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SED International Holdings, Inc. and Subsidiaries

Table of Contents

SED International Holdings, Inc. and Subsidiaries

See notes to condensed consolidated financial statements.

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SED International Holdings, Inc. and Subsidiaries

See notes to condensed consolidated financial statements.

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SED International Holdings, Inc. and Subsidiaries

See notes to condensed consolidated financial statements.

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SED International Holdings, Inc. and Subsidiaries

See notes to condensed consolidated financial statements.

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SED International Holdings, Inc. and Subsidiaries

See notes to condensed consolidated financial statements.

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SED International Holdings, Inc. and Subsidiaries

1. Basis of Presentation

The accompanying unaudited condensed consolidated financial statements of SED International Holdings, Inc. its wholly-owned subsidiaries, SED International, Inc., SED International do Brasil Distribuidora Ltda. (formerly SED Magna Distribuidora Ltda.), SED Magna (Miami), Inc., SED International de Colombia Ltda., Intermaco S.R.L., and E-Store.com, Inc. (E.Store.com, Inc. operations were discontinued during fiscal year 2002) (collectively, the “Company”) have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Rule 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Certain reclassifications have been made to the prior period’s financial information to conform with the presentation used in fiscal year 2003. Operating results for the six months ended December 31, 2002 are not necessarily indicative of the results that may be expected for the fiscal year ending June 30, 2003.

For further information, refer to the consolidated financial statements and footnotes thereto included in the SED Holdings, Inc. Annual Report on Form 10-K for the year fiscal year ended June 30, 2002.

2. Credit Facility and Bank Debt

On October 7, 2002, the Company entered into a three year, $35 million credit facility with Fleet Capital Corporation (the “Fleet Agreement”). The Fleet Agreement provides for revolving borrowings up to $35 million based upon the Company’s eligible domestic accounts receivable and inventory as defined therein. Borrowings under the Fleet Agreement accrue interest based upon a variety of interest rate options depending upon the computation of availability as defined therein. The interest rates range from the prime rate to the prime rate plus a margin of .5%, or the Federal funds rate plus a margin of .5%, or LIBOR plus a margin ranging from 2% to 2.75%. The Company is also subject to a commitment fee ranging from .25% to .5% on the unused portion of the facility. Interest is payable monthly. Borrowings under the Fleet Agreement are secured by substantially all domestic assets of the Company and 65% of each of the Company’s shares in its foreign subsidiaries, respectively. The Fleet Agreement matures on October 7, 2005.

The Fleet Agreement also contains certain covenants which, among other things, requires that if the Company’s availability is less than $5 million at any time during the agreement, the Company must restrict or limit capital expenditures and advances to the Company’s Latin American subsidiaries. Also, if the $5 million threshold is breached, the Fleet Agreement requires the maintenance of certain levels of earnings before interest, taxes, depreciation, and amortization, requires maintenance of minimum fixed charge coverage ratio beginning in the second quarter of fiscal 2004, and requires the maintenance of minimum tangible net worth, as defined, of negative $5 million. Based upon the Company’s experience in fiscal 2002 and through the date of entering into the Fleet Agreement, the Company would have had at least $5 million in availability under the Fleet Agreement. The Company’s availability under the Fleet Agreement was $13.3 million on February 3, 2003.

Until October 2002, the Company had a credit agreement with Wachovia Bank N.A. (“Wachovia”), which provided for borrowings under a line of credit of up to $25 million and $35 million at June 30, 2002 and 2001, respectively.

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SED International Holdings, Inc. and Subsidiaries

2. Credit Facility and Bank Debt (continued)

The Wachovia credit agreement was secured by accounts receivable and inventory of SED International, Inc. and required maintenance of certain minimum working capital and other financial ratios and had certain dividend restrictions. The Company was able to borrow at Wachovia’s prime rate (5.25% at September 30, 2002) plus .50% or the Company could fix the interest rate for periods of 30 to 180 days under various interest rate options. The credit agreement required a commitment fee of .50% of the unused commitment and expired November 1, 2002. Average borrowings, maximum borrowings and the weighted average interest rate for the quarter ended September 30, 2002 were $6.2 million, $13.6 million and 5.25%, respectively. Average borrowings, maximum borrowings and the weighted average interest rate for the six months ended December 31, 2002 were $3.2 million, $13.6 million and 5.25%, respectively. At September 30, 2002 the Company was in technical default with certain covenants under the Wachovia credit agreement; however, Wachovia and the Company subsequently waived the covenant violations and amended the agreement to achieve compliance.

The Company presently projects that it will be in compliance with the financial covenants associated with the Fleet Agreement in the future. However, there can be no assurance that the Company will remain in compliance with the Fleet Agreement covenants. If the Company falls out of compliance, Fleet may declare an event of default and could demand repayment of all outstanding borrowings and discontinue the agreement. If Fleet were to declare an event of default, the Company’s liquidity and business operations could be adversely affected. Full details of the Fleet Agreement are reported on Form 10-K for the year ended June 30, 2002.

