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SED INTERNATIONAL HOLDINGS INC - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) Overview SED International Holdings, Inc. ("SED") distributes microcomputer, consumer electronic and small appliance products in the United States, Latin America and the Caribbean. SED purchases more than 17,000 products from approximately 200 vendors (directly and indirectly), including such technology market leaders as Acer, Asus, Dell, Epson, Hewlett-Packard, Kingston, Lenovo, Lexmark, Microsoft, Seagate and Western Digital; consumer electronics manufacturers such as Canon, Coby, Haier, Panasonic, Samsung, Sansui, and VuPoint; and an extensive housewares offering, including Black & Decker, Brother, Hamilton Beach / Proctor Silex, Lasko, Norelco, Philips and Vornado. SED's vendors generally warrant the products distributed by SED and allow the return of defective products. SED sells its products through a dedicated sales force and robust website to reseller customers in retail, e-commerce, VAR, system builder, OEM, custom install and various other reseller channels. SED also offers custom-tailored supply chain management services ideally suited to meet the priorities and distribution requirements of the e-commerce, Business-to-Business and Business-to-Consumer markets. SED distributes its products in the United States, Latin America and the Caribbean region from its strategically located warehouses in Lawrenceville, Georgia; Miami, Florida; Keasbey, New Jersey; City of Industry, California; and Plano, Texas. SED services its customers in Latin America through its wholly-owned subsidiaries SED International de Colombia S.A.S. in Bogotá, Colombia and Intermaco S.R.L. in Buenos Aires, Argentina and from its warehouse in Miami, Florida. SED and its wholly-owned subsidiary, SED International, Inc. ("SED International") are incorporated in Georgia. As hereinafter used in this document the terms "SED," "Company," "we," "our" or "us" refer collectively to SED and its wholly-owned subsidiaries. The following discussion should be read in conjunction with the condensed consolidated financial statements of SED and the notes thereto included in this quarterly report. Historical operating results are not necessarily indicative of trends in operating results for any future period. Results of Operations The following table sets forth, for the periods indicated, the amounts and percentage of net sales of certain line items from SED's condensed consolidated statements of operations (dollar amounts in thousands): Three Months Ended December 31, 2012 2011 $ % $ % $ % Change Change Net sales 156,340 100.00 % 150,925 100.00 % 5,415 3.6 % Cost of sales 148,358 94.89 % 137,287 90.96 % 11,071 8.1 % Gross profit 7,982 5.11 % 13,638 9.04 % (5,656 ) (41.5 )% Operating expenses: Selling, general and administrative 8,139 5.21 % 8,894 5.89 % (755 ) (8.5 )% Depreciation and amortization 227 .15 % 187 .12 % 40 21.4 % Foreign currencytransaction (gain) loss (121 ) (.08 )% 282 .19 % (403 ) (142.9 )% Restructuring-related costs 825 .53 % 0 0 % 825 100.0 % Total operating expenses 9,070 5.81 % 9,363 6.20 % (293 ) (3.1 )% Operating income (loss) (1,088 ) (.70 )% 4,275 2.84 % (5,363 ) (125.5 )% Interest expense, net 266 .17 % 388 .26 % (122 ) (31.4 )% Income (loss) before income taxes (1,354 ) (.87 )% 3,887 2.58 % (5,241 ) (134.8 )% Provision for income tax expense 248 .16 % 121 .08 % 127 105.0 % Net income (loss) (1,602 ) (1.03 )% 3,766 2.50 % (5,368 ) (142.5 )% 11 Six Months Ended December 31, 2012 2011 $ % $ % $ % Change Change Net sales 282,705 100.00 % 306,764 100.00 % (24,059 ) (7.8 )% Cost of sales 267,712 94.70 % 285,607 93.10 % (17,895 ) (6.3 )% Gross profit 14,993 5.30 % 21,157 6.90 % (6,164 ) (29.1 )% Operating expenses: Selling, general and administrative 16,104 5.70 % 16,809 5.48 % (705 ) (4.2 )% Depreciation and amortization 444 .16 % 312 .10 % 132 42.3 % Foreign currency transaction loss 8 0 % 933 .31 % (925 ) (99.1 )%Restructuring-related costs 1,144 .40 % 0 0 % 1,144 100.0 % Acquisition-related costs 0 0 % 370 .12 % (370 ) (100.0 )% Total operating expenses 17,700 6.26 % 18,424 6.01 % (724 ) (3.9 )% Operating income (loss) (2,707 ) (.96 )% 2,733 .89 % (5,440 ) (199.1 )% Interest expense, net 550 .19 % 684 .22 % (134 ) (19.6 )% Gain on acquisition 0 0 % (998 ) (.33 )% 998 (100.0 )% Income (loss) before income taxes (3,257 ) (1.15 )% 3,047 1.00 % (6,304 ) (206.9 )% Provision for income tax expense 449 .16 % 111 .04 % 338 304.5 % Net income (loss) (3,706 ) (1.31 )% 2,936 .96 % (6,642 ) (226.2 )% The following table sets forth, for the periods indicated, the amounts of U.S. Generally Accepted Accounting Principles ("GAAP") net income (loss) and Earnings per Share as compared to non-GAAP net income (loss), Earnings per Share, and Adjusted EBITDA (dollar amounts