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ScanSource, Inc. (NASDAQ:SCSC)

F3Q10 (Qtr End 03/31/10) Earnings Call Transcript

April 22, 2010 5:00 pm ET

Executives

Rich Cleys – VP of Finance and CFO

Mike Baur – CEO

Analysts

Brian Drab – William Blair

Ajit Pai – Thomas Weisel Partners

Anthony Kure – KeyBanc Capital Markets

Chris Quilty – Raymond James

Gregory Macosko – Lord Abbett

Operator

Welcome to the ScanSource quarterly earnings call. All lines have been placed on a listen-only mode until the question-and-answer session. Today’s call is being recorded. If anyone has any objections, you may disconnect at this time.

I would now like to turn the call over to Mr Rich Cleys, CFO. Sir, you may begin.

Rich Cleys

Thank you, Gerard, and thank you for joining us for the ScanSource conference call to discuss financial results for the quarter ended March 31, 2010. My name is Rich Cleys, and with me are Scott Benbenek, President of Worldwide Operations; and Mike Baur, CEO of ScanSource. We will review with you the quarter’s operating result 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. The statements made in this call are made as of the date hereof even if subsequently made available on ScanSource’s Web site or otherwise.

ScanSource does not assume any obligation to update the forward-looking statements provided to reflect events that occur or circumstances that exist after the date on which they were made. Any number of important factors could cause actual results to differ materially from anticipated results. For more information concerning the factors that could cause such a difference, see the company’s Annual Report on Form 10-K for the year ended June 30, 2009 filed with the Securities and Exchange Commission.

This afternoon the company released results for our third quarter and year to date period ended March 31, 2010. I will start our discussion by providing overall sales and operating results for the quarter. Later in the call, Mike will comment specifically on quarterly results and the outlook for each of our business units.

For the quarter ended March 31, 2010 the company generated a worldwide net sales of $496 million, which represents a 27% increase in sales over the comparative prior year quarter, and a 9.5% decrease from the quarter ended December 31, 2009. Our net sales for the quarter were below our expectations and we attribute these results largely to product shortages in our AIDC POS business units and less demand than the December quarter in our communications business units.

The quarter’s sales results also include an entire quarter of revenues due to the acquisition of the assets of Algol Europe on November 30, 2009. This acquisition is a key step in our strategy to expand our communications business in Europe. On a geographic basis, sales originating from our North American distribution segment increased 21% in comparison to the prior year quarter. Our international segment grew 55% and when measured in local currency grew 48%. Our international business is 24% of total revenues.

Within our product lines, we experienced a 26% increase of worldwide sales of our POS bar coding and security product categories over the prior year quarter. These product categories represented 62% of the total sales for the current quarter with the remaining 38% of our total sales originating from communications products. Our communications businesses experienced an increase of 30% in comparison to the prior year quarter.

The company’s consolidated gross margin percentage was 11% for the quarter ended March 31, 2010, which was lower than the prior year quarter gross margin of 12.2%. The prior year quarter benefited from the sale of lower cost inventory in Europe. Excluding this unusual event in Europe, gross margins were largely consistent between the two periods. Sequentially from December 2009, gross margin increased 70 basis points primarily due to vendor program benefits and favorable customer mix due to fewer large deals.

Operating expenses in the current quarter increased to $35.4 million compared to $32.4 million in the comparative prior year period. The majority of this increase relates to the addition of operations of the former Algol Europe business that did not use this in the prior year’s quarter. Operating expenses as a percent of net sales decreased to 7.1% compared to 8.3% for the prior year period.

Operating income for the March 2010 quarter increased to $19 million, a 25.5% increase from operating income of the comparative prior year of $15.1 million. Expressed this percentage of sales, operating income was 3.8% in the current quarter compared to 3.9% for the prior year period.

Interest expense was $377,000 for the quarter. The effective tax rate for the March 2010 quarter decreased to 36.5% compared with the prior year quarter of 37.6%. Our return on investment capital was 16.5% for the quarter, which compares to 13.8% for the prior year.

In summary, the March 2010 quarter had reported EPS of $0.45 versus a reported EPS of $0.35 for the March 2009 quarter. This increase was primarily due to higher sales and related gross profit dollars than the previous year’s quarter.

