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EPLUS INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) This discussion is intended to further the reader's understanding of our consolidated financial condition and results of operations. It should be read in conjunction with the financial statements included in this quarterly report on Form 10-Q and our annual report on Form 10-K for the year ended March 31, 2012 (the "2012 Annual Report"). These historical financial statements may not be indicative of our future performance. This Management's Discussion and Analysis of Financial Condition and Results of Operations contains a number of forward-looking statements, all of which are based on our current expectations and could be affected by the uncertainties and risks described in Part I, Item 1A, "Risk Factors," in our 2012 Annual Report, except as updated in our subsequently filed Forms 10-Q. Our financial results as of and for the three and six months ended September 30, 2011 has been revised. All information and disclosures contained in this management's discussion and analysis of financial condition and results of operations have been revised to reflect the restatement described in Note 2, "Restatement of Financial Statements." Summary of Restatement During the preparation of our financial statements for the fiscal year ended March 31, 2012, we reassessed the presentation of sales of third party software assurance, maintenance and services and, after giving further consideration with respect to gross versus net reporting, we concluded that these transactions should be presented on a net basis in accordance with Codification Topic, Revenue Recognition, Subtopic Principal Agent Considerations. We determined that we should have been considered an agent in the transaction because a third party is responsible for the day to day provision of services under the contract. This change in the determination of that status results in different accounting treatment of the revenue resulting from the sale of such third party software assurance, maintenance and services, requiring the revenue to be reported net of the associated cost of the underlying contract with the third party service provider. Under net sales recognition, the cost paid to the third party service provider is recorded as a reduction to sales of products and services, resulting in net sales being equal to the gross profit on the transaction. This change in accounting policy and restatement affects our revenues and offsetting costs and expenses for the identified periods but does not affect our previously reported earnings before provision for income tax, net earnings, net earnings per common share or unaudited condensed consolidated statement of cash flows. EXECUTIVE OVERVIEW Business Description ePlus and its consolidated subsidiaries provide leading IT products and services, flexible leasing solutions, and enterprise supply management software to enable our customers to optimize their IT infrastructure and supply chain processes. Our revenues are composed of sales of product and services, sales of leased equipment, financing revenues and fee and other income. Our operations are conducted through two business segments: our technology sales business segment and our financing business segment. Financial Summary In recent years, the United States experienced substantial uncertainty in the economic environment, including financial market disruption. In addition, the debt crisis in certain countries in the European Union has contributed to continuing economic weakness and uncertainty in the United States. A reoccurrence of the economic downturn could cause our current and potential customers to once again delay or reduce technology purchases and result in longer sales cycles, slower adoption of new technologies and increased price competition. Credit risk associated with our customers and vendors may also be adversely impacted. In addition, although we do not anticipate the need for additional capital in the near term due to our current financial position, a reoccurrence of the economic downturn may adversely affect our access to additional capital. However, in calendar year 2011, IT spending in most categories increased, driven by the general economic recovery, the deferral of IT spending by many customers in prior years, customer interest in cloud computing, the positive return on investment that can be gained by virtualization technologies, and the reduction of manufacturer shipment delays in the supply chain. In 2012, many industry analysts are forecasting an increase in overall IT spending in the U.S. as compared to 2011, and the first half of the calendar year produced solid results in many sectors of the industry. However, some analysts have lowered their forecast for overall IT spending for the second half of calendar year 2012 and calendar year 2013. We believe that customers are continuing to focus on cost savings initiatives by utilizing technologies such as virtualization and cloud computing, and we continue to provide these and other advanced technology solutions to meet these needs. 22-------------------------------------------------------------------------------- Table of Contents During the three months ended September 30, 2012, total revenue increased 27.7% to $260.1 million and total costs and expenses increased 26.8% to $243.1 million, as compared to the same period last fiscal year. During the six months ended September 30, 2012, total revenue increased 31.9% to $504.8 million and total costs and expenses increased 30.2% to $474.3 million. To help manage our rapid growth, continue our sales revenue expansion and to expand our geographical footprint and solutions offering, we increased hiring in our technology sales business segment. Over the past 12 months, we added 92 personnel in several existing and new locations, and acquired two companies. The company has expanded from 759 employees as of September 30, 2011 to 851 employees as of September 30, 2012. Gross margin for product and services was 18.0% and 18.1% during the three months ended September 30, 2012 and 2011, respectively, and 17.5% and 17.6% during the six months ended September 30, 2012 and 2011, respectively. Our gross margin on sales of products and services was 17.0% for the three months ended June 30, 2012 and increased sequentially due to higher sales of third party software assurance, maintenance and services, which are presented on a net basis. Gross margins on sales of product and services are affected by our customers' investment in technology equipment, the mix and volume of products sold and changes in incentives provided to us by manufacturers. Net earnings increased 42.0% to $10.0 million and 68.1% to $18.1 million for the three months and six months ended September 30, 2012 over prior year periods ended September 30, 2011. Cash and cash equivalents increased $10.2 million to $43.9 million at September 30, 2012, compared to March 31, 2012. Business Segment Overview Technology Sales Business Segment The technology sales business segment sells IT equipment and software and related services primarily to corporate customers, state and local governments, and higher education institutions on a nationwide basis, with geographic concentrations relating to our physical locations. The technology sales business segment also provides Internet-based business-to-business supply chain management solutions for information technology products. Our technology sales business segment derives revenue from the sales of new equipment, software, maintenance, and service engagements. These revenues are reflected in our unaudited condensed consolidated statements of operations under sales of product and services and fee and other income. Customers who purchase IT equipment and services from us may have customer master agreements, or CMAs, with us which stipulate the terms and conditions of our relationship. Some CMAs contain pricing arrangements, and most contain mutual termination for convenience clauses. Our other customers place orders using purchase orders without a CMA in place or with other documentation customary for the business. Often, our work with governments is based on