in thousands): Three Months Ended Six Months Ended December 31 December 31 2012 2011 2012 2011 Reconciliation of GAAP net income (loss) and EPS to Non-GAAP measures: GAAP net income (loss) $ (1,602 ) $ 3,766 $ (3,706 ) $ 2,936 Stock-based compensation (2) 39 114 119 229 Restructuring related costs (3) 825 0 1,144 0 Acquisition related costs (4) 0 0 0 370 Non-GAAP normalized adjusted net income (loss) $ (738 ) $ 3,880 $ (2,443 ) $ 3,535 GAAP net income (loss) per diluted common share: Basic income (loss) per common share $ (0.32 ) $ 0.79 $ (0.74 ) $ 0.61 Diluted income (loss) per common share $ (0.32 ) $ 0.78 $ (0.74 ) $ 0.60 Non-GAAP normalized net income (loss) per common share: Normalized basic income (loss) per common share $ (0.15 ) $ 0.81 $ (0.49 ) $ 0.73 Normalized diluted income (loss) per common share $ (0.15 ) $ 0.80 $ (0.49 ) $ 0.72 Weighted average number of common shares outstanding: Basic 5,010,000 4,779,000 4,979,000 4,815,000 Diluted 5,010,000 4,826,000 4,979,000 4,884,000 12 Reconciliation of GAAP net income (loss) to adjusted EBITDA is as follows: GAAP net income $ (1,602 ) $ 3,766 $ (3,706 ) $ 2,936 Depreciation and amortization 227 187 444 312 Stock-based compensation (2) 39 114 119 229Restructuring related costs (3) 825 0 1,144 0 Interest expense, net 266 388 550 684 Provision for income tax expense 248 121 449 111 Gain on acquisition (5) 0 0 0 (998 ) Non-GAAP adjusted EBITDA $ 3 $ 4,576 $ (1,000 ) $ 3,274 (1) This presentation includes non-GAAP measures. Our non-GAAP measures are not meant to be considered as a substitute for comparable GAAP measures and should be read only in conjunction with our financial statements prepared in accordance with GAAP. (2) Stock-based compensation related to non-cash charges for stock awards. (3) Restructuring costs associated with severances, consulting, and other costs associated with the reorganization of the management team and departmental structure. (4) Acquisition related costs were incurred as part of the purchase of the Lehrhoff assets. (5) Gain on the acquisition of the Lehrhoff assets recorded as a bargain purchase under ASC 805. These non-GAAP financial measures, including "Normalized Adjusted Net Income", "Adjusted EBITDA" (Earnings Before Interest, Tax, Depreciation and Amortization), and "Normalized EPS" (Earnings Per Share) are used by management as key operating metrics for measuring operational performance. These non-GAAP terms, as defined by the Company, may not be comparable to similarly titled measures used by other companies. Normalized Net Income, Adjusted EBITDA, and Normalized EPS are not measures of financial performance under generally accepted accounting principles. The Company believes that items excluded from Normalized Net Income, Adjusted EBITDA, and Normalized EPS are significant components in understanding and assessing financial performance. These non-GAAP measures should not be considered in isolation or as a substitute for net earnings, operating income and other consolidated earnings data prepared in accordance with GAAP or as a measure of our profitability. These non-GAAP measures are not intended to replace any presentation included in our consolidated financial statements under GAAP and should not be considered an alternative to operating performance or an alternative to cash flow as a measure of liquidity. Three Months Ended December 31, 2012 and 2011 Net sales. Net sales for the three months ended December 31, 2012 were $156.3 million, an increase of $5.4 million, or 3.6%, compared with $150.9 million for the three months ended December 31, 2011. Net sales increased from our previous quarter in Fiscal 2013 by 23.7%, or $29.9 million, compared to $126.4 million for the three months ended September 30, 2012. Net sales for the current quarter were driven by increased demand in the consumer product categories which include tablets, notebooks, and television products. Comparative revenues by SED geography are summarized below (dollar amounts in thousands): Three Months Ended December 31, Change 2012 2011 Amount Percent United States: Domestic $ 100,270 $ 97,448 $ 2,822 2.9 % Export 21,553 19,922 1,631 8.2 % Total U.S. 121,823 117,370 4,453 3.8 % Latin America 34,517 33,555 962 2.9 % Consolidated $ 156,340 $ 150,925 $ 5,415 3.6 % Domestic revenues were $100.3 million for the three months ended December 31, 2012, a 2.9% increase, compared with $97.4 million for the same period in 2011. The net increase in domestic revenue is attributable to unit sale increases in our e-commerce customer base during the period. Export revenues were $21.6 million and $20 million for the three months ended December 31, 2012 and 2011, respectively, representing an increase of 8.2%. Latin America sales were $34.5 million and $33.6 million for the three months ended December 31, 2012 and 2011, respectively, an increase of 2.9%. The Latin America sales were unchanged once adjusted for currency fluctuations. 