Scansource Inc (SCSC) 2006 Q4 法說會逐字稿

Good afternoon. My name is Kerri and I will be your conference operator today. At this time, I would like to welcome everyone to the Quarterly Earnings Release Conference Call. (Operator Instructions.) Thank you. I would now like to turn the conference over to Mr. Jeff Bryson. Mr. Bryson, you may begin your conference.

Thank you very much. Thank you for joining us for the ScanSource Conference Call to discuss financial results for the quarter-ended June 30, 2006. My name is Jeff Bryson. I'm Executive VP of Administration and Investor Relations. And with me today are CFO, Rich Cleys, and Mike Baur, President and CEO. We will review with you 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 Exchange Commission.

Rich Cleys will start our discussion by providing overall sales and operating results.

Thank you, Jeff. The Company posted sales of 461.1 million for the quarter ended June 30, 2006, an increase of 21% over sales of 381.2 million for the same quarter last year. Measuring sales based upon our product groups shows year-over-year growth of 21% in the AIDC and point of sale, along with a 21% year-over-year in communications products for the quarter-ended June 30, 2006. That produced a 61/39 mix of AIDC POS versus communications products.

We'd like to call your attention to two things which affect comparability to last year. Since we implemented FAS-123R on July 1, 2005, this will be the last quarter in which we will need to isolate the effect of option expensing on the current year numbers to enhance comparability to June 2005 results, which were not retroactively adjusted. This quarter, the adjustment for option expense was expected to lower earnings per share by a split adjusted $0.03 per share. But the effect this period was a reduction of only $0.01 per share, as shown on page seven of the press release.

This difference in part reflects a change in the expected term from 10 years to 6.5 years for options issued from 2003 to 2005. This 6.5-year expected term is the suggested term using the SEC's shortcut approach to implementing FAS-123R. Since we implemented FAS-123R on July 1, 2005, this will be the last quarter in which we will need to isolate the effect of option expensing on current year numbers to enhance comparability to June 2005 results, which were not retroactively adjusted.

Another issue affecting comparability was the stock split. In May, we completed a 2-for-1 stock split, which doubled our shares outstanding, which has the related effect of reducing earnings per share by half.

Gross margin was 9.74% for the June 2006 quarter, compared to 10.3% for the same period last year. The gross margin was lower as a result of an increase of the inventory reserve due to a Paracon vendor experiencing financial difficulties, and a change in mix of orders led by some larger POS deals.

Operating expenses were 27.3 million, including the 364,000 recorded for option expense. Without option expense, operating expenses were 27 million and 5.9% of sales, which was slightly lower than operating expense as a percentage of sales for each of the past several quarters. Operating income, without option expense, increased by 12% to 17.9 million, which is 3.9% of sales. Net interest expense was 568,000, which is comparable to 510,000 for the same period last year.

We had an unusually low tax rate due to our burn through of NOLs as a result of excellent performance in our European business unit. The quarterly tax rate was under 28% and the year-end tax rate was reduced to 35%. Lower taxes caused EPS to be $0.06 higher than it would have been if our historical rate of approximately 38% had been applied to the quarter's income before tax. In future periods, we see our tax rate returning to a more normal 38%.

June 2006 quarter-end net income, without the effects of option expensing, increased 32% to 12.4 million and 2.7% of sales, compared to 9.4 million in the June 2005 quarter. We were very pleased with our return on invested capital this quarter, which while including option expensing continues to be strong at 24%. As you know, we manage our balance sheet in light of changes in our gross margin, meaning that the right mix of inventory turns, account receivable days, and the number of account payable days helps us to achieve our targeted ROIC results. The T2 acquisition will initially have an adverse impact on ROIC, as we've added invested capital to acquire the business.

Balance sheet metrics and cash management were as follows. Inventory turns were 7.2x at the end of June 2006, which is comparable to the 7.3 turns posted in the June 2005 quarter, and up slightly from the previous quarter. The number of days in receivables, DSO, was 58 at June 30, 2006, compared to 51 days posted in June 2005. Our line of credit was 27.6 million at June 30, 2006, as our business was roughly cash neutral since June 30, 2005, which is typical when our full year annual growth rate is at above 13%.

