Scansource Inc (SCSC) 2004 Q2 法說會逐字稿

Good afternoon. My name is Rocky, and I will be your conference facilitator today. At this time, I would like to welcome everyone to the ScanSource earnings release conference call.

All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question and answer period. If you would like to ask a question during this time, simply press star then the number one on your telephone keypad. If you would like to withdraw your question, press the pound key. Thank you. Mr. Bryson, you may begin your conference.

Thank you. Thank you for joining us for the ScanSource conference call to discuss results for the quarter ended December 31, 2003.

My name is Jeff Bryson, Vice President of Administration and Investor Relations for ScanSource, and with me are Mike Baur, President and CEO, and Rich Cleys, Vice President and CFO. We will spend a few minutes reviewing the quarter's operating results and then take your questions. This conference call contains certain comments which are forward-looking statements that involve risks and uncertainties.

These statements are subject to the Safe Harbor created by the Private Securities Litigation Reform Act of 1995. Any number of important factors could cause actual results to differ materially from anticipated results.

For more information concerning factors that could cause such a difference, see the company's annual report on Form 10(K) and quarterly reports on Form 10(Q) filed with the Securities and Exchange Commission. Rich Cleys, ScanSource CFO, will now comment on overall sales and operating results.

Thank you, Jeff. Good afternoon. The company posted sales of $289 million for the quarter ended December 31, 2003, an increase of 16% over sales of $250.1 million for December 31, 2002.

Measuring sales based upon our product group shows a year over year growth of 22% in AIDC and point of sale, along with a 7% year over year increase in telephony for the quarter ended December 31, 2003. That produced a 6139 mix of AIDC and point-of-sale versus telephony sales.

Our next discussion will focus on consolidated operating results.

Gross margin was 10.7% for the second quarter of fiscal 2004 versus 10.8% for last year, and is within a normal range compared to our most recent quarters.

Operating expenses were 20 million and 6.9% of sales compared to 16.5 million and 6.6 % of sales last year.

For the quarter just ended, the company took a special charge of 1.25 million for a disputed sales and use tax assessment, and made a profit sharing contribution of $1 million to its retirement plans. We will talk more about the sales and use tax issue in a moment.

If the December quarter is adjusted for these amounts, selling general and administrative would have been 6.2%, which is lower than recent quarters but typical when revenues grow faster than expected.

Operating income, fully burdened by the sales tax issue, increased by 4% to 10.9 million, which is 3.8% of sales compared to 10.4 million and 4.2% of sales for the December, 2002 quarter end.

Net interest expense was only 199,000 versus 274,000 for the same period last year.

Our overall effective tax rate has decreased to approximately 37% from 42% for the years ago period, since the company is now making use of net operating loss carry-forwards available in its foreign units.

We expect our blended tax rate for the upcoming March quarter to be between 37% and 39%. December quarter-end net income, including the sales and use tax charge, increased 15% to 6.7 million, and 2.3% of sales compared to 5.8 million in December, 2002.

We will now take a minute and tell you more about the special charge we had this quarter that prompted our GAAP to nonGAAP disclosures in the press release. The company has recently been notified that it will receive an assessment for state sales and use tax for the three calendar years ended 2001.

Based upon this notification, after consulting with our advisors, the company has determined a probable range for the disposition of that assessment and for taxes that may yet to be assessed for the two subsequent calendar years ended December 31, 2003. Although the company disputes this assessment and intends to vigorously defend its position, we accrued 1.25 million for this issue in SG&A for the quarter ended December 31, 2003.

For the quarter ended December 31, 2003, nonGAAP net income, which excludes the special tax charge of 1.25 million -- which is 775,000 net of tax -- increased 28% to 7.4 million compared to 5.8 million last year. NonGAAP diluted earnings per share increased 26% to 58 cents per share, compared to 46 cents per share last year.

Please refer to the companies statements regarding nonGAAP financial information and the related reconciliation of GAAP results to nonGAAP results located in this release and also located in the Investor Relations section of the company's Web site at www.scansource.com.

