Canon Inc (CAJ) 2005 Q2 法說會逐字稿

Good morning ladies and gentleman and welcome to the Imagistics International second quarter earnings release conference hosted by Marc Breslawsky, Chairman and CEO. Today’s meeting will be tape-recorded. Taping and re-broadcasting of this call are prohibited without express permission of Imagistic. After the initial remarks there will be a question and answer session. During this meeting, Imagistics management will make comments that constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.

Forward-looking statements are based on assumptions and expectation, and are subject to risks and uncertainties that could cause actual results to differ materially from those projected in such a forward-looking statement.

Information concerning certain factors that could cause actual results to differ materially is included in the Company’s 2003 form 10-K and other filing.

The Company does not intend to update any forward-looking statements made during this meeting.

At this time I would like to turn the meeting over to Mr. Marc Breslawsky.

Thank you and good morning, ladies and gentlemen and thanks for joining us for our second quarter 2005 earnings conference call. With me this morning are Joe Skrzypczak, our President and COO; Tim Coyne, our CFO; and Jim Magrone, our VP of Corporate Communications and Industrial Relations; Nat Gifford, our VP of Products and Development and Marketing, is on the telephone.

For our agenda today, I’ll briefly review the highlights of our second quarter and then discuss our strategic progress. Following that, Tim Coyne will discuss the financial details. Then I will open the floor up for questions.

I assume that you’ve all had the opportunity to read our earnings announcement along with the financial schedules released earlier this morning. A copy of which is attached at our investor website www.IGIInvestor.com, where it can also be archived.

Let me begin by saying that I’m very pleased with our performance in the second quarter of 2005. EPS grew 24 percent in the second quarter of 2005. Excluding the severance charge this quarter and an insurance recovery, last year EPS growth was 54 percent compared to a comparable period last year.

We continued to successfully execute our strategic plan to grow our core Copier/MFP business, capitalize on the potential of color in the marketplace, introduce new products and expand our geographical reach into new markets. Our core Copier/MFP business continues to grow at a healthy rate. Great products, good value, a professional sales force and fast, reliable service is our formula for success. Color product continues to be a key driver in our Copier/MFP growth. Looking at our products in Segments Three and Four, representing the 31 to 69 page permanent market, due to our introduction of color products and our success in selling them, our overall product mix is returning significantly more revenue per unit placement. Going forward all our capable units are expected to continue to boost our revenue and our Copier/MFP product line gross margin as the market for office color Copier/MFPs continue to grow and these products deliver more valuable color page volume.

In the second quarter 2005, our average revenue for color enabled Copier/MFP was almost twice that of the similar speed monochrome machines. While our installed base of color Copier/MFP is relatively small, color Copier/MFP placement in the second quarter of this year were up over 200 percent year-over-year and gained nearly 20 percent sequentially.

June 2005 was our best month ever of color placements with nearly 40 percent of Segment 3 placement color enabled. Year-to-date 2005 color placements were more then triple that of the comp able 2004 period. We continue to strengthen our product line. In May, we introduced the new monochrome IM3511 and 4511 products. We’ve introduced more products in the first half of this year then in all of 2004 and we have more new products in the pipeline, both color and black-and-white. In the second quarter, two of our recently introduced products, the SX2100 and the color capable CM3520 received the prestigious Pick of the Year award from Buyers Lab. These products have been very successful in the marketplace. We’re excited about the strength and potential of our product line and we believe that we are well positioned to continue growth in our core Copier/MFP business this year.

In the second quarter of 2005, we closed on two acquisitions to continue to expand our direct sales and service capability. In April of 2005, we acquired Lakeside Office Systems, a digital copier dealership of Konica and Minolta products in British Columbia. Lakeside was established in 1996 and has annual revenues of $2.5 million Canadian. This acquisition expands our footprint into the western Canadian marketplace. In the late June, we acquired the office solutions business of Rentokil Initial in the United Kingdom. The acquired business is based in London and Birmingham and has annual revenues of approximately $3 million pounds sterling. This acquisition significantly increases our presence in the United Kingdom.

As we have previously stated, we are in the final phase of our ELP implementation and continue to expect that the implementation will be completed this year. Total direct ELP related expenditures were approximately $1 million in the second quarter of 2005 at essentially a maintenance level, and we’re the lowest since our spin off over 3 ½ years ago.

Cash generated by operations were strong at $30 million in the second quarter of 2005. This enabled us to grow our rental asset base, fund our capital expenditures, complete the 2 acquisitions and aggressively repurchase Imagistic shares, all with just a slight increase in total debt.

Reflecting the confidence we have in our future, we repurchased 653,000 shares in the second quarter of 2005. This is the highest level of share repurchase since the third quarter of 2002 and more shares were repurchased then in all of the full year 2004. Since the beginning of the stock buyback program in 2002, we have repurchased approximately 4.7 million shares or approximately 24 percent of the shares that were outstanding when Imagistics was spun off in December 2001.

Our Board of Directors recently increased our share repurchase authorization by an additional $30 million. This is the fifth time the board has increased the repurchase authorization.

Finally, let’s discuss our outlook. We are affirming our annual guidance for 2005 in the $1.58 to $1.63 range, which represents an increase of 17 to 21 percent over the $1.35 per share earned in 2004 as restated for stock option expenses. The 2005 guidance, as previously announced, is after expense in stock options and charges for restructuring in severance taken in the first half of this year.