We ended the year at a negative six days of paid for inventory, meaning that our investment in inventory was more than offset by trade payables to vendors. This metric can be temporarily lower or higher due to the normal timing issues as to when the last day of the quarter ends relative to the bimonthly payments we make to vendors.

Jeff will now give you an update regarding each of our reporting segments.

Thanks, Rich. Our North America segment includes sales from all three of our technology areas - AIDC and point of sale via ScanSource; communications products through two sales units - Catalyst Telecom and Paracon; and electronic security products through ScanSource security distribution. North America posted sales of $392.6 million, a growth rate of 19% over last year. Beginning next quarter, T2 sales will be included in the North America Communication Team's results.

Our next discussion will focus on the ScanSource AIDC and POS sales unit. We had a record quarter in the ScanSource North America Unit led by strong year-over-year and sequential growth in point of sale systems products aimed at the specialty retail and hospitality segments of the market from leading vendors, such as IBM, NCR, and Elo. In AIDC we saw excellent performance across all product lines. One area of exceptional strength was sales of wireless terminals led by Symbol, HandHeld, and Intermec.

This quarter has strong sales from new resellers resulting from our recruiting activities and from resellers who manufacturers are encouraging to consider two-tier distribution. Supply chain issues have been a problem in the AIDC industry, and especially impact resellers who buy direct from manufacturers. Once many of these resellers have begun to purchase from ScanSource, they receive a better customer experience because they are free to spend their time selling instead of dealing with product availability issues.

During the quarter, we experienced record usage of our Systems Integration Team in Memphis, prompted by an increase in our point of sale business. Our systems integration service reduces cost for the reseller and the manufacturer and improves delivery times to the end user. Our vendors have encouraged us to invest in additional resources and processes to improve the attach rate of vendor extended warranty programs to resellers. We have seen a significant improvement over the past year in this area and believe that these service programs will continue to grow.

We will next discuss the first of our communication units, Catalyst. Catalyst had a record quarter despite continued supply chain issues with Avaya. In addition, our other key partners, Extreme, SpectraLink, Juniper, and Polycom had record quarters. Some of the growth came from new customers who were either recruited several quarters ago by our business development teams, or came to us from competitors. The new customers helped to contribute to our record results in this unit. We have added a new business team within Catalyst that is focused on growing our Avaya SMBS business, and increasing sales of Juniper, Polycom, and Extreme.

Catalyst and Avaya have teamed to create a web portal to provide resellers with one source for all of their SMBS needs. The web portal, www.catalystteleport.com, provides sales collateral and technical support resources, along with promotions and training opportunities. The portal is filled with information that can help resellers boost their productivity, improve their sales presentations, and learn how to become an authorized Avaya business partner. Resellers will find white papers, frequently asked questions, and useful links, all aimed at helping them enhance their solutions offering and grow their business.

Catalyst Telecom held its Annual Convergence Connection Partner Conference in June on Hilton Head Island, South Carolina where more than 280 of Catalyst's leading business partners along with executives from Catalyst and its vendor partners were on hand to hear about Catalyst's convergence strategy for the coming year. With a theme of "Where Super Heroes Are Born," Catalyst focused on helping take its business partners to the next level with service, support, and total convergence solutions.

On July 3, ScanSource purchased the assets of T2 Supply to create our newest communication business unit, which will continue to be called T2. T2 markets video conferencing and telephony products from leading vendors, such as Polycom and Plantronics, and is based in Lenexa, Kansas. Jill Phillips and Tod Vedock will continue with T2 in the roles of President and VP of Sales, respectively.

The acquisition of T2 helps us fill out our convergence strategy by adding video conferencing products and expertise. As Polycom's largest U.S. distributor, T2 has validated the specialty technology business model we have used successfully in our other markets. The focus and skill set that T2's management team and employees bring to the audio and video marketplace have proven to be the key differentiator in this market. This team will continue to pursue audio and video opportunities outside the Catalyst and Paracon customer base.

The addition of T2's voice and video conferencing reseller should provide many cross-selling opportunities and their products will complement the offerings of our other communication sales units, Catalyst and Paracon. With our companies' combined resources, we believe T2's manufacturer partners will benefit from more value-added programs, such as Solution City, our multi-vendor, vertical market tradeshow and website.

