漢威聯合 (HON) 2008 Q2 法說會逐字稿

Good afternoon, and welcome to the Intermec conference call.

(OPERATOR INSTRUCTIONS.) Today's conference is being recorded.

If you have any objections, you may disconnect at this time.

And, now, I'd like to turn the conference over to Mr.

Kevin McCarty, Director of Investor Relations.

Sir, you may begin

Great.

Good afternoon, everyone, and welcome to Intermec's second quarter fiscal year 2008 earnings conference call.

With me on the call today is Intermec's President and Chief Executive Officer, Patrick Byrne, Chief Financial Officer, Lanny Michael, and joining us on the phone is Mike Wills, our Senior Vice President of Global Sales and Service.

As usual, we will begin with some prepared remarks, and then subsequent to that we will take questions from the participants on the call.

Now, let me quickly cover the Safe Harbor statement.

Today's discussions may include predictions, estimates, or other information that might be considered forward-looking under the Private Security Litigation Reform Act of 1995.

Some of the statements we make today may be considered forward-looking, including but not limited to Intermec's expected financial performance, as well as Intermec's strategic and operational plan, along with additional examples that are set forth in today's earnings release.

These statements involve a number of risks and uncertainties that could cause actual results to differ materially.

Please note that these forward-looking statements reflect our opinions only as of the date of this presentation, and we undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements.

For a more detailed description of the risk factors that may affect our results, please refer to our SEC filings, including our Annual Report on Form 10-K, our quarterly reports on Form 10-Q.

Copies can be obtained from the SEC or by visiting the Investor Relations section of our website.

With that, it's now my pleasure to turn the call over to Pat.

Thanks very much, Kevin, and good afternoon, everyone.

Joining Lanny and I on the call today is Mike Wills, our Senior VP of Global Sales and Service.

Mike will be available for the question and answer section of the call.

As we've outlined in the previous conference calls, our objectives are to accelerate growth and improve profitability toward the target business model of double-digit revenue growth and operating profit.

In Q2 we made progress in our strategy, especially in the areas of channel development and product gross margins, in spite of a revenue shortfall compared to our expectations.

Looking forward, there are some very good signs in the underlying business performance that I want to discuss today, as well as some important changes we've recently announced, which we expect to improve future results.

Now, I've been here a year now as CEO of Intermec, so I'm going to spend some time taking a broader view of our progress over the last year in improving growth and profitability.

Total revenue for the second quarter was $218 million, up from $210.5 million last year, or 4% growth.

The shortfall in revenue compared to our expectations of $227 million to $232 million was due primarily to some enterprise projects that have moved out of Q2 into the second half.

The largest of these was Royal Mail, which we have since completed the contract and will begin rollout in Q3.

There were several other enterprise deals which moved into Q3, as well, some of which we have since received orders for and will begin shipping this quarter.

The good news is that we've won the business, that moved from Q2 into the second half, Intermec expertise continues to be very valuable for our customers, even in an uncertain economic environment.

In fact, higher fuel prices are creating compelling return on investment for improved route management and in-transit visibility.

Some customer projects, however, are taking longer to get through the approval phase and are getting higher degrees of scrutiny for funding.

In our guidance moving forward, we remain cautious about enterprise spending, especially in the U.S.

I want to spend a few minutes on Royal Mail.

We've been working on this contract for a number of months, and I wanted to outline its importance.

Royal Mail is one of the largest postal delivery organizations in the world, with thousands of delivery workers throughout the United Kingdom.

The letters business handles over 80 million items per night.

Royal Mail is in the middle of a major transformation of mobile IT infrastructure to improve automation efficiency and to support improved revenue generation and customer service in an increasingly competitive environment.

As announced yesterday, Royal Mail Group has selected Intermec for an initial deployment of over 25,000 CN3 rugged mobile computers for in-transit visibility, one of our core market applications.

So what is in-transit visibility?

It answers the questions of where is every item in the journey, what mailbag, what mail truck, where's the truck, and when will it arrive at the destination.

Intermec was selected because of our innovative technologies, as well as the proven expertise and the results we've demonstrated with our partners during the trial period.

The contract that we have with Royal Mail involves hardware, accessories, as well as services, and will be deployed over several quarters.

As I stated earlier, the first revenue from Royal Mail will begin this quarter.

The total contract, including services and accessories, exceeds $30 million.

The majority of the hardware portion we expect to ship in the second half of 2008.

In the midst of economic uncertainty it is important, I feel, to point out the customers are making these large investment decisions to transform business operations with mobile solutions from Intermec.

The European postal delivery systems are going through major IT transformations to support increased automation and efficiency in a newly deregulated and competitive environment.

Royal Mail is a leader in this field and Intermec's win at Royal Mail, and Royal Mail's initial deployment provides us with a leadership position for future postal business in Europe.

Going back to the summary of Q2 revenue, regionally North America grew 5%, Europe, Middle East and Africa grew 11%, Asia-Pacific or APAC declined 10%, and Latin America declined 14% compared to Q2 of last year.

From a product line point of view, systems and solutions grew 10%, printer media declined 2%, and service declined 6%.

With this mix picture for Q2 growth rate, it's very important to take the broader picture and look underneath the numbers.

First, in North America, this increase when combined with Q1 of 25% growth delivers 14% growth year-to-date, meaning that our largest region is contributing in a major way to our overall corporate objectives.

Furthermore, this growth in North America was achieved in spite of the delays in some enterprise spending, which I mentioned earlier, and despite the absence of large projects in this quarter's North America revenue.

Our channel business in North America now contributes 60% of sales in the region, and enables a broader business and a simplified distribution system.

Through this approach, we expect to increase our reach and revenue stability in the region, and be able to lower our SG&A costs in the future.

I'm very encouraged by our progress in North America channel participation.

Now, turning to Europe, Middle East, and Africa, or EMEA, we grew the business 10% in Q2, continuing the strong momentum from Q1.

This is before the Royal Mail contract, which we expect to be reflected on our growth rates beginning in Q3.

We're very well positioned in EMEA, and we are seeing good results across all our product lines.

For example, in printers, we've seen 16% growth in EMEA compared to Q2 of last year.

Turning to Asia-Pacific, this is an area which will receive more focus going forward.

