NCR Voyix Corp Q3 FY2020 Earnings Call

Good day, ladies and gentlemen, and welcome to today’s NCR Corporation’s Third Quarter Fiscal Year 2020 Earnings Call. A quick reminder that today’s conference is being recorded. And at this time, I would like to turn the floor over to Mr. Michael Nelson, the Vice President of Investor Relations. Please go ahead, sir.

Good afternoon and thank you for joining our third quarter earnings call. Joining me on the call today are Mike Hayford, President and CEO; Owen Sullivan, COO; and Tim Oliver, CFO. Before we get started, let me remind you that our presentation and discussions will include forward-looking statements. These statements reflect our current expectations and beliefs, but they’re subject to risks and uncertainties that could cause actual results to differ materially from those expectations. These risks and uncertainties are described in our earnings release and our periodic filings with the SEC, including our Annual Report. On today’s call, we will also be discussing certain non-GAAP financial measures. These non-GAAP measures are described and reconciled to their GAAP counterparts in the presentation materials, the press release dated October 27, 2020 and on the Investor Relations page of our website. A replay of this call will be available later today on our website, ncr.com. With that, I would now like to turn the call over to Mike.

Thanks, Michael and thank you everyone for joining us today. I will begin with an overview of our third quarter performance and an update on our progress executing against our strategic initiatives. Before turning it over to Tim, who will review our third quarter financial numbers, then Owen, Tim and I will take your questions. I’ll begin on Slide 4 with the highlights from the third quarter. NCR delivered solid performance despite the current business and operating challenges that continue to be impacted by COVID-19. Our teams have continued to show resiliency in these unprecedented times and continue to focus on taking care of our customers. On our last call, I noted that NCR would start shifting management attention from the pandemic and instead get more focused on growing our business during the second half of 2020 versus the first half of the year. In the third quarter, we have successfully taken steps down that path. First, one of the primary highlights of the third quarter was our strong free cash flow generation. We delivered $150 million of free cash flow in the quarter and $299 million of free cash flow through the first three quarters of the year. Tim will discuss in more detail the drivers of our strong free cash flow production. Second, we expanded EBITDA margin to 15.7% in the third quarter, which represents an increase of 220 basis points from the second quarter, and an increase of 10 basis points from the third quarter of 2019. As we discussed on our second quarter earnings call when the pandemic began, we focused on reducing cash costs. In the third quarter, we began to execute the productivity improvement initiatives that were temporarily sidelined by the pandemic. These initiatives are focused on reducing recurring costs to drive margin expansion and our performance in the third quarter is the result of some of these early actions we have taken. Third, we delivered 7% recurring revenue growth in the third quarter. This marked our third consecutive quarter delivering that level of year-over-year growth, which speaks to the steady progress we are making generating increased recurring revenue, which is consistent with our 80/60/20 goals. Fourth, we began taking steps to reduce our leverage and simplify our capital structure while also maintaining a strong liquidity position. Tim will speak to this in his remarks. And finally, while we don’t expect a near-term end to the COVID-19 pandemic, we are adjusting to this new environment for both our customers and our NCR team. We continue to expect impacts to our business with hardware sales to be the most challenged. Now, moving to Slide 5. We have forged ahead executing our strategy despite unprecedented market disruption. We have added new customers, deepened our relationship with existing customers and continued to invest in our strategic growth products like digital banking, Aloha Essentials; Emerald, our retail cloud POS; and payments. We will continue to focus on a transformation to drive NCR as-a-Service and achieve our 80/60/20 strategic goals. In the third quarter, software and services were 71% of our total revenues and 53% of our revenues were recurring. EBITDA margin was 15.7%. In banking, we continue to have positive momentum in our digital banking platform with six new customers signed in the third quarter. We’ve also had success cross-selling existing clients with new products, including 12 business banking deals done in the quarter. Also, in the quarter, our digital banking registered users increased 12% to more than 24 million on a year-over-year basis. We are also having increased success shifting our banking software revenue to recurring revenues, both software historically attached to an ATM sale as well as software unrelated to an ATM sale. In the third quarter, we signed nearly 250 banking deals to a recurring revenue model that previously would have been sold as an upfront software license. One example is a top five U.S. bank that recently agreed to a multi-year recurring software agreement to move to our Activate Enterprise, NextGen platform to modernize their software stack that serves a multi-vendor ATM environment. In retail, we are seeing increased adoption of our self-checkout solutions. We experienced demand across customers and geographies as consumer preferences accelerate. We continue to be excited about the sales funnel of our Emerald offering, which is our next-gen, cloud-based retail point-of-sale solution. In hospitality, the momentum of Aloha Essentials, which bundles software, services, hardware and payments continued in the third quarter. This model is proving itself in our ability to attract new customers, as well as better service existing customers. During the third quarter, roughly 80% of all SMB Aloha sites sold through our direct offices were sold as a subscription bundle, with payments attach rate also strong at roughly 80% for sales into new sites. As we drive the transformation of our business, we will strive to be even more efficient and effective stewards of our resources. We continue to focus on taking care of our customers, advancing our product capabilities with investments in our strategic growth platforms and continuing to strive to improve our productivity. With that, let me pass the call over to Tim.

