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NAVARRE CORP /MN/ - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations.(Edgar Glimpses Via Acquire Media NewsEdge) Overview We offer a vertically integrated, multi-channel platform of e-commerce services and distribution solutions to retailers and manufacturers. We offer retail distribution programs, website development and hosting, customer care, e-commerce fulfillment, and third party logistics services. Since our founding in 1983, we have established retail distribution relationships with major retailers including Best Buy, Wal-Mart/Sam's Club, Apple, Amazon, Costco Wholesale Corporation, Staples, Target, Office Depot and OfficeMax, and we distribute to nearly 31,000 retail and distribution center locations throughout the United States and Canada. In November 2012 we acquired SpeedFC, Inc. ("SpeedFC"), a leading provider of end-to-end e-commerce services. This acquisition allows us to provide a broad array of e-commerce services that includes website development and integration, web hosting, cross-channel order management and reporting, and fulfillment and customer care to online retailers and manufacturers. Beginning in the quarter ended December 31, 2012, we changed our reporting segments in connection with the acquisition of SpeedFC, Inc. We previously reported segment information under two reporting segments including distribution and publishing. Effective the quarter ended December 31, 2012, our business operates through two business segments: Distribution and E-Commerce and Fulfillment Services. Through our distribution business, we distribute computer software, consumer electronics and accessories and video games, and sell proprietary software products for the PC and Mac platforms. Through our ecommerce and fulfillment services business, we provide web site development and hosting, customer care, e-commerce fulfillment and third party logistics services. The distribution segment results as reported prior to the quarter ended December 31, 2012 included operating results of fee-based logistical services which is now included in the e-commerce & fulfillment services segment. In addition, the results of the previously reported publishing segment are included in the distribution segment beginning the quarter ended December 31, 2012. Recent events On November 20, 2012, Navarre acquired all of the equity interests from all of the stock and option holders (the "SFC Equityholders") of SpeedFC, Inc. (a Delaware corporation), through a merger of that entity with and into a Navarre wholly-owned subsidiary, now named SpeedFC, Inc., a Minnesota corporation ("SpeedFC")(the transaction, the "Acquisition") pursuant to the terms of that certain Agreement and Plan of Merger dated September 27, 2012, as amended on October 29, 2012 (the "Merger Agreement"). SpeedFC is a leading provider of end-to-end e-commerce services to retailers and manufacturers and is part of the Company's e-commerce and fulfillment segment. The aggregate Acquisition consideration consisted of initial consideration of $50.0 million in cash and shares of Navarre common stock, with additional contingent payments in cash and common stock available as described below, both payable to the SFC Equityholders proportionate to their prior ownership in SpeedFC, as adjusted pursuant to the Merger Agreement. The initial consideration paid at closing was comprised of: (i) $25.0 million in cash (less certain escrow and holdback amounts, and subject to certain net working capital and post-closing adjustments); and (ii) $25.0 million worth of shares of Navarre common stock, or 17,095,186 shares. The contingent consideration payable to the SFC Equityholders is subject to the achievement of certain financial performance metrics by SpeedFC in the 2012 calendar year related to an adjusted EBITDA target, which, if met, would require: (i) the payment of up to a maximum of $5.0 million in cash consideration, with up to a maximum of $1.25 million payable in early 2013 and up to a maximum of $3.75 million (before interest of five percent per annum) payable in equal, quarterly installments beginning in late fiscal 2013 and ending on February 29, 2016 (the "Contingent Cash Payment") and (ii) the issuance of up to 6,287,368 shares of Navarre common stock to the SFC Equityholders, with up to 2,215,526 ("First Equity Amount") shares payable in early 2013, up to 738,509 shares ("Second Equity Amount") payable in late 2013, and 3,333,333 shares payable at the same time as the Second Equity Amount (all equity amounts together, the "Contingent Equity Payment"). The Contingent Cash Payment and Contingent Equity Payment amounts are subject to certain escrow conditions and adjustments in connection with the measurement periods for evaluation of the achievement of financial performance metrics. If all contingent equity amounts are fully earned, a total of 23,382,554 shares of Navarre common stock could be issued in connection with the Acquisition. 21 --------------------------------------------------------------------------------Executive Summary Consolidated net sales for the third quarter of fiscal 2013 increased 16.1% to $178.3 million compared to $153.5 million for the third quarter of fiscal 2012. The $24.8 million increase in net sales was primarily due to an increase in net sales in the consumer electronics and accessories category of $14.7 million compared to the third quarter of fiscal 2012, due to distribution of new products to existing and new customers, and due to our recent acquisition of SpeedFC, which generated $13.6 million of net sales in the third quarter of fiscal 2013. In addition, net sales increased $3.3 million in our software category due to expanded distribution to existing and new customers, partially offset by a decrease in net sales in the video game category of $8.9 million compared to the third quarter of fiscal 2012 and a decrease in net sales in the home video category of $3.5 million compared to the third quarter of fiscal 2012 due to our transition out of the home video product category. Our gross profit increased to $17.0 million, or 9.5% of net sales, in the third quarter of fiscal 2013 compared to $7.5 million, or 4.9% of net sales, for the same period in fiscal 2012. The $9.5 million increase in gross profit was principally due to a higher volume of consumer electronics and accessories products of $1.2 million and the contribution of gross profit of $2.3 million from SpeedFC. Additionally, the third quarter of fiscal 2012 includes restructure and impairment charges of $8.8 million. Total operating expenses for the third quarter of fiscal 2013 were $14.5 million, or 8.2% of net sales, compared to $21.7 million, or 14.1% of net sales, in the same period for fiscal 2012. The third quarter of fiscal 2012 includes $8.2 million of restructure and impairment charges. The remaining $500,000 decrease is primarily due to operating efficiencies resulting from the Restructuring Plan completed in fiscal 2012 offset by transaction and transition costs related to the acquisition of SpeedFC of $1.5 million. Net income for the third quarter of fiscal 2013 was $10,000 or zero per diluted share compared to a net loss of $29.1 million or $0.79 per diluted share for the same period last year. Consolidated net sales for the nine months ended December 31, 2012 increased 2.6% to $373.7 million compared to $364.1 million for the first nine months of fiscal 