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Executives

Douglas Fox - VP of IR

Anders Gustafsson - CEO

Michael Smiley - CFO

Mike Terzich - SVP of Global Sales and Marketing

Analysts

Reik Read - Robert Baird & Co

Jeremy Grant - Stanford Group

Jeff Rosenberg - William Blair

Ajit Pai - Thomas Weisel

Chris Quilty - Raymond James

Anthony Kure - KeyBanc

Marc Heilweil - Spectrum Advisory Services

Richard Davis - Richard Davis & Company

Scott Scher - Clovis Capital

Richard Glass - Morgan Stanley

Zebra Technologies Corp. (ZBRA) Q2 2008 Earnings Call July 24, 2008 11:00 PM ET

Operator

Good morning and welcome to Zebra Technology’s First Quarter Earning Release Conference Call. Joining us from Zebra Technology’s are Anders Gustafsson, CEO; Michael Smiley, CFO; Mike Terzich, Senior Vice President, Global Sales and Marketing, SPS and Douglas Fox Vice President Investor Relations.

All lines will be in listen-only mode until after today’s presentation. Instructions will be given at the time in order to ask a question. At the request of Zebra Technologies this conference call is being recorded. Should anyone have any objections please disconnect at this time. At this time, I would like to introduce Mr. Douglas Fox of Zebra Technologies. Sir, you may begin.

Douglas Fox

Thank you and Good morning. Thank you for joining us today. Certain statements wee will 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. Words such as expect, believe and anticipate are a few examples of the words identifying a forward-looking statement. Forward-looking information is subject to various risks and uncertainties, which could significantly affect expected results. Risk factors were noted in the news release we issued this morning, and are also described in Zebra’s 10-K for the year ended December 31, 2007, which is on file with the SEC.

Now let me turn the call over to Anders Gustafsson for some brief opening remarks.

Anders Gustafsson

Thanks Doug and Good morning everyone. Thanks you joining us. In addition to Doug we have with us today Mike Smiley, our new CFO and Mike Terzich, Senior Vice President for Global Sales and Marketing for our specialty printing group.

Today Zebra reported record sales and strong operating results for the second quarter. We also announced a more cautious outlook for Q3. Our solid performance across the company was driven by our programs to diversify our customer base, extend to Zebra’s geographic footprint and introduce new products to meet more customer needs. The addition of new channel partners, vertical market expansion and more resources in our international regions benefited our specialty-printing group.

Our strong sequential sales increase put us at the top end of our forecasted range for the Enterprise Solutions Group as a result of improving fraction over the recently introduced products and continued deployments of terminal operating systems. Gross margin exceeded 50% for the first time since the fourth quarter of 2005.

During the quarter, we made progress on our strategic initiatives to accelerate sales growth and increase profitability. First, the continued integration of the WhereNet, proveo, Navis and MSSI into one division ESG that strengthened the organizations infrastructure to support and manage the business as well as how best to acquire the breadth of our technologies to meet more customer needs.

Second, our global supply chain transformation is well underway. Third, a number of new product introductions have helped us win additional business with new customers in attractive growth verticals.

Let me now cover some of the highlights in our second quarter results.

In our Specialty Printing group, record international sales and nearly 10% growth in North America enabled us to deliver the second consecutive quarter of double-digit growth. It was the business unit’s fifth consecutive quarterly sales increase. The growth was broad-based with several printer lines posting new sales records.

The increased resources to focus on channel development and vertical market applications resulted in another record quarter of Latin America.

During the quarter, we secured significant new wins in manufacturing and government. Stronger Latin American economies are creating additional opportunities in manufacturing which compliments our strong position in retail and mobile workforce applications.

In China, our strategies to penetrate new vertical markets and expand our presence in additional major cities continued to generate results.

In Asia Pacific, record sales resulted from key wins in manufacturing retail and government. The launch of our Partner First Channel Program for the region gained traction with the recruitment of additional new channel partners. We anticipate further growth in this region, which hold significant long-term opportunities for Zebra.

The second quarter saw a short rebound in our SPG North America business. The region benefited from continued strong growth through the channels, aided by the success of our diversification efforts and growth to the market expansion. During the quarter, we secured business with new retail customers including some with Kiosk printers, a definite growth area for the company.

Other highlights of the quarter include important wins in direct store delivery, hospitality and government. These successes offset weaker sales for key accounts in retail and small package delivery.

The rapidly changing economic environment in Western Europe caused SPG EMEA to fall short of its targets for the time and nearly for the years, a slowdown in Italy and the UK with notable certain weakness in retail, offset strength in France, the Nordics, Germany, and Eastern Europe.

Let me spend a moment on Zebra Enterprise Solutions Group. With the period of solid bookings, ESG had good revenue flow from Maritime Licenses and Services. During the quarter, we announced new terminal operating system wins in Vietnam, Canada, Latin America and the Middle East. I am particularly pleased that Navis is tracking ahead of expectations with several go-live dates for our new platform, the SPARCS N4 Terminal Operating System, than for the remainder of this year.

Business interest and opportunities will prevail, and are also on track for implementations of new systems to management airport ground support equipment. Building on the ESP integration in the first quarter, we consolidate this strategy and product management, good service and support into a single organization and we are in the process of integrating the MSSI and WhereNet’s hardware groups.

We also began implementing a common supply chain, and are now in the early stages of developing a channel strategy for 2009, as well as focusing migrating solutions across verticals.

All of this work has led to improved visibility in this new business unit in addition to finding new opportunities for growth. We are taking collective actions as needed to address the issues we have uncovered in the integration process.