Thank you, Mike and thanks to all of you on the phone for tuning in today. As it’s been our practice, my comments will again presume a constant currency adjustment that removes the impact of foreign exchange. So, this quarter currency had only a minor impact. Starting then on Slide 6, which presents a top level overview of our third quarter financial performance, as you can see, we added a rolling five-quarter view to these metrics. While they typically focus on year-over-year comparisons, the significant disruption to economic activity caused by the pandemic may overwhelm typical seasonality and make sequential comparisons illustrative at least for the next couple of quarters. Starting in the top left, consolidated revenue was $1.59 billion, down $194 million or 11% versus the 2019 third quarter. As expected, revenue was negatively impacted by the broader economic pause, but the year-over-year decline did improve from the second quarter and in fact, revenue was up 7% versus our second quarter results. We will dig into the more specific drivers of the decline by business unit, but in aggregate, $165 million or 85% of that decline is attributable to lower hardware revenue, which was down 26%. As Mike described in his remarks, our continued effort to shift to recurring revenue streams again accelerated sequentially. We shifted $27 million or over 1.5 points of revenue that previously would have been booked upfront as a perpetual sale to a recurring revenue stream. This compares to just $11 million in last year’s third quarter or $22 million in this year’s second quarter. Sequentially, all of our business units showed growth and impressively revenue in our retail business was actually up year-over-year. In the top right, adjusted EBITDA decreased $29 million, or 10% year-over-year to $249 million in line with the revenue decline and we were able to expand EBITDA margin rate by 10 basis points to 15.7%. Sequentially, adjusted EBITDA grew 24% and EBITDA margin rate extended by 220 basis points. This expansion was the result of cost reductions we initiated during the second quarter, but that reached their full impact in Q3. As Mike mentioned, we have now begun to drive significant productivity improvement initiatives across the entire organization that were planned for the spring, but were delayed by the pandemic. And while actions taken in Q2, like salary reductions and discretionary spending constraints were immediate and significant, they’re of a more temporary nature. Our ongoing productivity efforts are more permanent and of larger magnitude, which will assure sustainable margin expansion even at pandemic levels of revenue. Similar to discussion of revenue, the shift to recurring revenue was an important descriptor of our relative EBITDA results. $21 million of adjusted EBITDA did shift out of the quarter, accompanying the respective revenue shift. This compares to $7 million in the year-ago Q3 and $18 million sequentially from Q2. In the bottom left, non-GAAP EPS was $0.54, down $0.19 in the prior year third quarter and double the $0.27 we posted in Q2. The tax rate of 15% for Q3 declined due to lower annual income and the relative size and timing of discrete tax benefits within the year. And finally, and maybe most importantly, we delivered an exceptionally strong $150 million of free cash flow versus $57 million in the year-ago quarter. This increase is due primarily to an increased focus on working capital improvements particularly on past-due receivables, on cash cycle linearity, and on raw and finished goods inventory. Year-to-date, our free cash flow generation is $299 million versus a use of cash of $27 million through the first three quarters of last year. Moving to slide 7, which describes our Banking segment results. Banking revenue decreased $165 million or 17%, mainly driven by a 40% decline in ATM hardware sales. Our hardware sales remain soft due to the banks' pandemic spending constraints. Remember that we also are comparing to a very extraordinary quarter in last year’s third quarter, where ATM sales were up 60%. On an absolute basis, ATM hardware sales seem to have settled into a relatively consistent range of $200 million to $250 million per quarter and we anticipate this range will persist at least for the next couple of quarters. Most of the remaining decline in banking revenue can be attributed to the service revenue associated with a forgone installation of those new machines and the continued expansion of our recurring revenue model. Excluding the decline in new ATM hardware and the directly related revenues, our remaining banking businesses would have shown modest growth year-over-year. Operating income decreased $47 million or 32% and operating margin rate dropped by 280 basis points to 12.7%. These declines were driven by lower revenue and the resulting unabsorbed costs, partially offset by lower discretionary spending and other caution that was put in place earlier in the year. Operating expenses were down 4%. On a sequential basis, revenue was up 2% and operating margin expanded by 60 basis points. Moving to slide 8, which shows our retail segment results. Retail revenue increased $17 million or 2%. Last quarter, we discussed the delay for installing self-checkout units at several of our largest customers, as many of these customers were too busy operating their stores during the pandemic to undertake an installation project. As anticipated, these orders were delayed and not canceled. In the third quarter, we delivered some of those orders. As a result, self-checkout revenue experienced strong double-digit growth. In concert with revenue, operating income was up $9 million or 25%. The increase was driven by higher revenue, as well as by discretionary spending and cost initiatives taken earlier this year. Operating expenses were down 7%. On a sequential basis, revenue was up 15% and operating margin expanded by 460 basis