13 Microcomputer product sales were $135.8 million for the three months ended December 31, 2012, an increase of 8% over similar product sales of $125.7 million reported for the same period in 2011. The increase in the microcomputer product sales were primarily attributable to increased demand in our tablets, notebooks, hard drives, and software product categories. Part of the increase in microcomputer product sales were attributable to the launch of Windows 8 which drove demand in new software as well as Windows 7 and Windows 8 systems. Sales of microcomputer products represented approximately 86.9% of SED's second quarter net sales compared to 83.3% for the comparable period in 2011. Consumer electronics sales, all of which were in the U.S., for the three months ended December 31, 2012 were $11.7 million, a decrease of 28.2%, compared to $16.3 million for the comparable period in 2011. Sales of consumer electronics products accounted for approximately 7.5% of SED's second quarter net sales compared to 10.8% for the comparable period in 2011. This decrease was from a decline in the sales of televisions predominantly caused by both price drops and fewer units sold as industry demand for this product category decreases. Small appliance and housewares sales, all of which were in the U.S., for the three months ended December 31, 2012 were $8.8 million, a decrease of 1.1%, compared to $8.9 million in the same period in 2011. The sales in small appliances are primarily related to the product categories acquired from ArchBrook Laguna LLC ("ABL"). Sales of small appliances and housewares accounted for approximately 5.6% of net sales for the second quarter compared to 5.9% for the comparable period in 2011. Gross Profit Margins. Gross profit for the three months ended December 31, 2012 was $8.0 million, a decrease of $5.6 million, or 41.5%, compared with $13.6 million for the same period in 2011. Gross profit was lower in the current quarter compared to the same period in 2011 due to the higher than normal sales prices on hard drives a year ago. The higher sales prices last year were driven by supply constraints resulting from interrupted production of hard drives in flooded areas in Thailand. SED continues to monitor and add product lines which will improve SED's overall margin percentages. Margins in our small appliance and housewares product lines as well as SED's foreign subsidiaries continue to have a positive impact. Argentine government import restrictions continue to constrain inventory supply which has had a positive impact on product margins. Selling, General and Administrative Expenses. Selling, general and administrative expenses were $8.1 million for the three months ended December 31, 2012, a decrease of 8.5% compared with $8.9 million for the same period in 2011. The decrease is attributable to personnel related reductions and other operating expense controls. Depreciation and Amortization. Depreciation and amortization was $0.2 million for the three months ended December 31, 2012 and 2011. Capital expenditures during the quarter were associated with the move of SED's distribution center located in the City of Industry, California. Foreign Currency Transaction. SED has U.S. dollar denominated liabilities recorded in its subsidiaries in Argentina and Colombia to meet certain vendor payment requirements. The revaluation/devaluation of the peso in Colombia and Argentina versus the U.S. dollar resulted in a net foreign currency transaction income totaling $0.1 million for the three months ended December 31, 2012 as compared to expense of $0.3 million for the same period in 2011. Restructuring-related costs. SED recognized restructuring costs of approximately $0.8 million during the three months ended December 31, 2012. The costs were attributable to organizational restructuring of the management team including severance payments, change in organizational alignment of sales, product and marketing, and information technology outsourcing. These initiatives implemented during the current quarter are expected to benefit future periods. Operating Loss. For the three months ended December 31, 2012, SED reported operating loss of $1.1 million compared with operating income of $4.3 million for the comparable period in 2011. The change in operating income from the prior year period was due to the current quarter restructuring costs of approximately $0.8 million and the higher than normal margins on hard drives recorded inthe prior year period. Interest Expense. Interest expense, net of interest income, was $0.3 million for the three months ended December 31, 2012, compared to $0.4 million for thesame period a year ago. Provision for Income Taxes. Income tax expense was $0.2 million for the three months ended December 31, 2012, compared to $0.1 million for the same period last year. The provision is primarily attributed to income generated by SED's Latin American subsidiaries as SED in the U.S. has the benefit of a tax loss carryforward for Federal and all but two state tax jurisdictions. 