public bids and our written bid responses. A substantial portion of our sales of product and services are from sales of Cisco and Hewlett Packard products, which represented approximately 51.6% and 10.1%, respectively, of sales of product and services for the six months ended September 30, 2012, as compared to 44.0% and 16.4%, respectively, of sales of product and services for the six months ended September 30, 2011. Included in the sales of product and services are revenues derived from performing advanced professional services that may be bundled with sales of equipment which are integral to the successful delivery of such equipment. Our service engagements are generally governed by statements of work, and are primarily fixed price (with allowance for changes); however, some service agreements are based on time and materials. We endeavor to minimize the cost of sales in our technology sales business segment through vendor consideration programs provided by manufacturers and other incentives provided by distributors. The programs we qualify for are generally set by our reseller authorization level with the manufacturer. The authorization level we achieve and maintain governs the types of products we can resell as well as such items as pricing received, funds provided for the marketing of these products and other special promotions. These authorization levels are achieved by us through sales volume, certifications held by sales executives or engineers and/or contractual commitments by us. The authorization levels are costly to maintain and these programs continually change and, therefore, there is no guarantee of future reductions of costs provided by these vendor consideration programs. We currently maintain the following authorization levels with our primary manufacturers: 23-------------------------------------------------------------------------------- Table of Contents Manufacturer Manufacturer Authorization Level Apple Apple Authorized Corporate Reseller Cisco Systems Cisco Gold DVAR (National) Advanced Wireless LAN Advanced Unified Communications Advanced Data Center Storage Networking Advanced Routing and Switching Advanced Security ATP Video Surveillance ATP Cisco Telepresence Video Master Partner ATP Rich Media Communications Master Security Specialization Master UC Specialization Master Managed Services Partner Citrix Systems, Inc. Citrix Gold (National) EMC Velocity Premier Level Hewlett Packard HP Preferred Elite Partner (National) IBM Premier IBM Business Partner (National) Lenovo Lenovo Premium (National) Microsoft Microsoft Gold (National) NetApp NetApp STAR PartnerOracle Gold Partner Sun SPA Executive Partner (National) Sun National Strategic Data Center Authorized VMware National Premier Partner We also generate revenue in our technology sales business segment through hosting arrangements and sales of our Internet-based business-to-business supply chain management software, agent fees received from various manufacturers, support fees, warranty reimbursements, and interest income. Our revenues also include earnings from certain transactions that are infrequent, and there is no guarantee that future transactions of the same nature, size or profitability will occur. Our ability to consummate such transactions, and the timing thereof, may depend largely upon factors outside the direct control of management. The earnings from these types of transactions in a particular period may not be indicative of the earnings that can be expected in future periods. These revenues are reflected on our unaudited condensed consolidated statements of operations under fee and other income. Financing Business Segment The financing business segment offers financing solutions to domestic governmental entities and corporations nationwide and in certain other countries. The financing business unit derives revenue from leasing primarily IT and medical equipment and the disposition of that equipment at the end of the lease. These revenues are reflected under financing revenues on our unaudited condensed consolidated statements of operations. The finance business also derives revenues from the financing of third party software licenses, software assurance, maintenance and other services through notes receivables. These revenues are included in financing revenues on our unaudited condensed consolidated statements of operations. Financing revenues consist of amortization of unearned income on notes receivables, direct financing and sales-type leases, rentals due under operating leases, net gains or losses on the sales of financing receivables, and sales of equipment at the end of a lease, as well as other post-term financing revenue. The types of revenue and costs recognized by us are determined by each lease's individual classification. Each lease is classified as either a direct financing lease, sales-type lease, or operating lease, as appropriate. · For direct financing and sales-type leases, we record the net investment in leases, which consists of the sum of the minimum lease payments, initial direct costs (direct financing leases only), and unguaranteed residual value (gross investment) less the unearned income. The unearned income is amortized over the life of the lease using the interest method. Under sales-type leases, the difference between the present value of minimum lease payments and the cost of the leased property plus initial direct costs (net margins) is recorded as profit at the inception of the lease. · For operating leases, rental amounts are accrued on a straight-line basis over the lease term and are recognized as financing revenue. We account for the transfer of financing receivables that meet the definition of financial assets and certain criteria outlined in Transfers and Servicing in the Codification, including surrender of control, as sales for financial reporting purposes. The net gain on the transfer of these financial assets is recognized in financing revenues in our unaudited condensed consolidated statements of operations. 24-------------------------------------------------------------------------------- Table of Contents Our financing business segment sells the equipment underlying a lease to the lessee or a third party other than the lessee. These sales occur at the end of the lease term and revenues from the sales of such equipment are recognized at the date of sale. The net gain or loss on these transactions is presented within financing revenue in our unaudited condensed consolidated statement of operations. We also recognize revenue from events that occur after the initial sale of a financial asset and remarketing fees from our off lease equipment. These revenues are reflected in our unaudited condensed consolidated statements of operations under fee and other income. Fluctuations in Revenues Our results of operations are susceptible to fluctuations for a number of reasons, including, without limitation, customer demand for our products and services, supplier costs, changes in vendor incentive programs, interest rate fluctuations, general economic conditions, and differences between estimated residual values and actual amounts realized related to the equipment we lease. Operating results could also fluctuate as a result of a sale prior to the expiration of the lease term to the lessee or to a third party or from other post-term events. We expect to continue to expand by opening new sales locations and hiring additional staff for specific targeted market areas in the near future whenever we can find both experienced personnel and desirable geographic areas. These investments may reduce our results from operations in the short term. RECENTLY ADOPTED ACCOUNTING PRONOUNCEMENTS In June 2011, the FASB issued ASU 2011-12, "Comprehensive Income" (ASU 2011-12), which amended existing guidance by allowing only two options for presenting the components of net income and other comprehensive income: (1) in a single continuous financial statement, statement of comprehensive income or (2) in two separate but consecutive financial statements, consisting of an income statement followed by a separate statement of other comprehensive income. ASU 2011-12 requires retrospective application, and it is effective for