points. Turning to slide 9, slide 9 shows our Hospitality segment results. Hospitality revenue decreased $43 million or 20%, driven primarily by lower hardware sales. As expected, our Hospitality segment has been the most impacted by the coronavirus with capacity limitations and changes to our customers’ behaviors. Third quarter operating income declined $3 million, mainly due to the flow-through impact from lower revenue while we were able to reduce operating expenses by 17% with our cost initiatives. Prudently higher reserves on accounts receivable offset some of those savings. On a sequential basis, revenue was up 8% and operating margin expanded by 400 basis points. Turning to slide 10, we provide our third quarter revenue results under our previous operating segments for both continuity and color. Software revenue decreased $44 million or 9% due to the shift from one-time to recurring revenue, lower sales attached to new hardware and challenging conditions for our hospitality business. Services revenue increased $15 million or 3%, driven by an increase in recurring services revenue including hardware maintenance, managed services, and digital connected services revenues, all partially offset by lower installation revenues. And finally, as I mentioned previously, hardware revenue was most impacted in the quarter by the pandemic declining $165 million or 26%. ATM revenue declined 40% while the combination of self-checkout and point-of-sale declined 7%. Software and services as a percentage of total company revenue increased to 71% from 65% in Q3 of 2019, admittedly in large part due to lower hardware sales. Recurring revenues increased $50 million or 7%, driven by a programmatic effort to shift our sales away from single sales events, characterized by perpetual licensing and uncertain service revenues to predictable multi-year commitments with relatively high certainty of revenue generation. This quarter’s improvement came from shifting our professional services contracts to provide more standard ready services, shifting our software licenses to term licenses that include appropriate termination clauses and providing more services in the cloud. Recurring revenue, as a percentage of total company revenue, increased to 53% from 45%, also benefiting from lower hardware sales. On slide 11, we present free cash flow, net debt, and adjusted EBITDA metrics. As I mentioned earlier, we were very pleased with our performance on the cash side. Free cash flow was $150 million for the quarter, which was a significant improvement from the $57 million in the prior year. Year-to-date free cash flow of $299 million, up from a use of $21 million in the prior year. Our efforts to improve working capital and drive more linearity in our annual cash flow generation are working well. This slide also shows our net debt-to-adjusted EBITDA metric with a net debt leverage ratio of 3.1 times, which is consistent with last quarter, and with the prior year. As you know, at the end of March, we drew down over $600 million on our revolver. In the beginning of April, we issued a $400 million bond as a precautionary measure to de-risk our balance sheet and ensure financial flexibility in uncertain times. The cumulative effect of all those actions was a very solid balance sheet with sufficient liquidity and no significant near-term debt maturities. We ended the third quarter with $1.6 billion of cash, having already reduced our term note debt by $200 million. Since that time, we’ve executed a couple of other transactions to delever, which I’ll update on the next slide. We remain well within our debt covenants, and ended the third quarter with credit facility leverage of approximately 3.3 times, well under our debt covenant maximum of 4.75 times. And my last slide is slide 12, which provides a description of the three different, but related redeployments of excess cash to reduce leverage and describes the impact of those transactions. As we discussed last quarter, as we become less uncertain about the economic environment and become more certain about our ability to operate effectively at these pandemic-impacted levels of demand, we have begun to reduce some of the precautionary leverage that we added back in the spring. First, we addressed an approaching debt maturity stack in 2022 and 2023, and took advantage of a favorable credit market environment. In August, we closed two new bond offerings for $650 million at 5% and $450 million at 5.25% with maturities of eight and 10 years respectively. We used these proceeds augmented by $200 million of existing cash to redeem our prior $600 million 5% senior notes and $700 million, 6.38% senior notes. These transactions extended our weighted average debt maturities, eliminated near-term refinancing risk and lowered our interest expense. These new debt offerings will result in lower annual interest expense of approximately $19 million and as a result, are expected to be accretive to EPS in both 2020 and in 2021. Second, at the beginning of the fourth quarter, we purchased and retired 132,000 shares of the outstanding Series A Convertible Preferred Stock, which represented about 32% of NCR’s outstanding convertible preferred stock. This transaction will reduce our annual dividend burden by more than $7 million and it’s expected to be net accretive due to the $4.4 million share reduction and our diluted share count on an annual basis. And third, based on the strong free cash flow performance year-to-date and our confidence in the outlook for our business, early in the fourth quarter, we paid down $470 million of a revolver. This will further reduce our interest expense by $8 million. In total, since the beginning of the third quarter, we have redeployed a net $800 million in capital transactions for an annual savings of $34 million through lower interest and dividends. And with that, I’ll turn it back to Mike for his closing comments.