For the second half of 2005 we are continuing to assume that Copier/MSP revenues will grow in the mid-single digit percent range experienced in the first half of this year and facsimile revenue is expected to decline at an annual rate in the mid- to high-20 percent range. As you can see by our result in the second quarter of this year, we have taken aggressive actions to reduce expenses. For the full year 2005, we continue to expect cost reductions to be at least $20 million exclusive of any future acquisitions. As such we remain confident in our outlook for 2005 and beyond.

At this time I’d like to turn the call over to Tim Coyne for his comments on our financial results. Tim.

Thank you, Marc and good morning everyone.

Let me provide some detail on our second quarter results. Let’s start with earnings per share. Diluted earnings per share of $0.41 in the second quarter of 2005 was up 24 percent compared with $0.33 per share in the second quarter of last year. The second quarter of 2005 included a severance charge of $0.02 per share, excluding that, normalized diluted earnings per share was $0.43. The second quarter of 2004 included a benefit from the insurance recovery of $0.05 per share, excluding that, normalized deluded earnings per share was $0.28 in the second quarter of 2004.

On a normalized basis, diluted earnings per share of $0.43 in the second quarter of 2005 was up 54 percent compared with $0.28 per share in the second quarter of 2004 on a normalized basis. Most of this improvement is the result of the actions we have taken to reduce SS&A expenses.

Now let’s discuss revenue. Starting with total revenue and then moving to our 3 business lines, which we define as Copier/MFP, fax and sales to PD Canada. In the second quarter of 2005, total revenue for the Company decreased 4 percent to $145.7 million, with recurring revenue 70 percent of total revenue. For the quarter total Copier/MFP revenue increased 6 percent to $109.8 million in line with our expectations. Copier/MFP revenue has shown consistent growth for the 14 consecutive quarters since our spin off. The Copier/MFP product line continues to be the dominant part of our revenue portfolio and in the second quarter of 2005 it grew to 76 percent of our total revenue.

Copier/MFP sales increased 7 percent to $60 million in the second quarter of 2005, reflecting continued unit volume growth including strong demand for color Copier/MFP products and growth in aftermarket supplies. Our Copier/MFP rental revenue of $28.3 million grew 3 percent on both the year-over-year and sequential basis in the second quarter of 2005.

As we have indicated in our recent quarterly conference calls, the rental growth rate continues to be impacted by the expiration of certain federal government contracts that were not renewed. The company expects that year-over-year Copier/MFP rental growth will continue to be modest in the third quarter of 2005, but will significantly improve in the fourth of quarter of 2005 due to a strong level of recent business activity and the aforementioned U.S. government contracts which are expected to have less of a negative year-over-year impact. Support Services revenue for Copier/MFPs grew 5 percent to $21.5 million in the second quarter of 2005.

Now let’s look at facsimile. In the second quarter of 2005, total facsimile revenue declined 24 percent to $34.7 million, also in line with our expectations. Facsimile sales were down 13 percent to $15.1 million in the second quarter of 2005 reflecting lower supply sales primarily due to the continuing industry-wide reduction in facsimile usage, partially offset by a large rental to sale conversion of facsimile equipment in the quarter.

Rental revenue from the facsimile product line declined 33 percent to $17.9 million compared with the second quarter of 2004. This reflects the decline of the rental installed base due in part to the impact of rental to sales conversions coupled with lower per unit pricing.

Support Services from facsimile equipment declined 7 percent to $1.7 million in the second quarter of 2005. Total facsimile revenue represented 24 percent of the total revenue for the Company in the second quarter of 2005.

Our sales to PB Canada declined $400,000 to $1.2 million in the second quarter of 2005. As we have stated in the past, sales to PB Canada are at low margins, so the decline in revenue had no significant impact on profitability. We are now beyond the point of PB Canada having an impact on our top line, as revenues from PB Canada was $1 to $2 million per quarter beginning in the second quarter of 2004.

Now let’s discuss gross margins. In the second quarter of 2005, the sales gross margin was 44.3 percent up 7/10 percentage points compared with the second quarter of 2004. The improvements in the sales gross margin was due to the previously mentioned rental to sales conversion of facsimile equipment and lower inventory obsolescent charges partially offset by lower margins from certain large competitively bid sales transactions and the continuing shift in product mix away from the higher margin facsimile product line for the lower margin Copier/MFP product line.

The rental gross margin of 68.3 percent declined 3.4 percentage points compared with the second quarter last year. The lower rental gross margin was primarily the result of the continuing shift in product revenue mix from facsimile to Copier/MFP.

As we have previously disclosed, facsimile gross margins are greater than those of Copier/MFP by approximately 14 percentage points.

Now let’s move to selling service and administrative expenses, as well as our ERP project costs. We are pleased with our progress in significantly reducing SS&A expenses. Reported SS&A expenses were $75.9 million in the second quarter of 2005, down 9 percent compared with the second quarter of 2004. SS&A expenses in the second quarter of 2005 included a previously announced severage charge of $600,000. Excluding that charge, SS&A expenses were $75.3 million in the second quarter of 2005. As previously disclosed, SS&A expenses in the second quarter of 2004 included an insurance recovery of $1.4 million for business interruption claims related to the World Trade Center. Excluding that benefit, SS&A expenses were $84.5 million in the second quarter of 2004. Comparing year-over-year SS&A expenses excluding the aforementioned severance charge and insurance recovery, SS&A expenses in the second quarter of 2005 were down $9.2 million or 11 percent on a normalized basis. The reduction in SS&A expenses in the second quarter of 2005 was the result of lower compensation and benefit expenses and lower ERP implementation and related administrative support costs. This was partially offset by the absence of the previously mentioned insurance recovery received in the second quarter of 2004 and higher operating expenses associated with direct distribution expansion. We remain highly focused on continuing to reduce SS&A expenses, as we believe there is more work to do.

