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SCANSOURCE INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) Overview ScanSource, Inc., together with its subsidiaries (the "Company"), is a leading wholesale distributor of specialty technology products, providing value-added distribution services to resellers in specialty technology markets. The Company distributes approximately 100,000 products worldwide. The Company has two geographic distribution segments: the North American distribution segment serving the United States and Canada from the Southaven, Mississippi distribution center, and an international segment currently serving Latin America and Europe from distribution centers located in Florida, Mexico and Brazil, and in Belgium, respectively. Each segment is managed around its geographic customer and vendor bases and is supported by its centralized infrastructure, such as warehousing and back office operations as appropriate. The North American distribution segment markets automatic identification and data capture ("AIDC") and point-of-sale ("POS") products through its ScanSource POS and Barcode sales unit; voice, data, video and converged communications equipment through its Catalyst Telecom sales unit; video conferencing, telephony and communications products through its ScanSource Communications sales unit; and electronic security products and wireless infrastructure products through its ScanSource Security sales unit. The international distribution segment markets AIDC, POS, communications and security products through its ScanSource Latin America sales unit; AIDC and POS products through its ScanSource POS and Barcode, Europe sales unit; and communication products through its ScanSource Communications, Europe sales unit. The Company was incorporated in South Carolina in December 1992 and is headquartered in Greenville, South Carolina. The Company serves North America from a single, centrally-located distribution center located in Southaven, Mississippi, near the FedEx hub. The single warehouse and management information system form the cornerstone of the Company's cost-driven operational strategy. The Company distributes products for many of its key vendors in all of its geographic markets; however certain vendors only allow distribution to specific geographies. The Company's key vendors in its worldwide POS and Barcode sales units include Bematech, Cisco, Datalogic, Datamax-O'Neil, Elo, Epson, Honeywell, Intermec, Motorola, NCR, Toshiba and Zebra Technologies. The Company's key vendors in its worldwide communications sales units, including Catalyst Telecom, include Aruba, Avaya, Audiocodes, Cisco, Dialogic, Extreme Networks, Meru Networks, Plantronics, Polycom and ShoreTel. The Company's key vendors in its security sales units include Arecont, Axis, Bosch, Cisco, Datacard, Exacq Technologies, Fargo, HID, March Networks, Panasonic, Ruckus Wireless, Samsung, Sony and Zebra Card. Our distribution agreement with Juniper Networks ended in the first quarter of this fiscal year. Accordingly, sales of Juniper products, which were primarily distributed by our Catalyst Telecom sales unit in North America and to a lesser extent by ScanSource Communications Europe, have significantly declined in the nine months ended March 31, 2013 compared to prior periods. Our Latin America subsidiary is experiencing a significant drop in revenue in Venezuela due to increased country-specific risks. In Venezuela, the Company's transactions are denominated in U.S. dollars, however, our Venezuelan resellers are having difficulties getting U.S. dollars to pay us since the government controls the available U.S. dollars within the country. Hence, we have heightened risk of collectability in this country. At March 31, 2013, the Company held $3.2 million in accounts receivable and $0.7 million in reserves specific to accounts receivable in this country. The Company announced the restructuring of its Communications business unit in Europe to support a strategy for profitable growth. The new organizational structure will provide focused business unit leadership, as well as dedicated merchandising, sales and technical support teams, at a scale for profitable growth. In addition, the Company will move certain European support functions to centralized global teams in the United States to gain efficiencies. The annualized cost savings in connection with the restructuring, principally associated with the elimination of positions, are estimated to be approximately $3.1 million. The Company incurred approximately $1.2 million in associated costs, including related severance expenses. These restructuring costs, which were accrued as of March 31, 2013, are included in selling, general and administration costs in the accompanying condensed consolidated income statements. The liability, which is recorded in accrued expenses and other current liabilities in the accompanying condensed consolidated balance sheets, is expected to be substantially utilized by the end of fiscal 2013. 