In the first half of this year, we took remedial actions to improve WhereNet product performance issues in the marine terminal markets. This is an important of our overall plan to maximize the value of our investment in WhereNet and ESG. We also introduced a new material low solution to enable manufacturers to better manage their replenishment operations.

Based on WhereNet technology, material flow was an important contributor to second quarter ESG sales and it has a growing pipeline, which gives us confidence for further growth in the second half of the year.

Material Flow helps manufacturers decrease labor cost, lower inventory levels and eliminate underutilized assets which is a key area of scrutiny by manufacturers, all while delivering a hard and rapid ROI. Our ESG team is working hard to bring the WhereNet solution to the level of performance required by our customers. I am satisfied that we are moving in the right direction and that our ESG investment will deliver the value we expect for our investors.

Overall, I am pleased with how our total business is performing. Clearly, Zebra continues to extend its global leadership in helping customers identify, track, and manage valued assets, transactions and people across the supply chain and within the enterprise. We continue to increase the value content of our solutions with a greatest set for identification of technologies and application software.

We entered the second half of the year more cautious on the economy and the seasonal slowdown in Europe. However, we continue to have a great deal of confidence in our ability to execute on our long-term business plan, and implement additional initiatives to support our growth objectives.

Now, I will turn the call over to Mike to provide a detailed review of our second quarter results and guidance for the third quarter of 2008.

Michael Smiley

Thank you, Anders. Before I get to the numbers, let me say I am very pleased to be here at Zebra. I have already met some of you and look forward to meeting all of you in the near future.

This year we started breaking out results from the Enterprise Solutions Group and specialty printing group. Results of each group reflect fully burdened numbers with depreciation and amortization and allocations of directly identifiable expenses provided by corporate related to those units. On an operating basis both business units contributed to strong sales growth. Record SPG sales included record international sales and the second highest quarterly sales for North America.

For ESG, we had strong sequential sales growth. We maintained gross margins, and operating expenses were within our forecasted range. Sales in the quarter SPG were up 12.8%, Fx net of the $5 million loss in hedging activities in the quarter versus a $1 million loss in hedging a year ago contributed $5.6 million or 2.8 percentage points of growth. ESG contributed $25 million to second quarter sales. MSSI, which we acquired at the beginning of the second quarter, had no material impact on the 16% sequential sales growth.

We have burned off about a million dollars in lost purchase accounting revenue in the quarter to leave about $4.8 million to deliver. The strength largely came from continued deployments of terminal operating systems supplemented by growth in our new Material Flow-Replenishment product. The trajectory on these and other products make us optimistic for another sequential sales in increase for ESG in the third quarter.

Let’s take a look at sales by product line. Hardware sales were $185.6 million of 17.3% over the last year and representing 73.1% of total sales. All bar code center product lines experienced growth with particularly strong growth and record sales of kiosk printers from this three point acquisition in 2006.

The percentage of printer sales from new printers held steady at 19% from the first quarter and up from 9.2% for the second quarter last year. We shipped 238,458 printers in the second quarter, a 5.3% increase. Average unit price of $603 was up 9.9% over a year ago, driven by product mix, better pricing and foreign exchange. Record supply sales were $43.8 million or 8.7% and comprised 17.3% of total sales.

The percentage of revenue from service and software continue to interest. This category driven principally from the addition of Navis represented 10.8% of second quarter sales, compared with 10.2% for the first quarter and 4.6% a year ago. During the quarter, Zebra incurred revenue hedging losses of $5 million. This loss set up a $0.05 per share impact on earnings. We entered into these hedging contracts, a year ago, at an average product rate of $1.36. The significant weakening of the dollar against the euro to an average settled rate of $1.55 resulted in loss. We entered in similar contracts for settlement in the third and to a less extent with fourth quarter.

Turning to regional sales breakdown, international sales were up 28%. Both Latin America and Asia-Pacific sales, each increased better than 38% to record levels. AMEA increased 23.2%, it fell short of our growth goal as Anders mentioned. Real growth in the region before Fx and ESG acquisition demanded to 5.4%.

Second quarter sales in North America were a record $112.3 million, an increase of 14.1% over last year. Consolidated gross profit reached 50.3% up from 47.6% a year ago. Gross profit includes some one-time items, which netted a 1-percentage point contribution to quarterly margin. SPG gross margin increased to 50.5% from 47.9% because it improved product mix and lower material cost and Fx impact.

Gross margin of 49.1% for ESG was up from 37.5% a year ago, but down from 51% for the first quarter of this year on ships and revenue mix. Consolidated operating income increased 8.8% and delivered a GAAP operating margin of 14.6%, on a fully burdened basis, SPG operating margin was 26.1% up 0.9 percentage points for the year ago.

Direct operating expenses in SPG were up 20% from an unusually low level a year ago largely driven by cost for our first global partners conference this quarter. Annual merit increases and additional marketing expenses. Results for SPG also included $4.7 million exit cost for the outsourcing initiative, which lowered EPS by $0.05 per share.

The bulk of Zebra’s operating expense increase relates to the Navis acquisition. ESG expenses also include an incremental $1.7 million from the MSSI acquisition. Included in the ESG numbers is $4.5 million in intangible amortization and stock options expense.

For the third quarter, we are expecting a significant reduction in the operating loss for ESG. On a consolidated basis we expect the reduction and the spend rates for the third quarter with the elimination of expenditures for the SPG global partners conference. Navis world customer conference and other one-time items.