fiscal years, and interim periods within those years, beginning after December 15, 2011, with early adoption permitted. We adopted this amendment on April 1, 2012 and are presenting our components of net income and other comprehensive income in two separate but consecutive financial statements. CRITICAL ACCOUNTING ESTIMATES The preparation of financial statements in conformity with U.S. GAAP requires management to use judgment in the application of accounting policies, including making estimates and assumptions. If our judgment or interpretation of the facts and circumstances relating to various transactions had been different, or different assumptions were made, it is possible that alternative accounting policies would have been applied, resulting in a change in financial results. On an ongoing basis, we reevaluate our estimates, including those related to revenue recognition, residual values, vendor consideration, lease classification, goodwill and intangibles, reserves for credit losses and income taxes specifically relating to uncertain tax positions. We base estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. For all of these estimates, we caution that future events rarely develop exactly as forecasted, and therefore, these estimates may require adjustment. We consider the following accounting policies important in understanding the potential impact of our judgments and estimates on our operating results and financial condition. For additional information on these and other accounting policies, see Note 1, "Organization and Summary of Significant Accounting Policies" to the unaudited condensed consolidated financial statements included elsewhere in this report. REVENUE RECOGNITION. The majority of our revenues are derived from the following sources: sales of third party products, software, software assurance, maintenance and services; sales of our services and software, and financing revenues. For all these revenue sources, we determine whether we are the principal or agent in accordance with Codification Topic, Revenue Recognition, Subtopic Principal Agent Considerations. Our revenue recognition policies vary based upon these revenue sources. Generally, sales of technology products and third party software are recognized when the title and risk of loss are passed to the customer, there is persuasive evidence of an arrangement for sale, delivery has occurred and/or services have been rendered, the sales price is fixed or determinable and collectability is reasonably assured. Using these tests, the vast majority of our product sales are recognized upon delivery due to our sales terms with our customers and with our vendors. For proper cutoff, we estimate the product delivered to our customers at the end of each quarter based upon an analysis of current quarter and historical delivery dates. 25-------------------------------------------------------------------------------- Table of Contents We sell software assurance, maintenance and service contracts where the services are performed by a third party. Software assurance is a maintenance product that allows customers to upgrade at no additional cost to the latest technology if new applications are introduced during the period that the software assurance is in effect. As we enter into contracts with third party service providers, we evaluate whether we are acting as a principal or agent in the transaction. Since we are not responsible for the day to day provision of services in these arrangements, we concluded that we are acting as an agent and recognize revenue on a net basis at the date of sale. We also sell services that are performed by us in conjunction with product sales. We allocate the total arrangement consideration to the deliverables based on an estimated selling price of our products and services. We determine the estimated selling price using cost plus a reasonable margin for each deliverable, which was based on our established policies and procedures for providing customers with quotes, as well as historical gross margins for our products and services. Revenue from the sales of products is generally recognized upon delivery to the customers and revenue for the services performed by us is generally recognized when the services are complete, which normally occurs within 90 days after the products are delivered to the customer. Financing revenues include income earned from investments in leases, leased equipment, third party software and services. We classify our investments in leases and leased equipment as either direct financing lease, sales-type lease, or operating lease, as appropriate. Revenue on direct financing and sales-type leases is deferred at the inception of the leases and is recognized over the term of the lease using the interest method. Revenue on operating leases is recorded on a straight line basis over the lease term. We classify third party software and services that we finance for our customers as notes receivable and recognize interest income over the term of the arrangement using the effective interest method. RESIDUAL VALUES. Residual values represent our estimated value of the equipment at the end of the initial lease term. Our estimated residual values will vary, both in amount and as a percentage of the original equipment cost, and depend upon several factors, including the equipment type, manufacturer's discount, market conditions, lease term, equipment supply and demand, and new product announcements by manufacturers. We evaluate residual values on a quarterly basis and record any required impairments of residual value, in the period in which the impairment is determined. No upward adjustment to residual values is made subsequent to lease inception. GOODWILL AND INTANGIBLE ASSETS. Goodwill represents the premium paid over the fair value of net tangible and intangible assets we have acquired in business combinations. We review our goodwill for impairment annually, or more frequently if indicators of impairment exist. A significant amount of judgment is involved in determining if an indicator of impairment has occurred. Such indicators may include a sustained, significant decline in our share price and market capitalization, a decline in our expected future cash flows, a significant adverse change in legal factors or in the business climate, unanticipated competition, and/or slower growth rates, among others. We first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. Qualitative factors we consider include, but are not limited to, macroeconomic conditions, industry and market conditions, company specific events, changes in circumstances, after tax cash flows and market capitalization. If the qualitative factors indicate that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, we perform the two step process to assess our goodwill for impairment. First, we compare the fair value of our reporting units with its carrying value. We estimate the fair value of the reporting unit using various valuation methodologies, including discounted expected future cash flows. If the fair value of the reporting unit exceeds its carrying value, goodwill is not impaired, and no further testing is necessary. If the net book value of our reporting unit exceeds its fair value, we perform a second test to measure the amount of impairment loss, if any. To measure the amount of any impairment loss, we determine the fair value of goodwill in the same manner as if our reporting unit were being acquired in a business combination. Specifically, we allocate the fair value of the reporting unit to all of the assets and liabilities of that unit, including any unrecognized intangible assets, in a hypothetical calculation that would yield the estimated fair value of goodwill. If the estimated fair value of goodwill is less than the goodwill recorded on our balance sheet, we record an impairment charge for the difference. VENDOR CONSIDERATION. We receive payments and credits from vendors, including consideration pursuant to volume sales incentive programs, volume purchase incentive programs and shared marketing expense programs. Many of these programs extend over one or more quarters' sales activities and are primarily formula-based. Different