VeriFone in Tough Times

San Jose, California-based VeriFone Holdings Inc. (PAY) designs, markets and services transaction automation systems that facilitate electronic payments between consumers, merchants and financial institutions. The company is expected to report third-quarter results on Sept. 1.

Management is not expecting any rebound in overall markets in the near future as the economy still reels under the effect of deep recession. The company will thus keep on seeing contractions of inventory in the North American distribution network, failures of large retailers and possible collapse of businesses that will disrupt its network. VeriFone also continues to face currency translation risk.

A significant chunk of inventory reduction and lower capital expenditures resulted in free cash flow of $60 million during the second quarter. However, management indicated in the earnings conference call that inventory may remain at current levels, implying that free cash flow generation may not be the same in the upcoming quarter.

As sales growth remains challenging, VeriFone is taking steps to maintain profitability. Since the beginning of 2008, the company has reduced its quarterly expense run rate by $4.5 million representing $18 million in annualized expense reductions. In addition, VeriFone reduced its headcount by approximately 500 in the past twelve months.

VeriFone also announced a re-orientation of its engineering efforts towards cost redesign across all of its major platforms and completed seven of the 14 cost-cutting projects. The target for this initiative is a 300 basis point reduction in cost of goods sold by the fourth quarter of 2009.

Given continued near-term uncertainty, we maintain our Neutral rating on the stock.

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