18-------------------------------------------------------------------------------- Table of Contents We are developing an Enterprise Resource Planning system ("ERP") that is intended to be used globally and standardize our processes throughout the world. Through our wholly-owned subsidiary Partner Services, Inc. ("PSI"), we filed a lawsuit in the U.S. District Court in Atlanta, Georgia on January 2, 2013 against our former ERP software systems integration partner, Avanade, Inc. ("Avanade"). The lawsuit alleges, among other things, fraud, tortious misrepresentation and breach of contract on the part of Avanade in connection with its performance on the ERP project. PSI is seeking recovery of damages that it has incurred and will continue to incur, as a result of Avanade's misconduct. The Company had engaged a new systems integration partner, Tata Consultancy Services ("TCS"), to replace Avanade. In March 2013, TCS presented an integrated project plan that included the time and costs to complete the project. This plan indicated that the effort remaining was going to approach the $72 million upper end of our previously-disclosed total project cost range. We are currently evaluating our project plan. In April 2013, we moved a significant number of Company team members who were working on our ERP project back into business roles and are evaluating our alternatives for next steps. During the third quarter 2013, SG&A expenses included $2.3 million in ERP related costs including internal personnel costs. In the fourth quarter we expect to spend less than half of what we spent in the third quarter. We have incurred approximately $41.4 million on the project from inception to date, which includes capital expenditures associated with the project of $28.6 million as of March 31, 2013. Meanwhile, our legacy ERP systems continue to run our business successfully. We face numerous challenges that require attention and resources. Certain of our business units and geographies are experiencing increased competition for the products we distribute. This competition may come in the form of pricing, credit terms, service levels, product availability and in some cases, changes from a closed distribution sales model, in which resellers must purchase exclusively from one distributor, to an open distribution sales model, in which resellers may choose to purchase from multiple distributors. As this competition could affect both our market share and pricing of our products, we may change our strategy in order to effectively compete in the marketplace. Evaluating Financial Condition and Operating Performance We place a significant emphasis on operating income and Return on Invested Capital ("ROIC") in evaluating and monitoring financial condition and operating performance. We use ROIC, a non-GAAP measure, to assess efficiency at allocating capital under our control to generate returns. ROIC is computed by the Company as net income plus interest expense, income taxes, depreciation and amortization ("EBITDA") annualized by calendar days and divided by invested capital. Invested capital is defined as average equity plus daily average funded debt for the period. The following table summarizes annualized return on invested capital ratio for the quarters ended March 31, 2013 and 2012, respectively: Quarter ended March 31, 2013 2012 Return on invested capital ratio, annualized 13.3 % 13.5 % The discussion that follows this overview explains the change in ROIC from the comparative period. Management uses ROIC as a performance measurement because we believe this metric best balances our operating results with asset and liability management, excludes the results of capitalization decisions, is easily computed and understood, and drives changes in shareholder value. The components of this calculation and reconciliation to our financial statements are shown on the following schedule: Quarter ended March 31, 2013 2012 (in thousands) Reconciliation of EBITDA to net income: Net income $ 13,978 $ 14,756 Plus: income taxes 7,202 7,049 Plus: interest expense 102 254 Plus: depreciation & amortization 2,274 2,754 EBITDA (numerator) $ 23,556 $ 24,813 19-------------------------------------------------------------------------------- Table of Contents Quarter ended March 31, 2013 2012 (in thousands)Invested capital calculations: Equity - beginning of the quarter $ 696,960 $ 616,103 Equity - end of the quarter 709,912 642,450 Average equity 703,436 629,277 Average funded debt (a) 15,675 111,247 Invested capital (denominator) $ 719,111 $ 740,524 Return on invested capital (annualized)(b) 13.3 % 13.5 % (a) Average funded debt is calculated as the daily average amounts outstanding on our short-term and long-term interest-bearing debt. (b) The annualized EBITDA amount is divided by days in the quarter times 365 days per year (366 during leap years). There were 90 and 91 days in the current and prior year quarters, respectively. Our annualized return on invested capital was 13.3% for the quarter, down from 13.5% in the same quarter of the prior year. The decrease in EBITDA is largely the result of lower sales volumes and an increase in SG&A expenses related to bad debt expenses and the restructuring