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PC CONNECTION INC - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION(Edgar Glimpses Via Acquire Media NewsEdge) AND RESULTS OF OPERATIONS Our management's discussion and analysis of our financial condition and results of operations include the identification of certain trends and other statements that may predict or anticipate future business or financial results that are subject to important factors that could cause our actual results to differ materially from those indicated. See Item 1A."Risk Factors" in our Annual Report on Form 10-K for the year ended December 31, 2011 on file with the SEC. OVERVIEW We are a leading direct marketer of a wide range of information technology, or IT, solutions. We help companies design, enable, manage, and service their IT environments. We provide IT products, including computer systems, software and peripheral equipment, networking communications, and other products and accessories that we purchase from manufacturers, distributors, and other suppliers. We also offer an extensive range of services involving design, configuration, and implementation of IT solutions. These services are performed by our personnel and by third-party providers. We operate through three sales segments, which serve primarily: (a) small- to medium-sized businesses and consumers and small office/home office ("SOHO") customers, in SMB, through our PC Connection Sales subsidiary, (b) large enterprise customers, in Large Account, through our MoreDirect and ValCom Technology ("ValCom") subsidiaries, and (c) federal, state, and local government and educational institutions, in Public Sector, through our GovConnection subsidiary. We generate sales primarily through outbound telemarketing and field sales contacts by account managers focused on the business, education, and government markets, our websites, and inbound calls from customers responding to our catalogs and other advertising media. We seek to recruit, retain, and increase the productivity of our sales personnel through training, mentoring, financial incentives based on performance, and updating and streamlining our information systems to make our operations more efficient. As a value added reseller in the IT supply chain, we do not manufacture IT hardware or software. We are dependent on our suppliers-manufacturers and distributors that historically have sold only to resellers rather than directly to end users. However, certain manufacturers have on multiple occasions attempted to sell directly to our customers, and in some cases, have restricted our ability to sell their products directly to certain customers, thereby attempting to eliminate our role. We believe that the success of these direct sales efforts by suppliers will depend on their ability to meet our customers' ongoing demands and provide objective, unbiased solutions to meet their needs. We believe more of our customers are seeking total IT solutions, rather than simply the acquisition of specific IT products. Our advantage is our ability to be product-neutral and provide a broader combination of products, services, and advice tailored to customer needs. By providing customers with customized solutions from a variety of manufacturers, we believe we can mitigate the negative impact of continued direct sales initiatives from individual manufacturers. Through the formation of our ProConnection services group, and our acquisition of ValCom, we are able to provide customers complete IT solutions, from identifying their needs, to designing, developing, and managing the integration of products and services to implement their IT projects. Such service offerings carry higher margins than traditional product sales. Additionally, the technical certifications of our service engineers permit us to offer higher-end, more complex products that generally carry higher gross margins. We expect these service offerings and technical certifications to continue to play a role in sales generation and improve gross margins in this competitive environment. Market conditions and technology advances significantly affect the demand for our products and services. Virtual delivery of software products and advanced Internet technology providing customers enhanced functionality have substantially increased customer expectations, requiring us to invest more heavily in our own 11 -------------------------------------------------------------------------------- IT development to meet these new demands. This investment includes planned expenditures to update our websites. As buying trends change and electronic commerce continues to grow, customers have become more sophisticated due to the amount and quality of information available and the increased number of readily available choices. Customers are also better able to make price comparisons through the Internet, thereby necessitating more aggressive pricing strategies to remain