programs have different vendor/program specific goals to achieve. These programs can be very complex to calculate and, in some cases, targets are estimated based upon historical data. 26-------------------------------------------------------------------------------- Table of Contents Vendor consideration received pursuant to volume sales incentive programs is recognized as a reduction to cost of sales, product and services on our unaudited condensed consolidated statements of operations. Vendor consideration received pursuant to volume purchase incentive programs is allocated to inventories based on the applicable incentives from each vendor and is recorded in cost of sales, product and services, as the inventory is sold. Vendor consideration received pursuant to shared marketing expense programs is recorded as a reduction of the related selling and administrative expenses in the period the program takes place only if the consideration represents a reimbursement of specific, incremental, identifiable costs. Consideration that exceeds the specific, incremental, identifiable costs is classified as a reduction of cost of sales, product and services on our unaudited condensed consolidated statements of operations. RESERVES FOR CREDIT LOSSES. We maintain our reserves for credit losses at a level believed by management to be adequate to absorb potential losses inherent in the respective balances. We assign an internal credit quality rating to all new customers and update these ratings regularly, but no less than annually. Management's determination of the adequacy of the reserve for credit losses for our accounts and notes receivable is based on the age of the receivable balance, the customer's credit quality rating, an evaluation of historical credit losses, current economic conditions, and other relevant factors. Management's determination of the adequacy of the reserve for credit losses for minimum lease payments associated with investments in direct financing and sales-type leases may be based on the following factors: an internally assigned credit quality rating, historical credit loss experience, current economic conditions, volume, growth, the composition of the lease portfolio, the fair value of the underlying collateral, and the funding status (i.e. not funded, funded on a recourse or partial recourse basis, or funded on non-recourse basis). The reserve for credit losses for the six months ended September 30, 2012 and year ended March 31, 2012 included a specific reserve of $2.9 million due to a specific customer, which filed for bankruptcy. RESERVES FOR SALES RETURNS. Sales are reported net of returns and allowances, which are maintained at a level believed by management to be adequate to absorb potential sales returns from product and services. Management's determination of the adequacy of the reserve is based on an evaluation of historical sales returns and other relevant factors. These determinations require considerable judgment in assessing the ultimate potential for sales returns and include consideration of the type and volume of product sold. INCOME TAXES. We make certain estimates and judgments in determining income tax expense for financial statement reporting purposes. These estimates and judgments occur in the calculation of certain tax assets and liabilities, which principally arise from differences in the timing of recognition of revenue and expense for tax and financial statement reporting purposes. We also must analyze income tax reserves, as well as determine the likelihood of recoverability of deferred tax assets, and adjust any valuation allowances accordingly. Considerations with respect to the recoverability of deferred tax assets include the period of expiration of the tax asset, planned use of the tax asset, and historical and projected taxable income as well as tax liabilities for the tax jurisdiction to which the tax asset relates. Valuation allowances are evaluated periodically and will be subject to change in each future reporting period as a result of changes in one or more of these factors. The calculation of our tax liabilities also involves considering uncertainties in the application of complex tax regulations. We recognize liabilities for uncertain income tax positions based on our estimate of whether, and the extent to which, additional taxes will be required. BUSINESS COMBINATIONS. We account for business combinations using the acquisition method, which requires that the total purchase price of each of the acquired entities be allocated to the assets acquired and liabilities assumed based on their fair values at the acquisition date. The purchase price of the acquired entities may include an estimate of the fair value of contingent consideration. The allocation process requires an analysis of intangible assets, customer relationships, trade names, acquired contractual rights and assumed contractual commitments and legal contingencies to identify and record all assets acquired and liabilities assumed at their fair value. Any excess of the purchase price over the fair value of assets acquired and liabilities assumed is recorded as goodwill. To the extent the purchase price is less than the fair value of assets acquired and liabilities assumed, we recognize a gain in our unaudited condensed statement of operations. The results of operations for an acquired company are included in our financial statements from the date of acquisition. 27-------------------------------------------------------------------------------- Table of Contents RESULTS OF OPERATIONS The Three and Six months Ended September 30, 2012 Compared to the Three and Six months Ended September 30, 2011 Technology Sales Business Segment The results of operations for our technology sales business segment for the three and six months ended September 30, 2012 and 2011 were as follows (in thousands): Three months ended September 30, Six months ended September 30, 2012 2011 Change 2012 2011 Change Sales of product and services $ 250,178 $ 193,493 $ 56,685 29.3 % $ 484,460 $ 362,814 $ 121,646 33.5 % Fee and other income 1,591 2,128 (537 ) (25.2 %) 3,593 4,037 (444 ) (11.0 %) Total revenues 251,769 195,621 56,148 28.7 % 488,053 366,851 121,202 33.0 % Cost of sales, products and services 205,199 158,429 46,770 29.5 % 399,590 299,103 100,487 33.6 % Professional and other fees 2,260 1,986 274 13.8 % 4,763 4,060 703 17.3 % Salaries and benefits 24,414 21,717 2,697 12.4 % 48,496 42,379 6,117 14.4 % General and administrative 5,011 4,267 744 17.4 % 9,450 8,034 1,416 17.6 % Interest and financing costs 21 19 2 10.5 % 52 39 13 33.3 % Total costs and expenses 236,905 186,418 50,487 27.1 % 462,351 353,615 108,736 30.7 % Earnings before provision for income taxes $ 14,864 $ 9,203 $ 5,661 61.5 % $ 25,702 $ 13,236 $ 12,466 94.2 % Total revenues. Total revenues during the three months ended September 30, 2012 were $251.8 million compared to $195.6 million during the three months ended September 30, 2011, an increase of 28.7%, which is due to increases in demand for our products and services, particularly from Fortune 100 companies. Total revenues increased 33.0% during the six months ended September 30, 2012 and totaled $488.1 million compared to $366.9 million for the six months ended September 30, 2011. We experienced sequential and year over year increases in the sales of products and services during the quarters ended September 30, 2012 and 2011, except for a slight decrease in sequential revenues during the quarter ended March 31, 2012, as we had higher demand for our product and services during our second and third fiscal year quarters. The sequential and year over year changes in products and services is summarized below. Sequential Year over Year September 30, 2011 14.3 % 10.6 % December 31, 2011 9.7 % 16.4 % March 31, 2012 -1.2 % 26.3 % June 30, 2012 11.7 % 38.4 % September 30, 2012 6.8 % 29.3 % We rely on our vendors to fulfill shipments to our customers, which have been occurring on a regular basis. Our average open orders for the twelve months ended September 30, 2012 and 2011 were $65.3 million and $49.2 million, respectively. In addition, we had deferred revenue of $17.0 million at September 30, 2012, compared to $25.4 million at