Turning to the balance sheet, inventory turned 5.7 times during the quarter which was lower than the 6.8 turns generated in the December 2009 quarter plus the same in the comparative quarter last year. As inventory balances continued to increase during the current quarter, paid for inventory days were a positive 17.7 days compared to a positive six days for the December 2009 quarter, and a positive 5.4 days for the comparative prior year quarter.

The company has maintained increased inventory levels in anticipation of sales volume improvement and to mitigate potential product shortages. In spite of our efforts, we did experience product shortages in certain high moving products during the quarter. Accordingly inventory on hand as of March 31, 2010 was $312.5 million versus $309 million at December 31, 2009, and $216.8 million as of June 30, 2009. Since much of this inventory was purchased early in the quarter, a greater portion had been paid for by the (inaudible) quarter than usual.

So in summary, we had higher levels of inventory in anticipation of improved sales and we paid for their products before the quarter’s end. There are $62.1 million in checks written but not cleared in the March accounts payable balance. At June 2009, this amount was $45.6 million and at December 2009 this amount was $65.4 million.

The number of days in receivables DSO was 59 days at March 31, 2010 the same as in the sequential quarter and the 58 days outstanding for the comparative quarter. As discussed during previous calls, we continue to be cautious about the economic environment and believe that our underwriting policies are appropriate under current conditions.

During the quarter the company had capital expenditures of $3.2 million, which is higher than our norm. This reflects expenditures incurred under the company’s plan to implement new software systems over the next two years. The company’s cash and cash equivalents decreased to $29.7 million on hand on March 31 compared to $38 million at December 31, 2009 and $127.7 million on hand at June 30, 2009. These decreases are largely attributed to the significant growth in our inventory and receivable balances over the last several quarters.

Total interest bearing debt remained unchanged at $30.4 million at March 31, 2010 and June 30, 2009. In addition at March 31, 2010 we continued to have $250 million of available funds for borrowing under our revolving credit facility.

Mike will now give you an update on our business.

Mike Baur

Thanks, Rich. The March quarter turned out to be more difficult to forecast than prior quarters. Historically, the March quarter revenues declined from December but this year we expected a different result.

As a reminder, ScanSource operates without a backlog except in cases of product shortages. Our sales orders are fulfilled the same day from each of our distribution centres. As a result, our ability to forecast is always inherently difficult as other factors beyond our control can affect our revenues and profits.

The two primary issues that affected our revenues were product shortages, primarily in our AIDC POS business units and lower demand in our communication business units as compared to December. We began experiencing product shortages and longer lead times in 2009, and have added more inventory and placed more orders to our vendors as lead times lengthened. However as revenue growth has returned over the last few quarters, the supply chain of products is just not keeping up with demand. Our vendors have told us to expect shortages through the June quarter.

As we noted on the last conference call in January, we saw a spike upward in large deals in December and we believe this was a result of an end user budget flush at year-end. As we developed our March forecast, we received inputs from our business units, vendors and resellers that suggested a continuing sequential improvement in end-user demand across all of our technologies. As it turned out, demand was good in our AIDC POS and security businesses but product shortages hurt our results. We believe we will retain most of this demand in the June quarter but our communications business units did not have the demand that we expected and that resulted in lower revenues than forecasted.

Now, I will comment on each of our reporting segments. North American distribution includes sales into the United States and Canada and posted sales of $377.6 million, an increase of 21% year over year and a decrease of 11.8% from the December quarter. North American discussion will start with Catalyst Telecom. The Catalyst sales unit had a disappointing quarter compared to our expectations as sales decreased from December. However, sales did grow as compared to last year when Catalyst experienced the worst of the recessions. Almost all Catalyst vendors showed sales growth compared to last year but most of them also declined compared to the December quarter.

We believe there were some pooling business in the December quarter and demand weakened in March as we said earlier. We believe that we continued to maintain market share for the quarter. During the quarter, Avaya resellers and Catalyst invested time and resources preparing for the addition of Nortel products. Avaya announced changes to the distribution strategy by authorizing Catalyst to carry Nortel voice and data products in the US. Catalyst has hosted a series of seven road shows across the US and Canada to educate and meet approximately 250 Nortel and Avaya resellers.

The annual Catalyst partner conference will be a great opportunity for Catalyst executives and/or vendor executives to network and discuss the key issues for 2010 with our top customers and prospects. This is the largest event of the year for Catalyst and is planned for May 11 through 13 and will include hundreds of Catalyst resellers.

