. Thanks to Able VASCO adds 20 appliances to its offerings including VPN, firewall, anti-virus, hacker detection, statistics and reporting, contents scanning and more.

VASCO Controller is already integrated into Able's award-winning aXs GUARD products. The result is that VASCO has a comprehensive and integrated product range gathered around VACMAN Controller. The flexibility of the system allow us even more than before to offer our customer a la carte authentication and e-security. If we translate VASCO's offering to the physical worlds we could say that strong authentication is about doors and keys. Fraud detection focuses on police patrols, guards, cameras and security reports. The acquisition of Able 8, sorry gates, [hotwire] and [online] systems to the offering.

Around VACMAN Controller its core authentication platform VASCO is building an integrated comprehensive security model with strong authentication as the center surrounded by building blocks with the related technologies. With regard to the markets we can say that VASCO grows in every geographical market. As Ken already mentioned we have continuing success in the United States of America. In the third quarter we won 29 new banks in the US bringing the total number of US banking customers to over 80. In Europe both the enterprise security and the banking markets are growing rapidly whilst we are making headways in Latin America and Asia.

Our vertical reach is expanding too. In addition to the traditional banking and enterprise security market VASCO is breaking through in the B2B e-commerce market. We also see encouraging signs in the B2C e-commerce and e-government. In the vertical market it is clear that our products are used beyond the banking sector. We will, of course, keep our focus on the financial sector but without turning a blind eye at opportunities in other sectors. We are implementing clear business models for a number of strategic verticals. You will hear a lot more from this.

The people, at the end of the third quarter VASCO counted 161 employees. Although it isn't easy to find the right kind of people. We succeed in attracting new competent professionals and importantly we succeed in growing without jeopardizing our profitability.

The cash, we are on Cliff Bown's [territory] here. I won't say too much about the financial position but it is important to note that we succeed in financing our own growth and acquisitions with our own cash. We have proven this with the acquisition of AOS-Hagenuk, Logico and Able.

Ladies and gentlemen as you know our product and marketing strategy is simple but effective. Number one, we develop a product range that suits every bank's needs. We take the product range to other vertical markets beyond banking. Number three, we add products and technologies that are needed to suit the specific needs of customers within those verticals. Some people may still think that VASCO is a vendor of low-cost hardware tokens to the financial sector. They are wrong. That image does not correspond with reality for the following reasons, low cost.

The full option strategy is working. If you look at VASCO gross margin you will understand that we are creating a substantial added value. Customers do not only buy our Digipass products. They also go for VASCO software and services, they opt for VASCO's authentication platform. When they become a VASCO customer they choose for VASCO's know-how, experience and customer dedication. That is one of the secret's of VASCO's success.

Another reason is that once a company have installed VACMAN Controller the growth path to tomorrow's authentication needs is wide open. All of VASCO's current and future products, services and technologies are and will be compatible with VACMAN Controller and later with our Identikey server.

Number two the hardware, we see an increasing interest in software Digipass including Digipass for Java phone and Digipass for Web. Last quarter we have added fraud detections and analyzer services to our offerings. On the service side VACMAN Controller gets the recognition that it deserves, an extremely flexible, easy to integrate to use and to maintain server authentication product.

The acquisition of Able and the launch of fraud detection services had widened our product range dramatically. Number three tokens, our Digipass is much more than a token. Calling Digipass a token is the same as calling a PC a typewriter. A token is a quite basic hardware tool that calculates one-time passwords. VASCO's Digipass is much more.

The functionalities of Digipass are user authentication, digital/electronic signatures, host authentication, challenger response, time-based authentication, event-based authentication, [S, SSS], [ISOed], EMV, AMV capped algorithms, certificates. Number four the financial sector. We are quickly growing our all-terrain strategy. We have customers in over 15 different vertical markets from banking or national soccer leagues, ASPs and the real estate sector, telcos, etcetera, etcetera. The financial sector will stay a crucial part of our offering but VASCO's reach goes beyond banking.

Ladies and gentlemen, VASCO is growing rapidly and is very successful to adapting to ever-changing market conditions. We are convinced that we will do even better in the future. Thank you.

Thank you, Jan very much. At this time I'd like to turn the call over to Cliff Bown, our Chief Financial Officer. Cliff?

Thank you, Ken, and hello to all on the call. Revenues for the third quarter and nine months ended September 30th, 2006 were 18.7 million and 50.9 million respectively, an increase of 5.4 million or 41% over the third quarter of 2005 and an increase of 13.8 million or 37% over the nine months ended September 30th, 2005.