Thanks, Tim. In closing, our key priorities moving forward are clear. First, we will continue to further execute on our NCR as-a-Service and 80/60/20 strategy. We have made notable progress this year despite some of the challenging conditions. Second, our financial position is sound; we have ample liquidity and financial flexibility, while also investing in our innovative solutions. We will continue to allocate capital in our strategic growth platforms such as digital banking, Emerald, next generation Aloha payments and digital-connected services. We will also consider acquisitions and paying down debt. Third, we will continue to focus on driving significant free cash flow generation, which go hand in hand with advancing our strategy. Fourth, we are building momentum across the business for improved execution and performance in 2021. And lastly, I’d like to extend an invitation to each of you to participate in our Virtual Investor Day, which is scheduled for December 3. We are looking forward to an event; intend to take a deep dive into our strategy and path forward in achieving our 80/60/20 goals. Thank you for your time today. And with that, we will open up the call for your questions. Operator?

Thank you, sir. All right. And first from RBC Capital Markets, we have Dan Perlin.

Yes. Good evening. It’s actually Matt Roswell filling in for Dan. Hope everyone’s doing well. A couple of quick questions; first of all, on the margins and the cost reduction efforts, how much of what you had planned to do earlier in the year before the pandemic hit, do you think you’ve accomplished and sort of how much is left?

Yes. So, we originally announced at the beginning of the year that we would do about $90 million of cost takeout in 2020. As the pandemic hit, we put that at hold; we didn’t think it was appropriate during a very difficult time to be letting our employees go. So, we deferred any actions other than kinds of cost takeout that we could do. We took down some salaries, some of the executives did, and we reduced discretionary spend and those savings flowed into the third quarter. On the second quarter call, we talked about getting back to focus on executing our business in the second half of the year. And we said as part of that — and I think we called it 2020.5 — that as part of that we’re going to get our cost structure aligned with our business. So, we did some of those actions in the third quarter. We have plans to continue some into the fourth quarter. We will certainly reach that $90 million by the end of the year, meaning, we’ll have a $90 million run rate as we head into 2021.

Okay. Switching to the banking business, with hardware, I think it’s — with the ATM business sort of being about $200 million to $250 million a quarter, given the growth in digital and the other products, when do you sort of see a kind of a crossover point meaning ATM business kind of flat-ish, but then you actually see growth because of the other pieces?

