斑馬技術公司 (ZBRA) 2005 Q2 法說會逐字稿

Good morning, and welcome to the Zebra Technologies Second Quarter Earnings Release Conference Call. Joining us from Zebra Technologies are Mr. Charles Whitchurch, CFO, and Mr. Ed Kaplan, CEO of Zebra Technologies. All lines will be in a listen only mode until after today's presentation. Instructions will be given at that time in order to ask a question. At the request of Zebra Technologies, this conference call is being tape recorded. Should anyone have any objections, please disconnect at this time.

At this time, I would like to introduce Mr. Charles Whitchurch, CFO of Zebra Technologies. Sir, you may begin.

Thank you. Good morning and thank you for joining us today. Certain statements I'll make on this call will relate to future events or circumstances, and therefore, will be forward-looking statements within the meaning of the Securities Litigation Reform Act of 1995. In particular, any statements we make regarding our financial forecast for the 2005 third quarter and expectations about trends in the companies business will be forward-looking statements.

The forward-looking statements involve risks, uncertainties, and other factors that could cause Zebra's actual results to differ materially from those expressed or implied by such forward-looking statements. Additional information concerning such factors is available in the press release issued today by Zebra, as well as Zebra's filings with the Securities and Exchange Commission. In particular, we direct your attention to the Company's Form 10K for the year ended December 31, 2004.

Now let me turn the call over to Ed Kaplan.

Thanks, Randy, and welcome to everybody. This morning, Zebra reported financial results that did not meet our performance expectations. We entered 2005 with a plan that included higher sales growth than we reported in Q1 and in Q2, and operating expense increases targeted at supporting that level of growth.

Clearly, we have fallen short of our sales goal and are now faced with a variety of choices. Among these choices are to trim current operating expenses to bring them into line with near-term sales outlook, reserve profitability and sustain higher earnings for 2005.

We, however, made a different choice. Our guidance indicates that we have opted to maintain operating expenses at the current level of nominally $50 million per quarter in the face of slower sales growth to expand global leadership and build a more formidable company in 2006 and beyond. We made this choice because we have a great deal of confidence in the future of our Company and the industry in which we operate. We have the resources to support this decision without damaging the financial integrity of the Company. Most important, we believe this course of action is the best for the Company and will ultimately build the greatest value for our stockholders.

In the second quarter, sales increased by 8.5% to a new quarterly record. We incurred operating expenses of $51.9 million and delivered earnings of $0.37 per share, unchanged from the first quarter of this year. Higher than anticipated legal expenses resulted from vigorously defending our products from the third party claims and pressing our own intellectual property rights.

Second quarter results reflect the near term realities of weak sales to retail customers and softened economic conditions in Europe. They also include the real benefits of following a growth strategy that continues to deliver results. Specifically, Zebra's global expansion program continues to produce results. High growth in Latin America and Asia-Pacific is a direct effect of the ongoing placements of more Zebra associates in emerging territories. This program also helped to deliver robust sales growth in previously underserved parts of Europe, including Eastern Europe.

Secondly, our unmatched channel, innovative products and programs led to firm growth in the non-retail customers worldwide and continued market share leadership. Product and technology leadership led to strategic wins in mobile direct store delivery and router counting applications, strong growth in supply sales and ongoing high growth in most printer product lines. Our investments in RFID, including a patent cross-licensing agreement, further secured Zebra's leadership in this emerging technology.

During the second quarter, we introduced products that are compliant with European standards and received country certifications. We are pleased with our progress in placing RFID printer encoders with the next group of 200 Wal-Mart suppliers, as well as suppliers in other retailers beginning to implement their own RFID programs. We secured alignment with key defense contractors and were the first to demonstrate EPC Generation 2 technology in an RFID printer encoder.

Expanded distribution capacity with the on-time, on-budget opening of our new facility in Heerenveen, Netherlands, greatly increased distribution capacity, improved service and lowered shipping cost to our European customers. We now have a fully staffed sales and marketing team devoted to emerging applications for patient safety and other areas of healthcare.

These and other accomplishments derive from a commitment to support important programs for long-term success. We are no less optimistic about Zebra's growth prospects. Zebra's business remains in alignment with its goals, and the fundamental reasons for Zebra's success over many years remain firmly in place. The Company operates in attractive global markets.

We hold a strategic position in delivering specialty printer solutions that enable companies in a competitive environment to lower costs, improve quality, strengthen security, and deliver better customer service. The diversity of our products and our business across geographies, products and markets provide resiliency and multiple avenues of growth.

