Item 1. Business
General
Hypercom Corporation is one of the largest global providers of complete electronic payment and transaction solutions and value-added services at the point of transaction. Our vision is to be the world’s most recognized and trusted brand for electronic transaction solutions through a suite of secure and certified, end-to-end electronic transaction products and software, as well as through a wide range of support and maintenance services. Our customers include domestic and international financial institutions, electronic payment processors, transaction network operators, retailers, system integrators, independent sales organizations (“ISOs”) and distributors. We also sell our products to companies in the hospitality, transportation, healthcare, prepaid card and restaurant industries. Customers around the globe select us because of our proven leadership and expertise in the global electronic payments industry, commitment to our customers’ success, continued support of technologies and the quality and reliability of our products and services. We deliver convenience and value to businesses that depend on reliable, secure, high-speed and high-volume electronic transactions.
We believe our strength lies in our people, technology and a commitment to delivering excellent value to our customers. Our products enable our customers to accept a wide range of payments and other transactions, including credit cards, signature and PIN (Personal Identification Number) based debit cards, contactless identification and near field communications (“NFC”), stored-value cards, and electronic benefits transfer. We will continue to enhance our product and service portfolio, and make long-term investments in technology for the evolving needs of our customers. We are positioned to meet the increased demands of the global marketplace and capitalize on key geographic and vertical market opportunities in order to achieve our goal of increasing market share and profitability.
Business History
We design and sell a variety of electronic transaction terminals, peripheral devices, transaction networking devices, transaction management systems, application software and information delivery services. Additionally, we provide directly, or through qualified contractors, support and related services, which include maintenance, on-site technology assessments, network training, and design and implementation.
Founded in Australia 1978, our operations were primarily focused on Asia-Pacific markets until 1987, when we expanded our operations into the United States, and later into South America, Central America, Europe, and the Middle East. We reincorporated in 1996 under the laws of Delaware and shortly thereafter, through a series of corporate restructurings, became a U.S. holding company for the Australian corporation and its subsidiaries. In 1997, we completed an initial public offering of our common stock, which is listed on the New York Stock Exchange (“NYSE”) under the symbol “HYC.”
We report our operating information in four business segments: (i) the Americas, (ii) Northern EMEA (“NEMEA”), (iii) Southern EMEA (“SEMEA”) and (iv) Asia-Pacific. The countries in the Americas consist of the United States, Canada, Mexico, the Caribbean, Central America, and South America. The countries in the NEMEA segment consist of Belgium, Sweden, Turkey, Austria and Germany. The countries in the SEMEA segment consist of France, Spain, the United Kingdom, countries within Western and Central Eastern Europe, Russia, Hungary, the Middle East, and Africa. The countries in the Asia-Pacific segment consist of China, Hong Kong, India, Indonesia, the Philippines, Singapore, Thailand, Australia, and New Zealand. See Note 21 to our consolidated financial statements included herein.
On April 1, 2008, we acquired all of the outstanding shares of Thales e-Transactions SA, Thales e-Transactions GmbH, Thales e-Transactions Ltd, and Thales e-Transactions España, (collectively, “Thales e-Transactions” or “TeT”). Thales e-Transactions was a leading provider of secure card payment solutions in some of Europe’s largest markets, including France, Germany, Spain and the United Kingdom. With the acquisition, Hypercom has become one of the largest providers of electronic payment solutions and services in Western Europe, solidifying our position as the third largest provider globally, and expanded our team of experts that will lead our operations going forward.
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On February 17, 2010, we and The McDonnell Group formed a new venture, Phoenix Managed Networks, LLC (“PMN”), which equips payment processors, banks and retailers worldwide with highly reliable and cost-effective data communications services for transaction-based applications. In this transaction, an affiliate of The McDonnell Group contributed $1.0 million to PMN in consideration for which it received preferred membership interests in PMN representing 60% of PMN’s outstanding preferred interests. At the same time, our wholly owned subsidiary, Hypercom U.S.A., Inc. (“HYC USA”), contributed certain assets, including all of the outstanding membership interests of HYC USA’s wholly owned subsidiary, HBNet, Inc. (“HBNet”), to PMN in consideration for which HYC USA received preferred membership interests in PMN, representing the remaining 40% of PMN’s outstanding preferred interests and $1.0 million in cash. See Note 3 to our consolidated financial statements included herein.
With worldwide headquarters in Scottsdale, Arizona, we market our products in more than 100 countries through a global network of sales, service and development offices. Our main regional sales headquarters are located in the U.S., Brazil, Mexico, France, Germany, and the Philippines.
Recent Developments
On November 17, 2010, we entered into a definitive merger agreement with VeriFone Systems, Inc. (“VeriFone”), and Honey Acquisition Co, Inc., a direct wholly-owned subsidiary of VeriFone (“Merger Sub”), under which we will be merged with and into Merger Sub, with Hypercom continuing after the merger as the surviving corporation and a wholly-owned subsidiary of VeriFone, pursuant to which VeriFone will acquire Hypercom in an all-stock transaction. The merger was approved by our stockholders on February 24, 2011 and is anticipated to close in the second half of 2011, subject to the satisfaction of applicable regulatory approvals and other customary closing conditions. Upon the consummation of the merger, each share of our common stock issued and outstanding immediately prior to the merger will be converted into the right to receive 0.23 of a share of VeriFone common stock.
Electronic Payments Industry
Over the past several decades, consumers worldwide have increasingly utilized card-based payment methods, such as credit, debit, and gift cards, to replace checks and cash. Card-based payments require the use of a point of sale (“POS”) terminal capable of reading a cardholder’s account information from the card’s magnetic stripe or chip and combining this information with the transaction information. The POS terminal electronically captures and securely transmits this information over a communications network to an authorized computer data center and then displays the returned approval or denial response.
The structure of the electronic payments industry can be described by examining the entities involved and their relationship to one another. Card associations, like Visa and MasterCard, which license their “brand” to card issuers, such as banks, operate high volume communications networks connecting card issuers with transaction processors. Card associations also define the standards that POS terminals must meet to be certified for use in their respective networks. Transaction acquirers and their agents sign up merchants, install POS terminal equipment, capture the transaction data, and route it through the credit or debit card network to obtain transaction approval. Payment processors charge an interchange fee to authorize the customers’ transactions, providing a tally of these transactions to merchants, and transfer funds to merchants to cover card purchases. Card issuers provide consumers with the payment card and settle their accounts. Equipment providers make the POS terminal hardware and software and, in our case, also network equipment upon which high-performance and secure payment processing networks rely. Transaction services providers facilitate the delivery of the transaction data between merchants and payment processors. This structure may vary in each geographic region or country where multiple functions may be performed by a single entity such as a bank.
Card associations, bank card issuers, transaction acquirers and payment processors are differentiating their offerings, in part, by offering value-added applications and incorporating innovative acceptance technologies including contactless, biometrics and flexible connectivity options like wired and wireless internet protocol technologies. As a result, electronic payment systems that can run multiple value-added applications and incorporate emerging technologies are becoming increasingly important in today’s market.
Payment systems require an exceptionally high level of reliability and security, as even an apparently small system failure or a security breach can have significant consequences. The electronic payments industry operates in a secure environment of dedicated systems, applications, specialized hardware products and access networks. The industry will continue to evolve as the demands of the market and the rules that govern its standards and security change rapidly.
Since 2009, there has been continuing focus on the security of the payment system. Several large breaches of transaction processors’ and retailers’ systems around the world have resulted in increasing levels of fraud. As a result, there has been an increased focus on the security standards and audit requirements followed by the industry. In order to promote a common understanding of published security requirements and develop security best practice guides, Hypercom, Ingenico SA (“Ingenico”) and VeriFone formed the Secure POS Vendors Alliance in April 2009.
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Under current industry rules, retailers around the world have been forced to invest considerably in security audits in order to demonstrate compliance with the Payment Card Industry (“PCI”) security requirements. These audit expenses can extend into the millions of dollars yet, as has been demonstrated by several breaches, compliance does not guarantee immunity from security breaches. As a result, some major retailers outsource to third parties their complete payment systems, from card swipe or insertion through transaction settlement and reporting, in order to remove all payment card data from their systems and significantly reduce or eliminate their PCI audit expense. Hypercom has been successful in providing outsourced payment solutions for several large retailers in France. We believe this is a trend that will continue to grow across numerous major card payment markets and geographies, which we believe will provide us with future growth opportunities.
Market Growth Drivers
The following are a number of factors that have contributed to recent growth in our industry and that we believe will continue to do so in the near future:
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Security Standards. New industry security and interoperability standards are driving recertification and replacement of electronic payment systems, particularly in Europe and the U.S. In order to offer electronic payment systems that connect to payment networks, electronic payment system providers must certify their products and services with card associations, financial institutions and payment processors and also comply with government and telecommunication company regulations. The major card associations have introduced new security standards to address the continually growing need for transaction security. The two major security standards initiatives in the industry are EMV and PCI. The name EMV comes from the initial letters of EuroPay International, MasterCard International and Visa International, the three companies that originally cooperated to develop the standard. EMV is a set of global specifications for cards, terminals, and applications designed to ensure interoperability between smart cards and electronic payment systems on a global basis, increase functionality of electronic payment systems and reduce fraud. The move to comply with EMV specifications should continue to significantly promote terminal replacement, particularly in regions such as Europe, Asia-Pacific, and Central and South America, where EMV implementation conversion dates have been established. Visa International and MasterCard International cooperated in recent years to develop and release the PCI specification and test methods for the certification of electronic payment systems for secure debit transactions. This new set of standards supersedes previous security standards separately issued by Visa and MasterCard (not including EMV) and has been a driver of additional terminal replacement.
In late 2008 and early 2009, there were several high profile security breaches in Tier 1 payment transaction processors in the U.S. These breaches in systems that had been certified as compliant with PCI standards have caused a review of the existing standards and may result in an industry move, at least in the U.S., to mandate end-to-end encryption (“E2EE”) of payment transactions. During 2010, we have seen an increasing focus on E2EE. In August 2010, we introduced to the U.S. a new version of EFTSec, the largest operational E2EE software product implemented worldwide through which an estimated 3.4 million card payment transactions are protected every month in Asia. As of the end of 2010, few customer pilots in the U.S. are operational; however, we expect that, in 2011 and following years, large rollouts of E2EE systems will occur in the U.S. and other countries that have not migrated to EMV style chip cards. It should be noted, however, that EMV is not a complete solution against payment card fraud. Several large transaction processors and acquirers in EMV based countries (particularly the United Kingdom) are considering rolling out E2EE solutions to securely encapsulate the EMV transaction messages.
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Interoperability Standards. In the U.S., payment processors have two levels of certification, referred to as Class A and Class B. Class B certification ensures that an electronic payment system adheres to the payment processor’s basic functional and network requirements. Class A certification adds another stipulation that the payment processor will support the electronic payment system on its internal help desk systems. Obtaining these certifications can be costly and time intensive, and is required by U.S. payment processors. In other countries outside of the U.S., payment applications have to be certified with local banks, processors or card schemes. Electronic payment systems must also comply with evolving country-specific security regulations. Countries such as Australia, Canada, Germany, the Netherlands, New Zealand, Singapore, Sweden and Switzerland have particularly stringent and specific security standards. Electronic payment systems must also comply with recommendations of quasi-regulatory authorities and standard-setting committees, which address, among other things, fraud prevention, processing protocols and technologies utilized. New standards are continually being adopted as a result of worldwide fraud prevention initiatives, increasing the need for system compatibility and new developments in technology. These complex and evolving requirements will provide an opportunity for continuous replacement of outdated equipment with newly certified electronic payment systems.
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Broadband & Internet Protocol. Internet Protocol (“IP”) connectivity provides faster transmission of transaction data at a lower cost, enabling more advanced payment and other value-added applications at the point of sale. Major telecommunications carriers have expanded their communications networks and lowered fees to allow more merchants to utilize IP networks cost effectively. The faster processing and lower costs associated with IP connectivity have opened new markets for electronic payment systems, many of which have previously been primarily cash-only industries such as quick service restaurants (“QSRs”).
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Contactless. Contactless technology, based on the deployment of contactless cards or radio frequency identification-enabled mobile telephones, creates a convenient way to pay for goods and services. It is an emerging technology that is rapidly gaining acceptance due to its delivery of extremely fast transaction times, reduced waiting times and elimination of the need for paper signatures and receipts. It is especially suitable for access control and use in cafeterias, QSRs, gas stations and public transit systems.
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Near Field Communications. NFC represents an enhancement to contactless technology in which typically an NFC-enabled mobile phone can act as a contactless card or powered contactless reader, thus enabling two-way communication between another NFC-enabled device, including NFC-enabled POS terminals. With such an infrastructure in place, a consumer could pay at the point of sale using his or her phone, instead of using a contact or contactless payment card. In November 2010, Google CEO Eric Schmidt announced that the next operating system for its Android mobile telephones would support NFC amid speculation that Apple’s next version of the iPhone will support NFC as well. As a result of these developments, several third-party analysts predict that NFC-enabled mobile phone volumes will double every year through 2012, and that one in every six mobile subscribers globally will have an NFC-enabled device by 2014. NFC represents a significant growth opportunity for point of sale payment terminal providers since the vast majority of the installed base of payment terminals worldwide will need to be upgraded or replaced with NFC-enabled terminals.
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Wireless. Wireless electronic payment solutions are being developed to increase transaction efficiency and mobility. Wireless terminals are generally broken down into two categories: those that operate over short-range local area networks (“LAN”) and those that provide data connectivity over wide area networks (“WAN”). Our Wi-Fi and Bluetooth wireless LAN terminals require a base station to transmit data from the terminal to a central host or gateway. Wireless WAN terminals transmit data from anywhere over carrier networks via General Packet Radio Service without the distance restrictions set by a central base station. Wireless terminals can provide consumers with additional security by allowing them to maintain control of their payment card at all times. Additionally, the cost per transaction using wireless WAN terminals may be lower than that of wired terminals in regions burdened with high telecommunications costs such as Europe and Asia-Pacific. It also enables terminal deployment in those regions lacking an established landline telecommunications infrastructure.
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Debit. Debit is the dominant payment instrument in most international markets and is rapidly growing in the U.S. In 2010, debit card spending in the United Kingdom overtook cash for first time. Debit cards allow banks to reach a wider population of potential cardholders, thereby increasing the number of transactions. The cost of a debit transaction is generally lower than that of a credit transaction and combined with PIN-based security or biometric technology, provides a solution that helps reduce fraud. As a consequence, electronic payment is now an affordable and convenient option in markets lacking a significant consumer credit base as well as for small ticket or lower margin merchants.
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Emerging Regions and Markets. In the U.S. and Europe, consumer markets such as QSRs and unattended/self service have started using IP terminal devices. These lesser penetrated vertical markets represent a significant opportunity for us, as well as other geographies in each of our business segments, such as Brazil, China, Eastern Europe, India, Mexico and Russia, which are experiencing rapid growth in the usage of card-based payments. The increasing adoption of electronic payments in these regions is driven primarily by economic growth, improving telecommunications infrastructure development, strong support from governments seeking to increase sales tax collection, and the dramatic increase of wireless networks for voice and data communications.
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Multiple Applications. In addition to payment, terminals have the capability to perform concurrent applications like loyalty, stored value, on-screen advertising, electronic signature capture, age identification, and benefits authorization and transfer. The secure integration of these applications along with payment processing provides a comprehensive solution that allows merchants a means of competitive differentiation, revenue enhancement and cost reduction.
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Smartphone Based Terminals. With the increasing processing power and popularity of Smartphone and PDA devices in the hands of the small or occasional merchant, there is an emerging opportunity to enable these devices to accept card based payments. These devices have been capable of taking card payments where the card number is manually entered into the application running on the device for some time. However, a manually-entered card number attracts a considerably higher transaction cost than one where the physical card is swiped or entered (card present transaction). Recently, some providers have offered mobile “add-on” hardware and software applications, particularly around the Apple iPhone, whereby a device can be attached to the Smartphone or PDA to enable card present transactions to take place. While deployment of these types of devices may have some effect on the sales of existing mobile payment terminals, it is expected that the overall total available market for mobile payments will increase.
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Non-Traditional Applications. The healthcare sector is a significant opportunity for terminal providers, particularly in European Union countries. Electronic transaction terminals and transaction services technology can be utilized in the healthcare sector to provide fast and secure transmission of health benefits eligibility, authorization and payment. Additionally, strong industry and consumer support for unattended payment terminals and kiosks, particularly in the areas of gasoline/petrol stations and mass transit, provides a growing market for these equipment makers. Lastly, the government sector, particularly in the U.S., has produced initiatives such as identity verification, check imaging/conversion, electronic benefit transfer programs, and the U.S. military’s payment programs, all of which are potential drivers of terminal deployment.
Quarterly Trends and Fluctuations
We generally expect that our quarterly results of operations will be lower in the first quarter compared to the remaining quarters of our fiscal year, principally due to decreased first quarter demand for our products from North American retailers.
Competition
The electronic payments industry is intensely competitive and subject to an increasing rate of technological change, evolving customer requirements and changing business models. We face competition from well-established companies and entities with differing approaches to the market. Our main direct global competitors are Ingenico, a French company, and VeriFone, a U.S. company, both of which are publicly-held companies that are substantially larger and historically more profitable than we are. These two competitors have grown larger and have entered new markets through a spate of acquisitions in recent years, including Ingenico’s acquisitions of Sagem Monetel in France and EasyCash in Germany, Transfer-to in Singapore and Payzone in France, as well as an investment in Korvac in Singapore. VeriFone’s recent acquisitions in the U.S. include Semtek, WAY Systems, VeriFone Transport Systems, and Clear Channel Taxi Media. Outside the U.S., VeriFone’s acquisitions include the POS solutions business of Gemalto, a public company incorporated in the Netherlands, Orange Logic in South Korea, and All Business Solutions in Italy. The combined acquisitions and investments by Ingenico and VeriFone have increased these companies’ respective sizes substantially. In any particular market, we may also find ourselves in competition with local or regional providers.
In our multi-lane business line (department stores, grocery stores, QSR and other merchants), we compete with additional vendors including Fujitsu, Hand Held Products Inc. (a division of Honeywell International Inc.), Retail Solutions Inc., ViVOtech, PAX Technology, Inc., UIC, and others.
The POS terminal market is highly concentrated with the top three POS terminal providers (VeriFone, Ingenico and Hypercom) accounting for the majority of terminals shipped. The remaining portion of the market is spread among approximately 30 providers who compete on either a regional or local country basis, within specific markets or with a limited range of products and services. We believe the following market constraints are barriers to entry and may inhibit the ability of certain terminal providers to take advantage of future market growth in our industry:
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Price. Pricing is a significant consideration in our customers’ purchase decisions. Consequently, terminal providers have been increasingly challenged to deliver products and services that target critical specifications at competitive price points.
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Scale. The design, manufacture and distribution of POS terminals on a global basis requires a significant investment in development, manufacturing and distribution resources. As a result, smaller or regional providers may have limited ability to compete with larger providers who can spread costs across a broader base at higher volumes.
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Certification Standards and Costs. All payment solutions must be certified with card associations, financial institutions and payment processors. Many banking organizations have their own national or even regional standards for communications messaging, user operation, security and local card acceptance. These standards and certification requirements are constantly changing and the certification process can be a lengthy and expensive undertaking. Several terminal providers in the industry lack the relationships, knowledge and experience necessary to obtain these certifications quickly and cost-effectively, thereby limiting or delaying their time to market and overall competitiveness.
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Commitment to Future Technologies. New standards, regulations and certifications in the electronic payments industry require terminal providers to continually develop new technologies that enhance the performance and profitability of both customers and end-users. Such requirements necessitate significant annual investment in research and development.
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Global Presence. Large customers may prefer terminal providers that have a worldwide presence with the ability to provide services and support in many geographic regions. Smaller or regional providers may be competitive in their niche, but they may not be able to provide cost-effective equipment, services and timely support on a global scale.
Despite these barriers to entry, the rapid pace of technological change creates new opportunities for existing competitors and start-ups, and may render existing technologies less valuable. Customer requirements and preferences continually change as new technologies emerge or become less expensive, and as concerns such as security and privacy rise to new levels.
Competitive Strategy
Our strategy is to distinguish ourselves by combining operational excellence, technology and customer relationships with an end-to-end comprehensive portfolio of products and services that drives merchant revenue and reduces their total cost of ownership. Key elements of our competitive strategy include:
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Further Penetrate Existing Markets. We plan to continue promoting and marketing the functionality of our product portfolio to address the specific needs of key vertical markets. We intend to continue to focus on increasing our penetration in the following markets: automatic teller machines (“ATMs”), Electronic Benefit Transfer (“EBT”) and eHealth, as well as unattended applications such as transportation ticketing and integrated kiosks. In planning to maintain our leadership in the independent retail market, we have further organized our products to target high-end and low-end markets, through acceptance of magnetic stripe and smart cards, support of credit, debit, check, EBT and a full range of prepaid products, including gift cards and loyalty programs, among others. Our products are easily integrated with a full range of optional internal or external devices, including secure PIN pads, check imaging equipment, barcode readers, contactless and NFC readers and biometric devices. Our secure PIN pads support credit and debit transactions, as well as a wide range of applications that are either built into electronic payment systems or connect to electronic cash registers (“ECRs”) and other electronic payment systems.
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Capitalize on Demand for Wireless Transactions. We plan to accommodate the growing demand for reliable, secure, convenient and cost-efficient wireless devices. Potential users of this technology include mobile merchants such as taxi and delivery drivers, in-flight airline service providers, stadium event operators, off-site services and pay-at-table restaurants. These merchants are looking for a terminal that utilizes the convenience of wireless communication technologies and the security of being able to receive real-time authorizations with the reliability of a wired terminal. Simultaneously, we are aggressively transitioning into the consumer transaction market by providing processing alternatives like stored value and prepaid replenishment services for the transportation sector and digital wallet technology as an alternative to cash payments.
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Capitalize on Terminalization Requirements of Emerging Geographic Regions. We plan to continue seeking opportunities to expand global market share by leveraging our product portfolio and distribution channels in emerging, high-growth regions in Europe, Asia-Pacific and South America. In addition to expanding into new geographic markets, we will benefit from a replacement cycle that is ongoing in various geographic regions for a variety of reasons, including valued-added technologies (signature capture, contactless, multi-application); new security standards (EMV and PCI); and newer communications technologies (wireless, IP connectivity).
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Focus on Market-Driven Product Development. We plan to continue concentrating our research and development resources on new products and services that address current and near future requirements of our customers. We plan to focus our development efforts in the following areas: enhanced security at the terminal and transaction level; advanced communications technologies such as IP-enabled and wireless terminals; multiple-application; contactless technologies; and products for new vertical markets such as unattended/integrated kiosks and ATMs. We will continue to work with our customers to ensure our products meet their needs and technical requirements, and are brought to market in a timely and cost-effective manner.
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Continue to Pursue Recurring Revenue Opportunities. We plan to further identify and pursue opportunities that are complementary to our existing products to provide recurring revenue, including expanding our services business, which provides deployment, help-desk, repair and other post-sale services in Australia, Brazil, Chile, France, Germany, Mexico and the United Kingdom. We will continue to pursue similar opportunities that will help us enhance our primary business of terminal manufacturing to a more diversified business model that includes both one-time and recurring revenue streams.
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Consider Strategic Acquisitions and Joint Ventures. We may augment our growth by acquiring complementary businesses, new products to enhance our core competencies, or new technologies to complement our research and development activities or enter into additional joint ventures. Any acquisition or joint venture would be intended to broaden our suite of electronic payment solutions, expand our presence in selected geographies, broaden our customer base, expand recurring revenue opportunities or increase our penetration of selected channels and vertical markets.
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Clearly delineate our business from that of our customers. During 2009, we have seen our two main competitors execute strategies that place them in direct competition with some of their customers. We believe that we can gain market share as a result of these actions. Our marketing message emphasizes that we will respect our customers’ businesses and try to avoid entering into arrangements that place us in direct competition with customers, unless mutually agreeable.
Product Lines and Services
Our products and services include electronic transaction terminals, peripheral devices, application software, transaction networking devices, transaction management systems, asset management services, transaction services, and payment solutions. Unless otherwise noted below, we sell a full range of products and services in the Americas, NEMEA, SEMEA and Asia-Pacific business segments. We completed the migration from the TeT product set and, with the 2010 introduction of the L5000 multilane terminal on our next generation platform, will accelerate our move to a common, Linux-based payment terminal architecture.
Terminals and Peripherals
We currently offer the following terminal and peripheral products, the sale of which accounted for 77.5%, 74.7%, and 73.9% of total revenue during the years ended December 31, 2010, 2009, and 2008, respectively.
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Terminals - includes the next generation L5300 announced in May 2010, as well as the Optimum L4150, and L4250-compact, high-performance signature capture and PIN entry card payment terminals specifically designed for multilane retailers; the Optimum T4200 family and Artema Compact-powerful 32-bit desktop terminals for true multiple applications; the Artema Hybrid family of countertop terminals specifically designed to manage highly secure EMV transactions; the next generation M5000 announced in December 2010, as well as the Optimum M4100, M4230 and M4240-mobile terminals that leverage the latest in wireless communication technologies.
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Peripherals - includes printers, PIN pads, contactless devices and external modems. Our family of durable, high-security PIN pads and card acceptance devices are designed for either indoor or outdoor use. The products include the Optimum P2100-a PIN pad for integrated retail environments (currently offered only in our NEMEA and SEMEA segments); the P1300 family-PIN entry devices that meet the recent PCI security standards; and the S9 family-secure PIN pads that include integrated card readers. The PIN pad product family is augmented with the Artema PIN Hybrid and Artema S10 PIN Pads servicing the high security markets formerly served by TeT. The Wymix PIN Pad, which has a built-in contactless reader, is installed in the large retail market segment serviced by the Wynid family of retail payment solutions, including some of the world’s largest retailers, primarily in France. Finally, our R3210 contactless reader features a clip-on or countertop design and easy plug and play setup that allows merchants using Hypercom's terminals to upgrade their current device to accept contactless transactions.
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Unattended Solutions - includes a range of PIN pads and keyboards, card readers and payment controllers designed to permit the efficient integration of payment functionality in a variety of self-service environments such as transportation ticketing, gasoline/petrol station pumps, on and off-street parking machines, and general purpose kiosks. As well as being a leading supplier of highly secure Encrypting PIN Pads (“EPPs”) for ATMs, our unattended payment solution, Artema Modular, is widely regarded as best-in-class by the many system integrators who have deployed it worldwide.
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eHealth - in 2008 we launched the medLine family of terminals to support the next generation German eHealth healthcare system. The medLine family includes a full range of terminal devices for both attended and unattended environments within the public healthcare environment.
Transaction Networking Devices, Transaction Management Systems and Application Software
Products that interface with our terminal technology include our industry exclusive network access controllers and gateway devices specifically designed to support the unique requirements of high volume/high value transaction-based networks. Products in this family include the next generation IntelliNAC announced in December 2010, the MegaNAC® 180 and 8000, ATMConnect™ and the IN- tact® family of Ethernet/Internet gateway devices. Every network application software program we produce includes a management and control module that interacts with our IntelliView for the IntelliNAC or HypercomView® management system to monitor system operations. We also offer a complete portfolio of software applications for terminal operations, network device operations, systems development and management, and retail POS systems designed for use on a personal computer (“PC”).
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Services
We are committed to providing a high level of service and support to our customers either directly, or through our distributors or other third-party providers. We offer a wide range of support services that contribute to the increased profitability of our customers and meet their individual needs. Our service business is organized around three important markets: asset management services; trusted transaction services; and payment solutions. Services accounted for 22.5%, 25.3%, and 26.1% of total revenue during the years ended December 31, 2010, 2009, and 2008, respectively.
Asset Management Services - Our services organizations are focused on protecting our customer’s investment in payment systems and principally provide deployment, help desk, repairs, extended warranties, on-site support, logistics and inventory management services, as well as payment systems supplies provisioning. Additionally, these entities manage special projects such as software uploads or terminal enhancement programs requested by our customers. Terms of our service arrangements are set forth in separate service contracts ranging from one to five years, although termination is allowed with appropriate advance notification. In many cases we provide services not only for our products, but also for other manufacturers’ terminals and other hardware. Revenue under these contracts are recognized as we perform the service. Asset management revenue accounts for approximately 60-70% of our service revenue.
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Full Service Centers - In several markets we offer a full array of Asset Management Services to major banks, card associations and other customers in our industry. Our service organization in Brazil is our largest, covering, directly and indirectly (through the use of third-party contractors), all of Brazil with multiple service centers and service resources located throughout the country. We continually seek to expand our service market share by increasing the deployed population of our terminals and product offerings in Brazil, as well as servicing terminals manufactured by our competitors. Our service organizations in Mexico, Chile, the United Kingdom, France, and Australia operate under a similar business model as that in Brazil and cover substantially all of their respective countries.