Yes. Obviously, we had a strong ATM last year and this year we’ve seen the banks feeling more cautious on some of their spending—particularly on the hardware side. They continue to make investments in digital banking and some of the other software products, as well as some of the professional services that we deliver with the software during 2020. I don’t know that we have a specific timeframe. As we’ve taught the last couple of years, our ATM business is still an important part of our strategy. We have shifted the focus to the digital side — digital-first on our software products — and those continue to have pretty good strength here in 2020 versus ATMs, which have slowed down. Tim, if you want to add to that…

Yes. We’ve been running for the last several quarters at about $220 million a quarter on ATMs. And it’s been relatively consistent for the last three. I would expect for the next couple that’ll remain true as well. I don’t know at what point in time banks will loosen up their capital spending. We would hope that there’d be a little pickup when that happens. But we ought to have easier comparisons in Q1 next year, and be relatively flattish from an ATM perspective, which will allow the rest of our banking business to demonstrate its growth. I’d also like to say that in this quarter for the first time in a while, non-ATM hardware was higher in terms of revenue than ATM hardware was.

Okay. One more question if you allow me. Switching over to hospitality, it looks like Aloha is seeing great demand. Are you seeing an acceleration in the shift to sort of the services model? You mentioned the subscription bundle — is that pandemic-driven, is that you all doing it, or is it just the timing and it’s simply happening?

Well, I’d say primarily our focus is to shift that business to be able to run the restaurant. So, bundling up the software, bundling up the hardware, bundling up the services to install and support, and then bundling up the payments. That’s been the shift of our business focus and that’s why those numbers we talked about — 80% of our uptake is on a bundle and the payments attach rate has been very strong in the SMB market as well. I think it’s playing well in a COVID market, where people in that market need help getting up and running and they want subsidy. They want a single vendor who can come and deliver a full turnkey to run their restaurant. So, I think that’s part of this — I think the primary driver is a shift in our business model.

All right. moving on to our next questions from Stephens, we have Brett Huff. Please go ahead.

Yes. Hey, guys, this is Joel on for Brett. Thanks for taking our questions. So, just on digital banking, could you talk about maybe the competitive environment, you guys seem to be more competitive and any color that you can provide on that would be extremely helpful. And then just as a follow-up to that, any color around penetration or adoption rates among your bank clients using digital banking? Thank you.

Well, I mean, I’ll start with the competitiveness. We talked about this last year and this year. Last year our team there, led by Doug Brown, did a phenomenal job changing, in particular, Digital Insight in terms of focus on customers and retention, and being able to start adding accounts. As we got into 2020, they continued to do that. We compete with everybody out there. We certainly believe we’re winning. Competitively, from time-to-time we’re probably going to lose one or two deals here and there, but we feel really good that we are adding in 2019 and that we will continue to add in 2020 in terms of the marketplace. I think that competitive aspect is exactly what’s happening, and our D3 product is doing really well as well. So, we feel pretty good about digital banking as we move forward. The pickup rate and the adoption — I think we referenced the numbers and Owen will speak to it — but that’s what customers talk about: the shift to digital and increased consumer activity on the digital platform.

I think consistent with what both Tim and Mike talked about, we are clearly seeing a step-up in investment from the banks on their digital platforms. We’re seeing it both with the Digital Insight and D3 product; we’re seeing it with the rest of the banking platform that we have in the market and it’s coming across in license, it’s coming across in the professional services space. While we haven’t disclosed exact growth rates, we clearly are seeing — and this is COVID-enhanced — a pickup in our customers' and consumers' activity on the digital platform.

Our next question comes from Dan Kurnos, who is with The Benchmark Company.

Great, thanks. Maybe, Mike, can you just give us some geographic color on what you’re saying? It would just be helpful and I’ll leave it to you if you want to break it down by segment or not. And then just as we think about sort of this COVID-driven evolution of the entire landscape — I know that you guys have done a great job with free cash right now, which probably gives you some of the runway you want to go back to doing some of your tuck-ins — but how do you view that on the tech side versus maybe partnership opportunities that could get you deeper penetrated into some of the verticals that we’re seeing develop here?