Next up is ScanSource Communications. ScanSource Communications had another strong sales quarter with record sales from Polycom and Plantronics. ScanSource took market share from former Tech Data customers, as a reminder Tech Data is no longer a distributor for Polycom, and we saw better sales growth from our focus on service providers and AV or audio visual integrators in addition to our tradition VAR channel.

At the Polycom partner conference in February, the new executive management team from Polycom announced joint marketing alliances with two of our other key vendors, Avaya and Juniper. These alliances plus the additional 100 plus Polycom sales people recently hired should help drive end-user demand for the channel.

Next, I will discuss the North American POS and bar code business unit. This sales unit had a disappointing quarter due to significant product shortages yet they still grew sales year over year. Most of our vendors had supply chain problems that caused orders to be lost or delayed. Although we saw supply chain issues in earlier quarters, only in the March quarter did it result in a material reduction of revenues. This unit also saw a significant decline in large deals from the December quarter. However this unit saw good demand from a large number of customers across all markets and vendors.

Now, for an update on our third technology area ScanSource Security. The Security team had strong year-over-year growth but was down a small percentage sequentially. Several key vendors had strong growth including Panasonic, Axis, Zebra Card, and Motorola. However our large deals were down for the quarter. This unit is focused on IP security products continue to drive growth by increasing share in the fastest growing segment of the Security market.

Our second reporting segment is international distribution. Our international business which includes Europe, Latin America and Mexico posted sales of $118.5 million, an increase of 55% from last year and when measured on a local currency basis grew 48% year over year, and was flat sequentially from December.

In Europe the AIDC POS team had an excellent quarter while gaining market share with our key vendors. ScanSource Europe had a better inventory mix than our competitors and that allowed them to win new customers and achieve record sales results with several key vendors. In the quarter this team hosted a partner tour event in the Netherlands and attracted 160 plus resellers. The Netherlands also was a top growth country for the quarter in addition to the UK, Spain, Italy and the Nordics.

Our gross margins in Europe are being pressured by new distributors and by new channel programs from certain vendors, and like last quarter, we did benefit from the transition of certain customers distribution by a few vendors. ScanSource Europe grew the total number of customers in the quarter through a large number of aggressive marketing programs and by the addition of more head count.

In our Europe communications business, the March quarter was the first full [ph] quarter with Algol revenues. We are now marketing our business as ScanSource Communications Europe with offices in the UK and Germany. This business unit has strong growth year over year and sequentially. Key vendors include Avaya, Freecom, Extreme, ShoreTel, Juniper, Plantronics, and (inaudible). As in our North American business, we will be adding Nortel voice and data products to our European communications business. During the quarter the sales and marketing teams were focused on the new release of IP office from Avaya, which should lead to growth opportunities in June.

Turning to Latin America, this unit achieved strong sales growth year over year but slightly lower than expected due to product shortages. Certain countries did very well led by Columbia, Peru and Mexico. This team is challenged by margin pressure due to more competition and some vendor program changes in our AIDC POS business. As a result, we have been adding additional product lines in the security and communication areas. ScanSource in Mexico has recently launched Extreme, Datalogic, Axis and (inaudible).

Now, we will conclude this part of our call with closing comments. We believe that total revenues for the June 2010 quarter could range from $530 million to $550 million, and our earnings per share could range from $0.42 to $0.46 per diluted share.

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

Question-and-Answer Session

Operator

Thank you. (Operator instructions) Our first question comes from Brian Drab from William Blair. Go ahead, your line is open.

Brian Drab – William Blair

Hi, Mike; hi, Rich.

Rich Cleys

Hi Brian.

Mike Baur

Hi.

Brian Drab – William Blair

First question, just to get some more detail on the product shortages, I guess first can you talk a little bit about what percentages of those orders that you did not ship due to the shortages are in your mind lost at this point, and what percentage would be delayed?

Mike Baur

Brian, this is Mike. I think it is difficult to give you an accurate answer since we have not had this problem at this scale before. We always have orders in every quarter that come in and either we will not have the inventory rise at the time, and they might find it another distributor. And so you tend to always have that dynamic going on. So I would say that we feel like that we will maintain the business that we have not lost it to another distributor. So unless our customer loses it because the end user is tired of waiting, I think that is our biggest risk.