The decline in Q2 reverses a growth trend in the region established in recent quarters.

Year-to-date we've grown in Asia, but we expect better results.

I recently met with over 100 channel partners in Bangkok, and they are very excited to work with Intermec.

Turning to Latin America, the 14% decline in business compared to Q2 of last year continues a trend from Q1.

The decline is driven by a comparison to first half of 2007, when we had several large deals in consumer packaged goods, direct store delivery, mobile rugged computer application.

That business is still strong for Intermec in the region, but these customers are between purchase cycles.

The key to sustained growth in Latin America is a broader channel business, and our recent visits to the region indicate that our partner and channel business will be contributing to the Company's objectives, and there are many attractive opportunities.

Turning now to the product line revenue, systems and solutions grew 10% in Q2, and when combined with the 25% growth in Q1 this product line achieved 21% growth year-to-date.

The CN3 and CN3e continue to ramp, and when combined with the rest of our portfolio, including RFID and EX25 near/far imaging solutions, represent a very powerful platforms to improve the productivity of the mobile worker.

In the industrial and warehousing space, we are experiencing solid bookings growth, led by the [CK31EX] and [SR61EX] product lines.

The growth engine for Intermec are these mobile solutions, enabled by our products and expertise, focused on our customers' business transformation.

We have very exciting new product developments underway that will further strengthen our portfolio and position Intermec to continue its leadership position.

I'm very confident of our position, market results, customer engagement, and growth prospects in this product line.

Printer media declined slightly compared to Q2 of last year, after a strong Q1.

We've seen solid increases in worldwide channel sales for printers, but this was offset in Q2 by some weakness in Latin America in project business.

For example, fixed printers, comprising high performance commercial and desktop products, grew worldwide 13% in Q2 compared to Q2 of last year.

We've recently made changes that enable select North America channel partners to service our printers under the Intermec Partner Service Program, or IPSP.

This has been very well accepted and represents a significant growth opportunity for Intermec and our channel partners and printers.

The focus going forward is to continue to make progress in the printer go-to-market execution.

We have a solid product portfolio and plan to introduce more new product soon that will meet customer needs and align well with the channel.

Turning now to the service business, the service business declined in both revenue and margins in Q2.

Last year's Q2 we had an unusually high level of gross margin in services.

As we announced on July 10, we have taken action to streamline this business by consolidating North America repair depots and outsourcing onsite services where the team was underutilized.

When combined with improved attachment rate objectives in both direct and indirect channels, we expect the service business to improve growth and profitability.

We've already improved service growth margin 200 basis points sequentially from the first quarter.

Now that I've covered the update on growth, I want to turn to gross margins.

This is the key driver of the improved profitability specified in our target business model.

In November of last year I outlined that our objective was to improve Company gross margins by 5 points to 43% by the end of 2009.

The largest factor for Intermec to improve gross margins is the product business.

There are four primary strategies we are employing to improve product gross margins, including selling discipline with average sales price, new product introductions, operational efficiencies, and supply chain simplification.

Over the last year we've been delivering improved product gross margins based upon the first three strategies, before materially changing the supply chain.

In Q2 we delivered 400 basis point improvement in product gross margins compared to Q2 of '07.

Over the last year, product gross margins have improved 370 basis points compared to the trailing four quarters.

That's a major accomplishment.

Average sales prices have stabilized through selling and value discipline, and operations is running more efficiently, while new products are making a contribution through innovation.

All these product gross margin strategies will continue to be a priority.

On July 10, we announced our plan to transfer final assembly of our products to Venture Corporation.

This is a major step in the transformation of our supply chain.

This decision is consistent with the strategic outline I provided last November, and is part of a multiyear supply chain improvement initiative.

Venture is a proven partner of Intermec, working with us as a contract manufacturer for over 10 years.

They specialize in high quality electronics manufacturing and engineering services.

We've developed a comprehensive implementation plan to transfer the final assembly to Venture, that will reduce our manufacturing and distribution costs, as well as inventory from the supply chain.

We expect this will increase cash generation capability and improve flexibility, while enabling the next major steps in lowering total cost.

Our expectation is that this project will be completed in the next 9 to 12 months.

We expect to see the benefits from this transfer starting in early 2009 and to enable us to achieve our target gross margins by exit 2009 of 43% Companywide, another 300 to 400 basis point improvement in current product gross margins.

Operating expenses ran higher in Q2.

Lanny will cover the major factors that increased, compared to our unusually low level of spending in Q2 of last year.

The major increase was in SG&A and driven by foreign currency losses, a weaker U.S.

dollar, and a Corporate ERP upgrade.

R&D spending was also up, driven by new product developments underway.

Reducing spending as a percentage of revenue is a priority of the Management Team, and will be phased in as we simplify and streamline the overall operations, while not limiting growth.

Our target business model is to run operating expenses at or below 33% of revenue.

We expect our channel model to enable us to lower SG&A spending as a percentage of revenue in the future.

I'd like to turn it over to Lanny now to review the financial results in more detail.

Thanks, Pat.

Intermec's first half revenue growth over the comparable period in 2007 is up 12%, with first half year-to-date operating leverage of 35% over the comparable period in 2007.

As Pat noted earlier, operating leverage is measured as incremental operating profit over the incremental revenue achieved.

Intermec's second quarter revenue of $218 million represented a 4% growth over the prior year's second quarter.

Second quarter GAAP earnings per share were $0.13 compared to $0.13 in the comparable quarter last year.

Second quarter revenue was impacted primarily by certain enterprise level projects that were deferred into the second half of the year.

Reviewing our product line performances, growth in our systems and solutions revenues helped drive overall revenue growth in the quarter and year-to-date.

Systems and solutions revenues increased 10% over the second quarter of 2007 to $129 million.

This product line represented 59% of total revenues.

Printer and media revenues of $51 million, representing 23% of total revenues, and service revenue of $38 million, representing 17% of total revenues, declined 2% and 6%, respectively, from prior year's second quarter.

Total gross margin was 40.7%, this compares to 38.6% a year ago, representing a 210 basis point increase.

Year-to-date gross margin of 40.5% represents a 310 basis points improvement compared to the second quarter year-to-date in 2007.

Second quarter product gross margin was 40% and improved 400 basis points from the year ago margin of 36%.