Yes. Let me address the second part first in terms of COVID impacts and where we see that. We talked on our March and April calls that it was difficult to see the depth and duration of the pandemic, but we recognized second quarter would be difficult and third quarter similar. We did a little better in the third quarter than the second quarter. If you look at year-over-year comparisons, we were about 12% constant currency in the second quarter and a little better than the third quarter. I think now we would say we don’t see the health crisis ending immediately, and so it’s probably going to bleed a little into 2021. Certainly we don’t think it’s going to be over in the first quarter. When do we get back to normal — when people can go back to restaurants, when stores can operate normally — we think that’s pushed into next year. We did, as you pointed out, put a lot of focus the whole year on cash flow. We had very successful cash flow in the third quarter based on managing our costs, even with lower revenue, and managing our cash cycle itself. Year-to-date, we’re not only ahead of where we were last year-to-date, but we are at a higher number than we looked at for the full year last year. So, we feel really good about the cash flow; that gives us the opportunity to take down debt and consider tuck-in acquisitions. We announced in the second quarter call that we would start looking at tuck-ins, which we will pursue — acquisitions that help us grow and accelerate our strategy. We will continue to do that going forward. Tim, I’ll let you add comments on how we kind of view 2020 and 2021 from a numbers perspective.

Yes. I think this quarter will play out similarly to the third quarter into the fourth quarter. From a revenue perspective, there’s no reason to think that the markets our customers sell into are going to get materially better in the near term. I would expect similar demand for us in Q4 that we saw in Q3, and I expect the mix to be relatively similar as well. I also expect it will hit a margin rate that’s similar to what we just achieved in this quarter. The cost actions we took in Q2 were relatively temporary or immediate; we’re making this shift to much more permanent productivity initiatives that will drive future period profitability and make that a more sustainable improvement to margin rate. On the cash flow side, Mike is right — we’re getting much more linear in the way we conduct our business from the top down and that has made a huge difference on cash flow. The performance we saw in Q3 was outsized relative to our typical Q3 performance; Q4 will be positive and demonstrably so. We may have borrowed forward a little bit of typically very strong Q4 cash flow into Q3, but Q4 should still be positive.

And then just maybe Mike, obviously the ATM is understandable — nobody is really spending right now — but I’m just wondering how the conversations are going around ITM and future branch closures where you’re trying to get stuff on paper. Are you thinking about that in conjunction with obviously the strength you’re seeing in digital?

Great question. The conversations we are having across markets — Europe, Middle East, Australia, and here in the U.S. — show the banking community is focused on the self-service bank platform. As I mentioned, we’re seeing investment in digital platforms and software. What we are seeing is a clear pause in discretionary capital spending, and that has impacted ATM activity. To Tim’s comment, we have been seeing a range of $220 million to $250 million on ATMs, which we think is a fair number as we move forward and we expect the ATM market to be relatively flat over the next several years. The ATM and ITM remain a key part of the strategy going forward. We are not hearing anyone running away from ATM or ITM; rather, banks are preserving capital right now and waiting to see how the market evolves.

Moving on, we have Matt Summerville with D.A. Davidson.

Thanks. Just a couple questions; first, Owen, I want to make sure I heard you correctly. You’re not anticipating a sort of normal seasonal sequential uptick in revenue for any of the businesses in Q4 relative to Q3?

No, we’re not. There are a couple of things at play. The market dynamic we’re seeing is more contemplated spend on ATMs, which is what we’re hearing from our bank customers. The other thing, which both Tim and Mike touched on, is a cultural shift we’re trying to instill in the company to create more predictable quarter-to-quarter performance from a revenue standpoint, EBITDA, and free cash flow. We’ve tried to smooth out performance quarter-to-quarter, which we think allows us to be a better performing business. You’ll see it in the way we have moved our software from perpetual to subscription, which has changed behavior at the end of a quarter and certainly at the end of a year for our salespeople. We’ve consciously tried to smooth our performance which reduces end-of-quarter pushes that can create pricing erosion. So, we have tried to create more predictable performance. The current behavior in the ATM market is partly coincidental and partly the result of customer capital preservation.

Got it. And then maybe, if you guys can spend a couple of minutes just talking a little bit about what came in the self-checkout environment — is the demand there remaining strong, incoming orders and backlog, and do you think that strength has multi-year legs behind it given the shift toward more frictionless transactions?

Yes. Self-checkout and being able to manage your own interaction in a store has been solid. The pandemic has accelerated that trend and we expect it to continue. The ability to walk into a store and do your own scanning and checkout without a person touching your items is valuable. As we discussed on the last quarterly call, we have helped a number of our large clients activate pay-from-phone and pay-from-app solutions. The professional services team has had a lot of activity supporting these implementations in both Q2 and Q3. We think this area will continue to be a strength going forward.

Self-checkout accounted for more than all of the growth in the retail business, and the retail business went up year-over-year. So, I’d say it was a bright spot in our quarter. The order book is strong.

