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ELECTRO RENT CORP - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations.(Edgar Glimpses Via Acquire Media NewsEdge) (in thousands, except per share amounts) The following discussion of our financial condition and results of operations should be read in conjunction with the consolidated financial statements and the notes thereto and the other financial and statistical information appearing elsewhere in this Form 10-K. Overview We are one of the largest global organizations devoted to the rental, lease and sale of new and used electronic T&M equipment. We purchase that equipment from leading manufacturers such as Agilent and Tektronix primarily for use by our customers in the aerospace, defense, telecommunications, electronics, industrial and semiconductor industries. Although it represents only approximately 8%, 13% and 18% of our revenues in fiscal 2011, 2010 and 2009, respectively, we believe our DP division is one of the largest 17-------------------------------------------------------------------------------- rental businesses in the United States for personal computers and servers from manufacturers including Dell, HP/Compaq, IBM and Toshiba. We have also recently expanded our efforts in the rental, lease and sale of industrial equipment such as electrical test equipment and inspection equipment. Our resale agreement with Agilent gives us the exclusive right to sell Agilent's more complex T&M equipment to small and medium size customers (who previously purchased directly from Agilent) in the United States and Canada. We began selling T&M equipment under the resale agreement during our third quarter of fiscal 2010. We have added approximately 58 people to our sales and support staff to serve these customers, and this agreement is material to our operations. On March 31, 2010, we completed the acquisition of certain assets (including accounts receivable and rental equipment but excluding certain designated assets) and select liabilities of Telogy, LLC ("Telogy"), for $24.7 million in cash, subject to post-closing adjustments. The purchase price was reduced by $0.3 million in fiscal 2011 reflecting the final determination of assets acquired and other components of the purchase price in accordance with specific provisions of the asset purchase agreement with Telogy. Telogy, headquartered in Union City, California, was a leading provider of electronic T&M equipment in North America. We accounted for the acquisition under Accounting Standards Codification ("ASC") 805, Business Combinations. (See Note 4 to the consolidated financial statements included in this Form 10-K.) Our financial results for fiscal 2010 were impacted by competitive pressure on rental rates due in large part to the recession in the U.S. and our major international markets. However, our utilization rates improved due to an increase in demand and equipment on rent. During fiscal 2011, we have seen a modest improvement in our T&M and DP rental rates and a significant increase in our equipment on rent, while maintaining a high utilization rate, in particular in our North American and European operations. As a result of these improvements, our recent acquisition of Telogy, and sales of T&M equipment in connection with our Agilent resale agreement, we have experienced substantial growth in revenues and operating profit for fiscal 2011. Despite this growth, our customers and competitors continue to be affected by the recent recession in the U.S. and global economy, resulting in more stringent credit requirements and reduced access to capital. We must continue to be focused on remaining profitable in the current conditions, as well as being prepared for the possibility that recessionary trends may continue in future periods. In fiscal 2011, 86% of our rental and lease revenues was derived from T&M equipment, compared to 83% for fiscal 2010. We have experienced growth in both our T&M and DP rental revenues, due to increased rental activity and a modest increase in our T&M and DP rental rates. Our T&M rental revenues for fiscal 2011 and the fourth quarter of fiscal 2010 include the rental revenues acquired from Telogy. For fiscal 2011, rental revenues were 90% of our rental and lease revenues, compared to 86% for the fiscal 2010. The increase is the result of an increase in our T&M and DP rental activity, including the rental revenues associated with assets acquired from Telogy, while our lease revenues declined due to a decrease in demand for DP leases. To maximize our overall profit from the rental, leasing, and sales of equipment, we manage our equipment pool on an on-going basis by controlling the timing, pricing and mix of our purchases and sales of equipment. We acquire new and used equipment to meet current technological standards and current and anticipated customer demand, and we sell our