The transaction was completed on July 3, 2006 as a purchase of assets for cash. After acquisition expenses and additional interest costs of approximately $0.02 per share for the September quarter, the acquisition is expected to be non-dilutive to earnings. T2 Supply has 36 employees in various roles, including sales, technical support, marketing, and product management. T2 products have now been consolidated into ScanSource's North America distribution center in Memphis.

One of our other communication sales units is Paracon, which focuses on converged communications products. Paracon had record sales for the quarter while dealing with the disruption caused by the announcement of the planned sale of the Intel Communications Group. A buyer was announced in the past two weeks, and we believe this will be a positive for this product set. In the quarter, sales were also driven by good results from some newer Paracon vendors, such as Quintum and AudioCode, each of which provide gateways, and Envox, which makes toolkits.

At the close of the quarter, we were surprised to learn that one of Paracon's newer vendors, Zultys, was experiencing financial problems, and as a result, we have significantly increased our reserve against their inventory. We believe we will have difficulty selling the remaining inventory and are adjusting our business accordingly.

We'll now take a moment to update you regarding our third technology area, ScanSource security distribution. The Security Unit had strong sales of card printers from manufacturers such as Datacard, Fargo, and Zebra Card. The card printer business grew due to our achieving critical mass, which helped us achieve market share gains. The Security Unit benefited from some programs whereby some vendors are encouraging resellers to buy from distribution. We also had a record quarter in the sale of traditional security products from vendors like Panasonic, Bosch, KeyScan, Samsung, and Tempest.

ScanSource security distribution signed Digital Security Controls, DSC, a leading supplier of intrusion security products, to its line card. DSC is a market leader in intrusion control panels, motion detectors, glass break detectors, central station receivers, and wireless sensors and receivers, and sells almost entirely through distribution to resellers. The Security Unit also added Tropos Networks, the market leader for metro scale WiFi mesh network systems. By integrating Tropos solution into ScanSource Securities product offering, resellers are able to easily convert their wire security solutions to wireless.

Tropos products also help resellers provide more efficient larger security solutions that can be installed in expansive environments where end users might need multiple wireless network systems. Tropos products allow resellers to transmit video surveillance over a wireless network. Wireless technology is instrumental in the installation of security solutions because it frees up cabling, trenching, and hard wiring, which may be cost prohibitive for some end users looking to install security solutions.

Our second reporting segment is international distribution. International distribution, which includes the geographies of Europe and Latin America, posted record sales of 68.5 million, compared to last year's quarter of 50.9 million, a growth rate of 35%. If measured on a local currency basis, our international sales growth would have been virtually the same.

Europe had a record quarter year-over-year and sequentially while in the midst of vendors adopting new RoHS standards. The RoHS initiative encouraged some resellers to buy products in the June quarter that they might otherwise have bought in the September quarter. In order to help our resellers transition through RoHS compliance, we chose to have higher than normal inventory levels. We believe that will continue through the September quarter.

Just as in the U.S., one of our key [indiscernible] is the availability of inventory and the right mix across all product lines. AIDC sales growth was led by Symbol, Zebra, and Intermec, as these vendors have continued to encourage two-step distribution on a Pan European basis. Some of these vendor programs encourage one-tier partners to move to two-tier, which results in our granting extended credit terms similar to what the vendors have offered them.

In addition, our point of sale business is gaining traction with key vendors, Epson, IBM, and Elo. We had surprisingly good sales results in point of sale, especially in the U.K. As we've done in past quarters, we continued to add new customers across Europe in spite of the large number of competitors in each region. Many of those distributors are smaller and country-specific who have longstanding relationships with local vendor sales teams. The combination of our service levels, value-added services, and local sales presence are beginning to help us win over these vendor reps. As an example, we had record sales growth in both France and Italy.

Latin America had strong performance, which was, once again, led by significant growth in Mexico, particularly on the Symbol, Zebra, and Elo product lines. In Mexico, we have been successful due to the local presence we've established over the past two years. Local inventory, credit people, and sales representatives have allowed us to get excellent support from our vendors, resulting in our taking a dominant market position there.