Expenditures for the ERP project were $900,000 in the second quarter of 2005, down $2.2 million from the first quarter of 2005 and 3.6 million from the fourth quarter of 2004. Of the $900,000 in total direct ERP expenditures in the second quarter of 2005, $300,000 was capitalized and $600,000 was expensed. We continue to expect that we will complete the ERP implementations this year.

Interest expense increased by $300,000 compared to the second quarter of 2004 due to higher levels of debt and higher interest rates. The effective income tax rate of 41.9 percent in the second quarter of 2005 was down from 42.4 percent in the prior year.

We continue to be engaged in ERP stabilization efforts with a particular focus on billing and collection. These sales outstanding continue to improve to 61 days in the second quarter of 2005 compared to its 63 days in the first quarter of 2005 and 65 days in the fourth quarter of 2004. DSO was 71 days in the second quarter of 2004. Improvement to the accounts receivable balance was masked by the timing of several large sales transactions and the reduction of accrued billings in the second quarter of 2005.

Turning to other balance sheet and cash flow items. At June 30, 2005 our cash balance was $11.4 million. Inventory decreased $6.3 million from March 31, 2005 due to strong equipment sales and rental placement. Cash generation from operations this quarter was strong at $29.6 million. We used this cash generation to finance capital expenditures which amounted to $11.8 million including $10.8 million to grow our rental asset base, and $1 million to continue building our infrastructure. In the quarter we completed two acquisitions for a total of $4.4 million. Additionally, as Marc mentioned earlier, we repurchased 653,420 imagistic shares at a total cost of $17.7 million. And we did all this while increasing debt by only $1.4 million. Debt to total capitalization remains at a conservative 23 percent as of June 30, 2005.

Now, I'd like to turn the call back over to Marc.

Thanks a lot, Tim. Now, what I would like to do is take any of your questions. Operator, may I have the first question, please?

[OPERATOR INSTRUCTIONS] Our first question comes from David Manthey from Robert W. Baird.

First question relates to the Federal Government headwind that you're experiencing. Could you give us some idea of what you think the growth was depressed this quarter because of the expirationalist contracts?

We've been impacted quarter after quarter. This is Joe Skrzypczak by the way, David. We've been impacted quarter by quarter. We think that what will happen is we'll be impacted slightly again in the third quarter but then it will come down to a normalized run rate in the fourth quarter. I think both of those contracts will be expired. What I would like to say also is that we have taken some action just recently to add some products to the GSA contract. We were able to find some product that our manufacturer in Japan, we are in the process of getting them added to the contract which we believe will be added to the contract probably within the next 30 days, and then we'll be taking orders that will probably be impacting us, let's say, late in the fourth quarter. So we're very pleased to see that first off, that the runoff of these other contracts that we previously had that have come to almost a halt, or at least it will be at a halt in the third quarter, but we will also now have products available to offer our federal customers that meet the requirements of the federal government and our manufacturers in Japan.

We would hope that with the recent evaluation of the dollar to the Chinese currency, that the government would take a close look at their buying practices. And the government would do a lot better acquiring products manufactured in China than in Japan, so it's my belief, there's no guarantee of this and I'm not a government official, but it's my hope that China ban effectively will come off of products that we would be able to bid on. We've been very successful at the state and municipal level and we think we could be very successful at the federal government level also.

Okay. Can you give us an idea though in terms of the current quarter of the organic copier MFP growth? Would that have been 200 basis points higher or 150, or is there some ballpark number you can approximate for us?

We really have never broken that ground.

Actually, David, as you know, the acquisitions that we have completed are very, very small in nature. It's more or less an expansion of our sales effort in expanding in some of those geographic areas where we do not participate. So it's not all that meaningful.

Okay. Okay. And then the second question, in terms of what changes from here into the back half of the year allowing you to get to your guided range, we've always known there's a pretty steep ramp here into the back half. But when I look at the types of levers that you have available to increase EPS in the second half of this year, it would seem like the logical ones would be reducing SS&A, making accretive acquisitions of buying that stock in an accretive manner. When you look at the range of those things and you think about what might move the needle from the second quarter kind of levels into the third and fourth, what are--I know you saying at least 20 million reductions in SS&A. Are you extremely confident that it could be much higher than that? It would seem like it would have to be much higher than that to get to the guided range unless there's something else outside of those three that we're thinking of.

David, you have followed the facts. We have not broken out the detail of all of the areas we would be getting it at, and obviously there are a lot of leverage factors including revenue growth in the calculation. But we have not fine-tuned that publicly.

I think, David, you have to see that we have actually achieved what we said we've set out to do. We said that we were going to be reducing expenses. We have made a lot of in roads in that regard. We said that those expenses would come down even further in the third and fourth quarter and we've been executing for that plan and I think we've been delivering on that plan too.