So we believe as inventory is replenished, we will continue to get our dominant share of that inventory, since we are the dominant player in these markets and hopefully maintain most of that business that is at least our assumption at this point.

Brian Drab – William Blair

Okay and Mike you made the comment that you do not usually carry a backlog except for in times of product shortages, does that suggest that maybe you have a substantial backlog at this point?

Mike Baur

Well, what I was trying to be clear on with this is that our inventory level still looked pretty high and part of that is because we have got a fair amount of orders that normally we would ship complete and that means we have to wait on the total product configuration to come in and in some cases we were waiting on literally cables or cradles or batteries or maybe just scanners when we got the mobility product. So historically, we do not even look at the number but now we are and we have got a sense for how much of those products once we get in the remaining parts can shift assuming the customer still wants them.

So yes, that is what I was trying to indicate is that a fair amount of the inventory that we have on hand today is already committed to orders just waiting on the pieces that are missing.

Brian Drab – William Blair

Okay are you guys willing to tell us roughly what the contribution from Algol was in the quarter or are you not reporting that level of detail?

Rich Cleys

Algol is an individual unit we are not reporting the details but when we acquired them, that was about a $60 million a year business.

Brian Drab – William Blair

Right, great, and then if I could ask one more, could you just provide some detail regarding the software implementation and how is that across the company overall and what the details are there?

Mike Baur

I think, Brian, right now, we are not going to talk about the details of everybody. Clearly more money than we have been spending on software so we wanted to make sure we flagged it for you guys when you saw it in our reporting that. It is something that we are planning to do over the next two years and we have started that process.

Brian Drab – William Blair

Okay but you are not going to talk about whether it is a new ERP system or just in general what you are doing at this point?

Mike Baur

No, I do not think so. We are not ready yet.

Brian Drab – William Blair

Okay, thanks.

Operator

Our next question comes from Ajit Pai from Thomas Weisel Partners. Go ahead, your line is open.

Ajit Pai – Thomas Weisel Partners

Yes, good afternoon.

Mike Baur

Good afternoon, Ajit.

Ajit Pai – Thomas Weisel Partners

A couple of quick questions, I think the first is you talked about Europe and talked about increased competition there, but in terms of business conditions in Europe right now, could you give us some color as to whether you see them improving, you see them still very sluggish or do you see them actually getting worse right now?

Mike Baur

I think what we saw was number one, we believed we gained market share, right, and so our market share does not give us a better view like you are looking for the end user dynamics but we did see again fewer big deals, and so what it is suggesting to us, and this is Europe and the US is that our run rate business that really is catering more to the small-to-medium enterprises was pretty strong. And so we felt good about that in all of our regions but we did miss the normal big deals that we would have thought we would have had in this quarter, they did not materialize.

Ajit Pai – Thomas Weisel Partners

Okay. Then the second question is looking at your overall telecom business, especially looking at Avaya of course Nortel, especially with all the activity undertaken over the past few months, why is your guidance – you said this was a weak quarter for telecom overall, why is your guidance still so conservative even though we have got so much more products to sell and of the overall sort of new Avaya Nortel combined what percentage over time do you think that prior Nortel products would be overall to the Avaya business?

Mike Baur

A couple of comments there specifically to the Nortel contribution, it is not clear to us yet for a couple of reasons. One, is Avaya has announced the product road map as you know back at the end of December, early January but it really is not in place yet. So, the customers that are Nortel customers are still buying Nortel products, and they are still buying it from their Nortel resellers, from their current Nortel distributors. So right now, we do not have a significant Nortel contribution in our guidance, okay? So the existing distribution and reseller landscape will not start to change materially until we get over the next couple of quarters, for sure not until the beginning of the September quarter.

Ajit Pai – Thomas Weisel Partners

Got it. And then the last question would be, just looking at the security business, now it has been with you for several years, you had some sort of (inaudible) changes, etc, but after that you have had some fairly decent momentum for a fairly long period of time. Could you give us some color as to when do you expect that business to actually become a double-digit percentage of your overall sales? And also you talked about taking the initiative into the market but I have not heard you mention before into Mexico, etc. Could you give us some color as to whether security risks and the markets are looking more attractive in areas that are different from what you were thinking about three to five years ago?