used equipment where we believe that is the most lucrative option. We employ a complex equipment management strategy and our proprietary PERFECT™ software to adjust our inventory and pricing on a dynamic basis in order to maximize equipment availability, utilization and profitability. We manage each specific equipment class based on a separate assessment of that equipment's historical and projected life cycle and numerous other factors, including the U.S. and global economy, interest rates and new product launches. If we do not accurately predict market trends, or if demand for the equipment we supply declines, we can be left with inventory that we are unable to rent or sell for a profit. We assess the carrying value of the equipment pool on a quarterly basis or more frequently when factors indicating potential impairment are present. 18-------------------------------------------------------------------------------- Profitability and key business trends Comparing fiscal 2011 to fiscal 2010, our revenues increased by 56.8% from $145.9 million to $228.7 million, our operating profit increased 100.4% from $18.4 million to $36.9 million and our net income increased by 104.8% from $11.6 million to $23.8 million. Our rental and lease revenues increased 25.3% from $94.2 million to $118.0 million. The increase in our rental and lease revenues reflects increased rental activity and T&M and DP rental rates in our North American and European operations, which are attributable to improved market conditions and the T&M rental revenues acquired from Telogy. In addition, our T&M sales activity increased 120.1% from $49.3 million to $108.5 million. The increase in our T&M sales activity is due to new equipment sales in connection with our Agilent resale agreement, and an increase in our used equipment sales attributable to improved demand and pricing. The increase in T&M sales more than offset declines in revenues from finance leases and distribution sales. Some of our key profitability measurements are presented below: Fiscal 2011 Fiscal 2010 Fiscal 2009 Net income per diluted common share (EPS) $ 0.99 $ 0.48 $ 0.47 Net income as a percentage of average assets 8.2 % 4.2 % 4.2 % Net income as a percentage of average equity 10.3 % 5.2 % 4.9 % The increase in our operating profit is due primarily to a significant increase in rental revenues and sales of new equipment for fiscal 2011. The increase was partially offset by an increase in depreciation expense of $5.3 million, or 12.5%, as we have invested in additional rental equipment to support our growth, and an increase in selling, general and administrative expenses of $11.0 million, or 23.6%, primarily related to our hiring of sales and support staff in connection with our Agilent resale agreement. The amount of our equipment on rent, based on acquisition cost, increased 7.5% to $214.5 million at May 31, 2011 from $199.5 million at May 31, 2010. Acquisition cost of equipment on lease decreased 2.8% to $27.8 million at May 31, 2011 from $28.6 million at May 31, 2010. The average amount of our equipment on rent, based on average acquisition cost, increased 28.8% to $212.1 million for fiscal 2011 from $164.7 million for fiscal 2010. The average acquisition cost of equipment on lease increased 2.4% to $28.7 million for fiscal 2011 from $28.0 million for fiscal 2010. Average rental rates for our T&M and DP segments increased by 2.4% for fiscal 2011 from fiscal 2010, while average lease rates declined by 9.4% for the same period. Average utilization for our T&M equipment pool, based on average acquisition cost of equipment on rent and lease compared to the total average equipment pool, was 70.0% for fiscal 2011 compared to 65.1% for fiscal 2010. Over the same period, the average utilization of our DP equipment pool decreased to 41.9% from 43.7%. RESULTS OF OPERATIONS Fiscal 2011 Compared with Fiscal 2010 Total Revenues: Total revenues for fiscal 2011 and 2010 were $228.7 million and $145.9 million, respectively. The 56.8% increase in total revenues was due to a 25.3% increase in rental and lease revenues and a 114.2% increase in sales of equipment and other revenues. Rental and lease revenues for fiscal 2011 were $118.1 million, compared to $94.2 million for the same period of the prior fiscal year. This increase reflects an increase in our T&M and DP rental activity and rental rates in our North American and European operations, due to improved market conditions, the 19-------------------------------------------------------------------------------- acquisition of Telogy in the fourth quarter of fiscal 2010, and an increase in T&M leasing activity that was partially offset by a continued decline in DP leasing demand. Sales of equipment and other revenues increased to $110.7 million for fiscal 2011 from $51.7 million in fiscal 2010. The increase is due to the full year effect of sales of