Outside of Mexico, we had a good quarter, but continue to be challenged by the large number of distributors being allowed to compete with us. Despite this, we are continuing to invest in the programs that we think vendors want and are expecting vendors to start rationalizing their distribution strategy for Latin America over the next couple of quarters. Many of the smaller countries in Latin America cannot support a true two-step distributor on a local basis, so we believe having our team serve those countries from Miami is still the right model. Proof of this belief are the good sales results we achieved in Argentina, Venezuela, and Chile.

We will conclude this part of the call with our expectations for the September 30, 2006 quarter. We think total revenues, including those from the T2 acquisition, for the September quarter could range from 465 million to 485 million. And diluted earnings per share, including the predicted $0.02 of acquisition costs and additional interest, could range from $0.37 to $0.40 per share.

As a result of the T2 acquisition, we are modeling net interest expense for the September quarter to be about 1.5 million, which is a result of higher interest rates and increased debt on working capital and acquisitions.

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

(Operator Instructions.) Your first question comes from the line of Jeff Rosenberg.

Hi. I'm trying to quickly factor in the things you've just said. But I'm coming up with an operating margin of around 3.9%, so a pretty flat type operating margin with all things considered here in terms of the acquisition. Is that right, Rich?

That would be reasonable, yes.

Okay. And then, can you talk a little bit about--I mean, I assume you don't want to be too specific about the contribution of T2 to the revenue. But maybe just talk a little bit about just trends in the business in terms of normally you'd see a little bit of sequential growth in the September quarter - certainly some strong sequential growth with the telecom business. And maybe just a little bit of commentary about how your businesses look quarter-on-quarter, exclusive of the acquisition.

Yes. This is Mike, Jeff. I'll take a shot at that. Of course, internationally, this is always a down quarter for them due to seasonality in Europe and Latin America, offset somewhat by historically a strong Avaya quarter since it's their fiscal year-end. We're still concerned a little bit about that just relative to supply chain issues that continue to be a challenge in Avaya--in Avaya's business.

We also had such a strong June quarter, frankly, all around that we were surprised by that. And so, going from that strong of a quarter to the midpoint of our guidance of 475, we think is a very reasonable target.

So does that imply that that's a little bit--that's a couple percent down sequentially all things considered? Because it sounds like you're not--you're being conservative relative to the--or concerned about how strong your Avaya boost is and obviously you would likely be down. So are you looking at it net-net being down a little bit?

Well, of course, we never plan our business to be sequentially quarter-to-quarter. We've never guaranteed that to people or talk about it because there's always different things. Again, if you look at the June quarter, a couple of things did happen that we referred to. One is we probably got some additional revenue in Europe from RoHS that came into June that could have normally gone into July. Some of the things going on with Avaya led us to have a really strong June, and possibly some of that would have been in the July/August/September quarter, also. So with all of these supply chain issues, I would say we want to be very careful of what we suggest for the September quarter.

Okay. And then, the other thing I wanted to ask about was--.

--Hey, Jeff. I forgot one other thing is this Paracon vendor, Zultys, we're going to have to sell through the loss of that revenue as well. Sorry.

Oh, and I'm glad you mentioned that because I wanted to ask you just quickly on that. You're--you don't have--I mean, the situation they're in, you don't have the right of return of any of this inventory that you have? I mean, normally I think of you as being protected in that regard. Can you talk about that?

Well, the right of return is only good if there's some way they could pay us.

Okay. So it's--I got you. All right. I wasn't sure exactly how dire their situation is. And in terms of the security vendor that you added, you talked about them selling mostly through a reseller network. Is that a reseller network that you have the ability to sell into, or is there any plan to try to carve out some of those resellers to actually have them buy through distribution? I mean, what kind of a boost in opportunity does this give the security business?

Well, you're talking about DSC?

Yes.

Yes. That's--clearly they're selling into the traditional low voltage reseller market in security. And that still is our challenge is how do we become the--one of the major players there. We've now become one of the major players clearly in the card printer business, and we've seen that--results. But for us, we continue to find that the vendors like DSE and others have existing partners and they're counting on us to deliver incremental customers for them.

Having said that, there aren't any barriers that prevent us from selling to some existing resellers, but there's not a strategy in place that would move any of those resellers to our distribution unit unnaturally.