Right. And I agree that even sequentially normalized, SS&A came down at about a $20 million run rate already. And I'm just wondering in terms of the afterburners here, is there benefit that you may--you may have only seen a partial benefit this quarter that will extend into the back half or, you've obviously said there are other things you think you can do?

It will, it will. Again a lot of those expenses that we identified were taken out but some of them are taken out at the end of the quarter too. We'll see a full impact of that in the third and fourth quarter. Fourth quarter will obviously be the strongest.

Right. Okay, great. And then last question here, in terms of this inventory obsolescence number being lower. Could you talk about why that was and is that a sustainable thing or does that come back up as we go forward?

David, this is Tim Coyne. I think in large part what you're seeing is the continual refreshment of our product line and a much tighter inventory control. You'll see if you look back over time, inventory levels have declined significantly both as a result of product cost declines but also as a result of better inventory management. And we are past the point where the switch from analog to digital equipment is having any impact at all. So we believe that we will continue to tightly manage inventory and we don't expect that we would return to the inventory obsolescence levels that we had seen in the past. But market conditions change on a continual basis and that we will just continue to do our best to monitor the inventory levels and manage them appropriately.

Okay. Thanks very much guys.

Our next question comes from Herb Hart with Monnet. Please go ahead with your question.

A couple questions. One is while you've been focusing on the ERP system in this country, there hasn't been that much news out of London and I notice with this acquisition, does this mean things are going to start developing there a little more quickly?

Yes, actually we’ve got…as you remember, when we first spun off, the UK operation was exclusively a facsimile business, 100 percent with facsimile, and we have been in the process of transitioning that business over to Copier/MFP. We’ve brought on a very talented individual, Adam Shepard, to drive that effort in the UK and he is having some very good success there. He has brought on a lot of talented people. We are seeing very good growth in the Copier/MFP area and now we’re starting to expand in some of those geographic areas that we don’t participate in the UK by requiring them looking at some of the dealerships that are out there.

Is it probable that your acquisitions have tended to be accretive after six months or so? Is that about the same in the UK?

Yes.

The formulas we use are pretty consistent, whether it’s the US, the UK or Canada. We like to acquire companies by adding our values. We can get an excellent return on what we pay for those businesses.

My other question is the rate of the buy back was finally up to standards this quarter.

We’re not sure what that means but we doubt--

I think shareholder’s applaud it, certainly many of us and can we look forward to an equally stellar rate in the--

We never forecast our stock like that, you know that Herb, so, but we obviously think the stock is a very good value.

Thank you very much.

Our next question comes from Margot Murtaugh with Snyder Capital.

Okay, on the cost of sales and the cost of rental, do you expect both of those to continue with this…?

I’m sorry. Can you repeat…?

The cost of sales and the cost of rentals is this a number we should use going forward?

We’ve been very successful, Margot, as you know, in actually increasing our overall margin. We are continually feeling pricing pressures. At the same time, we’re transitioning the company from a mixture of fax and copier to exclusively Copier/MFP and in the Copier/MFP arena, our margins are lower than in facsimile, so we’re constantly dealing with that. We have been successful, though, over the last few years in transitioning that product mix and still improving margins, but we would expect margins to pretty much stabilize in each of those respective areas for copier and facsimile, but at the same time the company will be impacted as that product mix changes.

Also, within the segment, the margins could be effective one way or the other by the types of orders that we get, so if we get very large orders, typically the very large orders would be at lower margins than the small orders so it’s a proportion that would change from quarter to quarter and its never consistent. That could have an impact one way or the other on margins.

Okay. So that cost of rentals is up a lot because fax was down.

That’s right. That’s really a mix issue with rentals. Yes.

Okay. On the DSOs do you have a goal? You said also there were some non-recurring factors, I think that maybe that actually DSOs were better in the quarter than it appeared. So, what were they really and what progress do you expect to make the rest of the year?

We’ve--you know, just our competition, if you look at our competition; they are in the upper 50’s. We should definitely get to that level; hopefully exceed that. Some of the items that boosted the DSOs this quarter, we had some big sales that happened right at the end of the quarter.

Okay.

We had a great June and so, obviously, that gets pushed right into receivables, and we should see those collections in the third quarter.

We also had some additional receivables as a result of the acquisitions that we made in the quarter, too, that somewhat masked the improvement, as well, Margot.

Okay. Great. So, let’s see--cost savings--somebody asked a question. They’re already starting, but they’re going to be bigger in the third and fourth quarter--at 20 million you referred to?

We’re going to let you all forecast the pieces.

Okay.

We have forecast the--what we expect the total earnings to be.

Okay, and the tax rate, it was a little lower in this quarter, I believe and it has been. What’s the tax rate for the year, the expectations?

In the quarter, the tax rate declined compared to the last year and it was really just a mix of earnings. We have more earnings in Canada and the UK, as well as the US, and as well, there was a lower level of non-deductible expenses included in the calculations. So, that had a couple tenths of a percentage point impact on the calculation.

Yes. But for the tax rate—it would be 42 percent for the year?

We really don’t like to forecast exactly the tax rate, Margot.

Okay.

But, I mean, you can probably pretty much look at our patterns, I guess.

Our next question comes from Shannon Cross with Cross Research.

I just had a few questions here. I wanted to go back--on the inventory obsolescence, can you give us an idea--I don’t remember what the level of reserves are and if we should--

Shannon, can you speak up please?