2012. This $9.6 million increase in net sales was primarily due to an increase in net sales in the consumer and electronics category of $24.2 million compared to the first nine months of fiscal 2012 and our recent acquisition of SpeedFC which generated $13.6 million of net sales for the first nine months of fiscal 2013. The increase was partially offset by a decrease in net sales in the video game category of $14.4 million compared to the first nine months of fiscal 2012, a decrease in net sales in the software category of $8.6 million and a decrease in net sales in the home video category of $19.9 million compared to the first nine months of fiscal 2012 due to our transition out of the home video product category. Our gross profit increased to $39.0 million, or 10.4% of net sales, for the first nine months of fiscal 2013 compared to $33.5 million, or 9.2% of net sales, for the same period in fiscal 2012. The $5.5 million increase in gross profit was principally due to a higher volume of fulfillment services of $2.3 million and the contribution of gross profit of $2.3 million from SpeedFC. This increase was partially offset by the sale of lower gross profit margin software titles in the distribution segment. Additionally, fiscal 2012 includes restructure and impairment charges of $8.8 million. Total operating expenses for the first nine months of fiscal 2013 were $36.3 million, or 9.7% of net sales, compared to $49.9 million, or 13.7% of net sales, in the same period for fiscal 2012. Fiscal 2012 includes restructuring and impairment charges of $10.1 million. The remaining $3.5 million decrease was primarily due to operating efficiencies resulting from the Restructuring Plan completed in fiscal 2012 offset by $1.9 million of transaction and transition costs and $854,000 of operating expenses related to the acquisition of SpeedFC. Net loss for the first nine months of fiscal 2013 was $73,000 or zero per diluted share compared to net loss of $31.0 million or $0.84 per diluted share for the same period last year. Working Capital and Debt Our business is working capital intensive and requires significant levels of working capital primarily to finance accounts receivable and inventories. We finance our operations through cash and cash equivalents, funds generated through operations, accounts payable and our revolving credit facility. The timing of cash collections and payments to vendors may require usage of our revolving credit facility in order to fund our working capital needs. "Checks written in excess of cash balances" can occur from time to time, including period ends, and represent payments made to vendors that have not yet been presented by the vendor to our bank, and therefore a corresponding advance on our revolving line of credit has not yet occurred. On a terms basis, we extend varying levels of credit to our customers and receive varying levels of credit from our vendors. During the last twelve months, we have not had any significant changes in the terms extended to customers or provided by vendors which would have a material impact to the reported financial statements. 22 -------------------------------------------------------------------------------- On November 12, 2009, we entered into a three year, $65.0 million revolving credit facility (the "Credit Facility") with Wells Fargo Foothill, LLC as agent and lender, and a participating lender. On December 29, 2011, the Credit Facility was amended to eliminate the participating lender, reduce the revolving credit facility limit to $50.0 million, provide for an additional $20.0 million under the Credit Facility under certain circumstances and extend the maturity date to December 29, 2016. On November 20, 2012, 2012 the Credit Facility was amended to provide for the acquisition of SpeedFC, eliminate the additional $20.0 million available under the Credit Facility and extend the maturity date to November 20, 2017. The Credit Facility is secured by a first priority security interest in all of our assets, as well as the capital stock of our companies. Additionally, the Credit Facility, as amended, calls for monthly interest payments at the bank's base rate (as defined in the Credit Facility) plus 1.75%, or LIBOR plus 2.75%, at our discretion. At December 31, 2012 and March 31, 2012 we had $17.4 million and zero outstanding on the Credit Facility, respectively. Amounts available under the Credit Facility are subject to a borrowing base formula. Changes in the assets within the borrowing base formula can impact the amount of availability. Based on the facility's borrowing base and other requirements at such dates, we had excess availability of $26.4 million and $30.4 million at December 31, 2012 and March 31, 2012, respectively. At December 31, 2012, we were in compliance with all covenants under the Credit Facility and we currently believe that we will be in compliance with all covenants during the next twelve months. In association with, and per the terms of the Credit Facility, we also pay and have paid certain facility and agent fees. Weighted-average interest on the Credit Facility was 5.38% and 4.25% at both December 31, 2012 and March 31, 2012, respectively. Such interest amounts have been, and continue to be, payable monthly. Forward-Looking Statements / Risk Factors We make written and oral statements from time to time regarding our business and prospects, such as projections of future performance, statements of management's plans and objectives, forecasts of market trends, and other matters that are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Statements containing the words or phrases "will likely result," "are expected to," "will continue," "is anticipated," "estimates," "projects," "believes," "expects," "anticipates," "intends," "target," "goal," "plans," "objective," "should" or similar expressions identify forward-looking statements, which may appear in documents, reports, filings with the SEC, including this Quarterly Report on Form 10-Q, news releases, written or oral presentations made by officers or other representatives made by us to analysts, shareholders, investors, news organizations and others and discussions with management and other representatives. For such statements, we claim the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995. Our future results, including results related to forward-looking statements, involve a number of risks and uncertainties. No assurance can be given that the results reflected in any forward-looking statement will be achieved. Any forward-looking statement made by or on behalf of us speaks only as of the date on which such statement is made. Our forward-looking statements are based on assumptions that are sometimes based upon estimates, data, communications and other information from suppliers, government agencies and other sources that may be subject to revision. Except as required by law, we do not undertake any obligation to update or keep current either (i) any forward-looking statement to reflect events or circumstances arising after the date of such statement, or (ii) the important factors that could cause our future results to differ materially from historical results or trends, results anticipated or planned by us, or which are reflected from time to time in any forward-looking statement which may be made by or on behalf of us. 23 -------------------------------------------------------------------------------- In addition to other matters