Do they have a more robust reseller network than some of the other vendors that you've really--that have some scale that are currently on your line card?

I'd say it's similar. I think the real key difference with these guys is they're used to using distribution. They don't have direct customers, whereas most of our other vendors have a combination of one-tier direct [suppliers] and resellers versus distribution being a smaller piece of that.

Okay. Thanks.

Okay.

Your next question comes from the line of Reik Reed.

Hey, good afternoon.

Hey, Reik.

Mike, with respect to the--what--your comments in the press release on the point of sale business looking better, can you guys add a little bit of color in terms of what you saw there, what might have been the cause for things starting to move forward after seeing quarter after quarter of things being somewhat sluggish? And is this limited to some of the smaller guys that you referred to in your commentary, or is this getting to be a little bit more broad-based?

Well, I think the target for our comments were our larger point of sale resellers who are typically selling into larger end users. And that's why we referenced the system units from IBM, NCR, and also Elo. So these are typically larger end users with our larger resellers. And they've had--all of these deals that closed were in the pipeline for 12 to 18 months. And we had been--we'd seen them, they were visible, they just wouldn't drop. And no matter what happened last year, if you look at last calendar year '05, promotion incentives, et cetera, weren't able to convince the end user to make a decision.

So we don't know exactly why now, but clearly, the customers who said they wanted to buy 18 months ago, we eventually run out of runway in deciding if they've got to put in some new products to replace older products or to upgrade to some new technology. So eventually we felt comfortable it would happen. You just--we just never know is it all going to happen in one quarter or not. But this is two quarters in a row that we've seen better point of sale results, and we're very encouraged by that.

And did--I mean, do you have information that suggests that it might continue, or is it just that you're seeing two quarters and you're feeling better about it?

I think the latter. I think we see--we've seen two and we're feeling better. And if we don't have any in September, will I be shocked? I'd say no.

Okay.

So we're trying to make sure we're not going to get too excited about it yet. But we--we're thrilled with the results.

Okay. And with respect to RoHS and Europe, can you guys give us some sense as to how much you--how much business you think was pulled forward?

Well, we try not to breakdown our European numbers. But it was probably in the million to 2 million range roughly.

Okay.

Yes.

And then, just can you give us some just general comments on the state of the industry for you with respect to competition? And it sounds like you guys feel pretty confident that you are continuing to gain share. Can you talk a little bit about where you think that share is coming from? Now that [Ingram] has his own [nemex] for a while, can you give us an update on how you think that has changed things in the industry? And are there any changes that vendors may be asking for in terms of key services that may impact the growth or operating margins as we look throughout this fiscal year?

A pretty wide topic. [Indiscernible.] A couple of brief comments. I think in general we still have very strong competitors in all of our regions. And at the same time, we believe there's still been a certain amount of indirect channel shift going on that has allowed distributors, whether us or others, to go after some business. So I think there have been--some people have been wondering was the indirect channel over, number one, from direct to indirect, and the answer to that's no. There's still a lot of our vendors that have direct business today that is higher than their indirect business. So we still see the basic trend that got us started 13 years ago all still pretty much in place. There's a lot of direct business to end users. There's a lot of direct to [our] business. And again, this is true in North America as well as Europe.

And then, finally, I think, yes, I think vendors want us to do more than just have product in stock. I think they recognize that all along they could have lots of other distributors to do that function. So we know that that's important. As a matter of fact, we feel like our ability to provide inventory at the right time, right place, for the right price is still a significant value-add in this market. That it's--and I think this has happened with some of our other competitors. They've not been able to be as successful in some of our markets because it takes a certain volume of business in the markets we're in to really always have the product in stock at the right price in the right configuration.

So we still think that the scale and the size of our businesses relative to our competitors is a huge advantage. But we still have to invest in other programs to generate incrementally new customers. So we've been on the vertical market and solution selling campaign now for about two years, as you know. And we feel like that is bringing in incrementally new customers to the vendors, which is really how we measure our success or not. We talk to you guys about market share shift, but that doesn't build the franchise for our vendors. We have to do more than that for them.