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Pan-region Repair Services - Through NetSet Americas Centro Servicio, our repair facility in Hermosillo, Mexico, we provide quality repair services for in-warranty and out-of-warranty equipment repairs to North American customers. Similar Hypercom repair depots are strategically located in other locations, including the United Kingdom and Germany.
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Authorized Repair Facilities - In addition to our direct repair service offerings, we selectively authorize capable third-party repair facilities to service and repair Hypercom equipment through our Authorized Repair Facility program. This program seeks to offer increased choices for repair service with our assurance of repair service quality and cycle time for our customers.
Trusted Transaction Services - Our Trusted Transaction Services provide value-added data communication and other value added services for transaction-based applications through our new venture with the McDonnell Group, Phoenix Managed Networks, LLC. These capabilities include such functionality as protocol conversion, intelligent transaction routing and web-based, transaction-level reporting. As technologies such as IP and wireless take hold at the point of sale, this market will see a growing shift toward more sophisticated applications. Trusted Transaction Services provide a support infrastructure for our multi-application operating systems to quickly and cost-effectively deliver transactions to diverse processing entities. Early adopters include organizations involved in biometrics, health care, prepaid, micropayments, gift and loyalty. Market penetration of these complex applications is expected to dramatically increase in coming years as the consumer interaction can be transacted in several seconds with broadband connectivity, as compared to several minutes over dial-up connection.
Additionally, the Hypercom Mobile Network (“HMN”) permits a wireless payment device to be provisioned with a HMN SIM (subscriber identity module) card at the manufacturing or logistics center. The HMN SIM is only activated on deployment of the device and permits the terminal to connect to the wireless communications carrier with the strongest wireless signal in the area. The HMN offers a range of control and reporting functions to ease management of a large number of wireless devices, thereby significantly reducing the total cost of ownership for the device owner.
SmartPayments™ Savannah - Traditionally, only large retail merchants have been able to implement POS systems with interactive payment terminals. Through the acquisition in December 2006 of the existing technology and assets of TPI Software, LLC (“TPI”), a U.S.-based enterprise payment solutions business, we expanded our transaction services portfolio with the introduction of PC-based payment solutions, including support for PC-based retail POS systems, which enables us to broaden our customer base to include small- and medium-sized retailers. SmartPayments Savannah is also enabling the generation of new revenue streams by addressing the technology requirements of, and rising market interest in, a converged payment infrastructure that places electronic payment functionality on PC-based cash registers. Our strategy is to increase our recurring revenue stream by charging for enterprise payment services. SmartPayments Savannah is currently offered only in North America.
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SmartPayments Wynid - We complement our payment solutions business with the integrated payment solution developed by the SmartPayments Wynid business unit in France, acquired as part of the TeT acquisition. This powerful, server-based payment solution has been widely deployed by many of the leading retailers and hospitality organizations in France, and is being deployed internationally by some major retail and petrol companies. The SmartPayments Wynid solution was one of the first integrated payment solutions to be EMV certified worldwide, and has recently evolved to support transactions using contactless cards and NFC-enabled mobile phones.
Product Marketing
Our marketing organization benefits from a global product marketing group with product managers assigned to manage the life cycle of all new and legacy products. Our marketing communications strategy, which coordinates key market messaging across regions, is directed from our Scottsdale, Arizona headquarters; however, each region develops programs to meet the requirements of local markets. Components of our marketing program include product marketing, trade shows, news releases, editorial interviews, industry analyst briefings, speaking platforms and engagements, training and technology seminars, sales collateral and white papers, print advertising, articles and newsletters.
Sales and Distribution
Our major sales, marketing and distribution regions, broken down by business segment, include:
• the Americas;
• NEMEA;
• SEMEA; and
• Asia-Pacific.
In 2010, approximately 13.5% and 86.5% of our consolidated revenue came from U.S. and international sources, respectively. Our global customers include:
• Payment processors;
• Distributors/resellers;
• Large retail chains and QSRs;
• Financial institutions;
• System integrators;
• ISOs; and
• Government entities.
Sales to specific customers have historically accounted for a significant portion of our revenue. Beginning in 2007, and continuing through 2008 as a result of the TeT acquisition, we saw greater diversification of our customer base. However, we remain reliant on certain large customers for our revenue streams. For example, First Data Corporation (which includes TASQ Technology) accounted for approximately 10.6%, 5.2%, and 6.2% of our revenue in fiscal 2010, 2009, and 2008, respectively. In 2010, our top five customers accounted for 26.5% of our revenue compared to 19.0% in 2009 and 19.5% in 2008.
We distribute and sell our products internationally primarily to large retailers, financial institutions and distributors. Domestically, we primarily distribute and sell our products to financial institutions, payment processors, retail chains, ISOs, distributors and resellers.
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Some of our key sales attributes are:
•
Global Presence. We are one of the largest worldwide providers of electronic payment system solutions for use at the point of sale. We have developed a global network of sales, support and development centers. We believe that our experience and global presence enable us to market, distribute and service our products more effectively, and in more markets than most of our competitors.
•
Comprehensive Product Portfolio. We offer a full range of products and services that address the spectrum of market requirements. Our product portfolio ranges from the low-cost, established and reliable T7 family of terminals to the more recently released, high-performance 32-bit Optimum family and the Artema family of secure high-performance terminals acquired in the TeT transaction. With the announcement of the L5000 family of multilane terminals in 2010, we announced the first product to run on our next generation, Linux-based platform. Our terminals are further complemented by a wide variety of peripherals that enhance their capabilities. Our services include networking, deployment, help-desk, repair and maintenance. We have major service centers in each of our business segments: the Americas-Brazil and Mexico; NEMEA-Germany; SEMEA-the United Kingdom and France; and Asia-Pacific-Australia.
•
Low Total Cost of Ownership. The total cost of ownership includes the following costs: deployment, implementation, application certification, repair and maintenance and product obsolescence. We continue to support and focus on providing our customers with a clear migration strategy for new technologies, versus a buy today, replace tomorrow strategy.
•
Technology Adoption. Our technological advances have continued to support industry adoption of value-added features, such as electronic receipt capture, smart cards, electronic signature capture, positive identification and multi-application. We offer network products to host such multi-application offerings. Other technology innovations include IP and wireless connectivity, as well as RFID and contactless acceptance. Our engineering has consistently focused on quality and performance, including speed of the transaction, number of and type of completed transactions, the speed of application download and the user interface. Our modular design allows our customers to select only those features they require, thereby minimizing their costs and increasing their flexibility. We have reorganized our development team in recent years to more rapidly develop, prototype, and release new products to meet customer needs.
•
Terminal Management and Networking Expertise. We are a leader in terminal management and networking with a significant number of installations of our POS network controllers worldwide, managing not only our terminals, but those of our competitors as well.
•
Security Expertise. We are an industry leader in secure, state-of-the-art, network payment transactions providing full EMV and PCI certification, regulatory certifications, association certifications, contactless authentication, signature capture, identity and biometric authentication and enterprise security management, ensuring both physical and logical high performance interfaces are secure and certified for use globally, by both public telephony and mission critical computing processors. We are also on the forefront of bringing E2EE solutions to the electronic payments industry.
Research and Development
Our market-focused research and product development activities concentrate on developing new products, technologies and applications for our products, as well as enhancements and cost reduction measures for existing technologies and applications. We have typically designed and developed all of our own products and incorporate, where appropriate, state of the art technologies from leading third party vendors. We have recently transitioned to a joint development manufacturing model, whereby we will co-design and co-develop the hardware platform for our new products with a third-party. As part of this model, we will continue to design and develop internally the core operating software and security elements for our products. Development projects are evaluated and coordinated by our global product marketing team and follow a management review process that includes input from our sales, local marketing, finance, supply chain and engineering teams. Our product development process generally involves the following:
• Identification of the applicable market and development parameters;
• Rapid development of engineering specifications, including target costs;
• State of the art design and engineering;
• Accelerated testing;
• Quality assurance; and
• Pilot production.
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Through this process, we can assess the requirements of individual customers and markets, and develop products and platforms that address those needs globally. Bringing quality products to market in a timely manner is the primary objective of our product development initiatives.
Our research and development activities are coordinated through our Scottsdale, Arizona headquarters. To serve the needs of customers around the world, we “localize” many of our products to reflect local languages and conventions. Localizing a product may require modifying the user interface, altering dialog boxes, translating text and altering the communications messaging to suit local requirements. Each of our regional sales and marketing units has in-region development resources that can provide customization and adapt products to meet the needs of customers in local markets. International development groups are located in Australia, Brazil, China, France, Germany, Hong Kong, Hungary, Latvia, Mexico, Puerto Rico, Singapore, the Philippines, Sweden, and the United Kingdom.
Our research and development expenses were $47.1 million, $44.5 million, and $45.9 million for the years ended December 31, 2010, 2009, and 2008, respectively.
Manufacturing and Resource Procurement
During 2010, we have rationalized our outsource methodologies and manufacturing strategies at the global level introducing new partners in Europe and South America, and reducing our exposure and number of manufacturing partners to the minimum level necessary to enable Hypercom to sustain future organic growth in terms of capacity and desirable time to market for the next three to five fiscal years. Today our main partners are Venture Corporation (Singapore) Ltd. in Malaysia, Zollner Electronik AG in Romania, ENH Gmbh in Germany, and Jabil Circuit, Inc. in Brazil. Under our current contract manufacturing agreements, such manufacturers procure components and test, package and prepare all covered products for shipment. With limited exceptions, we are not required to purchase any minimum quantities or units of products; however, we are required to complete open purchase orders we place that fall within certain periods of time prior to shipment. We control the source and price of material by agreements at a worldwide level with key component suppliers, which ensures that our current contract manufacturers buy only certified and qualified components at the agreed prices.
We have recently moved to a joint development manufacturing model whereby we provide hardware specifications to a third party to design, develop and manufacture certain hardware. On February 1, 2011, we entered into a manufacturing agreement with MiTAC International Corporation (“MiTAC”), a Taiwanese-based outsourced development manufacturer, for the manufacture and assembly by MiTAC of certain products for us. The manufacturing agreement has an initial term of three years and will be renewed automatically for additional consecutive one-year periods unless either party provides written notification of termination within 180 calendar days prior to the end of such term or renewal term. Under a previously executed development agreement dated October 6, 2009, we subcontracted to MiTAC the design and development of the hardware of our forthcoming line of products and various other device level products for which we provided a high level product specification. We will continue to provide the software and security requirements for such products. The work performed pursuant to the development agreement will form the basis from which MiTAC will manufacture and assemble products pursuant to the manufacturing agreement. Based on currently anticipated timelines, we expect that a limited number of our products will be designed utilizing this joint development manufacturing model by the end of 2011. MiTAC is currently manufacturing some of our next generation products at its facilities in China.
To control product costs, we centrally manage product documentation, procurement and material requirements planning from our Scottsdale, Arizona headquarters, utilizing an integrated enterprise system linking all of our manufacturing and design centers. Centralized management of the planning processes, combined with regional procurement, enables us to control the quality and availability of our products. We continue to look for opportunities to reduce the cost of existing products by working with our suppliers to seek more favorable pricing, purchasing components in volume to achieve lower unit costs, and seeking greater efficiencies in product design and advance material sourcing in order to introduce newer technologies as they become available and compliant with our standard specifications.
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Industry Standards and Government Regulations
Electronic payment system providers must certify products and services with card associations, financial institutions and payment processors, as well as comply with government and telecommunications company regulations. We are also subject to other domestic and international legal and regulatory requirements.
We comply with the following standards and requirements:
•
Security Standards. Security standards in our industry are promulgated largely by regional bank associations and card associations, as well as certain government regulations. These standards ensure the integrity of the payment process and protect the privacy of consumers using electronic transaction systems. New standards are continually being adopted or proposed as a result of worldwide fraud prevention initiatives, increasing the need for new security solutions and technologies. We have developed a security architecture that incorporates physical, electronic, operating system, encryption and application-level security measures in order to remain compliant with the growing variety of international requirements. This architecture is particularly successful in countries that have stringent and specific security requirements.
•
EMV and PCI Standards. EMV standards define a set of requirements to ensure interoperability between chip cards and terminals on a global basis, regardless of the manufacturer, the financial institution, or where the card is issued or used. Specific certifications are required for all electronic payment systems and their application software. PCI provides a series of standards and certification criteria applicable to products and/or services offered by Hypercom to its customers to facilitate the processing of electronic transaction data. The intent of these standards is to validate the security of payment devices and ensure proper protection of any confidential payment transaction data during storage and/or in transit. We obtain EMV and PCI product certifications at a global level, prior to specific local market certifications.
•
Payment Processor/Financial Institution Requirements. We are required to certify our products with payment processors. We actively perform Class B and Class A product certifications with all the major payment processors in the U.S. and international markets. The Class B certification process pertains to successful testing of the integrity of the host (interface) message formats with the payment processor’s requirements and specifications. Once the Class B certification process is completed, the payment processor may elect to take the software application and the hardware for additional in-house testing and support. Class A certification (which may take up to 12 months or more) includes more intensive functional and user-acceptance testing in order to establish their help-desk infrastructure. Class A Certification enables payment processors to provide direct support, deploy and promote the new products with their merchant base and sales force. We have significant experience in attaining these critical payment processor certifications and have a large portfolio of Class A certifications with major U.S. payment processors. In international markets, we also obtain certifications from local financial institutions and payment processors so that our products can be used on their specific networks.
•
WEEE and RoHS Directives. In the European Union, we are subject to the Waste Electrical and Electronic Equipment (“WEEE”) Directive and the Restriction on Hazardous Substances (“RoHS”) Directive. The WEEE Directive requires producers of electrical and electronic equipment to label all covered products and also establish collection, treatment, and recovery systems for their electric and electronic equipment waste. The RoHS Directive restricts the use of certain substances in physical devices that include our solutions and/or requires active steps to promote the recycling of materials. A few countries and U.S. states that have either fully adopted the requirements of these directives or have adapted those requirements and implemented their own individual requirements.
•
Telecommunications Regulatory Authority and Carrier Requirements. Our products must comply with government regulations, including those imposed by the U.S. Federal Communications Commission (“FCC”), Underwriter’s Laboratories (“UL”) and similar regulatory authorities worldwide regarding EMC emissions, EMC immunity, radio frequency (“RF”) radiation, safety and connections with telephone lines and radio networks. Our products must also comply with recommendations of quasi-regulatory authorities such as the European Telecommunications Standards Institute and of standards-setting organizations such as the International Electrotechnical Commission. Our products have been certified as compliant with national requirements in a large number of countries, including those of the FCC and UL in the U.S., the Radio & Telecommunication Terminal Equipment Directive in Europe, and similar requirements in other countries. In addition to national requirements for telecommunications systems, many wireless network carriers have their own standards and requirements with which products connected to their networks must comply and unique certification processes for devices to be used on their networks.
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Segment, Geographic and Customer Information
See Note 21 to our consolidated financial statements included herein.
Proprietary Rights
We seek to establish and maintain our proprietary rights in our technology and products through the use of patents, copyrights, trademarks and trade secret laws. We file applications for and obtain patents, copyrights and trademarks in the United States and in selected foreign countries where we believe filing for such protection is appropriate. We also seek to maintain our trade secrets and confidential information by nondisclosure policies and through the use of appropriate confidentiality agreements.
We currently hold U.S. and international patents relating to POS terminals and related products and also have a number of pending patent applications relating to our POS terminal products and networking products. Granted patents typically have a life of twenty years from the date of filing of the application. While our earliest granted patent (assigned to us in the Thales e-Transactions acquisition) was filed in 1989, a majority of our patent applications have been filed since January 1, 2001. We believe that the duration of our patents is adequate relative to the expected lives of our products. Because of continual innovation and product development in the electronic payments industry, our products are often likely to reach their end of life before any patents related to them expire.
We currently hold trademark registrations in the U.S. and numerous other countries for the “Hypercom” mark and logo. In addition, we have a number of other U.S. and foreign trademark registrations, and pending trademark applications, relating to our products and services. We embed copyright notices in our software products advising all users that we own the rights to the software. We also place copyright notices on documentation related to these products. We routinely rely on contractual arrangements to protect our proprietary software programs, including written contracts prior to product distribution or through the use of click-through license agreements. We typically do not obtain federal copyright registrations for our software.
While we believe the protection afforded by our patents, copyrights, trademarks and trade secrets has value, our business as a whole is not significantly dependent on any one patent, copyright, trademark or trade secret. The rapidly changing technology in the electronic payments industry and uncertainties in the legal process for enforcement of intellectual property rights in certain countries make our future success more dependent on the innovative skills, technological expertise and abilities of our employees, rather than on the protection afforded by patents, copyrights, trademarks and trade secrets.
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Employees
As of December 31, 2010, we employed 1,431 people on a full-time basis, 253 of which are located in the U.S., with the remaining 1,178 located internationally, as set forth in the following table:
Employees by business segment, as of December 31, 2010, are as follows: the Americas (361); NEMEA (135); SEMEA (302); Asia-Pacific (235); and Shared Cost Centers (398).
We believe that we have an excellent relationship with our employees. We believe we have been successful in our efforts to recruit qualified employees, but we cannot guarantee that we will continue to be as successful in the future. Certain of our employees globally are subject to collective bargaining agreements, or are members of unions or other organized labor associations.
Available Information
Our principal executive offices are located at 8888 East Raintree Drive, Suite 300, Scottsdale, Arizona 85260, and our telephone number is (480) 642-5000. Our website is located at www.hypercom.com. We make available free of charge, through our website, our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to those reports, as soon as reasonably practicable after we electronically file or furnish such material to the Securities and Exchange Commission (“SEC”). The information found on our website is not part of this or any other report we file or furnish to the SEC.
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Item 1A.
Item 1A. Risk Factors
The risks set forth below may adversely affect our business, financial condition and operating results and cause actual results to differ materially from the results contemplated by the forward-looking statements contained in this Annual Report on Form 10-K or elsewhere in our SEC filings. In addition to the risks set forth below, and the factors affecting specific business operations identified elsewhere in this Annual Report on Form 10-K, there may also be risks of which we are currently unaware, or that we currently regard as immaterial based on the information available to us, that later may prove to be material .
Risks Related To Our Business
The pendency of our agreement to be acquired by VeriFone could have an adverse effect on our business.
On November 17, 2010, we entered into a definitive merger agreement with VeriFone pursuant to which VeriFone will acquire Hypercom in an all-stock merger. The merger was approved by our stockholders on February 24, 2011 and is anticipated to close in the second half of 2011, subject to the satisfaction of applicable regulatory approvals and other customary closing conditions.
The announcement and pendency of the acquisition by VeriFone could cause disruptions in our business. For example, although VeriFone has committed per the terms of the merger agreement to fulfill any Hypercom customer agreements or purchase orders, to provide warranty service on Hypercom’s products and repair and maintenance for the longer of three years from the closing of the merger or as required by law, and to continue to support software applications, including the provision of bug fixes and updates for the longer of one year from the closing of the merger or as required by law, all at service levels consistent with Hypercom’s current business practices, customers may still delay, reduce or even cease making purchases from us until they determine whether the merger will affect our products and services, including, but not limited to pricing, performance or support. Furthermore, third-party intermediaries such as distributors, value-added resellers, ISOs and other distribution channel partners may give greater priority to products of our competitors until they determine whether the merger will affect our products and services or our relationship with them. Our relationships with our vendors, suppliers, and contract manufacturers may deteriorate. In addition, key personnel may depart for a variety of reasons including perceived uncertainty as to the affect of the merger on their employment. The loss of key personnel could adversely affect our relationships with our customers, vendors, suppliers, contract manufacturers, and other employees. These disruptions may increase over time until the closing of the merger, and we cannot provide assurance that the merger will close in the second half of 2011, as currently as expected, if at all.
VeriFone and Hypercom are subject to the securities and antitrust laws of the United States and the antitrust laws of any other jurisdiction in which the merger is subject to review. VeriFone and Hypercom may be unable to obtain in the anticipated timeframe, or at all, the regulatory approvals required to complete the merger. Governmental entities with which filings are made may seek regulatory concessions, including compliance with material restrictions or conditions, including the divestiture of portions of VeriFone’s or Hypercom’s business, as conditions for granting approval of the merger. These actions may have a material adverse effect on VeriFone or Hypercom or a material adverse effect on the combined business. Under the merger agreement, VeriFone and Hypercom have both agreed to use reasonable best efforts to complete the merger, including to gain clearance from antitrust and competition authorities and to obtain other required regulatory approvals. Under the merger agreement, VeriFone’s reasonable best efforts includes a requirement by VeriFone to dispose of businesses or assets that produced up to $124 million in revenues for VeriFone, Hypercom and their respective subsidiaries during the 2009 fiscal year if such disposition is reasonably necessary to gain clearance from antitrust and competition authorities. VeriFone and Hypercom anticipate that Hypercom’s U.S. business will be divested in connection with the merger. These actions or any other actions that may be required to obtain regulatory approval for the transaction may have a material adverse effect on VeriFone or Hypercom or a material adverse effect on the combined businesses.
In addition to the required regulatory approvals, the merger is subject to a number of other conditions beyond either company’s control that may prevent, delay or otherwise materially adversely affect its completion. Neither VeriFone nor Hypercom can predict whether and when these other conditions will be satisfied. Further, the requirements for obtaining the required clearances and approvals could delay the completion of the merger for a significant period of time or prevent it from occurring. Any delay in completing the merger could cause the combined company not to realize some or all of the synergies that are expected to be achieved if the merger is successfully completed within its expected timeframe.
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In addition, to the extent a prolonged delay in completing the planned merger creates uncertainty among users of Hypercom’s products and services, there could be an adverse effect on Hypercom’s results of operations, and quarterly revenue could be substantially below the expectations of market analysts which could cause a reduction in the stock price of Hypercom common stock. Such effects are likely to be exacerbated the longer the time period between the signing and the closing or any termination of the merger agreement.
The merger agreement generally requires us to operate our business in the ordinary course pending consummation of the merger, but includes certain contractual restrictions on the conduct of our business that could affect our ability to execute on our business strategies and attain our financial goals. In addition, the pendency of the acquisition by VeriFone and the completion of the conditions to closing could divert the time and attention of our management.
All of the matters described above, alone or in combination, could materially and adversely affect our business, financial condition, results of operations, and stock price.
The failure to complete the merger with VeriFone could adversely affect our business and our stock price.
We cannot provide assurance that the pending acquisition by VeriFone will be completed. If the pending acquisition is not completed, the share price of our common stock may drop to the extent that the current market price of our common stock reflects an assumption that a transaction will be completed. On November 16, 2010, the day before the announcement of the pending merger, our stock’s closing price was $6.13. On November 17, 2010, following the announcement of the pending merger, our stock’s closing price was $7.13 and from November 17, 2010 through March 7, 2011 our stock’s closing price has ranged between $7.13 and $11.05.
In addition, under certain circumstances specified in the merger agreement, we may be required to pay VeriFone a termination fee of approximately $12.2 million. Our costs related to the merger, such as legal fees, accounting fees and expenses of our financial advisors must be paid by us even if the merger is not completed, and we may be required to record as expenses in our statement of operations items related to the proposed merger that would otherwise be reflected on our balance sheets. Further, a failed transaction may result in negative publicity and a negative impression of us in the investment community. We may not be able to find a partner willing to pay an equivalent or more attractive price for our stock than that which would be paid in the VeriFone merger. Further, any disruption to our business resulting from the announcement and pendency of the acquisition by VeriFone and from intensifying competition from our competitors, including any adverse change in our relationships with our customers, vendors, suppliers, contract manufacturers, and employees, could continue or accelerate in the event of a failed transaction. There can be no assurance that our business, these relationships or our financial condition, and our stock price, will not be adversely affected, as compared to the condition prior to the announcement of the merger, if the merger is not consummated.
If completed, our merger with VeriFone may not achieve its intended results.
We and VeriFone entered into the merger agreement with the expectation that the merger would result in various benefits, including, among other things, cost savings and operating efficiencies relating to the combined business. Achieving the anticipated benefits of the merger is subject to a number of uncertainties, including whether our business is integrated with that of VeriFone in an efficient and effective manner. Failure to achieve these anticipated benefits could result in increased costs, a decrease in the amount of revenue expected to be generated by the combined company, and diversion of management’s time and energy, and could have an adverse effect on the combined company’s business, financial results and prospects.
International operations pose additional challenges and risks that if not properly managed could adversely affect our financial results.
For the year ended December 31, 2010, we derived approximately 86.5% of our total net revenue outside of the U.S., principally in Europe, Asia-Pacific and Central and South America. We expect that international sales will continue to account for a significant percentage of our net revenue and operating income in the foreseeable future. In addition, all of our contract manufacturers are located outside of the U.S. Accordingly, we face numerous risks associated with conducting international operations, any of which could negatively affect our results of operations and financial condition. These risks include the following:
• changes in foreign country regulatory requirements;
• various import/export restrictions and the availability of required import/export licenses;
• imposition of foreign tariffs and other trade barriers;
• political and economic instability;
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• changes in local economic environments, including inflation, recession and foreign currency exchange rate fluctuations;
• inability to secure commercial relationships to help establish our presence in international markets;
• inability to hire and train personnel capable of marketing, installing and integrating our products, and services, supporting customers and managing operations in foreign countries;
• building our brand name and awareness of our products and services among foreign customers;
• competition from existing market participants that may have a longer history in and greater familiarity with the foreign markets we enter;
• extended payment terms and the ability to collect accounts receivable;
• the ability to repatriate funds or transfer funds among our subsidiaries and between our subsidiaries and their parent entities;
• complicated tax and regulatory schemes where failure to comply may result in fines, penalties or litigation;
• complications associated with enforcing legal agreements in certain foreign countries, including, but not limited to, Brazil, China and developing countries; and
• availability of qualified and affordable staff with which to manage our foreign operations.
Additionally, we are subject to the Foreign Corrupt Practices Act, which may place us at a competitive disadvantage to foreign companies that are not subject to similar regulations.
Quarterly revenue and operating results can vary, depending on a number of factors.
Our consolidated results of operations and financial position can vary significantly from quarter to quarter, which is not conducive to a predictable business or operating environment. Consequently, this can impact our overall business. The following factors impact our quarterly business operations and results:
• variations in product mix, pricing and product cost, timing and size of fulfilled orders as a result of customer deferral or cancellation of purchases and/or delays in the delivery of our products and services;
• accomplishment of certain performance parameters embedded in our service level agreements;
• market demand for new product offerings and the timing of market launches for such offerings;
• delays in the delivery of our products and services;
• the type, timing and size of orders and shipments;
• product returns and warranty claims;
• development of new relationships and maintenance and enhancement of existing relationships with customers and strategic partners;
• deferral of customer contracts in anticipation of product or service enhancements;
• deferral of certain revenue or gross margin in accordance with U.S. GAAP requirements;
• incremental costs incurred as a result of product quality and/or performance issues;
• inventory obsolescence and write-downs related to product life cycles;
• write-off of doubtful accounts receivable;
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• variations in operating expenses, including research and development, selling, and general and administrative expenses;
• lease portfolio risk adjustments and loss provisions;
• restructuring activities;
• employment and severance agreement charges;
• foreign currency exchange rate fluctuations;
• availability and cost of financing;
• variations in income tax as a function of income recognition by tax jurisdiction; and
• changing security standards or other technological changes.
The loss of one or more of our key customers could significantly reduce our revenue and profits.
We have derived, and believe that we may continue to derive, a significant portion of our net revenue from a limited number of large customers. For the fiscal year ended December 31, 2010, our largest customer accounted for 10.6% of our net revenue, and our five largest customers accounted for 26.5% of our net revenue. In addition, our largest customer does substantial business with some of our most significant competitors. Our customers may buy less of our products or services, depending on their own technological developments, end-user demand for our products, internal budget cycles and market conditions. A major customer in one year may not purchase any of our products or services in another year, which may negatively affect our financial performance. If any of our large customers significantly reduces or delays purchases from us or if we are required to sell products to them at reduced prices or unfavorable terms, our revenue and results of operations could be materially adversely affected. See “Item 1, Business - Sales and Distribution” for more information on our customer base.
Our products may contain defects that may be difficult or even impossible to correct. Product defects could result in lost sales, additional costs and customer erosion.
We offer technologically complex products that, when first introduced or released in new versions, may contain software or hardware defects that are difficult to detect and correct. The existence of defects and delays in correcting them could result in negative consequences, including the following:
• delays in shipping products;
• cancellation of orders;
• additional warranty expense;
• delays in the collection of receivables;
• product returns;
• the loss of market acceptance of our products;
• claims against us;
• diversion of research and development resources from new product development; and
• write-downs of and creation of reserves against inventory in our possession or located at our contract manufacturers.
Even though we test all of our products, defects may continue to be identified after products are shipped. In past periods, we have experienced various issues in connection with product launches, including the need to rework certain products and stabilize product designs. Correcting product defects can be a time-consuming, difficult and expensive task. Software errors may take several months to correct, and hardware errors may take even longer.
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We or our third-party contract manufacturers may accumulate excess or obsolete inventory that could result in unanticipated price reductions and write downs and adversely affect our financial results.