Oh, I’m sorry. Can you hear me now?

Yes.

Okay. It helps if I talk actually into the phone. The--what I’m curious about was inventory obsolescence, can you give us an idea of what to look for on the next couple of quarters in terms of ability to continue to drive down a little bit on the reserve. I know it fluctuates, but it was a fairly substantial change sequentially. So, what are your thoughts there, if you could give us any more details than you did with the prior question?

Shannon, this is Tim. What happened is, obviously, is we go into a cycle of new product introductions. We review our inventory rather closely to make sure that we can sell out the existing inventory on hand and to provide for parts and other end-of-life inventory items that may be in the inventory mix and we provide for those in advance of the product introduction. So, we will see fluctuations in the rate of inventory obsolescence based upon the product replenishment cycle and what the inventory results look like, but I think it’s a--my comments before were, over time because our inventory obsolescence charges have been coming down due to better inventory management, not necessarily on a quarter-by-quarter basis, but over time. So, I didn’t mean to suggest that our inventory--our obsolescence on a go-forward basis will look like they did this quarter, but over time, they will be declining compared to the annual levels on a historical basis.

I think, Shannon, you also have to take a look at our total inventory. If you look at where we were at the end of the year, we’re about 95 million dollars and at the end of June we’re at about 83 million dollars. And, obviously, with this lower inventory, we’re going to have lower inventory reserve. We generally have a reserve of about one third of our total inventory and I think that’s consistent.

Okay. And then, I was curious on the gross margin, I mean, a lot of your other competitors out there, with the exception of Global Imaging, but Xerox and Cannon and Icon all noted very substantial margin pressure and essentially the margin pressure that they were looking at was from the stand point of a mix shift down when you look at the high end enterprise contracts. And it sounds like you also saw some of that, which obviously was off set by some of the sales of the fax, but I’d be curious as net of fax, where do you think the gross margin would have been or net of the large fax sales, where do you think gross margin would have been and were the comments out of some of your peers sort of consistent with what you saw in the market place, which is --

There’s so much to do with gross margin in terms of mix of product volumes you get out of product. The more volume you get out of the product, the higher the gross margins would typically be. So, if we have more high volume users, we will typically do better than low volume users, part of it is the outright contracts we have. I think that mostly our competitors have said prices are down but there’s nothing new about that. I think you’ve been hearing that, you’ve followed the industry for a long time, you’ve been hearing that forever that we have a continuation, again, gross margins--it could be, they will fluctuate if we get large contracts would be a slower growth margin than small contracts. Because, too many items to be able to answer your question specifically.

Okay. I was just curious. So, specifically what we had heard was that the pricing pressure had not really increased any more than, sort of, traditionally is out there. But that what customers were buying were, say the mid range instead of the high end or the low end instead of the mid range, because the products have gotten that good.

We’ve been driven, always been driven heavily in segment three and segment four, so it’s not like we have been down selling. Some of our competitors have sold a lot of low volume equipment, and some of them have sold a lot of very, very high volume equipment. We, for the most part, have been in the office segment of the market, in segments three, segments four.

I think where we get excited, Shannon, is in the color sector. As we put more color units out there, we have experienced a lot more revenue coming out of each unit and even though maybe the percentage does not change all that much, we are getting more margin dollars out of every unit of color than we would in a monochrome area. And I think our product competitors are seeing that also, but we’ve been having some very good success with our color products and that’s also having impact on our margin dollar improvement.

What is your installed base of color right now? I assume it’s very low.

We don’t really disclose it but its pretty small.

Its probably lower than most of our competitors. It’s also growing faster as a percentage than most of our competitors. I think the industry looks on color at growth, or the projections on growth, if you look at most of the reports, is a little under 50 percent. In color, our growth rate in color at least for the six months is more than double.

More than double. Okay. Great, okay, I had one last question for you. With regard to how to think about your rental base going forward. You have had the benefits I would assume from some of the state contracts you signed and then the off-set from federal and obviously Tim, I think you said by fourth quarter we start lapse the tough -- we start to lapse into easier comps from a year-over-year standpoint. Any way to think about the magnitude of what the state contracts are bringing in?

Well, you know when you said we had the benefit -- we’ve gotten some very nice contracts but some of the larger ones we’ve had almost no revenue yet on them. Some of them don’t kick in until the end of the third quarter and the full valuations on them we’ll probably start getting in the fourth quarter. In addition to that on these state contracts, a lot of them they do not go in on day one. So if it is a three of four year contract it would go in over the two or three time period. So the big factor for us has been the negative which all came in and really started hurting us on the comparison in the third quarter of last year. That’s why Tim said in his presentation, we expect in the third quarter we don’t expect a great comparison on rental revenue. We wouldn’t expect to see any great growth there primarily because the flat in rental but by the fourth quarter the negatives are out of the equation and sequentially will grow from quarter-to-quarter. We had nice growth sequentially in the last few quarters. We have got nice growth and we expect that growth to continue so that by the fourth quarter rental will be a nice positive factor in the overall growth in the Copier/MFP segment of the marketplace.

Would you assume that growth rate would exceed what you are seeing in sales growth for copiers?

It’s going to be -- we think it will be very good.

Our next question comes from Ben Robertson with Daruma Asset Management.

I have a few questions on gross margin. My impression last quarter was that you expected that to be in roughly at a level that it had been because of the strength in color of the better margins there but obviously it didn’t happen. So I’m just wondering how we’re supposed to think about going forward?