competitive. While it is not possible for us to estimate with any degree of accuracy the level of sales we may have lost or may lose in the future as a result of such increased buyer sophistication, our consolidated Internet sales have consistently represented between 30%-35% of net sales over the last three years and our gross profit margins have generally increased year over year for the past two years. The primary challenges we continue to face in effectively managing our business are (1) increasing our revenues while at the same time maintaining or improving our gross margin in all three segments, (2) recruiting, retaining, and improving the productivity of our sales personnel, and (3) effectively controlling our selling, general, and administrative, or SG&A, expenses while making major investments in our IT systems and solution selling personnel. To support future growth, we are expanding our IT solution business, which requires the addition of highly-skilled service engineers. We are still in the early stages of this multi-year initiative, and, although we expect to realize the ultimate benefit of higher-margin service revenues, we believe that our SG&A expenses will increase significantly as we add service engineers. If our service revenues do not grow enough to offset the cost of these headcount additions, our operating results may decline. To operate more efficiently, we have undertaken a comprehensive review and assessment of our entire business software needs. That review and assessment includes the review of commercially available software that meets, or can be configured to meet, those needs better than our existing software. As of March 31, 2012, we have capitalized $9.5 million of software and integration costs for the initial phase of this software project. While we have not yet finalized our decisions regarding to what extent additional software will be acquired and implemented beyond the Customer Master Data Management ("MDM") software we have acquired to date, we expect to increase our capital investments in our IT infrastructure in the next three years, which will also likely increase SG&A expenses. RECENT EVENTS Effective January 1, 2012, we merged our Consumer/SOHO segment into our SMB segment to better serve the Consumer/SOHO customers and to achieve operating efficiencies. We have revised the reporting of operating segments to reflect the new basis for assessing performance and allocating resources. Under this revised reporting structure, the operating results related to our consumer and SOHO customers that were formerly reported separately are now included within the SMB segment. We have restated prior year segment information to conform to our revised segment reporting structure. 12 -------------------------------------------------------------------------------- RESULTS OF OPERATIONS The following table sets forth information derived from our statements of operations expressed as a percentage of net sales for the periods indicated: Three Months Ended March 31, 2012 2011 Net sales (in millions) $ 498.8 $ 461.9 Net sales 100.0 % 100.0 % Gross margin 13.4 12.7 Selling, general and administrative expenses 11.3 11.1 Special charges 0.3 - Income from operations 1.8 % 1.6 % Net sales in the first quarter of 2012 increased by $36.8 million, or 8.0%, as our SMB, Large Account, and Public Sector sales increased year over year by 0.2%, 23.5%, and 2.0% respectively. Excluding ValCom sales from both quarters, our consolidated net sales would have increased by 5.9% year over year. As noted above, we combined our SMB and Consumer/SOHO segments on January 1, 2012. Excluding sales to our consumer and SOHO customers, SMB sales would have increased by 4.0% year over year. Gross margin (gross profit expressed as a percentage of net sales) increased in all three segments primarily due to our focus on margin improvement. SG&A expenses increased in dollars and as a percentage of net sales due to investments in internal systems projects, incremental variable compensation, and the inclusion of the operating expenses of ValCom, which we acquired late in the first quarter of 2011. Operating income in the first quarter of 2012 increased year over year by $1.5 million due to the increase in net sales and gross margin. Net Sales Distribution The following table sets forth our percentage of net sales by business segment and product mix: Three Months Ended March 31, 2012 2011 Business Segment SMB 45 % 49 % Large Account 36 32 Public Sector 19 19 Total 100 % 100 % Product Mix Notebook 17 % 18 % Desktop/Server 17 15 Software 14 14 Video, Imaging and Sound 10 10 Net/Com Product 10 9 Storage 7 9 Printer and Printer Supplies 7 8 Memory and System Enhancement 3 4 Accessory/Other 15 13 Total 100 % 100 % 13 -------------------------------------------------------------------------------- Gross margin The following table summarizes our gross margin, as a percentage of net sales, over the periods indicated: Three