September 30, 2011, relating to product and service arrangements that were not completed at September 30, 2012. Total costs and expenses. Total costs and expenses for the three months ended September 30, 2012 increased $50.5 million or 27.1%, to $236.9 million due to increases in cost of sales of products and services, salaries and benefits and general and administrative expenses. Total costs and expenses for the six months ended September 30, 2012 increased $108.7 million or 30.7%, to $462.4 million. The increase in cost of sales, products and services was consistent with the increase in sales revenues of products and services. Our gross margin on sales of products and services was 18.0% and 18.1% during the three months ended September 30, 2012 and 2011, respectively, and 17.5% and 17.6% during the six months ended September 30, 2012 and 2011, respectively. Our gross margin on sales of products and services was 17.0% for the three months ended June 30, 2012 and increased sequentially due to higher sales of third party software assurance, maintenance and services, which are presented on a net basis. Gross margins are affected by the customer product mix as well as additional vendor incentives earned. The change in the amount of vendor incentives earned during the three months ended September 30, 2012 compared to the three months ended September 30, 2011 resulted in a 0.1% decrease in gross margins for products and services. The vendor incentives did not affect any change in gross margins for the six months ended September 30, 2012 from the prior year. There are ongoing changes to the incentives programs offered to us by our vendors. Accordingly, if we are unable to maintain the level of manufacturer incentives we are currently receiving, gross margins may decrease. 28-------------------------------------------------------------------------------- Table of Contents Professional and other fees increased $274 thousand, or 13.8%, to $2.3 million, compared to $2.0 million during the three months ended September 30, 2011. These increases are primarily due to fees related to the restatement of our financial statements. Patent infringement litigation costs remained at $0.7 million for the three months ended September 30, 2012 and 2011. Professional and other fees increased $0.7 million, or 17.3%, to $4.8 million, compared to $4.1 million during the six months ended September 30, 2011. The increases are primarily due to higher fees related to the restatement of our financial statements and other legal fees of $1.5 million. Offsetting this increase was a decrease in fees related to the patent infringement litigation of $0.8 million for the six months ended September 30, 2012. Salaries and benefits expense increased $2.7 million, or 12.4%, to $24.4 million, compared to $21.7 million during the three months ended September 30, 2011. This increase was driven by increases in the number of employees and commission expenses. Salaries and benefits expense increased $6.1 million, or 14.4%, to $48.5 million, compared to $42.4 million during the six months ended September 30, 2011. Our technology sales business segment had 793 employees as of September 30, 2012, an increase of 93 from 700 at September 30, 2011. A total of 63 employees were added as a result of the two acquisitions we completed over the last twelve months. Most of the increase in personnel relates to sales, marketing and engineering personnel. We continue to invest in sales and support personnel through hiring and strategic acquisitions in order to expand our geographical presence in the continental U.S. as well as extend our advanced technology solutions offerings. In addition, commission expenses increased due to the increase in the gross profit from sales of products and services. General and administrative expenses increased $744 thousand, or 17.4%, and $1.4 million or 17.6% during the three and six months ended September 30, 2012, respectively, over the same periods for prior year. These increases were primarily due to increases in office locations and sales force as a result of our continued expansion efforts and acquisitions, which resulted in higher telecommunications, rent, utilities, travel and entertainment expense, and other marketing expenses. Amortization expense increased as a result of intangible assets acquired from acquisitions. Segment earnings before tax. As a result of the foregoing, earnings before provision for income taxes increased $5.7 million, or 61.5%, and $12.5 million, or 94.2% for the three months and six months ended September 30, 2012, respectively, over prior year periods. Financing Business Segment The results of operations for our financing business segment for the three and six months ended September 30, 2012 and 2011 were as follows (in thousands): Three months ended September 30, Six months ended September 30, 2012 2011 Change 2012 2011 Change Financing revenue $ 7,413 $ 7,305 $ 108 1.5 % $ 15,313 $ 14,739 $ 574 3.9 % Fee and other income 869 729 140 19.2 % 1,409 964 445 46.2 % Total revenues 8,282 8,034 248 3.1 % 16,722 15,703 1,019 6.5 % Direct lease costs 2,461 2,078 383 18.4 % 4,704 4,174 530 12.7 % Professional and other fees 447 369 78 21.1 % 1,057 720 337 46.8 % Salaries and benefits 2,505 2,373 132 5.6 % 4,777 4,717 60 1.3 % General and administrative 400 240 160 66.7 % 616 506 110 21.7 % Interest and financing costs 425 329 96 29.2 % 799 691 108 15.6 % Total costs and expenses 6,238 5,389 849 15.8 % 11,953 10,808 1,145 10.6 % Earnings before provision for income taxes $ 2,044 $ 2,645 $ (601 ) (22.7 %) $ 4,769 $ 4,895 $ (126 ) (2.6 %) 29-------------------------------------------------------------------------------- Table of Contents Total revenues. Total revenues increased by $248 thousand, or 3.1%, to $8.3 million for the three months ended September 30, 2012, as compared to the prior year. Financing revenues increased $108 thousand, or 1.5% for the three months ended September 30, 2012, as compared to the prior year. Total revenues increased by $1.0 million, or 6.5%, to $16.7 million for the six months ended September 30, 2012, as compared to the prior year. Financing revenues increased $574 thousand, or 3.9% for the six months ended September 30, 2012, as compared to the prior year, due to an increase in the net gain on sales of financial assets. At September 30, 2012, we had $130.5 million of investment in notes and leases, compared to $113.2 million at September 30, 2011, an increase of $17.3 million or 15.3%. The increase in our portfolio was largely due to new notes receivables from several federal and state governments and agencies and large corporations. Fee and other income increased $140 thousand and $445 thousand for the three and six months ended September 30, 2012 over prior year due to increases in remarketing income. Total costs and expenses. Total costs and expenses increased $849 thousand, or 15.8%. Direct lease costs increased $383 thousand, or 18.4%, to $2.5 million partly due to increases in depreciation expense for equipment operating leases. General and administrative expenses increased $160 thousand for the three months ended September 30, 2012, as compared to the prior year, due to higher reserves for credit loses. During the six months ended September 30, 2012, total costs and expenses increased $1.1 million, or 10.6%, mostly driven by increases in direct lease costs and professional and other fees. Direct lease costs increased $530 thousand, or 12.7%, to $4.7 million partly due to increases in depreciation expense for equipment under operating lease during the six months ended September 30, 2012. Professional and other fees increased by $337 thousand, or 46.8%, to $1.1 million due to legal fees and outside services for software. General and administrative expenses increased $110 thousand, or 21.7%, to $616 thousand during the six months ended September 30, 2012 over the prior year six month period, due to reserves for credit losses. Salaries and benefits expense has remained consistent with prior periods. The number of personnel employed decreased slightly to 58 as of September 30, 2012 from 59 as of September 30, 2011. Interest and financing costs increased $96 thousand, or 29.2%, and $108 