Managing the proper inventory levels for components and finished products is challenging. In formulating our product offerings, we have focused our efforts on providing to our customers products with greater capability and functionality, which requires us to develop and incorporate the most current technologies in our products. This approach tends to increase the risk of obsolescence for products and components we or our third-party contract manufacturers hold in inventory and may compound the difficulties posed by other factors that affect our inventory levels, including the following:
• the need to maintain significant inventory of components that are in limited supply;
• buying components in bulk for the best pricing;
• responding to the unpredictable demand for products;
• responding to customer requests for short lead-time delivery schedules;
• failure of customers to take delivery of ordered products; and
• product returns.
In addition, we may in some cases have to reimburse, or incur other charges from, our third-party contract manufacturing partners for excess or obsolete inventory or unfulfilled, non-cancelable open purchase orders resulting from changes in product design or demand. If we accumulate excess or obsolete inventory, price reductions and inventory write-downs may result, which could adversely affect our results of operations and financial condition. The total impact of excess and obsolete inventory, including inventory held by our third-party manufacturers, on our financial results was $4.3 million, $6.4 million, and $8.3 million for the years ended December 31, 2010, 2009, and 2008, respectively.
Security is vital to our customers and therefore breaches in the security of transactions involving our products or services could adversely affect our reputation and results of operations.
Protection against fraud is of key importance to the purchasers and end-users of our solutions. We incorporate security features, such as encryption software and secure hardware, into our solutions to protect against fraud in electronic payment transactions and to ensure the privacy and integrity of consumer data. Our solutions may be vulnerable to breaches in security in the security mechanisms, the operating system and applications or the hardware platform. Security vulnerabilities could jeopardize the security of information transmitted or stored using our solutions. In general, liability associated with security breaches of a certified electronic payment system belongs to the institution that acquires the financial transaction. We have not experienced any material security breaches affecting our business. However, if the security of our solutions is compromised, our reputation and marketplace acceptance of our solutions will be adversely affected, which would adversely affect our results of operations, and subject us to potential liability.
If we are unable to adequately protect our proprietary technology, our competitors may develop products substantially similar to our products and use similar technologies, which may result in the loss of customers.
We rely on patent, copyright, trademark and trade secret laws, as well as confidentiality, licensing and other contractual arrangements, to establish and protect the proprietary aspects of our products. Our efforts may result in only limited protection, and our competitors may develop, market and sell products substantially equivalent to our products, or utilize technologies similar to those used by us. If we are unable to adequately protect our proprietary technology, these third parties may be able to compete more effectively against us, which could result in the loss of customers and adversely affect our business.
In addition, the legal systems of many foreign countries do not protect or honor intellectual property rights to the same extent as the legal system of the U.S. For example, in China, the legal system in general and the intellectual property regime in particular, is still in the development stage. It may be very difficult, time-consuming and costly for us to attempt to enforce our intellectual property rights in such jurisdictions.
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Our products and other proprietary rights may infringe on the proprietary rights of third parties, which may expose us to claims and litigation.
Although we believe that our products do not infringe on any third party’s patents, from time to time we have become involved in claims and litigation involving patents or proprietary rights. Patent and proprietary rights litigation entails substantial legal and other costs, and diverts the attention of our management resources. There can be no assurance that we will have the necessary financial and other resources required to appropriately defend or prosecute our rights in connection with any such litigation.
In the past, we have received third-party claims of infringement and may receive additional claims of infringement in the future. To date, such activities have not had a material adverse effect on our business and we have prevailed in litigation, obtained intellectual property or a license thereto on commercially acceptable terms or otherwise been able to modify any affected products or technology. However, there can be no assurance that we will continue to prevail in any such actions, or that any intellectual property or license required for such products or technology would be made available on commercially acceptable terms, if at all, or that we would be able to successfully modify our products or technology to negate claims of infringement.
A disruption in our third-party manufacturers or suppliers would negatively impact our ability to meet customer requirements.
We currently rely on third-party manufacturers, and in the future will increasingly rely on one or more original design manufacturers as part of our joint development manufacturing model, to co-design, co-develop, manufacture and assemble substantially all of our products and subassemblies. We also depend upon third-party suppliers to timely deliver components that are free from defects, competitive in functionality and cost, and in compliance with our specifications and delivery schedules. If we are unable to successfully manage our relationship with these third-party manufacturers, or if such manufacturers experience any significant disruption in their supply chain and manufacturing capabilities, or they experience economic, political and business issues that may impact their ability to fulfill their obligations to us, we may be unable to fulfill customer orders in a timely manner, which would have a material adverse effect on our business, operating results and financial condition.
In addition, our use of third-party manufacturers reduces our direct control over product quality, manufacturing timing, yields, and costs. Disruption of the manufacture or supply of our products or components, or a third-party manufacturer’s or supplier’s failure to remain competitive in functionality, quality or price, could delay or interrupt our ability to deliver our products to customers on a timely basis, which would have a material adverse effect on our business, operating results and financial condition.
The components used in our systems are purchased from outside sources. Certain components, such as semiconductors, wireless modules, and the like, are purchased from single suppliers. The failure of any such supplier to meet its commitment on schedule could have a material adverse effect on our business, operating results and financial condition. If a sole-source supplier were to go out of business or otherwise become unable to meet its supply commitments, the process of locating and qualifying alternate sources could take months, during which time our production could be delayed, and may, in some cases, require us to redesign our products and systems. Such delays and potential costly redesigns could have a material adverse effect on our business, operating results and financial condition.
We have experienced, and may in the future experience, delays in delivery of products or product components due to general market conditions creating long lead times for certain components, such as semiconductors, as well as failures on the part of some of our suppliers to timely deliver upon our previously agreed to component orders. In addition, we have occasionally experienced, and may in the future experience, delivery of products of inferior quality from component suppliers and third-party manufacturers. Although alternate manufacturers and suppliers are generally available to provide our products and product components, the number of manufacturers or suppliers of some of our products and components is limited, and qualifying, and transitioning to, a replacement manufacturer or supplier would take a significant amount of time. Such delays could have a material adverse effect on our business, operating results and financial condition.
We are increasingly dependent on original design manufacturers, contract manufacturers and third party logistics providers to design and manufacture our products and to fulfill orders for our products.
We have a joint development manufacturing model in place with one or more original design manufacturers and we are dependent primarily on such manufacturers (each of which is a third party original design manufacturer for numerous companies) to co-design and co-develop the hardware platform for our products. As discussed above, we also depend on independent contract manufacturers (each of which is a third party manufacturer for numerous companies) to manufacture and fulfill our products. These supply chain partners are not committed to design or manufacture our products, or to fulfill orders for our products, on a long-term basis in any specific quantity or at any specific price. Also, from time to time, we may be required to add new supply chain partner relationships or new manufacturing or fulfillment sites to accommodate growth in orders or the addition of new products. It is time consuming and costly to qualify and implement new supply chain partner relationships and new manufacturing or fulfillment sites, and such additions increase the complexity of our supply chain management. Our ability to ship products to our customers could be delayed if we fail to effectively manage our supply chain partner relationships; if one or more of our future design manufacturers does not meet our development schedules; if one or more of our contract manufacturers experiences delays, disruptions or quality control problems in manufacturing our products; or if one or more of our third party logistics providers experiences delays or disruptions or otherwise fails to meet our fulfillment schedules; or if we are required to add or replace design manufacturers, contract manufacturers, third party logistics providers or fulfillment sites. We may not be able to adequately manage costs related to overruns, delays or disruptions associated with the design and development of our products utilizing the joint development manufacturing model. In addition, these supply chain partners will have access to certain of our critical confidential information which could be susceptible to unauthorized disclosure. Moreover, all of our manufacturing is performed outside the U.S. and is, therefore, subject to risks associated with doing business in foreign countries and in foreign currencies. Each of these factors could adversely affect our business, financial condition and results of operations.
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We are subject to a complex system of domestic and foreign taxation and unanticipated changes in our tax rates or exposure to additional tax liabilities could affect our financial results.
We are subject to income and other taxes in both the U.S. and various foreign jurisdictions, and our domestic and international tax liabilities are subject to the allocation of expenses in different jurisdictions. Our effective tax rates could be adversely affected by changes in the mix of earnings in countries with differing statutory tax rates, in the valuation of deferred tax assets and liabilities or in tax laws, or by material audit assessments, which could affect our financial results. In addition, the amount of taxes we pay is subject to ongoing audits in various jurisdictions, and a material assessment by a governing tax authority could affect our financial results. Furthermore, tax law changes in jurisdictions in which we conduct business could materially affect our financial results.
We are responsible for charging end customers and remitting certain taxes in numerous international jurisdictions. In the ordinary course of our business, there are many transactions and calculations where the ultimate tax determination is uncertain. In the future, our determinations of tax liabilities may be subjected to audit by the tax authorities, which could result in changes to the estimates of such tax liabilities. We believe that we maintain adequate tax reserves to offset potential liabilities that may arise upon audit. Although we believe our tax estimates and associated reserves are reasonable, the final determination of tax audits and any related litigation could be materially different than the amounts established for tax contingencies. To the extent that such estimates ultimately prove to be inaccurate, the associated reserves would be adjusted resulting in our recording a benefit or expense in the period in which a final determination was made.
Fluctuations in currency exchange rates may adversely affect our financial results.
A substantial part of our business consists of sales to international customers and, as a result, the majority of our revenue and expenses related to our international operations are denominated in Euros and other non-U.S. Dollar currencies. Adverse currency exchange rate fluctuations could have a material impact on our financial results in the future, including our cash position. In addition, our balance sheet reflects non-U.S. Dollar denominated assets and liabilities, which can be adversely affected by fluctuations in currency exchange rates. In the past, we have entered into foreign currency forward contracts intended to hedge our exposure to adverse fluctuations in exchange rates, but these hedging arrangements are not always effective, particularly in the event of imprecise forecasts of non-U.S. Dollar denominated assets and liabilities and such attempts to mitigate these risks may be costly. Currently, we do not hedge against our entire foreign currency risk as it has become even more costly as a result of recent market developments. Accordingly, an adverse movement in exchange rates could have a material adverse effect on our financial results. In the year ended December 31, 2010, we incurred a foreign currency loss of approximately $0.4 million, net of foreign currency transaction gains or losses.
Furthermore, we utilize contract manufacturers in various international locations, including Malaysia, Germany, Brazil, Romania, China, and Tunisia. While the majority of our products are purchased from these manufacturers in U.S. Dollars, we also purchase some products in local currencies. Therefore, we may be impacted by fluctuations in foreign currency exchange rates.
With our use of a joint development manufacturing model for the next generation of our products, we expect that a larger proportion of our manufacturing costs may be denominated in U.S. Dollars. Therefore, our financial results, including our cash position, could be impacted by fluctuations in foreign currency exchange rates to a greater extent than in prior periods.
Adverse resolution of litigation may adversely affect our business or financial results.
We are party to litigation in the normal course of our business. Litigation can be expensive, lengthy and disruptive to normal business operations. Moreover, the results of complex legal proceedings are difficult to predict. An unfavorable resolution of a particular lawsuit could have a material adverse effect on our business, operating results, or financial condition. See “Item 3 - Legal Proceedings” below for more information on our litigation.
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Our future success is substantially dependent on the continued service of our senior management and other key employees.
The loss of the services of our senior management or other key employees could make it more difficult to successfully operate our business and achieve our business goals. The market for highly qualified and talented executives in our industry is very competitive and we cannot provide assurance that we will be able to replace these senior management members with equally-qualified executives in a timely and cost-effective manner, if at all.
We also may be unable to retain existing management, sales personnel and development and engineering personnel that are critical to our success, which could result in harm to key customer relationships, loss of key information, expertise or know-how, and unanticipated recruitment and training costs.
Shipments of electronic payment systems may be delayed by factors outside of our control, which can harm our relationships with our customers.
The shipment of payment systems requires us or our manufacturers, distributors or other agents to obtain customs or other government certifications and approvals, and, on occasion, to submit to physical inspection of our systems in transit. Failure to satisfy these requirements, and the process of trying to satisfy them, can lead to lengthy delays in the delivery of our solutions to our customers, which may harm our relationships with our customers.
While we believe we comply with environmental laws and regulations, we are still exposed to potential risks associated with them.
We are subject to environmental, legal and regulatory requirements, including the RoHS Directive and the WEEE Directive. The RoHS Directive sets a framework for producers’ obligations in relation to manufacturing (including the amounts of named hazardous substances contained in products sold) and the WEEE Directive sets a framework for treatment, labeling, recovery and recycling of electronic products in the European Union, which may require us to alter the manufacturing of the physical devices that include our solutions and/or require active steps to promote recycling of materials and components. In addition, similar legislation has been enacted in China and could be enacted in other jurisdictions, including in the U.S. If we do not comply with the RoHS Directive and the WEEE Directive, we may suffer a loss of revenue, be unable to sell in certain markets or countries, be subject to penalties and enforced fees and/or suffer a competitive disadvantage. Furthermore, the costs to comply with the RoHS Directive and the WEEE Directive, or with current and future environmental and worker health and safety laws, may have a material adverse effect on our results of operation, expenses and financial condition.
Force majeure events, such as threats of terrorism, terrorist attacks, other acts of violence or war, civil, military and governmental unrest, health epidemics, fire, floods, and other acts of God may adversely affect the markets in which our common stock trades, our ability to operate our business and our financial results.
Domestic and international threats of terrorism, terrorist attacks, wars, regional conflicts, natural disasters (including natural disasters that may increase in frequency as a result of the effects of climate change), and the like may cause instability in the global financial markets, and contribute to downward pressure on securities prices of U.S. publicly traded companies, such as us. Future terrorist activities or armed conflicts, epidemics, such as influenza, H1N1 (or swine) flu or bird flu, and pandemics could result in economic, political and other uncertainties that could adversely affect our revenue and operating results, and depress securities prices, including the price of our common stock. Such events may disrupt the global insurance and reinsurance industries, and adversely affect our ability to obtain or renew certain insurance policies, and may result in significantly increased costs of maintaining insurance coverage. Further, we may not be able to obtain insurance coverage at historical or acceptable levels for all of our facilities. Future terrorist activities, armed conflicts and epidemics could affect our domestic and international sales, disrupt our supply chain and impair our ability to produce and deliver our products. Such events could directly impact our physical facilities or those of our suppliers (including sole-source suppliers) or customers in the U.S. and elsewhere. Our primary facilities include administrative, sales and research and development facilities in the U.S., Australia, Brazil, China, France, Germany, Latvia, Mexico, the Philippines, Spain, and the United Kingdom., and our manufacturing partners’ facilities in Malaysia, Germany, Brazil, Romania, Tunisia, and China. Acts of terrorism, wars and epidemics may make transportation of our supplies and products more difficult or cost prohibitive.
China’s changing economic environment may impact our ability to grow our business in China.
In recent years, the Chinese government has been reforming the economic system in China to increase the emphasis placed on decentralization and the utilization of market forces in the development of China’s economy. These reforms have resulted in significant economic growth. However, any economic reform policies or measures in China may from time to time be modified or revised by the Chinese government. While we may be able to benefit from the effects of some of these policies, certain policies and other measures taken by the Chinese government to regulate the economy, such as relaxation of trade restrictions, could also have a significant negative impact on economic conditions in China that could result in an adverse impact on our business. In addition, although China is increasingly affording foreign companies and foreign investment enterprises established in China similar rights and privileges as Chinese domestic companies, special laws, administrative rules and regulations governing foreign companies and foreign investment enterprises in China may still place foreign companies at a disadvantage in relation to Chinese domestic companies and may adversely affect our competitive position.
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Uncertainties with respect to the Chinese legal system may adversely affect us.
We conduct our business in China primarily through direct or indirect wholly-owned subsidiaries incorporated in China and Hong Kong. Our subsidiaries are generally subject to laws and regulations applicable to foreign investment in China. Accordingly, our business may be affected by changes in China’s developing legal system. Many new laws and regulations covering general economic matters have been promulgated in China in recent years, and government policies and internal rules promulgated by governmental agencies may not be published in time, or at all. As a result, we may operate our business in violation of new rules and policies without having any knowledge of their existence. In addition, there are uncertainties regarding the interpretation and enforcement of laws, rules and policies in China. The Chinese legal system is based on written statutes, and prior court decisions have limited precedential value. Because many laws and regulations are relatively new and the Chinese legal system is still evolving, the interpretations of many laws, regulations and rules are not always uniform. Moreover, the relative inexperience of China’s judiciary in many cases creates additional uncertainty as to the outcome of any litigation, and the interpretation of statutes and regulations may be subject to government policies reflecting domestic political concerns. Finally, enforcement of laws or contracts based on existing law may be uncertain and sporadic, and it may be difficult to obtain swift and equitable enforcement, or to obtain enforcement of a judgment by a court of another jurisdiction. Any litigation in China may be protracted, have unexpected outcomes and result in substantial costs and diversion of resources and management’s attention.
If we are unable to maintain the quality of our internal control over financial reporting, any unremediated material weaknesses could materially and adversely affect our ability to provide timely and accurate financial information about our business, which could harm our business and stock price.
Section 404 of the Sarbanes-Oxley Act of 2002 (“SOX 404”) requires that we establish and maintain effective internal controls over financial reporting. SOX 404 also requires us to include a management report of internal control over financial reporting in our Annual Report on Form 10-K. Based on management’s evaluation of internal control over financial reporting as of December 31, 2010, we are able to conclude that our internal control over financial reporting is effective. However, we cannot be certain that our internal control over financial reporting will remain effective in the future. Any future failure to maintain adequate internal control over our financial accounting and reporting could harm our operating results or could cause investors to lose confidence in our reported financial results or condition, which could adversely affect our business and the trading price of our common stock.
Our business may be negatively affected by local or global economic conditions.
The business and operating results of our products and services businesses have been and will continue to be affected by local and global economic conditions, including the recent credit market crisis, and, in particular, conditions in the banking sector and other major industries we serve. The current economic climate, the credit market crisis, particularly the increased difficulty in securing credit, declining consumer and business confidence, fluctuating commodity prices, and other challenges currently affecting the global economy could impact our ability to sell and our customers’ ability to make capital expenditures, thereby affecting their ability to purchase our products. Additionally, customers in the financial services sector, which has been severely impacted by the credit crisis, have consolidated in response to the crisis, which could further impact our business by reducing our customer base. Certain of our retail customers who have seen significant dampening of consumer demand could face increased financial pressures that could impact their capital expenditures.
Also, although we believe that our cash flows from operations and other sources of liquidity, including borrowings available under our revolving credit facility or other financing options, will satisfy our working capital needs, capital expenditures, commitments, and other liquidity requirements associated with our operations and our TeT acquisition debt requirement through the next 12 months, in the event that we require additional capital to fulfill our future business plans, we may need to obtain additional financing from third parties. In light of the recent global credit crisis, if we experience such a need for additional financing, we may not be able to obtain sufficient financing on advantageous terms or at all, which could materially and adversely affect our business, financial condition, results of operations and long-term prospects.
The extent of the impact of the recent global economic crisis depends on a number of factors, including the timing of the emergence of the U.S. and the global economy generally from the effects of the severe recession. If the global economic recession continues for a significant period or there is significant further deterioration in the global economy, our results of operations, financial position and cash flows could be materially adversely affected.
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Our integration of future acquisitions we may make involves numerous risks. We may not be able to address these risks without substantial expense, delay or other operational or financial problems.
We have in the past and may in the future make acquisitions and strategic investments in related businesses, technologies, products or services. Acquisitions and investments involve various risks such as the following:
• the inability to assimilate the technologies, operations and personnel of the acquired business;
• the potential disruption of our existing business, including the diversion of management attention and the redeployment of resources;
• the loss of customers;
• the possibility of our entering markets in which we have limited prior experience;
• the loss of key employees of the acquired business;
• the necessity to respond to and negotiate with local labor unions or other organized labor associations, which may cause delays with and obstacles to our implementation of business initiatives; and
• the inability to obtain the desired strategic and financial benefits from the acquisition.
Future acquisitions and investments could also result in substantial cash expenditures, potentially dilutive issuance of our equity securities, our incurrence of additional debt and contingent liabilities, and amortization expenses related to intangible assets that could adversely affect our business, operating results and financial condition.
Risks Related To The Industry
The markets in which we compete are highly competitive, maturing, and subject to price erosion.
The markets in which we operate are maturing and highly competitive. Increased competition from manufacturers or distributors of products similar to or competitive with ours, or from service providers that provide services similar to ours, could result in price reductions, extended terms, free services, lower margins and loss of market share.
We expect to continue to experience significant and increasing levels of competition in the future. With respect to our products, we compete primarily on the basis of security, ease-of-use, product performance, price, features, quality, the availability of application software programs, the number of third-party network host and telecommunication system certifications we have obtained for our products and application programs, rapid development, release and delivery of software products, and customer support and responsiveness. Software products compete on the basis of security, functionality, scalability, price, quality and support.
We often face additional competitive factors in foreign countries, including but not limited to preferences for national vendors, difficulties in obtaining required certifications, conformity with local government policies and trade practices, and compliance with the Foreign Corrupt Practices Act. Some of our competitors and potential competitors are more established, benefit from greater name recognition and have significantly greater resources than we do. Moreover, there are limited barriers to entry that could keep our competitors from developing products or services and technology similar to ours, or from selling competing products or services in our markets. Further, there can be no assurance that we will be able to lower our product or operating costs to effectively compete in these markets.
We are subject to industry and technology changes and are dependent on development and market acceptance of new products. If we are unable to adequately respond to these changes and to market demands in a timely manner, our business will not be successful.
The industry in which we operate is characterized by rapid changes in technology and numerous new product introductions. Our success depends to a large degree upon our continued ability to offer new products and services, and enhancements to our existing products and services, to meet changing market requirements, including conformity with applicable standards. The introduction of new products, services and technologies by third parties could have an adverse effect on the sales of our existing products, services and technologies. We cannot be certain of our ability to successfully:
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• identify, develop, or manufacture new products, services and technologies in a cost effective manner;
• market or support these new products, services and technologies on a timely and effective basis;
• eliminate defects in new products and service offerings;
• gain market acceptance for new products, services and technologies; or
• respond to technological changes, new industry standards, and announcements of new products, services and technologies by competitors.
Developing new products, services and technologies is a complex, uncertain process requiring innovation and accurate anticipation of technological and market trends. When changes to our products are announced, we will be challenged to manage possible shortened life cycles for existing products, continue to sell existing products and prevent customers from returning existing products. Our inability to respond effectively to any of these challenges may have a material adverse effect on our business and financial results.
We and our contract manufacturers are subject to extensive industry standards and government regulations. Our failure to properly comply with these standards and regulations could adversely affect our business.
Our business is subject to a substantial and complex array of industry driven standards and governmental regulation, both domestic and foreign, including, but not limited to:
• industry standards imposed by EuroPay International, MasterCard International, VISA International, and others;
• certification standards required for connection to certain public telecommunications networks;
• U.S. Federal Communications Commission regulations;
• Underwriters Laboratories’ regulations (or other similar regulations in countries in which we sell our products);
• the WEEE and RoHS Directives in the European Union and other environmental laws, regulations and standards;
• U.S. Department of Labor regulations and state labor laws (or other similar regulations in countries in which we have employees or manufacture our products); and
• certification standards set by domestic processors.
Our failure, either directly or through our third-party contract manufacturers and suppliers, to properly comply with these standards and regulations could result in lost product sales, significant costs associated with required remedial measures or production stoppages, any of which could have a material adverse effect on our business and financial results.
We are subject to potentially competitive threats from alternative payment technologies.
Our hardware product sales have been historically predicated on the need for security within the POS terminal. Alternative payment technologies have arisen recently that can accept payments in the merchant or retailer’s physical store with or without a card and with varying degrees of security. Many of these payment alternatives leverage the enhanced capabilities and proliferation of Smartphones. Alternative forms of payment and payment acceptance that could prove disruptive include:
• PayPal on the point-of-sale terminal;
• numerous card reader attachments to Smartphones and tablet computers, including Square, Inc.’s magnetic stripe reader and Roam Data’s encrypting card reader;
• virtual currencies such as Facebook Credits moving from the virtual world into the physical store; and
• payment applications enabled by NFC-capable mobile phones.
Should the need for security within the POS terminal lessen due to fewer payment transactions including the transmission of sensitive cardholder data, our inability to respond effectively to any of these alternative payment technologies may have a material adverse effect on our business and financial results.
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Risks Related To Our Common Stock
Our stock price has been and may continue to be volatile. Because the merger exchange ratio is fixed and the market price of VeriFone common stock may fluctuate, the price of our common stock may continue to fluctuate substantially in the future and you could lose the value of your investment in Hypercom common stock.
The market price of our common stock has been, and is likely to continue to be, volatile. When we or our competitors announce new products, services, or customer orders, change pricing policies, experience quarterly fluctuations in operating results, announce strategic relationships, acquisitions or dispositions, change earnings estimates, fail to maintain effective internal controls, restate financial results, incur litigation, experience government regulatory actions or suffer from generally adverse economic conditions, our stock price is often affected. Recently, companies similar to ours have experienced extreme price fluctuations, often for reasons unrelated to their performance. The volatility of our stock price may be accentuated during periods of low volume trading.
In addition, upon completion of the merger with VeriFone, each share of common stock of Hypercom will be exchanged for 0.23 of a share of VeriFone common stock. The merger consideration will not change even if the market price of either or both the Hypercom common stock and VeriFone common stock fluctuates. Neither Hypercom nor VeriFone may withdraw from the merger, and Hypercom may not resolicit the vote of its stockholders, solely because of changes in the market price of shares of Hypercom common stock or VeriFone common stock or because of changes in the operating and financial performance of either company that do not amount to a material adverse effect, as defined in the merger agreement. The merger will not be completed until certain regulatory approvals have been obtained and other conditions have been satisfied or waived. In the interim period until completion of the merger, our common stock will likely trade in relation to the market price of VeriFone’s common stock. We cannot make assurances that the value of our common stock will not decline prior to the merger as a result of fluctuations in the value of VeriFone’s common stock.
Stockholders may sell substantial amounts of Hypercom common stock on the public market, which is likely to depress the price of our common stock.
Any substantial sales of Hypercom common stock on the public market by current stockholders may cause the market price of Hypercom common stock to decline.
If our current stockholders sell Hypercom common stock in the public market prior to the merger, it is likely that arbitrageurs will acquire those shares. These arbitrageurs will likely sell all those shares on the public market immediately following any announcement, or anticipated announcement, that the merger with VeriFone failed, or will likely fail, to close for regulatory or other reasons, which, in turn will likely cause the market price of Hypercom common stock to decline.
In addition to the other negative effects on Hypercom, those sales of Hypercom common stock might make it more difficult for us to sell equity or equity-related securities in the future if the merger with VeriFone is not completed.
Our stockholders will have a significantly reduced ownership and voting interest after the merger and will exercise less influence over management.
Immediately after the completion of the merger, it is expected that former Hypercom stockholders, who collectively own 100% of Hypercom, will own approximately 12.8% of VeriFone, based on the number of shares of Hypercom and VeriFone common stock, including restricted stock, outstanding as of December 28, 2010. Consequently, Hypercom stockholders will have less influence over the management and policies of VeriFone than they currently have over the management and policies of Hypercom.
We have incurred significant losses recently and in the past and our results of operations have and may continue to vary from quarter to quarter, impacted in particular by business reviews performed by management. If our financial performance is not in line with investor expectations, the price of our common stock will suffer and our access to future capital may be impaired.
We had net income of $6.7 million for the year ended December 31, 2010, and net losses of $6.9 million and $85.4 million for the years ended December 31, 2009, and 2008, respectively. If the results of our continuing efforts to improve profitability, increase our cash flow and strengthen our balance sheet do not meet or exceed the expectations of securities analysts or investors, the price of our common stock will suffer.
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Further, given the variability in our revenue, our quarterly financial results have fluctuated significantly in the past and are likely to do so in the future. Accordingly, we believe that period-to-period comparisons of our results of operations may be misleading and not indicative of future performance. If our quarterly financial results fall below the expectations of securities analysts or investors, the price of our common stock may suffer.
Our publicly-filed reports are reviewed by the SEC from time to time and any significant changes required as a result of such review may have a material adverse impact on the trading price of our common stock.
The reports of publicly-traded companies are subject to review by the SEC from time to time for the purpose of assisting companies in complying with applicable disclosure requirements and to enhance the overall effectiveness of companies’ public filings, and comprehensive reviews of such reports are now required at least every three years under the Sarbanes-Oxley Act of 2002. SEC reviews may be initiated at any time. While we believe that our previously filed SEC reports and all future reports will comply in all material respects with the published SEC rules and regulations, we could be required to modify or reformulate information contained in prior filings as a result of an SEC review. Any modification or reformulation of information contained in such reports could be significant and result in a material adverse impact on the trading price of our common stock.
We are subject to anti-takeover effects of certain charter and bylaw provisions and Delaware law that may discourage a third party from acquiring us and may adversely affect the price of our common stock.