Year-to-date product gross margins improved 450 basis points to 40% level.

These metrics demonstrate progress in achieving year-over-year gross margin improvement, one of our primary stated goals.

Service gross margin was 44% in the second quarter, compared to 49.2% in prior year.

This margin decrease on lower revenues impacted overall margins by more than $3 million in the quarter compared to last year.

As we commented, we are targeting cost productivities from the service depot consolidation that we announced on July 10th as part of our restructuring initiatives in the second half of this year, and we expect that hardware product growth along with improving attachment rates and contract renewals will serve to drive improvement in service margins in future quarters.

Operating expenses for the current quarter were $77.8 million, an increase of $9 million from the second quarter last year.

Over half of this expense or $5 million of the increase was driven by foreign exchange related matters associated with the weaker U.S.

dollar and its impact on SG&A spending and foreign exchange conversion losses related to the balance sheet reporting.

The balance of the increase was related primarily to IT expense associated with the ERP system platform upgrade and to stock compensation.

We experienced a $2.6 million increase in operating expenses sequentially from the first quarter due to the increased R&D expense, sales and marketing, and IT related expense in the quarter.

Also, a weaker U.S.

dollar had an incremental negative impact on SG&A operating expenses.

As we commented last quarter, we anticipated some increase in operating expense run rate over first quarter levels due to investment related areas, like R&D and the potential foreign exchange impact to SG&A related expenses.

Operating expenses in the second quarter of 2008 included the benefit of a $2.8 million gain from the sale of property, or $0.03 per share.

In the prior year's second quarter, operating expenses included an operating gain of $2 million, or $0.02 per share.

During the second quarter of 2008 the Company's engineering facility, located in Cedar Rapids, Iowa was impacted by the record flooding that occurred at the end of June.

G&A expenses in the second quarter of 2008 included net charges of approximately $1.1 million or $0.01 per share related to this flooding impact, reflecting total estimated charges of approximately $5.1 million, offset by anticipated insurance proceeds of $4 million.

The Intermec teams have done a tremendous job getting back in operation, while keeping projects on track.

The Company's second quarter 2008 effective tax rate was 35.5%.

The comparative effective tax rate for the first quarter of 2007 was 36.7%.

The Company's cash equivalents and short-term investments increased $11 million in the quarter to $199 million balance at the end of the second quarter.

Inventories were up more than expected, primarily due to finished goods staged for certain large enterprise rollouts that deferred out of the quarter, including the Royal Mail deployment.

We are focused on the management and oversight of inventories as we transition to the outsourcing initiative.

On July 10th, 2008 the Company announced its plan to relocate final assembly of product lines from the [Everett], Washington Facility to Venture Corporation.

Also, to consolidate two U.S.

service depots for a [break fix] to existing locations and transfer onsite service repair to a third-party supplier.

These actions are consistent with the Company's previously announced strategy to simplify and streamline our global supply chain and improve gross margins.

We announced that total restructuring costs are expected to be in the pretax range of $7.5 million to $9 million.

The Company expects to record approximately $6 million to $7 million of this restructuring charge in the second half of 2008, and expect the additional $1.5 million to $2 million be recorded in 2009.

Reviewing our guidance for the third quarter of fiscal 2008, we expect our third quarter revenues to be in the range of $220 million to $225 million.

Earnings per share from continuing operations are expected to be in the range of $0.06 to $0.10 per diluted share.

This EPS range is inclusive of our estimated costs related to the supply chain imitative, as discussed today by Pat.

Our EPS forecast includes restructuring costs in the third quarter of $4 million to $4.5 million or $0.04 to $0.05 per share.

Our EPS forecast also includes transition related costs of approximately $2 million to $3 million, or $0.02 to $0.03 per share.

These relate to costs and there is like overhead absorption and duplication of costs due to transition associated with the relocation of the final assembly operations to a third-party contract manufacturer.

Our EPS guidance assumes a diluted share count to be approximately 62 million shares for the third quarter.

We anticipate the effective tax rate for the full year of 2008 to approximately 36.5% to 37.5%.

That concludes my formal remarks.

I'll turn it back, now, over to Pat.

Thanks very much, Lanny.

Our strategy is making progress.

We're focused on accelerating growth and improving profitability towards the target business model of double-digit growth in operating profit.

We intend to capture the revenue opportunities through higher channel participation, vertical market focus, key customer engagements, and innovative new products.

For example, the large contract with Royal Mail is a key win for our CN3 product in our core application of in-transit visibility.

The CN3 and CN3e continue to ramp volume in other core applications, including route management and field service.

In order to accelerate growth we also intend to improve our international sales as a larger portion of the Company's revenue.

We're also focused on improving profitability with a target of high levels of operating leverage.

If we examine our Q3 guidance closely, we expect to deliver robust operating leverage on the incremental revenue when we set aside expected restructuring and transition costs.

As I look back at one year of being the CEO of Intermec, I'm very proud of the Team for progress in creating profitable growth.

Over the last year, the Company has more than tripled earnings per share from $0.19 to $0.60 on a trailing four-quarter basis.

The increase in earnings was driven by revenue growth and solid operating leverage.

The actions we have outlined to streamline our supply chain and consolidate service depots are expected to further enhance profitability, while enabling greater flexibility and productivity.

It will also be important to manage expenses carefully, and going forward, this will continue to be an area of management focus, especially in the SG&A line items.

There will be opportunities to capture the benefits from the simplified end-to-end supply chain and channel centric go-to-market strategy.

Our progress to date in the channel positions us well for these improved expense ratios.

In summary, we're confident in our belief that we can grow the Intermec's business while improving profitability.

Our core technologies and expertise are very valuable to customers, and the discipline of the operating leverage work we are doing will provide a roadmap for improved EPS growth as demonstrated by our progress in the last year.

I'd like to turn it now over to Kevin for the next stage of our phone call.

Thanks, Pat.

We would now like to open up our call for a question and answer period.

Sarah, you can now provide our callers with the instructions on how to queue for this session.

Thank you.

Thank you, sir.

(OPERATOR INSTRUCTIONS.)

Our first question, from Eli Lustgarten with Longbow.

Your line is open.

Good afternoon.

Good afternoon, Eli.

Yes.

Okay.