new T&M equipment through our Agilent resale agreement and an increase in our sales of used equipment in our T&M business, due in part to a large sale to a customer, partially offset by a decline in finance lease activity and distribution sales. Our unfilled orders for T&M equipment relating to our resale agreement were $17.0 million at May 31, 2011, compared to $9.7 million at May 31, 2010. We terminated our distribution agreement with Agilent (which was replaced with the resale agreement) on January 31, 2010. Depreciation of Rental and Lease Equipment: Depreciation of rental and lease equipment increased in fiscal 2011 to $47.9 million, or 40.6% of rental and lease revenues, from $42.6 million, or 45.2% of rental and lease revenues, in fiscal 2010. The increased depreciation expense in fiscal 2011 was due to a higher average rental and lease equipment pool, while the decreased ratio, as a percentage of rental and lease revenues, was due to higher average utilization for fiscal 2011. Costs of Revenues Other Than Depreciation: Costs of revenues other than depreciation increased 121.8% to $86.6 million in fiscal 2011 from $39.1 million in fiscal 2010. Costs of revenues other than depreciation primarily includes the cost of equipment sales, which increased as a percentage of equipment sales to 77.0% in fiscal 2011 from 73.2% for fiscal 2010. This increase is due to an increase in sales of new T&M equipment through our Agilent resale agreement, which generally carry a lower margin than used equipment sales. Our sales margin is expected to continue to decline as a result of anticipated growth in connection with our resale agreement. Our sales margin is also impacted by competition, the global recession, and customer requirements and funding. Selling, General and Administrative Expenses: Selling, general and administrative expenses increased 23.6% to $57.4 million in fiscal 2011 compared to $46.4 million in fiscal 2010. Our selling, general and administrative expenses increased primarily due to additional sales and support staff in connection with our Agilent resale agreement. As a percentage of total revenues, selling, general and administrative expenses decreased to 25.1% in fiscal 2011 from 31.8% in fiscal 2010, due to the increase in total revenues. Operating Profit: As a result of significant growth in both our rental and lease revenues and our sales of equipment and other revenues, due to improved market conditions, the acquisition of Telogy in the fourth quarter of fiscal 2010, and sales of new T&M equipment in connection with our Agilent resale agreement, operating profit increased 100.4% to $36.9 million, or 16.1% of total revenues, in fiscal 2011, compared to an operating profit of $18.4 million, or 12.6% of total revenues, in fiscal 2010. Interest Income, Net: Interest income, net, was $0.4 million in fiscal 2011, compared to $1.6 million in fiscal 2010, due to a lower cash balance, lower interest rates on our money market funds, and the redemption of our auction rate securities ("ARS") (which carried a higher interest rate) in our first fiscal quarter of fiscal 2011. Income Tax Provision: Our effective tax rate was 36.3% for fiscal 2011, compared to 42.1% for fiscal 2010. The decrease is due primarily to the derecognition of $1.4 million of interest and penalties resulting from the effective settlement of our uncertain tax positions in fiscal 2011. (See Note 7 to our consolidated financial statements included in this Form 10-K.) Fiscal 2010 Compared with Fiscal 2009 Total Revenues: Total revenues for fiscal 2010 and 2009 were $145.9 million and $130.5 million, respectively. The 11.8% increase in total revenues was due to a 61.0% increase in sales of equipment and other revenues, partially offset by a decrease in rental and lease revenues of 4.3%. Rental and lease revenues in fiscal 2010 were $94.2 million, compared to $98.4 million in fiscal 2009. This decrease reflected a decline in our DP lease revenues, primarily due to lower demand for leases, 20 -------------------------------------------------------------------------------- and a decrease in DP rental revenues, while our T&M rental and lease revenues remained essentially unchanged from fiscal 2009. Rental rates decreased for both our DP and T&M businesses, reflecting increased competitive pressures and the global recession. This decrease was partially offset by an increase in our T&M rental and lease activity, due in part to the Telogy acquisition. Sales of equipment and other revenues increased to $51.7 million for fiscal 2010 from $32.1 million in fiscal 2009. The increase was primarily due to an increase in used equipment sales in our T&M business, increased finance lease activity, resulting from a large sale to a customer and continued development of our vendor leasing program that provides customers with flexible financing alternatives, and sales of