Expenses for 123 totaled $3.1 million versus $3.2 million last year. Investment income totaled $2.7 million. Diluted earnings per share came in at $0.39 per share on $65.5 million average shares. The sequential increase in accounts receivable was due to higher business activity.

Inventories were up more than expected from additional stockings related to our outsourcing initiative. The building of parts is an advance of the launch of new product introductions and some increases related to differences in actual sales mix and the anticipated mix.

We are monitoring inventory levels closely. Capital expenditures totaled $114.3 million for the quarter, principally from the expenditures on our ERP implementation, which is on schedule and within budget. We ended the quarter with $270.1 million in cash and investments. During the quarter, we repurchased 461,000 shares of common stock.

Year-to-date, we have acquired about half of the shares under our 3 million share authorization with the deployment of $48.4 million. Our guidance for the third quarter indicates sales growth of 11 to 16% to $242 to $253 million, with SPG sales of $218 million to $225 million and ESG sales of $24 million to $28 million.

This forecast takes into account the usual summer slowdown in EMEA and expected $5 million loss in hedging activities and the realities of deferred economic headwinds going into the second half of the year, earning to expect in the range of $0.34 to $0.41 per share.

Our forecast assumes gross profit margin in the range of 48.5 to 50% in GAAP operating expenses of $86 million to $88.5 million, the reductions in the second quarter was $90.7 million. We are estimating outsourcing cost in the range of $3.2 million to $3.7 million. That concludes my formal remarks, and thank you for you attention.

Here is Anders for some concluding comments.

Anders Gustafsson

Thanks Mike. Zebra performed well in the first half of 2008. Sales were up 20% with strong organic growth in our Specialty Printing Group and increased momentum in our six month old Enterprise Solutions Group. We maintained high gross profit margins and continued to control our direct operating expenses.

Operationally, we made progress on those activities that will enable us to achieve our vision of providing solutions to customers to help them identify track and manage assets, transactions and people.

The success of our global expansion activity is evident. We have also made significant progress in our vertical market penetration with greater diversity in our customer base. Furthermore, we made progress and our goal to develop greater customer intimacy. We are now actively engaged with a large number of our top endusers in our targeted vertical markets. This high touch model has led to a growing pipeline and has already started new key brands for mobile workforce and retail.

That is the technology company; we rely on a vibrant product portfolio to stimulate growth. To paid revenue product introductions have increased. Most recently, we announced two important new printer products, the GPRS, the next generation of desktop printers, and the HC100 dedicated wrist band printer. We also added to our accessories offerings to allow the counting and direct store delivery solutions along with a new infant wrist band and other labeling surprises.

Our innovation and leadership in printer products recently led to the largest RFID deal, which we are aware of today. Approximately, 250 Zebra R4i UHF, RFID card printers will be deployed to print and encode seasons key passes as data resorts in Colorado this coming winter. The R4i is the only UHF card printer available in volume. It will be paired with RFID cards incorporating a Zebra designed in late. This project opens new opportunities for growth, both for product in our core specialty printing business and in our enterprise solutions group.

Going forward, we will continue to invest in developing the solutions and channels that will extend our leadership and secure long-term success. At the same time, we will continue to aggressively manage operating expenses due to the more challenging economic environment. As we have told investors many times, while Zebra is not immune from economic fluctuations, we are positioned better than many companies to sustain growth and profitability.

Thank you for listening. We are now happy to take your questions.

Question-and-Answer Session

Operator

Thank you. We will now conduct a question-and-answer session. [Operator Instructions]. Our first question comes from Reik Read with Robert Baird & Co. Please proceed with your question.

Reik Read - Robert Baird & Co

Hey, good morning. Can you talk a little bit about internationally, maybe two things, one, you gave some good detail in terms of the individual countries and how those did, but can you talk a little bit about how the environment might be changing. AND then two, ANDers in your comments with Latin America and to a certain extent with Asia you were saying some of the resource deployment helped drive some of the strength there. I would not look at channel resource deployment helping initially so I am assuming that what you are talking about is some investment that you have in the past but are there some things that you have done in the last quarter or so that to really start to accelerate that? Thanks.

ANDers Gustafsson

So, first on the overall environment is that we have seen internationally -- the slowdown we saw in Europe was quite specific to the UK and Italy and particularly exposed to retail. We saw there I think a general slowdown in the economy, your outlook for those countries are a bit more muted for the second half but we saw good growth in many other parts of the region like I said that in particularly Eastern Europe and the Scandinavian countries.

The overall growth, it was very strong for us in the emerging markets so the countries we have spoken about specifically for growth like the BRIC countries; Brazil, Russia, India, China and also Eastern Europe and Turkey did very well for us. AND the investments I talked about were in the channels were really done beginning of this year and is starting to pay off for us now. We have started to also, launched our Partners First in Asia which has had a good response from our partners there and we expect that to continue.

Mike Terzich

However, (inaudible) this is Mike Terzich, let me just add one point to ANDers’s comments particularly in relation to your Latin America question. The investments that we have made in Latin America, a big portion of that investment was focused on really two regions, Mexico and Brazil and those continue to be very strong contributors to our overall success in Latin America, particularly, investments we made about eighteen months ago, up to about twelve months ago in Brazil. We have expanded our infrastructure, we have grown resources, we have a legal entity, we have a new office and that is paying dividends as we have recruited new partners, we secured some new large pieces of business and we are very happy with what we are seeing out of that effort.