Compared to 2005 the increase in revenue for the third quarter and nine months ended September 30th reflected significant increases from both the banking and enterprise security markets. Revenues in the third quarter of 2006 from banking enterprise security markets increased 44% and 25% respectively. Revenues for the nine months ended September 30th from the banking and enterprise security markets increased 38% and 36% respectively.

The distribution of our revenue in the third quarter of 2006 between our two primary markets was 86% from banking and 14% from enterprise security and compares to 84% from banking and 16% from enterprise security in 2005. For both the nine months ended September 30th, 2006 and 2005 approximately 85% came from banking and 15% came from enterprise security.

The geographic distribution of our revenue in the third quarter of 2006 was slightly different than in 2005. In the third quarter of 2006 approximately 58% of our revenue came from Europe, 6% from the United States and the remaining 36% came from other countries which included significant contributions from Asia, India, South America, and Australia.

For the third quarter of 2005 60% of the revenue was from Europe, 10% was from the US and 30% was from other countries. The distribution of our revenue for the nine months ended September 30th was approximately 62% from Europe, 9% from the US and the remaining 29% from other countries. For the nine months ended September 30th 75% -- September 30th of 2005, 75% of the revenue was from Europe, 8% from the United States, 17% was from other countries.

As a result of our increasing customer base our revenues are getting spread more broadly to other countries. Gross profit as a percentage of revenue increased significantly in the third quarter of 2006 when compared to the third quarter of 2005. Gross profit as a percentage of revenue for the third quarter of 2006 was 68% compared to 61% for 2005.

For the nine months ended September 30th, 2006 gross profit as a percentage of revenue was approximately 67% compared to 63% for the same period in 2005. The improvement in margins are being driven by three components, first our mix of business continues to shift towards lower priced products that are highly suitable for the consumer market.

Second, we continue to reduce the cost of our manufactured product and in fact the percentage reduction in the cost of manufacturing has been greater than the reduction in our average sale price. And third, we have experienced lower costs in areas where the costs are not attributed directly to a product. As has often been noted previously our full-terrain strategy has positioned the company to compete effectively for larger deployment of Digipasses especially in the consumer market and has resulted in significant increases in the number of Digipasses sold. VASCO shipped approximately 2.9 million Digipasses in the third quarter of 2006, an increase of 60% over the third quarter of 2005.

For the nine months ended September 30th, 2006 VASCO shipped approximately 7.4 million Digipasses which is an increase of 50% in units over the nine months ended September 30th of 2005. The average selling price per Digipass including related software was approximately $6.39 for the third quarter of 2006 and $6.90 for the nine months ended September 30th, 2006.

In 2005 the average selling price for Digipass including related software was approximately $7.23 for the third quarter and $7.54 for the nine months ended September 30th of 2005.

Operating expenses for the third quarter of 2006 were 7.8 million, an increase of 2.2 million or 40% from the third quarter of 2005 and those operating expenses for the quarter included $455,000 related to the stock-based incentive plans. Operating expenses for the third quarter increased by 1,183,000 or 35% in sales and marketing, 544,000 or 60% in research and development and 496,000 or 44% in general administration categories when compared to the third quarter of 2005.

The majority of the increase in sales and marketing area were related to the company's increased investment in its sales, staff and marketing programs. The increase in research and development was primarily related to increased compensation due to increased headcount primarily from our acquisition of Logico in May of 2006. The increases in general and administrative expenses were primarily related to increases in headcount, stock-based incentive program costs, increased insurance costs and increased professional service costs.

Operating expenses for the first nine months of 2006 were 22.l million, an increase of 5.5 million or 33% from the comparable periods in 2005. Operating expenses for the nine period of 2006 included 1.2 million related to stock-based incentive plans. The reasons for the increase in the expense for the nine month period are generally the same as previously noted for the quarter-over-quarter Comparison.

Operating income for the quarter of 2006 -- for the third quarter of 2006 was 4,976,000, an increase of 2,438,000 or 96% from the 2,538,000 reported in the third quarter of 2005. Operating income for the nine months ended September 30th was 11,958,000, an increase of 5,212,000 or 77% from the 6,746,000 reported for the nine months ended September 30th of 2005.

Operating income as a percentage of revenue or operating margin was approximately 26.6% for the quarter and 23.5% for the nine months ended September 30th in 2006. The operating margin is approximately 7.5 percentage points for the quarter and 5.3 percentage points higher for the nine month period ended 2006 when compared to the same periods of 2005.