I think again just as I had spoken depending on the size of the contracts we get will have an impact on the Copier/MFP gross margin percentage. Actually as we run our business okay, we look at gross margin dollars, that’s the most important thing for us as apposed to percentage. So if there’s some big contracts to gain and they are at lower margins -- percentage margins, we still do go after them. It’s very difficult to make an evaluation from a gross margin percentage.

All right, so you’re looking at it more on an operating level?

Yes, that’s how we -- that’s how we -- you know we want to get gross margin dollars and Copier/MFP up and we want to get expenses down. That will make for a very nice bottom line.

Our margins from the first quarter actually improved, Ben. Our sales margins.

Okay. Well, so then if we look at the SS&A line is that -- this quarter is about 52% of sales for SS&A expense.

Yes, 51.7.

Is that -- should we use that as kind of a go forward run rate?

No.

So what kinds of things would cause that to go up?

We think again, again the guidance we’ve given has been on a bottom line basis the way we get there is through revenue growth and expense reductions. Those are the key drivers. Some for acquisition and some from share buyback. Those are the key drivers but again we’re letting everyone put their own numbers to each of those lines, we’re not doing that.

So if we look at the sort of $75 to $76 million in the second quarter is there any reason why that would go up from where it is now?

Only if we do some acquisition that would be substantial.

Okay. And then on the rental is there -- should that be growing roughly along with sales? I mean is there any reason why it wouldn’t grow at the same level as sales?

Depends on the deals that you get. We expect to see nice rental growth but it would be difficult -- it has never happened where they have grown consistently. There’s been times when rental has grown faster than sales; there’s been times when sales grow faster than rentals. We do not try to fine-tune that, okay. Customers either want to rent or they want to buy and so if we go into a period where we get heavy rental than that rental rate can exceed the sale rate or vice versa. If we get a heavy period of sale or get some big sale contracts that sale line can be substantially higher than the revenue. We want to grow both of those line consistently.

Okay. I guess last quarter you were talking about how successful of the CM3520 was and then you got the BLI Award. Is that--are you seeing continued strength with that?

Yes.

Would you it’s in the same level as in the first quarter or has it gotten even better?

Better.

It’s been a very good seller.

It’s a really hot product for us.

You know what we do not talk about it is all of the other awards that we’ve gotten also. You know the Buyer’s Lab is a great award, the JD Powers Associates—it is an item our sales people continue to sell getting it two years in a row. It is a big deal also. I mean they are both big deals.

But will you see almost double -- I guess you can assume it’s sort of one and half times to double the revenue off of the color enable machine in compared to black and white machine?

Yes, we’re seeing our size double.

Is that, I mean are those customers are they people who -- I mean does this kind of employees going under the radar. It seems like companies to be a little bit concerned about having a lot of color usage and incurring a lot more expense.

The formula in the world today has changed. The color products we sold a year ago were all much more expensive than the black and whites were. Today, with the new products that we introduce, some of them are still a lot more expensive in a higher speed color but with the new products that we introduce, they just sell at a slight premium to the black and white. So the real value we get in incremental revenues and is in usage itself where the volume -- each color copy they make, the revenue is significantly higher than the black and white. Though, as I see it -- it’s still a huge upside on color, which you would not see on the sale line. The sale line on these products might just be slightly higher. When the average is a lot higher than the black and white it would mean we would be selling products with a much higher entry price also. We are doing both right now.

Okay. What is this SX 2100? I do not remember -- I do not recall that, you said, that had gotten an award as well.

Yes, that had gotten a good award. We have John Riley with--it’s basically a low -- it’s a low-end machine. It’s a low-end machine, which is primarily used to fax.

Oh, all right, okay. So it’s really more of like a segment one or two?

That’s correct.

And that’s going well? Or is that just--

Yes, that’s going well also. It’s not going to change the world of fax for us.

Okay, all right.

I mean we are going down as we projected, we will be continue to be down in facsimile at the mid, the high 20s, maybe even 30 percent, that would be the range that we would be down. It is impossible to forecast it exactly.

And with the sale-lease back, how should we look at that as far as the impact on growth? Well, I’m sorry you had a buyout on one of your rental contracts?

We have some customers that have -- we had some customers that basically had rented machines for a number of years and have turned to us and said you know we just do not want to rent them anymore we would rather just buy them out. And so what happens in that case we offer them a buyout price that is recorded as a sale. We saw that in the second quarter so obviously that would affect the future rental revenue stream going forward on that product.

And is that part of what we saw with the drop in depreciation?

Exactly.

And also the progress in the accrued billings?

Not necessarily. No.

What’s the different between the -- your DSO you look like it made more progress in accrued billings than you did in accounts receivable? I assume you include both of those in the DSO count?

No, we just include receivables because by the nature of the beast the accrued billings are not eligible to be billed yet. So we would not want to include them, as part of a receivable calculation because it has not been billed so therefore could not be capable of being paid. But the accrued billings there are timing issues associated with when the bill -- we accrue them and recognize the revenue as we earn it and there are timing issues when we bill it that will move accrued billings either up or down and they go from accrued billings into accounts receivable. So there are timing issues.