From JPMorgan, we have Paul Chung.

Hey, guys. Thanks for taking my questions. So, just a follow-up on self-checkout: can you kind of walk us through the unit economics of sales? So, the ASP of the solution for a hardware standpoint, and then the relevant operating margins, and then the services and software offering over time, and then the life cycle. For example, based on a number of stores, can we get to a number of free cash flow from this deal over time?

Yes. Generically, every deal can be a little different depending on the client and whether it’s a pure hardware deal or a broader solution. With self-checkout there is a software component; some clients move forward with a more comprehensive POS software upgrade or the ability to manage lanes. As we’ve seen during the pandemic, frictionless options like pay-from-phone and app-based payments have increased. Professional services often accompany these deployments to support configuration and rollout. I can’t really provide a single average selling price or a specific breakout because self-checkout deals vary by customer and scope.

All right. Thanks for that. And then nice momentum on D3 with First Horizon — can you give us a sense of how to size up this win, how quickly can you deploy the solution, and what’s the timing of revenues and earnings potential over time?

First Horizon was already a D3 client. What we announced is that they moved from an on-premises instance to our cloud-managed offering on AWS. We’re seeing most of our D3 clients wanting to move to the cloud because it gives flexibility to scale rapidly and handle peaks. First Horizon also had a large acquisition that we brought onto the D3 platform and they added additional functionality. So, the First Horizon activity was an expansion and a shift of a longstanding relationship rather than a brand new win.

And our next question comes from Katy Huberty with Morgan Stanley.

Thank you. Good afternoon. Tim, I just want to revisit your comment about the December quarter when you talk about similar demand. Does that mean you’re thinking about a year-on-year decline in the 13% range that you’ve seen the last couple of quarters? Or does that mean that revenue is flat sequentially?

No. I think revenue will be up modestly sequentially. So, the number you described is probably about right for the year-on-year decline, but there’s a lot left to go in the quarter and any event can swing that a percent or two. As we sit here today, demand, particularly in things we can measure easily like hardware, looks to be very similar to what demand was in Q3.

The prior question around a big end-of-quarter, end-of-year spike in the hardware business — all we’re saying is we don’t necessarily see that occurring this year. Part of that is due to the shift in our business model and trying to smooth results, and part of it is due to COVID. Banks are saying, 'Let’s see what happens with the marketplace and economy before we start spending money on ATMs.' So, while we think that spending will resume, we’re not sure it will hit in the fourth quarter. On self-checkout, customers are very busy operating their stores this year, and they’re less able to undertake major installation projects. So again, we think Q4 may be slightly sequentially better than Q3, but maybe not the big pop we’ve seen in prior fourth quarters.

And as we think about EBITDA margins into next year, just from a high level, obviously the weaker mix of hardware is helping this year; as hardware starts to recover in 2021, do you think you can take out costs fast enough that you will be able to offset that and continue to expand EBITDA margins in the medium term?

Yes. Absolutely. The cost takeout we’re working on is more indirect and associated with our services and software businesses and not necessarily with our production or manufacturing footprint. We are planning capacity for production at levels more like what we’re seeing now in ATMs and SCO, so some costs will need to come out, and we expect to achieve that over the course of next year. These are more permanent productivity improvements that should allow us to expand margins even if hardware recovers somewhat.

Okay. And then lastly, Tim, you mentioned higher reserves in the hospitality business. Can you just talk about where losses are running right now and where the accrual set is versus what you saw in prior downturns?

We have not seen an increase in the number of defaults. We were pleased with the reserve levels we had in aggregate. We did take a little bit more on specific customer accounts that turned negative — these were very specific targeted adjustments. On the remainder of the reserves, we feel we are in very good stead for the smaller accounts and for general reserves.

Moving on from Oppenheimer, we have Ian Zaffino.

Hey, great. Thank you. Can I just delve a little bit more into maybe hospitality and retail? Is the strength in retail coming from larger customers or is it broad-based? And then do the same for hospitality — are smaller customers driving the weakness, or is it larger chains? Thanks.