The increase in operating margin for the quarter is attributed to both an improvement in the gross margins and to a reduction in operating expenses as a percentage of revenue.

Income tax expense for the third quarter of 2006 was $1.7 million, an increase of approximately $715,000 from the third quarter of 2005. The increase in tax expense is attributable to higher pre-tax income partially offset but a lower effective tax rate. The effective tax rate was 33.5% for the third quarter of 2006 compared to 35% for the third quarter of 2005.

Income tax expense for the first nine months of 2006 was $4 million, an increase of 1.5 million from the same period in 2005. The increase in tax expense again reflects the tax on increased earnings as the effective rates for both the first nine months of 2006 and 2005 was 35%. The tax rate for the first nine months of 2006 is higher than the expected tax rate for the full year as it does not include a benefit for the impairment charge. The normalized effective tax rate for full-year 2006 is currently 33% and compares to 35% in 2005.

The effective tax rate for both periods reflects the company's estimates of its full-year tax rate at the end of each respective period. The rate reported in 2006 is lower than the rate reported in 2005 as the company's expectations of earnings in countries in which the company has a tax loss carry forward are higher in 2006 than they were in the third quarter of 2005.

Earnings before interest, taxes and depreciation, EBITDA or operating cash flow, if you will, was 5.3 million and 12.2 million for the third quarter and nine months ended September 30th, 2006 respectively. EBITDA in 2006 reflects an improvement of 2.3 million, or 79% from the third quarter of 2005 and an improvement of 4.1 million or 51% for the nine months ended September 30th of 2005.

The third quarter of 2006 reflected the 15th consecutive quarter of positive operating cash flow. Our workforce as Jan mentioned as of September 30th of 2006 was 161 people worldwide with 92 people in sales, marketing and customers support, 49 persons in research and development, and 20 people in general and administration. The average headcount for the nine months ended September 30th, 2006 increased by approximately 37 persons or 33% over the average headcount in 2005.

Finally, I would like to make a few comments on the balance sheet. Our net cash balance and working capital balances both increased substantially from the prior quarter as a result of the company's strong operating performance. During the third quarter our net cash balance which is defined as total cash plus bank borrowings increased $7.4 million or 57% to 20.4 million from 13 million at June 30th of 2006.

Our working capital increased 4.2 million or 21% to 24 million from 19.9 million at March 30 -- or excuse me, at June 30th of 2006. Bank borrowings noted on the balance sheet of 3.1 million were borrowed under the line of credit and relate solely to our hedging program. There was no impact on working capital from the hedging program as additional cash was offset by short-term debt.

As Jan also mentioned I'm pleased to report that we were able to fully fund the recent acquisition of Able with our internally generated cash balances. During the quarter our days sales outstanding and accounts receivable decreased from 81 days at June 30th, 2006 to 66 days at the end of the third quarter. The decrease in DSOs is primarily related to the full payment of aged receivables and to a reduction in the percentage of each full quarter's revenue that was recognized in the last month of the quarter.

The company continues to add no term debt. The company had approximately $421,000 as of September 30th, 2006 available for additional borrowings under its line of credit that is secured by its receivables.

Now I would like to turn the meeting back to Ken.

Thank you, Cliff. First I would like to comment on order backlog for Q4 2006. Again, as of this date we have firm orders with shipments scheduled for the fourth quarter of approximately $21.5 million. Any new orders received before quarter's end and shipped during the quarter would be additive to this number. This backlog shows the strength of our order flow as it is 69% higher than the $12.7 million backlog going into Q4 of 2005. In addition the backlog is 23% higher than the $17.5 million in revenues actually reported for Q4 2005.

Today we are updating guidance for full-year 2006. As in the past we only comment on annual numbers not quarterly numbers. First we maintain our estimate that full-year revenue will grow between 35 and 45% in 2006 over 2005. Second, we maintain our estimate that full-year gross margins will be in the range of 60 to 65% of revenue. We are, however, now projecting that operating income will be in the range of 20 to 25% of revenue on a US GAAP basis up from our previous estimate of 15 to 20%.

In summary we are very pleased with our results for Q3 2006 and look forward to a strong performance for the remainder of 2006. And as always you can rely on VASCO's people to do their very best always. Operator, let's open the call to questions.

[OPERATOR INSTRUCTIONS].