We made good progress in accounts receivable, it doesn’t show up in absolute numbers because as we stated, we had acquisitions in there and we also said there were receivables to be acquired plus we also did a lot of shipments in late June, So those two factors would kind of mask what we believe is a nice improvement in accounts receivable. The key number we look at anyway, it stays outstanding and that was a nice improvement. It’s been a nice improvement from quarter-to-quarter now for I think as Tim had stated it was down from a year ago by 10 days or something like. It was down from last quarter also by a few days.

Clearly turning in the right direction.

Okay. What do you think drove the strength in late June?

The strength in business in late June?

Yes.

You know we are always driven at the end of quarter I think historically every one of our competitors will tell you there is a lot of business but maybe we just got more at the end of June than we had in the past and it’s impossible to say. Nothing spectacular in the world happened to drive that.

And that one conversion did occur in the month of June.

Okay, all right, so that would have been a boost. All right, as far as the ERP progress, there’s been some concern that the impact of the sales force as far their ability to focus on selling rather than fixing the accounts that were having problems, how is that going? Do you think the sales force --?

It’s still a fact it still isn’t perfect. It keeps getting better. The receivable seems to be getting under better control but it’s still not perfect. We’re doing sales compensation now, which is the last major stage of the ERP project. So when this is fully behind us we expect our sales organization to be more productive than they are today. We’ve improved in productivity. There is no doubt – there’s no doubt about that but to say we have no issues outstanding from the ERP would be a misstatement. We still do have some. It still does affect the sale of organization.

The good thing about this then is that we are going in the right direction and as we do move and become more proficient on the system we should get better sales productivity. I look at it as opportunity. Even though we’re producing very good results today, the upside for the future is bright because we are going in the right directions, we are becoming more proficient and sales productivity is improving.

Our next question comes from James Clement with Sidoti and Company.

If I may just ask a follow up to Ben’s question there. Can you talk a little bit qualitatively about what you’ve seen in the last couple of months related to the ERP system that has you encouraged and then perhaps the second part of the question would be, looking forward without getting into numbers, where should investors expect to see efficiencies from whether it’s the next 12 or 24 months, whatever?

The first obvious one is the DSO. I think that’s a true indication of billing accuracy. People are not going to pay unless the invoice is correct and what we’re seeing is a trend that people are paying, DSO is coming down even though our revenues are growing, so that’s a true indication. In addition, as you know we are – we just went live in the month of July with our sales comp that was really the last hanging piece. That seems to be progressing. We’re going through that but that seems to be looking favorable, also. So, we are really moving forward on this thing, and also if you look at our expenses, in this quarter, if you remember each quarter in the past we were generating costs of $6 million to $5 million a quarter in the ERP expenses, our total expenditures, total cash outlay, capital and expense, was less than $1 million. That’s another indication that the consultants are being taken off the job and we’re moving forward and kind of wrapping this whole project up. So, just a lot of positive news on this – the ERP front.

The biggest upside as I see it over the long term, I am not talking about over the next 2 or 3 months, but over the long term is you get this behind the customers, you get it behind with the sales organization. You should see nice, productivity increases per person. So, how big that is, it would be impossible to say since we haven’t gotten through it totally yet, but personally I’m very excited about that company.

Okay, thanks very much. That’s very helpful.

Our next question comes from Lloyd Zeitman with Bernstein Investment Research.

Could you give us some ideas to what your after market sales look like on the year-to-year basis in the quarter and for the year-to-date?

We’ve never really disclosed that. We disclosed recurrent revenue number, which is in the 70 – it’s in the 70s. We don’t break the sales out between supplies individually by segment by supplies and all that. So, nevertheless, that is a good – a growing item on the Copier/MFP side is a climbing item on the fax side.

Would you say in terms of the growth that you’re seeing on the copier side, are we talking something equivalent to sales or we seeing maybe something in excess of that or are you not willing to give that kind of guidance?

Well, although we don’t give that guidance, I can say again that the after market on color products is much higher than the after market on black and white. So, you can do the mathematics yourself to how the color business grew very, very nicely but it’s still is a small part of our base, but it’s become a larger and larger factor to undergo on the color basis. So, you can pretty much do the calculations yourself there.

Okay, and on the cost of rentals, we’ve seen the gross margin here decline for the second quarter in a row and of course, and you guys never hesitate to talk about the trends with copier growing and the fax declining that this is a negative for the gross margin. So, should we assume that the gross margin on rentals will decline quarter by quarter through the remainder of the year and for as long as we have this growth in copier at the expense of fax?

Grow again by—just remember that the fax again today at the end of quarter was 24 percent. It’s dropping substantially. We believe by the end of the year, fax will be about 20 percent, hopefully even less than that of total, but the margins on fax are higher than they are on MFP copiers. So, naturally we say we’ve always believed that that would– that the mix would have a negative impact upon us. If you look by segments, nevertheless, there again, depending on the size – the larger the rental contract we get on MFP copier, the margin percentage would then be affected by that negatively on larger contract, the margin dollars would be impacted positively by that. So again, in our organization here what we focus on is gross margin dollars minus operating expenses equal operating profits and operating profits are the key factor in our growth.

And what we see is there’s a few other dynamics in that rental margin. We’ve had quarters where actually even though our niche has changed more to MFP, our rentals margins have improved and that could be attributable to lower product cost. It could be attributable to the level renewals on machines that are fully depreciated. So, there are a number of factors that could also be involved in determining what the margins will be quarter after quarter. So, this doesn’t necessarily mean – but you’re right, as the mix changes, overall margin should go down but there are other factors that do play into it.