T&M equipment through our new Agilent resale agreement. Our unfilled orders for T&M equipment relating to our resale agreement were $9.7 million at May 31, 2010. Distribution sales in fiscal 2010 declined as a result of the termination of our Agilent distribution agreement on January 31, 2010. Depreciation of Rental and Lease Equipment: Depreciation of rental and lease equipment decreased in fiscal 2010 to $42.6 million, or 45.2% of rental and lease revenues, from $46.1 million, or 46.8% of rental and lease revenues, in fiscal 2009. The decreased depreciation expense in fiscal 2010 was due to a sale of excess T&M equipment, while the decreased depreciation ratio, as a percentage of rental and lease revenues, reflected the lower equipment level during most of the year and higher utilization. Costs of Revenues Other Than Depreciation: Costs of revenues other than depreciation increased 73.0% to $39.1 million in fiscal 2010 from $22.6 million in fiscal 2009. Costs of revenues other than depreciation primarily includes the cost of equipment sales, which increased as a percentage of equipment sales to 73.2% in fiscal 2010 from 67.3% in fiscal 2009. This increase reflected a decline in our used equipment sales margin, resulting from competitive pressures and the global recession, and an increase in our lower margin finance leases. In addition, fiscal 2010 includes sales of T&M equipment through the Agilent resale agreement, which generally carry a lower margin. Our sales margin is also impacted by competition, the global recession, and customer requirements and funding. Selling, General and Administrative Expenses: Selling, general and administrative expenses increased 4.5% to $46.4 million in fiscal 2010 compared to $44.5 million in fiscal 2009. Our selling, general and administrative expenses increased primarily due to additional sales and support staff in connection with our new Agilent resale agreement, and $0.2 million in transition costs related to the Telogy acquisition, partially offset by several cost cutting measures that we introduced at the beginning of fiscal 2010 to control or reduce our selling, general and administrative expenses in response to the recession in the U.S. and our major international markets. As a percentage of total revenues, selling, general and administrative expenses decreased to 31.8% in fiscal 2010 from 34.1% in fiscal 2009, due to an increase in total revenues. Operating Profit: As a result of significant growth in our sales of equipment and other revenues and a gain on bargain purchase of $0.7 million as a result of the Telogy acquisition, operating profit increased 6.0% to $18.4 million, or 12.6% of total revenues, in fiscal 2010, compared to an operating profit of $17.4 million, or 13.3% of total revenues, in fiscal 2009. Interest Income, Net: Interest income, net, was $1.6 million in fiscal 2010, compared to $1.5 million in fiscal 2009. Interest income, net, includes $0.7 million of unrealized losses on our put option to UBS AG ("UBS") which were offset by a related $0.7 million of unrealized gains on our investments, trading. Income Tax Provision: Our effective tax rate was 42.1% for fiscal 2010, compared to 37.8% for fiscal 2009. The increase was due primarily to changes in tax estimates, a valuation allowance on tax benefits for certain foreign subsidiary losses and a reduction of the benefit from tax-advantaged investments. Liquidity and Capital Resources Capital Expenditures. During the last three fiscal years, our primary capital requirements have been purchases of rental and lease equipment. We generally purchase equipment throughout the year to replace equipment that has been sold and to maintain adequate levels of rental equipment to meet existing and expected customer demands. To meet T&M rental demand, support areas of potential 21 -------------------------------------------------------------------------------- growth for both T&M and DP equipment and to keep our equipment pool technologically up-to-date, we made payments for purchases of $91.5 million of rental and lease equipment during fiscal 2011, $79.8 million in fiscal 2010, and $52.0 million in fiscal 2009. In response to increasing customer demand beginning in the second half of fiscal 2010 and continuing throughout fiscal 2011, purchases of equipment in fiscal 2011 were 14.7% higher than fiscal 2010. Capital expenditures for fiscal 2010 include $22.9 million of rental and lease equipment acquired from Telogy. Share Repurchases and Dividends. We periodically repurchase shares of our common stock under an authorization from our board of directors. Shares we repurchase are retired and returned to the status of authorized but unissued stock. During fiscal 2010 and 2009, we repurchased 44 and 2,138 shares of our common stock, respectively, for $0.4 million and $22.8 million, respectively, at an average price per share