Reik Read - Robert Baird & Co

Okay, and then if I COULD JUST ask a follow up on the ESG side of things, you mentioned, you saw very good sequential strength from a revenue stand point, but gross margin is down a little over a 100 basis points, can you talk about, may be some factors that divide impact out and specifically, could you comment on service revenue, software, the impact of the rebuild of the deferred revenue account and then any integration cost that might be a little high at this point?

ANDers Gustafsson

So the makeshift was an increased proportion of services compared to Q1 into Q2 and also hardware. So that was really with the account before the gross margin erosion. We are seeing opportunities for us to whether -- as you have said to prune and tune organization somewhat, in order to make sure that we have backlogged some investment but we do not have to see the same opportunities for growth but put those dollars to work but we do see the best opportunities, so we are rebalancing some of the investments within the group.

Reik Read - Robert Baird & Co

Great, thanks you so much.

Operator

Our next question comes from Jeremy Grant with Stanford Group; please proceed with your question.

Jeremy Grant - Stanford Group

Hey, thanks there, Good morning, I wanted to follow up a little bit more about the economies, specifically in your guidance, you were talking about how you want to see, you are particularly cautious given the economic situation I think a lot of the message we got to date has been that business has been holding up surprisingly well despite economic sluggishness around the world. AND I am wondering outside what you are seeing in UK and Italy if you are now starting to see a bit more of a slowdown from other parts of the world relative to what you are seeing in the first half of the year?

ANDers Gustafsson

So I think that the economic impact the economic head wins that we are feeling has been really focused on Western Europe and North America and when we talked to our channel partners they would say that if you compare this to say late 2007 at that point our end user --they would -- they used to say that they were growing, they had budgets and they were funding proceed with investment projects very quickly.

Today there is more scrutiny on projects they tend to go through a much more vigorous return on investment calculation which by the way really help us in any ways. They also go see that parties tend to get maybe divided up into more phases so they have not released the entire phase in one go.

However, we haven’t seen any cancellations of orders some push up but not cancellations. So but outside the Western Europe and the U.S. the only other caution for Q3 is China where we expect that we will see some slowdown due to the Olympics they are slowing down huge factories around Beijing, traffic in Beijing and so forth and we expect that to have some impact on our business in China in Q3.

Jeremy Grant - Stanford Group

Alright thanks. AND then on the follow up I wanted to ask a bit more about guidance fro operating expenses going forward. Obviously they have been going up quite a bit the last year both with the outsourcing initiative as well as integration of ESG, I realize and of course you only give guidance for one quarter. I am wondering if you can look a little bit beyond and talk about what SORT OF level you think that these numbers are going to stabilize that?

ANDers Gustafsson

First, for Q3, we are looking to reduce OpEx quite substantially, and even if you look at our headcount for our core Zebra business on the corporate side, we were basically flat on headcount in the second quarter. We just -- we felt that the economic outlook was more uncertain and wanted to make sure we did not get ahead of ourselves on reproving. AND I expect that we will continue to be very provable in our recruiting activities going forward, particularly in our core business. However, also in ESP to make sure, we do only recruit absolute necessary resources and in the right place.

Little uncomfortable to give you guidance on operating expenses for the longer term, because they do not obviously depend, somewhat down, what happens with the economy in Q4 and Q1. So I think, we do value our profit margins and we certainly are working hard to make sure we improve them, and we will deal with the OpEx situation based on what we see on the revenue side.

Jeremy Grant - Stanford Group

Okay. Thank you.

Operator

Our next question comes from Jeff Rosenberg with William Blair. Please proceed with your question.

Jeff Rosenberg - William Blair

Hi, I wanted to ask a couple more on ESG? If we look at the reported operating loss, it looks like incrementally it is up about $5 million year-over-year. Should we think of that as -- how actually should we think of that if things are getting tougher within WhereNet versus how should we think about the profitability of the other businesses you acquired? I know you do not want to think about them as an integrated unit, but just in general, I mean is the -- I know you are still on the process of integrating them, so when you look at the newer businesses, are they profitable or how far away they are from being where you expect them to be in terms of reaching breakeven?

ANDers Gustafsson

Yes. First, the largest acquisition we made today is Navis. That is performing very well and making money for us, and its value acquisition is brand new and we still have some work to do before we make that profitable. We do expect to see the material improvement in our profitability of ESP in the third and fourth quarter of this year.

Jeff Rosenberg - William Blair

That is it. I guess if it is occurring in the third quarter, it seems though it is not enough to really offset the overall decline in profitability by which obviously you know there is some negative leverage as you see sales decline in the core business. However, I guess can you give us some flavor for how material that improvement could be in Q3 if given overall, it seems like its seems more than offset by the negative effects of the weakness in the core business?

ANDers Gustafsson

Yes. So -- first maybe one more point on the year-over-year comparison, the amortization is obviously much, much bigger, so the operating situation is not that different. For Q3 though, we guided for between flat to plus $2.5 million of revenue for ESP, and I think you can assume that it will be a similar gross margin profile in that revenue stream also.

Jeff Rosenberg - William Blair

AND I know you have had exactly expenses there too?

ANDers Gustafsson

We are adding back some expenses also in the third quarter. We have absolutely done so.

Michael Smiley

Its multi top line growth that is driving this.

Mike Terzich

Yes. However, there is more pruning and tuning to make sure that we get the synergies that we have identified and that we have the resources where we believe that they can add the most value.

Jeff Rosenberg - William Blair

Got it. and then, one last question on this call. When does the deferred revenue from Navis begin to come back to contributing, is that a Q4 event, and can you give us a sense of what SORT OF profitability improvement that alone will give you?