Finally, our financial strength sustained ability to invest in business opportunities that support long-term growth and stockholder value creation.

Now here's Randy to give you a detailed review of the second quarter results and our guidance for the third.

Thank you, Ed, and good morning, everyone. Although sales of $176.6 million set a new record for Zebra, our 8.5% rate of growth was well below our expectations and caused principally by a shortfall in sales to retail customers in the quarter. This is reflected in hardware sales, which increased a modest 6.9% to $135.9 million. Supply sales growth of 17%, to $33.1 million, was a sharp rebound from the 4.4% growth we recorded in the first quarter and set a new record for supplies. Strong growth in labels geared for manufacturing and distribution applications more than compensated for weak supply sales targeted at retail customers.

By region, European sales were up 9.6% to $58.3 million. Sales here were also affected by the retail slowdown and a clear deterioration in economic conditions in the UK and Germany, our largest European markets. Sales into Eastern Europe, Italy, Iberia and the Benelux countries recorded solid year-over-year performance as a result of better economic fundamentals and focused sales efforts. We are well positioned in the high growth Eastern European markets, as more manufacturing moves to that region, with a new sales office in Poland that opened earlier this year, along with additional sales resources in the region.

Both Asia-Pacific and Latin America performed at record levels this quarter, with sales up 30.1% and 36.4% respectively. All product lines, including mobile, contributed to these strong numbers, which made for total international sales growth of 16.3%.

International sales were 49.2% of total sales in the quarter.

The clear sales disappointment was concentrated in North America, which saw its third consecutive quarter of reduced sales growth, most recently to 1.8%. As I mentioned, this slowdown was concentrated in the retail vertical. Sales to our largest customer, ScanSource, accounted for 15.2% of total sales, compared to 14% a year ago, and were up 17% for the quarter. We believe this figure is a good proxy for the health of our underlying market and is indicative that the source of our sales weakness was concentrated in the retail vertical.

Gross margin was down by 1.3 points compared to last year, to 50.6%. Two factors explain this change. First, and most importantly, capacity variance, resulting from sales below plan, and secondly, changes in foreign exchange rate that affected cost of sales. These two factors more than offset the positive effects of product cost reductions and a favorable sales mix.

Operating expenses of $51.9 million were $4.4 million over the midpoint of our guidance range. Two items explain the majority of this variance. First, and most importantly, we had a large increase in legal expenses related to our defense in the ongoing Paxar patent litigation. We are committed to vigorously defending our position in this action, and we could have high legal expenses for the next several quarters. Secondly, we had incremental expenses related to product development work.

Second quarter investment income totaled $3.1 million, equate to a 2.1% on beginning balances. Net income of $26.8 million was 15.2% of sales and $0.37 per diluted share. Free cash flow, normally weak this quarter because of two large tax payments, was a negative $1.9 million.

This year, tax payments were coupled with an unusually high level of investment in fixed and intangible assets. Receivables increased by $3.9 million, with days sales outstanding at 54 days. Inventory turns improved to 5.5, as we reduced inventories in Europe after opening Heerenveen and began a more focused effort to reduce inventories elsewhere in our system. These programs are expected to improve inventory turns over the next several quarters. Our cash position at quarter end was $57.4 million.

Our guidance for the third quarter financial results reflect ongoing weakness in sales to retail customers, of seasonal slowdown in Europe and a continuation of operating expenses to support long-term growth. Sales are expected to be between $170 and $180 million. We expect quarterly earnings to be in the range of $0.35 to $0.39 per share. This forecast implies a gross margin continuing between 50% and 50.5% and incorporates an operating expense assumption of $49 to $51 million and an effective tax rate for the year of 35%.

That concludes my formal remarks. Thank you for your attention. Now here is Ed for some concluding comments.

Thanks Randy. Clearly, second quarter results were not what we anticipated or hoped for. A few areas of our business softened more than expected, even if several segments improved. Expenses are on plan and supporting important programs for Zebra's future. In addition, we are now in an environment where intellectual property has become increasingly important. As a consequence, we will incur expenses in connection with the development of IP related to products and technologies and with the defense of our products and technologies against claims of others.

Fundamentally, we believe in our strategy and have confidence in the future. We'll work through the current business environment and focus on those things that have historically built stockholder value -- product innovation, channel development, and global expansion. We will maintain investments in these areas to gain share, extend leadership, and improve sales and earnings growth prospects. Our efforts on improving business execution have intensified and we'll be a better, stronger Company for it.