Okay, thanks.

Our next question comes from Charles Widmeir with Eagle Capital.

I was just wondering, I know the government contracts--it looks like in the fourth quarter, you might benefit from that, but I was wondering if you felt the increase in the fourth quarter and what you’re seeing in increased activity now is also in your base business as well in the copiers?

We are seeing, again, the government business was a decline, which went away over a few quarters. What we are seeing is sequential growth in that business, sequential growth from last quarter to this quarter was 3 percent per quarter. The turn annualized rate that is quarterly and I believe the quarter before that we had the same type of sequential growth. We believe we’ll continue to have nice sequential growth in the – in this area. Does that answer your question?

You said that your recent activity really looked for your fourth quarter to grow more rapidly.

In the year-to-year comparison.

Okay.

Okay, sequentially again, we’ve had – we have had good growth sequentially and that’s what we look at again if added for quarter to quarter to quarter. As it turns out, the fourth quarter of last year, that number has dropped pretty substantially from the third quarter –

Right.

Because of the loss of that contract. So, when you look at a year-to-year comparison in the fourth quarter, if we have the same sequential growth we’re having now, and you take a look at last year's numbers, it would show that a fourth quarter that the year-to-year growth would be a percentage would be a lot better.

Okay, thanks.

Our next question is a follow up question from Margot Murtaugh.

Okay, to belabor a couple more points. Well, my first question is when you gave earning guidance a few months ago you said there were $0.14 of non-recurring charges in this year.

Right.

Which is about 4 million, I think, and so I think you’ve taken like 2.8 million so far? Is that the case?

We’ve taken what we thought we would, Margot.

So you’ve already taken –?

We’ve taken in that region –first and second quarter we have taken everything.

You said you’ve taken everything –

Yes, we’ve taken all the people out of there.

No more severance or anything?

We don’t have any plans.

I think it was $0.12 impact in the first quarter and $0.02 impact in the second quarter.

Okay. Great.

And that $0.12 impact, Margot, of the roughly of the first quarter charge, some of it, 1.1 million of it was in cost of sales because it had to do with inventory obsolescence related to the Millford shutdown.

Okay.

So that may be where you’re missing the beat.

Right. Okay, that’s good to know. So, your estimate of 158 to 162 for the year includes that --?

Yes, it does.

$0.14?

That’s correct.

I have a 26 – I’m using – I have $0.26 for the first quarter. Is that the number you’re using to get to your—for the rest of the year or do you know offhand?

No.

I have a 26 operating – I have a $0.26 as your first quarter number.

That has been restated. The first quarter was restated, $0.09 plus 12, so it would be $0.21 for the first quarter on a normalized basis.

Okay. So that’s the number you’re assuming when you us our estimate – the estimate of 158 to 162 - $0.21 for the first quarter.

Yes.

Okay. I didn’t know that. Great. And just to belabor the cost of sales point again. Last year, in the second half, your cost of sales went down a lot to 51 percent. Is that – is that just – is there a normal seasonal pattern or a normal reason for that or was that just some other factor that isn’t going to follow this year?

Our cost of sales.

Yeah, that’s what I have.

As our margins were, I think, about 43.6 percent last – in the second quarter of last year? Is that what your –

No, the second half. The cost of sales went down a bunch from the first half last year.

It is not seasonal.

So that was just – that’s not necessarily something that recurs every year that you’re --?

No.

You know, so – we should be looking at the cost of sales so far this year and make our adjustments to get a better picture?

I mean we’re not –

I know there are many factors.

Yeah we can’t model – I mean but there’s nothing seasonal about it. No.

Okay. Did you ever give a size to the government business – tell us how much that was total?

No.

Okay. Okay. Thanks.

Our next question is a follow up question from Herb Hart.

I was curious about the government contracts and whether you’ve seen any movement to change the criteria away from denying things manufactured in China?

Well, as I mentioned earlier, Herb, we are in the process of adding a few products due to federal GSA contracts. They should be added to the contract within the next 30 days, then we’ll be launching this sort of sales force so that we could probably being selling products by let’s say the first half of – first quarter of next year.

Right. I understand that you’re using Japan as a source, but I was just curious, whether the government has – this could affect a lot of other things and whether you’ve seen any shift in the government stance relative to China?

Well we are hoping that we may see some of that, but we have not seen that, no.

Okay. Thank you.

It’s not something where the drive is, okay? I think it benefits everybody. For that to happen, maybe benefits of some more because we really don’t have very much in Japanese products but we, ourselves, have not been the ones lobbying it.

Okay. Thank you.

Before we leave, I was kind of concerned that based on Margot’s question that there may be some confusion. The first quarter of earnings per share number was $0.09 and that’s what’s included in the $1.58 to $1.63. On a normalized basis – it was also $0.12 worth of restructuring and severance charges in the first quarter, but it’s $0.09 was the first quarter earnings per share that was including in the $1.58 to $1.63 estimate that we reiterated.

So basically, the guidance that we have given is what we will be reporting.

[OPERATOR’S INSTRUCTIONS] We seem to have no further questions at this time.

Okay, if there are no further questions. Again I would like to thank you all for your continued support. We are very excited about the results in the second quarter and we are looking forward to a very good balance of the year. Thank you very much.

This concludes today’s conference call. You may disconnect at this time.