Now a cautionary word about the use of nonGAAP financial information. The reconciliation in the body of the press release and on pages seven and eight of the release shows the adjustment between results calculated using generally accepted accounting principles, and nonGAAP information provided in the release.

The nonGAAP data is included with the intention of providing investors a more complete understanding of our operating results and trends, but should only be used in conjunction with results reported in accordance with GAAP.

Our return on invested capital this quarter without the tax assessment was 27%, which is slightly above our target range. Balance sheet metrics and cash use were as follows -- Inventory turns improved to 6.7 times at the end of December, 2003, compared to 5.9 turns in the June, 2003, quarter.

The number of outstanding accounts receivable days was 46 at December 31, 2003, which is unchanged from the June, 2003 quarter. Cash of $2.1 million was provided by operating activities this quarter.

After cash use for capital expenditures, our line of credit balance decreased to 19.4 million. We ended the quarter at less than two days of paid for inventory; meaning that a significant portion of our investment in inventory was offset by our interest-free trade payables to creditors.

Jeff Bryson will now comment on each of our reporting segments.

Thanks a lot, Rich. North America distribution revenue, which includes sales from all three selling units -- ScanSource, CatalystTelecom and Paracon -- posted sales of 260 million, a growth rate of 12% over last year.

The ScanSource unit, included in North America distribution, saw growth across the board as we took additional market share. AIDC sales were strong this quarter, some of which came from larger Symbol [INAUDIBLE] who had previously sourced directly from the vendor, now choosing to buy from ScanSource under Symbol’s Partner Select Program.

Point of sale products sold well this quarter, led by some large deals for IBM and NCR Solutions, as retail end users took advantage of buying opportunities tied to the calendar year end.

For 2004, our manufacturers have asked us to help create incremental demand across specific vertical markets. The result of that is the launch of Solution City, which is our first ever marketing program designed to present multi-vendor solutions across all business units -- ScanSource, Catalyst, and Paracon. This effort will focus on total solutions, combining the resources of our manufacturers, independent software vendors, and service offerings, including those offered by our Partner Services Group.

Solution City is geared toward vertical markets, including retail, hospitality, government, education, financial services, distribution, manufacturing and healthcare. Solution City will help our customers identify key decision makers and market driven buying patterns, understand unique customer challenges for a variety of markets, find the best solution for specific verticals, and learn to market in different environments.

Solution City has several key thrusts. One, targeted reseller recruitment. Two, educational road shows and seminars. Three, a Web portal containing marketing and educational content; and four, traditional marketing and educational materials.

First, all sales units will direct reseller recruitment activities and current business development resources to reaching VARs who today may be selling a variety of computer and networking equipment into a particular vertical market. Our goal is to introduce those vertically focused VARs to additive high-margin sales they can make by including our specialty technologies of AIDC,

POS or converged communications into their solutions offering.

Second, we will kick off a new series of road shows beginning in March, 2004 in Anaheim California, where CatalystTelecom, Paracon and ScanSource, along with their vendors, will provide a vertical showcase, allowing resellers to get an up close view of the way various technologies work in specific vertical markets.

The show will feature a keynote speaker, vendor-sponsored seminars on how to successfully sell into vertical markets, plus a table top expo.

The centerpiece of the Solution City initiative is a Web portal that will provide a complete online educational and informational resource for VARs who want to learn more about how technologies work in vertical markets and how they can consistently match the right technology to the right market in order to open up new sales opportunities.

The site will be organized around Vertex, the demonstration of a particular type of technology solution for a specific vertical market.

Finally, the Solution City guide book will serve as the print version of our online knowledge database.

Like the Web portal, the guide book will be organized around Vertex, showing how various types of technology work in specific markets.

Solution City is the most ambitious marketing effort ScanSource has ever made and it is being enthusiastically received by our vendors and customers. ScanSource recently signed an agreement with Hewlett-Packard, HP, to fill a product gap in Solution City. During the March quarter, we will begin distributing the HP-RP 5000 POS, HPs new Web enabled point of sale platform.