Because of our commitment to product innovation, a broad range of printers, covering nearly every product segment, is currently under development and scheduled for introduction in the third and fourth quarters of this year and throughout 2006. These products include RFID printer encoders, additional mobile printers, car printer products, and printers optimized for targeted vertical market applications.

Channel development efforts will focus on expanding our highly successful Partners First channel program and building even stronger ties with new channel partners who are key solution providers in targeted high growth segments. We believe Zebra remains unmatched in the value that it delivers to its channel partners and end user customers.

Ongoing local expansion continues to deliver results. Going forward, we will leverage our greatly increased presence in China, now with four offices, a managing director for the country and several sales representatives, sales engineers and support personnel. In many areas, we expect to add mobile product specialists to support the significant opportunities for mobile printers in every region.

Thank you for listening. We'd be happy to answer your questions.

[CALLER INSTRUCTIONS.] Your first question comes from the line of Jeff Rosenberg with William Blair.

How are you?

Hi, Jeff.

First question I wanted to ask is to clarify, so when we look at roughly $50 million in operating expenses, should we assume that that was in line with what you originally thought were budgeted sales for the second half or the third quarter?

Yes, that's exactly right.

Okay. So if I do some back of the envelope calculations, is it fair to say that sales or sales growth is running about 10% below your original plan, or some ballpark in terms of when you say the [inaudible] is lower than you expected, maybe some color there on how much of a shortfall we're talking from your internal plans.

That would be the ballpark.

Okay. And relative to -- maybe add some -- I know it's hard to delineate this exactly, but external impact in kind of weaker end market environments versus internal things at Zebra that you would have liked to actually do better. Can you give us some feel as to how you'd divide up the shortfall between those?

I don't have any kind of percentage split between external factors and internal factors. There is a -- probably the most significant internal factor, although there's many, but one is that there is a product that we've had in development, and we expected that product to be shipping the beginning of this year. And it still is not shipping, and I think that you probably remember the last phone call, when we spoke about a write-off of some expenses, and there's actually some additional expenses that were written off this quarter. Those have to do with that product development. So that is a disappointment on our part. Something like that rarely happens, but it does happen.

We also find ourselves in a situation that has changed over the years in that we have more, what we would call strategic accounts -- code word for big buck accounts. And the problem with those accounts is that the size of the orders that we receive for them and the shipping schedules are not consistent at all. They come in in large quantities, and usually the rollouts are over relatively short periods of time, so you get these blips. In addition to that, those kinds of accounts are prone to delaying orders. So we have both of those kinds of experiences, big hit orders, and delays in shipments, oh, because of factors our customer has. And these customers typically have a great deal of influence. They're big, and you stand up and you salute and do what it is they want you to do.

So, we have both of those situations as major elements in terms of influencing our revenue over the course of this year.

Okay. That's helpful, thank you.

Yes.

Your next question comes from the line of Chris Quilty with Raymond James & Associates.

Good morning, gentlemen.

Good morning.

Okay. I just wanted to make sure I had you. Just a quick question on the orders in the retail side and the weakness there, would you characterize those as generally recurring sales into existing customers, or is the nature of that business such that it's lumpy and very cyclical, and you're seeing new customers every quarter?

Well, we are seeing new customers every quarter, but it is also -- it is both of the situations that you've offered here as choices. It's really both of those things, and I couldn't -- probably there's a bigger influence based on past customers than there is an influence of the new customers, however.

Okay. And is it simply based upon the retailers pushing orders out to the right, or are there any competitive issues that are impacting the timing of the orders or whether you're winning them or not?

I don't know, in the quarter, of any situation that was as a result of some competitive forces. It is companies that -- all kinds of weird things happen. We've got one account that discovered they had a storehouse of our product in inventory that they hadn't used. It was a large storehouse of product. So they said, "Hmm, why do we need to go ahead and take this shipment in the quarter? We have immediate supply in our stockroom." Well, that was a lot of business, and it's delayed. It's going to be shipped sometime down the road. So that kind of stuff just happens with that type of account -- not all of them. Some of them are really much better at scheduling out their requirements and sticking to them, but many of them do change.

Okay. And if I remember correctly, the retail business tends to have a much higher concentration of mobile printers, and mobile printers have a much higher attachment rate on consumables. So is there some reason that you actually good supplies growth in the quarter, despite a slowdown in retail, where it seems if the correlation held, you would also show some softness in the consumables, or is there a delay to that?

The consumables, while there is a fewer number of companies out there that are providing consumables for portable printers, the volume of supplies that go through portable printers is substantially different than other products in our product line. So, I don't think that that is a big influence.