14 The provision for income taxes differs from the amount which would result from applying the statutory Federal income tax rate due to: (a) taxes imposed on the foreign subsidiaries and (b) the anticipated changes in the valuation allowance for the year. At December 31, 2012, SED has a total net operating loss carry forward for Federal tax purposes of approximately $62.2 million and for state tax purposes of approximately $52.5 million, expiring at various dates through 2029. SED has recorded valuation allowances principally for all deferred tax assets, except for those relating to Intermaco S.R.L. (Intermaco) and SED International de Colombia S.A.S. (SED Colombia), as at this time it is not considered more likely than not that these assets will be realized. SED continues to monitor this assertion quarterly. Net Loss. SED's net loss for the three months ended December 31, 2012 was $1.6 million compared with a net income of $3.8 million in the same period last year. The net loss in the three months ended December 31, 2012, included restructuring related costs of approximately $0.8 million. The net income for the three months ended December 31, 2011 was primarily attributable to higher margins generated from the sale of hard drives due to inventory constraints from the suppliers in Thailand. Normalized Non-GAAP Net Loss. SED recognized a normalized non-GAAP net loss of $0.7 million for the three months ended December 31, 2012, compared to a normalized non-GAAP net income of $3.9 million for the same period last year. The primary adjustment in calculating normalized net loss is attributable to the restructuring related costs as mentioned above. These costs were related to the organizational restructuring of the management team including severance payments, change in organizational alignment of sales, product and marketing, and information technology outsourcing. These initiatives implemented during the current quarter are expected to benefit future periods. Six Months Ended December 31, 2012 and 2011 Net sales. Net sales for the six months ended December 31, 2012 were $282.7 million, a decrease of $24.1 million, or 7.8%, compared with $306.8 million for the six months ended December 31, 2011. Comparative revenues by SED geography are summarized below (dollar amounts in thousands): Six Months Ended December 31, Change 2012 2011 Amount Percent United States: Domestic $ 176,022 $ 192,148 $ (16,126 ) (8.4 )% Export 41,557 46,610 (5,053 ) (10.8 )% Total U.S. 217,579 238,758 (21,179 ) (8.9 )% Latin America 65,126 68,006 (2,880 ) (4.2 )% Consolidated $ 282,705 $ 306,764 $ (24,059 ) (7.8 )% Domestic revenues were $176 million for the six months ended December 31, 2012, an 8.4% decrease, compared with $192.1 million for the same period in 2011. The net decrease in domestic revenue is attributable to unit sale decreases in hard drives, PCs, notebooks, servers, and televisions which reflect similar declines within the microcomputer industry. Export revenues were $41.6 million and $46.6 million for the six months ended December 31, 2012 and 2011, respectively, a 10.8% decrease. Latin America sales were $65.1 million and $68 million for the six months ended December 31, 2012 and 2011, respectively, a decrease of 4.2% due to supply shortages in Argentina caused by Argentine government restrictions and less demand in Colombia. The Latin America sales decrease was 4.8% currency adjusted. Microcomputer product sales were $244.9 million for the six months ended December 31, 2012, a decrease of 7.9%, over similar product sales of $265.9 million reported for the same period in 2011. The decreases in the microcomputer product sales were primarily attributable to lower sales in the notebook, hard drives, and software product categories. Sales of microcomputer products represented approximately 86.7% of SED's net sales for the six months ended December 31, 2012 and 2011. Consumer electronics sales, all of which were in the U.S., for the six months ended December 31, 2012 were $21.9 million, a decrease of 28.2%, compared to $30.5 million for the comparable period in 2011. Sales of consumer electronics products accounted for approximately 7.7% of SED's net sales for the six months ended December 31, 2012, compared to 9.9% for the comparable period in 2011. This decrease was from a decline in the sales of televisions predominantly caused by price declines and less units sold. Small appliance and housewares sales, all of which were in the U.S., for the six months ended December 31, 2012 were $15.9 million, an increase of 52.9%, compared to $10.4 million in the same period in 2011. The increase was primarily due to the additional Lehrhoff product categories acquired from ABL. Sales of small appliances and housewares accounted for approximately 5.6% of net sales for the six months ended December 31, 2012, compared to 3.4% for the comparable period in 2011. 