Just listening to the talk, I mean you preannounced this quarter, so it's not a great surprise.

We're looking at a little better third quarter from a volume level and a profitability level, it looks like it's a little bit better.

Can you talk about the trends in the business?

I mean seasonally we've had a big fourth quarter last year, and I think the expectation was a relatively big fourth quarter this year, and the kind of environment and what we're seeing, is that something that we should still be expecting, or should we still be looking at, because of the economic environment both here and abroad, suggesting that it's either unpredictable or we'll be getting more of the same that we got, in fourth quarter and into 2009?

Okay.

I'll take a run at that first, and then I'm sure Mike will follow-up.

This is Pat.

I think what we've got is we've got a combination of factors.

One of them is that enterprise spending is something that is taking longer on some projects to get approval cycles.

At the same time, were' getting a broad channel based business that, if you look at Q2 we grew the business compared to Q2 of last year, in spite of some of these enterprise deals moving out in time into the second half.

But I think the underlying picture is that the demand still looks robust.

Mike, do you want to add to that?

Yes, if I could.

Eli, this is Mike.

First of all, your perspective and your comment about fourth quarter historically being our largest, we don't anticipate to break that trend this year in 2008, but I think combined with your observations, that we're all seeing at a macro level of, you know, the overall caution within our targeted vertical markets, I do believe that it will certainly have some degree of throttling affect associated with it, that Pat just mentioned.

But I don't anticipate that we're going to break that cycle.

Clearly, Q4 is anticipated to be a large quarter for us.

But, as Pat had mentioned, we are spending a lot of time now both with our partners and with our strategic account teams, focused on the timelines in the decision cycles that our customers are going through on these larger projects.

Okay.

In your guidance for Q3, I guess Q2 had the sale of a thing and you had an insurance issue or, you know, flooding issue that impacted the sales side a little bit.

There's no insurance numbers or impact from the flood in the third quarter anymore; is that correct?

Eli, this is Lanny.

And that's correct.

We have recorded the anticipated insurance of $4 million in the second quarter, and that offsets the $5.1 million of charges, and so that would be complete already in the second quarter.

Great.

Is there any, you know, you're sitting with a lot of cash and we're sitting with a lousy return on investment kind of environment.

On the cash, is there any thought of using that cash to either more aggressively to, you know, for shareholder value, you try to do share buyback, or doing something, a flat acquisition or something with the cash, or have you guys thought anymore of what we can do with that large cash holding given the pristine balance sheet of the Company?

Eli, let me comment, twofold.

As you mentioned, we have about $200 million of cash, which earlier this year we actually used $100 million of our cash to repay the last of our long-term debt, so we are now once again reestablishing better levels of liquidity, not looking past that maturity.

You know, we believe it's prudent to maintain certain levels of liquidity for working capital and operating flexibility, particularly in this timeframe where we see, as Pat and Mike had mentioned some transition in the marketplace with enterprise decision-making.

And that it also gives us some flexibility on a cash base just to be responsive to changing dynamics, to your point about strategic initiatives, and while we don't have anything specifically to comment on that, it would be in our perspective to give us some of that flexibility.

As you know, the last time we did a share repurchase was in the fourth quarter of '06 for $100 million, and while there currently is no authorized share repurchase program in place, this is a matter that our Board has routinely in the past, as well as looking forward, plans to consider.

Thank you.

I'll let somebody else ask.

Our next question comes from Andrew Abrams with Avian Securities.

Your line is open.

I wonder if we could talk a little bit about the Royal Mail?

Given the fact that this is a large deal, is this going to have impact on product margins for the period during which the hardware is sold?

I wonder if you could give us some color there?

Well, this is Pat.

I'll answer that question.

We've incorporated, you know, as we look at the hardware portion of this moving forward and shipping more than half of the total hardware revenue, the majority of the hardware revenue in the second half, we've included that in our guidance, what we anticipate to be the revenue profile looking forward in Royal Mail, so we've -- I won't comment specifically on the margin associated with Royal Mail, but it's incorporated in our plans.

And, also, if we could talk a little bit about the re-up process for Royal Mail?

If I understand it correctly, from what I know of it, there's a second review period after the product has been delivered and in use.

How specific is that to you guys, meaning, you know, is there something that could throw it off for the second round?

And can you give us some perspective on what they're thinking for the second round of this, and kind of some timing on when that might happen?

So, Pat, if you ...

Yes, go ahead and jump at that one, Mike.

Yes, I'd like to offer some guidance on that.

The, really the second opportunity, let's phrase it that way, under the second opportunity that we have at Royal Mail is a distinctly different application within their overall business.

Obviously, the two will be linked.

There is some type of platform usage on the software that they have contracted with some other parties to develop around this initial phase, that will be utilized in the second project.

The environment in which the products will be used will be similar.

So, obviously, there's a lot riding on this in terms of the performance of the Intermec CN3 in this current phase that, obviously, will be evaluated as they move into the second.

But this will almost be a heel, toe, or a serial type of approach.

They'll roll-out this phase, make their evaluation, and then proceed into the second phase.

But they were very diligent in their evaluation cycles.

They went through almost a seven-month pilot program, evaluating the CN3 and other products before they made their decision to start it moving forward.

Right.

So short of some product, which we wouldn't expect to have, you guys are there for the second phase, whatever that second phase happens to be?

I certainly like our position now as opposed to otherwise, Andrew.

Absolutely.

Got you.

Thank you very much.

Our next question from Jeremy Grant with Stanford.

Your line is open.

Hey, thanks.

Hey, guys.

I wondered on the Q3 guidance if you could talk a little bit more about there's, so we have guidance that there's going to be an impact from restructuring cost on EPS of $4 million to $4.5 million.

And then separately transition related cost of $2 million to $3 million.

Is the latter one something new that wasn't talked about in the preannounce?

Jeremy, this is Lanny Michael.

The announcement incorporated the restructuring component that you cited, and the information that we are providing in the release today is outside of what would be traditionally classified as restructuring, but it is transitional related costs that we wanted to give some visibility on that would be nonrecurring in nature and, therefore, we've clarified that in our discussions today.

Okay.

So that is something new, though, on top, that we should model in on top of what we did after the preannounce?

Correct.

Okay.