Michael Smiley

We had $2.3 million of revenue, we did not seek up through the P&L in the first quarter, $1 million in the second quarter, and I think we probably would have had an expectation for more of it to actually flow through in the first half and we have seen, so our expectation is this propelled roll off a little bit more slowly than we have seen in the past, and probably not really we consider the use until 2009.

Jeff Rosenberg - William Blair

Okay. Thanks a lot.

Michael Smiley

Yes.

Operator

Our next question comes from Ajit Pai with Thomas Weisel. Please proceed with your questions.

Ajit Pai - Thomas Weisel

Yes, good morning.

ANDers Gustafsson

Good morning.

Ajit Pai - Thomas Weisel

A Couple of quick questions. The first one is, back to ESG, I think you had indicated earlier that in the third quarter you expected to get to SORT OF a breakeven in that business. So it just stays in the column you have provided right now, if you exclude the impact of amortization, do you think that you could get there with the drop off in expenses or you think that it is still; it is unlikely given like a change in the environment?

Mike Terzich

We have also added the MSSI to ESG symptom and our expectation is that we will make a substantial improvement in profitability for ESG in the second and third quarter and it get close. I do not think we are going to say we are going to be profitable in the third quarter and we expect further improvement in the fourth quarter.

Ajit Pai - Thomas Weisel

Got it. AND then the second thing is, just given the change in leadership on the finance side, the hedging policy that you have been following over the past couple of years, could you give some color as to whether you know, the manner in which you think or thinking about it right now on a go-forward basis, the currency hedging?

Michael Smiley

Yes. I think that (inaudible) before has been to basically hedge 50 to 80% of the euro revenues going forward in this -- I think it is on the press release, the average spot rate, a lot of the hedges they were seeing, terminate or mature, this year we brought last year and so most of the hedging activities that you will see mature for the rest of the year were likewise brought last year.

For 2009, obviously, we will have a benefit for the full weakening of the dollar which is not really reflected in our results. So, for example, the $5 million of hedging losses that we had in Q2, next year if we are at the same exchange rate, that full benefit will flow through to roughly $0.05 a share in EPS.

As far as what we do, 2009, I think we do want to make sure we manage our foreign exchange exposure and try to avoid the volatility that that asset can provide but it is hard to explain SORT OF what the program will be in 2009, 2010, I do not think we want to talk about that right now.

Ajit Pai - Thomas Weisel

Okay but you do want to hedge it.

ANDers Gustafsson

Yes.

Ajit Pai - Thomas Weisel

Okay and then the second is just looking at the cash in your balance sheet and the acquisitions you have been making right now, could you give us some color as to how you would prioritize the use of that cash right now especially given the weakness in your stock and also what the pipeline of acquisitions looks like right now for Zebra?

ANDers Gustafsson

Well, we have a, brought back approximately $50 million worth of shares this year. I think that is a material number for us, compared to, particularly looking at that cash balances now, that is gone down to below $300 million. AND we have made one acquisition which was a relatively small one. I think the outlook for this year we are very cautious on acquisitions as we said before, we want to really bend down and get the value out of the acquisitions we have done in the ESG already, but it might be some small tuck-in that would, particularly on the technology side, that would enable us to accelerate some new applications or new revenues. We are obviously have nearly $1.5 million of the share buyback authorization and depending on the share price, we would be active in the market.

Ajit Pai - Thomas Weisel

Got it and when you are looking at your current tax rate, its entirely stable over a long period of time or range, as you shift your manufacturing strategy and some of the other growth that you are seeing in international market, what KIND OF tax rate, what KIND OF changes, do you expect in that?

ANDers Gustafsson

We expect that taxes will come down somewhat but I do not -- we are not quite ready to lay out the entire tax picture at this time.

Ajit Pai - Thomas Weisel

Okay, got it, thank you.

Operator

Our next question comes from Chris Quilty from Raymond James, Please proceed with your question.

Chris Quilty - Raymond James

Good morning, gentlemen, I was pleased to see that the North American market showed a nice hop, I think it was 12% or so, in your segment reporting. However, I was wondering if you could perhaps give us an idea of break down in the specialty printing group where you saw most of the North American weakness last year. How much of that was related to SPG?

Mike Terzich

Chris, this is Mike, I am not sure I understood the question, the last part of that question?

Chris Quilty - Raymond James

Okay, before you did the or acquired even WhereNet, we saw weak numbers in the specialty printing business in North America.

Mike Terzich

Right.

Chris Quilty - Raymond James

The number you reported today are 12% in growth in North America, includes both SPG and the Enterprise Solutions Group so if you took away the Enterprise Solutions Group, is most of that jump due to ESG or -- is it?

Mike Terzich

No, just the opposite, actually, its most of the North America growth is associated with the SPG business.

Chris Quilty - Raymond James

Okay and so that is a pretty dramatic lift from what you have seen in the last 4 or 5 quarters what specifically would you attribute that to?

Mike Terzich

Well there were a few things in the quarter. Our strategy as we have expanded and found over the last couple of years, vertical market expansion and we have got some nice wins in some markets for us particularly two places one was in direct store delivery space this is a space that we entered about two years ago. It is a mobile driven solutions sub space and what is going on with energy prices we are seeing a lot of increased interest in companies that are looking to take cost out of their ability to deliver goods. A lot of these goods are KIND OF retail base these are the guys that deliver sodas and bread, bake goods etcetera.