identified or described by us from time to time in filings with the SEC, there are several important factors that could cause our future results to differ materially from historical results or trends, results anticipated or planned by us, or results that are reflected from time to time in any forward-looking statement that may be made by or on behalf of us. Some of these important factors, but not necessarily all important factors, include the following: our revenues being derived from a small group of customers; our dependence on significant vendors and manufacturers and the popularity of their products; technological developments, particularly software as a service application, electronic transfer and downloading could adversely impact sales, margins and results of operations; inability to adapt to evolving technological standards; some revenues are dependent on consumer preferences and demand; our restructuring efforts may have unpredictable outcomes, including the possibility of us incurring additional restructuring charges; a deterioration in businesses of significant customers could harm our business; the seasonality and variability in our business and decreased sales could adversely affect our results of operations; growth of non-U.S. sales and operations could increasingly subject us to additional risks that could harm our business; the extent to which our insurance does not mitigate the risks facing our business or our insurers are unable to meet their obligations, our operating results may be negatively impacted; increased counterfeiting or piracy may negatively affect demand for our home entertainment products; we may not be able to protect our intellectual property rights; the failure to diversify our business could harm us; the loss of key personnel could affect the depth, quality and effectiveness of the management team; our ability to meet our significant working capital requirements or if working capital requirements change significantly; product returns or inventory obsolescence could reduce sales and profitability or negatively impact our liquidity; the potential for inventory values to decline; impairment in the carrying value of our assets could negatively affect consolidated results of operations; our credit exposure or negative product demand trends or other factors could cause credit loss; our ability to adequately and timely adjust cost structure for decreased demand; our ability to compete effectively in distribution and e-commerce and fulfillment services, which are highly competitive industries; our dependence on third-party shipping and fulfillment for the delivery of our product; our reliance on third-party subcontractors for certain of our business services; developing software is complex, costly and uncertain and operational errors or defects in such products could result in liabilities and/or impair such products' marketability; our dependence on information systems; future acquisitions or divestitures could disrupt business; future acquisitions could result in potentially unsuccessful integration of acquired companies; interruption of our business or catastrophic loss at any of our facilities could curtail or shutdown our business; future terrorist or military activities could disrupt our operations or harm assets; we may be subject to one or more jurisdictions asserting that we should collect or should have collected sales or other taxes; our ability to use net operating loss carryforwards to reduce future tax payments may be limited; we may be unable to refinance our debt facility; our debt agreement limits operating and financial flexibility; we may incur additional debt; changes to financial standards could adversely affect our reported results of operations; our e-commerce business has inherent cybersecurity risks that may disrupt our business; fluctuations in stock price could adversely affect our ability to raise capital or make our securities undesirable; the exercise of outstanding options could adversely affect our stock price; our anti-takeover provisions, our ability to issue preferred stock and our staggered board may discourage takeover attempts beneficial to shareholders; we do not intend to pay dividends on common stock, thus shareholders should not expect a return on investment through dividend payments; and our directors may not be personally liable for certain actions which may discourage shareholder suits against them. A detailed statement of risks and uncertainties is contained in our reports to the SEC, including, in particular, our Annual Report on Form 10-K for the year ended March 31, 2012 and other public filings and disclosures. We have identified additional risks under Item 1A. Risk Factors to this Form 10-Q. Investors and shareholders are urged to read these documents carefully. Critical Accounting Policies We consider our critical accounting policies to be those related to revenue recognition, allowance for doubtful accounts, goodwill and intangible assets, impairment of long-lived assets, inventory valuation, share-based compensation, income taxes, restructuring charges, software development costs and contingencies and litigation. Other than the addition of the accounting policy related to software development costs and acquisitions and the addition to our revenue recognition accounting policy below, there have been no material changes to these critical accounting policies as discussed in greater detail under this heading in Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the year ended March 31, 2012. Software development costs. Capitalization of software development costs begins upon the establishment of technological feasibility. In the development of our products and our enhancements to existing products, technological feasibility is not established until substantially all product development is complete, including the development of a working model. The establishment of technological feasibility and the ongoing assessment of recoverability of capitalized software development costs require considerable judgment by management with respect to certain external factors, including, but not limited to, technological feasibility, anticipated future gross revenues, estimated economic life, and changes in software and hardware technologies. Such costs are amortized using the straight-line method beginning when the product or enhancement is available for general release over the estimated economic life of the product or enhancement, generally three years. Acquisition. Initial consideration is recognized at fair value as of the acquisition date. Any contingent consideration is recognized as a liability at fair value as of the acquisition date with subsequent fair value adjustments recorded in operations. Acquisition costs are generally expensed as incurred. We allocate the purchase price of acquired entities to the underlying tangible and identifiable intangible assets acquired and liabilities based on their estimated fair values, with any excess recorded as goodwill. Determining the fair value of assets acquired and liabilities assumed requires management's judgment and often involves the use of significant estimates and assumptions, including assumptions with respect to future cash inflows and outflows, discount rates, asset lives and market multiples, among other items. We determine the fair values of such assets, principally intangible assets, generally in consultation with third-party valuation advisors. 