Okay. So this won't cause a slowdown in the consumables a quarter or two hence?

It doesn't mean that there isn't any business; it just means that on a relative basis, it's relatively small.

Okay. And a final question with regard to the patent litigation and costs, did you incur any kind of a one-time expense with the Intermec Rapid Start licensing program in this quarter, or might that be recognized next quarter?

We are not disclosing the terms of the agreement with Intermec.

Even if there were a one-time payment?

Even if there were a one-time payment.

Okay. Thank you.

Your next question comes from the line of Philip Alling with Bear Stearns.

Thank you very much. With respect to the spike in operating expenses in the quarter, and the growth there, certainly well in excess of your prior top line growth expectations, what is the thinking going forward? You've indicated that you're not planning on expense reductions, and certainly, you have been growing those much higher than what you'd indicated previously you thought you would be able to grow your core business. Is there a point at which, given continued weakness in some of these markets, that you may look to reduce op ex, and perhaps you can provide a little color there?

Yes, there is a point. That point is not going to be in the third and fourth quarter of this year, however. We expect to nominally spend $50 million per quarter in the next 2 quarters. There's a certain variance in that number, but -- and actually, the -- our -- well, actually, I have nothing else to add to that. That's it.

Just as a follow-up with respect to the question on the RFID licensing deal with UNOVA, should we expect to see any impact on the cash flow statement? You sort of said that you weren't going to discuss the terms of the deal. That's fine, but should investors -- is there something that we should expect to see either in the operating expense lines in future quarters, or anything in the cash flow statement that would be a change from what we might have expect otherwise, given that agreement?

I have no disclosure to make in that regard at this point in time.

Final question. Could you just give us a sense about those on the vertical split? You talked about sort of the retail vertical. What is typically that as sort of a percentage of your sales in the retail vertical?

You're striking out with me because we don't segment our sales into various vertical markets.

Good enough. I guess I'll pass it along and circle back.

Okay, sorry.

Your next question comes from the line of Reik Read with Robert Baird and Company.

Good morning. You guys had mentioned that the retail weakness, and Randy, I think in your comments, you said that in North America, it looks like it is predominately retail. But to be clear, does that mean that the other segments were coming in as expected, or are they also weak -- they're just relatively less weak?

Actually, the other parts of our business did very well, and I won't say that it's isolated, but it is absolutely predominant in that segment.

Okay. And then, in Europe, is that a situation where it is just retail, or is that more general weakness within Europe, and you're seeing it in a wide number of products? And I guess it sounds like it's limited to a couple of geographies, but is it a wide number of products as well, or a wide number of vertical markets?

I don't have detail on that. We could try and get you answer to that offline. I don't have that in front of me.

Sure. And then, with respect to the expenses, you've talked about $50 million roughly in the third and the fourth quarter. Is that something that you're trying to make a significant investment now in these various areas, legal, the development, the marketing area, and then it starts to ebb back a little bit, or is $50 million kind of the base line and you hope to lever that up with revenue?

We don't have a budget yet for '06, so in terms of what the actual revenues will be and what the operating expenses will be, we haven't made any determinations in that regard. There was something else you said that I really wanted to respond to. Maybe you could repeat your question.

All I had asked is you're spending $50 million a quarter for the next 2 quarters.

Yes.

Is that something that you'd be able to lever up, or are the legal development and marketing expenses, are they going to continue to increase or stay relatively [inaudible]?

Our position is this relative to this $50 million that we've announced. There are programs, investments that we started on early in the year, and we are faced with the choice, the basic choice -- do you stop or slow those programs, or do you go ahead and continue and complete those programs? And we opted for the continuation and completing of those programs, and that includes some important product development work, some important geographic expansion work.

Those are things that we could curtail, we could reduce. We've opted to not do that. And essentially, it's really -- I sit in the position and say, "Well, will we be better off in '06 if we pull back on that spending or we don't?" And the conclusion to me is obvious. We will be better off by spending the money now and getting the benefits down the road. What I basically expect to happen is, as we move into '06, and this is in the absence of budgets, I expect that the level of increase of operating expense going into '06 will be less than the level of increase of sales increases that we would see in '06, so that we will get ourselves back to a level where we're more comfortable with.

That's not a commitment at this point in time, but it's an expectation, but that expectation is, however, based -- with limited knowledge about what the choices of investments we'll be able to make in '06. So it's sort of like stay tuned until we have a budget, and we'll tell you what our plan will be.