Our certificate of incorporation and bylaws contain certain anti-takeover provisions, including those that:
• make it more difficult for a third party to acquire control of us, and discourage a third party from attempting to acquire control of us;
• may limit the price some investors are willing to pay for our common stock;
• enable us to issue preferred stock without a vote of our stockholders or other stockholder action;
• provide for a classified Board of Directors (the “Board”) and regulate nominations for the Board;
• make it more difficult for stockholders to take certain corporate actions; and
• may delay or prevent a change of control.
In addition, certain provisions of the Delaware General Corporation Law (“DGCL”) to which we are subject, including Section 203 of the DGCL, may have the effect of delaying or preventing changes in the control or management of Hypercom. Section 203 of the DGCL provides, with certain exceptions, for waiting periods applicable to business combinations with stockholders owning at least 15% and less than 85% of the voting stock (exclusive of stock held by directors, officers and employee plans) of a company.
Also, on September 29, 2010, the Board adopted the stockholder rights plan. Generally, the stockholder rights plan provides that if a person or group acquires 15% or more of our common stock, subject to certain exceptions and under certain circumstances, the rights may be exchanged by us for common stock or the holders of the rights, other than the acquiring person or group, could acquire additional shares of our capital stock at a discount off of the then current market price. Such exchanges or exercise of rights could cause substantial dilution to a particular acquirer and discourage the acquirer from pursuing our company. The mere existence of a stockholder rights plan often delays or makes a merger, tender offer or proxy contest more difficult. Our Board of Directors has taken action to render the stockholder rights plan inapplicable to the merger with VeriFone through an amendment to the stockholders’ rights plan.
The above factors, as well as other provisions of our charter documents, may have the effect of deterring hostile takeovers or otherwise delaying or preventing changes in the control or management of Hypercom, including transactions in which our stockholders might otherwise receive a premium over the fair market value of our common stock. As a result, the price of our common stock may be adversely affected.
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Our stock price could be affected because a substantial number of shares of our common stock will be available for sale in the future.
As of March 7, 2011, we had 56,377,663 shares of our common stock outstanding, all of which have been listed for trading according to the rules of the NYSE. We also had outstanding, as of March 7, 2011, options and warrants to acquire an additional 4,048,033 and 10,544,000 shares, respectively, of our common stock. All of the shares underlying the outstanding options and warrants have been registered for resale. Future public sales of our common stock, or the availability of such shares for sale, including the shares subject to outstanding options and warrants, could adversely affect the prevailing market price of our common stock and impair our ability to raise capital through the sale of additional equity securities.
The issuance of warrants to purchase common stock as part of the TeT acquisition could result in a lowering of our stock price.
In accordance with the terms of our credit agreement with Francisco Partners II, L.P. (“Francisco Partners”), upon funding of the loan and the closing of the TeT acquisition on April 1, 2008, we granted Francisco Partners a five-year warrant to purchase approximately 10.5 million shares of our common stock at $5.00 per share. The warrant contains a cashless exercise provision. We have also filed a registration statement covering the shares of common stock underlying the warrant. The market price of our common stock could decline as a result of sales of a large number of shares of our common stock in the market (or the perception that these sales could occur) if the warrant is exercised once our common stock is trading above the warrant exercise price of $5.00 per share. Any such sales, or the possibility that these sales may occur, also might make it more difficult for us to sell equity securities in the future at a time and at a price that we deem appropriate. Any issuance of common stock to the warrant holder upon exercise of the warrant would dilute the then-current common stockholders’ interests in our company.
We currently do not intend to pay any dividends on our common stock.
We currently do not intend to pay any dividends on our common stock. While we may declare dividends at some point in the future, we cannot assure you that you will ever receive cash dividends as a result of ownership of our common stock and any gains from investment in our common stock may only come from increases in our stock prices, if any.
Risks Related To Our Indebtedness and Merger Agreement
We are subject to various covenants and restrictions that limit the discretion of management in operating our business and could prevent us from engaging in some activities that may be beneficial to us and our stockholders.
The agreements governing our financing, including our $60.0 million credit agreement to partially fund the TeT acquisition and our $25.0 million revolving credit facility, and our merger agreement with VeriFone, contain various covenants and restrictions that, in certain circumstances, limit our ability and the ability of certain subsidiaries to:
• grant liens on assets;
• make restricted payments (including paying dividends on capital stock or redeeming or repurchasing capital stock);
• make investments (including investments in joint ventures);
• merge, consolidate or transfer all or substantially all of our assets;
• incur additional debt; or
• engage in certain transactions with affiliates.
As a result of these covenants and restrictions, we may be limited in how we conduct our business and may be unable to raise additional debt, compete effectively, make investments or pursue available business opportunities. These covenants may adversely affect our ability to finance our future operations or capital needs. A breach of any of these covenants could result in a default in respect of the related indebtedness or termination of the VeriFone merger agreement. If a default occurs under our debt agreements, the affected lenders could elect to declare the indebtedness, together with accrued interest and other fees, to be immediately due and payable.
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We may be required to incur additional debt to meet the future capital requirements of our business. Should we be required to incur additional debt, the restrictions imposed by the terms of our current and future debt arrangements could adversely affect our financial condition and our ability to respond to changes in our business.
If we incur additional debt, we may be subject to the following risks:
• our vulnerability to adverse economic conditions and competitive pressures may be heightened;
• our flexibility in planning for, or reacting to, changes in our business and industry may be limited;
• we may be sensitive to fluctuations in interest rates if any of our debt obligations are subject to variable interest rates; and
• our ability to obtain additional financing in the future for working capital, capital expenditures, acquisitions, general corporate purposes or other purposes may be impaired.
We cannot be assured that our leverage and such restrictions will not materially and adversely affect our ability to finance our future operations or capital needs or to engage in other business activities. In addition, we cannot be assured that additional financing, to the extent permitted under our existing covenants, will be available when required or, if available, will be on terms satisfactory to us.
The current condition of the credit markets may not allow us to secure financing for potential future activities on satisfactory terms, or at all.
Our existing cash and short-term investments are available for operating requirements, strategic investments, acquisitions of companies or products complimentary to our business, the repayment of outstanding indebtedness, repurchases of our outstanding securities and other potential large-scale needs. While we believe existing cash and short-term investments, together with funds generated from operations, should be sufficient to meet operating requirements for the foreseeable future, we may also consider, to the extent permitted under our existing covenants, incurring additional indebtedness and issuing additional debt or equity securities in the future to fund potential acquisitions or investments, to refinance existing debt or for general corporate purposes. As a result of recent subprime loan losses and write-downs, as well as other economic trends in the credit markets, we may not be able to secure additional financing for future activities on satisfactory terms, or at all, which may adversely affect our financial condition and results of operations.
Item 1B.
Item 1B. Unresolved Staff Comments
None.
Item 2.
Item 2. Properties
The Americas
Our current corporate headquarters building is located in Scottsdale, Arizona. The facility is 48,650 square feet, and the lease for this facility expires on June 23, 2018; however, we have the right to terminate the lease on June 23, 2015, provided we repay all unamortized tenant improvement costs and commission fees for unpaid rent. Our corporate headquarters serves as a shared cost center for all four of our geographic business segments.
In the U.S., we also lease offices in Savannah, Georgia, and Concord, New Hampshire, as well as a storage facility in Phoenix, Arizona. Internationally, we lease facilities in Brazil, Chile, Mexico and Puerto Rico for sales, support, and research and development activities.
We sold our 102,000 square foot facility in Brazil on April 19, 2010. See Note 6 to our consolidated financial statements included herein for additional transaction detail and the recognition of the gain associated with the building sale.
NEMEA
We lease facilities in Belgium, Germany and Sweden for sales, support, and research and development activities.
SEMEA
We lease facilities in France, Hungary, Latvia, Russia, Scotland, Spain, the United Arab Emirates, and the United Kingdom for sales, support, and research and development activities.
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Asia-Pacific
We lease facilities in Australia, China, Hong Kong, India, the Philippines, Singapore and Thailand for sales, support, and research and development activities.
We believe that our facilities are adequate for our current operations and will be sufficient for the foreseeable future.
Item 3.
Item 3. Legal Proceedings
We are currently a party to various legal proceedings, including those noted below. While we presently believe that the ultimate outcome of these proceedings, individually and in the aggregate, will not have a material adverse affect on our financial position, results of operations or cash flows, litigation is subject to inherent uncertainties, and unfavorable rulings could occur. An unfavorable ruling could include monetary damages or, in cases where injunctive relief is sought, an injunction. Were an unfavorable ruling to occur, it is possible such a ruling could have a material adverse impact on our financial position, results of operations or cash flows in the period in which the ruling occurs or in future periods.
Brazil Tax and Labor Contingencies
Our operations in Brazil are involved in various litigation matters and have received or been the subject of numerous governmental assessments related to indirect and other taxes, as well as disputes associated with former Hypercom employees and employees of various service providers with whom we contracted. The tax matters, which comprise a significant portion of the contingencies, principally relate to claims for taxes on the transfers of inventory, municipal service taxes on rentals and gross revenue taxes. We are disputing these tax matters and intends to vigorously defend our positions. The labor matters principally relate to claims made by former Hypercom employees and by former employees of various vendors that provided contracted services to us and who are now asserting that under Brazil law, we should be liable for the vendors’ failure to pay wages, social security and other related labor benefits, as well as related tax obligations, as if the vendor’s employees had been employees of Hypercom. As of December 31, 2010, the total amounts related to the reserved portion of the tax and labor contingencies was $0.7 million and the unreserved portion of the tax and labor contingencies totaled approximately $25.7 million. With respect to the unreserved balance, these have been assessed by management as being either remote or possible as to the likelihood of ultimately resulting in a loss to us. Local laws and regulations often require that we make deposits or post other security in connection with such proceedings. As of December 31, 2010 we had $5.2 million of deposits in Brazil regarding claims that we are disputing, liens on certain Brazilian assets as discussed in Note 6 with a net book value of $1.9 million, and approximately $3.5 million in letters of credit, all providing security with respect to these matters. Generally, any deposits would be refundable and any liens would be removed to the extent the matters are resolved in our favor. We routinely assess these matters as to probability of ultimately incurring a liability against our Brazilian operations and record our best estimate of the ultimate loss in situations where we assess the likelihood of an ultimate loss as probable. An unfavorable outcome in any of these matters could have a material adverse effect on our business, financial condition, results of operations, and cash flows.
CardSoft, Inc., et al. v. Hypercom Corporation, et al. (United States District Court for the Eastern District of Texas, Marshall Division, Civil Action No. 2:08-CV-00098, filed on March 6, 2008)
CardSoft, Inc. and CardSoft (Assignment for the Benefit of Creditors), LLC (collectively “CardSoft”) filed this action against us and others in March 2008, alleging that certain of our terminal products infringe two patents allegedly owned by CardSoft: U.S. Patent No. 6,934,945 (the “‘945 Patent”), entitled “Method and Apparatus for Controlling Communications,” issued on August 23, 2005, and U.S. Patent No. 7,302,683 (the “‘683 Patent”), also entitled “Method and Apparatus for Controlling Communications,” issued on November 27, 2007, which is a continuation of the ‘945 patent. CardSoft is seeking a judgment of infringement, an injunction against further infringement, damages, interest and attorneys’ fees. In June 2008, we filed our answer, denying liability on the basis of a lack of infringement, invalidity of the ‘945 Patent and the ‘683 Patent, laches, waiver, equitable estoppel and unclean hands, lack of damages and failure to state a claim. We also counterclaimed seeking a declaratory judgment of non-infringement and invalidity of the ‘945 Patent and the ‘683 Patent. The Markman hearing is scheduled for July 20, 2011 and trial is scheduled for November 7, 2011. This action is currently in the discovery stage and, as CardSoft has not made a specific claim for damages, we are unable to assess our range of potential loss, nor is it possible to quantify the extent of our potential liability, if any, related to this action. An unfavorable outcome could have a material adverse effect on our business, financial condition, results of operations, and cash flows.
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Lisa Shipley v. Hypercom Corporation. (United States District Court for the Northern District of Georgia, Civil Action No. 1:09-CV-0265, filed on January 30, 2009)
Lisa Shipley (“Shipley”), a former employee, filed this action against us in January 2009, alleging that we violated Title VII of the Civil Rights Act by discriminating against her on the basis of her gender, violated the Georgia Wage Payment laws, the Equal Pay Act and Georgia law by paying her lower compensation based on her gender. Ms. Shipley is seeking compensatory damages for emotional distress, damage to reputation, embarrassment, lost wages, back pay, accrued interest, punitive damages, attorney’s fees and expenses, and interest. In February 2009, we filed a motion to dismiss based on improper venue or, in the alternative, to transfer venue to the United States District Court for the District of Arizona. In June 2009, the Court denied the motion. In June 2009, we filed our answer, generally denying the material allegations of Ms. Shipley’s complaint. In October 2009, Ms. Shipley filed an amended complaint adding an allegation that we unlawfully retaliated against her. In November 2009, we filed our answer, denying the material allegations of the amended complaint. In February 2010, we filed a Motion for Judgment on the Pleadings as to Ms. Shipley's retaliation claim, which the Court subsequently denied. On July 19, 2010, we filed a motion for summary judgment on all claims. On February 15, 2011, the magistrate judge recommended that the Court grant our motion for summary judgment as to Ms. Shipley’s sexual harassment hostile work environment claim, the constructive discharge claim, and the Georgia wage payment statute claim, but denied our motion for summary judgment as to her disparate treatment, retaliation, Equal Pay Act and Georgia Sex Discrimination in Employment Act claims. On March 2, 2011, we filed a motion for leave to file a motion for partial summary judgment out of time seeking summary judgment on seven components of Ms. Shipley’s disparate treatment Title VII claim. On March 8, 2011, the Court denied our motion for leave to file a motion for partial summary judgment out of time. This action is in the discovery stage and, as Ms. Shipley has not made a specific claim for damages, we are unable to assess our range of potential loss, nor is it possible to quantify the extent of our potential liability, if any, related to this action. An unfavorable outcome could have a material adverse effect on our business, financial condition, results of operations, and cash flows.
Shareholder Class Action and Derivative Lawsuits
Commencing shortly after VeriFone publicly announced on September 30, 2010 that it had made an offer to acquire Hypercom and continuing following the announcement by us and VeriFone on November 17, 2010 that we had entered into a definitive merger agreement, certain putative class action lawsuits were filed in Arizona and Delaware state courts alleging variously, among other things, that the board of directors of Hypercom breached its fiduciary duties in connection with the merger and that VeriFone, Honey Acquisition Co., Hypercom, FP Hypercom Holdco, LLC, and Francisco Partners II, L.P. aided and abetted that alleged breach. These actions include: Gerber v. Hypercom, Delaware Court of Chancery, Case no. CA5868 (“Gerber”); Anarkat v. Hypercom, Maricopa County Superior Court, CV2010-032482 (“Anarkat”); Small v. Hypercom Corporation, Delaware Court of Chancery, Case no. CA6031 (Small”); Grayson v. Hypercom Corporation, Delaware Court of Chancery, Case no. CA6044 (Grayson”); and The Silverstein Living Trust v. Hypercom Corporation, Maricopa County Superior Court, Case no. CV2010-030941 (Silverstein”). The Anarkat and Silverstein cases have been consolidated in Maricopa County Superior Court as In Re Hypercom Corporation Shareholder Litigation, Lead Case No. CV2010-032482, and the Small and Grayson cases have been consolidated in the Delaware Court of Chancery as In Re Hypercom Corporation Shareholders Litigation, Consolidated C.A. No. 6031-VCL (the “Actions”). The Gerber case is dormant as the plaintiffs in that case have not prosecuted it since it was filed. On February 14, 2011, counsel for the plaintiffs and defendants in the Actions executed a Memorandum of Understanding (the “Memorandum”) pursuant to which (i) we provided additional disclosures recommended by the plaintiffs to supplement our proxy statement filed with the Securities and Exchange Commission, (ii) the defendants agreed to provide plaintiffs’ counsel with reasonable confirmatory discovery regarding the fairness and adequacy of the settlement and the additional disclosures, and (iii) the parties agreed to use their best efforts to execute and present to the court a formal stipulation of settlement within 45 days seeking court approval of (a) the settlement and dismissal of the Actions with prejudice, (b) the stay of all proceedings in the Actions, (c) the conditional certification of the Actions as a class action under Arizona law, (d) the release of all claims against the parties, (e) the defendants’ payment of $510,000 to the plaintiffs’ counsel for their fees and expenses, (f) the defendants’ responsibility for providing notice of the settlement to members of the class, and (g) the dismissal of the Delaware actions following the court’s final approval of the settlement. While the defendants deny that they have committed any violations of law or breaches of duties to the plaintiffs, the class or anyone else, and believe that their disclosures in the proxy statement regarding the merger were appropriate and adequate under applicable law, the defendants entered into the settlement solely to eliminate the uncertainty, distraction, burden and expense of further litigation and to lessen the risk of any delay of the closing of the merger as a result of the litigation. The defendants have agreed that the payment to the plaintiffs’ counsel will be jointly funded equally by VeriFone and the carrier of Hypercom’s directors and officers liability insurance policy, while we will bear the cost of the $250,000 deductible amount under the insurance policy.
Item 4.
Item 4. (Removed and Reserved)
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PART II
Item 5.
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Our common stock trades on the New York Stock Exchange (“NYSE”) under the symbol “HYC.” The following table sets forth, for the fiscal quarters indicated, the high and low sales prices for our common stock as reported on the NYSE.
RANGE OF SALES PRICES
Since becoming publicly-traded, we have not paid any cash dividends on our common stock. We currently intend to retain our earnings for our business and do not anticipate paying any cash dividends on our common stock in the foreseeable future. See “Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources” for more information on retained earnings.
As of March 7, 2011, we had approximately 108 stockholders of record of our common stock and approximately 4,370 beneficial stockholders of our common stock.
The information under the caption “Equity Compensation Plan Information as of Fiscal Year End” in our 2011 Annual Meeting Proxy Statement, which will be filed with the SEC within 120 days following our fiscal year end, is incorporated by reference into this Item 5.
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Item 6.
Item 6. Selected Financial Data
The following table contains selected consolidated financial data for the five years ended December 31, 2010, derived from our audited consolidated financial statements. Certain amounts in the prior-year financial statements have been reclassified to conform to the current year presentation. The selected financial data should be read in conjunction with our consolidated financial statements, related notes and the section of this Annual Report on Form 10-K entitled “Management's Discussion and Analysis of Financial Condition and Results of Operations.” Historical consolidated financial data may not be indicative of our future performance.
(a)
For the year ended December 31, 2010, we recorded a gain of $1.5 million due to the sale of a majority interest in HBNet, Inc and the sale of our Swedish service and leasing business.
(b)
In December 2008, we recognized asset impairment charges totaling $67.8 million for 2008, primarily related to the write-off of goodwill and intangible assets from our acquisition of TeT on April, 1, 2008. See Note 4 to our consolidated financial statements included herein.
(c)
In June 2007, we completed the sale of our former headquarters facilities, located in Phoenix, Arizona, for a sale price of $16.3 million. We recorded a gain of $3.8 million on the sale in the second quarter of 2007. During the second quarter of 2007, we initiated a reconfiguration of our global sales and marketing organizations and incurred charges of $2.9 million during the year. During the second quarter of 2007, we increased inventory reserves by $6.1 million primary related to non-PCI compliant products and components.
(d)
In December 2006, we acquired TPI and incurred a $1.0 million charge for the acquired in-process research and development.
(e)
In September 2006, we completed the sale of our real property in Hong Kong for $5.2 million. We recorded a gain of approximately $3.0 million on the sale in the third quarter of 2006.
See Note 23 to our consolidated financial statements included herein for a presentation of certain of the above information on a quarterly basis for each of the four quarters in the years ended December 31, 2010 and 2009.
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Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following sets forth a discussion and analysis of our financial condition and results of operations for the three years ended December 31, 2010. This discussion and analysis should be read in conjunction with our consolidated financial statements appearing elsewhere in this Annual Report on Form 10-K. The following discussion contains forward-looking statements. Our actual results may differ significantly from the results discussed in such forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in “Item 1A - Risk Factors” of this Annual Report on Form 10-K.
There are numerous references to the impact of foreign currency translation in the discussion of our results of operations. Over the past several years, the exchange rates between the U.S. Dollar and many foreign currencies, especially the Euro, have fluctuated significantly. When stronger U.S. Dollar exchange rates of the current year are used to translate the results of operations of the subsidiaries denominated in foreign currencies, the resulting impact is a decrease in U.S. Dollars of reported results as compared with the prior period. When the U.S. Dollar weakens, the resulting impact is an increase in U.S. Dollars of reported results as compared with the prior period.
On November 17, 2010, we announced that we entered into a definitive merger agreement under which VeriFone will acquire Hypercom in an all-stock merger. The transaction was approved on February 24, 2011 by our stockholders but is still subject to customary regulatory approvals, and is anticipated to close in the second half of 2011, subject to the satisfaction of applicable regulatory approvals and other customary closing conditions. For further information, see Note 1 to our consolidated financial statements included herein.
2010 Overview of Financial Results
The following overview highlights certain key events and factors impacting our financial performance for the year ended December 31, 2010.
During 2010, our primary objectives were: (i) expanding our market share through focus on certain geographies and specific product lines and services; (ii) continuing our margin expansion through operational efficiencies; (iii) strengthening our liquidity; and (iv) moving to a joint development manufacturing model where we will provide hardware specifications to a third party to design, develop and manufacture certain hardware. The objectives we put in place in 2009 and that we continued during 2010 have resulted in one of the strongest financial performances in the history of our Company. We reported record revenue, our gross and operating margins improved, we are back to profitability, and we have strengthened our liquidity with strong cash flows from operations. We also made good progress in our transition to a joint development manufacturing model and expect to start delivering a limited number of new products under this model during 2011.
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Net revenue for the year ended December 31, 2010 was $468.4 million, a 15.1% increase over the year ended December 31, 2009. The primary reasons for the increase were strong demand and new customers in virtually all regions, but primarily in Southern EMEA and Asia-Pacific.
Gross profit for the year ended December 31, 2010 was $155.0 million or 33.1% of revenue, compared to $128.4 million or 31.6% of revenue for the year ended December 31, 2009. Gross margin, net of amortization of purchased intangible assets, for the year ended December 31, 2010 includes a 35.4% product gross margin and a 26.6% service gross margin, compared to product and service gross margins of 34.9% and 24.4%, respectively, for the same period in 2009. Product gross margin remained comparable to 2009. The increase in service gross margin was primarily a result of our exiting a marginally profitable large service contract in Brazil during the third quarter of 2009.
During 2010, we recorded net income of $6.7 million or $0.12 per share, which was a significant improvement over our 2009 results where we incurred a net loss of ($6.9) million or ($0.13) per share. The 2010 net income was principally the result of record revenue levels during the second half of 2010 due to strong demands and new customers. The loss during 2009 was primarily due to a weak first quarter that was negatively impacted by the global economic downturn and the corresponding decrease in available credit to both businesses and consumers, as well as a general retail slowdown in the Americas.
In 2010, we incurred employee severance and related charges as a result of the following initiatives:
·
Reorganization of our service businesses in Australia and Brazil;
·
Reorganization of our operations in Asia-Pacific; and
·
Reorganization of our management team in our offices in Arizona, Mexico and the Caribbean.
As a result of these actions, we incurred charges of $2.5 million in 2010. Of the $2.5 million, $0.6 million was recorded in costs of revenue and $1.9 million was recorded in operating expenses.
2011 Outlook
On November 17, 2010, we entered into a definitive merger agreement with VeriFone pursuant to which VeriFone will acquire Hypercom in an all-stock merger. The merger was approved by our stockholders on February 24, 2011 and is anticipated to close in the second half of 2011, subject to the satisfaction of applicable regulatory approvals and customary closing conditions. Upon the consummation of the merger, each share of our common stock issued and outstanding immediately prior to the merger will be converted into 0.23 of a share of VeriFone common stock.
Critical Accounting Policies and Estimates
Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the U.S. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent liabilities. On an on-going basis, we evaluate past judgments and our estimates, including those related to bad debts, product returns, long-term contracts, inventories, goodwill and other intangible assets, income taxes, financing operations, foreign currency, and contingencies and litigation. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.
Revenue Recognition
Revenue is recognized when the following criteria are met: (a) persuasive evidence that an arrangement exists; (b) delivery of the products or services has occurred; (c) the selling price is both fixed and determinable; and (d) collectability is reasonably assured.
We generally recognize product revenue, including sales to distributors and sales under sales-type leases, upon shipment of product. We recognize service revenue as services are provided and collection of invoiced amounts is reasonably assured. Routine recurring services include terminal repairs, help-desk, on-site technician visits, deployment and the provision of supplies. Amounts received in advance of services being rendered are recorded as deferred revenue. Revenue from long-term contracts that require substantial performance of customized software and hardware over an extended period are recorded based upon the attainment of scheduled substantive performance milestones under the percentage-of-completion method. Operating lease revenue is recognized monthly over the lease term. The units leased under operating leases are included in the balance sheet under “Property, plant and equipment.” We accrue for warranty costs, sales returns and other allowances at the time revenue is recognized.
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Revenue from contracts with multiple element arrangements are recognized as each element is earned on the relative fair value of each element provided the delivered elements have value to customers on a standalone basis. Amounts allocated to each element are based on its objectively determined fair value, such as the sales price for the product or service when it is sold separately or based on competitor prices for similar product or services.
We present revenue net of sales taxes and value-added taxes in our consolidated statement of operations.
Sales-Type Leases
Certain product sales made under lease arrangement are recorded as sales-type lease. Lease contract receivables represent the total lease payments to be received reduced by lease payments already collected. Sales-type lease revenue consists of the initial sale of the product shipped and the interest and maintenance elements of the lease payments as they are earned. An allowance for estimated uncollectible sales-type lease receivables at an amount sufficient to provide adequate protection against losses in our sales-type lease portfolio is recorded. The allowance is determined principally on the basis of historical loss experience and management’s assessment of the credit quality of the sales-type lease customer base. If loss rates increase or customer credit conditions deteriorate, the allowance for uncollectible sales-type leases may need to be increased. Unearned income includes interest and is the amount by which the original sum of the lease contract receivable exceeds the fair value of the equipment sold. The interest element is amortized to lease income using the effective interest method.
Stock-Based Compensation
We recognize compensation expense over the requisite service period for the fair value of stock options and related awards. For stock options with graded vesting terms, we recognize compensation cost over the requisite service period using the accelerated method. The fair value of our stock-based awards is estimated at the date of grant using key assumptions such as future stock price volatility, expected terms, risk-free interest rates and the expected dividend yield. In addition, we estimate the expected forfeiture rate of our stock grants and only recognize the expense for those shares expected to vest.
Product Warranty
We accrue for estimated warranty obligations when revenue is recognized based on an estimate of future warranty costs for delivered products and specific known product issues. Such estimates are based on historical experience and expectations of future costs. We periodically evaluate and adjust the accrued warranty costs to the extent actual warranty costs vary from the original estimates. Our warranty period typically extends from one to five years from the date of shipment. Costs associated with maintenance contracts, including extended warranty contracts, are expensed when they are incurred. Actual warranty costs may differ from management’s estimates.
Legal and Other Contingencies
In the ordinary course of business, we are involved in legal proceedings involving contractual and employment relationships, product liability claims, intellectual property rights, and a variety of other matters. We record contingent liabilities resulting from asserted and unasserted claims against us, when it is probable that a liability has been incurred and the amount of the loss is estimable. Estimating probable losses requires analysis of multiple factors, in some cases including judgments about the potential actions of third-party claimants and courts. Therefore, actual losses in any future period are inherently uncertain. Currently, we do not believe any of our pending legal proceedings or claims will have a material impact on our financial position, results of operations or cash flows. However, if actual or estimated probable future losses exceed our recorded liability for such claims, we would record additional charges as other expense during the period in which the actual loss or change in estimate occurred.
For components not yet billed to us by our third-party contract manufacturers, contingent liabilities are recorded by component based on the likelihood of our ultimate usage of the components.
Costs Associated with Exit Activities
We record costs associated with exit activities such as for employee termination benefits that represent a one-time benefit when management approves and commits to a plan of termination, and communicates the termination arrangement to the employees, or over the future service period, if any. Other costs associated with exit activities may include contract termination costs, including costs related to leased facilities to be abandoned or subleased, and facility and employee relocation costs. In addition, a portion of our restructuring costs are outside the U.S. related to expected employees terminations. We are required to record a liability for this cost when it is probable that we will incur the costs and can reasonably estimate the amount.
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In addition, we accounted for costs of exit activities and involuntary employee termination benefits associated with our 2008 acquisition of TeT in the purchase price allocation of the acquired business if a plan to exit an activity of an acquired company exists, and those costs had no future economic benefit to us and were incurred as a direct result of the exit plan.
Foreign Currency
Assets and liabilities of subsidiaries operating outside the U.S. with a functional currency other than U.S. Dollars are translated into U.S. Dollars using year-end exchange rates. Revenue, costs and expenses are translated at the average exchange rates in effect during the year. Foreign currency translation gains and losses are included as a component of accumulated other comprehensive loss.