Sure. At a high level, we addressed this back in late March when we shared the mix of our business. In retail, our large grocery and big-box customers have been strong; department stores and specialty retail can be more at risk, and SMB is a smaller portion. In hospitality, quick-service restaurants are doing relatively well, some are even doing better than 2019 due to drive-thru and takeaway. Table-service restaurants have been more challenged where capacity constraints or restrictions exist. The at-risk portions of retail and hospitality are small relative to our total company revenue — retail at-risk components are about 5% of the retail segment and less than 2% of total company revenue; hospitality at-risk components are similar percentages. So, while there are pockets of stress, the overall impact to the company is limited.

Okay. And then on banking, you mentioned the hesitation from customers — is that driven by COVID uncertainty, or are they seeing trends that their customers are acting differently and that’s driving the pause? Or is it other parts of their business?

Banks are focused on expanding their digital footprint — investments in mobile and online banking remain strong. On the ATM side, banks are looking at their branch footprint and deciding how multifunction ATMs or ITMs will fit into a potentially smaller branch network. The feedback we’re getting is that ATMs remain part of the distribution strategy. The hesitation is primarily capital preservation due to COVID; banks are holding on to capital and being cautious about discretionary spending right now.

And moving on, ladies and gentlemen, we have our last question from Charles Nabhan, who is with Wells Fargo.

Hi, thank you for taking my question. I wanted to ask about the competitive landscape in the hospitality space. Some of your competitors in the space have had some struggles. I was hoping you could comment if you’ve seen inbound interest from some of their clients and whether you’ve been able to gain share in that space?

Hospitality has been more impacted than other segments, particularly table service. We’re pleased with the work our team has done helping clients navigate COVID. We rolled out order-at-table functionality that allows guests to order and pay from a handheld device at an Aloha client. Those innovations have helped differentiate our offering. The team has been aggressive in the market — we’re putting feet on the street where possible and engaging with restaurants whether virtually or in person when they’re open. It’s a tough environment, but we feel good about where we’ll come out the back end: adding customers, expanding product adoption with existing clients, and executing our strategy.

We’re seeing quarter-to-quarter momentum. Aloha Essentials — our turnkey subscription solution — is being well received, especially by smaller customers looking to minimize upfront capital. Our contactless commerce functionality for restaurants has been viewed as a positive response to the pandemic. While some competitors have been hit and made announcements, we’re doubling down on product investment and the field team, and the early returns are encouraging.

Got it. And as a follow-up, on the M&A strategy, it sounds like you’re moving closer to that being part of the conversation again. Are there any focal points you could highlight, relative to what you’ve done in the past where the focus has been point-of-sale and digital banking?

Yes. The general focus will be similar to past activity. We have three buckets: product acquisitions on the software side, channel or distribution acquisitions — particularly in hospitality where we’ve bought channel in the past — and service opportunities, either professional services or managed break-fix services. Historically, we have targeted early-stage companies with strong products that integrate well with our platforms and can be cross-sold through our distribution. We paused active M&A to focus on cash flow earlier in the year, and now that our cash performance has improved and uncertainty has decreased compared to March, we will selectively pursue tuck-ins that are accretive and support our strategy in banking, retail and hospitality.

All right. Ladies and gentlemen, that will conclude our Q&A session. I’d like to turn the floor back over to Mr. Mike Hayford for any additional or closing remarks today.

Thanks. I again reiterate what we said. We were very pleased with the third quarter performance in a very challenging environment. Our team did a great job focusing on execution in quite frankly an unprecedented pandemic. We focused first on taking care of our clients. Owen talked about the ability to take care of our clients and actually be able to add clients. Second, we continued to make progress on our strategic goals and we continue to invest in our strategic products. We continue to make the shift to being a software and services-focused company even during these difficult times. Third, Tim talked about how we improved productivity; we took down costs both on a temporary basis and also took actions that will allow cost savings to carry forward into 2021 and beyond. Fourth, we drove phenomenal cash flow performance for the third quarter. We said we were going to focus on cash flow at the start of the pandemic and the team did an even better job than we could have envisioned on cash flow management. That allowed us to pay down debt, deleverage and feel very good about where we sit today with less uncertainty in the environment. We can operate at this level and generate positive cash flows. That gave us confidence to reduce debt. Lastly, please plan on joining us on December 3 for Virtual Investor Day where we will talk more about our strategy to drive software and services revenue to 80%, recurring revenue to 60% and our goal of 20% EBITDA margin — our 80/60/20 strategic goal. Thank you for joining us today and thank you for participating on our third quarter earnings call.

And once again everyone, we do thank you for joining us. That does conclude our call for today. You may now disconnect.