of $8.94 and $10.67, respectively. There were no shares repurchased in fiscal 2011. We may make repurchases of our common stock in the future through open market transactions or otherwise, but we have no commitments to do so. For fiscal 2011, 2010 and 2009, we paid aggregate dividends of $14.4 million, $14.4 million and $15.0 million, respectively. We expect to continue paying a quarterly dividend in future quarters, although the amount and timing of dividends, if any, will be made at the discretion of our board of directors in each quarter, subject to compliance with applicable law. Dividend and Repurchase Summary Fiscal Year Ended May 31, Three Year (in thousands, except per share information) Totals 2011 2010 2009 Cash dividends paid $ 43,839 $ 14,449 $ 14,360 $ 15,030 Shares repurchased 2,182 - 44 2,138 Average price per share repurchased $ 10.64 $ - $ 8.94 $ 10.67 Aggregate purchase price $ 23,208 $ - $ 395 $ 22,813 Total cash returned to shareholders $ 67,047 $ 14,449 $ 14,755 $ 37,843 Cash and Cash Equivalents and Investments. Despite the $67.0 million in cash we have returned to our shareholders over the past three fiscal years, and the $24.7 million we paid in connection with the Telogy acquisition in fiscal 2010, we continue to maintain $41.4 million in cash and cash equivalents. We expect that the level of our cash and cash equivalents and investments may decrease as we pay dividends in future quarters, or if we decide to buy back additional shares of our common stock, increase equipment purchases in response to demand, finance another acquisition, or pursue other opportunities. We primarily invest our cash balance in money market funds, and corporate and government bond funds. At May 31, 2010, we held $14.3 million, at cost, in ARS, which we classified as investments, trading. On November 6, 2008, we accepted an offer from UBS providing us with rights related to our ARS (the "Rights"). The Rights permitted us to require UBS to purchase our ARS at par value, defined as the price equal to the liquidation preference of the ARS plus accrued but unpaid dividends or interest, at any time between June 30, 2010 and July 2, 2012. During the first quarter of fiscal 2011, UBS purchased our remaining ARS of $14.3 million at par value. During the second quarter of fiscal 2010, we sold our investments available-for-sale, which consisted of corporate and government bond funds, for $28.8 million, including a realized gain of $0.8 million, included in interest income, net, in our consolidated statements of operations. Cash Flows and Credit Facilities. We have three principal sources of liquidity: cash flows provided by our operating activities, proceeds from the sale of equipment from our portfolio, and external funds that historically have been provided by bank borrowings. 22 -------------------------------------------------------------------------------- During fiscal 2011, 2010, and 2009 net cash provided by operating activities was $68.8 million, $34.2 million and $59.0 million, respectively. The increase in operating cash flow for fiscal 2011 compared to fiscal 2010 was due primarily to: • an increase in net income to $23.8 million for fiscal 2011 from $11.6 million for fiscal 2010; and • an increase in our deferred tax liability of $23.5 million, due to the effective settlement of $4.5 million in unrecognized tax positions during fiscal 2011, and the enactment of bonus depreciation, which significantly increased our tax depreciation expense for fiscal 2011 and retroactively for our fiscal year ended May 31, 2010, resulting in deferral of payment of our current year tax expense of $13.5 million, and a refund of prior year taxes paid of $6.7 million. This increase was partially offset by an increase in other assets of $8.9 million for fiscal 2011 due to an increase in our demonstration pool inventory of $3.1 million and recording of an income tax receivable of $3.1 million. The decrease in operating cash flow for fiscal 2010 compared to fiscal 2009 was due primarily to: • a $7.5 million increase in accounts receivable for fiscal 2010, primarily due to higher revenues in fiscal 2010; • a decrease in our deferred tax liability of $2.8 million for fiscal 2010, resulting from an increase in used equipment sales in fiscal 2010; • an increase in other assets of $4.3 million for fiscal 2010, due to a large finance lease transaction in the second quarter of fiscal 2010; • an increase in accrued expenses of $2.5 million in fiscal 2010 due to an increase in current taxes payable as a result of the change in deferred taxes noted above; • a dividend accrual of $3.6 million in fiscal 2009 that was paid in fiscal 2010; and • an increase in deferred revenue of $1.1 million in fiscal 2010, resulting from an increase in revenues in our fourth fiscal quarter of 2010, due in part to the Telogy acquisition. The decrease also includes