24 -------------------------------------------------------------------------------- Addition to revenue recognition accounting policy. A portion of the e-commerce and fulfillment services business revenue arrangements include multiple service elements, such as web implementation and migration, web site support, e-commerce services and additional services. These deliverables are regarded as one unit of accounting and the revenue recognition pattern is determined for the combined unit. The contracted value of the revenue and related costs for elements not quoted on a monthly basis, such as web site implementation and migration, are deferred and recognized ratably over the term of the arrangement, approximately three years, beginning when delivery has occurred. The revenues from the remaining service elements are recorded on a monthly basis as the services are provided. Costs associated with the web site implementation and migration are deferred and recognized ratably over the term of the arrangement consistent with the recognition of revenues. Results of Operations The following table sets forth for the periods indicated the percentage of net sales represented by certain items included in our Consolidated Statements of Operations and Comprehensive Income (Loss). Three Months Ended Nine Months Ended December 31, December 31, (Unaudited) (Unaudited) 2012 2011 2012 2011 Net sales: Distribution 88.0 % 98.6 % 91.1 % 98.7 % E-commerce and fulfillment services 12.0 1.4 8.9 1.3 Total net sales 100.0 100.0 100.0 100.0 Cost of sales: Distribution 80.2 93.9 82.0 89.5 E-commerce and fulfillment services 10.3 1.2 7.6 1.3 Total cost of sales 90.5 95.1 89.6 90.8 Gross profit Distribution 7.8 4.7 9.1 9.2 E-commerce and fulfillment services 1.7 0.2 1.3 - Total gross profit 9.5 4.9 10.4 9.2 Operating expenses Selling and marketing 3.0 3.7 3.6 4.4 Distribution and warehousing 1.3 1.7 1.6 2.1 General and administrative 2.5 3.3 2.9 3.9 Information technology 0.9 1.0 1.0 1.1 Depreciation and amortization 0.4 0.5 0.6 0.6 Goodwill and intangible impairment - 3.9 - 1.6 Total operating expenses 8.1 14.1 9.7 13.7 Income (loss) from operations 1.4 (9.2 ) 0.7 (4.5 ) Interest income (expense), net (0.2 ) (0.2 ) (0.1 ) (0.2 ) Other income (expense), net (0.3 ) (0.1 ) (0.2 ) (0.2 ) Income (loss)- before taxes 0.9 (9.5 ) 0.4 (4.9 ) Income tax benefit (0.9 ) (9.4 ) (0.4 ) (3.6 ) Net income (loss) - % (18.9 )% - % (8.5 )% 25-------------------------------------------------------------------------------- Distribution SegmentThe distribution segment distributes computer software, consumer electronics and accessories and video games. Fiscal 2013 Third Quarter Results Compared To Fiscal 2012 Third Quarter Net Sales Net sales for the distribution segment increased $5.6 million, or 3.7%, to $156.9 million for the third quarter of fiscal 2013 compared to $151.3 million for the third quarter of fiscal 2012. Net sales in the software product group increased $3.3 million to $107.6 million during the third quarter of fiscal 2013 from $104.4 million for the same period last year due to increased demand for our software products. Consumer electronics and accessories net sales increased $14.7 million to $47.4 million during the third quarter of fiscal 2013 compared to $32.6 million for the same period last year due to distribution of new products to existing and new customers. Video games net sales decreased $8.9 million to $1.9 million in the third quarter of fiscal 2013 from $10.8 million for the same period last year, due to fewer video game releases. Home video net sales decreased to zero in the third quarter of fiscal 2013 from $3.5 million in the third quarter of fiscal 2012, due to our transition out of home video exclusive content. We believe future net sales will be dependent upon our ability to continue to add new, appealing content and upon the strength of the retail environment and overall economic conditions. Gross Profit Gross profit for the distribution segment was $13.8 million, or 8.8% of net sales, for the third quarter of fiscal 2013 compared to $7.2 million, or 4.7% of net sales, for the third quarter of fiscal 2012. Fiscal 2012 includes restructure and impairment charges of $8.8 million. Excluding the restructure and impairment charges, the $2.2 million decrease in gross profit was primarily due to an increase in sales of lower margin software products and the decline in volume of video games. We expect gross profit rates to fluctuate depending principally upon the make-up of products sold; however, we anticipate experiencing similar margin blends going forward. Operating Expenses Total operating expenses for the distribution segment were $13.3 million, or 8.5% of net sales, for the third quarter of fiscal 2013 compared to $21.1 million, or 14.0% of net sales, for the third quarter of fiscal 2012. The third quarter of fiscal 2012 includes $8.3 million of restructure and impairment charges. Excluding restructure and impairment charges, the $500,000 increase is the result of $1.5 million of transaction and transition costs related to the acquisition of SpeedFC partially offset by a reduction in personnel and related costs resulting from the Restructuring Plan completed in fiscal 2012. Selling and marketing expenses for the distribution segment were $4.9 million, or 3.1% of net sales, for the third quarter of fiscal 2013 compared to $5.4 million, or 3.6% of net sales, for the third quarter of fiscal 2012. The third quarter of fiscal 2012 includes $300,000 of restructure and impairment charges. The remaining decrease is primarily a result of a reduction in personnel and related costs and advertising resulting from the Restructuring Plan completed in fiscal 2012. Distribution and warehousing expenses for the distribution segment were $2.4 million, or 1.5% of net sales, for the third quarter of fiscal 2013 compared to $2.7 million, or 1.8% of net sales, for the third quarter of fiscal 2012. The $291,000 decrease was primarily a result of a reduction in rent expense due to vacating a warehouse facility during fiscal 2012, in addition to a reduction of personnel and related costs. General and administrative expenses for the distribution segment consist principally of executive, accounting and administrative personnel and related expenses, including professional fees. General and administrative expenses for the distribution segment were $4.3 million, or 2.7% of net sales, for the third quarter of fiscal 2013 compared to $4.8 million, or 3.1% of net sales, for the third quarter of fiscal 2012. The third quarter of fiscal 2012 includes $1.8 million of restructure and impairment charges. The remaining decrease in the third quarter of fiscal 2013 was primarily a result of decreased personnel and related costs and professional fees offset by $1.5 million in transaction and transition costs related to the acquisition of SpeedFC. Information technology expenses for the distribution segment were $968,000, or 0.6% of net sales, for the third quarter of fiscal 2013 compared to $1.5 million, or 1.0% of net sales, for the third quarter of fiscal 2012. The decrease is primarily a due to a reduction in personnel and related costs resulting from the Restructuring Plan completed in fiscal 2012. 