ANDers mentioned we have some success in the quarter with kiosks, so there is a quite a bit of interest in self help unattended printing applications. So we have got some nice wins there. AND then the broader success we had in Q2 was we had very good spring through the channel. AND what this means is, this is typically driven by multiple markets but our channel business was very strong in the quarter and was offset a little bit by some of the spot weakness in some of the larger lot retail business was continues to be soft as you would imagine.

ANDers Gustafsson

Yes the actual growth for North America, the organic growth for our specialty printing group was 9.2%.

Chris Quilty - Raymond James

Good. AND when you look at those two areas the [DST] and kiosk do you think the strength was primarily underlined growth in the market or competitive wins?

ANDers Gustafsson

Well I would say it is a little bit of both I mean the application space have some opportunity in it and clearly in a couple of those areas, and the Kiosk is a very fragment in market. So I would not necessarily say those word take-share comparative wins. However, in the route space, we are competing against some traditional confident we are winning share.

Chris Quilty - Raymond James

Okay. AND if I can just circle back to the question that Ajit had asked about the earlier prediction of Q3 breakeven in the ESG Group. I put that note in my model, but thinking about it now. Will you -- with that original prediction were you talking about a EBIT breakeven as you report in your 10-Q in your press release or was that factoring out the deferred revenues and amortization of intangibles and more of a an EBIT adjusted EBITDA number?

ANDers Gustafsson

It was an adjusted EBITDA number. So it was on KIND OF on the direct operating profit level.

Chris Quilty - Raymond James

Okay. So --

Michael Smiley

Also as you know, again remember, that we have added on MSSI’s same staff since you said that.

Chris Quilty - Raymond James

I understand. So, if were to look at the $7.7 million loss, I think that was in this quarter, you would back out the $1.7 million of expenses from MSSI; I can not find my numbers here. $2.3 million of deferred revenue and couple of numbers of amortization.

Michael Smiley

2.3 was in the first quarter. There is 1.1 billion on deferred revenue in the second quarter.

Chris Quilty - Raymond James

AND amortization of couple a million?

Michael Smiley

Yes. Amortization was $3.3 million in the quarter.

Chris Quilty - Raymond James

For ESG?

Michael Smiley

Yes.

Chris Quilty - Raymond James

Okay. So, you are not all that far off from getting into the breakeven

ANDers Gustafsson

No

Chris Quilty - Raymond James

Alright.

Michael Smiley

We are making decent progress I think, and we said, we had a good confidence that we will be improving the financial report.

Chris Quilty - Raymond James

Good..

Michael Smiley

The top line Q3 and Q4.

Chris Quilty - Raymond James

AND finally a specific update on how the outsource that Jebel’s going?

ANDers Gustafsson

We are satisfied with the progress of our outsourcing activities with Jebel. We have moves -- we now actually manufacture 100,000 printers in Jebel, that is out of $700 annual run rate to say 750,000 printers, and so in the first half of this year we have done 100,000 printers. AND with equivalent quality as we have had in our North America facilities or particularly in Camarillo which is where these printers come from. The overall program is running probably 6 to 8 weeks behind based on our changing KIND OF the strategy of not moving tools but having to make new tools in China, but we on the other hand have been able to offset that delay would seeing greater than expected material cost savings. So the overall project P&L with a project MPV value is still very much intact.

Chris Quilty - Raymond James

Great. Thank you gentlemen.

Operator

Our next question comes from Anthony Kure with KeyBanc. Please proceed with your question.

Anthony Kure - KeyBanc

Good morning. Just a quick question on the other item in the gross margins, how --sorry if I missed it, but I am wondering if you could give a little color on that?

Michael Smiley

You are talking about the one-time items?

Anthony Kure - KeyBanc

Yes. That impacted gross margins or helped gross margins by 1 percentage points?

Michael Smiley

We had a two items that were affecting gross margins that went different ways. The first was we had an adjustment to a V-accrual, the V-accrual is basically to take in consideration the cost to recycle products that is an obligation we have within Europe, and we have had that program going on for about three years and we have examined that accrual and that we made and adjustment to that accrual. The other thing is we had some adjustments to some lease expenses. So, when you net that all out, those two items are basically a 1% improvement to gross margin.

Anthony Kure - KeyBanc

Okay, thank you. AND then, just a little more color on what is going on in Asia, obviously, there is strong growth there, just wondering if you can maybe talk a little about the end markets that are KIND OF driving it? Are you getting more into the manufacturing base there and taking share from local competitors or -- can you give an idea what is going on there?

Mike Terzich

Alright, Anthony, it is Mike, I will take that. Our business in Asia has been very good, it is been good for a number of periods now, and we saw growth predominantly out of two-sub regions within Asia. China was very strong for us and China has been and continues to be a core industrial manufacturing market for us. So we see lots of opportunity that have been created both by multinational manufacturers and local manufacturers. We are selling a lot of our big iron product in that region. Interestingly, China is also creating some opportunity on the mobile side as some of the per capita wealth is improving, retail is beginning to become a much stronger market for us. So, things in China look very good. Other markets that were strong in Asia in that region for us was Australia, and this has been a market that has really rapidly improved for us and it is been basically on the heels of some strong retail opportunity that we have had in the region with some of the large Australian retailers across a pretty wide range of our product portfolio.

Anthony Kure - KeyBanc

Okay, great. Thank you, that is all I had.

ANDers Gustafsson

Real growth in Asia Pac was 24.3% for the quarter.