a decline in net income to $11.6 million for fiscal 2010 from $11.8 million in fiscal 2009. During fiscal 2011, 2010, and 2009 net cash used in investing activities was $45.7 million, $9.5 million and $50.8 million, respectively. The increase in cash used in investing activities for fiscal 2011 was primarily due to increased purchases of rental and lease equipment of $91.5 million, compared to $56.9 million and $52.0 million for fiscal 2010 and 2009, respectively. For fiscal 2011, there were no purchases of investments or redemptions of investments, available-for-sale, compared to redemptions of investments, available-for-sale, of $28.7 million for fiscal 2010, and purchases of investments of $27.9 million in fiscal 2009. Redemptions of investments, trading, were $14.3 million, $7.3 million and $2.0 million for fiscal 2011, 2010 and 2009, respectively. Proceeds from sale of rental and lease equipment decreased to $32.9 million for fiscal 2011 compared to $36.7 million for fiscal 2010 and $27.3 million for fiscal 2009. Fiscal 2010 includes cash paid for the acquisition of Telogy of $24.7 million. Net cash flows used in financing activities were $14.2 million in fiscal 2011 and 2010, respectively, and $36.5 million in fiscal 2009. These funds used were primarily composed of payments for dividends of $14.4 million for fiscal 2011 and 2010, respectively, and $15.0 million fiscal 2009. There were no payments for the repurchase of common stock for fiscal 2011, compared to $0.4 million in fiscal 2010 and $22.8 million in fiscal 2009. 23-------------------------------------------------------------------------------- As the following table illustrates, aggregate cash flows from operating activities and proceeds from the sale of equipment have been more than sufficient to fund our operations during the last three fiscal years. Three Years Ended (in thousands) May 31, 2011 2011 2010 2009 Cash flows from operating activities1 $ 161,901 $ 68,751 $ 34,173 $ 58,977 Proceeds from sale of equipment 96,920 32,917 36,661 27,342 Total 258,821 101,668 70,834 86,319 Payments for equipment purchases (200,385 ) (91,538 ) (56,891 ) (51,956 ) Equipment purchased from Telogy (22,923 ) - (22,923 ) - Net increase in equipment portfolio at acquisition cost 53,137 35,765 13,457 3,915 ¹ For the components of cash flows from operating activities see the consolidated statements of cash flows. As indicated by the table, cash flows from operating activities and proceeds from sale of equipment provided 116% of the funds required for equipment purchased during the past three fiscal years. We have a $10.0 million revolving line of credit with an institutional lender, subject to certain restrictions, to meet equipment acquisition needs as well as working capital and general corporate requirements. We had no bank borrowings outstanding or off balance sheet financing arrangements during the last three fiscal years. We believe that cash and cash equivalents, cash flows from operating activities, proceeds from the sale of equipment and our borrowing capacity will be sufficient to fund our operations for at least the next twelve months. Inflation. Inflation generally has favorably influenced our results of operations by enhancing the sale prices of our used equipment. However, lower inflation rates and the continued availability of newer, less expensive equipment with similar or better specifications over a period of several years could result in lower relative sale prices for used electronic equipment, which could reduce margins and earnings. Prices of new and used electronic test equipment have not consistently followed the overall inflation rate, while prices of new and used personal computers and servers have consistently declined. Because we are unable to predict the advances in technology and the rate of inflation for the next several years, it is not possible to estimate the impact of these factors on our margins and earnings. CONTRACTUAL OBLIGATIONS We lease certain facilities under various operating leases. Most of the lease agreements provide us with the option of renewing the lease at the end of the initial lease term, at the fair rental value, for periods of up to five years. In most cases, we expect that facility leases will be renewed or replaced by other leases in the normal course of business. The table below presents the amount of payments due under our contractual obligations. The table reflects expected payments due as of May 31, 2011 and does not reflect changes that could arise after that time. 24 -------------------------------------------------------------------------------- Payments due by period Less than 1-3 3-5 More than Contractual Obligations (in thousands) Total 1 year years years 5 years Facility lease payments, not including property taxes and insurance $ 1,618 $797 $ 525 $ 296 $ - Total $ 1,618 $797 $ 525 $ 296 $ - CRITICAL