And any comments with respect to--now that Ingram has been in the market for a while, how that may have been shifting things, or is it still business as usual?

I don't want to comment on a specific competitor.

Okay, thanks.

Okay.

Your next question comes from the line of Ben Radinsky.

Hi. Good afternoon.

Hello.

The first question is can you quantify the effect of the increased inventory reserve on gross margins? Is there a way that we can figure out what a normalized gross margin would have been for the quarter?

I think looking forward, and looking backward also, we've been at about the 10% gross margin rate. And I think looking forward, we would expect, if we don't have any large influx of larger deals, to be at about that kind of rate - about 10%.

So you think that this quarter really had a normalized gross margin level with the exception of that one-time item?

Well, the one-time thing, and we did have an influx to some larger POS deals that do have an impact on our margins.

Okay. And then, I know this question has been asked, but let me try again. What would be the impact--what do you think your growth rate should be going forward organically? Is it the consistent 35 to 35% growth internationally, 20% growth in North America barring the growth rate from T2?

No, we don't break it out that way. Because what happened--this is Mike speaking, again. What happens is at different times, different quarters, we have different things going on. What we're trying to get at is that we've got the seasonality issue in Europe and Latin America this quarter, more so in Europe than Latin America. So you've got to keep that in mind for September. So if you're asking us for on an annual basis what we're looking at, we really don't give any projections out that far. So we're just trying to focus just on September right now.

And then, just two more for me. The cash conversion rate seems to be creeping up slightly. And I know that you mentioned the inventories are offset by the payables, but the DSOs continue to creep upwards. Is that because of your European business, and how should we think about that going forward?

That would be a combination of our international business as well as the mix of customers that we have domestically. So for instance when we get a customer from a manufacturer, a lot of times the manufacturer will give them extended--or terms beyond what some of our other customers have, so we will end up matching those terms.

So the DSO is a result of not only the international business, but the mix of our domestic customers. But maybe another point I would make is if you look at our DSO and our paid for inventory days and subtract the paid for inventory days when it's a negative or add it when it's a positive. If you look at our--what I would call working capital days, we run at about 51, 50, 52. So we continue to manage our working capital overall to achieve our goal.

Where do you think long-term normalized level would be for working capital days? Are you happy with 52? Do you think you could improve upon that?

I think we'll have to react to competition, but at this point in time, based on the way we're forecasting, we do have working capital growth with the growth of our sales. So we'll manage to that.

Okay. And then, the last question, the sequential up tick in SG&A seems pretty substantial relative to everything that you've mentioned so far. And I assume that that's largely due to the normalized stock-based compensation expense. Would you agree with that, or is there something else going on?

SG&A--if you look at the quarterly SG&A as a percent to revenue, it's actually a little bit of a down tick.

In your guidance--implied in your guidance for first quarter?

Well, if you target--if you target about a 10% gross margin, you'd be looking at something that's relatively flat on an SG&A basis.

Okay, that's it for me. Thank you very much.

Thanks.

(Operator Instructions.) Your next question comes from the line of Ajit Pai.

Yes. Good evening, gentlemen. And congratulations on a very solid quarter.

Thank you.

A couple of quick questions. The first one is just looking at your international operating margins. In the third quarter, the March quarter, you got about a 5.3% operating margin, which is I think the best that you ever had for--in the past several years in that segment. Is it safe to sort of assume that in this current quarter, given the strength that you talked about in international, that the operating margin was comparable?

I don't know if I'm ready to comment on the international operating margin yet. We still have to finalize some of those things, but I think generally speaking, it would be comparable.

Yes, I think what we've done there, Ajit, is we feel like we've made some significant investments in SG&A over the last couple of years and they just started to pay off in the last two quarters. And so, absent some other adjustments we might do at the end of the year, the quarter from an operating standpoint should be very similar. Yes.

Yes.

Ajit, this is Jeff. One other thing to think about with that March quarter, I remember we'd looked at that a little bit back at the time. There's a little bit of lumpiness. As you get a new business off the ground, occasionally you have--get some sort of discounting programs or you may be adjusting different parts of your business. So I think that was a little bit of a positive anomaly back in March and we encourage people to really think of the nine month to date as the more indicative of what was really going on in Europe.