Months Ended March 31, 2012 2011 Business Segment SMB 15.2 % 14.1 % Large Account 11.8 11.4 Public Sector 11.9 11.5 Total 13.4 % 12.7 % On a consolidated basis, gross margin increased year over year due primarily to improved invoice selling margins (25 basis points) and incremental vendor consideration (16 basis points) as a percentage of net sales compared to the prior year period. Invoice selling margins increased due to our company-wide focus on margin improvement and increased sales of higher-margin solution services and products. Cost of Sales and Certain Other Costs Cost of sales includes the invoice cost of the product, direct employee and third party cost of services, direct costs of packaging, inbound and outbound freight, and provisions for inventory obsolescence, adjusted for discounts, rebates, and other vendor allowances. Direct operating expenses relating to our purchasing function and receiving, inspection, internal transfer, warehousing, packing and shipping, and other expenses of our distribution center are included in our SG&A expenses. Accordingly, our gross margin may not be comparable to margins of other entities that include all of the costs related to their distribution network in cost of goods sold. Such distribution costs included in our SG&A expenses, as a percentage of net sales for the periods reported, are as follows: Three Months Ended March 31, 2012 2011 Purchasing/Distribution Center 0.68 % 0.69 % Operating Expenses The following table breaks out our more significant SG&A expenses for the periods indicated (dollars in millions): Three Months Ended March 31, 2012 2011 Personnel costs $ 40.6 $ 36.4 Advertising 5.8 4.9 Facilities operations 2.6 2.4 Professional fees 2.0 2.0 Credit card fees 1.5 1.7 Depreciation and amortization 1.6 1.3 Bad debts - 0.4 Other, net 2.4 2.2 Total $ 56.5 $ 51.3 Percentage of net sales 11.3 % 11.1 % 14 -------------------------------------------------------------------------------- Personnel costs increased year over year in the three months ended March 31, 2012, due to investments in solutions sales and support areas, increased variable compensation associated with higher gross profits, and the inclusion of the SG&A expenses of ValCom, which we acquired late in the first quarter of 2011. Year-Over-Year Comparisons Three Months Ended March 31, 2012 Compared to Three Months Ended March 31, 2011 Changes in net sales and gross profit by business segment are shown in the following table (dollars in millions): Three Months Ended March 31, 2012 2011 % of Net % of Net % Amount Sales Amount Sales Change Sales: SMB $ 225.3 45.2 % $ 224.7 48.7 % 0.2 % Large Account 181.3 36.3 146.9 31.8 23.5 Public Sector 92.2 18.5 90.3 19.5 2.0 Total $ 498.8 100.0 % $ 461.9 100.0 % 8.0 % Gross Profit: SMB $ 34.2 15.2 % $ 31.6 14.1 % 8.0 % Large Account 21.4 11.8 16.8 11.4 27.8 Public Sector 11.0 11.9 10.4 11.5 5.7 Total $ 66.6 13.4 % $ 58.8 12.7 % 13.2 % Net sales increased in the first quarter of 2012 compared to the first quarter of 2011, as explained below: • Net sales for the SMB segment increased only slightly year over year. Software and net/com sales increased year over year by double-digit growth rates, however, these increases were partially offset by lower sales to consumer and SOHO customers. Excluding these lower sales, SMB sales would have increased by 4.0% year over year. Sales representatives for the SMB segment totaled 395 at March 31, 2012, compared to 390 at March 31, 2011, and 391 at December 31, 2011. • Net sales for the Large Account segment increased by 23.5% year over year. This segment includes the operating results for ValCom, a provider of infrastructure management and onsite managed services, which we acquired late in the first quarter of 2011. Excluding ValCom's sales for the quarter, Large Account sales would have increased year over year by 17.1% as IT demand continued to be strong in the enterprise sector. Sales representatives for our Large Account segment totaled 128 at March 31, 2012, compared to 122 at March 31, 2011, and 133 at December 31, 2011. • Net sales to government and education customers (Public Sector segment) increased year over year by 2.0% to $92.2 million. Sales to state and local government and educational institutions were relatively unchanged compared to last year, while sales to the federal government increased by 5.5% year over year. Sales representatives for our Public Sector segment totaled 136 at March 31, 2012, compared to 141 sales representatives at both March 31, 2011 and December 31, 2011. Gross profit for the first quarter of 2012 increased year over year in dollars and as a percentage of net sales (gross margin), as explained below: • Gross profit for the SMB segment increased primarily due to an increase in gross margin. Gross margin was higher year over year due to an increase in vendor consideration (44 basis points) and invoice selling margins (37 basis points). We attribute the improvement in invoice selling margins to our margin-improvement initiatives and increased sales of higher-margin solution products and services. 