And is that -- the $2 million to $3 million, is that a onetime charge that you only have these transition related costs in Q3, or should we also as we're modeling I guess the broader costs of this whole transition, be expecting more of those in the next few quarters, as well?

We anticipate that the transition related costs would be contained in the second half.

We've not given specific guidance for the fourth quarter yet, but those transition costs, or I should say some transition costs, probably not more than, but we don't have the specific number yet that we've given guidance on, but there would be some additional in the fourth quarter.

Okay.

So we should count on something else there as we're putting this together going forward.

Other question I had on Royal Mail, and congratulations on that award, by the way, is can you break out of the $220 million to $225 million of the guidance for Q3, you know, what your rough idea is of how much contribution you'll have from Royal Mail in that quarter?

Yes.

I'll go ahead and answer that question.

We would not be breaking that out in the quarter.

As I've said, the -- what we've guided is that we'll see the majority of the hardware in the second half, but we wouldn't be describing how much of that revenue will show-up in Q3, but it's part of our overall guidance of $220 million to $225 million.

Okay.

So there'd be some then, some Q4, and we'll probably be smart enough to figure out the difference.

Yes, that's right.

Okay.

That's all I had.

I'll drop from the queue.

Thanks.

Thank you.

Our next question from Ajit Pai with Thomas Weisel Partners.

Your line is open.

Yes, good afternoon.

Good afternoon, Ajit.

A couple of quick questions.

The first one is on the service side of things.

I think you mentioned that the big sort of margin impact was due to lower revenues.

Could you give us some color as to what the pricing situation is over there and why your service revenues are falling?

The main reason that our service revenues have fallen and is really associated with the North America trailing hardware business.

So as we build the North America business, so you just think about it this way, the hardware gets sold, then the service contracts get established.

Over time those service contracts have to be renewed, and now you're supporting an installed base, so the -- as the hardware revenues build in North America, the service revenue gets restored but on a lagging basis.

That's what is -- that's what we're seeing in the affect of the service business.

Now, as we build the hardware business, and our hardware business is building in North America as we've outlined, our largest region has grown 14% year-to-date, that will enable us to build a larger installed base in which to have contracts for the service business.

That plus the operating leverage we gain from the efficiencies of a more integrated supply chain with our consolidated service depots, combined with higher attachment rates, is what drives the operating leverage moving forward in the service business.

And the pricing?

That's the backward looking picture.

And the pricing environment for services?

The pricing environment -- Mike can comment on this, as well -- but the pricing environment for services is pretty stable.

Yes, I would agree with that, Pat.

It's been stable for a period of time.

Ajit, you know there was, probably two years ago, I may be off by a quarter or two, but about two years ago there were some introductions of some new no fault programs and other things that seemed somewhat aggressive at the time.

And, of course, we matched to maintain and gain share at the time.

That is still a very small portion of our business, as most customers are signing up for typical medallion depot service programs.

So the pricing literally on a global basis has been identical, if not highly similar over the last two years, as Pat mentioned.

Got it.

And then just looking at the AIT 3 contract, I think it's been now four years, and it's about another year before ...

Right.

...

get the announcement for AIT 4, so in the past pattern, I think you had AIT 1, you know, you didn't manage to get AIT 2.

You were back on in the AIT 3.

Can you look -- I mean is that a pattern that you expect to continue?

Are you in the running for AIT 4?

When does the bidding process begin, and how well positioned are you for that?

And what would the revenue impact of that be?

So, Pat, if you don't mind, I'll take that.

I'm going to answer your questions in reverse order, Ajit.

Obviously, too early at this point to start framing revenue expectations against a contract that will be in a proposal phase in 2009.

I will tell you that the AIT 3 contract has been an important one for us to win and hold.

Obviously, a lot of DOD spending has been diverted to other areas over the last couple of years, obviously, with global theaters going on.

Nonetheless, the AIT Program has provided a conduit for us to enjoy attractive growth in the government sector, within specifically the four DOD branches.

Looking at AIT 4, we do position ourselves and consider that an attractive program.

There is some degree of specific needs that the government always looks to accommodate in those contracts.

We have to evaluate what those specs are going to look like at the time that the specs hit the street, but at this point in time we anticipate participating in it.

It's an attractive growth conduit for us.

Got it.

I'll just add to that, that I recently was in Washington, D.C.

and met regarding this -- we're doing a really good job in this part of the business, and I think we'll be competitive, and we intend to pursue it.

Okay.

And then just looking at -- the last question will be about your Asia and Latin America, you know, the percentage of your business has been small but was a very rapidly growing part of your business last year.

So now the first half its been quite disappointing, and while there are difficult comps in Latin America, a large number of your competitors also had difficult comps there but have been executing in Brazil, particularly, quite well.

So could you give us some color as to what went wrong in the first half of this year in both Asia and Latin America and why your growth is, you know, what it is, and what steps you're taking.

I think you mentioned that you expect to actually see that reaccelerate, what steps you're taking to help that?

Sure.

Pat, I'll take that, if you don't mind?

So let's talk about Latin America for a second, Ajit.

I'll take both of these bullets.

Specifically, talk about Latin America, and really we consider Latin America in two distinct areas, northern Latin America, which is Mexico and Central America, and then southern Latin America, which is basically Argentina, Brazil, Chile, Peru, et cetera, with obviously the major commerce center in San Paulo, Rio, and greater Brazil area.

I just, as a matter of fact, a couple of weeks ago came back from an extended tour down there, meeting with many of our alliance partners, Cisco and others, as well as many of our partners, and some key customer contacts down there.

There is a very attractive infusion of growth going on in some specific verticals that through some partnerships we are getting access to.

We're seeing some attractive growth in [Sola].

On the other side of that, if you look at the year-to-year declines, as you've already mentioned, Ajit, we have been, and Pat mentioned this in his notes at the beginning, dependent on three very large consumer package good companies for some significant project revenues over the year, [Bembos], [Sebritas], [Spimsa], and some others.

But those are the big three that we have a large presence in.

And, frankly, we're in between or what I would refer to as a quiet cycle.

We're in between some large project rollouts right now, and we are building out our rate business through distribution and partners.

The funnel for the back half of the year and going into 2009, specifically in [Nola], looks attractive.

We're looking at target markets, such as petroleum and gas, and government, as I mentioned, both in Nola and Sola.