Operator

We have a follow-up question from Reik Read with Robert Baird. Please proceed with your question.

Reik Read - Robert Baird & Co.

I just wanted to follow-up on the ESG side of things. ANDers, I think in your comment you had mentioned that you had to retool some retool some [warhead] products for the marine area. Is that something that added some incremental costs and now those costs are going to come out and that also helps the transition that you are talking about?

ANDers Gustafsson

The cost -- they are not really like incremental cost, they are already in our P&L largely. So I do not expect that they will come out based on that but we have been working forward to that, basically that six months to improve the performance of the solution in marine terminals. AND that should open up more opportunities for us elsewhere as we get the performance to be that much higher.

Reik Read - Robert Baird & Co.

Yes, I just -- I am just asking, is the bulk of that done and so therefore -- you that is much?

ANDers Gustafsson

The bulk of that is done, we still have some work to do but we expect that by the end of the third quarter we should be largely done with that.

Reik Read - Robert Baird & Co.

Okay and then I just like wanted to follow-up and maybe I just did not understand, it sounds like you are saying from a mixed perspective software will kick in a little more as deferred revenue KIND OF kicks back in the third quarter. I am just trying to understand the incremental difference (inaudible)?

ANDers Gustafsson

I do not think we said that for the third quarter particularly. I think in the third quarter we would expect the mix to be similar because we had deferred revenue in Q2 but we are also going to have deferred revenue in Q3.

Mike Terzich

AND we expect to be similar from quarter to quarter.

Reik Read - Robert Baird & Co.

Okay, great. AND then just one other question if I could, you have seen pretty good quarterly improvement, really over the last year in your ASP. Can you talk a little bit about what is behind that and are you seeing some component inflation that is defeating that away or not.

Mike Terzich

Riek this is Michael, let me, I will talk about the ASP portion of that. We have, you are right. Absolutely, it is a good observation. We have been very focused on our pricing strategy and we have made a couple of changes across the globe that has helped that. Primarily, we get some discipline, good discipline as we roll out partners first across the regions, we get, we tend to get better pricing discipline with our channel partners and that has improved our situation there and particularly over the last couple of years, in our Asia Marcet which has been more price sensitive, we put some more administrative controls in place and some of the special pricing opportunities that we have seen and then you are getting as you know, you are getting some foreign exchange benefit that is driving up the ASP, so net-net, we are on a very nice trend over the last few periods that is relative to average unit price. The other piece that you are mentioning as we have seen some cost increases and the side of business, with the oil being what it is, we are seeing some increases from our supplier on the label and the ribbon part of our business and like everyone else, we have passed those cost increases on to our customer base.

Reik Read - Robert Baird & Co.

AND Mike, with the disciplines that you are talking about with respect with ASPs, it now seems like you are KIND OF lacking at is, is that something where you really do not see a whole lot of additional improvement, it just becomes stable, is that the right way to look at that?

Mike Terzich

Yes, it may very well be, I think it is a run at the course for us, I think it is been good, I think as we introduce new product that helps potentially to offer some other opportunities for us but I think its okay.

Reik Read - Robert Baird & Co.

Okay, great, thanks a lot.

Operator

Our next question comes from Marc Heilweil with Spectrum Advisory Services. Please proceed with your question.

Marc Heilweil - Spectrum Advisory Services

Hi and I just really have a chance to ask you a broader question, Zebra before the last downturn has shown a steady it has had a not a great, sharp slope decline in its profit margins and its profitability. Certainly from the 90s and maybe I guess at the beginning of this century. What is your view of -- a reasonable view of what KIND OF profitability, profit margins and perhaps return on assets this company can realize over a smooth, out over a cycle?

ANDers Gustafsson

Well we do expect that we will be able to generate good revenue growth over the next 3/4 years both from our core business and also from the ESG and that should give us some scale to improve our margins. We have also had some substantial significant programs in place to reduce our cost structure. First and foremost really our outsourcing program which we have said we expect to get the cost savings of between $25 million and $30 million by 2010. We also have many people doing implementation which should enable us to drive some more synergies and improvements. AND when we get to -- three years out there so we have mentioned that we expect to have a cash earnings, the cash in EBITDA number of 22 to 25%.

Marc Heilweil - Spectrum Advisory Services

What do you think accounts for the decline in the profitability of this corporation over the last six to seven years?

ANDers Gustafsson

It is a long time. Yes, approximately if you prepare to 2004 may be present here -- I think our margins KIND OF peak, that was a year, when we had some very, very large orders from a large retail customer house and we grew revenue in lot of cash and then we could grow OpEx and as we extend price to diversify the business the more vertical markets being now the cost of sales model has gone up a bit. All this being up in more recent time here the additional ESG has been diluted to our short-term earnings. However, we expect the decision is clearly that we will take that a good additive part of the business.

Marc Heilweil - Spectrum Advisory Services

Okay. Thank you.

ANDers Gustafsson

AND then also may, if you think that out from -- compared to our peer group. We are still substantially more profitable and more robust margin structure than any of our peers I think.

Marc Heilweil - Spectrum Advisory Services

I understand. Thanks.

Operator

We have a follow up question from Jeremy Grant with Stanford Group. Please proceed with your question.

Jeremy Grant - Stanford Group

Hey thanks. I just wanted to talk a little bit more about ESG. We talked about how Q3 it is on an adjusted EBITDA basis, it should be breakeven and pretty close to it. Wondering what revenue run rate you would have to be at in order to actually be breakeven on SORT OF a normal EBIT basis?