So I would predict, before Rich completes all of his work, my prediction would be that the fourth quarter would look a lot more like the nine-month to date that it would look like the one quarter in March.

So like closer to about 2.5, 3% rather than closer to 5%?

My gut would be it would be somewhere closer to that than it would be to 5.3.

Okay. So you are like continuing to focus on growing that business by investing in it, right?

Yes. We still think there's--.

--The investment phase is not over?

That's correct.

Okay. And then, when you're looking at your tax rate, you did walk us through what was responsible this quarter for the improved tax rate. But could you give us some color as to as this mix changes, and if you expect international to grow faster than domestic, how much--what would the expected tax rate be for next year? And then, the year after that, do you expect it to go down further?

I don't know if I'm ready to predict 2008, but I think for modeling this year, I would expect us to be more towards the 38% on a blended rate.

And then, why would that be if your international business is growing faster? Are you going to use up all of your sort of tax losses overseas within a quarter or two?

It burned through--we've burned through the NOL benefit.

Okay. It's burned through already. Got it.

Solid fourth quarter.

Okay. And then, at this point, are you willing to tell us the percentage of your AIDC business, whether the security business has become a material percentage, or is it above 5% of your Company as yet?

I don't think we're willing to say.

Okay. But you did mention that once it reaches 10% you'd break it out for us.

We did talk about that. Yes.

Yes. Okay. So at that point you'll let us know.

Yes.

And then, when you're looking at stock compensation in this particular quarter, we see that that expense is down. Is that just seasonality or is that a change in the way you are sort of looking at the compensation using equity?

What that represents is a year-to-date impact on the change to the SEC-recommended 6.5-year term for the 2003 to 2005 option grant year.

Got it. And then, the--when you're looking at the--sort of the issue that you talked about with the vendor - the inventory sort of charge that you took. Could you quantify it? And are you seeing any such other potential issues with your customers that--any of them reacting to rising interest rates or any kind of slowdown in their vertical in an adverse way? Or are business conditions fairly - from a credit point of view - fairly stable for the past three to four quarters?

I'll take a shot and I'll let Rich say something, too. This is Mike. I think overall we haven't seen a change in our customer behavior. I think they certainly are all cautious, as everybody is when there's some question about interest rates, et cetera. But for our customers, we've not seen any impact. I mean, they're really not as focused on that. I think back to the vendor issue, for us it's one of those where we--with this kind of a vendor, it's a fairly new vendor.

So it's unusual for us to be in a position to where we have this kind of adjustment to a reserve for a vendor anytime. And it kind of surprised us with the information we received from them at the severity of their financial situation. They were a new vendor. They had not been a long-term partner with us. Particularly with our long-term vendors, we're much closer to their business and how they stand financially. So this one really surprised us.

Okay. Well, thank you.

Okay.

Your next question comes from the line of [Gary Schnero].

Hi, guys.

Hi, Gary.

Can you talk about--I think you guys were adding some non-Avaya resellers in your communication business. Is that right? Can you talk about that?

Yes. I think one of the strategies we were trying to do all along is to find some resellers who were selling other brands and either sell them--move them over to Avaya and other products we carry or, frankly, try to use some of our other brands like Juniper and Polycom is a great example to recruit new customers. And so, frankly, when we found the opportunity for T2, that has opened up a set of customers that we had not targeted before.

They have a group - a subset of their customer base - that was not overlapping with ours, although there was some overlap. There was a subset that was focused in an area that I would call the audio visual marketplace. And we had never had anybody focused in there, so that brings us new opportunity. But, yes, you're right. We have a new business team within Catalyst that's focusing on new customers that are not currently Avaya opportunities, as well as we have a group like that in Paracon.

How many employees does ScanSource have, excluding T2?

I'd say about 950.

Right. And when you were talking about the point of sale, the deals in the pipeline that dropped, can you quantify generally how much of the pipeline was that? I mean, was that just a piece of the pipeline? Was that the majority of the pipeline?

Well, I'd say there's still a pipeline.

That's actually precise for you guys. Thanks.

Anything else, Gary?

Your next question comes from the line of [Craig Watner].

Hi, guys. Can you give us any cash flow items - CapEx or D&A or total cash from operations or free cash flow or anything like that?