But it is highly impacted by the fact especially in Nola where we're in this quiet cycle of these three large customers right now and some rollouts.

If we kind of transition to Asia-Pac, Asia-Pac is a little bit of a different story.

We've got historically we've had a smaller footprint there, Ajit, as you know, and our challenge there is just building out distribution presence.

Although year-to-date we are growing in Asia-Pac, and we intend to grow for the year, we obviously know and recognize that we're leaving growth on the table, opportunity is there for us to seize, and obviously with this move to contract manufacturing, additional resources will move to Asia-Pac that will help us accelerate our growth there.

Okay.

Got it.

Thank you.

Our next question comes from Tavis Mccourt with Morgan Keegan.

Your line is open.

Hi.

This is [Chuck McPatterson] for Tavis.

Hi, how are you doing?

Fine, thanks.

How are you?

Good.

Thanks.

Yes, just a couple quick questions.

First, could you break-out growth on a constant currency basis for your international market?

We -- I won't respond quite to your question probably in terms of constant currency, because we're not necessarily equating it to that.

Okay.

Something that we have historically or, I should say in the past commented on is the impact of currency rates on revenue.

The -- we estimate that the currency conversion rates favorably impacted total revenue by about $9.8 million this quarter over last year, with probably about $8 million of that being in EMEA.

Now, I want to footnote that, however, because the way we go about this as we refer to it internally is a formulaic type of calculation, and is not all a direct correlation to our consolidated revenue.

And what that means is that local currency price pressure, the results from stronger purchasing power, of certain foreign currencies, is impacting this.

And, therefore, not necessarily capturing, we're capturing a portion of this, but not all of that calculated revenue number that I gave you which is a sort of a static, what had happened last year if you just do it on a constant currency basis, is necessarily in this quarter's revenue number.

So, hopefully, that was understandable.

I mean the point I guess is is that it's a static number but it's not necessarily a measure of the absolute revenue that was captured in our reporting of revenue this quarter.

Right.

Got it.

Thanks.

Now, just a quick kind of accounting issue.

I notice that inventories were up a little bit again this quarter, after rising substantially in Q1.

Is that just more a function of kind of some of those deals flipping out of Q2 into Q3, and should we expect that to tick back down, heading into the upcoming quarter?

Yes, as a comment, and I'll just reiterate it, it was higher than we anticipated in the finished goods area, and this was directly impacted by the enterprise rollout that were deferred, as we had staged inventory, for example, for the Royal Mail deployment.

And as Pat and Mike have commented, some of those deployments are underway in the third quarter.

So to answer your second part of your question, on two accounts we would expect that finished goods inventory would reduce because of that, and while we don't have a specific target in mind yet, into the third and the fourth quarter the transition to our supply chain, third-party supply chain initiatives, we're also targeting a reduction of revenue from that process.

So the inventory -- yes, I'm sorry.

Okay.

And I guess for my final question, I notice you were focused on kind of for the concerns at least about the U.S.

or North American macro environment here, and I was curious if you're seeing any weakness in any specific verticals at this point?

So, Pat, I'll take that if you don't mind?

Chuck, I'm going to be cautious to use the word weakness, and just kind of reuse the term cautious again.

It's -- it really applies to larger projects, IT investments, a higher level of scrutiny in terms of CapEx associated with IT expenditures is what we see going on, and it is not contained, to the point of your question, in a specific vertical.

I see the behavior going on inside all of our specific core verticals -- transportation, logistics, retail, cpg, and industrial.

But I'm also, when I talk to our partners and distributors, I'm seeing elements of that outside of our core four verticals.

That being said, the projects that we're tracking, although they're going through higher rounds of scrutiny and longer cycle times of evaluation, they stay on track and they stay funded, and we are not losing these in terms of competitive share, nor do we see the projects getting killed, just deferred, and the decisions I think being a little bit more cautious.

Okay.

Got it.

So pretty much pervasive ...

Yes.

...

and a little bit soft here and there.

Yes.

Is there any price concessions on any of these products to get them closed?

Not on our behalf.

In fact, you've seen I think demonstrated with our product margins that Pat led with, we're actually seeing margin expansion and our pricing holding, and being able to extract premiums when we can.

And we're not seeing behavior from our competitors in this particular scenario right now.

So it's kind of stable.

Okay.

Got it.

Thanks.

Our next question from Reik Read with Robert Baird and Company.

Your line is open.

Hey, good afternoon.

Thanks.

Good afternoon, Reik.

I just wanted to see if I can focus in a little bit on the operating expense side of things and the profitability side.

When I look at the service side of things, and you guys touched on this, flat revenue quarter-over-quarter, but gross margin up basically 2 percentage points, is there anything that's onetime in there that kind of distorts that or is this some kind of sustained improvement that you're seeing at this point?

Well, I'll answer that.

We're looking for consistent improvement to the profitability of the service business.

The changes we've announced, consolidation of the North America service depots, combined with attachment rates, we expect that we will improve profitability moving forward in the service business, and we're seeing progress in Q2 compared to Q1.

As I had said, going back to Q2 of last year was unusually high, if you look at the numbers over the last several quarters, but we do expect continuous improvement to the profitability of the service business moving forward.

Okay.

And I guess part of the question, Pat, is that you've now announced the consolidation activities, and maybe these have been well underway, but it seems like you ought to see continued improvement throughout the remainder of this year, and is it a reasonable thought that you can start to see 44%, 45% as we get towards the end of this year?

Well, I think that those are the kind of numbers that we've seen before, so we'll be moving up the margins.

I don't want to give specific guidance on service margins, but I do think that we can improve the revenue and restore the margins to the levels that we have seen in the past, and that's what Dave Jones, who runs this business for us, is working on hard.

Mike, do you want to add anything to that?

No, I think you've modeled it exactly the way that we've kind of structured the plan in front of us, Reik.

The key balance here is like any manufacturing environment, Reik, there's a balancing point between volume and skills and capabilities that are rolling through a repair center.

And so we have modeled that, obviously, with our consolidation, and we'll take advantage of those consolidated volume streams coming through a smaller subset and obviously are looking for improved margins out of that.

So I think as the plan matures, and as we execute to it, then we'll be able to speak a little bit more definitively on the results.