This new HP POS product is an open standards-based device designed to connect to best of breed POS peripheral devices.

The RP 5000 combines the functionality and warranty programs of popular proprietary systems, with the lower price and flexibility of PC-based POS systems.

The ScanSource merchandising team is looking to sign four to five complimentary vendors to round out Solution City and to continue to be a one-stop shop for our resellers. To that end, this quarter, ScanSource signed an agreement with O'Neill Product Development to distribute O'Neill's complete line of portable thermal, portable impact, and thermal wireless printers. O'Neill printers are easy to operate, have a rugged construction and excellent dependability, and are available with Blue Tooth and 802.11V radio capability.

We will now discuss the CatalystTelecom sales unit. Telephony demand was higher than expected this quarter, given the fact that Catalyst sales of the Avaya [INAUDIBLE] are usually not as strong sequentially in their first fiscal quarter following their fiscal year end of September 30.

Avaya's channel growth strategy requires each reseller to create demand to drive incremental revenue in their geographical and/or vertical marketplace. Because Avaya is Catalyst's key vendor and because there is less shift in sales from direct to indirect, Catalyst's opportunity will be closely tied to general market growth and Avaya's gaining share with new products.

CatalystTelecom is also continuing to sign vendor lines which are complimentary to the Avaya offering.

Avaya has announced that Extreme Networks is going to be their provider of data products, so we will be working with Avaya and Extreme Networks to develop a go-to market strategy. Extreme now uses commodity distribution channels for its reseller strategy, so they look forward to the added help they can receive from Catalyst value-added focus.

Our third selling unit is Paracon, which focuses on converged communications products from Intel and NEC. Paracon had a strong December quarter, led by record sales for the Intel product line.

Intel sales were driven by an increase in Paracon's market share, more shift in business from direct to indirect, and increased business development activity by the Paracon sales team.

The NEC relationship was begun last quarter, and we are developing the programs and processes to accelerate the expansion of their two tier distribution strategy. This quarter, we will add new employees in tech support, sales, business development and merchandising, as we ramp up our recruiting efforts.

The NEC products require authorization and certification for dealers and will require Paracon to invest considerable resources to make the line successful. NECs target reseller group includes traditional voice resellers, as well as successful data and networking products VARs. We are looking forward to beginning our sales activity with the NEC line in the March quarter.

Our second reporting segment is International Distribution. International Distribution, which includes Latin America and Europe, posted sales of 29 million, compared to last year's quarter of 18 million. Approximately 3.3 million of the increase in international sales was the result of favorable foreign currency. exchanges.

Taking foreign exchange out of the current year amount would show a growth rate of 43%.

International sales were led by AIDC products in both Europe and Latin America. The Symbol Partner Select program has been successfully implemented in those regions and ScanSource has benefited from the transition of former direct VARs to begin buying from distribution.

Intermec, HHP and Zebra are all in the process of implementing similar programs in those regions. We are continuing our efforts to boost sales of POS products in Europe and Latin America, and have added merchandising staff accordingly.

In Europe, our U.S.-based AIDC vendors were strong, and AIDC sales there have been enhanced by strong performance from DataLogic.

DataLogic, headquartered in Italy, is the largest European manufacturer of bar code readers and portable data collection terminals. We recently negotiated a pan-European contract with DataLogic, where we previously had a U.K.-only agreement to distribute their hand-held readers and portable data collection terminals. DataLogics' hand-held readers includes Contact, Instinctive, Distance, 2D and Mobile versions.

The PDC product range includes a variety of portable, compact, and ergonomic terminals, together with software development tools and solutions for wireless communication and networking.

We will now conclude this part of the call with our expectations for the March 31, 2004 quarter.

Looking ahead to the March, 2004 quarter, we think total revenues could range from 260 million to 280 million, and diluted EPS could range from 45 cents to 54 cents per share.

At this time, we will be glad to answer your questions.

Ladies and gentlemen, to ask a question, please press star one on your telephone keypad. We'll pause for a moment to compile the Q&A roster. Your first question comes from Jeff Rosenberg.