Our first question comes from Jonathan Ruykhaver of Raymond James & Associates. Please go ahead.

Hey Ken?

Yes Jonathan.

Hi congratulations on the quarter.

Thank you very much.

Looking at the gross margin in the quarter can you elaborate more on why the high profitability in the face of obviously strong unit shipments and also declining revenue per token? Is it more of a mix shift or is it more respective of efficiencies on the production side?

Well always it seems to be a combination of those two Jonathan. It's no exception this quarter. It was a bit of a mix and our average cost price continues to go down. Cliff, would you like to expand on that?

Yes if you compare in the quarter alone our average selling price declined about 12% but our average cost of product declined almost 28%.

So it's definitely more a case of -- for production efficiencies?

Well we've actually reduced the manufactured cost for each token that is sold. We continue to look at the engineering design and find efficiencies in it. With our growing scale we continue to negotiate with our manufacturers to get better pricing so that is a piece of it. We also have a change in the mix as our consumer business rolls out and as the software side of the Digipass grows our cost base will actually go down as a result of that also. So those are really the two primarily drivers is the reduction in the cost itself for each unit that is manufactured and its a change in the mix as we continue these very large deployments to either a lower end model like a GO 3 instead of the higher end model and/or the software components of the Digipass.

Given that why is it that you don't feel comfortable taking up gross margin guidance?

Well as we look forward we continue to see the potential for some very large deals. So as we do our guidance we're looking at what we have in backlog and what the specific mix is of those products. And at this point you can see that our gross margin through the first six months or nine months is slightly above the range but I guess the message is we would anticipate that given the large increase in revenues we would expect a reduction in margins over where we are on a year-to-date basis.

Okay, okay good. And then just one final quick question can you give us some color on activity you might be experiencing with your fraud detection service, maybe pilot activity? Have you signed any customers to date?

Well that's a brand new announcement, a brand new capability. I will direct that question to Jan.

Yes thank you Ken. I can of course not comment on customers and prospects, future decisions. What I can comment is that fraud detection we see that as an add-on on our VACMAN Controller full authentication product line and we offer than in the banking industry to over 550 banks and also to new prospects. We see a very nice potential in that market.

How will you be pricing and recognizing revenue on the service? Will it be a subscription model based on per-user pricing?

Yes.

Okay.

But license-based and per-user based.

Okay per-user base will that be a revenue item that's deferred on the balance sheet?

If the payments are received fully upfront they will be. It will depend on how the customers build.

Okay so deferred revenue may be showing accelerated growth could be a metric we could use to try to gauge the success with that product over time.

It could be I think it will be masked with the rest of our deferred revenue. As you know when we have large orders or new customers very often we ask for a payment in advance. And so our deferred revenue is not comparable to what you see from many other companies in our industry.

All right.

And ours will be lumpy. I would really not recommend that you look at that to any great degree as a predictor of the future revenues.

Certainly not short term. Jonathan may I excuse you.

Yes that's great, thanks.

And go onto the next question, thanks very much.

Our next question is coming from Daniel Ives of Friedman, Billings, Ramsey. Please go ahead.

Hey guys, great quarter. Hey Ken with profitability where it is are you going to start flying first class now?

Absolutely not.

Sticking to it is what I see. Look on FFIEC I mean earlier in the year you were kind of like lukewarm on it, didn't have teeth but it seems like it's changed. I mean what's the catalyst? What's driven kind of the spending there? I mean you've definitely had a change, you've seen it in your business. What's that catalyst that's happened over the last three to six months?

Well I think in August the FDIC came out with another statement saying banks, we are very serious about the guidance that we gave you in October of 2005. The timeframe has not been extended. You are expected to adhere to that guidance by no later than December 31st, 2006. So indeed we are seeing a lot of activity. I've been consistent, however, with saying we don't expect, we haven't expected to see a substantial amount of revenue from these activities. I think most of the banks are exhibiting a good faith effort to the FDIC that they are putting measures in place. They're doing RFIs. They're meeting with vendors. In some cases they're doing pilots and so you can see that the number of new accounts that we've experienced in the United States for banks has spiked.

However, the revenues I don't think will follow until 2007.

Can I maybe add something Ken there?

Yes absolutely Jan.

Of course our regulator is always good for our business but we see also a growth in the activity of criminals, more and more -- and also more and more in the US. That is also a reason why our banking portfolio is growing so fast in the US.