Reik Read. Okay. And then just one last quick question, can you just comment on pricing and do it in two ways -- one, just relative to the products themselves, is there any incremental pricing pressure? And then just from an average selling price, is that changing? And the question would relate to mix, is that causing a change in the ASPs?

There is substantially different prices from one product category to another, so mix changes in any given quarter can affect that ASP. You know that products like our portable products, mobile products and the desktop products are relatively low in price or lower prices, whereas our high end, our XI products and mid-range products, have much higher prices. So that mix has an impact.

In terms of pricing pressure, while there's always a certain degree of pricing pressure, I wouldn't say that it is severe, except for some isolated parts of our business, and I really don't want to go into just which product lines or which market segments those are, but there are certain segments where there is pressure on price. You can still see that Zebra's margins are quite favorable, and we're able to compete very effectively in these spaces. But yes, there are some areas where people will seek to gain orders, increase share by utilizing price.

Zebra's generally a company that, while it wants to be competitive in the marketplace, it tends to fight its battles with things other than price, and that's really the quality of the channel we have, the level of integration that can be done, the differentiation that you have in the products themselves in terms of value they create for our customers. Those are the things that we concentrate on in terms of protecting our price, if you will.

Great, thank you.

Sure

Your next question comes from the line of Ajit Pai with Thomas Weisel Partners.

Hey, good morning, guys, and congratulations on a record quarter for revenues.

Thank you. We're not getting too many congratulations today.

A few quick questions on the part of the strategy going forward. Two of the fastest growing areas you pointed out, or three of them, are Latin America -- you talked about Eastern Europe, and you talked about Asia-Pacific. As these grow, and you invest in these areas, could you give us some color as to the margins in these areas? Typically, businesses that go [inaudible] that price points are more competitive over Europe because of -- can you give us some color there?

I'm going to ask Randy if he can provide some color. We're not inclined to go ahead and segment up margins by the region.

Yes, actually Ajit, there's -- interestingly enough, on a gross margin basis, the margins across the world are not all together that different from one another. And that's really the only meaningful way we segment it. So, I'd say growth in those areas does not imply anything with respect to changes in margins.

So the gross margin is comparable to the company average gross margins?

Absolutely right.

Okay. And then the second question would be just looking at some of the new initiatives that you're taking, when you talk about the contracts that are penetrating from the digital photography market, etc., it's been like more than a year now since you acquired the contract. Could you give us some color as to the progress that's been made in that particular area?

Yes, sure. We have developed -- we have product in development and products that we are basically at the very tail end of development, two products in the photo printing category, and the applications for those products are many, but I can tell you that one of those applications -- I believe you'll find this in our annual report -- one of the applications are the photo kiosks. You go to your local drugstore and you see these self-service kiosks. Probably the most predominant one that's in the marketplace is the Kodak Picture Maker, and the printers that are used in that picture maker product, the next generation that is coming out will utilize Zebra printers. So that's where we are in the photo printer business, or an example of where we are in the photo printer business.

Right. When you look at the other businesses, you had the contract in the Eltron businesses, and earlier you used to provide us some color as to progress in terms of growth rates in those two, which is the wireless portable printer business, as well as the card printer business. Can you give us some color as to the drivers, first on the card printer side, whether Homeland Security is going to kick in this year or perhaps next year, and then after that, on the portable printer side, whether the growth rate is still in the 20 to 30% range?

I don't know that we ever quoted what the growth rates were in our portable printer line, but it's possible that you heard that. It wouldn't be the kind of thing that we would normally be communicating. What you asked about were the drivers in the card printer line and in the mobile printer line, is that right?

Yes

Okay. Well, in the card area, there are a variety of markets. I'll tell you about a couple that are important to us. One would be drivers' licenses and those drivers' licenses are produced, and actually, what I'll call drivers' licenses, as well as national ID cards. So that is an important segment for us. Within the United States, roughly half of the states are utilizing Zebra product to produce their drivers' licenses. So we're pretty happy with that. That market, basically, divides up into really two segments, what people would call over the counter type of printing, versus what's called central issuance printing. In the over the counter market, which is where Zebra plays, you walk in, they take your photo, and they hand a card to you, and the transaction's done; whereas in the central issuance, you get it sent to you down the road.

Other important markets for card is things like access control. Particularly in the post 9/11 world, access control becomes a more important thing. Another area would be loyalty cards. These are cards that a Sam's Club or Costco, etc., you are a member of a club, and in that case, it gives you access to the products in those stores. Another would be memberships to health clubs and things of that nature.