Hi, how are you? Let's see, the first thing, a couple of clarifications. When you said 22% growth in AIDC, is that lumping together domestic and international?

Yes.

Okay, and then the second question is, you said telephony was up 7% year over year, but if I'm doing this right I get you flatish to down a little bit sequentially, but I thought you said you were up sequentially with Catalyst.

No, it was flat, but I think the message I think there, Jeff, is that it was basically a flat quarter, for us but we were not anticipating a lot of strong change in the dynamics of that relationship where we are going to see a lot more shift.

Okay. Yeah.

And could you comment a little bit -- are you at a point where you've completed the negotiation with Avaya for the year, and sort of whether that -- any color you can add as to what that means for your economics in terms of how much you need to grow there to get margins where you want them to be, that sort of thing?

Yeah, I think we are happy with where we are with them. We finished those negotiations and we feel comfortable that we've got the right structure in place for this year.

I think -- back to your other question -- I think in general, historically in the December quarter we always had a down quarter for Avaya, and I think, you know, this was the first year where that's not been the case.

Historically we always went from the September quarter being a very strong one and then down, and the December quarter which is the first fiscal quarter for Avaya, as you recall. So that's why it was surprisingly strong for us relative to our expectation.

Okay. That makes sense. And then, just wanted to ask a question on gross margin.

I mean, would you say that the large deals with IBM -- excuse me, with POS, and maybe with some of the larger VARs from Symbol, is that why we saw gross margins kind of coming down at the lower end of the range -- or I guess I'm comparing that against whether there's any effect from the fact that you seem to be holding a little bit less inventory.

No, I think you've got it right.

We definitely had, this past quarter, some large POS deals in CR and IBM, and we certainly did see, or are seeing, an impact as we shift some of the larger Symbol VARS into distribution it will come in at lower margins.

So I think you’ve got it right there. It's really that mix of some lower margin business that came in last quarter surprisingly strong.

And so that said, the other side of the equation -- it seems like you’ve been able to ramp up your inventory turns without really suffering on gross margin.

Is that sustainable or what do you think there?

Well, I think what happened is we have gotten more critical mass with each one of these vendors, and we got a more senior management team now within the different product groups.

And I think there is a consistent trend from all the key vendors we do business with now to reduce over time the number of variations of products. So we are seeing more focus on less SKU's. So that's helping us with inventory turns.

That's great. Thanks.

Thanks, Jeff.

Your next question comes from Chris Quilty.

Good afternoon, gentlemen. Your discussion -- or perhaps you could flush out a little bit more the discussion on Avaya and less mix shift from direct to indirect.

I know they are still at an extremely low level of indirect sales, and I know this is something you've been talking about for the past year, but is there anything specific that flushed out in the negotiations in terms of how it's going to be structured or their dedication towards moving to indirect?

Well, I think part of the reason I mentioned it was, you guys recall, Avaya recently purchased the Expanets business back and Expanets is now going to be part of their direct business. And so that certainly is a change for Avaya, and I think they had a lot of people focused on that last quarter and will continue to this quarter, maybe the next.

So I think they are trying to figure out where that plays and how much that business could be put back out into the channel through some of our dealers to service rather than the Avaya direct force.

So that's a pretty significant change.

Okay. So it's probably a period of retrenchment as they figure out how to get that business working.

That's right.

And in general, over the last year -- as we talked about a year ago -- a little over a year ago -- when they brought in some new management in the Avaya channel organization and they started to look at what role distribution plays, I would say they are still going through some of that.

I don't think they have made as hard a decision as some other manufacturers have to use the channel more. Clearly, distribution is the way they are primarily going to the channel.

They really don't have any large direct resellers to speak of; but in general, their direct business has still been a very key part of their strategy.

And as they have experienced changes in their management team, they continue to look at that. And we are just saying right now we are not anticipating this year, and this next quarter, being a shift quarter.

Okay. Specific areas of strength with the Avaya product line where you think they are doing well?