ACCOUNTING POLICIES AND ESTIMATES The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America ("generally accepted accounting principles") requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. On a regular basis, we review these estimates, including those related to asset lives and depreciation methods, impairment of long-lived assets (including rental and lease equipment), impairment of goodwill and definite lived intangible assets, investments, allowance for doubtful accounts and income taxes. These estimates are based on our historical experience and on various other assumptions we believe to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies affect the more significant judgments and estimates used in the preparation of our financial statements: Asset Lives and Depreciation Methods: Our primary business involves the purchase and subsequent rental and lease of long-lived electronic equipment. We have chosen asset lives that we believe correspond to the economic lives of the related assets. We have chosen depreciation methods that we believe generally match our benefit from the assets with the associated costs. These judgments have been made based on our expertise in each equipment type that we carry. If the asset life and depreciation method chosen do not reduce the book value of the asset to at least our potential future cash flows from the asset, we would be required to record an impairment loss. Depreciation methods and useful lives are periodically reviewed and revised as deemed appropriate. Investments in Debt Securities: Our investment portfolio may at any time contain direct obligations of the United States government, securities issued by agencies of the United States government, money market or cash management funds, corporate and government bond funds, and ARS. ASC 820, Fair Value Measurements, establishes three levels of inputs that may be used to measure fair value (see Note 3 to our consolidated financial statements included in this Form 10-K). Each level of input has different levels of subjectivity and difficulty in determining fair value. Level 1 - Observable inputs, such as quoted prices in active markets for identical assets or liabilities. Determining fair value for Level 1 investments generally does not require significant management judgment. Level 2 - Inputs, other than the quoted prices in active markets, that are observable either directly or through corroboration with observable market data. Level 3 - Unobservable inputs, for which there is little or no market data for the assets or liabilities, such as internally-developed valuation models. The determination of fair value for Level 3 investments requires the most management judgment and subjectivity. All of the securities classified as Level 3 investments have been ARS. Although none were held at May 31, 2011, during fiscal 2010, we sold $7.3 million of our ARS at par value. During the first quarter of fiscal 2011 we sold all of our remaining ARS to UBS at par value, for $14.3 million in cash. Our ARS were long-term debt instruments backed by student loans, a substantial portion of which was guaranteed by the United States government. Prior to their sale, we valued the ARS from quotes received from our 25 -------------------------------------------------------------------------------- broker, UBS, which were derived from UBS's internally developed model. In determining a discount factor for each ARS, the model weighted various factors, including assessments of credit quality, duration, insurance wraps, portfolio composition, discount rates, overall capital market liquidity and comparable securities, if any. Impairment of Long-Lived Assets: On a quarterly basis, we review the carrying value of our rental and lease equipment to determine if the carrying value of the assets may not be recoverable due to current and forecasted economic conditions. This requires us to make estimates related to future cash flows from the assets and to determine whether any deterioration is other than temporary. If these estimates or the related assumptions change in the future, we may be required to record additional impairment charges. Allowance for Doubtful Accounts: We maintain an allowance for doubtful accounts for estimated losses resulting from the inability of customers to pay our invoices. The estimated losses are based on historical collection experience in conjunction with an evaluation of the status of the existing accounts. If the financial condition of our customers were to deteriorate, then additional allowances could be required that would reduce income. Conversely, if the financial condition of our customers were to improve or if legal remedies to collect past due amounts were more successful than expected, then the allowance for doubtful accounts might need to be reduced and income would be increased. Goodwill Impairment: Goodwill is