Mike Baur

Yes, I will try. I mean, I think in general we have avoided the discussion of the revenues for primarily confidentiality issues with our competitors. As you noticed, as we tend to do things, people follow us, not too long ago one of the broad line distributors announced the security initiative and another one announced the telecom initiative. So we are trying to be a little more closer to this but I can tell you that the strategy of working with the dominant IP vendors is really working for us, and frankly all of the analog camera vendors did not want us, and that is kind of okay now because the market is moving pretty swiftly from analog to IP or digital, and we believe we are going to really catch that wave, and we believe we are frankly in front of most of the traditional security distributors now in that space.

So I believe our strategy of focusing primarily as IP is the key and we still continue to see our – which was our great surprise, a strong card printer business this quarter, and actually it was strong in the December and the March quarter. And then finally to your international question, we have gotten – because we have done well with the vendors that we have in Security, they have been very receptive to us in Latin America and so we have decided to go ahead and implement a strategy and we have started it with a few vendors to see can our team down there add this to their portfolio without me having to create a totally separate security business, and that seemed to be working. We have carved out some dedicated people, we have hired some folks that have some security knowledge, and the vendors are very receptive and so far the customers are. So we will be talking more about that initiative over the next few quarters.

Ajit Pai – Thomas Weisel Partners

Got it, I will get back in queue.

Mike Baur

Thank you.

Operator

Our next question comes from Tony Kure from KeyBanc Capital Markets. Go ahead, your line is open.

Anthony Kure – KeyBanc Capital Markets

Hi guys, how are you doing tonight?

Rich Cleys

Hi, Tony, good, thanks.

Mike Baur

Hi, Tony.

Anthony Kure – KeyBanc Capital Markets

Hi, couple of questions, just looking at the guidance implied, let us call it $0.44 at the mid point for the fourth quarter, let us call it the mid point of $540 million or so, and that implies a sequential decline of about 40 BIPS or so from your (inaudible) in the operating margin line, I guess looking back over the last couple of years sequentially, operating margins have increased anywhere from 20 to 60 basis points or so historically in the June quarter. So I guess, what is driving this out of character sort of decline in operating margins in the fourth quarter?

Rich Cleys

Yes, Tony, this is Rich. One is because we did not achieve targets for the March quarter that has program impact in our gross margin in the June quarter, and our guidance would imply some big deals, which do carry some lower margin. So on a gross margin basis, this is a little bit less than what you would have seen in the past.

Anthony Kure – KeyBanc Capital Markets

Has pricing, I know that has kind of abated in the past, in the last couple of quarters certainly in the December quarter, but is pricing becoming more into the picture now as a pressure?

Rich Cleys

There has been some pricing pressure and we are anticipating that to continue.

Anthony Kure – KeyBanc Capital Markets

Okay. I read a thing from Ingram Micro saying that they are claiming now to be in the number two guys in the AIDC market, is it primarily them or is it smaller guys coming in?

Mike Baur

This is Mike, it would surprise me if they are number two because there are some other players out there but they could be, they do not disclose it. It would be interesting if they would tell everybody what their revenue is.

Anthony Kure – KeyBanc Capital Markets

I cannot prove it.

Rich Cleys

That is just what they said.

Mike Baur

But I would say that the broadline distributors without calling out any names that typically operate any of our businesses operate at lower margins and they are allowed to do that until the manufacturers get frustrated at their lack of investment in growing the core business. So I would say in general the broadline business model is the one that causes us the most problems, yes.

Anthony Kure – KeyBanc Capital Markets

Okay. And then finally, on the Security, can you just talk about what sort of markets are sold into their – is it safe to assume, is it small little retailers or is it bank branches sort of financials, maybe a little end market discussion there if you can or if you happen to know?

Mike Baur

Sure, what was interesting in this quarter security debt, I cannot remember even if I have said this, so I will say it now, we did not have as many large deals and we were disappointed because we have had an increasing number of large projects they call in the Security business and led frankly by our IP guys and one of our newer vendor Cisco. And so that was probably a little bit of a surprise for us in the March quarter was the lack of big deals in security, and when those big deals happen, you hit one of them, a lot of them are banks, they tend to be the larger enterprises. Our core business has always been business to business, none of the business that we do that we are aware of goes in the residential. So it is either large enterprise with big deals or small to medium across all verticals including retail.