of our European operations. Results of Operations Currency In this Management Discussion and Analysis, we make references to "constant currency," a non-GAAP performance measure, that excludes the foreign exchange rate impact from fluctuations in the weighted average foreign exchange rates between reporting periods. Certain financial results are adjusted by translating current period results from currencies other than the U.S. dollar using the comparable weighted average foreign exchange rates from the prior year period. This information is provided to view financial results without the impact of fluctuations in foreign currency rates, thereby enhancing comparability between reporting periods. Net Sales The following table summarizes our net sales results (net of inter-segment sales) for the quarters and nine months ended March 31, 2013 and 2012, respectively: Quarter ended March 31, 2013 2012 $ Change % Change (in thousands) North American distribution $ 508,394 $ 529,845 $ (21,451 ) (4.0 )% International distribution 174,571 178,038 (3,467 ) (1.9 )% Net sales $ 682,965 $ 707,883 $ (24,918 ) (3.5 )% Nine Months ended March 31, 2013 2012 $ Change % Change (in thousands) North American distribution $ 1,602,193 $ 1,666,240 $ (64,047 ) (3.8 )% International distribution 562,093 594,587 (32,494 ) (5.5 )% Net sales $ 2,164,286 $ 2,260,827 $ (96,541 ) (4.3 )% 20-------------------------------------------------------------------------------- Table of Contents North American Distribution The North American distribution segment consists of net sales to technology resellers in the United States and Canada. For the quarter ended March 31, 2013, net sales decreased $21.5 million or 4.0%. For the nine months ended March 31, 2013, net sales decreased $64.0 million or 3.8%. The North American distribution segment's POS and barcode product lines experienced modest growth in sales in the current three and nine month periods compared to the prior year. Meanwhile, the ScanSource Security sales unit had high single digit year-over-year sales growth for the quarter, largely driven by vendors such as Ruckus Wireless and Axis Communications. The Company has two North American sales units that sell communications products - Catalyst Telecom and ScanSource Communications. The combined net sales of these units decreased by 10.3% from the prior year quarter and 11.1% from the prior year nine month period. These decreases were largely attributable to lower Avaya Enterprise and Juniper sales. Our distribution agreement with Juniper Networks ended in September 2012. These declines however, were partially offset by increased volumes with our wireless communications products with vendors such as Aruba. International Distribution The international distribution segment markets POS, AIDC, communications and security products in Latin America and POS, AIDC and communications products in Europe. For the quarter ended March 31, 2013, net sales for this segment decreased by $3.5 million or 1.9% from the prior year quarter. On a constant currency basis, net sales were flat with the prior year quarter. Net sales were down in Europe from the prior year quarter primarily due to the loss of Juniper revenues and weaker deal volume in Germany, both of which affected our Communications business. Meanwhile, Latin America POS & Barcode business unit experienced a decrease in revenues from the prior year driven by difficulties in selling products in Venezuela and Argentina due to economic turmoil in both countries. For the nine months ended March 31, 2013, net sales decreased by $32.5 million or 5.5%. The sales decrease over the prior year nine month period is primarily driven by foreign currency exchange translation which had a $37.7 million unfavorable impact on our net sales for the period ended March 31, 2013. On a constant currency basis, net sales increased $5.2 million or 1% over the prior year nine month period. Our international segment's growth was driven by contributions from our Brazilian and other Latin American business units. Gross Profit The following tables summarize the Company's gross profit for the quarters and nine months ended March 31, 2013 and 2012, respectively: % of Net Sales Quarter ended March 31, March 31, 2013 2012 $ Change % Change 2013 2012 (in thousands)North American distribution $ 51,340 $ 50,187 $ 1,153 2.3 % 10.1 % 9.5 % International distribution 17,492 19,081 (1,589 ) (8.3 )% 10.0 % 10.7 % Gross profit $ 68,832 $ 69,268 $ (436 ) (0.6 )% 10.1 % 9.8 % % of Net Sales Nine Months ended March 31, March 31, 2013 2012 $ Change % Change 2013 2012 (in thousands)North American distribution $ 158,178 $ 164,176 $ (5,998 ) (3.7 )% 9.9 % 9.9 % International distribution 59,045 64,021 (4,976 ) (7.8 )% 10.5 % 10.8 % Gross profit $ 217,223 $ 228,197 $ (10,974 ) (4.8 )% 10.0 % 10.1 % 21-------------------------------------------------------------------------------- Table of Contents North American Distribution Gross profit for the North American distribution segment increased 2.3% or $1.2 million and decreased 3.7% or $6.0 million for the quarter and nine months ended March 