thousand, or 15.6% during the three months and six months ended September 30, 2012, as compared to the same periods last year due to the increase in non-recourse and recourse notes payable to $34.7 million at September 30, 2012 as compared to $23.0 million at September 30, 2011. Segment earnings before tax. As a result of the foregoing, earnings before provision for income taxes decreased $601 thousand, or 22.7%, to $2.0 million for the three months ended September 30, 2012 and segment earnings decreased $126 thousand, or 2.6%, to $4.8 million for the six months ended September 30, 2012. Consolidated Income taxes. Our provision for income tax expense increased $2.1 million to $6.9 million for the three months ended September 30, 2012, and increased $5.0 million to $12.4 million for the six months ended September 30, 2012 as compared to the same periods last year. Our effective income tax rates for the three months and six months ended September 30, 2012 were 40.7% and 40.6%, respectively, as compared to 40.4% and 40.6% for the three months and six months ended September 30, 2011. Net earnings. The foregoing resulted in net earnings of $10.0 million for the three months ended September 30, 2012, an increase of 42.0%, as compared to $7.1 million during the three months ended September 30, 2011. For the six months ended September 30, 2012, net earnings were $18.1 million, an increase of 68.1%, as compared to $10.8 million during the six months ended September 30, 2011. Basic and fully diluted earnings per common share were $1.29 and $1.27, respectively, for the three months ended September 30, 2012, as compared to $0.87 and $0.85, for the three months ended September 30, 2011. Basic and fully diluted earnings per common share were $2.34 and $2.29, respectively, for the six months ended September 30, 2012, as compared to $1.31 and $1.28, for the six months ended September 30, 2011. Weighted average common shares outstanding used in the calculation of basic and diluted earnings per common share for the three months ended September 30, 2012 were 7,770,206 and 7,920,927, respectively. Weighted average common shares outstanding used in the calculation of basic and diluted earnings per common share for the three months ended September 30, 2011 were 8,153,495 and 8,327,748, respectively. 30-------------------------------------------------------------------------------- Table of Contents Weighted average common shares outstanding used in the calculation of basic and diluted earnings per common share for the six months ended September 30, 2012 were 7,745,506 and 7,912,818, respectively. Weighted average common shares outstanding used in the calculation of basic and diluted earnings per common share for the six months ended September 30, 2011 were 8,230,022 and 8,422,099, respectively. LIQUIDITY AND CAPITAL RESOURCES Liquidity Overview Our primary sources of liquidity have historically been cash and cash equivalents, internally generated funds from operations, and borrowings, both non-recourse and recourse. We have used those funds to meet our capital requirements, which have historically consisted primarily of working capital for operational needs, capital expenditures, purchases of equipment for lease, payments of principal and interest on indebtedness outstanding, acquisitions and the repurchase of shares of our common stock. Our subsidiary ePlus Technology, inc., part of our technology sales business segment, finances its operations with funds generated from operations, and with a credit facility with GECDF, which is described in more detail below. There are two components of this facility: (1) a floor plan component; and (2) an accounts receivable component. After a customer places a purchase order with us and we have completed our credit check, we place an order for the equipment with one of our vendors. Generally, most purchase orders from us to our vendors are first financed under the floor plan component and reflected in "accounts payable-floor plan" in our unaudited condensed consolidated balance sheets. Payments on the floor plan component are due on three specified dates each month, generally 30-60 days from the invoice date. On the due date of the invoices financed by the floor plan component, the invoices are paid by the accounts receivable component of the credit facility. The balance of the accounts receivable component is then reduced by payments from our available cash. The outstanding balance under the accounts receivable component is recorded as recourse notes payable on our unaudited condensed consolidated balance sheets. There was no outstanding balance at September 30, 2012 or March 31, 2012, while the maximum credit limit was $30.0 million for both periods. The borrowings and repayments under the floor plan component are reflected as "net borrowings on floor plan facility" in the cash flows from financing activities section of our unaudited condensed consolidated statements of cash flows. Most customer payments in our technology sales business segment are remitted to our lockboxes. Once payments are cleared, the monies in the lockbox accounts are automatically transferred to our operating account on a daily basis. On the due dates of the floor plan component, we make cash payments to GECDF. These payments from the accounts receivable component to the floor plan component and repayments from our cash are reflected as "Net borrowings on floor plan facility" in the cash flows from financing activities section of our unaudited condensed consolidated statements of cash flows. We engage in this payment structure in order to minimize our interest expense and bank fees in connection with financing the operations of our technology sales business segment. We believe that cash on hand, and funds generated from operations, together with available credit under our credit facility, will be sufficient to finance our working capital, capital expenditures and other requirements for at least the next twelve calendar months. Our ability to continue to fund our planned growth, both internally and externally, is dependent upon our ability to generate sufficient cash flow from operations or to obtain additional funds through equity or debt financing, or from other sources of financing, as may be required. While at this time we do not anticipate requiring any additional sources of financing to fund operations, if demand for IT products declines, our cash flows from operations may be substantially affected. Cash Flows The following table summarizes our sources and uses of cash over the periods indicated (in thousands): Six months ended September 30, 2012 2011 Net cash used in operating activities $ (7,393 ) $ (20,125 ) Net cash provided by (used in) investing activities 5,607 (2,613 ) Net cash provided by (used in) financing activities 11,937 (7,592 ) Effect of exchange rate changes on cash 6 (20 ) Net increase (decrease) in cash and cash equivalents $ 10,157 $ (30,350 ) Net cash (used in) provided by operating activities. Cash used in operating activities totaled $7.4 million during the six months ended September 30, 2012, compared to $20.1 million during the same period last year. Cash used during the six months ended September 30, 2012 resulted primarily from increases in accounts receivable of $19.6 million, decreases in accounts payable-equipment and accounts payable - trade of $11.1 million, accrued expenses and other liabilities of $4.9 million, partially offset by a reduction in inventories of $7.6 million, depreciation and amortization expenses of $5.6 million and notes receivable of $1.0 million. 