And just a final question, look with the RSA acquisition from EMC I mean has there been any change competitively there I mean you guys being the biggest pure play in the banking side? I mean without trashing competitors and maybe you could just speak to the competitive environment if that EMC acquisition has had any ramifications, positives for VASCO? Thanks.

Yes personally speaking I think that that acquisition probably clouded the RSA brand because indeed they're no longer a security pure play. They are now part of a much larger, more powerful, better funded company so I don't want to under-estimate their ability. I'd say that we have seen a very positive feedback from the channel, from distributors and resellers that in the past we've been unsuccessful in convincing them to also carry the VASCO product. We're not only getting a lot of encouraging signs, we're actually having some of those distributors and resellers contact us unsolicited. So generally speaking I think that transaction helped VASCO.

All right.

Operator next question.

Thank you our next question is coming from Ranjini Chandirakanthan of Think Equity Partners. Please go ahead.

Good morning. Just a follow up Ken on your backlog comment. When you report in the third week of the quarter we've seen 86 to 87% of your revenue coming from backlog and I know last quarter, the fourth quarter of '05 was perhaps an anomaly of 72% of revenue coming from backlog. And I'm curious to the fourth quarter as we look into fourth quarter '06 I mean can you give us some color on whether it appears to be a normal quarter or we should more, be more comparable to Q4 '05?

Ranjini as you know one of the reasons why the backlog figure does vary and the percentage, that backlog percentage of the final revenue for the quarter does vary is because our earnings call aren't held on the same day of the quarter. And so as an example in the first quarter I think we were 52 or 53 days into the quarter before we had our earnings call and announced the backlog. In the last quarter we were at the 27th of July and here we are on the 26th of October. So Cliff why don't you address that, you know, my statement.

Yes I think Ranjini as we look back at each of the quarters the percentage of the full quarter that backlog represents is variable. Each of the last two quarters the backlog has been about 86% of what the final amount had been. But when we look back on it and we see the comparisons of prior quarters we see some similarity in terms of percentage coverage of fourth quarter of last year's the final, the year before fourth quarter to final and those spreads in the fourth quarter have generally been larger than what they are in the other quarters. The third quarter has generally been smaller because of the vacation and holiday schedule in Europe.

But as you do do that analysis and you look back please remember that 2005 results we had the pull forward in essence of revenue. As we stated in the first quarter of this year the amount of business that we did in the fourth of last year compared to the backlog and what we expected was about $2 million higher and that was because our customers were demanding product quicker than what they had the firm purchase orders in for.

Got it and that's what I expected perhaps was an anomaly in December '05.

2005 may have been an anomaly but we're seeing a strong business flow in the fourth quarter of this year as evidenced by that backlog being so much higher this year than it was the same point a year ago.

Great and then just a follow up to that as we look to December '05 going into March '06 there was a significant drop in revenue because perhaps because of that pull through of 2 million. I guess my question is should we be expecting that seasonality as we go from December '06 to March '07?

Historically I'd say for the last several years the strong quarters are the second quarter and the fourth quarter. And the trend seems to be that the second quarter is a very strong quarter and then the third quarter is level to up just a small amount. Then we have a very strong fourth quarter and the first quarter is level to up a small percentage. That seems to be the trend. Other than last year where you had that $2 million pull from the first quarter into the fourth quarter. If you took the 2 million from the fourth quarter, put it back into the first quarter of this year you'd see the normal trend.

Got it thanks a lot.

You're welcome Ranjini.

Thank you our next question is coming from Brad Lehl of Jefferies & Co. Please go ahead.

Hey hi guys.

Hi Brad.

Great quarter.

Thank you.

Ken, just a couple of quick things. Going back to the backlog number I guess I'm just curious if you can provide any more color in terms of what exactly is making up that backlog number? Are you seeing a large number of US deals come through? Is it more of follow ons from existing customers? Can you just give us some qualitative commentary on exactly what's comprising that big backlog number?

Yes I'll direct that question to Jan.

Thank you, Ken. Well first of all if you look at the growth of our new customers basically what we did in the third quarter was one new bank by working day. A lot of that growth come from the US and as Ken mentioned already a couple of times first they place an order and then the growth is coming in the next quarters. The second thing is in the backlog you will find traditionally larger orders at the beginning of the quarter due to the fact that we ship very fast the orders of the enterprise security. So basically I should say if you follow a little bit the growth path of our new customers as well in the banking, as well in the enterprise security.

Secondly we are a company that are making a lot of recurring business that give you some flavor of the content of our backlog.