Anthony Kure – KeyBanc Capital Markets

Okay that is all I have, thank you.

Mike Baur

You bet.

Operator

Our next question comes from Chris Quilty of Raymond James. Go ahead, your line is open.

Chris Quilty – Raymond James

Mike, I want to follow-up a little bit on the sort of the nature of the shortage you encountered, was it vendor specific, was it basically across all of the vendors just because they did not plan well and produce enough products or was it sort of component driven or commodity driven where everybody is having problems because there is a shortage of memory or something like that?

Mike Baur

Yes, Chris, in general from what I have heard, it is the latter where there is a shortage of components. The example I heard two weeks ago from one of our vendors, I will not say who was that an (inaudible) component was causing them delays in shipments, and so it is amazing but it is consistent with what I have heard anecdotally from other vendors is that when demand came back starting in September, the factories that produced their products which they are producing not only AIDC products as we know but cell phones and other stuff, as demand came back there was a shortage of raw components to go into the final assembly process. And as demand came back early December it made it even worse.

We thought we were ahead of the game on our inventory ordering but at the end of the day even though we had larger orders, and our orders ran earlier than some others; there is a sense that most manufacturers had to be fair in their allocation of product. That is why we also got a little bit disappointed if you will with some of our allocations, and this was across all vendors to that point. There was no single vendor that jumped out at us.

Chris Quilty – Raymond James

So, got you. So at least going into that process, did you feel like you were sitting in a better inventory position than some of your competitors?

Mike Baur

Absolutely.

Chris Quilty – Raymond James

And still are.

Mike Baur

Still are even though I would say, I would argue that I wanted by “unfair” share but I did not get it, but I guess I got to give some stuff to somebody occasionally. But yes, I think the difference Chris with the shortages in North America versus Europe, it is in Europe I think we had an even bigger advantage because our competitors are generally much smaller companies and they did not have the financial capability to invest like we did. So I think we had a bigger advantage over our competition in Europe than in the US.

Chris Quilty – Raymond James

Okay. And Rich, anything else that we should work into the gross margins looking ahead on a go-forward basis? You gave some color with regards to next quarter’s guidance, but you don’t have any other major inventory issues or pre-buys or discounts or things that might cause a swing factor?

Rich Cleys

In the gross margin?

Chris Quilty – Raymond James

Yes.

Rich Cleys

It will be volume driven. This last quarter we had some benefits on our gross margin. So, let me just kind of walk you through the EPS reconciliation, this will help you looking forward too. So, if you look at what our guidance was, we have guided the $0.46 to about $545 million. We missed our volume by about $0.12, but customer mix, which is fewer large deals rebates and programs as well as some benefits on price frankly, gave us about $0.08 to offset that $0.12. So we only missed our margin by about $0.04 a share. What we did do, and this is the answer to your margin, but what we did do is we had some favorable bad debt expense against our expectation because we actually had some recoveries this quarter. So that brought us back about $0.03 going the other way. So as we performed this quarter with a lower sales the programs are going to affect us, I mentioned some of the price pressure that we see out there, and by and large that is what we have been looking at going forward.

Chris Quilty – Raymond James

Very helpful, thank you, guys.

Rich Cleys

You bet.

Operator

(Operator instructions) Ajit Pai of Thomas Weisel Partners, go ahead, your line is open.

Ajit Pai – Thomas Weisel Partners

Yes, a quick question on the operating margins, just looking at the fact that you have highlighted that your operating margins are so much significantly higher than the broadline distributors and the fact that you also invest more in the business, back in ’02 your margins had gone down and then they rebounded very nicely over the next few years. Currently when you are watching your margins go down, is there anything that is structural that is indicating your industry is becoming more competitive and they will not bounce back to prior highs, or do you think that there is no reason why they should not come back to prior highs, and that is also looking at the mix of international and the mix of Security in your business.

Mike Baur

Ajit, this is Mike. Let me tackle just one piece of it and then see if Rich wants to chime in. I would say do not forget that, as we have always said, whenever margins are at the high end of 3s and low 4s, we view that as indicator that we should be making investment. So if you think about the investments we made in 2009 in the recession and continue to do in 2010, we are expanding European communications. So that is a business opportunity which for us is going to run below normal operating margins, because we feel like we can invest in our infrastructure right and be prepared to grow significant revenues over there, so that is number one.