Well--for the year?

No, for the quarter.

For the quarter, we did have CapEx--we purchased a facility for future growth late in the quarter or end of May, and that was about $5 million. You'll see that in our 10-Q. And then, from--other CapEx, it would be fairly normal.

Okay. Of your cash decline, about $13 million, is there a level of cash that you're comfortable with or you're kind of targeting to run the business with, or--?

I was pleased to see the cash decline like that, because what that means is they take my bank line down. And that's reflective I think of as we've grown in size in some of our international businesses, we've been able to manage that cash debt better than we had a year ago.

Okay. So is there a target level for cash in the business, or--?

There's not really a target level for cash, no. What we're trying to do is keep our bank line, which is a daily kind of thing, try to keep that as close as we can to minimize the interest expense.

Okay. Do you guys think you've generated cash this quarter?

For the quarter, I think if we compared the cash flow to the prior cash flow, that we would have used cash, but that's fairly typical of a growth quarter.

Okay. And is there any reason why you're not breaking out T2 at all? I mean, is there any way we could kind of try to calibrate?

It's really competitive. We're not really eager to let our competitors know about T2.

That and there's some--there is some overlap of customers that we had our Catalyst unit selling to some of them. And so, it's a question then of which business do you attribute it to. So typical with acquisitions in the past, that was always one of our challenges was how you really attribute to revenue. So I think the one denominator we gave in the press release was the number of employees, which was 36.

So is it fair to say that on a heads per--to revenue basis, you're implying that it's going to be fairly comparable to ScanSource?

We just took that number out to give you guys some guidance.

Okay. All right. Thanks very much.

Thanks. The next question, Operator?

Your next question comes from the line of Chris Quilty.

Hi, guys. This is Todd Rachichenes for Chris. Congratulations on a good quarter. I just had a question. I was wondering if you could please provide some commentary on RFID deployments. Are you seeing a pickup in pilot activity and/or full scale deployment?

Sure. I think we're overall still very disappointed in the overall deployment of RFID, just like our vendors. We have the same position they do. The only RFID deployments that have been successful or that have been rolled out are the closed loop applications that have been around a long time. So still very small. We've said all along that we thought it was a late calendar year '06 opportunity for us. And now that we're starting to see that in our gun sights, we probably don't think that that's going to be as strong as we would have thought a year ago. So I would say we're disappointed in the RFID opportunity right now.

Okay. And so, that--RFID would not be included in your guidance?

I mean, it's included--.

--But it's small--.

--But clearly, it's not significant.

Okay. And going back to T2, would it be--would you guys be able to provide '05 sales for T2?

We don't plan to.

Okay. And then, interest expense, I believe you said 1.5 million. Is that net for next quarter?

Yes. That would be net interest.

All right. Thank you very much.

Thanks.

Your next question comes from the line of [Seth Wounder].

Just one more question on T2 for you. Have you guys broken out how big in terms of the cost of the acquisition is?

No, we have not.

Okay. I guess you're not willing to do that now. We know eventually it will be in your financial statements.

That's correct.

Okay. And then, also, next year for the guidance, are you going to break--I know you don't have to, but are you going to break out the stock comp, or that's going to be now embedded in the P&L?

It would be embedded in the P&L going forward since we've now got a full year behind us with stock compensation included in the P&L.

And should there--should it show the--let me make sure I get the number right here--the 364--364,000 run rate from the June quarter? Is that about where it should be going forward, or--?

What you should do is take the full year and maybe assume that that's an annualized number until such time as we will have new grants, and then, there would be a little tick up for what the new grants would be valued at.

So the 3 million on the full year--.

--If you take the full year number and divide it by four, that's probably a reasonable run rate until we have new grants. And there would be no significant new grants--or there would be no new grants anticipated for this next quarter.

Okay. So the 3 million run rate divided by four.

I think it will be about 800,000, if you look at the annual number.

Yes. And I just want to make sure I have everything. Okay. Thank you.

Yes, thanks.

There are no further questions at this time.

Okay. Thank you very much. We appreciate you joining our call. And our next scheduled call will be on October 26 to talk about September 30 quarterly numbers. Thanks, again.

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