26 -------------------------------------------------------------------------------- Depreciation and amortization expense for the distribution segment was $760,000 for the third quarter of fiscal 2013 compared to $771,000 for the second quarter of fiscal 2012. Operating Income (Loss) Net operating income for the distribution segment was $499,000 for the third quarter of fiscal 2013 compared to net operating loss of $14.0 million for the third quarter of fiscal 2012. Fiscal 2013 Nine Months Results Compared With Fiscal 2012 Nine Months Net Sales Net sales for the distribution segment decreased $18.7 million, or 5.2%, to $340.5 million for the first nine months of fiscal 2013 compared to $359.2 million for the first nine months of fiscal 2012. Consumer electronics and accessories net sales increased $24.2 million to $83.9 million during the first nine months of fiscal 2013 from $59.7 million for the same period last year due to the distribution of new products to existing and new customers. Net sales decreased $8.6 million in the software product group to $249.8 million for the first nine months of fiscal 2013 from $258.4 million for the same period last year primarily due to decreased demand for our software products. Video games net sales decreased $14.4 million to $6.8 million for the first nine months of fiscal 2013 from $21.1 million for the same period last year, due to fewer video game releases. Home video net sales decreased to zero for the first nine months of fiscal 2013 from $19.9 million for the first nine months of fiscal 2012, due to our transition out of home video exclusive content. We believe future net sales will be dependent upon our ability to continue to add new, appealing content and upon the strength of the retail environment and overall economic conditions. Gross Profit Gross profit for the distribution segment was $34.2 million, or 10.0% of net sales, for the first nine months of fiscal 2013 compared to $33.3 million, or 9.3% of net sales, for the first nine months of fiscal 2012. Fiscal 2012 includes restructure and impairment charges of $8.8 million. The decrease in gross profit is due to the decrease in sales volume and an increased mix of lower gross profit margin security and utility software products. We expect gross profit rates to fluctuate depending principally upon the make-up of products sold. Operating Expenses Total operating expenses for the distribution segment were $34.2 million, or 10.0% of net sales, for the first nine months of fiscal 2013 compared to $48.3 million, or 13.5% of net sales, for the same period of fiscal 2012. Fiscal 2012 includes $10.1 million of restructure and impairment charges. The remaining $4.0 million decrease is primarily due to operating efficiencies as a result of the Restructuring Plan completed in fiscal 2012 offset by $1.9 million of transaction and transition costs related to the acquisition of SpeedFC. Selling and marketing expenses for the distribution segment decreased $2.2 million to $12.9 million, or 3.8% of net sales, for the first nine months of fiscal 2013 compared to $15.1 million, or 4.2% of net sales, for the first nine months of fiscal 2012. Fiscal 2012 includes $300,000 of restructure and impairment charges. The remaining decrease was primarily due to a reduction in variable freight costs due to decreased net sales and efficiencies in addition to a reduction of personnel and related costs. Distribution and warehousing expenses for the distribution segment were $5.9 million, or 1.7% of net sales, for the first nine months of fiscal 2013 compared to $7.6 million, or 2.1% of net sales, for the same period of fiscal 2012. The $1.7 million decrease was primarily a result of a reduction in rent expense due to vacating a warehouse facility during fiscal 2012 in addition to a reduction of personnel and related costs. General and administrative expenses for the distribution segment consist principally of executive, accounting and administrative personnel and related expenses, including professional fees. General and administrative expenses for the distribution segment were $10.1 million, or 3.0% of net sales, for the first nine months of fiscal 2013 compared to $13.3 million, or 3.7% of net sales, for the first nine months of fiscal 2012. Fiscal 2012 includes $3.3 million of restructure and impairment charges. Further, expenses decreased in the first nine months of fiscal 2013 due to decreased compensation expense, offset by $1.9 million of transaction and transition costs related to the acquisition of SpeedFC. 27 -------------------------------------------------------------------------------- Information technology expenses for the distribution segment were $3.1 million, or 0.9% of net sales, for the first nine months of fiscal 2013 compared to $4.0 million, or 1.1% of net sales, for the first nine months of fiscal 2012, primarily a result of decreased personnel costs. Depreciation and amortization for the distribution segment was $2.2 million for the first nine months of fiscal 2013 and $2.3 million the first nine months of fiscal 2012. Operating (Loss) Income Net operating income for the distribution segment was $21,000 for the first nine months of fiscal 2013 compared to net operating loss of $15.0 million for the same period of fiscal 2012. E-commerce and Fulfillment Services SegmentThe e-commerce and fulfillment business provides web site development and hosting, customer care, e-commerce fulfillment and third party logistics services. Fiscal 2013 Third Quarter Results Compared To Fiscal 2012 Third Quarter Net Sales Net sales for the e-commerce and fulfillment services segment were $21.4 million for the third quarter of fiscal 2013 compared to $2.2 million for the third quarter of fiscal 2012. The $19.2 million, or 874.4% increase in net sales, was primarily due to organic growth of the existing e-commerce and fulfillment services business of $5.6 million and the acquisition of SpeedFC effective November 20, 2012, which generated net sales of $13.6 million during the third quarter of fiscal 2013. We believe sales results in the future will be dependent upon our ability to continue to win new client relationships and generate new opportunities in our client pipeline. Gross Profit Gross profit for the e-commerce and fulfillment services segment was $3.2 million, or 14.9% of net sales, for the third quarter of fiscal 2013 compared to $367,000, or 16.7% of net sales, for the third quarter of fiscal 2012. The increase in gross profit is a result of growth of service revenue volume and the contribution of SpeedFC for the quarter of $2.3 million. We expect gross profit rates to fluctuate depending principally upon the make-up of service revenue mix. Operating Expenses Total operating expenses for the e-commerce and fulfillment services segment increased to $1.2 million, or 5.7% of net sales, for the third quarter of fiscal 2013, compared to $544,000, or 41.4% of net sales, for the third quarter of fiscal 2012, all primarily related to the addition of SpeedFC in the quarter. Selling and marketing expenses for the e-commerce and fulfillment services segment were $395,000, or 1.8% of net sales, for the third quarter of fiscal 2013 compared to $290,000, or 22.1% of net sales, for the third quarter of fiscal 2012. General and administrative expenses for the e-commerce and fulfillment services segment consist principally of executive, accounting and administrative personnel and related expenses, including professional fees. General and administrative expenses for the e-commerce and fulfillment services segment were $271,000, or 1.3% of net sales, for the third quarter of fiscal 2013, compared to $254,000, or 19.3% of net sales, for the third quarter of fiscal 2012. 