So those are the markets that are driving consumption, and the growth rates in each of those markets vary a lot. In the area of drivers' licenses, we have states that do an installation, and they've got product which can last them for a number of years, until they go ahead and upgrade to the next generation of product; whereas, in other applications, you find a steady increase in terms of consumption of product.

Let me talk a little bit about the mobile printer segment of the market. The applications in mobile printing are many. The auto rental area is a popular area for the use of Zebra printers. That's providing a receipt when you return your car. There's what's called the line busting or cue busting application that you would find in retail establishments. You would find things like shelf labeling applications, where you needed to produce a shelf label to identify the product, usually with a bar code, which is an assistance in terms of the consumer, as well as for inventory purposes. So, those are some of the important places where mobile printers are used.

Okay. And last question would be acquisitions. Your cash balance this quarter hasn't grown as much as it usually does, but you still have a very solid cash balance. So you did get someone on board, and evaluations have come in a little bit in certain markets. What does the pipeline look like right now? Are you finding attractive things out there?

We've actually hired another person into the department, so that adds to the one that we added earlier this year. And yes, our pipeline is growing, and the types of acquisitions that we're willing to consider is evolving. So we continue to want to do an important transaction, and, look at me, I look forward to making that announcement.

Okay. Thank you so much.

Sure.

Your next question comes from the line Mark Howell with Spectra [sic] Advisory.

Hi, it's Spectrum Advisory. We're not quite in the Spectra category yet. And I also wanted to congratulate you on the many accomplishments of Zebra.

Thank you.

Ed, first, could you remind us of how you're investing the cash?

Randy?

Yes, the vast majority of the cash assets are invested with what you would characterize as normal corporate cash managers, and with basically short-duration bond portfolio.

The legal issues that the company's involved with seem to have taken on a somewhat greater importance. I imagine some of these lawsuits are matters of public record. Can you just give us a little -- maybe some identifying marks for those of us who want to look at the cases? Is the company the defendant, or, obviously, there are cross complaints being filed, but did the company initiate actions in most of these?

First of all, I could refer you to our 2004 10K, and anticipating a question in this regard, I'll read to you just a little bit about -- or what's in the 10K. There is a lawsuit that was filed by Paxar Americas, Incorporated, on April 23, 2003, and this is relative to -- they're alleging patent infringement by Zebra. And so I'll give you just some -- let me just read a little section here until you get the gist of where we stand in terms of communication on this topic. "The outcome of litigation is inherently uncertain, particularly in cases such as those where sophisticated factual issues must be assessed and complex technical issues must be decided. As a result, we cannot accurately predict the outcome of these lawsuits. In the event we are unsuccessful in our defense of Paxar America's infringement claims, we could be liable for economic and other damages which could be material, and we may be forced to incur ongoing licensing expenses or to change how we design, manufacture, or market our products."

I just wanted to give you that color relative to this particular lawsuit. This lawsuit is filed, again, on April 23, 2003, and it is scheduled for hearing later this year. And mentioning this now because we've made remarks about substantial material, I believe, legal expenses, and part of those legal expenses come about as a result of moving toward trial on this particular lawsuit.

Okay, good. Thanks, that's very helpful. A final question. Perhaps you and others and the press have been talking about the excitement of RFID for some time now. Remembering that such attractive markets and the like do attract new capital investment and all, do you want to just comment? I know earlier, you made comments that there are really -- in this quarter anyway, competitive pressures were not anything extraordinary, but do you see some areas of this market that are starting to get over supplied or where there's too many entrants?

The topic of RFID is a very, very broad topic. It covers a lot of different markets and a lot of different product and a lot of different technology, where a high percentage of the hoopla, the hype, the interest has been in the area of the supply chain, particularly the retail supply chain, moving product from the point of manufacture to ultimately the point of sale. And Wal-Mart has been the big impetus in this area, and essentially, what they did is mandated -- well, they laid out a schedule for the adoption of RFID technology for use in the supply chain. And we're actually moving toward what is called Generation 2 technology, and that's a standard that has been set for this marketplace.

So, Wal-Mart set a requirement on their top 100 suppliers to run through essentially a pilot that involved three Wal-Mart distribution centers. That work was completed -- well, completed is probably the wrong word. It was scheduled, and many companies in the top 100 did go through the process, and quite successfully. Actually, as it turns out, Zebra supplied more than half of those particular people who went through this pilot program with printer encoding devices, and in some cases, with smart labels to be used in that application. Wal-Mart Photo has announced now that they want to bring their next 200 suppliers in through a similar process, and they're extending this from three distribution centers to, I believe, nine total distribution centers. That gives you some feel for what's going on in a very well publicized situation.