the excess of the acquisition cost of a business over the fair value of the identifiable net assets acquired. We recognized goodwill of $3.1 million on the acquisition of Rush Computer Rentals in January 2006. Impairment testing for goodwill is performed annually, on May 31, or more frequently if indications of potential impairment exist under the provisions of ASC 350, Intangibles-Goodwill and Other("ASC 350"). The impairment test for goodwill uses a two-step approach, which is performed at the reporting unit level. We have separate operating segments (reporting units) for T&M and DP equipment, although these two segments are aggregated into a single reportable segment in accordance with ASC 280, Segment Reporting. Step one of the impairment test compares the fair value of the reporting unit using a market approach to its carrying value. If the carrying value exceeds the fair value, there is a potential impairment and step two must be performed. Step two compares the carrying value of the reporting unit's goodwill to its implied fair value (i.e., fair value of reporting unit less the fair value of the unit's assets and liabilities, including identifiable intangible assets). If the implied fair value of goodwill is less than the carrying amount of goodwill, impairment is recognized. Definite-lived Intangible Assets: Definite-lived intangible assets consist of customer lists and covenants not-to-compete. The assets are amortized over their useful lives and reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable in accordance with ASC 350. If any indications of impairment are present, then we test for recoverability by comparing the carrying amount of the asset to the net undiscounted cash flows expected to be generated from the asset. If the net undiscounted cash flows indicate the asset is not recoverable, we determine the fair value of the asset and record any impairment. We reevaluate the useful life determinations for these intangible assets each reporting period to determine whether events and circumstances warrant a revision in their remaining useful lives. Income Taxes: We are required to estimate income taxes in each of the jurisdictions in which we operate. Significant judgment is required in determining the provision for income taxes and deferred tax assets and liabilities. This process involves us estimating actual current tax exposure and assessing temporary differences resulting from differing treatment of items, such as depreciation and amortization, for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within our consolidated balance sheet. We then assess the likelihood that our deferred tax assets will be recovered. To the extent management believes that recovery is not likely, we establish a valuation allowance. We determined that a valuation allowance was required in fiscal 2011, 2010 and 2009 of $0.6 million, $0.5 million and $0.3 million, respectively, for our deferred tax asset related to certain foreign net operating loss carry forwards and other related timing differences. Effective January 1, 2007, the Financial Accounting Standards Board issued new accounting guidance regarding uncertain income tax positions. This guidance found under ASC 740, Income Taxes, provides that the tax effects of a position be recognized only if it is "more-likely-than-not" to be sustained based 26 -------------------------------------------------------------------------------- solely on its technical merits as of the reporting date. The more-likely-than-not threshold represents a positive assertion by us that our company is entitled to the economic benefits of a tax position. If a tax position is not considered more-likely-than-not to be sustained based solely on its technical merits, no benefits of the position are to be recognized. Moreover, the more-likely-than-not threshold must continue to be met in each reporting period to support continued recognition of a benefit. At adoption, companies must adjust their financial statements to reflect only those tax positions that are more-likely-than-not to be sustained as of the adoption date. Any necessary adjustment would be recorded directly to retained earnings in the period of adoption and reported as a change in accounting principle. Pursuant to our adoption of this guidance on June 1, 2007, we recorded a net decrease of $0.4 million to retained earnings. During the second quarter of fiscal 2011 we effectively settled our remaining uncertain tax positions, and derecognized $4,515 of previously recognized uncertain tax positions, and the related deferred tax asset, and $1,396 for interest and penalties previously recognized. (See Note 7 to our consolidated financial statements included in this form 10-K.) OFF BALANCE SHEET TRANSACTIONS As of May 31, 2011 we did not have any "off-balance-sheet arrangements," as defined in Item 303(a)(4)(ii) of Regulation S-K. |