I think in general what we saw as a surprise was last quarter we were able to maintain sales compared to the September quarter, when normally when we are sitting there giving guidance for the December quarter we are always factoring in a less amount of business, and we couldn't figure out necessarily how much of that we really got in the September quarter. Do you remember from our last call, we were trying to figure out, did we really get any incremental in September that was early from the December quarter. It's always hard for to us predict that.

So I think in general, they had just consistent product strength last year and we are seeing that continue into this year.

They've got certainly a lot of IP enabled products now that are getting a lot of attention in the press, and as the end users starts to look at who are the key products, who provides the key products in IP enabled switches, I think Avaya has got a leadership position.

On the international business, can you give us an idea of what you are seeing in terms of the swing from, you know, a drag on earnings to profitability and where the upside in that business could go?

Well, I think right now we are still not at mature operating margins.

I think we are still at an investment mode, and we will continue in that for a little while. A couple of things, of course, different in Latin America and Europe is that we typically have higher SG&A because we have more people out in the region than we have centralized, because of the multiple countries we are trying to serve.

So I would say still not at critical mass in either one of those markets, but that over time we still expect to get there. That's still our plan, but we are pleased with the over all growth from a revenue standpoint.

I want to make sure that we continue to invest the infrastructure a little bit ahead of that so that we are prepared for that more mature model.

Okay. And any remaining issues in Latin America?

I know you had some country specific issues in the last six to 12 months.

Yeah, I think Venezuela was still challenging for us. They had a lot of issues going on there. Columbia, I think we are doing almost zero business there now. So we clearly have. I think Mexico is probably the bright spot. It's actually coming back for us, so we are pleased with that performance.

And have you established distribution facility in Mexico?

Yeah, yeah we sure did. We did that a few quarters ago, and started to really get a feel for what type of product we wanted to carry locally. So really, keeping our high movers in the Mexico facility. We still ship it in bulk down from Memphis, that way we've got our top few hundred products available for local delivery in Mexico City.

Okay, very good. And the guidance you gave at the very end of the call -- at least the earnings guidance for the upcoming third quarter -- looks to be bracketed towards the high-end, or at least the consensus estimate is up towards the high-end.

As you look through the earnings models out there, is there a general -- anything you'd point to where they might be too aggressive on perhaps the SG&A or margin in this quarter, as you're investing more in the NEC and European operations?

Well, this is Rich. In terms of our projection, we are investing in people -- I think in the commentary, we are investing in people in Paracon, certainly investing in people in Europe and then the Solution City effort is an additional investment that we've got.

So those kinds of things would be in the SG&A.

Okay. Thank you very much, guys.

Thanks, Chris.

Your next question comes from Patrick [INAUDIBLE].

Yeah, a couple of questions on the AIDC business. Can you remind us, what was that year over year growth last quarter in AIDC?

Yeah, that was 17%.

Okay, fair enough. So there was some acceleration there.

And then in terms of seasonality for the March quarter, what are you guys thinking about for that AIDC business sequentially?

Well, historically, the March quarter was up, historically. I think the challenge for us, frankly, is predicting our telephony business, because it's not always tracking the same.

I think that's where some of our caution is.

And so in terms of the AIDC business, you are looking for up sequentially 5%, or are you thinking about that being flat or how are you thinking about that?

We are not breaking it out. I would say built into our forecast, those assumptions are built into that.

And, of course, right now some of that growth, just as a reminder, is coming out of international. So that 22% AIDC growth is strong international growth. And so as our international business continues to become a bigger part of the business, that's what's making it grow faster.

Fair enough. And in terms of -- maybe I didn't catch it -- what was the foreign exchange benefit for the quarter to the top line.

The foreign exchange was about 3.3 million to the revenue line.

Okay, and in terms of Partner Select, I think you talked about that helping in the quarter.

Could you quantify that in some way, in terms of either VARs added or sales on a year over year or sequential basis?

No, we don't really break that out, but I think that's been a continuing trend throughout the year, so we wanted to highlight that that's continuing going to on throughout the December quarter.

Okay. And I think you also talked about other Partner Select-like programs being rolled out by Intermec and [INAUDIBLE],I think you said.