And I think that you guys have talked about the service growth being impaired by the previous North American shortages that you had really with the product transition.

Now that you've had three quarters of growth is it fair to think that those service revenues are at least bottoming out and, therefore, you're not going to have to fight any volume issues?

This is really going to be focused on the cost improvement execution?

I think that's a good way to think about it.

Okay.

And if I could ask, on the operating expenses, I just want to make sure I have the math correct here.

I'm not including the flood charge, but I look at what you reported between SG&A and R&D, and I come up with $76.6 million, and there's a real estate gain there, so on a business operations standpoint, I come up with $79.5 million, is that the correct way to look at that?

Reik, this is Lanny.

The way I would look at it I guess is that in the second quarter of this year and the second quarter of last year there were two operating gains from -- unrelated to the business, and they don't cancel each other out, but they come close approximation.

And you're right, the $1.1 million for Cedar Rapids is not recurring, it was a onetime type of issue.

So if you just, if you take that on a relative magnitude, that sort of evens each other out.

And so I'm not necessarily taking anything out specifically beyond the $9 million increment that occurs, other than those three items somewhat net each other within maybe a half a million dollars.

The other thing that I would add just to that is that there were some onetime expenses in Q2 associated with the ERP upgrade, and so we are very aware about the expense ratios, as I outlined before, and that we don't want to run the business at $79 million per quarter.

We're headed into a situation where there is uncertainties.

As I've said, we think we'll continue to grow the business, our guidance is to grow the business in Q3, but we're examining carefully that, and intend to take the actions to make sure that this thing is not at a run rate that is as high as the calculations you just ran at.

Now, we have to scrutinize things, and there are onetime things, but I would not build a picture that keeps growing from $79 million on up.

And I guess that's exactly what I was trying to get at, Pat, is just you had a big bump.

Yes.

First quarter to second quarter, and I understand that there is some SG&A initiatives that you're trying to get at, and maybe a little bit of product development, but it seemed like a big bump.

And I guess the questions off of that is how much was onetime with ERP that it would come out pretty quickly?

And then what are some of the -- I know you probably don't want to get too specific, but how quickly can some of these other things come out?

Well, let me just comment that I would say, I think what you're looking to to some degree is that with all the things we've said and, as you say, kind of the puts and the takes, third quarter operating expense in its entirety, including R&D and SG&A, will probably still be approximately the level of second quarter and some degree because of the timing of R&D investments and we certainly always scrutinize those, as well as the comment in the year-over-year number there was quite an impact, a foreign exchange impact in our spending levels.

And while that was more modest from first to second quarter, there was almost a million dollars of that impact just from first to second quarter.

So to some degree those fluctuations could reoccur if we continue to see, you know, economic decline on the dollar, or they could moderate.

So I -- my comment would be that giving all those puts and takes the third quarter OpEx level would probably at a somewhat comparable level to second quarter given the visibility we have at this point.

Okay.

And then let me just ask one maybe bigger picture question?

Pat, you guys have done a nice job with improving the gross margin so far, and I know that there's more to go.

But just can you talk a little bit about from an operating margin standpoint, you've talked about a 10% operating margin goal, at least for now.

What's the slope of that curve look like?

Is it kind of flat as you go through these consolidation activities in the next couple of quarters, and then it really starts to move forward more significantly in '09?

Is it backend loaded?

Any just direction would be helpful?

Sure.

Let me outline that.

If you just think about that the second half revenues will be more than the first half revenues, because Q4 is a strong quarter and Q3 we've already provided the guidance.

If we, you know, we are going to be examining carefully the percentage of revenue in expenses.

As I said, these things can't change overnight.

There's things that have to be done.

We'll start to see the benefit.

So that's the first thing is really ensuring that we're managing expenses as a percentage of revenue with some of these uncertainties, but there are also some of these things that Lanny has outlined about currency.

So we're keeping all that in mind.

Now, margins, the product gross margins, we start to see the benefit of the product gross margin move in the beginning part of 2009.

that's what we've outlined, is that the product transfer to Venture, we start to see the benefit in the first -- in the early part of 2009, but we don't get all of it.

It slopes through 2009 with our -- and just reiterating what I've said before, which is our plan is to get to these 43% Company gross margins, you know, in the -- as we're exiting 2009.

So we'll start to see the benefit, long -- short answer is we start to see the benefit in early 2009, we'll see the full benefits of that according to the things that we've outlined by, well, at least the portion that is required to be get to us, to 43% as we exit 2009.

And I take it, Pat, you mean both gross margin and expense scrutiny will really kind of kick in in early '09?

Yes, those are the -- that's right.

So the way to think about that is there's six quarters between now and the end of '09, and we're looking at both expense ratios and gross margins improving, product gross margins, over that six-quarter period.

Now, we don't -- we're managing transformations here, so these things are multi-quarter, and you have to think about this looking backward and forward over multiple quarters, but we expect to continually show the progress along these, to get to this target business model.

Okay, okay, that's very helpful.

I appreciate you going into that detail.

And then just one follow-up question for Mike, just on the Royal Mail/European opportunity.

Can you give us an idea of what the -- you talked about things happening sequentially, what the timing is on phase two of the process, and then are there other larger deals that you're down the road with right now that maybe aren't going to generate revenue in the near term, but you're starting pilot programs?

Yes, so my comments, Reik, about phase two were really specifically about the second project phase of Royal Mail.

They clearly have communicated to us that that is not a process that they will start in any kind of serious manner until 2009.

This is a significant rollout that they have in front of them right now.

Not just the complexity of the project, but, of course, just the introduction of change into their own business processes, that they've got to get through.

So phase two for Royal Mail is -- which is the Walker Program, the actual letter and small parcel delivery process is a 2009 type activity.

Relative to the other postal projects that are going on specific to Europe, we do obviously have activity going on in [LaPost], Spanish Post, Italian Post, recently some promising signs in the Saudi Post in terms of our direction, but all of those that I just mentioned previous to that are really entering final selection phases in late Q4 with probable selections, Reik, in first half of 2009.

Okay.

Great.

I appreciate you guys taking the time.

Thank you.

You're welcome.

Our next question from Chris Quilty with Raymond James & Associates.

Your line is open.

Thanks, gentlemen.