15 -------------------------------------------------------------------------------- • Gross profit for the Large Account segment increased due to higher net sales and gross margin. Improved invoice selling margins (32 basis points) and an increase in vendor funding (18 basis points) contributed to the margin improvement. We attribute the increase in invoice selling margins to the inclusion of higher-margin services revenue of ValCom, which we acquired in the first quarter of 2011. • Gross profit for the Public Sector segment increased due to an increase in net sales and gross margin. Gross margin improved as an increase in invoice selling margins (79 basis points) more than offset a decrease in vendor consideration (30 basis points). Selling, general and administrative expenses increased in dollars and as a percentage of net sales in the first quarter of 2012 compared to the prior year quarter. SG&A expenses attributable to our three operating segments and the remaining unallocated Headquarters/Other group expenses are summarized below (dollars in millions): Three Months Ended March 31, 2012 2011 % of Net % of Net % Amount Sales Amount Sales Change SMB $ 28.0 12.4 % $ 26.5 11.8 % 5.6 % Large Account 14.1 7.8 11.0 7.5 28.4 Public Sector 11.0 11.9 10.9 12.1 0.9 Headquarters/Other 3.4 2.9 16.3 Total $ 56.5 11.3 % $ 51.3 11.1 % 10.1 % • SG&A expenses for the SMB segment increased in dollars and as a percentage of net sales due to increased marketing expenditures and investments in solution sales and support personnel. Incremental variable compensation associated with the increase in gross profits discussed above also contributed to the overall dollar increase. • SG&A expenses for the Large Account segment increased in dollars and as a percentage of net sales. The dollar increase resulted from investments in sales support areas, increased marketing expenditures, and the inclusion of the operating expenses of ValCom, which we acquired late in the first quarter of 2011. Incremental variable compensation associated with the increase in gross profits discussed above also contributed to the overall dollar increase. The increase as a percentage of net sales was due primarily to the higher SG&A expense rate attributable to ValCom and its services business model. • SG&A expenses for the Public Sector segment increased slightly in dollars, but decreased as a percentage of net sales. The increased usage of centralized headquarter services was largely offset by a decrease in advertising and personnel costs. • SG&A expenses for the Headquarters/Other group increased due to an increase in unallocated personnel and related costs. The Headquarters/Other group provides services to the three reportable operating segments in areas such as finance, human resources, IT, marketing, and product management. Most of the operating costs associated with such corporate headquarters functions are charged to the operating segments based on their estimated usage of the underlying functions. The increase relates to personnel and other costs related to senior management oversight, which is not normally allocated to operating units. Special charges totaled $1.1 million in the first quarter of 2012 and were related to the retirement of a former executive officer, as well as workforce reductions. We did not record any such charges in the three months ended March 31, 2011. Income from operations for the first quarter of 2012 increased to $9.0 million, compared to $7.5 million for the first quarter of 2011. Income from operations as a percentage of net sales was 1.8% for the first quarter of 2012, compared to 1.6% of net sales for the prior year quarter. The increases in operating income and operating margin resulted primarily from the respective increase in net sales and gross margin. 16 -------------------------------------------------------------------------------- Our effective tax rate was 39.6% for the first quarter of 2012 compared to an effective tax rate of 40.5% for the first quarter of 2011. Our tax rate will continue to vary based on variations in state tax levels for certain subsidiaries, valuation reserves, and accounting for uncertain tax positions, however we do not expect these variations to be significant in 2012. Net income for the first quarter of 2012 increased to $5.5 million, compared to $4.5 million for the first quarter of 2011, principally due to the increase in operating income. Liquidity and Capital Resources Our primary sources of liquidity have historically been internally generated funds from operations and borrowings under our bank line of credit. We have used those funds to meet our capital requirements, which consist primarily of working capital for operational needs, capital expenditures for computer equipment and software used in our business, repurchases