15 Gross Profit Margins. Gross profit for the six months ended December 31, 2012 was $15.0 million, a decrease of $6.2 million, or 29.1%, compared with $21.2 million for the same period in 2011. Gross profit was lower in the current quarter compared to margins a year ago due to a higher than normal sales prices on hard drives. The higher margins last year were driven by supply constraints resulting from interrupted production of hard drives in flooded areas in Thailand. SED continues to monitor and add product lines which will improve SED's overall margin percentages. Margins in our small appliance and housewares product lines as well as SED's foreign subsidiaries continue to have a positive impact. Argentine government import restrictions continue to constrain inventory supply which drives up the prices of product. Selling, General and Administrative Expenses. Selling, general and administrative expenses were $16.1 million for the six months ended December 31, 2012, a decrease of 4.2% compared with $16.8 million for the same period in 2011. Certain initiatives such as IT outsourcing, labor reductions, and operating efficiencies implemented during the six months ended December 31,2012 will benefit future periods. Depreciation and Amortization. Depreciation and amortization was $0.4 million for the six months ended December 31, 2012, compared to $0.3 million for the same period in 2011. The increase in depreciation is attributable to SED's distribution center moves in Georgia, New Jersey, and California. Foreign Currency Transaction. SED has U.S. dollar denominated liabilities recorded in its subsidiaries in Argentina and Colombia to meet certain vendor payment requirements. The revaluation/devaluation of the peso in Colombia and Argentina versus the U.S. dollar resulted in a net foreign currency transaction expense totaling $8,000 for the six months ended December 31, 2012 as compared to expense of $1.0 million for the same period in 2011. Restructuring-related costs. SED recognized restructuring costs of approximately $1.1 million during the six months ended December 31, 2012. The costs were attributable organizational restructuring of the management team including severance payments, change in the organizational alignment of sales, product and marketing, and informational technology outsourcing. The initiatives implemented during the six months ended December 31, 2012 is expected to benefit future periods. Acquisition-related cost. There were no acquisition costs in the six months ended December 31, 2012. Acquisition-related expenses associated with the acquisition of the Lehrhoff assets from ABL (the "Lehrhoff Assets") for the six months ended December 31, 2011 were approximately $0.4 million and consisted primarily of professional and legal fees associated with the transaction. Operating Loss. For the six months ended December 31, 2012, SED reported operating loss of $2.7 million compared with operating income of $2.7 million for the comparable period in 2011. The loss reported during the current quarter is partially attributable to the restructuring severance expense recognized during the quarter. SED continues to focus on increasing sales while reducing recurring operating expenses. Gain from Acquisition. There was no gain from acquisition in the six months ended December 31, 2012. During the three months ended September 30, 2011, we acquired certain items including finished goods inventories, customer and supplier lists, and intellectual property of Lehrhoff. For fiscal 2012, the estimated fair value of the acquired assets of $5.4 million exceeded the $4.1 million cash consideration paid resulting in a bargain purchase gain of $1.3 million of which $1 million was recognized for the six months ended December 31, 2011. Interest Expense. Interest expense, net of interest income, was $0.6 million for the six months ended December 31, 2012, compared to $0.7 million for the same period a year ago. Provision for Income Taxes. Income tax expense was $0.4 million for the six months ended December 31, 2012, compared to income tax expense of $0.1 million for the same period last year. The provision is primarily attributed to income generated by SED's Latin American subsidiaries as SED in the U.S. has the benefit of a tax loss carryforward for Federal and all but two state tax jurisdictions. The provision for income taxes differs from the amount which would result from applying the statutory Federal income tax rate due to: (a) taxes imposed on the foreign subsidiaries and (b) the anticipated changes in the valuation allowance for the year. At December 31, 2012, SED has a total net operating loss carry forward for Federal tax purposes of approximately $62.2 million and for state tax purposes of approximately $52.5 million, expiring at various dates through 2029. SED has recorded valuation allowances principally for all deferred tax assets, except for those relating to Intermaco S.R.L. (Intermaco) and SED International de Colombia S.A.S. (SED Colombia), as at this time it is not considered more likely than not that these assets will be realized. SED continues to monitor this assertion quarterly. 