There are many, many, many situations that are not so well publicized. I'll just name a few, just to give you some information on it. One that's been around for really quite some time, people don't think that much about these days, is the mobile speed pass. That is an RFID application. Many of the states in the United States utilize automatic toll collection systems. In Illinois it's called an I-Pass. That's another RFID application. So we're going to see more and more of that kind of rollout of the technology.

And Zebra, as a company, has invested heavily in the RFID area. And, unfortunately, and this is well publicized, the adoption rate for the technology is well below most analyst estimates that have been made. Most analysts, who I've read, have essentially reduced their rollout schedules that they're projecting. So while the technology itself continues along the development path, the revenues that many companies are seeing in this space are relatively insignificant, and Zebra's definitely in that category. While we've done very well in terms of penetrating pilot programs of a vast array of different types of pilots, most of these situations have not turned into high productions situations yet.

Thanks a lot Ed, good job.

Your next question comes from the line of Kevin Starke with Weeden and Company.

Good morning. Forgive me if you've addressed this already, but can you tell me what zero exchange rate your guidance is predicated on?

Yes, it's predicated on the exchange rate of 121.

121. I know you gave a little color on ASPs, but could you do the same on unit sales?

I don't know what we could tell you.

Yes, I can get that, but it's going to be a second.

Okay, Randy's searching for the treasure vault here.

Okay, another real quick question. Paxar suit's scheduled for trial on October 2nd; is that still correct?

I think it's early October. It might be the 2nd, 3rd,something like that.

Okay, nothing's changed. And then finally, one more qualitative question. What are retailers telling you, particularly in the U.S., in terms of why the purse strings are so tight this far into the year?

Gosh, I don't have specifics. Okay. The unit count is 180,000 in the second quarter.

That'll do it for me, thank you.

Sure.

Your next question comes from the line of Mark Roberts with Roberts and Company.

Thank you, good morning. Ed, you've addressed this a couple of different ways in response to other questions, but you indicated earlier in the call that there would be some spending and some allocation of cost with regard to gathering IP. Are you implying that there could be some further litigation costs or an increase in litigation costs in the back half of the year related to your attempts to protect your IP beyond the patent litigation we already know about?

Well, I didn't want to allude that there was something specific in the offing, but I will say that -- let me back up a little bit on this. The auto ID sector, if you look at it from a manufacturer's perspective, over the course of the last 20 years, there has been a tremendous amount of IP litigation. A big percentage of that has involved Symbol Technologies. They've owned some -- they've been a relatively innovative company and have a lot of IP, I think, over several hundred patents, and consequently, have found themselves in the position of defending their intellectual property rights and there have been a number of lawsuits in that regard.

As it turns out, most of the litigation over this 20 year time period has been in the area of scanning and -- mostly scanning; some amount in the data collection area, and some amount in the areas of wireless mobility. There has really been, on a comparative basis, very little litigation that has involved printing, particularly bar code printing, and so that doesn't mean that companies haven't had IP in this area. I'm sure that many companies have a considerable amount of IP in the area, but the way things have gone, there hasn't been litigation. And things changed a lot, I think, with this lawsuit that was filed against us on April 23, 2003.

And, subsequent to that, things started percolating in the RFID space, and there have been lawsuits now that have been filed in that area, and there is -- frankly, I would expect that there will be more lawsuits that will be filed in that area. The area of printing and the area of RFID has sort of like moved into this cauldron of IP litigation. And so I think companies are looking at this and saying, "Okay. IP is becoming more important. I better concentrate more on the development of that IP, defending your IP rights, and being able to really participate in a market that is more litigious."

And consequently, I think a lot of companies are going to experience a lot more IP related expenses. They're going to have legal expenses relative to filing for that IP, and developing a portfolio of IP, as well as some companies are going to be sued for violating other people's rights, or at least the alleged violation of other people's rights. There is definitely, within this industry, a change as it relates to IP and litigation. Okay?

Okay. One other question, if I could. On the guidance you've given for slower growth in the next quarter, has the composition of your customers changed in any way to where you have any more visibility? I think traditionally, you really haven't had much visibility in the sales until you get the service sales reports from your agents.