For subsidiaries operating outside the U.S. where the functional currency is U.S. Dollars, monetary assets and liabilities denominated in local currency are remeasured at year-end exchange rates whereas non-monetary assets, including inventories and property, plant and equipment, are reflected at historical rates. Revenue, costs and expenses are translated at the average exchange rates in effect during the year. Any gains or losses from foreign currency remeasurement are included in foreign currency loss on our consolidated statements of operation.
Income Taxes
Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities from a change in tax laws (including rates) is recognized in income in the period that includes the enactment date. See Note 16 to the consolidated financial statements regarding the valuation reserve against our deferred tax assets.
We do not provide for federal income taxes on the undistributed earnings of our international subsidiaries because earnings are reinvested and, in the opinion of management, will continue to be reinvested indefinitely.
Goodwill
Goodwill is recorded when the purchase price paid for an acquisition exceeds the estimated fair value of the net identified tangible and intangible assets acquired. The Company is required to perform an impairment assessment at least annually and more frequently under certain circumstances. The Company performs its annually required impairment assessment on its December 31 goodwill balance. If the Company determines through the impairment process that goodwill has been impaired, the Company will record the impairment charge in the statement of operations. There can be no assurance that future goodwill impairment tests will not result in a charge to earnings.
Impairment of Long-Lived Assets
The Company assesses the potential impairment of long-lived assets, other than goodwill, when events or changes in circumstances indicate that the carrying value of the assets may not be recoverable. Factors that the Company considers in deciding when to perform an impairment review include significant under-performance of a product line in relation to expectations, significant negative industry or economic trends, and significant changes or planned changes in the Company’s use of the assets. Recoverability of assets that will continue to be used in the Company’s operations is measured by comparing the carrying amount of the asset grouping to the Company’s estimate of the related total future net cash flows. If an asset carrying value is not recoverable through the related cash flows, the asset is considered to be impaired. The impairment is measured by the difference between the asset grouping’s carrying amount and its fair value, based on the best information available, including market prices or discounted cash flow analysis. If the assets determined to be impaired are to be held and used, the Company recognizes an impairment loss through a charge to operating results to the extent the present value of anticipated net cash flows attributable to the asset are less than the asset’s carrying value. When it is determined that the useful lives of assets are shorter than originally estimated, and there are sufficient cash flows to support the carrying value of the assets, the Company will accelerate the rate of amortization charges in order to fully amortize the assets over their new shorter useful lives. This process requires the use of estimates and assumptions, which are subject to a high degree of judgment. If these assumptions change in the future, the Company may be required to record impairment charges for these assets. There can be no assurance that future long-lived asset impairment tests will not result in a charge to earnings.
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Brazilian Building Sale
In connection with the sale of real property in Brazil, we will continue to defer the gain related to the sale until we no longer have continuing involvement in the building, the buyer’s initial and continuing investments are adequate to demonstrate a commitment to pay for the property, and collectability of the remaining amounts due is reasonably assured either by collection of the majority of the receivable or our determination that the amounts due are not subject to future subordination from a bank or other lender.
Impact of Recently Issued Accounting Pronouncements
See Note 2 to the consolidated financial statements included herein for a discussion of recent accounting pronouncements.
Comparison of Years Ended December 31, 2010 and 2009
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Net Revenue
Net revenue increased approximately $61.5 million or 15.1% in 2010 compared to 2009. The increase was comprised of $58.9 million or 19.4% in product revenue, and $2.7 million or 2.6% in net service revenue.
The $58.9 million increase in products revenues during 2010 is principally the result of increased product demand across all of our geographic segments. The increase was driven primarily by growth of $28.7 million in SEMEA, $14.3 million in Asia-Pacific, and $7.5 million in NEMEA.
The $2.7 million increase in service revenue during 2010 was due primarily due to stronger demand and new customer contracts in Australia where service sales increased by $6.0 million. This increase was partially offset by $4.1 million in fewer services revenue due to our exiting a marginally profitable service contract with a large customer in Brazil during the third quarter of 2009.
In the fourth quarter of 2010, we were notified by a significant customer in Australia that it would not renew its service contract which is expected to end during the first quarter of 2011. This customer accounted for approximately $10.0 million dollars of total service revenue for the year ended December 31, 2010.
Costs of Revenue and Gross Profit
Costs of revenue include the costs of raw materials, manufacturing and service labor, overhead and subcontracted manufacturing costs, telecommunication costs, and inventory valuation provisions. Costs of revenue also include amortization of certain intangible assets. Total gross profit as a percent of revenue increased to 33.1% during 2010 from 31.6% during 2009.
Product Gross Profit
Product gross profit excluding amortization was 35.4% in 2010 compared to 34.9% in 2009. The slight product gross profit increase was principally due to continued cost reductions gained from our third party contract manufacturers, partially offset by increases in sales of lower margin product in regions such as Southeast Asia and Brazil.
Service Gross Profit
Service gross profit excluding amortization was 26.6% in 2010 compared to 24.4% in 2009. The increase in the gross profit percentage from 2009 to 2010 was principally due to the decision to exit a marginally profitable service contract with a large customer in Brazil during the third quarter of 2009 and improved software margins in Northern Europe, partially offset by a $1.0 million extended warranty sale to a third party that did not reoccur during 2010.
Amortization of Purchased Intangibles
The amortization of purchased intangibles included in cost of revenue decreased $1.5 million due to certain intangible assets becoming fully amortized during 2010 and lower exchange rates.
Operating Expenses
Research and development - Research and development expenses as a percent of revenue were 10.1% in 2010 compared to 10.9% in 2009. Research and development expenses consist mainly of software and hardware engineering costs and the cost of development personnel. Research and development expenses increased approximately $2.6 million or 5.9% in 2010 compared to 2009, primarily due to more development work related to our new generation of products that will begin to be sold in 2011.
Selling, general and administrative - Selling, general and administrative expenses as a percentage of revenue were 17.7% for 2010 and 18.4% for 2009. Sales and marketing expenses, administrative personnel costs, and facilities operations are the primary components of selling, general and administrative expenses. Selling, general and administrative expenses increased approximately $8.2 million or 11.0% in 2010 as compared to 2009. The increase was primarily due to $2.1 million of professional fees related to the VeriFone acquisition and $2.0 million of increased legal fees related to our defense and settlement of certain legal claims. Stock-based compensation expense also increased by $2.2 million primarily due to the accelerated vesting of certain awards granted to employees who were terminated. In addition, the provision for doubtful accounts increased by $1.2 million.
Impairment of goodwill and intangible assets - Our annual goodwill impairment tests at December 31, 2010 and 2009 indicated no impairment.
Amortization of purchased intangibles - Amortization of purchased intangibles expense decreased approximately $0.7 million or 11.4% in 2010, as compared to 2009, primarily related to lower exchange rates.
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Interest expense
We incurred interest expense of $12.5 million in 2010 compared to $11.0 million in 2009. Interest expense includes amortization of the fair value of warrants that were accounted for as a debt discount, resulting in additional interest expense of $6.9 million in 2010 and $6.7 million in 2009. In 2010, we made early repayments totaling $8.0 million of our debt to Francisco Partners and, as a result, we incurred additional non-cash interest expense of $1.0 million in 2010.
Income tax benefit (provision)
Federal, state and foreign taxes resulted in a provision of $2.6 million in 2010 compared to a benefit of $0.8 million in 2009. The income tax provision for 2010 was primarily related to tax on foreign operations of $4.1 million offset by a release of $1.5 million of tax and interest related to the expiration of the statue of limitations on certain tax benefits in certain foreign tax jurisdictions.
During 2010, we continued to provide a valuation allowance on substantially all of our deferred tax assets. That valuation allowance is subject to reversal in future years at such time that the benefits are actually utilized or the operating profits in the U.S. become sustainable at a level that meets the recoverability requirements of the accounting standards.
Comparison of Years Ended December 31, 2009 and 2008
Net Revenue
Net revenue decreased approximately $27.3 million or 6.3% in 2009 compared to 2008. This decrease was comprised of $16.7 million or 5.2% in product revenue, and $10.6 million or 9.4% in service revenue.
The $16.7 million decrease in product revenue during 2010 was principally the result of decreases in countertop and PIN pad products in the Americas and Asia-Pacific. Countertop revenue in North America decreased $18.1 million as a result of the retail slowdown in the U.S. and weak global economic environment. Also, countertop revenue in Asia-Pacific decreased $3.7 million due to the global recession. These reductions were partially offset by an increase of $5.7 million of new product revenue related to our decision in 2009 to begin selling products into the Brazilian market, and by incremental revenue from the acquisition of TeT, which was not included in our results for the first quarter of 2008.
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The $10.6 million decrease in service revenue during 2009 was primarily due to our exiting a marginally profitable service contract with a large customer in Brazil during the third quarter of 2009. This reduction was partially offset by incremental revenue from the acquisition of TeT, which was not included in our results for the first quarter of 2008.
Costs of Revenue and Gross Profit
Costs of revenue include the costs of raw materials, manufacturing and service labor, overhead and subcontracted manufacturing costs, telecommunication cost, and inventory valuation provisions. Costs of revenue also include amortization of certain intangible assets. Total gross profit as a percent of revenue increased to 31.6% during 2009 from 28.5% during 2008.
Product Gross Profit
Product gross profit excluding amortization was 34.9% in 2009 compared to 31.5% in 2008. The product gross profit increase was principally due to higher gross margins on TeT product sales, changes in product mix for countertop, mobile, and multilane products, as well as cost reductions gained from our third party contract manufacturers. In addition, gross profit in 2008 was negatively impacted by costs associated with the shut down of our China manufacturing plant totaling approximately $2.5 million and additional liabilities recorded of approximately $4.2 million primarily related to excess components at our third-party contract manufacturers.
Service Gross Profit
Service gross profit excluding amortization was 24.4% in 2009 compared to 22.7% in 2008. The increase in the gross profit percentage from 2008 to 2009 was principally due to the decision to exit a marginally profitable service contract with a large customer in Brazil during the third quarter of 2009 combined with a $1.0 million extended warranty sale to a third party that met the criteria of revenue. This was partially offset by $1.3 million of restructuring charges incurred in Brazil and Australia.
Operating Expenses
Research and development - Research and development expenses as a percent of revenue were 10.9% in 2009 compared to 10.6% in 2008. Research and development expenses consist mainly of software and hardware engineering costs and the cost of development personnel. Research and development expenses decreased approximately $1.4 million or 3.1% in 2009 compared to 2008, primarily due to $2.2 million of lower professional expenses for projects in Germany. This decrease was offset by additional expenses from the acquisition of TeT, which was not included in our results for the first quarter of 2008.
Selling, general and administrative - Selling, general and administrative expenses as a percentage of revenue were 18.4% for 2009 and 18.7% for 2008. Sales and marketing expenses, administrative personnel costs, and facilities operations are the primary components of selling, general and administrative expenses. Selling, general and administrative expense decreased approximately $6.5 million or 8% in 2009 compared to 2008. The decrease was primarily due to lower integration costs from the TeT acquisition, including reductions of $2.0 million in professional fees and $1.5 million of legal expenses. In addition as part of our continued effort to reduce costs there were reductions of $1.5 million in travel and entertainment expenses and $0.7 million in marketing expenses. Stock-based compensation expense decreased by $1.5 million primarily the result of lower fair value of new grants due to the decrease in our share price. Also, due to lower revenue in 2009 as compared to 2008, commission expense decreased by $1.9 million. These items were offset by a $2.0 million increase in bonus expense and $1.1 million of depreciation expense related to development expenses for internal use software as a result of our integration of TeT.
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Impairment of goodwill and intangible assets - During the fourth quarter of 2008, we concluded that the economic environment and the significant decline in our share price compared to our net book value represented significant adverse events, and therefore, we evaluated our goodwill and long-lived assets for impairment as of December 31, 2008. Our evaluation of goodwill and long-lived assets resulted in the recognition of asset impairment charges totaling $67.8 million for 2008, primarily related to our acquisition of TeT on April, 1, 2008.
We performed our annual goodwill impairment test during the fourth quarter of 2009 and determined that there was no impairment needed as of December 31, 2009.
Amortization of purchased intangibles - Amortization of purchased intangibles expense decreased approximately $0.2 million or 6.0% in 2009 compared to 2008, primarily related to lower exchange rates.
Interest income and interest expense
We recognized $0.3 million in interest income in 2009 compared to $1.5 million in 2008. This decrease was principally attributable to lower average cash, cash equivalent, and short-term investment balances in 2009 compared to 2008 due to the acquisition of TeT.
We incurred interest expense of $11.0 million in 2009 compared to $6.8 million in 2008. The increase in interest expense is primarily due to the acquisition financing of TeT that occurred on April 1, 2008. Interest expense includes amortization of the fair value of warrants that were accounted for as a debt discount, resulting in additional interest expense of $6.7 million in 2009 and $4.6 million in 2008. In December 2009, we made an early repayment of $3.0 million of our debt to Francisco Partners and, as a result, we incurred additional non-cash interest expense of $0.5 million in the fourth quarter of 2010.
Income tax benefit
Federal, state and foreign taxes resulted in a benefit of $0.8 million in 2009 compared to a benefit of $1.2 million in 2008. The income tax benefit for 2009 was primarily related to a $2.7 million reversal of a deferred tax liability in the United Kingdom, offset by $1.7 million of income taxes, interest and penalties related to uncertain tax positions in other foreign tax jurisdictions.
During 2009, we continued to provide a valuation allowance on substantially all of our deferred tax assets. That valuation allowance is subject to reversal in future years at such time that the benefits are actually utilized or the operating profits in the U.S. become sustainable at a level that meets the recoverability requirements of the accounting standards. Due to our net operating loss position and our valuation allowance against our deferred tax assets, the consolidated effective tax rates for 2009 and 2008 are not meaningful.
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Segment and Geographic Information
Our product revenue primarily relates to the sale of terminals, peripheral devices, and transaction networking devices. Our service revenue is comprised of asset management services, trusted transaction services and payment solutions, as described in Part I to this Annual Report on Form 10-K. No other type of revenue exceeded 10% of our consolidated net revenue in 2010, 2009 or 2008.
Comparison of Years Ended December 31, 2010 and 2009
Net revenue for the Americas was $126.0 million in 2010 compared to $123.7 million in 2009. The $2.3 million increase in net revenue was principally due to the increase of $3.6 million of countertop and $3.3 million of mobiles sales in Mexico and the Caribbean due to overall stronger demand in the region. There were also increases of $4.4 million in countertop, $3.2 million in mobile sales and $2.5 million in PIN pad products in North America as a result of overall stronger demand. This increase was partially offset by $9.2 million of lower multilane sales due to a large contract in 2009 that did not produce revenue in 2010. The increase in the Americas was also attributable to a $4.6 million increase of new product sales in Brazil, partially offset by a $4.1 million reduction of service sales primarily due to our exiting a marginally profitable service contract with a large customer.
Net revenue for NEMEA was $110.2 million in 2010 compared to $102.5 million in 2009. The $7.7 million increase in net revenue was principally due to increases of $4.9 million in unattended products and $2.7 million in mobile products in Scandinavia as a result of stronger demand.
Net revenue for SEMEA was $161.8 million in 2010 compared to $131.5 million in 2009. The $30.3 million increase in net revenue was principally due to increases of approximately $6.0 million in countertop, $4.0 million in mobile and $2.0 million of PIN pad products in Eastern Europe as a result of new customers and strong demand in the region. There were also increases of $3.9 million in unattended products, $2.7 million in countertop and $2.9 million of mobile products in the United Kingdom, also as a result of stronger demand and new customers. France also had an increase of $5.0 million in net revenue of mostly countertop products.
Net revenue for Asia-Pacific was $70.4 million in 2010 compared to $49.2 million in 2009. The $21.2 million increase in net revenue was principally due to increases of $6.6 million of countertop products in Asia, by $6.0 million in service revenue and $3.1 million of mobile sales in Australia due to a new customer contract signed in 2009, and stronger demand.
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Operating Income
Operating income for the Americas was $25.0 million in 2010 compared to $21.1 million in 2009. The $3.9 million increase was primarily due to higher revenue with consistent gross margins as compared to 2009.
Operating income for NEMEA was $28.4 million in 2010 compared to $19.3 million in 2009. The $9.1 million increase was primarily due to higher revenue with consistent gross margins as compared to 2009.
Operating income for SEMEA was $37.2 million in 2010 compared to $24.7 million in 2009. The $12.5 million increase was primarily due to higher revenue with consistent gross margins as compared to 2009.
Operating income for Asia-Pacific was $14.3 million in 2010 compared to $9.1 million in 2009. The $5.2 million increase was primarily due to higher revenue with consistent gross margins as compared to 2009.
Shared cost center expenses were $83.9 million in 2010 compared to $71.0 million in 2009. The $12.9 million increase was primarily due to a $3.4 million increase in R&D expenses principally as a result of the development of our new generation of products, $2.2 million of professional fees related to the VeriFone acquisition and $2.0 million of increased legal expenses related to various litigation matters. Stock-based compensation expense increased by $2.4 million primarily due to revaluation of compensation expense related to accelerated vesting of awards granted to certain terminated employees. These increases were partially offset by a $0.7 million gain on sale of a majority interest in HBNet and a $0.9 million gain on the sale of our Swedish lease and service business.
Comparison of Years Ended December 31, 2009 and 2008
Net Revenue
Net revenue for the Americas decreased in 2009 compared to 2008, principally as a result of declines in countertop and PIN pad products in North America, and decreases in service revenue in Brazil. Offsetting these decreases were increases of new products revenue related to our decision in 2009 to resume the sale of products in Brazil. NEMEA and SEMEA net revenue increased due to the acquisition of TeT during 2008, while net revenue in Asia-Pacific remained consistent over the two-year period.
Operating Income
The Americas operating income increased in 2009 compared to 2008, principally as a result of a write-down of goodwill and intangible assets in 2008, whereas no write-down was required in 2009.
Operating income for NEMEA was $19.3 million in 2009 compared to a loss of $6.1 million in 2008. The $25.3 million increase was primarily due to a $24.4 million write-down of goodwill and intangible assets in 2008, whereas no write-down was required in 2009. Also, 2009 benefited from an $8.7 million increase in revenue in 2009, as well as incremental operating income not included in the first quarter of 2008 related to our TeT acquisition, partially offset by lower foreign exchange rates.
Operating income for SEMEA was $24.7 million in 2009 compared to a loss of $8.5 million in 2008. The $33.2 million improvement was primarily due to a $32.4 million write-down of goodwill and intangible assets in 2008, whereas no write-down was required in 2009. Also, 2009 benefited from incremental operating income not included in the first quarter of 2008 related to our TeT acquisition, partially offset by lower foreign exchange rates.
Operating income for Asia-Pacific was $9.1 million in 2009 compared to $4.4 million in 2008. The $4.7 million increase is primarily due to a $4.5 million write-down of goodwill and intangible assets in 2008, whereas no write-down was required in 2009.
Shared cost center expenses decreased in 2009 compared to 2008, principally as a result of lower integration costs from the TeT acquisition, including reductions of $2.0 million in professional fees and $1.5 million of legal expenses. In addition, as part of our continued effort to reduce costs in 2009 there were reductions of $0.7 million in global marketing expenses and $2.2 million of lower global research and development professional expenses. Stock-based compensation expense decreased by $1.5 million, primarily due to lower fair value associated with stock options granted in 2009.
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Liquidity and Capital Resources
We have historically financed our operations primarily through cash generated from operations and occasionally from borrowings under a line of credit or other debt facilities. During 2010, our primary source of cash was cash generated by our operating activities. Our ability to service our long-term debt, to remain in compliance with the various restrictions and covenants contained in our debt agreements, and to fund working capital, capital expenditures and business development efforts, will depend on our ability to generate cash from operating activities, which in turn is subject to, among other things, future operating performance, as well as general economic, financial, competitive, legislative, regulatory and other conditions, some of which may be beyond our control. We have available to us, upon compliance with certain conditions, a revolving credit facility, less any letters of credit outstanding under the sub-line of the revolving credit facility. Availability under our revolving credit facility for cash and outstanding letters of credit was $16.1 million as of December 31, 2010, after deducting outstanding letters of credit of $3.1 million under this revolving line of credit at December 31, 2010. The revolving credit facility expires on January 14, 2012.
Cash flows from operating activities
Cash flow from operating activities was $20.0 million for the year ended December 31, 2010. Cash provided by operations before changes in working capital amounted to $48.8 million for the year ended December 31, 2010 and consisted of $6.7 million of net income and $42.1 million of non-cash items consisting primarily of depreciation and amortization, stock-based compensation expense, non-cash interest, excess and obsolete inventory and warranty expenses.
Changes in working capital resulted in a $28.8 million decrease in cash and cash equivalents during the year ended December 31, 2010. The main drivers of this decrease were as follows:
• A $16.5 million increase in accounts receivable primarily due to our revenue growth.
• A $19.7 million increase in inventory primarily due to anticipated sales growth.
The decrease was partially offset by:
• A $5.7 million increase in deferred revenue primarily as a result of an increase in revenue deferred for customers’ prepayments and required deferrals of revenue.
Cash flows used in investing activities
Cash flows used in investing activities of $12.4 million consist principally of capital expenditures for property, plant and equipment of $10.2 million and $4.6 million for software development costs capitalized.
The capital expenditures were principally for upgrades to computer software and hardware related to the TeT acquisition, manufacturing tools and equipment related to new product launches and our move to contract manufacturing, and expenditures related to outfitting the new corporate headquarters. Depending on the global economic environment, we intend to spend approximately $13.0 million to $15.0 million over the next 12 months for capital expenditures related to computer software to further integrate the TeT product line and for manufacturing tools and equipment for new product launches.
Cash flows from financing activities
Cash flows used in financing activities of $4.7 million consist of $8.0 million in payments made to Francisco Partners for partial, early extinguishment of the debt financing related to the TeT acquisition, offset by $3.5 million of proceeds from issuance of common stock.
Projected liquidity and capital resources
At December 31, 2010, cash and cash equivalents were $56.9 million. The amount of consolidated cash is subject to intra-month and seasonal and currency fluctuations and includes balances held by subsidiaries worldwide that are needed to fund their operations.
On January 15, 2008, we entered into a Loan and Security Agreement (“Loan Agreement”) with Bank of America, N.A. that provides for a revolving credit facility of up to $25.0 million with the ability to borrow up to $40 million if certain conditions are met. Available borrowings under the Loan Agreement are subject to borrowing base calculations based on the value of eligible inventory and accounts receivable. The Loan Agreement includes customary covenants and certain negative covenants prohibiting the occurrence of certain types of debt, limiting capital expenditures or disposing of assets. The obligations under the revolving credit facility are secured by the inventory and accounts receivable of certain of our subsidiaries in the U.S. and the U.K. The remaining balance of our consolidated assets is unencumbered under the Loan Agreement and, if needed, may be used as collateral for additional debt.
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During the second quarter of 2008, we completed the acquisition of TeT for approximately $150.5 million. To fund the acquisition, on February 13, 2008, we entered into a credit agreement (the “Credit Agreement”) with Francisco Partners. The Credit Agreement provided for a loan of up to $60.0 million to partially fund the acquisition at closing. The loan under the Credit Agreement bears interest at 10% per annum, provided that, at our election, interest may be capitalized and added to the principal of the loan to be repaid at maturity. The loan was funded by an affiliate of Francisco Partners, FP Hypercom Holdco, LLC (the “Lender”). All amounts outstanding under the Credit Agreement are due March 31, 2012.
On February 10, 2010, the Loan Agreement was amended to allow us to enter into a transaction between our former subsidiary, HBNet, and The McDonnell Group, as well as making additional changes, including, among others, providing for the outstanding amounts under the Loan Agreement to now bear interest, at our option, at either: (i) LIBOR plus 200 or 250 basis points; or (ii) the bank’s prime rate plus 50 or 75 basis points depending on certain financial ratios. In addition, the borrowing base was amended to eliminate inventory from the borrowing base calculation. On December 30, 2010, the Loan Agreement was amended whereby all amounts outstanding are now due on January 14, 2012. In addition, the revolving credit facility under the Loan Agreement is set at a maximum of up to $25.0 million (previously up to $40.0 million if certain conditions were met). The forgoing description of the amendment to the Loan Agreement is qualified in its entirety by reference to the complete terms and conditions of the amendment to the Loan Agreement.
Based on past performance and current expectations, we believe that our cash flows from operations and other sources of liquidity, including borrowings available under our revolving credit facility or other financing options, will satisfy our working capital needs, capital expenditures, commitments, and other liquidity requirements associated with our operations and our TeT acquisition debt requirement through the next year. Should operating results prove unfavorable, we may need to obtain additional capital sources to meet our short-term liquidity and capital resource requirements.
Contractual Obligations
The following table summarizes our significant contractual obligations at December 31, 2010, and the effect such obligations are expected to have on our liquidity and cash flows in future periods (dollars in thousands):
(1)
Our long-term debt obligation includes principal and accrued interest through the maturity of the debt in 2012.
(2)
Minimum purchase obligations include all outstanding obligations to purchase goods or services from our contract manufacturers and other suppliers at December 31, 2010 including agreements that are cancelable without penalty and agreements that are enforceable and legally binding. We estimate that approximately 70% of the outstanding purchase obligations at December 31, 2010 are non-cancelable due to the customized nature of the order and the long lead time requirements.
(3)
The total amount of unrecognized tax benefits at December 31, 2010 was $47.0 million, of which $3.3 million would impact our effective tax rate were it to be recognized.
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Off-Balance Sheet Arrangements
As of December 31, 2010, we did not have any off-balance sheet arrangements, as defined in Item 303(a)(4)(ii) of SEC Regulation S-K.
Effect of Inflation
Inflation has not had a significant effect on our operations for any period presented above.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
At December 31, 2010, our cash equivalent investments were primarily in money market accounts and certificates of deposit and are reflected as cash equivalents because all maturities are within 90 days from date of purchase. Our interest rate risk with respect to existing investments is limited due to the short-term duration of these arrangements and the yields earned, which approximate current interest rates for similar investments.
We are exposed to financial market risks, including changes in interest rates and foreign currency exchange rates in connection with our international operations and markets. Nevertheless, the fair value of our investment portfolio or related income would not be significantly impacted by a 100 basis point increase or decrease in interest rates, primarily due to the short-term nature of the major portion of our investment portfolio.
A substantial portion of our revenue and capital spending is transacted in either U.S. Dollars or Euros. However, we do at times enter into transactions in other currencies, such as the Hong Kong Dollar, Australian Dollar, Brazilian Real, British Pound and other Central and South American, Asian and European currencies. In March 2009, we suspended hedging activities due to the cost of entering into forward contracts, the possible short term cash requirements for forward contract payables, along with the inability to repatriate cash from foreign countries on a short term basis to offset any hedge forward contract payable. We are currently reviewing our hedging strategy for 2011. Prior to our decision to suspend hedging in March 2009, we hedged the translation of our net investment in foreign subsidiaries in an attempt to neutralize the effect of translation gains or losses in the statement of operations. We also entered into hedge contracts to mitigate certain significant transactional exposures. Financial hedging instruments were limited by our previous policy regarding foreign currency forward or option contracts and foreign currency debt. At December 31, 2010 and 2009, we had no foreign currency forward contracts.
We do not purchase or hold any such derivative financial instruments for the purpose of speculation or arbitrage. See “Item 1A, Risk Factors - International operations pose additional challenges and risks that if not properly managed could adversely affect our financial results ” elsewhere in this Annual Report on Form 10-K.
At present, all of our long-term debt obligations are at a fixed interest rate over the term of the agreement and there are no borrowings under our revolving credit facility at December 31, 2010.
During the normal course of business, we are routinely subjected to a variety of market risks, examples of which include, but are not limited to, interest rate movements and foreign currency fluctuations, as we discuss in this Item 7A, and collectability of accounts receivable. We continuously assess these risks and have established policies and procedures to protect against the adverse effects of these and other potential exposures. Although we do not anticipate any material losses in these risk areas, no assurance can be made that material losses will not be incurred in these areas in the future.
Item 8.
Item 8. Financial Statements and Supplementary Data
The financial statements and supplementary data required by Regulation S-X are included in Part IV, Item 15 of this Annual Report on Form 10-K.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
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Item 9A.
Item 9A. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
We maintain disclosure controls and procedures designed to ensure information required to be disclosed in the reports we file or submit under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), is recorded, processed, summarized and timely reported as specified in the SEC’s rules and forms. They are also designed to ensure that such information is accumulated and communicated to our management, including our Chief Executive Officer, Chief Financial Officer, and Chief Accounting Officer, as appropriate, to allow timely decisions regarding required disclosure.
Our management, with the participation of our Chief Executive Officer, Chief Financial Officer, and Chief Accounting Officer, has evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this report. Based on such evaluation, our Chief Executive Officer, Chief Financial Officer, and Chief Accounting Officer have concluded that, as of the end of such period, our disclosure controls and procedures were effective, having been effectively designed to ensure that information we are required to disclose in reports we file or submit under the Exchange Act is (1) recorded, processed, summarized and reported timely as specified in SEC rules and forms and is (2) accumulated and communicated to our management, including our certifying officers, as appropriate to allow timely decisions regarding required disclosures.