16 Net Loss. SED's net loss for the six months ended December 31, 2012 was $3.7 million, compared with a net income of $2.9 million in the same period last year. The net loss in the six months ended December 31, 2012, included restructuring related costs of approximately $1.1 million. The net income for the six months ended December 31, 2011 was primarily attributable to higher margins generated from the sales of hard drives due to inventory constraints from the suppliers in Thailand. Normalized Non-GAAP Net Loss. SED recognized a normalized non-GAAP net loss of $2.4 million for the six months ended December 31, 2012, compared to a normalized non-GAAP net income of $3.5 million for the same period last year. The primary adjustment in calculating normalized net loss is attributable to the restructuring related costs as mentioned above. These costs were related to the organizational restructuring of the management team including severance payments, change in organizational alignment of sales, product and marketing, and information technology outsourcing. These initiatives implemented during the current quarter are expected to benefit future periods. Critical Accounting Policies and Estimates Allowance for Doubtful Accounts. An allowance for doubtful accounts has been established based on collection experience and an assessment of the collectability of specific accounts. Management evaluates the collectability of accounts receivable based on a combination of factors. Initially, management estimates an allowance for doubtful accounts as a percentage of accounts receivable based on historical collections experience. This initial estimate is periodically adjusted when management becomes aware of a specific customer's inability to meet its financial obligations (e.g., bankruptcy filing) or as a result of changes in the overall aging of accounts receivable. The overall determination of the allowance also considers credit insurance coverage and deductibles, which SED has maintained from time to time. SED maintains credit insurance, which protects the Company from credit losses exceeding certain deductibles for certain domestic sales and certain export shipments from the United States. SED maintains credit insurance in many Latin American countries (subject to certain terms and conditions). Inventories - Slow Moving, Obsolescence, and Lower of Cost or Market. Certain SED vendors allow for either return of goods within a specified period (usually 45-90 days) or for credits related to price protection. However, for other vendor relationships and inventories, SED is not protected by vendors from the risk of inventory loss. Therefore, in determining the net realizable value of inventories, the Company identifies slow moving or obsolete inventories that (1) are not protected by vendor agreements from risk of loss, and (2) are not eligible for return under various vendor return programs. Based upon these factors, the Company estimates the net realizable value of inventories and records any necessary adjustments as a charge to cost of sales. If inventory return privileges were discontinued in the future, or if vendors were unable to honor the provisions of certain contracts, which protect SED from inventory losses, including price protections, the risk of loss associated with obsolete, slow moving or impaired inventories would increase. Revenue Recognition. Revenue is recognized once four criteria are met: (1) SED must have persuasive evidence that an arrangement exists; (2) delivery must occur, which generally happens at the point of shipment (this includes the transfer of both title and risk of loss, provided that no significant obligations remain which is usually the case); (3) the price must be fixed or determinable; and (4) collectability must be reasonably assured. Shipping revenue is included in net sales while the related costs, including shipping and handling costs, are included in the cost of sales. SED allows its customers to return product for exchange or credit subject to certain limitations. A provision for such returns is recorded based upon historical experience. Financial Instruments. SED's principal