Number two, still investing in securities, so again at lower than mature operating margins, okay, and then in Catalyst for the first time we are making investments because of the Nortel opportunity and so those things are going on right now that are part of the reason why you should not expect to see that margin pop up unless there is some unusual volume contribution, okay.

Ajit Pai – Thomas Weisel Partners

Got it. Over time you do not see any structural change in your business that margins are going to stay lower, there is no reason why over time they will not trend up into sort of the high 3s and low 4s, right?

Mike Baur

That is kind of what our history has been, right.

Ajit Pai – Thomas Weisel Partners

And nothing is seen that is changed in the industry dynamic right now?

Mike Baur

No, the answer to that is nothing has changed to change that.

Ajit Pai – Thomas Weisel Partners

Got it. The second is you did talk about the fact that your receivables have been fairly prudent in managing your risk, etc over there. But in terms of color I know you have made some connections unexpectedly that you know provided you have $0.03 in this quarter, but from a broad perspective, both in terms of your relationship with your lenders and your relationship on the receivable side with the value-added resellers and your customers, are you seeing the quality of credit and the availability of credit to you improve for you folks, as well as when you are lending, are you looking at the default rate or the terms that your customers want from you, are you being relieved of the pressure or is the pressure still pretty high?

Mike Baur

Let me answer because that is on both sides. So our ability to borrow, we have got a primary borrowing facility as a revolver and we negotiated a five-year revolver. So that revolver goes through 2012, and we have $250 million available on that revolver. It is led by JP Morgan. We have got a very strong bank group, and frankly our business model is one that we think the banks like because when times got tougher, we paid down debt because we liquidate receivables in inventory, and then when things start to get better, then we start to borrow. So, we have got a good profile and I believe that our availability to cash is as strong as it has ever been, and we have a stronger balance sheet as we have ever had.

Now for the customer side, we continue to utilize the same underwriting policies and techniques that we have in the past. We are very aware of the environment that our customers are working in. We know that some of our customers have come out of this recession with weaker balance sheet, and we worked very closely with them to be able to continue to sell products to them but they are some as you can see by our bad debt reserve that we have increased some of our risk coverage with the bad debt reserve but our performance overall on the receivables, if you look at receivable days, and if you look at our overall performance when I talk about bad debt expense, it is still pretty good. So we are feeling that we should not cut back, we should not really change our underwriting, we are still very, very pro with our customers.

Ajit Pai – Thomas Weisel Partners

So that would mean that you have not cut off customers because of their credit. So far the kind of underwriting policies that you had in analyzing risk have not changed at all over the past couple of years.

Mike Baur

Our underwriting policies are the same and we probably have more customers today than we had a year ago. This quarter we have more customers than we did the quarter before.

Ajit Pai – Thomas Weisel Partners

Got it, thank you.

Mike Baur

Thank you.

Operator

Our next question comes from Gregory Macosko from Lord Abbett. Go ahead, your line is open.

Gregory Macosko – Lord Abbett

Yes, just one question, I just want to understand the shareholders’ equity, the cumulative other comprehensive income that has shifted quite a bit and still small, but could you just explain what that line is?

Rich Cleys

You are looking at the inclusion of the cumulative exchange reserve, which has got exchange rate changes.

Gregory Macosko – Lord Abbett

Okay that is for the exchange rate?

Rich Cleys

Yes that is the biggest piece.

Gregory Macosko – Lord Abbett

Okay that can swing a fair amount over the year then?

Rich Cleys

Right.

Gregory Macosko – Lord Abbett

Okay, thank you very much.

Operator

There are no further questions at this time.

Rich Cleys

Very good, thanks, Gerard. Thank you for joining us. A replay of this call will be available in one hour on the ScanSource Inc. Web site. A full transcript of this call will be available in 24 hours.

To access the replay or transcript, visit the Investor Relations tab on the ScanSource Inc. Web site. This information will be available until our next earnings call. Our next conference call to discuss the June 30 quarterly and full-year earnings is expected to be on August 19, 2010. Again, thank you for joining us today.

Operator

That concludes today’s conference. Thank you for your participation. You may disconnect at any time.

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Source: ScanSource, Inc. F3Q10 (Qtr End 03/31/10) Earnings Call Transcript
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