Yes.

Is there anything different there or what are the elements of those programs?

Well, you know, for each bidder to brag about each one, I think they all are going at it in the same general way which is, everybody is concerned about how do we make sure we reward VARs who create demand and make sure that those guys are more profitable than they were in the past. And so I think it's consistent with our approach this year to recruiting more demand generation-type VARs to our Solution City program. So that's really the common theme throughout all those programs is making sure the good guys continue to get good margins.

Fair enough. And then in terms of pricing, I think you talked about the margin impact as a result of Partners Select also as a result of NCR and IBM. So what about pricing on the AIDC side? Any one guy getting more aggressive than the other?

Well, we felt like we took some market share last quarter, and so we feel like we are very competitive in the AIDC space with our competition.

Thank you very much.

You bet. Thanks.

Gentlemen, your final question comes from Reik Read.

Good afternoon. Can you guys talk a little bit more about the point-of-sale area? You've added some product lines from IBM -- NCR has historically been very direct-oriented and is looking to get more indirect. To what extent are those things still ramping, or is this just the case where it is end of year purchasing and that's where the strength comes?

Let me try it in a couple of ways. Number one is, IBM and NCR historically are competing in larger end user opportunities with our larger VAR. So that's where they tend to play and that's why when those deals happen they tend to make a bigger impact when they are lumped in.

As kind of a reminder, of our other key POS vendors that are contributing that we don't talk about a lot. You’ve got Epson, who is the predominant player in printers, and they continue to have a good quarter and good year; as well as Elo, who is one of our touch screen vendors.

So we’ve got really a couple of other players that are feeding into that overall success; but whenever we have a strong quarter that we reference, it's because of those larger VARs and larger [INAUDIBLE] deals. I think that's what happened last quarter with IBM and NCR, both of them.

Is this a situation where because you have added some new product lines and because of NCR's kind of change in thinking that there might be a little bit more of a ramp in the next couple of quarters?

I understand your question, is your question about adding product line?

Yeah, I mean, my understanding was that you had added a number of IBM product lines -- I think it was the share point of sale area, and then from an NCR standpoint -- you know, they continue to talk about going more indirect in their retail business and I'm just wondering are those events that are occurring, and could account for a little bit more of a ramp than you might normally see?

You know, not specifically.

We didn't really add anything that was incremental, necessarily, to the product lines. I think some of it was just evolutionary that as IBM evolved their product space, we added more.

I think in general, I think there's an overall feeling that the POS market is going to be better in 2004.

Some of our vendors shared with us last week coming from the National Retail Show in New York that there was a lot more activity, frankly, than they've seen in about six years. So I think overall, we've seen more vendors come to us with ideas and programs as well as some products, including the fact that we added HP this quarter as well, that they believe that the market is going to grow and there's room for market expansion through the addition of ScanSource and our partners.

Okay, and I wanted to ask on Europe, too. You had mentioned that Symbol is ramping a little bit more than they had been with the Partner Select program.

One of the things had you previously expected to happen, too, is that Symbol and perhaps the other folks that are out there would start to consolidate their distribution base and use fewer distributors, and presumably you guys would be one of the winners. Has that started to happen?

Yeah, I think it has.

I think one of the things that's happened already is the focus by Symbol on requiring distributors to choose away from a mixed model and choose either being a two tier distributor only, selling only to resellers, or becoming a large bar.

And so by requiring the distributors that are already over there to choose their business model, that has already resulted in some changes in the landscape.

I think it will change incrementally over time; but certainly by the end of this calendar year, we will see, I think, some fairly significant change there.

And with HHP, Zebra and Intermec doing the same thing over in Europe, is that going to be a ramp that starts as early as the March quarter, or does that delay later on?

Well, I think they've all started it, but maybe -- without calling it with some formal programs -- they really all started it last year, and that's a reason that we've been growing over the last few quarters at a little faster clip internationally, because all of those vendors recognize that they've got to figure out a way to lower their cost to get to the market and that a ScanSource-type distribution model gives them value-add plus a lower cost to do that.