28 --------------------------------------------------------------------------------Information technology expenses for the e-commerce and fulfillment services segment were $565,000, or 2.6% of net sales, for the third quarter of fiscal 2013 compared to zero for the third quarter of fiscal 2012. Operating Income The e-commerce and fulfillment services segment had a net operating income of $2.0 million for the third quarter of fiscal 2013 compared to net operating loss of $177,000 for the third quarter of fiscal 2012. Fiscal 2013 Nine Months Results Compared With Fiscal 2012 Nine Months Net Sales Net sales for the e-commerce and fulfillment services segment were $33.2 million for the first nine months of fiscal 2013 compared to $4.9 million for the same period of fiscal 2012. The $28.3 million, or 576% increase in net sales, over the prior year nine months was primarily due to organic growth of the existing e-commerce and fulfillment services business of $14.7 million in addition to the acquisition of SpeedFC as of November 20, 2012 which contributed $13.6 million in net sales for the first nine months of fiscal 2013. We believe sales results in the future will be dependent upon our ability to continue to win new client relationships and generate new opportunities in our client pipeline. Gross Profit Gross profit for the e-commerce and fulfillment services segment was $4.8 million, or 14.5% of net sales, for the first nine months of fiscal 2013 compared to $256,000, or 5.2% of net sales, for the first nine months of fiscal 2012. We expect gross profit rates to fluctuate depending principally upon the make-up of services provided to the e-commerce and fulfillment services customers. Operating Expenses Total operating expenses increased $551,000 for the e-commerce and fulfillment services segment to $2.1 million for the first nine months of fiscal 2013 from $1.5 million for the first nine months of fiscal 2012, primarily as a result of the acquisition of SpeedFC. Selling and marketing expenses for the e-commerce and fulfillment services segment were $932,000, or 2.8% of net sales, for the first nine months of fiscal 2013 compared to $683,000, or 13.9% of net sales, for the first nine months of fiscal 2012. General and administrative expenses for the e-commerce and fulfillment services segment consist principally of executive, accounting and administrative personnel and related expenses, including professional fees. General and administrative expenses for the e-commerce and fulfillment services segment decreased to $602,000, or 1.8% of net sales, for the first nine months of fiscal 2013 compared to $863,000, or 17.6% of net sales, for the first nine months of fiscal 2012. The $261,000 decrease was primarily due to a decrease in personnel costs as a result of operating efficiencies offset by additional expenses incurred for the SpeedFC acquisition. Information technology expenses for the e-commerce and fulfillment services segment were $565,000, or 1.7% of net sales, for the first nine months of fiscal 2013 compared to zero for the first nine months of fiscal 2012. Operating Income The e-commerce and fulfillment services segment had net operating income of $2.7 million for the first nine months of fiscal 2013 compared to net operating loss of $1.3 million for the first nine months of fiscal 2012. Consolidated Other Income and Expense Interest income (expense), net was expense of $325,000 for the third quarter of fiscal 2013 compared to expense of $292,000 for the third quarter of fiscal 2012. Interest income (expense), net was expense of $586,000 for the first nine months of fiscal 2013 compared to expense of $873,000 for the same period of fiscal 2012. The decrease in interest expense for the first nine months of fiscal 2013 was a result of a reduction in borrowings. 29 -------------------------------------------------------------------------------- Other income (expense), net, which consists primarily of foreign exchange loss, for the three and nine months ended December 31, 2012 was expense of $503,000 and $602,000, respectively. Other income (expense), net, which consists of foreign exchange loss, for the three and nine months ended December 31, 2011 was expense of $171,000 and $501,000, respectively. Consolidated Income Tax Benefit We recorded income tax expense of $1.6 million for the third quarter of fiscal 2013 or an effective tax rate of 99.4% compared to income tax expense of $14.5 million or an effective tax rate of negative 98.9% for the third quarter of fiscal 2012. We recorded income tax expense for the first nine months of fiscal 2013 of $1.6 million or an effective tax rate of 104.7% compared to income tax expense of $13.2 million or an effective tax rate of negative 74.8% for the first nine months of fiscal 2012. We did not record a provision for or benefit from income taxes for our Canadian subsidiary because we have available net operating losses to offset future taxable income. For the nine months ended December 31, 2012, the effective tax rate differs from the federal tax rate of 34% primarily due to state taxes, unrecognized income tax benefits and costs related to the acquisition of SpeedFC, Inc. Deferred tax assets are evaluated by considering historical levels of income, estimates of future taxable income streams and the impact of tax planning strategies. A valuation allowance is recorded to reduce deferred tax assets when it is determined that it is more likely than not, based on the weight of available evidence, we would not be able to realize all or part of our deferred tax assets. An assessment is required of all available evidence, both positive and negative, to determine the amount of any required valuation allowance. As a result of the current market conditions and their impact on our future outlook, management has reviewed its deferred tax assets and concluded that the uncertainties related to the realization of some of its assets, have become unfavorable. As of both December 31, 2012 and March 31, 2012, we had a net deferred tax asset position before valuation allowance of $29.8 million and $38.9 million, respectively, which is composed of temporary differences, primarily related to net operating loss carryforwards, which will begin to expire in fiscal 2029. The Company also has foreign tax credit carryforwards which will begin to expire in 2016. We have considered the positive and negative evidence for the potential utilization of the net deferred tax asset and have concluded that it is more likely than not that we will not realize the full amount of net deferred tax assets. Accordingly, a valuation allowance of $19.4 million and $18.9 million has been recorded as of December 31, 2012 and March 31, 2012, respectively, including a full valuation allowance against our Canada net operating losses. We recognize interest accrued related to unrecognized income tax benefits ("UTB's") in the provision for income taxes. At March 31, 2012, interest accrued was approximately $190,000, which was net of federal and state tax benefits, and total UTB's net of federal and state income tax benefits that would impact the effective tax rate if recognized, were $518,000. During the nine months ended December 31, 2012, $89,000 of UTB's were reversed due to statute lapses, which was net of $51,000 of deferred federal and state income tax benefits. At December 31, 2012, interest accrued was $219,000 and total UTB's, net of deferred federal and state income tax benefits that would impact the effective tax rate if recognized, were $819,000. Consolidated Net Income (Loss) For the third quarter of fiscal 2013, we recorded net income of $10,000 compared to a net loss of $29.1 million for the same period last year. For the first nine months of fiscal 2013, we recorded a net loss of $73,000, compared to net loss of $31.0 million for the same period last year. Market Risk At December 31, 2012, we had $17.4 million outstanding indebtedness subject to interest rate fluctuations. A 100-basis point change in the current LIBOR rate would cause our projected annual interest expense, based on current borrowed amounts, to change by approximately $174,000. The fluctuation in our debt service requirements, in addition to interest rate changes, may be impacted by future borrowings under our credit facility or other alternative financing arrangements. 