of common stock for treasury, and as opportunities arise, acquisitions of new businesses. We believe that funds generated from operations, together with available credit under our bank line of credit and inventory trade credit agreements, will be sufficient to finance our working capital, capital expenditures, and other requirements for at least the next twelve calendar months. Aside from our expenditures on the Customer MDM software initiative, we expect our capital needs for the next twelve months to consist primarily of capital expenditures of $9.0 to $12.0 million and payments on capital lease and other contractual obligations of approximately $3.7 million. In addition, we continue to evaluate and assess our entire business software needs. That assessment includes the review of commercially available software that meets, or can be configured to meet, those needs better than our existing software. While we have not finalized our decisions regarding to what extent new software will be acquired and implemented beyond the Customer MDM software we have acquired to date, the additional capital costs of such a project, if fully implemented, would likely exceed $20.0 million over the next three years. As of March 31, 2012, we have capitalized $9.5 million of software and integration costs for the Customer MDM software project, the first stage of our overall IT initiative, of which $1.2 million was capitalized in the first quarter of 2012. We expect to meet our cash requirements for the next twelve months through a combination of cash on hand, cash generated from operations and, if necessary, borrowings on our bank line of credit, as follows: • Cash on Hand. At March 31, 2012, we had approximately $49.8 million in cash. • Cash Generated from Operations. We expect to generate cash flows from operations in excess of operating cash needs by generating earnings and offsetting net changes in inventories and receivables with compensating changes in payables to generate a positive cash flow. • Credit Facilities. We did not have any borrowings outstanding at March 31, 2012 against our $50.0 million bank line of credit, which is available through February 2017. Accordingly, our entire line of credit was available for borrowing at March 31, 2012. This line of credit can be increased, at our option, to $80.0 million for approved acquisitions or other uses authorized by the bank. Borrowings are limited, however, by certain minimum collateral and earnings requirements, as described more fully below. Our ability to continue funding 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 we do not anticipate needing any additional sources of financing to fund our operations at this time, if demand for IT products declines, our cash flows from operations may be substantially affected. See more about this and related risks listed under Item 1A. "Risk Factors" in our Annual Report on Form 10-K for the year ended December 31, 2011. 17 -------------------------------------------------------------------------------- Summary of Sources and Uses of Cash The following table summarizes our sources and uses of cash over the periods indicated (in millions): Three Months Ended March 31, 2012 2011 Net cash provided by operating activities $ 55.1 $ 29.1 Net cash used for investing activities (2.8 ) (5.8 ) Net cash used for financing activities (7.2 ) (0.1 ) Increase in cash and cash equivalents $ 45.1 $ 23.2 Cash provided by operating activities increased by $26.0 million in the first quarter of 2012 compared to the prior year quarter. Operating cash flow in the first quarter of 2012 resulted primarily from a decrease in accounts receivables and inventory, partially offset by a decrease in accounts payable. Accounts receivable decreased by $52.8 million from the prior year-end balance due to improved collection efforts and lower net sales in first quarter of 2012 compared to the fourth quarter of 2011. Days sales outstanding were 43 days at March 31, 2012, compared to 41 days at March 31, 2011, and 47 days December 31, 2011. Inventory decreased in the first quarter of 2012 by $14.9 million from the balance at December 31, 2011, due to lower inventory in transit and reduced stocking levels, which were previously elevated due to hard drive product constraints that existed at December 31, 2011. Inventory turns increased to 25 turns for the first quarter of 2012 compared to 24 turns for the prior year quarter. At March 31, 2012, we had $111.9 million in outstanding accounts payable. Such accounts are generally paid within 30 days of incurrence, or earlier when favorable cash discounts are offered. This amount includes $16.4 million payable to two financial institutions under inventory trade credit agreements we use to finance our purchase of certain inventory, secured by the inventory so financed. We believe we will be able to meet these obligations with cash flows from operations and our existing line of credit. Cash used for