31, 2013, respectively. As a percentage of net sales for the North American distribution segment, our gross profit increased to 10.1% from 9.5% in the prior year quarter and remained flat at 9.9% compared to the prior nine month period. The increase in margin percentage is primarily due to changes in product and customer mix as well as timing of vendor programs compared to the prior year quarter. International Distribution In our international distribution segment, gross profit decreased 8.3% or $1.6 million and 7.8% or $5.0 million for the quarter and nine months ended March 31, 2013, respectively, compared to the prior periods. As a percentage of net sales for the international distribution segment, our gross profit decreased to 10.0% from 10.7% in the prior year quarter and to 10.5% from 10.8% in the prior nine month period. The decline in gross margin is primarily due to weaker demand and competitive pricing pressures. Operating Expenses The following table summarizes our operating expenses for the quarters and nine months ended March 31, 2013 and 2012, respectively: % of Net Sales Quarter ended March 31, March 31, 2013 2012 $ Change % Change 2013 2012 (in thousands) Selling, general and administrative expense $ 47,937 $ 46,711 $ 1,226 2.6 % 7.0 % 6.6 % Change in fair value of contingent consideration 100 1,072 (972 ) (90.7 )% 0.0 % 0.2 % Operating expense $ 48,037 $ 47,783 $ 254 0.5 % 7.0 % 6.8 % % of Net Sales Nine Months ended March 31, March 31, 2013 2012 $ Change % Change 2013 2012 (in thousands) Selling, general and administrative expense $ 144,392 $ 141,753 $ 2,639 1.9 % 6.7 % 6.3 % Change in fair value of contingent consideration 1,396 1,244 152 12.2 % 0.1 % 0.0 % Operating expense $ 145,788 $ 142,997 $ 2,791 2.0 % 6.7 % 6.3 % Selling, general and administrative expense ("SG&A") increased 2.6% or $1.2 million and 1.9% or $2.6 million for the quarter and nine months ended March 31, 2013, respectively. As a percentage of net sales, SG&A totaled 7.0% and 6.7% for the quarter and nine months ended March 31, 2013, respectively, up from the prior nine months ended March 31, 2012. SG&A expenses for the March 2013 quarter included approximately $1.2 million for restructuring costs associated with our Communications business unit in Europe. In addition, SG&A expenses included increases to bad debt reserves, based on our evaluation of collectability of certain balances for Europe Communications and higher country-specific risk reserves in Venezuela. Accordingly, the allowance for bad debts increased to $31.0 million at March 31, 2013 from $29.8 million at December 31, 2012, while accounts receivable declined. The increase compared to the prior year nine months included $2.1 million in costs associated with tax compliance and personnel replacement costs in our Belgium office. These costs include severance benefits, as well as tax accruals and professional fees. These increased costs were partially offset by lower employee costs. We have elected to present changes in fair value of the contingent consideration owed to the former shareholders of CDC separately from other selling, general and administrative expenses. In the current quarter and nine month periods, we have recorded fair value adjustment losses of $0.1 million and $1.4 million, respectively. These losses are primarily the result of the recurring amortization of the unrecognized fair value discount and changes in actual results. 22-------------------------------------------------------------------------------- Table of Contents Operating Income (Loss) The following table summarizes our operating income (loss) for the quarters and nine months ended March 31, 2013 and 2012, respectively: % of Net Sales Quarter ended March 31, March 31, 2013 2012 $ Change % Change 2013 2012 (in thousands)North American distribution $ 24,973 $ 21,471 $ 3,502 16.3 % 4.9 % 4.1 % International distribution (4,178 ) 14 (4,192 ) (29,942.9 )% (2.4 )% 0.0 % $ 20,795 $ 21,485 $ (690 ) (3.2 )% 3.0 % 3.0 % % of Net Sales Nine Months ended March 31, March 31, 2013 2012 $ Change % Change 2013 2012 (in thousands) North American distribution $ 73,216 $ 77,501 $ (4,285 ) (5.5 )% 4.6 % 4.7 % International distribution (1,781 ) 7,699 (9,480 ) (123.1 )% (0.3 )% 1.3 % $ 71,435 $ 85,200 $ (13,765 ) (16.2 )% 3.3 % 3.8 % For the North American distribution segment, operating income increased 16.3% or $3.5 million and decreased 5.5% or $4.3 million from the prior year quarter and nine months, respectively. Operating income as a percentage of net sales increased to 4.9% and decreased to 4.6% for the quarter and nine months ended March 31, 2013, respectively. The increase in operating income percentage in North America for the current quarter is primarily due to changes in product and customer mix as well as timing of vendor rebate programs and lower bad debt expenses. The decrease for the current nine month period is due to lower sales volumes . For the international distribution segment, operating losses totaled $4.2 million and $1.8 million for the quarter and nine months ended March 31, 2013, respectively, compared with operating