30 -------------------------------------------------------------------------------- Our sales to customers in Canada are increasing. The majority of the sales and purchasing activity related to these customers results in receivables and accounts payables denominated in Canadian dollars. When these transactions are translated into U.S. dollars at the exchange rate in effect at the time of each transaction, gain or loss is recognized. These gains and/or losses are reported as a separate component within other income and expense. During the three and nine months ended December 31, 2012 we had foreign exchange transaction loss of $388,000 and $493,000, respectively and foreign exchange transaction loss of $172,000 and $501,000, respectively, for the three and nine months ended December 31, 2011. Additionally, our balance sheet pertaining to these foreign operations is translated into U.S. dollars at the exchange rate in effect on the last day of each month. The net unrealized balance sheet translation gains and/or losses are excluded from income and are reported as accumulated other comprehensive income or loss. At December 31, 2012 we had accumulated other comprehensive gain related to foreign translation of $150,000 compared to a loss of $9,000 at March 31, 2012. Though changes in the exchange rate are out of our control, we periodically monitor our Canadian activities and attempt to reduce exposure from exchange rate fluctuations by limiting these activities or taking other actions, such as exchange rate hedging. At this time, we do not engage in any hedging transactions to mitigate foreign currency effects, but we continually monitor our activities and evaluate such opportunities periodically. Seasonality and Inflation Quarterly operating results are affected by the seasonality of our business. Specifically, our third quarter (October 1-December 31) typically accounts for our largest quarterly revenue figures and a substantial portion of our earnings. As a supplier of products ultimately sold to retailers, our business is affected by the pattern of seasonality common to other suppliers of retailers, particularly during the holiday selling season. Poor economic or weather conditions during this period could negatively affect our operating results. Inflation is not expected to have a significant impact on our business, financial condition or results of operations since we can generally offset the impact of inflation through a combination of productivity gains and price increases. Liquidity and Capital Resources Cash Flow Analysis Operating Activities Cash used in operating activities for the first nine months of fiscal 2013 was $6.8 million compared to $9.3 million for the same period last year. The net cash used in operating activities for the first nine months of fiscal 2013 mainly reflected our various non-cash charges, including depreciation and amortization of $3.7 million, share-based compensation of $705,000, a decrease in deferred income taxes of $412,000, offset by our working capital demands. The following are changes in the operating assets and liabilities during the first nine months of fiscal 2013: accounts receivable increased $63.9 million, resulting from the timing of sales and the addition of SpeedFC receivables; inventories increased $10.1 million, primarily reflecting additional inventory related to our growing consumer electronics and accessories product line; prepaid expenses decreased $795,000, primarily resulting from the timing of payments; accounts payable increased $61.9 million, primarily as a result of timing of payments and purchases and the addition of SpeedFC payables; and accrued expenses increased $896,000, net of various accrual payments. The net cash used in operating activities for the first nine months of fiscal 2012 mainly reflected our net loss, combined with various non-cash charges, including the reversal of the first anniversary Punch! contingent payment accrual of $526,000 which was unearned, depreciation and amortization of $2.8 million, amortization of debt acquisition costs of $448,000, amortization of software development costs of $1.9 million, share-based compensation of $933,000, goodwill and intangibles impairment of $6.0 million, a decrease in deferred income taxes of $13.4 million, offset by our working capital demands. The following are changes in the operating assets and liabilities during the first nine months of fiscal 2012: accounts receivable increased $34.4 million, resulting from the timing of sales, net of decreased sales during the quarter; inventories increased $8.0 million, primarily reflecting additional inventory related to our growing consumer electronics and accessories product line; prepaid expenses decreased $5.9 million, primarily resulting from the write-down of prepaid expenses and recoupment of prepaid royalties; income taxes receivable increased $20,000, primarily due to the timing of required tax payments and tax refunds; accounts payable increased $33.8 million, primarily as a result of timing of payments and purchases; income taxes payable decreased $37,000 primarily due to the timing of required tax payments and tax refunds; and accrued expenses decreased $661,000, net of various accrual payments and a decrease in accrued wages due to timing of pay periods. 31 --------------------------------------------------------------------------------Investing Activities Cash flows used in investing activities totaled $26.2 million for the first nine months of fiscal 2013 and cash flows provided by investing activities totaled $20.0 million for the same period last year. The Company used $24.5 million in cash for the acquisition of SpeedFC in the first nine months of fiscal 2013. The Company made investments in software development of $102,000 and $905,000 for the first nine months of fiscal 2013 and 2012, respectively. The purchases of property and equipment totaled $1.6 million and $593,000 in the first nine months of fiscal 2013 and 2012, respectively. Purchases of property and equipment in fiscal 2013 and 2012 consisted primarily of computer equipment. Proceeds from the sale of discontinued operations totaled $22.5 million and payment of the note payable - acquisition totaled $1.0 million, both in the first nine months of fiscal 2012. Financing Activities Cash flows provided financing activities totaled $27.4 million for the first nine months of fiscal 2013 and cash flows used in financing activities totaled $8.8 million for the first nine