Changes in Internal Control over Financial Reporting
There was no change in our internal control over financial reporting, as defined in the Exchange Act Rules 13a-15(f) and 15d-15(f), that occurred during our most recently completed fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
Management’s Report on Internal Control Over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over Hypercom’s financial reporting, as defined in the Exchange Act Rules 13a-15(f) and 15d-15(f). Under the supervision of our Chief Executive Officer, Chief Financial Officer, and Chief Accounting Officer, and with the participation of other management, Hypercom conducted an evaluation of the effectiveness of internal control over financial reporting as of December 31, 2010 based on the framework established by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) entitled Internal Control - Integrated Framework .
Based on this evaluation, our management concluded that, as of December 31, 2010, our internal control over financial reporting was effective.
Our independent registered public accounting firm, Ernst & Young LLP, has issued an attestation report on management’s assessment of our internal control over financial reporting, which follows.
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Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders of Hypercom Corporation
We have audited Hypercom Corporation’s internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Hypercom Corporation’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the company’s internal control over financial reporting based on our audit.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, Hypercom Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2010, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Hypercom Corporation as of December 31, 2010 and 2009, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2010, and our report dated March 10, 2011 expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
Phoenix, Arizona
March 10, 2011
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Item 9B.
Item 9B. Other Information
None.
PART III
Item 10.
Item 10. Directors, Executive Officers and Corporate Governance
Executive Officers of the Registrant
The following are our executive officers as of March 7, 2011:
The additional information required by this item regarding our directors, audit committee and compliance with Section 16 of the Exchange Act is incorporated by reference from the information contained in our 2011 Annual Meeting Proxy Statement, which will be filed with the SEC within 120 days following our fiscal year end.
We have adopted a code of ethics that applies to all directors, officers and employees of our company, including our Chief Executive Officer, Chief Financial Officer, Chief Accounting Officer, or persons performing similar functions. A copy of our Code of Ethics is available on our website at www.hypercom.com. We intend to satisfy the disclosure requirements under Item 10 of Form 8-K in the event of an amendment to, or a waiver from, a provision of our Code of Ethics that applies to our Chief Executive Officer, Chief Financial Officer, Chief Accounting Officer, or persons performing similar functions, by disclosing such information on our website.
Item 11.
Item 11. Executive Compensation
Information required in response to this item is incorporated by reference to our 2011 Annual Meeting Proxy Statement, which will be filed with the SEC within 120 days following our fiscal year end.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Information required in response to this item is incorporated by reference from our 2011 Annual Meeting Proxy Statement, which will be filed with the SEC within 120 days following our fiscal year end.
Item 13.
Item 13. Certain Relationships and Related Transactions, and Director Independence
Information required in response to this item is incorporated by reference from our 2011 Annual Meeting Proxy Statement, which will be filed with the SEC within 120 days following our fiscal year end.
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Item 14.
Item 14. Principal Accountant Fees and Services
Information required in response to this item is incorporated by reference from our 2011 Annual Meeting Proxy Statement, which will be filed with the SEC within 120 days following our fiscal year end.
PART IV
Item 15.
Item 15. Exhibits and Financial Statement Schedules
a. The following documents are filed as part of this Annual Report on Form 10-K:
(1)Audited Consolidated Financial Statements
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets at December 31, 2010 and 2009
Consolidated Statements of Operations for the years ended December 31, 2010, 2009, and 2008
Consolidated Statements of Stockholders’ Equity for the years ended December 31, 2010, 2009, and 2008
Consolidated Statements of Cash Flows for the years ended December 31, 2010, 2009, and 2008
Notes to Consolidated Financial Statements
(2) Financial Statement Schedules
Financial statement schedules are omitted because of the absence of the conditions under which they are required or because the required information is included in the Consolidated Financial Statements or the notes thereto. The financial statements of unconsolidated subsidiaries are omitted because, considered in the aggregate, they would not constitute a significant subsidiary.
(3) Exhibits
See Exhibit Index beginning on page 94 of this Annual Report on Form 10-K.
b. See Item 15(a)(3) above.
c. See Item 15(a)(2) above.
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Annual Report to be signed on our behalf by the undersigned, thereunto duly authorized.
HYPERCOM CORPORATION
By: /s/ Philippe Tartavull
Philippe Tartavull
Chief Executive Officer and President
Date: March 10, 2011
Pursuant to the requirements of the Securities Exchange Act of 1934, this Annual Report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated on March 10, 2011.
Philippe Tartavull, by signing his name hereto, does sign and execute this Annual Report on Form 10-K on behalf of such of the above named directors of the registrant on this 10th day of March, 2011, pursuant to the power of attorney executed by each of such directors filed as Exhibit 24.1 to this Annual Report on Form 10-K.
*By: /s/ Philippe Tartavull
Attorney-in-Fact
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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Stockholders of Hypercom Corporation
We have audited the accompanying consolidated balance sheets of Hypercom Corporation as of December 31, 2010 and 2009, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2010. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Hypercom Corporation at December 31, 2010 and 2009, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2010, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Hypercom Corporation’s internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 10, 2011 expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
Phoenix, Arizona
March 10, 2011
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HYPERCOM CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2010
1. Description of Business
Hypercom Corporation (“Hypercom” or the “Company”) is one of the largest global providers of complete electronic payment and transaction solutions and value-added services at the point-of-transaction. Hypercom designs and sells electronic transaction terminals, peripheral devices, transaction networking devices, transaction management systems, application software, and information delivery services. Additionally, Hypercom provides directly, or through qualified contractors, support and related services that complement and enhance its hardware and software products. Hypercom’s customers include large domestic and international financial institutions, electronic payment processors, large retailers, independent sales organizations (“ISOs”) and distributors as well as companies in the transportation, healthcare, pre-paid card and quick service restaurant (“QSR”) industries. Hypercom operates in one business market-electronic payment products and services.
Hypercom is headquartered in Scottsdale, Arizona, where its operations include corporate administration, product development, sales and marketing, distribution, repairs management and customer service. Hypercom has sales and support offices in Australia, Brazil, Belgium, Chile, China, France, Germany, Hong Kong, Hungary, Latvia, Mexico, the Philippines, Puerto Rico, Russia, Scotland, Singapore, Spain, Sweden, Thailand, the United Arab Emirates and the United Kingdom (“U.K.”). These sales and support offices perform sales, marketing, distribution, customer service and custom development functions. Hypercom’s primary manufacturing is performed by third party contract manufacturing operations located in Malaysia, Germany, Brazil, Romania, and Tunisia. Hypercom has global product development facilities primarily in the U.S., Germany, France, Philippines and Latvia.
On November 17, 2010, the Company entered into a definitive merger agreement with VeriFone Systems, Inc. (“VeriFone”) and Honey Acquisition Co, Inc., a direct wholly-owned subsidiary of VeriFone (“Merger Sub”), under which Hypercom will be merged with and into Merger Sub, with the Company continuing after the merger as the surviving corporation and wholly-owned subsidiary of VeriFone, pursuant to which VeriFone will acquire Hypercom in an all-stock transaction. The merger was approved by the Company’s stockholders on February 24, 2011 and is anticipated to close in the second half of 2011, subject to the satisfaction of applicable regulatory approvals and customary closing conditions. Upon the consummation of the merger, each share of our common stock issued and outstanding immediately prior to the merger will be converted into 0.23 of a share of VeriFone common stock.
Certain prior period amounts have been reclassified to conform to the current year presentation.
2. Significant Accounting Policies
Principles of Consolidation
The consolidated financial statements include the accounts of Hypercom and its wholly-owned subsidiaries (collectively, the “Company” or “Hypercom”). The Company, directly or indirectly, owns 100% of the outstanding stock of all of its subsidiaries with the exception of one subsidiary in Thailand. As of December 31, 2010, the Company owned a controlling interest in the Thailand subsidiary and certain nominee shareholders owned the remaining nominal shares. Subsequent to December 31, 2010, the shares held by the nominee shareholders were transferred to one of the Company’s subsidiaries and the Thailand subsidiary is now an indirect wholly-owned subsidiary of the Company. All of the Company’s subsidiaries are included in the consolidated financial statements, and all significant intercompany accounts and transactions have been eliminated in consolidation.
Use of Estimates
The preparation of the consolidated financial statements in conformity with U.S. generally accepted accounting principles requires management to make numerous estimates and assumptions that affect the accounting, recognition and disclosure of assets, liabilities, stockholders’ equity, revenue and expenses. The accounting estimates that require management’s most significant, difficult and subjective judgments include collectability of accounts receivable; determination of inventory obsolescence; recoverability of long-lived assets and goodwill; expected product warranty costs; recognition and measurement of current and deferred income tax assets and liabilities; legal and tax contingency accruals; the recognition and measurement of contingent liabilities to the Company’s third-party contract manufacturers for component parts that the Company may not ultimately use, and restructuring reserves. The actual results experienced by the Company may differ from management’s estimates.
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Cash and Cash Equivalents
The Company considers all financial instruments, including money market accounts and certificates of deposits, with a remaining maturity of three months or less when purchased, to be cash equivalents.
Fair Value of Financial Instruments
The carrying amounts of cash and cash equivalents approximate fair value due to the short maturity of those instruments. The fair value of marketable securities is determined based on quoted market prices, which approximate fair value. The fair value of sales-type leases and long-term obligations is estimated by discounting the future cash flows required under the terms of each respective lease or debt agreement by current market rates for the same or similar issues of leases or debt with similar remaining maturities. The fair value of financial hedge instruments are based on quotes from brokers using market prices for those or similar instruments.
Allowance for Doubtful Accounts
Payment terms for product and services trade receivables generally range from 30 to 90 days depending on the circumstances of each order or service contract. Any payments not received within the agreed upon due date are considered past due.
The Company maintains an allowance for doubtful accounts for estimated losses resulting from the inability of its customers to make required payments. Such allowance is computed based upon a specific customer account review of larger customers and balances past due as well as a general reserve against individually smaller accounts receivable balances. The Company’s assessment of its customers’ ability to pay generally includes direct contact with the customer, investigation into customers’ financial status, as well as consideration of customers’ payment history with the Company. If the Company determines, based on its assessment, that one of the Company’s customers will be unable to pay, the Company will charge off their account receivables to the allowance for doubtful accounts. A rollforward of the activity in the allowance for doubtful accounts for the years ended December 31, 2010, 2009 and 2008 is as follows:
Sales-Type Leases
Certain product sales made under lease arrangements are recorded as sales-type leases. Lease contract receivables represent the total lease payments to be received reduced by lease payments already collected. Sales-type lease revenue consists of the initial sale of the product shipped and the interest and maintenance elements of the lease payments as they are earned. An allowance for estimated uncollectible sales-type lease receivables at an amount sufficient to provide adequate protection against losses in the Company’s sales-type lease portfolio is recorded. The allowance is determined principally on the basis of historical loss experience and management’s assessment of the credit quality of the sales-type lease customer base. If loss rates increase or customer credit conditions deteriorate, the allowance for uncollectible sales-type leases may need to be increased. Unearned income includes interest and is the amount by which the original sum of the lease contract receivable exceeds the fair value of the equipment sold. The interest element is amortized to lease income using the effective interest method.
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Inventories
Inventories are stated at the lower of cost or market. Cost is computed using standard cost, on a first-in, first-out basis. Write-downs for estimated excess and obsolete inventory are recorded on a product or part level basis based upon historical usage and expected future demand and establish a new cost basis for the respective item.
Property, Plant and Equipment
Property, plant and equipment are stated at cost. Expenditures for major additions and improvements to facilities are capitalized, while maintenance and repairs are charged to expense as incurred. When property is retired or otherwise disposed of, the related cost and accumulated depreciation are removed from the accounts and any resulting gain or loss is reflected in the consolidated statements of operations.
In 2009, the Company revised the estimated useful lives of property, plant and equipment acquired through business acquisitions to conform with its policies regarding property, plant and equipment. Depreciation is provided over the estimated useful lives of the assets using the straight-line method. The estimated useful lives of the Company’s property and equipment are as follows:
Leasehold improvements are amortized over the shorter of the lease term or the life of the asset.
Capitalized Software Development Costs
The Company capitalizes certain internal and external expenses related to developing computer software used in the products it sells. Costs incurred prior to the establishment of technological feasibility are charged to research and development expense. The Company considers technological feasibility to have been established for a product when all of the following conditions have been met: (a) the detail program design has been completed and it has been determined that the necessary skills, hardware, and software technology are available to produce the product; (b) the detail program design has been traced to product specifications; and (c) all high-risk development issues have been resolved through coding and testing. Upon general release to customers of the product in which the software is included, capitalization ceases, and such costs are amortized using the straight-line method over an estimated life of one to three years. The amounts capitalized and recorded in Intangible assets during the years ended December 31, 2010, 2009 and 2008, were $4.6 million, $1.1 million and $0.1 million, respectively.
Impairment of Long-Lived Assets
The Company assesses the potential impairment of long-lived assets, other than goodwill, when events or changes in circumstances indicate that the carrying value of the assets may not be recoverable. Factors that the Company considers in deciding when to perform an impairment review include significant under-performance of a product line in relation to expectations, significant negative industry or economic trends, and significant changes or planned changes in the Company’s use of the assets. Recoverability of assets that will continue to be used in the Company’s operations is measured by comparing the carrying amount of the asset grouping to the Company’s estimate of the related total future net cash flows. If an asset carrying value is not recoverable through the related cash flows, the asset is considered to be impaired. The impairment is measured by the difference between the asset grouping’s carrying amount and its fair value, based on the best information available, including market prices or discounted cash flow analysis. If the assets determined to be impaired are to be held and used, the Company recognizes an impairment loss through a charge to operating results to the extent the present value of anticipated net cash flows attributable to the asset are less than the asset’s carrying value. When it is determined that the useful lives of assets are shorter than originally estimated, and there are sufficient cash flows to support the carrying value of the assets, the Company will accelerate the rate of amortization charges in order to fully amortize the assets over their new shorter useful lives. This process requires the use of estimates and assumptions, which are subject to a high degree of judgment. If these assumptions change in the future, the Company may be required to record impairment charges for these assets. For the years ended December 31, 2010, 2009 and 2008, long lived asset impairment charges for the intangible assets totaled zero, zero and $8.8 million, respectively. There can be no assurance that future long-lived asset impairment tests will not result in a charge to earnings.
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Brazilian Building Sale
In connection with the sale of the Brazilian building, the Company entered into a leaseback transaction with the buyer to allow for a transition of the Company’s services operations. The Company has not received the remaining payments due on the sale. Therefore, the Company will continue to defer the gain related to the sale until the Company no longer has continuing involvement in the building, the buyer’s initial and continuing investments are adequate to demonstrate a commitment to pay for the property, and collectability of the remaining amounts due are reasonably assured either by collection of the majority of the receivable or when the Company is assured the amounts due are not subject to future subordination from a bank or other lender. See Note 6 for further discussion.
Goodwill
Goodwill is recorded when the purchase price paid for an acquisition exceeds the estimated fair value of the net identified tangible and intangible assets acquired. The Company is required to perform an impairment assessment at least annually and more frequently under certain circumstances. The Company performs its annually required impairment assessment on its December 31 goodwill balance. If the Company determines through the impairment assessment process that goodwill has been impaired, the Company will record the impairment charge in the statement of operations. For the years ended December 31, 2010, 2009 and 2008, goodwill impairment charges totaled zero, zero and $59.0 million, respectively. There can be no assurance that future goodwill impairment tests will not result in a charge to earnings.
Discontinued Operations
The Company analyzes its operations that have been divested or classified as held-for-sale in order to determine if they qualify for discontinued operations accounting. Only operations that qualify as a component of an entity can be included in discontinued operations. In addition, only components where the Company does not have significant continuing involvement with the divested operations would qualify as a discontinued operation. Continuing involvement would include the Company continuing to exert significant influence or continue to have contractually obligated run-off operations related to the operations it is divesting. See Note 6 and Note 10 for further discussion.
Revenue Recognition
Revenue is recognized when the following criteria are met: (a) persuasive evidence that an arrangement exists; (b) delivery of the products or services has occurred; (c) the selling price is both fixed and determinable; and (d) collectability is reasonably assured.
The Company generally recognizes product revenue, including sales to distributors and sales under sales-type leases, upon shipment of product. The Company recognizes service revenue when the services have been provided and collection is reasonably assured. Routine recurring services include terminal repairs, help-desk, on-site technician visits, deployment and the provision of supplies. Amounts received in advance of services being rendered are recorded as deferred revenue. Revenue from long-term contracts that require substantial performance of customized software and hardware over an extended period are recorded based upon the attainment of substantive scheduled performance milestones under the percentage-of-completion method. Operating lease revenue is recognized monthly over the lease term. The units leased under operating leases are included in the balance sheet under “Property, plant and equipment.” The Company accrues for warranty costs, sales returns and other allowances at the time of shipment.
Revenue arrangements with multiple deliverables are evaluated to determine if the deliverables (items) can be divided into more than one unit of accounting. An item can generally be considered a separate unit of accounting if all of the following criteria are met:
•
The delivered item(s) has value to the customer on a standalone basis;
•
There is objective and reliable evidence of the fair value of the undelivered item(s); and
•
If the arrangement includes a general right of return relative to the delivered item(s), delivery or performance of the undelivered item(s) is considered probable and substantially in the control of the Company.
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Items that do not meet these criteria are combined into a single unit of accounting. If there is objective and reliable evidence of fair value for all units of accounting, the arrangement consideration is allocated to the separate units of accounting based on their relative fair values. In cases where there is objective and reliable evidence of the fair value(s) of the undelivered item(s) in an arrangement but no such evidence for one or more of the delivered item(s), the residual method is used to allocate the arrangement consideration. In cases in which there is not objective and reliable evidence of the fair value(s) of the undelivered item(s) but a portion of the arrangement is considered to be a lease, the Company recognizes where it has sufficient evidence to make an estimate of the relative fair values of the delivered elements.
The Company presents revenue net of sales taxes and value-added taxes in its consolidated statements of operations.
Shipping and Handling Costs
Shipping costs include charges associated with delivery of goods from the Company’s facilities to its customers and are reflected in cost of product. Shipping costs paid to the Company by its customers are classified as revenue.
Product Warranty
The Company accrues for estimated warranty obligations when revenue is recognized based on an estimate of future warranty costs for delivered products and specific known product issues. Such estimates are based on historical experience and expectations of future costs. The Company periodically evaluates and adjusts the accrued warranty costs to the extent actual warranty costs vary from the original estimates. The Company’s warranty period typically extends from one to five years from the date of shipment. Costs associated with maintenance contracts, including extended warranty contracts, are expensed when they are incurred. Actual warranty costs may differ from management’s estimates.
Legal and Other Contingencies
In the ordinary course of business, the Company is involved in legal proceedings involving contractual and employment relationships, product liability claims, intellectual property rights, and a variety of other matters. The Company records contingent liabilities resulting from asserted and unasserted claims against it, when it is probable that a liability has been incurred and the amount of the loss is estimable. Estimating probable losses requires analysis of multiple factors, in some cases including judgments about the potential actions of third-party claimants and courts. Therefore, actual losses in any future period are inherently uncertain. Currently, the Company does not believe any of its pending legal proceedings or claims will have a material impact on its financial position, results of operations or cash flows. However, if actual or estimated probable future losses exceed the Company’s recorded liability for such claims, it would record additional charges as other expense during the period in which the actual loss or change in estimate occurred.
For components not yet billed to the Company by its third-party contract manufacturers, contingent liabilities are recorded by component based on the likelihood of the Company’s ultimate usage of the components. The Company’s reserve for such potential billings of $4.8 million is included in accrued other liabilities in the Company’s consolidated balance sheet at December 31, 2010.
Costs Associated with Exit Activities
The Company records costs associated with exit activities such as for employee termination benefits that represent a one-time benefit when management approves and commits to a plan of termination, and communicates the termination arrangement to the employees, or over the future service period, if any. Other costs associated with exit activities may include contract termination costs, including costs related to leased facilities to be abandoned or subleased, and facility and employee relocation costs. In addition, a portion of the Company’s restructuring costs are outside the U.S. related to expected employees terminations. The Company is required to record a liability for this cost when it is probable that it will incur the costs and can reasonably estimate the amount.
In addition, for acquisitions prior to January 1, 2009, the Company accounts for costs to exit an activity of an acquired company and involuntary employee termination benefits associated with acquired businesses in the purchase price allocation of the acquired business if a plan to exit an activity of an acquired company exists, and those costs have no future economic benefit to the Company and will be incurred as a direct result of the exit plan. Any reserves established in the TeT acquisition are adjusted through goodwill.
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Advertising Costs
Advertising costs are expensed as incurred and totaled $0.4 million, $0.1 million and $0.3 million for the years ended December 31, 2010, 2009 and 2008, respectively.
Stock-Based Compensation
The Company recognizes compensation expense over the requisite service period for the fair-value of stock options and related awards. For stock options with graded vesting terms, the Company recognizes compensation cost over the requisite service period using the accelerated method. The fair value of stock-based awards are estimated at the date of grant using key assumptions such as future stock price volatility, expected terms, risk-free interest rates and the expected dividend yield. In addition, the Company estimates the expected forfeiture rate of the Company’s stock grants and only recognizes the expense for those shares expected to vest.
Foreign Currency
Assets and liabilities of subsidiaries operating outside the U.S. with a functional currency other than the U.S. Dollar are translated into U.S. Dollars using year-end exchange rates. Revenue, costs and expenses are translated at the average exchange rates in effect during the year. Foreign currency translation gains and losses are included as a component of accumulated other comprehensive loss.
For subsidiaries operating outside the U.S. where the functional currency is the U.S. Dollar, monetary assets and liabilities denominated in local currency are remeasured at year-end exchange rates whereas non-monetary assets, including inventories and property, plant and equipment, are reflected at historical rates. Revenue, costs and expenses are translated at the monthly average exchange rates in effect during the year. Any gains or losses from foreign currency remeasurement are included in foreign currency gain or loss in the consolidated statements of operations.
Income Taxes
Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax laws (including rates) is recognized in income in the period that includes the enactment date. See Note 16 regarding the valuation reserve against the Company’s deferred tax assets.
The Company does not provide for federal income taxes on the undistributed earnings of its international subsidiaries because earnings are reinvested and, in the opinion of management, will continue to be reinvested indefinitely.
Income (Loss) Per Share
Basic income (loss) per share is computed by dividing net income (loss) by the weighted-average number of common shares outstanding during the period. Diluted income (loss) per share reflects the potential dilution that could occur if the income were divided by the weighted-average number of common shares outstanding and potentially dilutive common shares from outstanding stock options and warrants. Potentially dilutive common shares are calculated using the treasury stock method and represent incremental shares issuable upon exercise of the Company’s outstanding options and warrants. Antidilutive securities not included in the dilutive earnings per share calculations for 2010 amounted to 14,955,114. Due to losses in 2009 and 2008, potentially dilutive securities are not included in the calculation of dilutive loss per share as their impact would be anti-dilutive. In those years, excluded options and warrants amounted to 15,593,654 and 15,007,528, respectively. The following table reconciles the weighted average shares used in computing basic and diluted income (loss) per share in the respective years:
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Derivative Financial Instruments
The Company does not acquire, hold or issue derivative financial instruments for trading purposes. Derivative financial instruments are used to manage foreign exchange and interest rate risks that arise out of the Company’s core business activities.
Derivative financial instruments used to manage foreign exchange risk were designated as hedging instruments for hedges of foreign currency exposure of the Company’s net investment in foreign operations. The primary objective of the Company’s hedging strategy is to protect its net investments in foreign subsidiaries and certain accounts receivable that are exposed to volatility in foreign currency exchange rates. In March 2009, the Company suspended hedging activities due to the cost of entering into forward contracts, the possible short term cash requirements for forward contract payables, along with the inability to repatriate cash from foreign countries on a short term basis to offset any hedge forward contract payable. Prior to the decision to suspend hedging in March 2009, the Company hedged the translation of its net investment in foreign subsidiaries in an attempt to neutralize the effect of translation gains or losses in the statement of operations.
Comprehensive Income (Loss)
Comprehensive income (loss) represents net income (loss) for the year adjusted for changes in stockholders’ equity from non-stockholder sources. Accumulated comprehensive income (loss) items typically include currency translation and the impact of the Company’s pension liability adjustment, net of tax.
Impact of Recently Issued Accounting Pronouncements
In June 2009, the FASB issued authoritative guidance on the consolidation of variable interest entities (“VIE”). This new guidance significantly affects the overall consolidation analysis. The Company adopted this guidance in the first quarter of fiscal 2010. The adoption of this guidance did not have a material impact on the Company’s consolidated financial position, results of operations or cash flows.
In October 2009, the FASB issued amendments to the accounting and disclosure for revenue recognition. These amendments, effective for fiscal years beginning on or after June 15, 2010 (early adoption is permitted), modify the criteria for recognizing revenue in multiple element arrangements and the scope of what constitutes a non-software deliverable. The implementation of these amendments is not expected to have a material impact on the Company’s consolidated financial position, results of operations or cash flows.
In January 2010, the FASB issued amendments that require additional fair value disclosures. These disclosure requirements became effective for interim and annual periods beginning after December 15, 2009, except for the gross presentation of the Level 3 roll forward, which is required for annual reporting periods beginning after December 15, 2010 and for interim reporting periods within those years. These amended standards do not significantly impact the Company’s consolidated financial position, results of operations or cash flows.
In January 2010, the FASB issued authoritative guidance to amend the accounting and reporting requirements for decreases in ownership of a subsidiary. This guidance requires that a decrease in the ownership interest of a subsidiary that does not result in a change of control be treated as an equity transaction. The guidance also expands the disclosure requirements about the deconsolidation of a subsidiary. The Company adopted this guidance in 2010 and it did not have a material impact on its financial statements.
In December 2010, the FASB issued authoritative guidance that modifies the requirements of step 1 of the goodwill impairment test for reporting units with zero or negative carrying amounts. This guidance is effective for fiscal years beginning after December 15, 2010. The implementation of this guidance is not expected to have a material impact on the Company’s consolidated financial position, results of operations or cash flows.
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3. Business Acquisitions and Others
Thales e-Transactions
On April 1, 2008, the Company acquired the TeT business line to expand the Company’s geographic reach in Europe and increase the Company’s size and scale, with the expectation of accelerating product cost reductions given the convergence towards a single, combined product family.
The consideration paid to acquire TeT was $150.5 million in cash. To fund a portion of the acquisition price, the Company entered into a credit agreement with Francisco Partners, which provided funding of $60.0 million. See Note 12 for additional information related to this credit agreement.
The purchase price consisted of the following (dollars in thousands):
On December 18, 2009, the Company agreed to settle amounts owed under the TeT acquisition agreement for a cash payment of approximately $4.1 million. The Company included $3.1 million as part of the purchase price and $1.0 million of professional fees for accounting and tax services provided to Thales had been expensed as incurred in 2008. On December 28, 2009, the Company paid $2.1 million of the settlement amount and the remaining $2.0 million was paid on January 8, 2010.
The acquisition was accounted for as a purchase business combination and accordingly, the results of TeT’s operations are included in the Company’s consolidated results from the date of the acquisition.
Under the purchase method of accounting, the total estimated purchase price as shown in the table above is allocated to TeT’s tangible and intangible assets acquired and liabilities assumed. The excess of the purchase price over the net tangible and intangible assets is recorded as goodwill, which will not be deductible for tax purposes.
The purchase price allocation is as follows (dollars in thousands):
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Intangible Assets. TeT’s customer relationships are represented through a distribution network of banks, distributors and retailers through which TeT sells the majority of its products and services. The Company expects to amortize the fair value of these assets over an average estimated life of five to ten years.
Supplier relationships represent third party manufacturing relationships through which the majority of TeT products are produced. The Company expects to amortize the fair value of these assets over an average estimated life of four years.
Product technology includes TeT products, principally the Artema product line. TeT technology and products are designed for hardware, software, solutions and services, serving the European markets. The Company expects to amortize the developed and core technology and patents over an average estimated life of two years.
The fair value of intangible assets was determined using an income approach, based on discussions with TeT management and a review of certain transaction-related documents and forecasts prepared by the Company and TeT management. The rate utilized to discount net cash flows to their present values is 19%. This discount rate was determined after consideration of the Company’s weighted average cost of capital specific to this transaction and the assets being purchased.
Estimated useful lives for the intangible assets were based on historical experience with technology life cycles, product roadmaps, branding strategy, historical and projected maintenance renewal rates, historical treatment of the Company’s acquisition-related intangible assets and the Company’s intended future use of the intangible assets. Deferred tax liabilities in the amount of $20.6 million were recorded based upon conclusions regarding the tax positions that were taken.
Of the total $74.2 million of intangible assets, $62.7 million was reported in NEMEA and $11.5 million in SEMEA. Intangible assets in these business segments are subject to translation adjustment for currency changes.