income for the prior year periods. The decreases internationally are primarily due to the increases in operating expenses described earlier. For the current quarter, decreases are primarily due to margin issues described above, higher bad debt expense and the restructuring charges in the European Communications business as well as lower pricing in certain geographies. Furthermore, the year-to-date operating income was also reduced by costs of $2.1 million for Belgian tax compliance and personnel replacement in the second quarter fiscal 2013. Total Other Expense (Income) The following table summarizes our total other (income) expense for the quarters and nine months ended March 31, 2013 and 2012, respectively: % of Net Sales Quarter ended March 31, March 31, 2013 2012 $ Change % Change 2013 2012 (in thousands) Interest expense $ 102 $ 254 $ (152 ) (59.8 )% 0.0 % 0.0 % Interest income (483 ) (780 ) 297 (38.1 )% (0.1 )% (0.0 )% Net foreign exchange (gains) losses 145 280 (135 ) (48.2 )% 0.0 % 0.0 % Other, net (149 ) (74 ) (75 ) 101.4 % (0.0 )% (0.0 )% Total other (income) expense, net $ (385 ) $ (320 ) $ (65 ) 20.3 % (0.1 )% 0.0 % 23-------------------------------------------------------------------------------- Table of Contents % of Net Sales Nine Months ended March 31, March 31, 2013 2012 $ Change % Change 2013 2012 (in thousands) Interest expense $ 356 $ 1,490 $ (1,134 ) (76.1 )% 0.0 % 0.0 % Interest income (1,648 ) (2,233 ) 585 (26.2 )% (0.1 )% (0.1 )% Net foreign exchange (gains) losses 328 3,571 (3,243 ) (90.8 )% 0.0 % 0.2 % Other, net (294 ) (208 ) (86 ) 41.3 % (0.0 )% (0.0 )% Total other (income) expense, net $ (1,258 ) $ 2,620 $ (3,878 ) (148.0 )% (0.1 )% 0.1 % Interest expense reflects interest incurred on borrowings from the Company's revolving credit facility and other long-term debt borrowings, as well as non-utilization fees. Interest expense for the quarter and nine months ended March 31, 2013 was $0.1 million and $0.4 million, respectively. Interest expense was down 59.8% and 76.1% from the prior year quarter and nine months, respectively, largely from decreased borrowings on our $300 million Revolving Credit Facility. Interest income for the quarter and nine months ended March 31, 2013 was $0.5 million and $1.6 million, respectively, and includes interest income generated on longer-term interest bearing receivables and interest earned on cash and cash-equivalents. Interest income decreased 38.1% and 26.2% from the prior year quarter and nine months, respectively. In September 2011, we transferred $22 million to our Brazilian subsidiary to prefund a portion of the future earn-out payments and finance current operations. With the use of this cash for our annual earn-out payments for the purchase of CDC and short-term working capital needs in Brazil, interest income has declined. Net foreign exchange losses consist of foreign currency transactional and functional currency re-measurements, offset by net foreign currency exchange contract gains and losses. Foreign exchange losses and gains are generated as the result of fluctuations in the value of the British pound versus the euro, the U.S. dollar versus the euro, the U.S. dollar versus the Brazilian real, the Canadian dollar versus the U.S. dollar and other currencies versus the U.S. dollar. While we utilize foreign exchange contracts and debt in non-functional currencies to hedge foreign currency exposure, our foreign exchange policy prohibits the use for speculative transactions. Net foreign exchange gains and losses for the quarter and nine months ended March 31, 2013 totaled $0.1 million and $0.3 million, respectively. Compared to the prior year nine months, net foreign exchange loss decreased $3.2 million. In the prior year, we incurred a $2.5 million loss in connection with an unfavorable forward exchange contract to purchase Brazilian reais. In August 2011, we decided to pre-fund a portion of the estimated earnout payments associated with the CDC acquisition and finance current operations as mentioned above. This contract was designed to preserve the currency exchange for the few weeks required to transfer the cash to Brazil. From the time we entered into the contract through settlement, the real devalued from the contractual rate by 11.8%, ultimately resulting in a $2.5 million loss. Further contributing to the prior year quarter foreign exchange loss, our Brazilian business incurred significant losses on the remeasurement of U.S. dollar denominated transactions that were not hedged at the time. Subsequently, we have been including these exposures in our ongoing hedging activities. Provision for Income Taxes For the quarter and nine months ended March 31, 2013, income tax expense was $7.2 million and $24.7 million, respectively. The effective tax rate for the same two periods was 34.0%. The effective tax rates in the quarter and nine months ended March 31, 2012 were 32.3% and 34.0%, respectively. The increase in the effective tax rate from the prior year quarter is due primarily to a cumulative adjustment in the prior year quarter to reduce tax expense. 