Yes, well, it's changed for us, particularly in the retail space. And the reason for that is that some proportion of our business in retail is done direct, and so we know the customer, we know the application, and we are in frequent contact with those people. There are other segments in the marketplace where we also do direct business, but by and large in terms of major sector, like for example, let's take manufacturing, a very high percentage of the sales that are made into the manufacturing sector are made through channel. And it might be made by us making a sale to a VAR, who in turn sells to the end use customer, or it might be a sale through what we would call two step distribution.

I think you know that we report -- well, everybody reports on it -- on over 10% customers. In our case, we have one of those. It's ScanSource, and they're a two step distributor. I believe something like 14% or so of our business is going through two step distribution. So that puts us even farther away from the end use customer. So yes, there are challenges in terms of knowing what the trends are, what customers are requiring down the road. That's the way things shape up for us.

Okay. And I know you've been sort of reluctant to be real specific on this in the past, but have you gotten any feedback from your channels or from your marketing analysis that any of the revenue shortfall in the last quarter was due to market share losses because you have had some competitors that have been pretty vocal out there, saying that they thought they were gaining market share.

Yes, who's that?

Thinking specifically about the folks at Intermec.

Oh, okay. Well, I don't think Intermec's reported yet for the second quarter, so I don't know. I really don't know whether or not they've gained share relative to Zebra or not, and there's lots of -- in terms of reporting, there's not a lot of granularity in the reporting, so it's hard to tell. People don't break that down by geography; they don't break it down by product category. So knowing just where you stand is difficult.

Historically, if you look through, which we have, look through Intermec's reports on the printing segment, their growth rate in that segment has been materially less than Zebra's growth rate. So perhaps what you're hearing has changed this quarter. I've not seen anything for second quarter.

Okay, thank you.

I'd like to interrupt at this minute. We're now at one hour into the conference call, so we are going to take one more question, and then if there are any additional questions remaining in the queue, we appreciate --, we'll be glad to respond to those offline. Okay, one more question please.

Your next question comes from the line of Josh Goldberg with Intrepid Capital.

Hey guys, how you doing?

Good, Josh.

Just two quick questions. One is, on your cash flow this quarter, it looks like your cash actually was flat quarter-over-quarter, and I'm just wondering if you can give me some more detail on why some of the earnings didn't translate into more cash flow. I see that your interest -- sorry, income tax payable went down, which I think happened last year as well, but was there anything sort of specific to this quarter on cash flow and [inaudible]?

Nothing in particular, Josh, other than what we previously mentioned in our comments. We did have two tax payments, and that's normal in this quarter. And secondly, we had some -- what I would characterize as larger than normal investments in the investment category, and those are detailed on the cash flow statement. Receivables were up in line with sales, and inventory did not decline as much as I had expected it to this quarter, although it did come down in certain areas. I would expect in the next couple of quarters we would actually see some improvement in that area, so those are the main reasons.

Okay. And looking just obviously on your guidance, I'm sure you're probably a little surprised just by the shortfall this quarter, but every year, going back 3, 4 years, your September quarter does have some sort of seasonal strength, and I was just wondering if your guidance of 170 to 180 is implicit of a slowdown in other areas without retail, or is it sort of just continuing to be a retail weak quarter, and everything else sort of in line to get you to the flat guidance for the quarter?

Let me say that there's lots of seasonal reasons to believe that the third quarter is relatively weak. If you look through our 4 quarters over a period of time, you'll see that. Now as it turns out, last year in the third quarter, we had one of those lumpy customers [sic]. Sometimes you giveth and sometimes you taketh. Well, that was one quarter where we received a very large order from one of our strategic accounts, and so it made the quarter look like it upticked from the second quarter. But in fact, it was greatly influenced by one very large order. Usually, since we do a large amount of business through Europe, our European business almost always slows down, frequently reduces, from the second quarter. So that's probably the most predominant seasonality in the pattern of our sales, is that Q3 generally somewhere near flat to Q2. But there are exceptions because of sometimes circumstances, but that would be the normal approach, the normal expectation.

And you say your business with ScanSource is what, 13, 14% of revenue?

15.2%

[Inaudible]?

Right.

That seemed to sort of still hold in there?

It increased as a percentage. ScanSource sales in the quarter were up 17% year-over-year, and because they sell to such a very broad cross section of small VAR's, that, to us, is a good proxy for the underlying strength of our core market. And on that positive note, I think we're going to end the call at this point, and let you guys go to the next call. And just a reminder that our next conference call for the third quarter is scheduled for November 1st at 10:00 Central Time, and we look forward to talking to you in November. Thank you very much for your time today.

This concludes today's Zebra Technologies Conference Call. You may now disconnect.