Goodwill. Of the total purchase price, approximately $80.0 million was allocated to goodwill. Goodwill represents the excess of the purchase price of an acquired business over the fair value of the underlying net tangible and intangible assets. Goodwill is not amortized but instead is tested for impairment at least annually (more frequently if certain indicators are present). In the event that the management of the combined company determines that the value of goodwill has become impaired, the combined company will incur an accounting charge for the amount of impairment during the fiscal quarter in which the determination is made. See Note 4 for a discussion of impairment charges related to the Company’s goodwill and intangible assets.
The following represents the actual results of operations for the year ended December 31, 2010, 2009 and proforma results for 2008 which and gives effect to the acquisition of TeT as if the acquisition was consummated at the beginning of fiscal year 2008. The unaudited pro forma results of operations for 2008 are not necessarily indicative of what would have occurred had the acquisition been made as of the beginning of the period or of the results that may occur in the future. Net loss includes additional interest expense of $2.4 million and amortization of intangible assets related to the acquisition of $2.8 million for the first quarter of 2008 (dollars in thousands, except for per share data):
Sale of Majority Interest in HBNet, Inc.
On February 17, 2010, the Company and The McDonnell Group formed a new venture, Phoenix Managed Networks, LLC (“PMN”), which equips payment processors, banks and retailers worldwide with highly reliable and cost-effective data communications services for transaction-based applications. In this transaction, an affiliate of The McDonnell Group contributed $1.0 million to PMN in consideration for which it received preferred membership interests in PMN representing 60% of PMN’s outstanding preferred interests. At the same time, the Company’s wholly-owned subsidiary, Hypercom U.S.A., Inc. (“HYC USA”), contributed certain assets, including all of the outstanding membership interests of HYC USA’s wholly-owned subsidiary, HBNet, Inc. (“HBNet”), to PMN in consideration for which HYC USA received preferred membership interests in PMN representing the remaining 40% of PMN’s outstanding preferred interests and $1.0 million in cash. For accounting purposes, the Company treated this transaction as a sale of 60% of its interest in HBNet to The McDonnell Group in exchange for $1.0 million, and a contribution of its other 40% interest in HBNet to PMN in exchange for a 40% interest in PMN. As a result, the Company recorded a gain of $0.7 million during the year ended December 31, 2010 from the sale of the 60% interest in HBNet. The excess of the cash received over the gain recorded ($0.3 million) was applied to reduce the net book value of the Company’s remaining investment in HBNet to $0.2 million, which was then exchanged for the Company’s 40% equity investment in PMN. The investment in PMN is included in other long-term assets in the Company’s consolidated balance sheet as of December 31, 2010, and is accounted for under the equity method of accounting.
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4. Intangible Assets and Goodwill
Intangible assets consist of the following at December 31, 2010 and 2009 (dollars in thousands):
Amortization of these intangibles is provided on the straight-line method over their estimated useful lives:
In 2008, the Company determined that $8.8 million of intangible assets were impaired. Of the total write-down, $2.4 million was related to the Company’s 2006 acquisition of TPI and $6.4 million from its 2008 acquisition of TeT. The Company performed the impairment test for these assets primarily due to the decline in its stock price that caused its book value to exceed its market capitalization, which was an indication that these assets may not be recoverable. The primary reason for these impairment charges relates to economic conditions and ongoing operations, which has caused the Company to reduce its estimates of projected cash flows.
Amortization expense related to intangible assets used in continuing operations was $7.6 million, $9.7 million and $9.9 million for the years ended December 31, 2010, 2009 and 2008, respectively. Based on the intangible assets recorded at December 31, 2010, and assuming no subsequent impairment of the underlying assets, the annual amortization expense for each period, is expected to be as follows: $7.0 million for 2011, $7.3 million for 2012, $6.4 million for 2013, $6.4 million for 2014 and $6.2 in 2015.
Activity related to goodwill consisted of the following at December 31, 2010 and December 31, 2009 (dollars in thousands):
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The goodwill adjustment was due to a reduction of the severance and other termination benefits that were initially accrued in connection with the Company’s acquisition of TeT in 2008.
During the fourth quarter of 2008, the Company concluded that the current economic environment and the significant declines in its market capitalization compared to its net book value represented significant adverse events, and therefore, management evaluated goodwill and long-lived assets for impairment as of December 31, 2008. In evaluating goodwill and long-lived assets for recoverability, estimates of after-tax undiscounted future cash flows of the Company’s individual reporting units were compared to the carrying value of the reporting units. As quoted market prices are unavailable for individual reporting units, fair value was determined by discounting estimated future cash flows. The estimated cash flows used to assess recoverability of long-lived assets and measure fair value of reporting units were derived from current business plans developed using near-term and long term management projections. The asset impairment evaluations, including the annual goodwill impairment test, required management to make several assumptions in determining estimates of future cash flows to determine fair value of the individual reporting units, including near and long-term revenue and cost assumptions.
The evaluation of goodwill resulted in the recognition of asset impairment charges totaling $59.0 million for 2008, primarily related to the assets acquired in the TeT acquisition on April 1, 2008. Of the total amount, $4.0 million related to the 2006 acquisition of TPI, $4.5 million related the 2007 acquisition of ACG and, $50.5 million related to the 2008 acquisition of TeT. The primary reason for these impairment charges relates to the economic recession, which has caused the Company to reduce its estimates for projected cash flows, has reduced overall industry valuations, and caused an increase in discount rates in the credit and equity markets.
Of the total $67.8 million impairment of goodwill and intangible assets, $6.4 million was reported in the Americas, $4.5 million in Asia-Pacific, $24.4 million in NEMEA, and $32.5 million in SEMEA.
The Company completed its annual goodwill impairment test as of December 31, 2010 and 2009 and concluded no impairment charge was required.
5. Restructuring and Other Charges
2010 Restructuring
In 2010, we incurred employee severance and related charges as a result of the following initiatives:
·
Reorganization of our service businesses in Australia and Brazil;
·
Reorganization of our operations in Asia-Pacific; and
·
Reorganization of our management team in our offices in Arizona, Mexico and the Caribbean.
The following table summarizes these charges and activities during the year ended December 31, 2010 (dollars in thousands):
As a result of these actions, the Company incurred charges of $2.5 million in 2010. Of the $2.5 million, $0.6 million was recorded in costs of revenue and $1.9 million was recorded in operating expenses. Of the $2.5 million, $0.8 million was recorded in the Americas, $1.0 million in SEMEA, $0.5 million in Asia-Pacific, and $0.2 million in Shared Cost Centers.
The Company expects to pay the accrued severance and benefits related charges in 2011. The amounts recorded and the additional restructuring charges the Company expects to incur are subject to change based on the negotiation of severance with employees and related work groups.
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Thales e-Transactions Restructuring
On April 1, 2008, the Company completed the acquisition of TeT and began formulating a restructuring plan. At the acquisition date, the Company accrued into the purchase price allocation restructuring costs related to reduction in workforce and future facilities lease obligations of approximately $9.1 million. The balance at December 31, 2010 was $0.5 million.
Activities of the restructuring balance related to the TeT acquisition are as follows (dollars in thousands):
Based on the Company’s current negotiations with workers councils in Europe, the Company expects the remaining amounts accrued to be paid in 2011. The amounts recorded are subject to change based on further negotiation of severance amounts to be paid.
2009 Business Restructuring
In 2009, the Company incurred employee severance and benefits-related charges as a result of the following initiatives:
·
Reorganization of the Company’s service businesses in Australia and Brazil;
·
Consolidation of the Company’s United Kingdom operations in the Salisbury facility, resulting in the closing of the Woking facility;
·
Reorganization of the Company’s operations in Asia-Pacific;
·
Reorganization of the Company’s management team in its offices in Arizona, Mexico and the Caribbean; and
·
Reorganization of the Company’s research and development activities in Europe.
As a result of these actions, the Company incurred charges of $3.0 million in 2009. Of the $3.0 million, $1.3 million was recorded in costs of revenue and $1.7 million was recorded in operating expenses. Of the $3.0 million, $1.2 million was recorded in the Americas, $0.4 million in SEMEA, $0.1 million in NEMEA, $0.2 million in Asia-Pacific, and $1.1 million in Shared Cost Centers.
2008 Business Restructuring
During the second quarter of 2008, the Company accrued the remaining lease termination and severance costs related to the exit out of its manufacturing facility in China. The total costs of the lease termination and severance costs of $0.5 million were recorded in costs of revenue in Asia-Pacific. The Company paid the cost during the third quarter of 2008.
6. Discontinued Operations and Assets Held for Sale
European Lease and Service Operation
During the fourth quarter of 2009, the Company made the decision to sell a European lease and service operation, which qualifies as discontinued operations. Accordingly, the lease and service business operating results have been classified as discontinued operations in the statements of operations and cash flows for all periods presented. General corporate overhead costs have not been allocated to discontinued operations. A summary of the operating results for the years ended December 31, 2010 and 2009 included in discontinued operations in the accompanying consolidated statements of operations is as follows (dollars in thousands):
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A summary of the assets and liabilities held for sale related to this European lease and service operation is as follows (dollars in thousands):
The Company expects to complete the sale during the second quarter of 2011.
Brazilian building
On April 19, 2010, the Company sold its Brazilian building for consideration of R$8.6 million Brazilian Reais (approximately $4.6 million U.S. Dollars), receiving R$2.9 million Brazilian Reais, or $1.7 million U.S. Dollars, upon execution of the sales agreement. The remainder was expected to be received in installments of 40% and 30% within 180 days and 270 days, respectively, of the signing of the sales agreement. The Company entered into a leaseback transaction with the buyer to allow for a transition of the Company’s services operations for a period of three months that ended on July 19, 2010.
The payment expected on October 20, 2010 was not received. The Company has deferred the potential gain related to the sale as of December 31, 2010. The gain will be recognized once the Company no longer has continuing involvement in the building, the buyer’s initial and continuing investments are adequate to demonstrate a commitment to pay for the property, and collectability of the remaining amounts due are reasonably assured either by collection of the majority of the receivable or when the Company is assured the amounts due are not subject to future subordination from a bank or other lender. The net book value of the building was $1.9 million and is classified as assets held for sale in the Company’s consolidated balance sheets as of December 31, 2010 and December 31, 2009, respectively. The $1.7 million received has been recorded as deferred revenue in the Company’s consolidated balance sheet as of December 31, 2010.
Australian Courier Business
On March 1, 2009, the Company sold its small courier business in Australia (“Australian Courier Business”) that was acquired in 2007. The Australian Courier Business qualified as discontinued operations and accordingly, the income (loss) from discontinued operations includes direct revenue and direct expenses of this operation. General corporate overhead costs have not been allocated to discontinued operations. A summary of the operating results at December 31 included in discontinued operations in the accompanying consolidated statements of operations is as follows (dollars in thousands):
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Effective March 1, 2009, the Company sold the Australian Courier Business for $0.3 million. The sale agreement includes all related rights and obligations of the Australian Courier Business. The sale agreement contains general warranty and indemnification provisions, which could result in additional liabilities to the Company if certain events occur or fail to occur in the future.
The Australian Courier Business was fully divested as of December 31, 2009; as such, no results of operations were included in discontinued operations in 2010.
U.K. Lease Portfolio
During the fourth quarter of 2005, the Company made the decision to sell its U.K. leasing business (the “U.K. Lease Business”). As of December 31, 2005, the U.K. Lease Business qualified as discontinued operations. The U.K. Lease Business operating results have been classified as discontinued operations in the statements of operations and cash flows for all periods presented.
Effective May 31, 2006, the Company sold the U.K. Lease Business for $12.1 million (the “U.K. Lease Sale”). The U.K. Lease Sale includes the lease arrangements with merchants and all related obligations and rights to payment under such agreements. The U.K. Lease Sale agreement contains covenants and indemnification provisions, which could result in additional liabilities to the Company if certain events occur or fail to occur in the future. A summary of the operating results at December 31 included in discontinued operations in the accompanying consolidated statements of operations is as follows (dollars in thousands):
7. Leases
Sales-Type Leases
The Company’s net investment in sales-type leases consist of the following at December 31, 2010 and 2009 (dollars in thousands):
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Future minimum payments to be received under sales-type leases are as follows (dollars in thousands):
8. Fair Value Measurements
The accounting framework for determining fair value includes a hierarchy for ranking the quality and reliability of the information used to measure fair value, which enables the reader of the financial statements to assess the inputs used to develop those measurements. The fair value hierarchy consists of three tiers as follows: Level 1, defined as quoted market prices in active markets for identical assets or liabilities; Level 2, defined as inputs other than Level 1 that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, model-based valuation techniques for which all significant assumptions are observable in the market, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities; and Level 3, defined as unobservable inputs that are not corroborated by market data.
The Company’s cash and cash equivalents were measured at fair value consist of the following at December 31, 2010 (dollars in thousands):
9. Inventories
Inventories consist of the following at December 31, 2010 and 2009 (dollars in thousands):
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10. Property, Plant and Equipment, net
Property, plant and equipment consist of the following at December 31, 2010 and 2009 (dollars in thousands):
Depreciation expense from continuing operations, which includes depreciation for assets under capital lease, was $9.6 million, $9.4 million and $8.8 million for the years ended December 31, 2010, 2009 and 2008, respectively.
Accumulated depreciation for equipment leased to customers amounted to $0.1 million for the years ended December 31, 2010 and 2009, respectively.
In 2010, the Company sold its Brazilian building (see Note 6). The net book value of the building at December 31, 2010 and 2009 was $1.9 million. The net book value is classified as current portion of assets held for sale as of December 31, 2010 and 2009. The net book value is included in property, plant and equipment, net by country in the segment and geographic information as disclosed in Note 21.
11. Product Warranty Liability
The following table reconciles the changes to the product warranty liability for the years ended December 31, 2010 and 2009 (dollars in thousands):
Deferred revenue associated with the Company’s extended warranty programs was $3.9 million and $3.5 million at December 31, 2010 and 2009, respectively.
12. Long-term Debt
Revolving Credit Facilities
On January 15, 2008, the Company and certain of its subsidiaries (the “Borrowers”) entered into a Loan and Security Agreement (the “Loan Agreement”) with a bank and other financial institutions party to the Loan Agreement. The bank also serves as agent for the lenders under the Loan Agreement (the “Agent”). The Loan Agreement provides for a revolving credit facility of up to $25.0 million. Under the Loan Agreement, if certain conditions are met, the Company may request an increase in the credit facility to an aggregate total of up to $40.0 million. Amounts borrowed under the Loan Agreement and repaid or prepaid during the term may be reborrowed. Outstanding amounts under the Loan Agreement bore interest, at the Company’s option, at either: (i) LIBOR plus 175 basis points; or (ii) the bank’s prime rate. All amounts outstanding under the Loan Agreement were due on January 15, 2011.
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Availability of borrowings and the issuance of letters of credit under the Loan Agreement are subject to a borrowing base calculation based upon a valuation of the Company’s eligible inventories (including raw materials, finished and semi-finished goods, and certain in-transit inventory) and eligible accounts receivable, each multiplied by an applicable advance rate.
On February 10, 2010, the Loan Agreement was amended to allow the Company to enter into a transaction between our former subsidiary, HBNet, and The McDonnell Group, as well as making additional changes, including, among others, providing for the outstanding amounts under the Loan Agreement to now bear interest, at the Company’s option, at either: (i) LIBOR plus 200 or 250 basis points; or (ii) the bank’s prime rate plus 50 or 75 basis points depending on certain financial ratios. In addition, the borrowing base was amended to eliminate inventory from the borrowing base calculation.
On December 30, 2010, the Loan Agreement was further amended whereby all amounts outstanding are now due on January 14, 2012. In addition, the revolving credit facility under the Loan Agreement is set at a maximum of up to $25.0 million (previously up to $40.0 million if certain conditions were met). No amounts were borrowed against the line of credit as of December 31, 2010. The Company had availability of $19.2 million as of December 31, 2010, which was decreased by outstanding letters of credit totaling $3.1 million at December 31, 2010.
In addition to representations and warranties, covenants, conditions and other terms customary for instruments of this type, the Loan Agreement includes negative covenants that prohibit the Company from, among other things, incurring certain types of indebtedness (excluding indebtedness secured by certain assets of the Company and its subsidiaries in an aggregate amount not to exceed $50.0 million for working capital purposes), making annual capital expenditures in excess of proscribed amounts, or disposing of certain assets. The Loan Agreement provides for customary events of default, including failure to pay any principal or interest when due, failure to comply with covenants, any representation made by the Company that is incorrect in any material respect, certain defaults relating to other material indebtedness, certain insolvency and receivership events affecting the Company, judgments in excess of $2.5 million in the aggregate being rendered against the Company, and the incurrence of certain liabilities under the Employee Retirement Income Security Act (“ERISA”) in excess of $1.0 million in the aggregate.
In the event of a default by the Borrowers, the Agent may, at the direction of the lenders, terminate the lenders’ commitments to make loans under the Loan Agreement, declare the obligations under the Loan Agreement immediately due and payable and enforce any and all rights of the lenders or Agent under the Loan Agreement and related documents. For certain events of default related to insolvency and receivership, the commitments of the lenders are automatically terminated and all outstanding obligations become immediately due and payable. The obligations of the Company under the Loan Agreement are secured by its inventory and accounts receivable of certain of the Company’s subsidiaries in the U.S. and the U.K. The remaining balance of the Company’s consolidated assets, including the subsidiaries acquired in connection with the TeT acquisition, is unencumbered under the Loan Agreement and, if needed, may be used as collateral for additional debt. The Company’s obligations as guarantor under the Loan Agreement are unsecured.
Acquisition Financing
In February 2008, in connection with the acquisition of TeT, the Company entered into a credit agreement (the “Credit Agreement”) with Francisco Partners (“FP II”) pursuant to a commitment letter dated December 20, 2007 between the Company and Francisco Partners. See Note 2 for additional information related to the TeT acquisition. The Credit Agreement provided for a loan of up to $60.0 million to partially fund the acquisition at closing. The loan under the Credit Agreement bears interest at 10% per annum, provided that, at the election of the Company, interest may be capitalized and added to the principal of the loan to be repaid at maturity. The loan was funded on April 1, 2008 by an affiliate of Francisco Partners, FP Hypercom Holdco, LLC. All amounts outstanding under the Credit Agreement are due four years from the funding date. On funding of the loan under the Credit Agreement and the closing of the acquisition, the lender was granted a five-year warrant to purchase approximately 10.5 million shares (the “Warrant”) of the Company’s common stock at $5.00 per share. The Warrant contains a cashless exercise provision that can be utilized by the lender at its sole option. The cashless exercise provision permits the lender, in lieu of making the cash payment otherwise contemplated to be made to the Company upon exercise of the Warrant in whole or in part, to receive upon such exercise the “net number” of shares of the Company’s common stock determined according to the agreement. In the event the lender elects a cashless exercise of the Warrant, the Company will not receive any cash payment for the shares delivered to the lender pursuant to such cashless exercise.
The estimated fair value of the Warrant at the date issued was $1.68 per share using a Black-Scholes option pricing model. The valuation date for the Warrant was February 14, 2008, when all relevant terms and conditions of the debt agreement had been reached. The total fair value of the Warrant of $17.8 million was recorded as a discount to the acquisition financing and has been recognized in equity as additional paid in capital. The loan discount is being amortized as interest expense over the life of the loan and totaled $5.1 million and $3.8 million for the years ended December 31, 2010 and 2009.
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In accordance with the loan agreement, the Company added to the loan balance interest of $6.9 million and $6.7 million during 2010 and 2009.
In addition to representations and warranties, covenants, conditions and other terms customary for instruments of this type, the Credit Agreement includes negative covenants that prohibit the Company from, among other things, incurring certain types of indebtedness, granting liens on assets, engaging in transactions with affiliates and disposing of certain assets. The Credit Agreement provides for customary events of default, including failure to pay any principal or interest when due, failure to comply with covenants, any representation made by the Company that is incorrect in any material respect, certain defaults relating to other material indebtedness, certain insolvency and receivership events affecting the Company, judgments in excess of $3.0 million in the aggregate being rendered against the Company, and the incurrence of certain ERISA liabilities in excess of $5.0 million in the aggregate.
In the event of a default by the Company, the Lender may declare the obligations under the Credit Agreement immediately due and payable and enforce any and all of its rights under the Credit Agreement and related documents.
The Company’s long term debts are classified within a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1), then to significant observable inputs (Level 2) and the lowest priority to significant unobservable inputs (Level 3). See Note 8 for further discussion of the different levels of the fair value hierarchy. The Company’s long-term debt meets the criteria described for Level 2, and fair value approximates the $67.2 million book value at December 31, 2010.
Long-term debt consisted of the following at December 31, 2010 and 2009 (dollars in thousands):
For the year ended December 31, 2010, the Company made early principal repayments of long-term debt totaling $8.0 million to FP II and recorded $1.2 million of interest expense to write-off portions of unamortized warrant discount related to the amounts paid.
Representatives for FP II hold two Board of Director positions of the Company as of December 31, 2010.
13. Stock-Based Compensation
The following table summarizes stock-based compensation expense included in the consolidated statements of operations for December 31, 2010, 2009 and 2008 (dollars in thousands):
Stock-based compensation expense included zero, zero, and $0.1 million of payroll tax paid on behalf of employees that received stock awards during the years ended December 31, 2010, 2009 and 2008, respectively.
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As of December 31, 2010, total unrecognized compensation cost, net of forfeiture, related to stock-based options and awards was $5.0 million and the related weighted-average period over which it is expected to be recognized is approximately 1.6 years.
Stock Options
At December 31, 2010, the Company had one active stock-based employee compensation plan. Stock option awards granted from this plan are granted at the fair market value on the date of grant, vest over a period determined at the time the options are granted, generally ranging from one to five years, and generally have a maximum term of ten years. For stock options with graded vesting terms, the Company recognizes compensation cost over the requisite service period on the accelerated method.
A summary of stock option activity within the Company’s stock-based compensation plans and changes for the year ended December 31, 2010 is as follows:
The aggregate intrinsic value of options exercised during the years ended December 31, 2010, 2009 and 2008 was $2.7 million, zero, and $0.2 million, respectively.
The key assumptions used in the Black-Scholes valuation model to calculate the fair value are as follows:
The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions, including the expected stock price volatility. Because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options. The risk-free interest rate is based on the U.S. treasury security rate in effect as of the date of grant. The expected lives of options and stock price volatility are based on historical data of the Company. The weighted average fair value of options granted in the years ended December 31, 2010, 2009 and 2008 were $3.07, $0.97 and $1.81, respectively.
Stockholder Rights Plan
On September 29, 2010, in connection with an unsolicited, non-binding acquisition proposal from VeriFone, the Company’s Board of Directors (the “Board”) adopted a Stockholder Rights Plan that provides for the distribution of one right for each share of common stock outstanding. Each right entitles the holder to purchase one one-thousandth (1/1000th) of a share of Series A Junior Participating Preferred Stock, par value $0.001 per share, of the Company (the “Preferred Stock”) at a price of $25.02 per one one-thousandth of a share of Preferred Stock, subject to adjustment. The rights generally become exercisable at the discretion of the Board following a public announcement that 15% or more of the Company’s common stock has been acquired or an intent to acquire has become apparent. The rights will expire on September 29, 2015, unless the final expiration date is advanced or extended or unless the rights are earlier redeemed or exchanged by the Company. Further description and terms of the rights are set forth in the Rights Agreement between the Company and Computershare Trust Company, N.A., (“the Rights Agent”).
On November 17, 2010, Hypercom entered into a definitive merger agreement with VeriFone by which VeriFone will acquire Hypercom in an all-stock transaction. In connection with the merger agreement, Hypercom and the Rights Agent entered into an amendment (the “Amendment”) to the Stockholder Rights Plan that provides that the Preferred Stock purchase rights issued under the Stockholder Rights Plan will be inapplicable to the VeriFone merger, the merger agreement, and the transactions contemplated by the merger agreement.
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Restricted Stock Awards
The Company grants restricted stock awards (“RSAs”) to certain employees, which are valued at the closing market value of the Company’s common stock on the date of grant, and the total value of the award is expensed using the accelerated method. Share-based compensation expense related to all RSAs outstanding in 2010, 2009, and 2008 was approximately $2.5 million, $0.2 million and $0.4 million, respectively. As of December 31, 2010, the total amount of unrecognized compensation cost, net of forfeitures, related to nonvested RSAs was approximately $2.1 million, which is expected to be recognized over a weighted-average period of one year. Compensation expense with respect to the grants could be reduced or reversed to the extent employees receiving the grants leave the Company prior to vesting in the award.
A summary of nonvested restricted stock activity for the years ended December 31, 2010, 2009 and 2008 is as follows:
The total value of restricted shares vested during the years ended December 31, 2010, 2009 and 2008 was $0.7 million, $0.3 and $0.5 million, respectively.
14. Stockholders' Equity
In 1997, the Board adopted and the stockholders of the Company approved the Hypercom Corporation Long-Term Incentive Plan, which was amended in 2001 (the “1997 Plan”), to allocate a total of 6,000,000 shares of common stock for issuance at the Company’s discretion. The 1997 Plan authorizes issuance of “incentive stock options” (as defined by the Internal Revenue Code of 1986), non-qualified stock options, stock appreciation rights, RSAs, performance share awards, dividend equivalent awards and other stock-based awards. Stock options issued under the 1997 Plan become exercisable over a period determined by the Board (generally over two to five years) and expire after a period determined by the Board (generally ten years after the date of grant).
In 2000, the Board approved the Hypercom Corporation 2000 Broad-Based Stock Incentive Plan, which was amended in 2002 (the “2000 Plan”), to allocate 7,000,000 shares of common stock for issuance at the Company’s discretion. The 2000 Plan authorizes the issuance of non-qualified stock options and RSAs, the majority of which must be issued to employees of the Company who are not officers or directors. Non-qualified stock options issued under the 2000 Plan become exercisable over a period determined by the Board (generally over two to five years), and expire after a period determined by the Board (generally ten years after the date of grant).
In 2010, the Board and the stockholders of the Company approved the Hypercom Corporation 2010 Equity Incentive Plan (the “2010 Plan”) to allocate 5.1 million shares of common stock for issuance, as well as the addition of up to 0.9 million shares that remained available for issuance under the Company’s predecessor plans (the 1997 Plan and 2000 Plan), for issuance at the Company’s discretion. The 2010 Plan authorizes the issuance of “incentive stock options” (as defined by the Internal Revenue Code of 1986), non-qualified stock options, stock appreciation rights, RSAs, performance share awards, dividend equivalent awards and other stock-based awards. Stock options issued under the 2010 Plan become exercisable over a period determined by the Board (generally over one to five years), and expire after a period determined by the Board (generally ten years after the date of grant). The 1997 Plan and 2000 Plan were terminated per the terms of the 2010 Plan; however, outstanding equity awards issued under such predecessor plans remain subject to the provisions of those plans.
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Subsequent to year end, substantially all of the outstanding stock options and RSAs will be dilutive in the first quarter of 2011, based on the Company’s weighted average stock price. In connection with the merger agreement as described in Note 1, the Company is precluded from issuing any stock-based compensation with the exception of shares available under the employee stock purchase plan.
Stock Options
A summary of the Company’s stock option activity, including stock options issued under the Directors Plan, defined below, and related information for the years ended December 31, 2010, 2009 and 2008 is as follows:
The following table summarizes additional information about the Company's stock options outstanding as of December 31, 2010:
Stock Warrants
In connection with the funding of the Acquisition Financing, the Company granted the lender a warrant to purchase approximately 10.5 million shares of the Company’s common stock at $5.00 per share. See further discussion in Note 13. The warrant expires on April 1, 2013.
Employee Stock Purchase Plan
In 1997, the Board adopted and the stockholders of the Company approved the Employee Stock Purchase Plan (the “Purchase Plan”). The Purchase Plan was subsequently amended and restated in its entirety in 2008 upon adoption by the Board and approval by the Company’s stockholders. The Purchase Plan allows eligible employees of the Company to purchase shares of the Company’s common stock through periodic payroll deductions every three months. At the end of each offering period, payroll deductions for the offering period are used to purchase shares of common stock for each participant’s account at a price equal to 85% of the fair market value of the common stock on either the first or last day of the offering period, whichever is less. Payroll deductions under the Purchase Plan are limited to 10% of each eligible employee’s earnings during the offering period, and no single participant will be granted an option to purchase shares with a value in excess of $25,000 for each calendar year. The Board has reserved 625,000 shares of common stock for issuance under the Purchase Plan, subject to adjustment in the event of a stock split, reverse stock split, stock dividend or similar event. Under the Purchase Plan, for the years ended December 31, 2010, 2009, and 2008 the Company sold 63,461, 159,561, and 59,997 shares to employees at weighted average prices of $2.58, $1.19, and $2.30, respectively. At the end of December 31, 2010, the Company had a balance of 81,165 shares of common stock available for issuance under the Purchase Plan.