investing activities decreased by $3.0 million in the first quarter of 2012 compared to the prior year quarter primarily due to our cash purchase of ValCom ($3.7 million, net) in the first quarter of 2011. Cash used to purchase property and equipment amounted to $2.8 million in the first three months of 2012, compared to $2.1 million in the prior year period. These expenditures were primarily for computer equipment and capitalized internally-developed software in connection with the IT initiative referred to in the above Liquidity and Capital Resources section. In addition, we agreed to pay up to $3.0 million upon the achievement of three performance milestones in connection with our acquisition of ValCom. The second of the three milestones was successfully achieved during the first quarter of 2012, and as a result, we paid $1.0 million in contingent consideration in April 2012. We expect to pay up to $1.0 million in additional contingent consideration for the remaining milestone in the fourth quarter of 2012. Cash used for financing activities in the first quarter of 2012 increased over the prior year period primarily due to repurchases of outstanding stock and the repayment of $5.3 million in borrowings on our bank line of credit. We repurchased 161,969 shares at a total cost of $1.5 million in first quarter of 2012 (an average price of $9.05 per share). These repurchases were placed in treasury and are available for future equity grants or retirement. In addition, we withheld 29,600 shares, having a fair value of $0.3 million, upon the vesting of a stock award to satisfy related tax obligations during the quarter ended March 31, 2012. We consider block repurchases directly from larger stockholders, as well as open market purchases, in carrying out our ongoing stock repurchase program. Debt Instruments, Contractual Agreements, and Related Covenants Below is a summary of certain provisions of our credit facilities and other contractual obligations. For more information about the restrictive covenants in our debt instruments and inventory financing agreements, see "Factors Affecting Sources of Liquidity" below. For more information about our obligations, commitments, and contingencies, see our condensed consolidated financial statements and the accompanying notes included in this Quarterly Report. 18 -------------------------------------------------------------------------------- Bank Line of Credit. Our bank line of credit provides us with a borrowing capacity of up to $50.0 million at the one-month London Interbank Offered Rate, or LIBOR, plus a spread based on our funded debt ratio, or in the absence of LIBOR, the prime rate (3.25% at March 31, 2012). The one-month LIBOR rate at March 31, 2012 was 0.24%. In addition, we have the option to increase the facility by an additional $30.0 million, based on sufficient levels of trade receivables to meet borrowing base requirements, and depending on meeting minimum Adjusted EBITDA (earnings before interest, taxes, depreciation, amortization, and special charges) and equity requirements, described below under "Factors Affecting Sources of Liquidity." Borrowings under the credit facility during the first quarter of 2012 were minimal in amount and duration and were utilized to facilitate short-term working capital requirements. We renewed our bank line of credit in February 2012 for a five-year period. The new bank facility contains substantially the same terms and conditions as our prior facility, except that the loan is collateralized only by receivables, and it no longer contains restrictions on the repurchase of our common stock or the payment of dividends. This facility operates under an automatic cash management program whereby disbursements in excess of available cash are added as borrowings at the time disbursement checks clear the bank, and available cash receipts are first applied against any outstanding borrowings and then invested in short-term qualified cash investments. Accordingly, borrowings under the line are classified as current. At March 31, 2012, the entire $50 million facility was available for borrowing. Inventory Trade Credit Agreements. We have additional security agreements with two financial institutions to facilitate the purchase of inventory from various suppliers under certain terms and conditions. These agreements allow a collateralized first position in certain branded products in our inventory that were financed by these two institutions. Although the agreements provide for up to 100% financing on the purchase price of these products, up to an aggregate of $47.0 million, any outstanding financing must be fully secured by available inventory. The cost of such financing under these agreements is borne by the suppliers by discounting their invoices to the financial institutions. We do not pay any interest or discount fees on such inventory. Amounts outstanding under such facilities, which equaled $16.4 million in