31-------------------------------------------------------------------------------- Table of Contents Net cash provided by (used in) investing activities. Cash provided by investing activities was $5.6 million during the six months ended September 30, 2012 compared to cash used in investing activities of $2.6 million during the same period last year. Cash provided by investing activities during the six months ended September 30, 2012 was primarily driven by a net decrease in notes receivable of $5.6 million, and a decrease in short-term investments of $5.4 million, offset by purchases of property, equipment and operating lease equipment of $6.2 million. Net cash provided by (used in) financing activities. Cash provided by financing activities was $11.9 million during the six months ended September 30, 2012 compared to cash used in financing activities of $7.6 million during the same period last year. Cash provided by financing activities during the six months ended September 30, 2012 was primarily due to net borrowings of notes payable of $14.1 million, partially offset by repurchases of our common stock of $1.6 million and net repayments on floor plan facility of $1.5 million Non-Cash Activities We assign lease payments to third-party financial institutions, which are accounted for as non-recourse notes payable financing activities. As a condition to the assignment agreement, certain financial institutions may request that lessees remit their lease payments to a trustee rather than to us, and the trustee pays the financial institution. Alternatively, if the structure of the agreement does not require a trustee, the lessee will continue to make payments to us, and we will remit the payment to the financial institution. The economic impact to us under either assignment structure is similar, in that the assigned lease receivable is paid by the lessee and remitted to the lender to pay down the corresponding non-recourse notes payable. However, these assignment structures are classified differently within our unaudited condensed consolidated statement of cash flows. More specifically, we are required to exclude non-cash transactions from our unaudited condensed consolidated statement of cash flows, so lease payments made by the lessee to the trustee are excluded from our operating cash receipts and the corresponding re-payment of the non-recourse notes payable from the trustee to the third party financial institution are excluded from our cash flows from financing activities. Given the assignment of lease payment is economically the same regardless of the structure of the payments, we evaluate our cash flows from operating and financing activities as if the assignments of lease payments had been structured without an intermediary. The non-GAAP financial measure for our cash flows from operating activities for the six months ended September 30, 2012 and 2011 is as follows (in thousands): Six months ended September 30, 2012 2011 GAAP: net cash used in operating activities $ (7,393 ) $ (20,125 ) Principal payments from lessees directly to lenders 7,374 8,627 Non-GAAP: adjusted net cash provided by (used in) operating activities $ (19 ) $(11,498 ) The non-GAAP financial measure for our cash flows from financing activities for the six months ended September 30, 2012 and 2011 is as follows (in thousands): Six months ended September 30, 2012 2011 GAAP: net cash provided by (used in) financing activities $ 11,937 $ (7,592 ) Principal payments from lessees directly to lenders (7,374 ) (8,627 ) Non-GAAP: adjusted net cash provided by (used in) financing activities $ 4,563 $ (16,219 ) A "non-GAAP financial measure" is a numerical measure of a company's historical or future financial performance, financial position or cash flows that excludes amounts, or is subject to adjustments that have the effect of excluding amounts, that are included in the most directly comparable measure calculated and presented in accordance with U.S. GAAP in the statement of income, balance sheet or statement of cash flows of the company; or includes amounts, or is subject to adjustments that have the effect of including amounts, that are excluded from the most directly comparable measure so calculated and presented. We use the financial measures in our internal evaluation and management of our business. We believe that these measures and the information they provide are useful to investors because they permit investors to view our performance using the same tools that we use and to better evaluate our ongoing business performance. These measures should not be considered an alternative to measurements required by U.S. GAAP, such as cash (used in) provided by operating activities and cash (used in) provided by financing activities. These non-GAAP measures are unlikely to be comparable to non-GAAP information provided by other companies. 32-------------------------------------------------------------------------------- Table of Contents Liquidity and Capital Resources We may utilize non-recourse notes payable to finance approximately 80% to 100% of the purchase price of the products being leased by our customers. Any balance of the purchase price remaining after non-recourse funding and any upfront payments received from the lessee (our equity investment in the equipment) must generally be financed by cash flows from our operations, the sale of the equipment leased to third parties, or other internal means. Although we expect that the credit quality of our leases and our residual return history will continue to allow us to obtain such financing, such financing may not be available on acceptable terms, or at all. The financing necessary to support our leasing activities has been provided by our cash and non-recourse borrowings. We monitor our exposure closely. Historically, we have obtained recourse and non-recourse borrowings from banks and finance companies. We continue to be able to obtain financing through our traditional lending sources. Non-recourse financings are loans whose repayment is the responsibility of a specific customer, although we may make representations and warranties to the lender regarding the specific contract or have ongoing loan servicing obligations. Under a non-recourse loan, we borrow from a lender an amount based on the present value of the contractually committed lease payments under the lease at a fixed rate of interest, and the lender secures a lien on the financed assets. When the lender is fully repaid from the lease payments, the lien is released and all further rental or sale proceeds are ours. We are not liable for the repayment of non-recourse loans unless we breach our representations and warranties in the loan agreements. The lender assumes the credit risk of each lease, and the lender's only recourse, upon default by the lessee, is against the lessee and the specific equipment under lease. At September 30, 2012, our non-recourse notes payable portfolio increased 25.4% to $33.0 million, as compared to $26.3 million at March 31, 2012. Recourse notes payable remained stable at $1.7 million as of September 30, 2012 and March 31, 2012. Whenever desirable, we arrange for equity investment financing, which includes selling lease payments, including the residual portions, to third parties and financing the equity investment on a non-recourse basis. We generally retain customer control and operational services, and have minimal residual risk. We usually reserve the right to share in remarketing proceeds of the equipment on a subordinated basis after the investor has received an agreed-to return on its investment. Credit Facility - Technology Business Our subsidiary, ePlus Technology, inc., has a financing facility from GECDF to finance its working capital requirements for inventories and accounts receivable. There are two components of this facility: (1) a floor plan component; and (2) an accounts receivable component. This facility has full recourse to ePlus Technology, inc. and is secured by a blanket lien against all its assets, such as chattel paper, receivables and inventory. As of September 30, 2012, the facility had an aggregate limit of the two components of $175.0 million with an accounts receivable sub-limit of $30.0 million. The credit facility with GECDF was amended and restated in July, 2012 which increased the credit limit from $125 million to $175 million and modified the covenants, interest rate and other requirements within the facility. The credit facility has full recourse to ePlus Technology, inc. and is secured by a blanket lien against all its assets, such as receivables and inventory. Availability under the facility may be limited by the asset value of equipment we purchase or accounts receivable, and may be further limited by certain covenants and terms and conditions of the facility. These covenants include but are not limited