financial instruments consist of cash and cash equivalents, accounts receivable, accounts payable and revolving credit facilities. The carrying value of these financial instruments approximate fair value based upon the short-term nature of the instruments, and the variable rates on credit facilities. The functional currency for SED's international subsidiaries is the local currency of the country in which the subsidiaries own their primary assets. The translation of the applicable currencies into U.S. dollars is performed for balance sheet accounts using exchange rates in effect at the balance sheet date and for revenue and expense accounts using a weighted average exchange rate during the period. Any related translation adjustments are recorded directly to stockholders' equity as a component of accumulated other comprehensive income (loss). It is SED's policy not to enter into derivative contracts for speculative trading purposes. SED conducts business in countries outside of the United States, which exposes SED to fluctuations in foreign currency exchange rates. SED may enter into short-term forward exchange or option contracts to reduce this risk. At December 31, 2012, SED held approximately $9.0 million of short-term forward exchange contracts, which mature over the next quarter. The fair value of these contracts is recorded in accrued and other current liabilities. SED's revolving credit facility is currently a variable rate facility. SED maintained an interest rate swap contract, which expired on January 26, 2013, to reduce the impact of the fluctuations in the interest rate on $15 million notional amount of the obligation under its revolving credit facility with Wells Fargo. SED is currently reviewing possibly entering into interest swap ratecontracts in the future. 17 Inflation and Price Levels. Inflation has not had a significant impact on SED's overall business because of the typically decreasing costs of products sold by SED and the fact that we also receive price protection from vendors for a significant portion of our inventory. In the event a vendor or competitor reduces its prices for goods purchased by SED prior to SED's sale of such goods, we generally have been able either to receive a credit from the vendor for the price differential or to return the goods to the vendor for credit. Argentina and Colombia have experienced high rates of inflation and hyperinflation from time to time in the past. SED has experienced higher operating costs related to government mandated wage increases in those countries. At this time, management believes that inflation may have a material impact on SED's Latin American business operations in the immediate future. Net Operating Tax Loss Carry Forwards. SED has accumulated net operating loss carry forwards for Federal income tax purposes of approximately $62.2 million and for state tax purposes of approximately $52.5 million, which expire in fiscal years 2019 through 2029. These losses are available to offset taxable income generated through those dates. The ultimate realization of these deferred tax assets is dependent upon the generation of sufficient future taxable income during the periods in which these carryforwards may be utilized. Liquidity and Capital Resources At December 31, 2012, SED had cash and cash equivalents totaling $12.5 million, an increase of $7.8 million, from $4.7 million at June 30, 2012. The increase in the cash balance was primarily due to the deposit of $7.3 million in cash on the final day of the period that has since been used to pay down the net borrowings of the Company. Consolidated net borrowings under the SED's credit facilities increased to $46.3 million at December 31, 2012 (before the $7.3 million deposit mentioned above), compared to $36.9 million at June 30, 2012. Working capital at December 31, 2012 was approximately $16.6 million. SED has financed its liquidity needs largely through internally generated funds, credit facilities, and vendor lines of credit. SED's principal source of liquidity is its cash, cash equivalents, trade receivables, inventories and amounts available under its lines of credit with vendors and its bank revolving credit facilities. At December 31, 2012, SED's global availability under its bank credit facilities was approximately $21.8 million, after deducting $4.7 million in reserves for outstanding letters of credit. Cash used in operating activities was $0.8 million for the six months ended December 31, 2012, a decrease of $13.0 million as compared to approximately $12.2 million provided by operating activities for the same period last year. The $13.0 million difference in cash used in operating activities is primarily attributable to decreases in inventories during the six months ended December 31, 2011 as compared to the same period in 2012. Changes in operating