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VeriFone Systems Inc. (PAY - Analyst Report) reported second quarter 2013 earnings of 36 cents, which missed the Zacks Consensus Estimate by 3 cents. Earnings (including stock-based compensation) decreased 36.0% year over year and 10.3% sequentially in the reported quarter.

Excluding stock-based compensation, amortization charges, acquisition-related charges and related tax effect; VeriFone reported earnings of 42 cents, which missed management’s guided range of 45 to 50 cents.

The miss was primarily due to continuing soft macroeconomic conditions in Europe, distribution problems in Middle East and Africa and certain internal execution challenges.

Revenues

Revenues (excluding amortization of step-down in deferred revenues at acquisition) decreased 10.4% from the year-ago quarter but remained flat sequentially at $429.7 million. Revenues fell short of management’s guided range of $435.0 million to $450.0 million.

System Solutions revenues (65.0% of revenues) decreased 18.8% year over year and 1.0% quarter over quarter to $279.1 million in the reported quarter. Services revenues (35.0% of revenues) increased 11.1% from the year-ago quarter and 1.9% sequentially to $150.6 million in the last quarter.

Revenues in North America (which comprises operations in the US and Canada) declined 5.5% year over year and 8.0% sequentially to $122.1 million. The weak result was primarily due to lower customer orders from the petroleum business.

During the quarter, VeriFone won a significant point-of-sale contract from one of its largest petroleum clients, which is expected to generate revenues of approximately $50.0 million over the next several quarters. In the US retail business, VeriFone won 12 customer awards for MX 900 systems.

Revenues in LAC (which comprises operations in South America, Central America, including Mexico, and the Caribbean) decreased 11.3% year over year but jumped 16.8% quarter over quarter to $85.3 million.

Revenues in EMEA (Europe, Middle East and Africa) declined 15.8% from the year-ago quarter but remained almost flat sequentially at $172.7 million. Revenues were negatively impacted by delayed product certifications in Europe and problems with the distribution channel in the Middle East and Africa.

ASPAC revenues (which comprises operations in Asia Pacific, including China, India, Japan, Australia, New Zealand and other countries in the region) climbed 1.6% year over year but decreased 2.7% sequentially to $49.7 million. Sales in China grew 11.0% year over year, while sales in India gained some momentum in the quarter.

Margins

Gross margin (including stock-based compensation) contracted 240 basis points (“bps”) from the year-ago quarter and 130 bps from the previous quarter to 42.1%. The year-over-year decline was due to 380 bps contraction in System solution gross margin. The decline was primarily attributed to unfavorable regional and product mix. This was partially offset by a 10 bps increase in Services gross margin.

Operating expenses as a percentage of sales jumped 350 bps from the year-ago quarter and 100 bps on a sequential basis to 29.0%. This sharp rise in operating expenses was due to higher research & development expense (“R&D”), which as a percentage of revenues increased 190 bps from the year-ago quarter and 70 bps from the previous quarter to 8.9%.

Sales and marketing (“S&M”) as a percentage of revenues jumped 110 bps year over year and 20 bps quarter over quarter to 10.7%. General & administrative (“G&A”) was up 40 bps from the year-ago quarter and 10 bps from the previous quarter to 8.7%.

Operating margin declined 590 bps year over year and 230 bps sequentially to 13.1% in the last quarter. The significant decline was primarily due to higher operating expenses and lower gross margin base.  

Net income margin declined 400 bps from the year-ago quarter and 120 bps sequentially to 9.1% in the reported quarter.

Liquidity

At quarter end, VeriFone had approximately $506.0 million in cash compared with $476.7 million in the previous quarter. Total debt was $1.28 billion compared with $1.29 billion in the previous quarter. Cash flow from operations was $79.2 million and free cash flow was $58.0 million in the quarter.

Outlook

VeriFone expects non-GAAP revenues to decline sequentially to approximately $400.0 million for the third quarter of 2013. Management expects third quarter non-GAAP earnings to be approximately 20 cents. Fourth quarter revenues and earnings are expected to improve sequentially due to improved product pipeline.

Recommendation

VeriFone reported disappointing second quarter results and provided a cautious outlook for the remainder of fiscal 2013. We believe that VeriFone’s innovative product pipeline, which includes mobile payment applications for both Apple’s (AAPL - Analyst Report) iOS and Google’s Android based phones will boost top-line growth going forward.

Moreover, VeriFone’s additional spending on research & development and technical sales personnel will drive sales volume going forward. However, this additional spending will continue to keep margins under pressure in the near term.

Additionally, competition continues to be stiff from the likes of NCR Corp. (NCR - Analyst Report), and is a major headwind. Organic growth also remains a matter of concern amid volatile macro economic conditions. Further, we believe that the rebuilding of the Middle East and African distribution channel will take some time and remain a headwind for top-line growth in the near term.

Currently, VeriFone has a Zacks Rank #3 (Hold).

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