The Company’s subsidiary, SED International do Brasil Distribuidora Ltda. operates under line of credit agreements with several Brazilian banks. Interest rates on borrowings are negotiated at the time of borrowing. The credit agreements are secured by the subsidiary’s accounts receivable and require the maintenance of certain financial ratios. At December 31, 2002, the Company had $952,398 as compared to $2.4 million at June 30, 2002 of borrowings outstanding under these facilities. The weighted average monthly interest rate under these loan agreements for the six month period ended December 31, 2002 was approximately 2.13%.

3. Restricted Cash

Restricted cash at June 30, 2002 consisted of term deposits pledged as collateral to secure letters of credit which expired during the first and second quarters of fiscal year 2003.

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SED International Holdings, Inc. and Subsidiaries

4. Accounts Receivable

5. Inventory

6. Comprehensive Income (Loss)

Comprehensive income (loss) was $276,000 and $(8.2) million, respectively, for the three months ended December 31, 2002 and 2001 and $(731,000) and $(11.9) million respectively, for the six months ended December 31, 2002 and 2001.

7. Other Income

In December of 2002, the Company entered into a confidential settlement agreement for claims arising out of a disagreement with a former insurance broker. The net proceeds of $512,932 were recorded net of attorneys’ fees of $96,420.

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SED International Holdings, Inc. and Subsidiaries

8. Segment Reporting

The Company operates in one business segment as a wholesale distributor of microcomputer and wireless telephone products. The Company operates and manages in two geographic regions, the United Sates and Latin America.

Financial information by geographic region is as follows:

Sales of products between the Company’s geographic regions are made at market prices and eliminated in consolidation. All corporate overhead is included in the results of U.S. operations.

Net sales by product category is as follows:

Approximately 11.3% and 17.4% of the Company’s net sales for the three months ended December 31, 2002 and 2001, respectively, consisted of sales to customers for export principally into Latin America and direct sales to customers in Brazil, Colombia, and Argentina.

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8. Segment Reporting (continued)

Sales of products between the Company’s geographic regions are made at market prices and eliminated in consolidation. All corporate overhead is included in the results of U.S. operations.

Net sales by product category is as follows:

Approximately 11.5% and 18.2% of the Company’s net sales for the six months ended December 31, 2002 and 2001, respectively, consisted of sales to customers for export principally into Latin America and direct sales to customers in Brazil, Colombia, and Argentina.

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9. Restricted Stock, Stock Options and Other Stock Plans

Effective July, 1, 2002, the Company adopted the fair value method of recording stock-based compensation in accordance with the provisions of SFAS No. 123, Accounting for Stock-Based Compensation, which is considered the preferable accounting for stock-based employee compensation. Historically, the Company had elected to follow the Accounting Principals Board Opinion No. 25 Accounting for Stocked issued to Employees (“APB 25”) and related Interpretations in accounting for its employee stock-based compensation. Accordingly, no compensation expense has been recognized for stock option plans in the past. The Company has elected to follow the prospective method and all employee awards granted, modified or settled after July 1, 2002 will be expensed over the vesting period based on the fair value at the date the stock-based compensation is granted. The following table illustrates the effect on net income and earnings per share as if the fair value based method had been applied to all outstanding and unvested awards in each period.

10. Recently Issued Accounting Standards

In July 2001, the Financial Accounting Standards Board (“FASB”) issued Statement No. 142 (“SFAS 142”), Goodwill and Other Intangible Assets. SFAS 142 requires companies to cease amortizing goodwill that existed at June 30, 2001 and established a new method for testing goodwill for impairment on an annual basis (or an interim basis if an event occurs that might reduce the fair value of a reporting unit below its carrying value.) Any goodwill resulting from acquisitions completed after June 30, 2001 will not be amortized. SFAS 142 also requires that an identifiable intangible asset that is determined to have an indefinite useful economic life not be amortized, but separately tested for impairment using a fair value based approach. The Company adopted SFAS 142 as of July 1, 2001. However, the Company did not complete the required transitional impairment tests until the second quarter ended December 31, 2001. During the three-month period ended December 31, 2001, the Company tested goodwill arising from a prior business combination of an enterprise based in Argentina as of July 1, 2001 primarily utilizing a valuation technique relying on the expected present value of future cash flows. As a result of this valuation process as well as the application of the remaining provisions of SFAS 142, the Company recorded a pre-tax transitional impairment loss of $6,372,000, representing the write-off of all of the Company’s existing goodwill. This write-off was reported as a cumulative effect of a change in accounting principle, on a net of tax basis, as of July 1, 2001

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in the Company’s Consolidated Statement of Operations for the six-month period ended December 31, 2001. The quarter ended September 30, 2001 was restated to reflect the implementation of SFAS 142 effective July 1, 2001. Prior to the adoption of SFAS 142 on July 2001, the Company amortized this goodwill over an estimated useful life of 30 years.