to a minimum excess availability of the facility and minimum earnings before interest, taxes, depreciation and amortization (EBITDA) of ePlus Technology, inc. Management believes we were in compliance with these covenants as of September 30, 2012. In addition, the facility restricts the ability of ePlus Technology, inc. to transfer funds to its affiliates in the form of dividends, loans or advances with certain exceptions for dividends to ePlus inc. Interest on the facility is assessed at a rate of the One Month Libor plus two and one half percent if the payments are not made on the three specified dates each month. The facility also requires that financial statements of the Company be provided within 45 days of each quarter and 90 days of each fiscal year end and also includes that other operational reports be provided on a regular basis. Either party may terminate with 90 days advance written notice. We are not, and do not believe that we are reasonably likely to be, in breach of the GECDF credit facility. In addition, we do not believe that the covenants of the GECDF credit facility materially limit our ability to undertake financing. In this regard, the covenants apply only to our subsidiary, ePlus Technology, inc. This credit facility is secured by the assets of only ePlus Technology, inc. and the guaranty as described below. We were in compliance with these covenants as of September 30, 2012. 33-------------------------------------------------------------------------------- Table of Contents The facility provided by GECDF requires a guaranty of $10.5 million by ePlus inc. The guaranty requires ePlus inc. to deliver its annual audited financial statements by certain dates. We have delivered the annual audited financial statements for the year ended March 31, 2012, as required. The loss of the GECDF credit facility could have a material adverse effect on our future results as we currently rely on this facility and its components for daily working capital and liquidity for our technology sales business segment and as an operational function of our accounts payable process. Floor Plan Component The traditional business of ePlus Technology, inc. as a seller of computer technology, related peripherals and software products, is in part financed through a floor plan component in which interest expense for the first thirty to forty-five days, in general, is not charged. The floor plan liabilities are recorded as accounts payable-floor plan on our unaudited condensed consolidated balance sheets, as they are normally repaid within the fifteen to sixty-day time frame and represent assigned accounts payable originally generated with the manufacturer/distributor. In some cases we are able to pay invoices early and receive a discount, but if the fifteen to sixty-day obligation is not paid timely, interest is then assessed at stated contractual rates. The respective floor plan component credit limits and actual outstanding balances for the dates indicated were as follows (in thousands): Maximum Credit Maximum Credit Limit at Balance as of Limit at Balance as of September 30, 2012 September 30, 2012 March 31, 2012 March 31, 2012 $ 175,000 $ 84,366 $ 125,000 $ 85,911 Accounts Receivable Component Included within the credit facility, ePlus Technology, inc. has an accounts receivable component from GECDF, which has a revolving line of credit. On the due date of the invoices financed by the floor plan component, the invoices are paid by the accounts receivable component of the credit facility. The balance of the accounts receivable component is then reduced by payments from our available cash. The outstanding balance under the accounts receivable component is recorded as recourse notes payable on our unaudited condensed consolidated balance sheets. There was no outstanding balance at September 30, 2012 or March 31, 2012, while the maximum credit limit was $30.0 million for both periods. Credit Facility - General 1st Commonwealth Bank of Virginia provides us with a $0.5 million credit facility, which matured on October 26, 2012. This credit facility was renewed for two years effective October 27, 2012. The credit facility is available for use by us and our affiliates and is full recourse to us. Borrowings under this facility bear interest at Wall Street Journal U.S. Prime rate plus 1%. The primary purpose of the facility is to provide letters of credit for landlords, taxing authorities and bids. As of September 30, 2012, we have no outstanding balance on this credit facility. Performance Guarantees In the normal course of business, we may provide certain customers with performance guarantees, which are generally backed by surety bonds. In general, we would only be liable for the amount of these guarantees in the event of default in the performance of our obligations. We are in compliance with the performance obligations under all service contracts for which there is a performance guarantee, and we believe that any liability incurred in connection with these guarantees would not have a material adverse effect on our unaudited condensed consolidated financial statements. 34-------------------------------------------------------------------------------- Table of Contents Off-Balance Sheet Arrangements As part of our ongoing business, we do not participate in transactions that generate relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of Regulation S-K or other contractually narrow or limited purposes. As of September 30, 2012, we were not involved in any unconsolidated special purpose entity transactions. Adequacy of Capital Resources The continued implementation of our business strategy will require a significant investment in both resources and managerial focus. In addition, we may selectively acquire other companies that have attractive customer relationships and skilled sales forces. We may also start offices in new geographic areas, which may require a significant investment of cash. We may also acquire technology companies to expand and enhance the platform of bundled solutions to provide additional functionality and value-added services. As a result, we may require additional financing to fund our strategy, implementation and potential future acquisitions, which may include additional debt and equity financing. Inflation For the periods presented herein, inflation has been relatively low and we believe that inflation has not had a material effect on our results of operations. Potential Fluctuations in Quarterly Operating Results Our future quarterly operating results and the market price of our common stock may fluctuate. In the event our revenues or earnings for any quarter are less than the level expected by securities analysts or the market in general, such shortfall could have an immediate and significant adverse impact on the market price of our common stock. Any such adverse impact could be greater if any such shortfall occurs near the time of any material decrease in any widely followed stock index or in the market price of the stock of one or more public equipment leasing and financing companies, IT resellers, software competitors, major customers or vendors of ours. Our quarterly results of operations are susceptible to fluctuations for a number of reasons, including, but not limited to, reduction in IT spending, our entry into the e-commerce market, any reduction of expected residual values related to the equipment under our leases, the timing and mix of specific transactions, the reduction of manufacturer incentive programs, and other factors. Quarterly operating results could also fluctuate as a result of our sale of equipment in our lease portfolio, at the expiration of a lease term or prior to such expiration, to a lessee or to a third party. Such sales of equipment may have the effect of increasing revenues and net income during the quarter in which the sale occurs, and reducing revenues and net income otherwise expected in subsequent quarters. See Part I, Item 1A, "Risk Factors," in our 2012 Annual Report. We believe that comparisons of quarterly results of our operations are not necessarily meaningful and that results for one quarter should not be relied upon as an indication of future performance. |