months of fiscal 2012. For the first nine months of fiscal 2013, we had proceeds from and repayments of the revolving line of credit of $133.1 million and $115.7 million, respectively. Checks written in excess of cash balances increased $10.8 million for the first nine months of fiscal 2013. Proceeds from the sale of discontinued operations totaled $22.5 million and payment of the note payable - acquisition totaled $1.0 million, both in the first nine months of fiscal 2012. For the first nine months of fiscal 2012, we had proceeds from and repayments of the revolving line of credit of $34.9 million and a decrease in checks written in excess of cash balances of $8.8 million. Capital Resources On November 12, 2009, we entered into a three year, $65.0 million revolving credit facility (the "Credit Facility") with Wells Fargo Foothill, LLC as agent and lender, and a participating lender. On December 29, 2011, the Credit Facility was amended to eliminate the participating lender, reduce the revolving credit facility limit to $50.0 million, provide for an additional $20.0 million under the Credit Facility under certain circumstances and extend the maturity date to December 29, 2016. On November 20, 2012, the Credit Facility was amended to provide for the acquisition of SpeedFC, eliminate the additional $20.0 million available under the Credit Facility and extend the maturity date to November 20, 2017. The Credit Facility is secured by a first priority security interest in all of our assets, as well as the capital stock of our companies. Additionally, the Credit Facility, as amended, calls for monthly interest payments at the bank's base rate (as defined in the Credit Facility) plus 1.75%, or LIBOR plus 2.75%, at our discretion. Amounts available under the Credit Facility are subject to a borrowing base formula. Changes in the assets within the borrowing base formula can impact the amount of availability. At December 31, 2012, we had $17.4 million outstanding on the Credit Facility and based on the facility's borrowing base and other requirements, we had excess availability of $26.4 million. 32 -------------------------------------------------------------------------------- In association with, and per the terms of the Credit Facility, we also pay and have paid certain facility and agent fees. Weighted-average interest on the Credit Facility was 5.38% and 4.25% at December 31, 2012 and March 31, 2012, respectively. Such interest amounts have been and continue to be payable monthly. Under the Credit Facility we are required to meet certain financial and non-financial covenants. The financial covenants include a variety of financial metrics that are used to determine our overall financial stability and include limitations on our capital expenditures, a minimum ratio of adjusted EBITDA to fixed charges and a minimum borrowing base availability requirement. At December 31, 2012, we were in compliance with all covenants under the Credit Facility. We currently believe we will be in compliance with the Credit Facility covenants over the next twelve months. Liquidity We finance our operations through cash and cash equivalents, funds generated through operations, accounts payable and our revolving credit facility. The timing of cash collections and payments to vendors can require the usage of our revolving credit facility in order to fund our working capital needs. "Checks written in excess of cash balances" may occur from time to time, including period ends, and represent payments made to vendors that have not yet been presented by the vendor to our bank, and therefore a corresponding advance on our revolving line of credit has not yet occurred. On a terms basis, we extend varying levels of credit to our customers and receive varying levels of credit from our vendors. During the last twelve months, we have not had any significant changes in the terms extended to customers or provided by vendors which would have a material impact on the reported financial statements. We continually monitor our actual and forecasted cash flows, our liquidity and our capital resources. We plan for potential fluctuations in accounts receivable, inventory and payment of obligations to creditors and unbudgeted business activities that may arise during the year as a result of changing business conditions or new opportunities. In addition to working capital needs for the general and administrative costs of our ongoing operations, we have cash requirements for among other things: (1) investments in inventory related to consumer electronics and accessories and other growth product lines; (2) investments to license content and develop software for established products; (3) legal disputes and contingencies (4) payments related to restructuring activities (5) equipment and facility needs for our operations; and (6) asset or company acquisitions. During the first nine months of fiscal 2013, we invested approximately $1.9 million, before recoveries, in connection with the acquisition of licensed and exclusively distributed product in our publishing and distribution segments. At December 31, 2012, we had $17.3 million outstanding on our $50.0 million Credit Facility. Our Credit Facility is available for working capital and general corporate needs and amounts available are subject to a borrowing base formula. Changes in the assets within the borrowing base formula can impact the amount of availability. At December 31, 2012, based on the facility's borrowing base and other requirements at such dates, we had excess availability of $26.4 million. At December 31, 2012, we were in compliance with all covenants under the Credit Facility and currently believe we will be in compliance with all covenants throughout the next twelve months. We currently believe cash and cash equivalents, funds generated from the expected results of operations, funds available under our Credit Facility and vendor terms will be sufficient to satisfy our working capital requirements, other cash needs, costs of restructuring and to finance expansion plans and strategic initiatives for at least the next twelve months. Additionally, with respect to long-term liquidity, we filed a Registration Statement on Form S-3 on October 22, 2012 to renew our shelf registration statement covering the offer and sale of up to $20.0 million of common and/or preferred shares, which registration statement was declared effective on February 4, 2013. Any further growth through acquisitions would likely require the use of additional equity or debt capital, some combination thereof, or other financing. 33 --------------------------------------------------------------------------------Contractual Obligations The following table presents information regarding contractual obligations that exist as of December 31, 2012 by fiscal year (in thousands): Less than 1 1-3 3-5 More than 5 Total Year Years Years Years Operating leases $ 44,143 $ 3,634 $ 8,077 $ 8,940 $ 23,492 Capital leases 129 53 64 12 - License and distribution agreements 2,407 2,047 360 - - Total $ 46,679 $ 5,734 $ 8,501 $ 8,952 $ 23,492 ________ We have excluded liabilities resulting from uncertain tax positions of $1.5 million from the table above because we are unable to make a reasonably reliable estimate of the period of cash settlement with the respective taxing authorities. Additionally, interest payments related to the Credit Facility have been excluded as future interest rates are uncertain. |