So I think the other guys are right behind Symbol in executing their program. Some of them, though, frankly, are moving faster than others, and we applaud them.

And then just last question for me.

I want to make sure I understand this correctly, is you guys had mentioned a couple of times that you are gaining share. Does that mean -- How are you measuring that, does that mean that you are gaining products from vendors or is there some share metrics? And can you comment, too, on how you are able to do that at this point?

Well, I think where we get that data from is talking to our manufacturers about how much of their overall distribution business we represent. And so our sense was from last quarter in specific areas like Paracon with Intel and with the ScanSource business unit that we took, we increased our percentage of their overall distribution market last quarter from some key vendors. So generally, that comes from either better programs and services for the reseller or as the manufacturer shifts more VARs to the distribution opportunity, we get more than the other guys get. And so I think those are the two ways that we gain share.

Great. Thank you, Mike.

Okay, you bet.

Your next question comes from Kevin Starke.

Hello. First question, Mike, is would you be able to tell us what head count was at the end of the last quarter versus the quarter just ended and where you might expect it to be at the end of the March quarter, just roughly?

Okay.

Well, we keep head count at about 709 here at the end of this period and it was about 685 at the end of September.

Okay.

Any idea what it might be at the end of the March quarter after you've rolled out some of these programs?

I think it's probably a net add of about a dozen people.

Okay. Could you comment -- and I'm sorry if you covered this because I came in late -- but gross margin in international versus domestic, just rough, against the corporate average?

Well we don't break it out for competitive reasons, but we've always said that we've got to have about a 2.5, 3% better operating, gross margin, just because we have higher SG&A and the fact that we have more salespeople to cover the same business, we have more outside business development resources, and in general, just a higher operating cost there.

So generally that's been the range we've given -- is we need 2.5 to 3 gross margin points more than we do in the U.S., especially in an early stage model.

Do you see that changing over time?

Well, I think certainly as we get critical mass we can certainly operate with more leverage, and I think the vendors expect us to do that, yes.

Okay. The Expanets purchase by Avaya, do you notice any effect of that on the NEC channel so far?

There's really nothing that's definitive out, there but the sense we have is that there will be some of those companies that were acquired by Expanets that were former NEC dealers will now become NEC dealers again.

So that's kind of the sense that I have right now. That's no announcement coming from me, that's just the things that we hear. So we expect that some of the NEC [INAUDIBLE] branch offices will be broken out from Expanets.

That's a potential market for you, then?

Well, I would say probably not right now, just because they are probably going to be direct purchasers from NEC.

Okay. Finally, you mentioned DataLogic before.

I know that that's a key account for one of your competitors. Has there been any movement with that vendor here in the United States or is that strictly a European phenomenon?

Right now it's clearly European. We already had a relationship that we acquired through ADC when we bought that company, and it was really more of an expansion and an acknowledgment by DataLogic that a pan-European distribution model was the right way to go. So we have no plans right now for U.S. distribution for DataLogic.

Okay, thank y'all.

Thanks, Kevin.

Your next question comes from Steven McVoy.

Hi guys, thanks.

First, you talked a fair bit about having to expand your service offerings of late, whether it's Solution City or roll outs, being examples.

Is this -- just so I understand - is this simply a natural progression in the business, or is this reacting to stepped up competition, if you will?

I think we've always had a business plan that said the difference in what we do and what commodity distribution does is that we help create demand.

And early on in the company's history we actually had a marketing program that we did in partnership with another distributor, because we didn't have critical mass. And I think this is just one of those evolutionary cycles where you're hearing us spend more time looking at ways to help create demand in these vertical market ways in general.

And what I mean by that is, four or five years ago when we got started with some of our vendors, they really wanted us to have hundreds or thousands of VARs, but they didn't care who they were.

I think in the last year and a half to two years when you've seen the roll-out of Partners Select from Symbol and you've seen Intermax honors program and HHP's and Zebra's they now say, we don't want just a thousand of anybody -- we want specific VARs in specific markets to help us.