24-------------------------------------------------------------------------------- Table of Contents Liquidity and Capital Resources Our primary sources of liquidity are cash flow from operations, borrowings under our $300 million revolving credit facility (the "Revolving Credit Facility"), borrowings under our industrial development revenue bond, and borrowings under our European subsidiary's €6 million line of credit. As a distribution company, our business requires significant investment in working capital, particularly accounts receivable and inventory, partially financed through our accounts payable to vendors and revolving lines of credit. Overall, as our sales volume increases, our working capital needs typically increase, which, in general, results in decreased cash flow from operating activities. Conversely, when sales volume decreases, our working capital needs typically decrease, which, in general, results in increased cash flow from operating activities. Our cash and cash equivalent balance totaled $93.9 million at March 31, 2013, compared to $29.2 million at June 30, 2012, of which $24.1 million and $18.7 million were held outside of the United States as of March 31, 2013 and June 30, 2012, respectively. Cash balances are generated and used in many locations throughout the world. Prior to this quarter, management's intent was to permanently reinvest these funds in our businesses outside the United States to continue to fund growth in our international operations. During the quarter, we reviewed and modified our policy toward permanently reinvested foreign earnings. Prospectively, the Company will provide for U.S. income taxes for the earnings of its Canadian subsidiary. Earnings from all other geographies will continue to be considered retained indefinitely for reinvestment. If these funds were needed in the operations of the United States, we would be required to record and pay significant income taxes upon repatriation of these funds. As mentioned above, our business model typically yields an inverse relationship between cash flows from operating activities and our sales volumes. Net sales are down $96.5 million from the prior year nine month period. On a constant currency basis, net sales are down $58.9 million. As a result, cash from operating activities increased to an inflow of $76.0 million versus an inflow of $25.1 million in the prior year nine month period. Our net investment in working capital has increased to $587.9 million at March 31, 2013 from $533.5 million at June 30, 2012 and increased compared to the March 31, 2012 balance of $567.8 million. Net working capital has increased $54.4 million since the June 30, 2012. The increase is largely attributable to increases in our cash balance generated by lower inventory, lower accounts receivable and payable levels due to lower sales. Our net investment in working capital is affected by several factors such as fluctuations in sales volume, net income before non-cash charges, timing of collections from customers, increases and decreases to inventory levels, payments to vendors as well as cash generated or used by other financing and investing activities. The number of days sales in receivables (DSO) was 57 days at March 31, 2013, compared to 56 and 57 days at June 30, 2012 and March 31, 2012, respectively. Inventory turned 5.6 times during the third quarter of fiscal year 2013 versus 5.7 and 5.0 times in the sequential and prior year quarters. We are developing a new ERP system and have incurred approximately $41.4 million on the project from inception through March 31, 2013. Of the total amount incurred, $28.6 million has been capitalized. We believe that the total spend will range from $58 million to $72 million, though this is currently under review. We expect to incur costs and expenses in connection with the implementation beyond 2013, however, we expect a significant reduction in these costs in the fourth quarter 2013 while our project is under review. Through our wholly-owned subsidiary Partner Services, Inc. ("PSI") we filed a lawsuit in the U.S. District Court in Atlanta, Georgia on January 2, 2013 against our former ERP software systems integration partner, Avanade, Inc. ("Avanade"). The lawsuit alleges, among other things, fraud, tortious misrepresentation and breach of contract on the part of Avanade in connection with its performance on the ERP project, and PSI is seeking recovery of damages that it has incurred and will continue to incur, as a result of Avanade's misconduct. The Company had engaged a new systems integration partner, TCS, to replace Avanade. In March 2013, TCS presented an integrated project plan that included the time and costs to complete the project. This plan indicated that the effort remaining was going to approach the $72 million upper end of our previously-disclosed total project cost range. We are currently evaluating our project plan. In April 2013, we moved a significant number of Company team members who were working on our ERP project back into business roles and are evaluating our alternatives for next steps. During the third quarter 2013, SG&A expenses included $2.3 million in ERP related costs including internal personnel costs. In the fourth quarter we expect to spend less than half of what we spent in the third quarter. Meanwhile, our legacy ERP systems continue to run our business successfully. Cash used in investing activities for the nine months ended March 31, 2013 was $4.5 million, compared to $10.2 million used in the prior year period. Current and prior year investing cash flows are primarily attributable to the investment in our new ERP system. 