Yes Brad don't forget that a large percentage of our revenue continues to be from banking and finance, something in the mid 80% range, 85, 86% range. They tend to give us 12-month purchase orders. They schedule those shipments and I think the strong growth goes right back to this chant that I have every single quarter and that's the sustainable, repeatable revenue model that we have and that we enjoy. And it's just a result of multiple banks that are rolling out their respective applications and then more banks joining in and adding their applications and starting their roll outs over 12 months so it's a compounding of that sustainable, repeatable revenue flow that I talk about all the time.

Okay and then might, the other thing too on the 29 US banks that you guys obtained this quarter, I'm just curious are those a combination of corporate and consumer? Are they still primarily corporate at this point or can you give us some commentary on that?

Yes at this time I think most of the applications are for the corporate client or business client of the banks. That's historically what we've always done is go into a bank, call on the EVP of corporate or business banking, make that sale, integrate VACMAN Controller. Once that's up and running then we go to a different department and call on the EVP of retail or consumer banking and then make a sale there. It's much easier to do that because once we have Controller, the middleware installed, the application for the consumer is very easy to implement.

Okay and then -- thanks, and then just one more quick one, I know it's pretty early but as you look out to '07 and you just kind of think about the growth rates and the margin structure and so forth, can you give us any, not guidance, I don't expect that, but just any kind of qualitative commentary on where you see the growth and the margin structure kind of settling in as you look out to '07?

Well I think generally speaking we can expect the type of growth in terms of top line, the type of gross margin in terms of that range and it should be no secret by now that what we're trying to do as a management team is to manage our operating income at 20% or lower and as we exceed that 20% plateau we try to hire as many sales and business development people as we can to further fuel the top-line growth. It's hard to spend money fast enough with the model that we have to keep the margin, the operating margin under 20%. And you can see that from our results.

Yes absolutely, okay that's all. Thanks a lot guys, good quarter.

You're welcome. Thank you.

Thank you, our next question is coming from Andrey Glukhov of Brean Murray. Please go ahead.

Thank you, congratulations on a good quarter.

Thanks, Andrey.

Ken, first as far as the business through some of your partners is concerned can you comment on just roughly what percentage of your business they're contributing now and how quickly do you expect that to ramp up next year?

What kind of partners are you speaking about? Like Verizon?

Like Verizon, like Fiserv.

Yes well I don't know that I have a number. It's still nascent I would say at this time. Fiserv is starting to knock down some deals and they're becoming more and more visible. As far as them being a significant contributor to our revenue that's not the case as yet. Partnerships like Fiserv and FUNTEC and others those are starting to shape up quite nicely. They're not in that 10% range yet but they certainly have the potential to be. So I'd say generally speaking I think VASCO is very happy with the relationships we have its partners, its OEM partners, its reseller partners and it's a part of our strategy for continuing our strong growth.

So do you expect that to ramp up to maybe 10% by next year?

We actually have no way of telling Andrey. This is Cliff. As I mentioned in my prepared remarks with our customer base growing at the rate that it is we're seeing that our business is spread over a much broader base. When we look back at our results year-to-date, Q3, our top ten customers are now at 54% of our revenue where last year they were at 70% of our revenue. So we've had a significant expansion of the base.

What we also see is when we look at that year-to-date we only now have one customer that's greater than 10% of revenue. And generally our policy is to not disclose specific numbers for specific customers unless we're required to under the SEC rules by exceeding 10%. So as I look forward it would be my hope that none of those partners would be 10% that our customer base would be broad enough that our risks and exposure to any given customer would be below that threshold.

Understood and then secondly as far as the acquisition that you just did is concerned can you maybe talk about forward revenue expectations and also any investments into the channel that you need to do to ramp it up? Thank you so much.

Definitely we cannot talk about specific department or business unit within VASCO particularly since Able is so new. We can say that we are very optimistic because Able is a very robust company in terms of product line but they've been kind of geographically bound in the Benelux countries and so their true potential has not been realized. That's why we're so excited about having them join us and taking their product set and running it through our growing reseller channel, 1,500 resellers, 45 distributors in 108 plus countries.

Thank you our next question is coming from Amit Dayal of Rodman and Renshaw. Please go ahead.

Thanks great execution guys. Congratulations.

Thanks, Amit.

My questions surround on the Digipass for Web offering. To begin with could you tell us if you recognize any revenues from Digipass for Web in 3Q '06 and how much it was?