assets and liabilities during the six months ended December 31, 2012 are as follows: Net trade receivables were $64.6 million at December 31, 2012 and $54 million at June 30, 2012. Average day's sales outstanding for the quarter were approximately 34 days at December 31, 2012 and 38 days at December 31, 2011. A shorter cash cycle on certain large volume customers helped to achieve the decrease in days sales outstanding. Inventories decreased $0.2 million to $61.6 million at December 31, 2012 from $61.8 million at June 30, 2012. Inventory turns for the quarter ended December 31, 2012 and 2011 were approximately 10.3 and 8.8, respectively. Other current assets decreased to $7.4 million at December 31, 2012 from $8.1 million at June 30, 2012. Trade accounts payable increased by $11 million to $74.1 million at December 31, 2012 compared to $63.1 million at June 30, 2012. The increase is primarily attributable to the increase in purchases to accommodate the related increase in net sales for the current quarter. Accrued and other current liabilities increased to $9.5 million at December 31, 2012 from $8.7 million as of June 30, 2012. SED's cash flows are affected by changes in exchange rates in Argentina and Colombia. Exchange rate changes had the effect of providing $50,000 in cash for the six months ended December 31, 2012, compared to using $0.2 million in cash for the same period last year. SED maintained an interest rate swap contract to reduce the impact of fluctuations in the interest rates on $15 million notional amount of the revolving credit facility under the Wells Fargo Agreement which expired on January 26, 2013. The fair value, not in SED's favor, of the interest rate swap was $0.1 million and $0.5 million as of December 31, 2012 and 2011, respectively, and is included in accrued and other current liabilities. SED does not hold or issue derivative financial instruments for trading purposes. 18 While SED has historically derived a material portion of its operating income and cash flows from its foreign subsidiaries, management believes that if there were to be deteriorating economic conditions in Argentina or Colombia or a devaluation of the peso in either country it may have a negative effect on our foreign subsidiaries' net income and the ability to generate cash flows from operations. The movement of cash from SED's foreign subsidiaries may be restricted at times due to governmental restrictions, domestic banking agreements, international monetary restrictions, and other restrictions from time to time, therefore movement of cash may be uncertain. Currently thereare no such restrictions. The domestic and global economic downturn created several risks relating to SED's financial results, operations and prospects. SED has experienced a rapid decline in demand for the products it sells resulting in a more competitive environment and increased pressure to reduce the cost of operations. The benefits from cost reductions will take longer to fully realize and may not fully mitigate the impact of the reduced demand. The recent economic downturn may also result in changes in vendor terms and conditions, such as rebates, cash discounts and cooperative marketing efforts, which may result in further downward pressure on SED's sales and gross margins. Deterioration in the financial and credit markets heightens the risk of customer bankruptcies and delays in payment. Deterioration in the credit markets in Latin America and the United States have resulted in reduced availability of credit insurance to cover customer accounts. This has resulted in a reduction of the credit lines SED provides to its customers, thereby having a negative impact on its sales. Also, volatile foreign currency exchange rates increase SED's risk related to products purchased in a currency other than the currency in which those products are sold. The realization of any or all of these risks would likely have a significant adverse effect on SED's future financial results. Historically, SED has financed its liquidity needs largely through internally generated funds, borrowings under the Wells Fargo credit facility, subsidiary bank credit agreements, and vendor lines of credit. There can be no assurance that any or all of the aforementioned sources of capital will be available to SED when needed. For example, SED's creditors may tighten their lending standards and SED may find it necessary to tighten credit availability standards to its customers due to the general weakening of the economic environment. However, SED believes that funds generated from operations, together with its Wells Fargo credit facility, subsidiary bank credit agreements, vendor credit lines, and current cash and cash equivalents will be sufficient to support its working capital and liquidity requirements for at least the next 12 months. |