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The Company’s Purchase Plan is considered compensatory. During the years ended December 31, 2010, 2009 and 2008, the Company recorded compensation expense of $60,000, $61,938, and $59,000, respectively, related to the Purchase Plan.
Directors' Stock Plan
In 1997, the Board adopted and the stockholders of the Company approved the Hypercom Corporation Nonemployee Directors’ Stock Option Plan, which was amended in 2002 and 2006 (the “Directors Plan”). The Directors Plan is administered by a committee appointed by the Board and provides for an initial grant to each Nonemployee Director of an option to purchase 15,000 shares of Common Stock; thereafter, each Nonemployee Director will receive an annual grant of an option to purchase 15,000 shares of Common Stock. The aggregate number of shares of Common Stock subject to the Directors Plan may not exceed 600,000, subject to adjustment in the event of a stock split, reverse stock split, stock dividend or similar event. Options granted under the Directors Plan are fully vested and become fully exercisable on the first anniversary of the date of grant and have a term of ten years. The exercise price per share under the Director Plan is equal to the fair market value of such shares upon the date of grant. In general, options may be exercised by payment in cash or a cash equivalent, and/or previously acquired shares having a fair market value at the time of exercise equal to the total option exercise price.
Stock Repurchase
In August 2003, the Board authorized a stock repurchase program to allow the purchase of up to $10.0 million of the Company’s common stock. In November 2005, the Board authorized a stock repurchase program to purchase up to $20.0 million of the Company’s common stock. When treasury shares are issued, the Company uses a first-in, first-out method and any excess of repurchase costs over the reissue price is treated as a reduction of paid in capital. Any excess of reissue price over repurchase cost is treated as an increase to paid-in capital.
During 2006, the Company purchased 1,346,628 shares of its common stock for $10.7 million. In 2010, the Company purchased 34,105 shares of its common stock for $0.04 million due to the cashless exercise of RSAs by employees. The repurchased shares were recorded as treasury stock and resulted in a reduction to stockholder’s equity. The timing and amount of any future repurchases will depend on market conditions and corporate considerations.
Preferred Stock
The Company is authorized to issue 10,000,000 shares of $0.001 par value preferred stock. As of December 31, 2010 and 2009, there were no preferred shares outstanding.
15. Brazilian Health Ministry Contract
The Company has been involved in a long-term contract with the Brazilian Health Ministry requiring substantial delivery of customized software and hardware. Revenue and a resulting margin under this contract were recorded based on the achievement of contract milestones approved by the Brazilian Health Ministry. The margin for the entire contract was estimated to be 9%. Inherent in this margin was an expectation of realizing all amounts owed under the terms of the original contract and recovering claims for additional contract revenue, due to changes in the scope of the contract and additional currency exchange variation adjustments. Scope changes involved expanding the overall design specifications requiring additional hours and administration costs. The currency adjustments represented the inflation of cost on imported equipment caused by currency movements. At the end of 2003, the Company formally presented a claim to the Brazilian Health Ministry detailing the amount and nature of the scope changes and currency variation impact. The Company did not recognize revenue above the original contract amount, and contract costs associated with the scope changes and currency adjustments amounting to $11.3 million were deferred in anticipation of recognizing contract revenue. Due to the lack of timely acknowledgement and acceptance of the pending claim, the Company recorded a charge to operations for the deferred costs during the year ended December 31, 2004.
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There were no amounts collected from the Brazilian Health Ministry during 2010, 2009, and 2008, however, since 2004 the Company has actively pursued discussions with the Brazilian Health Ministry regarding both the collection of the contract costs as well as renewal of the maintenance element of the contract; however, there is no certainty as to how much will ultimately be collected, whether revenue for work previously done will be recorded or if the maintenance element of the contract will ultimately be extended.
16. Income Taxes
Loss before income taxes and discontinued operations consisted of the following for the years ended December 31, 2010, 2009 and 2008 (dollars in thousands):
The (provision) benefit for income taxes for the years ended December 31, 2010, 2009 and 2008 consisted of the following (dollars in thousands):
A reconciliation of the U.S. federal statutory income tax rate to the Company’s effective tax rate for the years ended December 31, 2010, 2009 and 2008 is as follows:
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Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the Company’s deferred tax assets and liabilities at December 31, 2010 and 2009 are as follows (dollars in thousands):
For the year ended December 31, 2010, the Company’s current valuation allowance increased by $6.6 million, primarily related to increases of the inventory and compensation accruals. The Company’s non-current valuation allowance decreased by $8.9 million, primarily related to the decrease of the U.S. tax loss carryforwards. The Company does not expect to realize its deferred tax assets through expected future taxable profits and has recorded a valuation allowance for all U.S. federal and state deferred tax assets and the majority of its foreign deferred tax assets. The valuation allowance is subject to reversal in future years at such time as the benefits are actually utilized or the operating profits become sustainable.
At December 31, 2010, the Company has a gross deferred tax asset of $21.2 million associated with its U.S. federal and state tax net operating loss carryforwards of $60.7 million. The U.S. federal and state net operating loss carryforwards will begin to expire in 2020 through 2028 if not previously utilized. The Company’s ability to utilize its net operating losses may be restricted due to statutory “ownership changes” (as defined for purposes of Section 382 of the Internal Revenue Code).
As of December 31, 2010, the Company has a gross deferred tax asset of $26.1 million associated with foreign net operating loss carryforwards of $84.6 million. The foreign net operating loss carryforwards begin to expire in various periods if not previously utilized.
At December 31, 2010, the Company had a liability for uncertain tax positions of $3.2 million that, if recognized, would favorably affect the Company’s tax position, and $43.8 million of unrecognized tax benefits, the realization of which would be offset by an increase in the valuation allowance. The Company does not expect there will be any material changes in its unrecognized tax positions over the next year. A reconciliation of the beginning and ending amount of unrecognized tax benefits for the years ended December 31, 2010 and 2009 is as follows (dollars in thousands):
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The Company and its subsidiaries file income tax returns in the U.S. federal jurisdiction, and various states and foreign jurisdictions. With few exceptions, the Company is no longer subject to U.S. federal, state and local, or non-U.S. income tax examinations by tax authorities for years prior to 2000. The Company’s policy is to recognize interest and penalties related to unrecognized tax benefits as part of the tax provision. Accrued interest and penalties are $1.0 million and $0.4 million respectively at December 31, 2010. The Company believes that it has appropriate support for the income tax positions taken and to be taken on its tax returns and that its accruals for tax liabilities are adequate for all open years based on an assessment of many factors including past experience and interpretations of tax law applied to the facts of each matter.
It is reasonably possible that the amount of unrecognized tax exposures for the Company will decrease within the next year by $1.3 million relating to income tax exposure in various foreign jurisdictions as the statute of limitations will expire. The anticipated reduction is based on the Company’s ongoing assessment of the administrative practices and precedents of the taxing authorities in the respective foreign jurisdictions.
Undistributed earnings of the Company’s foreign subsidiaries total $12.7 million at December 31, 2010 and management considers these earnings to be permanently reinvested. Accordingly, no provision for U.S. federal and state income taxes or foreign withholding taxes has been provided. Determination of the potential amount of unrecognized deferred federal and state income tax liability and foreign withholding taxes is not practicable because of the complexities associated with its hypothetical calculation; however, unrecognized foreign tax credits would be available to reduce some portion of the federal liability.
17. Benefit Plans
Defined Benefit Plan
In conjunction with the acquisition of TeT, the Company assumed pension plans for eligible employees in Germany and France. Benefits are based primarily on a benefits multiplier and years of service. The Company had no defined benefit plan or pension expenses prior to the acquisition of TeT.
The expected long-term rate of return on plan assets is updated annually taking into consideration the related asset allocation, historical returns on the types of assets held in the plan, and the current economic environment. Based on these factors, the Company expects its plan assets to earn a long-term rate of return of 4.5%. Actual year-by-year returns can deviate substantially from the long-term expected return assumption. However, over time it is expected that the amount of over performance will equal the amount of underperformance. Changes in the mix of plan assets could impact the amount of recorded pension income or expense, the funded status of the plan and the need for future cash contributions. The discount rates used to calculate the expected present value of future benefit obligations as of December 31, 2010 ranged from 4.75% to 5.15%. The Company periodically reviews the plan asset mix, benchmark discount rate, expected rate of return and other actuarial assumptions and adjusts them as deemed necessary.
The Company recognizes the funded status of a defined benefit postretirement plan as an asset or liability in its balance sheet and the changes in that funded status is recognized in other comprehensive income in the year in which the changes occur. The funded status of a defined benefit pension plan is measured as the difference between plan assets at fair value and the plan’s projected benefit obligation.
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The following table shows a reconciliation of changes in the plans’ benefit obligation and plan assets for the year ended December 31, 2010 and 2009 and a reconciliation of the funded status with amounts recognized in the consolidated balance sheets as of December 31, 2010 and 2009 (dollars in thousands):
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The components of net periodic benefit cost and other amounts recognized in other accumulated comprehensive loss at December 31, 2010 and 2009 are as follows (dollars in thousands):
As of December 31, 2010, the average expected future working lifetime for each participant of the plans ranges from 12 to 22 years.
The Company’s weighted-average assumptions used to determine net periodic benefit cost for the years ended December 31, 2010 and 2009 are as follows:
The Company modifies important assumptions when changing conditions warrant. The discount rate is typically changed at least annually and the expected long-term rate of return on plan assets will typically be revised every three to five years. Other material assumptions include the rates of employee termination and rates of participant mortality.
The discount rate was determined by projecting the plans expected future benefit payments as defined for the projected benefit obligation, discounting those expected payments using a theoretical zero-coupon spot yield curve derived from a universe of high-quality bonds as of the measurement date, and solving for the single equivalent discount rate that resulted in the same projected benefit obligation.
The expected return on plan assets was determined based on historical and expected future returns of the various asset classes, using the target allocations described below.
The expected long-term rate of return on pension assets is selected by taking into account the expected duration of the Projected Benefit Obligation (“PBO”) for the plan, and the asset mix of the plan. The rate of return is earned over the period until the benefits represented by the current PBO are paid. The expected return on plan assets is based on the Company’s expectation of historical long-term average rates of return on the different asset classes held in the pension fund. This is reflective of the current and projected asset mix of the funds and considers the historical returns earned on the Company’s asset allocation and the duration of the plan liabilities. Thus, the Company has taken a historical approach to the development of the expected return on asset assumption. The Company believes that fundamental changes in the markets cannot be predicted over the long-term. Rather, historical returns, realized across numerous economic cycles, should be representative of the market return expectations applicable to the funding of a long-term benefit obligation.
The Company’s plan assets are classified within a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1), then to significant observable inputs (Level 2) and the lowest priority to significant unobservable inputs (Level 3). See Note 8 for further discussion of the different levels of the fair value hierarchy.
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The Company’s fair value of pension plan assets at December 31, 2010 is as follows (dollars in thousands):
In determining the asset allocation, the investment manager recognizes the Company’s desire for funding and expense stability, the long-term nature of the pension obligation and current and projected cash needs for retiree benefit payments. The pension fund is actively managed within the target asset allocation ranges.
The plan invests in a variety of asset classes to diversify its assets. The plan’s assets are currently invested in a variety of funds representing most standard equity and debt security classes. While no significant changes in the asset allocation are expected during the upcoming year, the Company may make changes at any time.
As of December 31, 2010, the Company’s pension plan assets did not hold any direct investment in the Company’s common stock.
The following estimated future benefit payments, including future benefit accrual, which reflect expected future service, as appropriate, are expected to be paid (dollars in thousands):
Funding requirements for subsequent years are uncertain and will significantly depend on whether the plan’s actuary changes any assumptions used to calculate plan funding levels, the actual return on plan assets, changes in the employee groups covered by the plan, and any legislative or regulatory changes affecting plan funding requirements. While the current market conditions could have an adverse effect on the plan investments, any additional required contribution is not expected to have a material effect on the consolidated financial statements. The Company expects to fund additional contributions from its cash balances and operating cash flows. For tax planning, financial planning, cash flow management or cost reduction purposes, the Company may increase, accelerate, decrease or delay contributions to the plan to the extent permitted by law.
18. Profit Sharing Plan
The Company has a 401(k) profit sharing plan (the “401(k) Plan”), which commenced in fiscal 1998, covering all eligible full-time employees of the Company. Contributions to the 401(k) Plan are made by the participants to their individual accounts through payroll withholding. Additionally, the 401(k) Plan provides for the Company to make profit sharing contributions in amounts at the discretion of management. The employer contribution was $0.1 million for each of the years ended December 31, 2010, 2009 and 2008.
19. Commitments and Contingencies
Lease Commitments
The Company leases office and warehouse space, equipment and vehicles under non-cancelable operating leases. The office space leases provide for annual rent payments, plus a share of taxes, insurance and maintenance on the properties.
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Future minimum payments under operating leases are as follows (dollars in thousands):
Rental expense from continuing operations amounted to $6.2 million, $5.6 million and $6.7 million for the years ended December 31, 2010, 2009, and 2008, respectively.
Litigation
The Company is currently a party to various legal proceedings, including those noted below. While the Company presently believes that the ultimate outcome of these proceedings, individually and in the aggregate, will not have a material adverse affect on the Company’s financial position, results of operations or cash flows, litigation is subject to inherent uncertainties, and unfavorable rulings could occur. An unfavorable ruling could include monetary damages or, in cases where injunctive relief is sought, an injunction. Were an unfavorable ruling to occur, it is possible such a ruling could have a material adverse impact on the Company’s consolidated results of operations or financial position in the period in which the ruling occurs or in future periods.
Brazil Tax and Labor Contingencies. The Company’s operations in Brazil are involved in various litigation matters and have received or been the subject of numerous governmental assessments related to indirect and other taxes, as well as disputes associated with former Company employees and employees of various service providers with whom the Company had contracted. The tax matters, which comprise a significant portion of the contingencies, principally relate to claims for taxes on the transfers of inventory, municipal service taxes on rentals and gross revenue taxes. The Company is disputing these tax matters and intends to vigorously defend our positions. The labor matters principally relate to claims made by former Company employees and by former employees of various vendors that provided contracted services to the Company and who are now asserting that under Brazil law the Company should be liable for the vendors’ failure to pay wages, social security and other related labor benefits, as well as related tax obligations, as if the vendor’s employees had been employees of the Company. As of December 31, 2010, the total amounts related to the reserved portion of the tax and labor contingencies was $0.7 million and the unreserved portion of the tax and labor contingencies amounted totaled approximately $25.7 million. With respect to the unreserved balance, these have been assessed by management as being either remote or possible as to the likelihood of ultimately resulting in a loss to the Company. Local laws and regulations often require that the Company to make deposits or post other security in connection with such proceedings. As of December 31, 2010 we had $5.2 million of deposits in Brazil regarding claims that we are disputing, liens on certain Brazilian assets as discussed in Note 6 with a net book value of $1.9 million, and approximately $3.5 million in letters of credit, all providing security with respect to these matters. Generally, any deposits would be refundable and any liens would be removed to the extent the matters are resolved in our favor. We routinely assess these matters as to probability of ultimately incurring a liability against our Brazilian operations and record our best estimate of the ultimate loss in situations where we assess the likelihood of an ultimate loss as probable. An unfavorable outcome could have a material adverse effect on the Company’s business, financial condition, results of operations, and cash flows.
CardSoft, Inc., et al. v. Hypercom Corporation, et al. (United States District Court for the Eastern District of Texas, Marshall Division, Civil Action No. 2:08-CV-00098, filed on March 6, 2008) . CardSoft, Inc. and CardSoft (Assignment for the Benefit of Creditors), LLC (collectively “CardSoft”) filed this action against the Company and others in March 2008, alleging that certain of the Company’s terminal products infringe two patents allegedly owned by CardSoft: U.S. Patent No. 6,934,945 (the “‘945 Patent”), entitled “Method and Apparatus for Controlling Communications,” issued on August 23, 2005, and U.S. Patent No. 7,302,683 (the “‘683 Patent”), also entitled “Method and Apparatus for Controlling Communications,” issued on November 27, 2007, which is a continuation of the ‘945 patent. CardSoft is seeking a judgment of infringement, an injunction against further infringement, damages, interest and attorneys’ fees. In June 2008, the Company filed its answer, denying liability on the basis of a lack of infringement, invalidity of the ‘945 Patent and the ‘683 Patent, laches, waiver, equitable estoppel and unclean hands, lack of damages and failure to state a claim. The Company also counterclaimed seeking a declaratory judgment of non-infringement and invalidity of the ‘945 Patent and the ‘683 Patent. The Markman hearing is scheduled for July 20, 2011 and trial is scheduled for November 7, 2011. This action is currently in the discovery stage and, as CardSoft has not made a specific claim for damages, the Company is unable to assess its range of potential loss, nor is it possible to quantify the extent of the Company’s potential liability, if any, related to this action. An unfavorable outcome could have a material adverse effect on the Company’s business, financial condition, results of operations, and cash flows.
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Lisa Shipley v. Hypercom Corporation. (United States District Court for the Northern District of Georgia, Civil Action No. 1:09-CV-0265, filed on January 30, 2009) . Lisa Shipley (“Shipley”), a former employee, filed this action against the Company in January 2009, alleging that the Company violated Title VII of the Civil Rights Act by discriminating against her on the basis of her gender, violated the Georgia Wage Payment laws, the Equal Pay Act and Georgia law by paying her lower compensation based on her gender. Ms. Shipley is seeking compensatory damages for emotional distress, damage to reputation, embarrassment, lost wages, back pay, accrued interest, punitive damages, attorney’s fees and expenses, and interest. In February 2009, the Company filed a motion to dismiss based on improper venue or, in the alternative, to transfer venue to the United States District Court for the District of Arizona. In June 2009, the Court denied the motion. In June 2009, the Company filed its answer, generally denying the material allegations of Ms. Shipley’s complaint. In October 2009, Ms. Shipley filed an amended complaint adding an allegation that the Company unlawfully retaliated against her. In November 2009, the Company filed its answer, denying the material allegations of the amended complaint. In February 2010, the Company filed a Motion for Judgment on the Pleadings as to Ms. Shipley's retaliation claim, which the Court subsequently denied. On July 19, 2010, we filed a motion for summary judgment on all claims. On February 15, 2011, the magistrate judge recommended that the Court grant our motion for summary judgment as to Ms. Shipley’s sexual harassment hostile work environment claim, the constructive discharge claim, and the Georgia wage payment statute claim, but denied our motion for summary judgment as to her disparate treatment, retaliation, Equal Pay Act and Georgia Sex Discrimination in Employment Act claims. On March 2, 2011, we filed a motion for leave to file a motion for partial summary judgment out of time seeking summary judgment on seven components of Ms. Shipley’s disparate treatment Title VII claim. On March 8, 2011, the Court denied the Company’s motion for leave to file a motion for partial summary judgment out of time. This action is in the discovery stage and, as Ms. Shipley has not made a specific claim for damages, the Company is unable to assess its range of potential loss, nor is it possible to quantify the extent of the Company’s potential liability, if any, related to this action. An unfavorable outcome could have a material adverse effect on the Company’s business, financial condition, results of operations, and cash flows.
Shareholder Class Action and Derivative Lawsuits. Commencing shortly after VeriFone publicly announced on September 30, 2010 that it had made an offer to acquire Hypercom and continuing following the announcement by the Company and VeriFone on November 17, 2010 that the Company had entered into a definitive merger agreement, certain putative class action lawsuits were filed in Arizona and Delaware state courts alleging variously, among other things, that the board of directors of Hypercom breached its fiduciary duties in connection with the merger and that VeriFone, Honey Acquisition Co., Hypercom, FP Hypercom Holdco, LLC, and Francisco Partners II, L.P. aided and abetted that alleged breach. These actions include: Gerber v. Hypercom, Delaware Court of Chancery, Case no. CA5868 (“Gerber”); Anarkat v. Hypercom, Maricopa County Superior Court, CV2010-032482 (“Anarkat”); Small v. Hypercom Corporation, Delaware Court of Chancery, Case no. CA6031 (Small”); Grayson v. Hypercom Corporation, Delaware Court of Chancery, Case no. CA6044 (Grayson”); and The Silverstein Living Trust v. Hypercom Corporation, Maricopa County Superior Court, Case no. CV2010-030941 (Silverstein”). The Anarkat and Silverstein cases have been consolidated in Maricopa County Superior Court as In Re Hypercom Corporation Shareholder Litigation, Lead Case No. CV2010-032482, and the Small and Grayson cases have been consolidated in the Delaware Court of Chancery as In Re Hypercom Corporation Shareholders Litigation, Consolidated C.A. No. 6031-VCL (the “Actions”). The Gerber case is dormant as the plaintiffs in that case have not prosecuted it since it was filed. On February 14, 2011, counsel for the plaintiffs and defendants in the Actions executed a Memorandum of Understanding (the “Memorandum”) pursuant to which (i) the Company provided additional disclosures recommended by the plaintiffs to supplement its proxy statement filed with the Securities and Exchange Commission, (ii) the defendants agreed to provide plaintiffs’ counsel with reasonable confirmatory discovery regarding the fairness and adequacy of the settlement and the additional disclosures, and (iii) the parties agreed to use their best efforts to execute and present to the court a formal stipulation of settlement within 45 days seeking court approval of (a) the settlement and dismissal of the Actions with prejudice, (b) the stay of all proceedings in the Actions, (c) the conditional certification of the Actions as a class action under Arizona law, (d) the release of all claims against the parties, (e) the defendants’ payment of $510,000 to the plaintiffs’ counsel for their fees and expenses, (f) the defendants’ responsibility for providing notice of the settlement to members of the class, and (g) the dismissal of the Delaware actions following the court’s final approval of the settlement. While the defendants deny that they have committed any violations of law or breaches of duties to the plaintiffs, the class or anyone else, and believe that their disclosures in the proxy statement regarding the merger were appropriate and adequate under applicable law, the defendants entered into the settlement solely to eliminate the uncertainty, distraction, burden and expense of further litigation and to lessen the risk of any delay of the closing of the merger as a result of the litigation. The defendants have agreed that the payment to the plaintiffs’ counsel will be jointly funded equally by VeriFone and the carrier of Hypercom’s directors and officers liability insurance policy, while the Company will bear the cost of the $250,000 deductible amount under the insurance policy.
20. Concentrations of Credit and Other Risks
Financial Instruments
The Company’s financial instruments that are exposed to concentrations of credit risk consist primarily of cash and cash equivalents, accounts receivable and short-term investments.
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The Company’s cash and cash equivalents and short-term investments are maintained with major, high-quality international banks and financial institutions. Generally, these securities are traded in a highly liquid market, may be redeemed upon demand and bear minimal risk. Management regularly monitors the composition and maturities of these investments and the Company has not experienced any material loss on its investments. Cash and cash equivalents at times may exceed the FDIC limits. The Company believes that no significant concentration of credit risk exists with respect to these cash investments.
The Company’s accounts receivable primarily result from credit sales to a broad customer base, both nationally and internationally, with a concentration generally existing among five to ten customers. The Company’s top five customers amounted to 26.5%, 19.0% and 22.1% of the Company’s total revenue for the years ended December 31, 2010, 2009 and 2008, respectively. These same five customers accounted for 25.3% and 14.2% of the Company’s net accounts receivable balance at December 31, 2010 and 2009, respectively. Sales to the Company’s largest customer totaled 10.6%, 5.2% and 6.2% of total revenue in 2010, 2009 and 2008, respectively.
The Company routinely assesses the financial strength of its customers, requiring letters of credit from certain foreign customers, and provides an allowance for doubtful accounts as necessary.
Inventories
The Company’s entire inventory is purchased from third party manufacturers that are considered to be outside sources. The failure of any such third party manufacturer to meet its commitment on schedule could have a material adverse effect on the Company’s business, operating results and financial condition. If a sole-source supplier were to go out of business or otherwise become unable to meet its supply commitments, the process of locating and qualifying alternate sources could require up to several months, during which time the Company’s production could be delayed. Such delays could have a material adverse effect on the Company’s business, operating results and financial condition.
All of the Company’s third party manufacturers are located in foreign jurisdictions and are subject to certain risks, including the imposition of tariffs and import and export controls, together with changes in governmental policies. The occurrence of any of these events could have a material adverse effect on the Company’s business, operating results and financial condition.
The Company estimates inventory provisions for potentially excess and obsolete inventory on a part level basis based on forecasted demand and historical usage. Actual demand may differ from such anticipated demand and may have a material adverse effect on inventory valuation.
International Operations
The Company’s international business is an important contributor to the Company’s net revenue and operating results. However, a substantial portion of the Company’s international sales are denominated in the U.S. Dollar, and an increase in the value of the U.S. Dollar relative to foreign currencies could make products sold internationally less competitive. The operating expenses of the Company’s overseas offices are paid in local currencies and are subject to the effects of fluctuations in foreign currency exchange rates.
The Company maintained significant accounts receivable balances outside of the U.S. comprising 81.3% and 78.3%, respectively, of the Company’s net accounts receivable balance at December 31, 2010 and 2009. These balances are subject to the economic risks inherent to those regions.
21. Segment, Geographic, and Customer Information
During the fourth quarter of 2008, the Company initiated organizational changes and made enhancements to its internal management reporting and in 2009 began to report information pertaining to its four business segments: (i) the Americas, (ii) NEMEA, (iii) SEMEA and (iv) Asia-Pacific. The countries in the Americas consist of the United States, Canada, Mexico, the Caribbean, Central America, and South America. The countries in the NEMEA segment consist of Belgium, Sweden, Turkey, Austria and Germany. The countries in the SEMEA segment consist of France, Spain, the United Kingdom, countries within Western and Central Eastern Europe, Russia, Hungary, the Middle East, and Africa. The countries in the Asia-Pacific segment consist of China, Hong Kong, Indonesia, the Philippines, Singapore, Thailand, Australia, and New Zealand.
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The Company’s Chief Operating Decision Maker (“CODM”) is its CEO. The CODM has access to discrete financial information for each of its business segments regarding revenue, gross margins (using fully burdened manufacturing costs), direct local service costs, direct operating expenses consisting of expenses directly associated with the business segment, and indirect operating expenses consisting of global shared cost centers such as global R&D, marketing, corporate general and administrative expenses, and stock-based compensation. The Company operations are managed by the Managing Directors for each business segment that report directly to the CEO and have responsibility for all business activities and combined operating results of their respective business segments. These individuals are compensated and evaluated based on the performance (Direct Trading Profit) of their business segment. Operating income also includes amortization of purchased intangible assets.
The Company’s goodwill by business segment is as follows (dollars in thousands):
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The Company’s intangible assets by business segment are as follows (dollars in thousands):
The Company’s depreciation and amortization of property, plant, and equipment and acquired intangible assets are as follows (dollars in thousands):
The Company’s impairment of goodwill and intangible assets is as follows (dollars in thousands):
The following table presents net sales by country based on the location of the Company’s customers:
One customer exceeded 10% of the Company’s consolidated net revenue in 2010, of which the majority is included in the Americas segment. There were no customers that exceeded 10% of the Company’s consolidated net revenue in 2009 or 2008.
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The following table presents long-lived assets that cannot be readily removed:
There were no other country outside of the United States with long-lived assets that cannot be readily removed with a net book value of greater than 10% of total property, plant and equipment, net as of December 31, 2010, 2009 and 2008.
22. Supplemental Cash Flow Information
Supplemental cash flow information for the years ended December 31, 2010, 2009 and 2008 is as follows (dollars in thousands):
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Discontinued Operations:
Year 2010. The net cash provided by operating activities primarily relates to a European lease and service operation and was due to its operating activities for the year.
Year 2009. The net cash provided by operating activities primarily relates to a European lease and service operation and was due to its operating activities for the year.
Year 2008. The net cash provided by operating activities relates to the Company’s Australian Courier Business and a European lease and service operation and was due to its operating activities for the year.
23. Interim Financial Results (Unaudited)
The following tables set forth certain unaudited consolidated financial information for each of the four quarters in the years ended December 31, 2010 and 2009. In management's opinion, this unaudited quarterly information has been prepared on the same basis as the audited consolidated financial statements and includes all necessary adjustments, consisting only of normal recurring adjustments that management considers necessary for a fair presentation of the unaudited quarterly results when read in conjunction with the Consolidated Financial Statements and Notes. The Company believes that quarter-to-quarter comparisons of its financial results are not necessarily meaningful and should not be relied upon as an indication of future performance (dollars in thousands, except per share data).
(1) The summation of quarterly net income per share may not equate to the calculation for the full fiscal year as quarterly calculations are performed on a discrete basis where securities may have an anti-dilutive effect during individual quarters but not for the full year.
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EXHIBIT INDEX
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*
Filed herewith.
**
Furnished herewith.
***
Management or compensatory plan or agreement.
†
Certain Confidential Information contained in this Exhibit was omitted by means of redacting a portion of the text and replacing it with an asterisk. This Exhibit has been filed separately with the Secretary of the Securities and Exchange Commission without the redaction pursuant to Confidential Treatment Request under Rule 24b-2 of the Securities Exchange Act of 1934, as amended.
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