Well we actually don't have that data at hand, Amit, so that's why the long pause but I guess the other thought is --.

But there was revenue from this?

We had some minor amounts as I recall. It's not ramped up any significant degree so it's not a major factor in the third quarter results.

Right.

But I think as a management team as well we don't generally talk about what any given products' percentage is. And the reason for that is VACMAN Controller allows a user to use Digipass for Web along with hardware Digipasses or Digipass for phone. And so really the core is that VACMAN controller engine. And rather than talk about what our customers are attaching to that engine we'd rather focus on the fact that our customers have that flexibility as opposed to what percent is coming from what type of connection there is.

So I have two follow ups to that then. The first one do orders for Digipass for Web reflect in the backlog or will orders for Digipass for Web reflect in the backlog going forward? And the second question is given that you have all these offerings now, you know, VACMAN is already placed with customers, which offering do you push first through plans? I mean if you could provide some color on that I'd appreciate it.

Well Digipass for Web is one of 40 different products that VASCO has. And our strategy is to have the middleware product, VACMAN Controller that makes it easy for our clients to choose the right solution or product for their users. That's part of our strategy and I think it's one of the reasons we've been so successful in the banking community is that we offer that flexibility.

Digipass for Web I think/we think offers a tremendous opportunity before -- because we have -- even though I should say, even though we have 550 banks as clients we've barely penetrated the available or target audiences that we always go after. Typically the business side of the bank, the corporate or business clients of the bank more than likely at least one or more Digipass units will be bought for the banks, by the banks, for each one of their clients.

On the retail side, however, the penetration is not 100%. It's typically 30, 40%, 50% or higher or lower and so there are a lot of opportunities for us to go back into our own customer base where we've penetrated less than 10% of those two target audiences and introduced Digipass for Web. So -- and of course it's another advantage that we have when we go to a brand new customer, a brand new bank to be able to offer this multitude of flexibility and products so that the bank can choose the appropriate product for the appropriate user.

Back to your specific question on whether it's in the backlog if we had an order for Digipass for Web that we had not delivered yes it would be in the backlog. If we have an existing customer that has Digipass for Web installed and we have recurring maintenance stream from that because of the way it was build, whether it was a [feet] licence or some other form that is spread over time it would not be in the backlog. So the backlog is really still geared today mostly for those large banking orders that have not yet shipped. And if there was a component of that delivery that included Digipass for Web it would be in backlog, otherwise not.

Right so probably the way to look at this would be a year from now for example, Digipass for Web is going to be increasing in the backlog versus today where this thing is just rolling out and you don't have it in the backlog yet?

It could be Amit or it could be equally case that you'll see the difference between what we have in backlog and our final quarter numbers continuing to grow.

Exactly that's what I was getting at. Thank you so much guys.

Thanks Amit.

Your next question comes from Sean Jackson of Avondale Partners. Please go ahead.

Yes a question concerning the acquisition again. Now is the acquisition closed already?

Yes it is.

Okay so how much of an impact is it going to be in the fourth quarter?

We haven't computed the specific impact yet, Sean, because we have to go through all of the purchase accounting so we've got to take the purchase price allocate it to all of the various types of assets that are there including intangibles that would be amortized and intangibles that won't be amortized. So I think if you view it within the guidance that we've given for operating margin that's still the best way to consider it.

Also when you look at the transaction itself I believe it will fall below the radar screen in terms of being a significant acquisition and therefore I don't think at this point we plan on providing pro formas. So I think for the purposes of the market today it won't have a significant impact on the fourth quarter 2006. As we look forward in 2007 and we position the product for roll out to our channel I wouldn't anticipate it having a significant accretive or dilutive effect in 2007 which is consistent to what we put in the press release.

But that over time as it rolls out through our full distribution channel it really does round out product portfolio and I think represents substantial opportunity.

Okay and also lastly given the fourth quarter is typically seasonally strong and it looks like the revenue numbers are going to be a lot higher versus the third quarter what is a possible scenario that your operating margins could decline in the fourth quarter versus the third quarter?

On a quarter-over-quarter basis that's certainly the case. We've giving the guidance of 60 to 65% gross margins and year-to-date Q3 were 67%. So the fact though we're saying that we believe that there will be large volume in the fourth quarter given the backlog but they will be at smaller margins.

Okay, all right thanks.

But that also when you look at that, Sean, also consider it within the context of operating margins. We continue to debate internally whether gross margins is even a relevant factor to give as guidance because what really counts is what flows through to the operating income line and the operating margin.