25-------------------------------------------------------------------------------- Table of Contents On October 11, 2011, we entered into a five-year, $300 million multi-currency senior secured revolving credit facility pursuant to the terms of an Amended and Restated Credit Agreement (the "Credit Agreement") with JPMorgan Chase Bank, N.A., as administrative agent and a syndicate of lenders named therein. The Credit Agreement allows for the issuance of up to $50 million for letters of credit and has a $150 million accordion feature that allows the Company to increase the availability to $450 million subject to obtaining commitments for the incremental capacity from existing or new lenders. At our option, loans denominated in U.S. dollars under the Revolving Credit Facility, other than swingline loans, shall bear interest at a rate equal to a spread over the London Interbank Offered Rate ("LIBOR") or prime rate depending upon our ratio of total debt (excluding accounts payable and accrued liabilities), measured as of the end of the most recent quarter, to adjusted earnings before interest expense, taxes, depreciation and amortization ("EBITDA"), for the most recently completed four quarters (the "Leverage Ratio"). The Leverage Ratio excludes the Company's subsidiary in Brazil. This spread ranges from 1.00% to 2.25% for LIBOR-based loans and 0.00% to 1.25% for prime rate-based loans. The spread in effect as of March 31, 2013 was 1.00% for LIBOR-based loans and 0.00% for Prime rate-based loans. Additionally, we are assessed commitment fees ranging from 0.175% to 0.40%, depending upon the Leverage Ratio, on non-utilized borrowing availability, excluding swingline loans. Borrowings under the Revolving Credit Facility are guaranteed by substantially all of our domestic assets as well as certain foreign subsidiaries determined to be material under the Revolving Credit Facility and a pledge of up to 65% of capital stock or other equity interest in each Guarantor. We were in compliance with all covenants under the Revolving Credit Facility as of March 31, 2013. For the nine months ended March 31, 2013, cash used in financing activities amounted to $6.8 million, in comparison to $7.4 million in the prior year period. The change in cash used in financing activities is primarily attributable to less borrowing activity on our Revolving Credit Facility as a result of lower sales volumes and the prior year repayment of our $25.0 million unsecured note payable. There were no outstanding borrowings on our $300 million revolving credit facility as of March 31, 2013 and June 30, 2012. On a gross basis, we borrowed $515.3 million and repaid $515.9 million on our Revolving Credit Facility in the nine months ended March 31, 2013. In the prior year-to-date period, we borrowed $1,133.0 million and repaid $1,117.3 million and additionally paid $1.4 million of debt issuance costs. The average daily balance on the Revolving Credit Facility was $12.5 million and $92.8 million for the nine months ended March 31, 2013 and 2012, respectively. There were no standby letters of credits issued and outstanding as of March 31, 2013, leaving $300 million available for additional borrowings. In addition to our Revolving Credit Facility, a subsidiary of the Company has a €6.0 million line of credit, which is secured by the assets of our European operations and is guaranteed by ScanSource, Inc. This agreement can be withdrawn by the lender with minimal notice. Our subsidiary line of credit bears interest at the 30-day Euro Interbank Offered Rate ("EURIBOR") plus a spread ranging from 1.25% to 2.00% per annum. The spread in effect as of March 31, 2013 was 1.25%. Additionally, we are assessed commitment fees ranging from 0.10% to 0.275% on non-utilized borrowing availability if outstanding balances are below €3.0 million. The interest rate spread and commitment fee rates related to the €6.0 million line of credit refer to the Leverage Ratio as defined by our Revolving Credit Facility. There was no outstanding balance at March 31, 2013 and $4.3 million was outstanding at June 30, 2012. In fiscal year 2011, we acquired all of the shares of CDC Brasil, S.A. The purchase price was paid with an initial payment of $36.2 million, net of cash acquired, assumption of working capital payables and debt, and variable annual payments through October 2015, based on CDC's annual financial results. As of March 31, 2013, we have $13.3 million recorded for the contingent earnout obligation, of which $4.5 million is classified as current. Future contingent earnout payments will be funded by cash on hand and our Revolving Credit Facility. We believe that our existing sources of liquidity, including cash resources and cash provided by operating activities, supplemented as necessary with funds under our credit agreements, will provide sufficient resources to meet the present and future working capital and cash requirements for at least the next twelve months. 