the aggregate as of March 31, 2012, are recorded in accounts payable. The inventory financed is classified as inventory on the condensed consolidated balance sheet. Capital Leases. We have a fifteen-year lease for our corporate headquarters with an affiliated company related through common ownership. In addition to the rent payable under the facility lease, we are required to pay real estate taxes, insurance, and common area maintenance charges. The initial term of the lease expires in 2013, and we have the option to renew the lease for two additional terms of five years each. Operating Leases. We also lease facilities from our principal stockholders and facilities and equipment from third parties under non-cancelable operating leases which have been reported in the "Contractual Obligations" section of our Annual Report on Form 10-K for the year ended December 31, 2011. Sports Marketing Commitments. We have entered into multi-year sponsorship agreements with the New England Patriots and the Boston Red Sox that extend to 2013 and 2014, respectively. These agreements, which grant us various marketing rights and seating access, require annual payments aggregating from $0.1 million to $0.4 million per year. Off-Balance Sheet Arrangements. We do not have any other off-balance sheet arrangements that have, or are reasonably likely to have, a current or future material effect on our financial condition or changes in financial condition. Contractual Obligations. The disclosures relating to our contractual obligations in our Annual Report on Form 10-K for the year ended December 31, 2011 have not materially changed since the report was filed. 19 -------------------------------------------------------------------------------- Factors Affecting Sources of Liquidity Internally Generated Funds. The key factors affecting our internally generated funds are our ability to minimize costs and fully achieve our operating efficiencies, timely collection of our customer receivables, and management of our inventory levels. Bank Line of Credit. Our credit facility contains certain financial ratios and operational covenants and other restrictions (including restrictions on additional debt, guarantees, investments, and liens) with which we, and all of our subsidiaries, must comply. Any failure to comply with these covenants would constitute as a default and could prevent us from borrowing additional funds under this line of credit. This credit facility contains two financial tests: • The funded debt ratio (defined as the average outstanding advances under the line for the quarter, divided by the consolidated Adjusted EBITDA for the trailing four quarters) must not be more than 2.0 to 1.0. We did not have any outstanding borrowings under the credit facility at March 31, 2012, and accordingly, the funded debt ratio did not limit potential borrowings at the quarter end. Future decreases in our consolidated Adjusted EBITDA, however, could limit our potential borrowings under the credit facility. • Minimum Consolidated Net Worth must be at least $250.0 million, plus 50% of consolidated net income for each quarter, beginning with the quarter ended March 31, 2012 (loss quarters not counted). Such amount was calculated at March 31, 2012, as $252.7 million, whereas our actual consolidated stockholders' equity at this date was $278.4 million. Inventory Trade Credit Agreements. These agreements contain similar financial ratios and operational covenants and restrictions as those contained in our bank line of credit described above. These agreements also contain cross-default provisions whereby a default under the bank agreement would also constitute a default under these agreements. Financing under these agreements is limited to the purchase of specific branded products from authorized suppliers, and amounts outstanding must be fully collateralized by inventories of those products on hand. Capital Markets. Our ability to raise additional funds in the capital market depends upon, among other things, general economic conditions, the condition of the information technology industry, our financial performance and stock price, and the state of the capital markets. SUMMARY OF CRITICAL ACCOUNTING POLICIES AND ESTIMATES Our critical accounting policies have not materially changed from those discussed in our Annual Report on Form 10-K for the year ended December 31, 2011. These policies include revenue recognition, accounts receivable, vendor allowances, inventory, and the value of goodwill and long-lived assets, including intangibles. INFLATION We have historically offset any inflation in operating costs by a combination of increased productivity and price increases, where appropriate. We do not expect inflation to have a significant impact on our business in the foreseeable future. 20 -------------------------------------------------------------------------------- PC CONNECTION, INC. AND SUBSIDIARIES PART I-FINANCIAL INFORMATION |