Okay and that was one of my questions, I guess which item on the operating margin side do you anticipate increasing the most in the fourth quarter versus the third? Is there one spike that you expect?

Well no, I don't think so. As you look at our results this quarter we were 26.6% operating margin. Year-to-date we're 23.5 and what we're really saying in Q4 because we've increased the guidance to 20 to 25% we think we'll be in that same range. We don't think we'll have enough incremental spending on those new programs Ken talked about new sales people, new marketing programs and so forth to take us out of the range that we're in currently.

Okay, all right thank you.

Operator, two more questions please.

Thank you our next question comes from Joe Maxa of Dougherty & Company. Please go ahead.

Yes thank you and congrats guys.

Thanks Joe.

Ken did you hint that you may have had some US banks use your products for retail applications?

Did I hint that I --?

Well it sounded like you might have got a little hint earlier when someone asked the question.

Well certainly I think that we're selling hard. When we get into a bank and make that first sale for the corporate client of the bank we're always pushing for the retail side. So yes you can take to the bank that we are working hard to make that happen and we think that you'll see some successful deployments of our products on the consumer or retail side of several banks.

Okay but have you as of today had any deployments?

Other than pilots, no.

Okay and then I just wanted to ask you about the overall market worldwide as far as mandates or standards going to strong authentication. What are you seeing out there? I know several countries have made some indication -- just maybe give me an update of what you are seeing and maybe if you expect additional maybe larger countries to [inaudible - microphone inaccessible]?

Well generally speaking I think one of the reasons why we've been so successful outside the United States is that historically we've seen just that. We've seen directives. We've seen laws. A very specific law was announced two years ago in June in Hong Kong. It was very explicit. It said that you may not -- banks you may not do online banking without some form of two factor authentications. They were very explicit with what that meant. That meant your user name and what you know and what you have, a physical device like a Digipass token or Digipass calculator or a US V-stick or a Smart card. So yes I think country by country this is becoming more and more of an issue and is becoming either guidance or directive or law. Jan, you probably have a better view of that than I do. Would you like to add any color?

Yes, yes so there are some countries like the US, like Singapore where the regulators are obliging banks to do something to secure the online banking. But beyond that we see a lot of increase of criminal activities. It's not only any more phishing. It's also more a more Trojan horses that is also increasing a lot in our business. That's the first thing. So to give you a flavor in the banking, more and more, more and more online banking users by bank, by country. And secondly due to the fact that the criminal activities are increasing and due to the regulators we see an increase for strong authentications in those banks.

The second thing that I can say is it's not only any more banks like we've mentioned in our expose is we see a lot, a lot more other applications using real strong authentications in the business to business. We have now our Controller and Digipass is integrated in more than 50 other applications than banking and that's also due to the increase of criminal activities.

A third thing is that I should say that SOX can be seen as a worldwide phenomenon. It's not only a US. A lot and lot of local companies are following the SOX rules and needs to secure IT applications, the internal auditor is saying that strong authentication is needed. So it's a mixture, a little bit of everything, that we see [our activities] in the market.

Okay great. Thanks a lot guys.

Sir our final question comes from Ruchir Lahoty of Thomas Weisel. Please go ahead.

Hi guys. Congratulations on a good quarter.

Thank you.

Thank you.

I observed that the revenue from the US were lesser than last quarter. Any part of a reason for that?

I think the reason we'd share is really just that the US business is not big enough yet to have a continuous flow so it's going to be lumpy. We're going to have some quarters that are large in volume, other quarters that are going to be less because of the timing of when some of those large orders ship. So as the US market matures I would expect to see more of a normalized growth pattern with it. But for now we're in that stage of getting the new customers. So as we talked about the significant number of new banks signed in the third quarter that bodes well as we look forward into 2007 and beyond as that will start to normalize more.

Yes and as they add more of these new banks and they start these multiple year roll outs that I described and continue to describe as the sustainable, repeatable revenue flow the revenue will be a little more predictable. Right now they're really experiencing a greenfield, an opportunity to get as many new clients, new account clients as possible and that's what they're focusing on.

Okay thanks guys.

You're welcome. Ladies and gentlemen thanks for joining us today and VASCO people around the world thank very much for your hard work and your great efforts. I'm very proud of you. Have a good day everybody.

That concludes today's Third Quarter 2006 VASCO Data Security International Inc. conference call.

You may now disconnect your lines and have a wonderful day.