Just, Mike, following up on that, how many Walkers does Royal Mail have?

I mean what sort of volumes might you be looking at for that phase?

Well, Chris, I'm going to give you a range.

I think the bigger question is will they enable all of them with a [rugged] device?

That's the outstanding question, but you could be looking at 60,000 to 80,000 devices if they enabled everybody, which I don't think actually that they will do, but depending on the success and the attractive return that they get out of this first phase, it may dictate the degree in which they ramp that second phase.

Got you.

And obviously a lot of things went into your selection on that contract.

Congratulations, by the way.

But how important do you think the integrated GPS was as a distinguisher relative to the competition?

It was, as a differentiator it was a big deal.

It clearly it differentiated us not only early, but throughout the entire evaluation process.

But if you read the press release and the quote from Robin, the CIO at Royal Mail, he specifically announces two things.

It's the performance of the product, which is not only just the integrated feature set of GPS and the radio packages, but just the performance of that product under fire, that the pilot program really drug that product through some grueling tests, as you can only imagine.

And CN3 held-up really, really well.

The other side of that comment that Robin makes in the press release, which they wrote and submitted in terms of that quote for us, had to do with the entire team, the project team that we placed on that.

So the customer in the selection process put obviously a value on the product and the value associated with the feature sets in the product, but also a value on the inherent intelligence and support that they were getting from the project team that we wrapped around this opportunity.

Yes, I just wanted to add to that, Chris.

I've talked to Robin a bunch of times, been to London a bunch of times, and this is a major transformation for Royal Mail.

They have -- it's a 360-year-old organization, with tens of thousands of people, and they have a lot of responsibility, the thing has got to work.

And the team did a great job in not just deploying the technology, but ensuring that with our partners it works well.

So it's not just about a GPS technology, that's a key enabler, it's also about the capabilities on the ground to make it work under fire, as Mike has outlined.

Okay.

That's great to hear.

I wasn't sure how much weight to put in that quote since Kevin wrote the press release.

[Rob Endark] wrote that particular part, so.

Good, good.

We can rely on it.

It's a lifetime away, but relative scale, opportunity of Spain, Italy, Saudi Arabia, relative to Royal Mail?

Yes, there's, obviously, Royal Mail was not only the first to go, but it is by size the largest, Chris.

I would say just proportionate sizes these are in the 25% to 40% kind of sizes of Royal Mail in terms of total.

Okay.

And is it likely or fair to believe that one or more of your competitors may have an integrated GPS by then?

I think that's a fair assumption.

I mean we assume that in our strategic plans in every one of these accounts.

Okay.

Also, just on the product side, you mentioned the EX25, [near/far imager], which you hadn't in awhile.

Is that product beginning to provide some positive traction for you?

Yes, I'll comment on that.

The [EX25] has been very well accepted, as I mentioned the [CK31EX], it's really a very highly differentiated technology.

It's got good, you know, it adds to the average sale price, it enables the average sale price and the gross margins.

We've seen good progress in the last year since I came here.

It had been introduced, and we had some longer deliveries a year ago, but the delivery is very good and the quality is very good, and it's getting strong acceptance.

Great.

And presumably you're going head-to-head with Motorola on their lower [X], on those sort of contracts?

Right, correct.

Okay.

For, Lanny, interest income was up a bit there in the quarter.

You aren't doing anything with auction rate securities?

That's correct, we are not.

Okay.

I mean to answer your question, we've got a little bit better cash balances, and with the cash being distributed across the world, it's not all concentrated, it kind of depends on our ability to do short-term investments, overnight investing with cash and bank and what-not, so we would anticipate that the interest income would probably stay at a similar level looking out the next couple of quarters.

Okay.

And, also, just on numbers here, you didn't give the specific number but I'm -- am I correct in about a 4.7% growth for North America, if I back into it from your year-to-date in Q1 that you've already given?

We gave the -- I think we've just said 4%, but the actual computation ...

We -- yes, I think we've calculated 5%, so ...

Yes.

...

that's right.

Okay.

And the jump in deferred revenue in the quarter related to Royal Mail, it's up about $8 million or so, sequentially?

No, it's not related to Royal Mail, it's related to some other, I guess you might say enterprise type of accounts.

Okay.

And a final question here, the printer business, which has been a bit of a headache for quite awhile.

I guess late last year you hired on Earl Thompson to run the business.

I know you've done some things with bringing more of the product development in-house, and yet you don't seem to have really gained much traction.

What's the plan for that business either product wise or channel wise to finally get it working and meeting up to its expectations?

Well, we have seen growth in printers in the first half, as I've outlined.

Q1 was 10% growth in printer media, Q2 was slightly down.

When you look below the surface, and you look at the fixed printer growth in the second quarter, when you look at EMEA growth, as I said the weakness in Q2 is really Latin America project business on a comparative basis.

And so we're getting very good acceptance of our channel initiatives there, and our plan is to expand the business through the channel.

The IPSP Program, shorter deliveries, a channel centric go-to-market, that's the work that Earl's team is doing, I'm confident that that will -- we have a good set of products here, it really is about leveraging the channel to expand the business, and the underlying bookings growth and activity in distribution is strong there.

Got you.

And I think it'll show results.

It already has year-to-date, and I think we're on a good path there.

Got you.

Actually, following up on that, partner service program, you announced here that you're going to basically outsource some of your service activities to your larger, more competent channel partners, which seems to be the opposite of the trend that we've seen in the industry in the last three or four years.

[Symbol] tried to pull all that stuff in and had a channel revolt when they did it.

But you're clearly going to earn some channel points by passing out that attractive service business, but is that not going to ding your overall service growth if you let more of that business go out to the channel?

Yes, this is Pat -- we've done all that work to understand this, and we believe this is a high leverage move because what you do is you're incenting the channel partners to reach and that the -- and, therefore, the improvement in the business and the hardware growth rates, as well as you just look at what we trade off and what we trade on, it's a favorable improvement to enable these channel partners.

Got you.

All right.

Congratulations, gentlemen.

Thanks, Chris.

And, gentlemen, at this time, I'd like to turn the conference back over to you for any closing remarks.

Great.

Thanks, Sarah.

Once again, we appreciate everybody joining us on our call this afternoon.

That will conclude our call for today, and we wish you the best evening.

Good night.