ANDers Gustafsson

Yes, I think you can go back and do the math on that. However, at this point, I think we are again focusing on the third quarter and on a cash flow basis that the numbers we projected. We are in the ball park of being cash flow positive and so did the direction that we are at right now.

Jeremy Grant - Stanford Group

Alright, thanks.

Operator

Our next question comes from Richard Davis with Richard Davis & Company. Please proceed with your question.

Richard Davis - Richard Davis & Company

I am intrigue by the possibilities particularly in the direct store delivery market our rather vertical markets, how the customer saves money and somebody mentioned that on the call then I thought just expand that point a little bit.

Mike Terzich

Sure, Richard. This is Mike. We are happy to do that. You know that market is all about its route management when you look at what is going on in that space right now higher fuel prices, what these our manufacturers are looking to do is to get more routes completed in the -- a typical eight-hour shift, be more efficient and how there those trust navigate free to save on fuel and where we come into play is the real crates, carton boxes full of goods into a potential store. AND they are printing the transaction receipt on demand by wearing mobile printing devices and that saves that driver steps valuable steps to walk back to the truck to get a receipt and that allows these companies to squeeze more deliveries into a day and it saves money, improves their efficiency and also ties to automating their billing system.

Richard Davis - Richard Davis & Company

Thank you very much.

Mike Terzich

Alright.

Operator

Our next question comes from Scott Scher with Clovis Capital. Please proceed with your questions.

Scott Scher - Clovis Capital

A couple of questions the exit cost, what is your estimate for complete ’08 and then what do you think ’09 will be on the exit cost?

ANDers Gustafsson

I do not think we have forecasted, we know we said that the cost for -- exit cost was -- the total cost of that not the exit cost but the total cost for the outsourcing project for 2008 was $16 million to $18 million and that is still the forecast we have, and we said the total cost for the entire project was approximately $25 million, and we are also come through with that forecast at this stage.

Scott Scher - Clovis Capital

So, in periods in 2009, that dramatically has to drop off quite significantly versus 2008?

ANDers Gustafsson

Correct.

Scott Scher - Clovis Capital

That is correct?

ANDers Gustafsson

Yes, that is correct.

Scott Scher - Clovis Capital

Okay. AND then, when you talk about the -- you are taking about ESG, you talking about it, and KIND OF improving here in the back half for the year. Is it too early to talk about 2009 in terms of a ramp for profitability, because I know you have goals out there that you laid out your Analyst Day by 2010 or 2011 to have SORT OF 15% margins or something like that, much of that linear or an up, is it too early to talk about the ESG, what the improvement would be in 2009 versus 2008 in terms of profitability?

ANDers Gustafsson

I think it is a little early for us to get into real forecast for 2009. We obviously expect the business to improve revenues and improve margins, but I do not think we are quite comfortable giving any more specific targets at this stage.

Scott Scher - Clovis Capital

AND, were there any other extraneous cost in the quarter in terms of severance for management or anything like that, were there any other SORT OF expenses in this quarter that were extraordinary?

Michael Smiley

Yes, there was certainly severance expense in the quarter. We normally have some severance expense, but the severance expense line was high this quarter than normal.

Scott Scher - Clovis Capital

Okay, thank you.

Douglas Fox

We have, this is Doug. We have time for one more question. AND then we will be around certainly to answer your questions offline. Also, just as a reminder our next conference call will be held on October 29th.

Operator

Our last question will be from [Richard Glass] with Morgan Stanley. Please proceed with your question.

Unidentified Analyst

Hi, I have another form of -- KIND OF a comment on the questions you got a little bit earlier, I mean all we are hearing on this call is that we are seeing growth in the printers, we are seeing growth in the SG, we are seeing growth in Asia, that is all well and good but as stock holders we would like to actually see some profits. You have had a languishing earnings number for years. You have had a languishing stock for longer than that and maybe there needs to be a change in focus from just purely growth to actually worrying about driving the bottom line and talking about goals three years out is nice but it is difficult to see it from where we are sitting today.

AND maybe there needs to be a different set of incentive for management in terms of getting to profitability. Looking through the profit, it seems like its very growth focused and absolute operating income base as opposed to return base, no profitability base. How are we going to change our focus and when are we going to start seeing an eye on profits being what matters and not give it on growth?

ANDers Gustafsson

Yes, so first on the incentive that we have, as a management team we are very much incented to improve the share price so there would be a return and it is going to be aligned with you, that is the biggest part of, certainly on my compensation and it is a very substantial part of certainly on, everybody on the executive teams view. We have a number of very significant activities that are looking to drive profitability as I mentioned. Outsourcing is something that can generate $25 million to $30 million of cost savings. The ERP program can certainly provide a lot of synergies. I wish that we could, implement those in a quarter or two but those are large projects and it is going to take some time for us to get those done. However, also I think we need to balance it with trying to get some growth for the business and make sure that we stand our market base and I think that we have so far executed well on those plans and that should generate good long-term returns. AND if you look it out -- if you back out the cost for our outsourcing, we have a pretty substantial improvement in the EPS year-over-year.

Unidentified Analyst

Thank you.

Operator

I would like to turn the call back over to management for closing comment.

ANDers Gustafsson

Yes, with that, thank you very much. Again we will talk to you again on October 29 and if you have any questions, we will be around to talk to you offline. Thank you very much.

Operator

This concludes today’s teleconference. You may disconnect your lines at this time, thank you for your participation and have a great day.

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Source: Zebra Technologies Corp. Q2 2008 Earnings Call Transcript
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