And so I think this is an evolution of our sitting down with those vendors and saying, where do you want us to recruit from now, because in the past it was just, give us numbers, but they felt like that no longer is the best way to grow. They want specific customers targeting specific markets with specific solutions, and that's why we’ve changed our approach to how we're going to recruit this year.

So having said that, I guess hence the vertical market breakdown within Solution City initiative, I guess?

Yeah and it gives us really a focus. So that way our target is -- as far as it may not have been traditional targets by ScanSource, these are guys that would not call themselves an AIDC or POS or telephony bar, but they may be playing in those markets with other products, and our point is that we can help them sell these products in those vertical markets better than our competitors. So we see the net add of this is more customers this year; but very specific customers in specific markets.

A question -- that's helpful, but maybe put a different way -- are you sensing any vendors seeing benefits from any of your competitive distributors in terms of what they may offer relative to yourself? I mean I guess -- the thrust of the question is, I guess my diligence leads me to believe that certain distributors have kind of limited line cards but at the same point in time, the threat here is that resellers, whether in perception or reality, they see value in these competitors' offerings.

Well, I think for us the plan was certainly from the very beginning that if a customer only sees value in availability and price, we have to make sure we can meet that, too.

So we have some of these larger VARs who don't need our help in their vertical market, who are very skilled in selling some of these products. Today they are very concerned about, can I get the product when I want it? So we have not eased up on our development of infrastructure improvements.

I feel like our logistics and operations are better now, which is why we can actually run with less inventory. So we think our challenge is to make sure they don't buy from us because we force them to buy from us, it's because when they are presented a choice, we still are the best choice, even for nonvalue-added services.

So our credit offering, our basic tech support, our salespeople and the logistics still have to be world-class better than anybody else out there.

Great.

And just on Expanets, just so I can clarify my understanding here. From your perspective, is it fair to say that this ought to unfold as an incremental opportunity? Presumably not all that business goes direct, and I guess at the same point in time, there's competing vendor products in there that obviously would flip over.

Yeah, I would say we'd be guessing right now. I probably have said too much about it.

I mean, I wouldn't even let Avaya tell that story. But we -- right now, we don't see an impact to our business either way right now.

Okay. And on the NEC relationship, I think you made the point that has to be authorized. Within the PVX product, is that a closed structure?

Yeah, it's very similar to the Avaya structure, it sure is, Steven.

So what we do is, our job right now is to find resellers who want to consider being NEC resellers. We are bringing those candidates to NEC for their approval and they can say yes or no and then we have to live with that decision.

So our challenge right now is finding and developing a core group of NEC resellers, because right now there is a shift going on where they’re sending their smaller customers to us.

So this is why a little bit of development -- that's why there's more infrastructure investments, and especially in this March quarter, too, that won't be offset by revenue right away.

So their philosophy remains one in terms of demand generation as opposed to channel shift.

Yes.

And then with respect to HP, is that much the same?

Is that demand generation as opposed to channel shift?

Yeah, I think a little difference there is they have a pretty aggressive direct sales force in retail -- HP does -- and so they are looking to partner with some of our key existing VARs. And so I think there we'll have a joint go to market strategy to some end users, and so there might be a former end user opportunity that gets handed through a lot of work with one of our VARs. But I think that's the difference, yeah.

Okay, and Mike, just curious, how high is a new technology on your priority list for '04?

I guess from my perspective it seems like 2003 was a -- from an execution perspective -- a year of managing the vendor shifts which seem to be rolling out favorably in your favor here and in Europe, is 2004 a year of a new technology add?

It's on the list. We continued throughout 2003, believe it or not, to evaluate opportunities, and we are continuing to do that in 2004.

Our goal would be not to do it out of any desperation. We certainly would only do it if it makes good sense. But yes, it clearly has remained since really late 2002 as a key focus for our executive management team.

Great.

Thanks so much.

You bet.

That was your last question. Are there any closing comments?

No, not at this time.

Thank you very much for joining the ScanSource call.

Ladies and gentlemen, this concludes today's ScanSource earnings releases conference call. You may now disconnect at this time.