26-------------------------------------------------------------------------------- Table of Contents Contractual Obligations There have been no material changes in our contractual obligations and commitments as disclosed in our Annual Report on Form 10-K as of August 24, 2012. Accounting Standards Recently Issued Effective for interim and annual reporting periods for fiscal 2013, we have implemented ASU 2011-05, Presentation of Comprehensive Income. The objective of this update is to improve the comparability, consistency and transparency of financial reporting and to increase the prominence of items reported in other comprehensive income. This update eliminates the option to present components of other comprehensive income as part of the statement of changes in shareholders' equity or in a separate footnote and requires companies to present all non-owner changes in shareholders' equity either in a single continuous statement of comprehensive income or in two separate but consecutive statements. We are presenting a separate condensed consolidated statement of comprehensive income. Effective for the annual goodwill impairment testing during fiscal 2013, the Company will implement ASU 2011-08, Testing Goodwill for Impairment. The amendments in the update permit an entity to 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 as a basis for determining whether it is necessary to perform the two-step goodwill impairment test described in ASC Topic 350. The more-likely-than-not threshold is defined as having a likelihood of more than 50 percent. The adoption of this amendment is not expected to have an impact on the Company's condensed consolidated financial statements. In July 2012, the Financial Accounting Standards Board ("FASB") issued ASU 2012-02, Testing Indefinite-Lived Intangible Assets for Impairment. This amendment allows companies to first assess qualitative factors of impairment of all indefinite-lived intangible assets, similar to the provisions in ASU 2011-08. The amendment becomes effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012, but early adoption is permitted. The Company has elected early adoption for this amendment. The adoption of this amendment did not have an impact on the Company's condensed consolidated financial statements. There are currently no new accounting standards that have been issued that are expected to have a significant impact on our financial position, results of operations and cash flows upon adoption. 27-------------------------------------------------------------------------------- Table of Contents Critical Accounting Policies and Estimates Critical accounting policies are those that are important to our financial condition and require management's most difficult, subjective or complex judgments. Different amounts would be reported under different operating conditions or under alternative assumptions. We have evaluated the accounting policies used in the preparation of the consolidated financial statements and related notes and believe those policies to be reasonable and appropriate. See Note 1 of the Notes to Consolidated Financial Statements in our Annual Report on Form 10-K for the year ended June 30, 2012 for a complete listing of our significant accounting policies. Goodwill Goodwill is not amortized but is tested annually for impairment at a reporting unit level. Additionally, goodwill is tested for impairment on an interim basis if at any time facts and circumstances indicate that an impairment may have occurred. As discussed in Item 7 of the Company's 2012 Annual Report on Form 10-K under Critical Accounting Policies, we performed our annual goodwill impairment test for the Brazilian reporting unit as of June 30, 2012 and found that the fair value of the reporting unit exceeded its carrying value by 7%. We monitor results of this business on a quarterly basis, as missing estimated expectations or changes to the projected future results of this operation could result in a future impairment of goodwill for this reporting entity. The business missed its projected results by a wider margin than expected during the March 31, 2013 quarter, however, based on current projected future results, we do not believe there is a more likely than not expectation that a goodwill impairment exists. The goodwill associated with the Brazilian testing unit as of March 31, 2013 is $19.9 million. Recent financial results in Europe have generated pre-tax losses, primarily the result of our Europe Communications business. The overall European results as a goodwill testing unit could generate an impairment if this business unit continues to miss projected results. The goodwill associated with the European goodwill testing unit as of March 31, 2013 is $9.8 million. |