In July 2002, the FASB issued Statement No. 146, Accounting for Costs Associated with Exit or Disposal Activities (SFAS 146). SFAS 146 addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies the Emerging Issues Task Force Issue No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity including Certain Costs Incurred in a Restructuring. SFAS 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred, whereas EITF 94-3 had required recognition of the liability at the commitment date to an exit plan. The Company is required to adopt the provisions of SFAS 146 effective for exit or disposal activities initiated after December 31, 2002. The Company is currently evaluating the impact of the adoption of this statement.

Effective July 1, 2002, the Company adopted the fair value method defined in SFAS No. 123, Accounting for Stock-Based Compensation. (“SFAS No. 123”). In December 2002, the FASB issued SFAS 148, Accounting for Stock-Based Compensation- Transition and Disclosure - an amendment of FASB Statement No. 123. For information regarding the adoption of the fair value method defined in SFAS No. 123, refer to Note 9.

In November 2002, the FASB issued FASB Interpretation Number 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees. Including Indirect Guarantees of Indebtedness of Others (“FIN 45”). FIN 45 requires an entity to disclose in its interim and annual financial statements information with respect to its obligations under certain guarantees that it has issued. It also requires an entity to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. The disclosure requirements of FIN 45 are effective for interim and annual periods after December 15, 2002. These disclosures are presented in Note 10. The initial recognition and initial measurement requirements of FIN 45 are effective prospectively for guarantees issued or modified after December 31, 2002. The Company is currently assessing the initial measurement requirements of FIN 45. However, management does not believe that the recognition requirements will have a material impact on the Company’s financial position, cash flows or results of operations.

In January 2003, the Emerging Issues Task Force (“EITF”) of the Financial Accounting Standards Board (“FASB”) issued EITF Issue No. 02-16, Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor (“the Issue”). The Issue addresses accounting and reporting issues related to how a reseller should account for cash consideration received from vendors. Generally, cash consideration received from vendors is presumed to be a reduction of the price of the vendor’s products or services and should, therefore, be characterized as a reduction of cost of sales when recognized in the customer’s income statement. However, under certain circumstances this presumption may be overcome and recognition as revenue or as a reduction of other costs in the income statement may be appropriate. While the Company does receive cash consideration from vendors subject to the provisions of the Issue, the Company has not yet completed its evaluation of the potential impact that the Issue may have on its financial statements. The Issue is effective for fiscal periods beginning after December 15, 2002.

11.  Subsequent Event

In February 2003, the Company approved a plan to discontinue commercial operations of its Brazilian subsidiary, SED International do Brasil Distribuidora, Ltda. The Company anticipates taking a charge of approximately $3.5 million related to the disposal of the operations during the March 2003 quarter. The loss on disposal includes non-cash related charges of approximately $3.2 million, including cumulative foreign currency translation losses of $2.5 million, and the write down of accounts receivable, inventory, and other assets.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The Company, from time to time, makes “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements reflect the expectations of management of the Company at the time such statements are made. The reader can identify such forward-looking statements by the use of words such as “may,” “will,” “should,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “intend(s),” “potential,” “continue,” or the negative of such terms, or other comparable terminology. Forward-looking statements also include the assumptions underlying or relating to any of the foregoing statements.

Actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors including, but not limited to, those set forth under “Risk Factors That May Affect Future Results” below. All forward-looking statements included in this Report on Form 10-Q are based on information available to the Company on the date hereof. The Company assumes no obligation to update any forward-looking statements.

Overview

The Company is an international distributor of microcomputer products, including personal computers, printers and other peripherals, supplies, networking products and wireless telephone products, serving value-added resellers and dealers throughout the United States and Latin America.

Critical Accounting Policies and Estimates

General. Management’s discussion and analysis of the Company’s financial condition and results of operations are based upon the Company’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, management evaluates its estimates, including those related to vendor programs and incentives, bad debts, inventories, investments and income taxes. Management bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Management believes the following critical accounting policies affect its more significant judgments and estimates used in the preparation of its consolidated financial statements.

Revenue Recognition. The Company recognizes revenues in accordance with the guidance of Staff Accounting Bulletin (“SAB”) No. 101, “Revenue Recognition in Financial Statements.” The Company recognizes revenue for products sold at the time shipment occurs and collection of the resulting receivable is deemed probable by the Company. The Company allows its customers to return product for exchange or credit subject to certain limitations. Provision for estimated losses on such returns are recorded at the time of sale. Funds received from vendors for product rebates are accounted for as a reduction of product cost. Shipping and handling revenues are included in net sales and shipping costs are included in cost of sales.

Commitments and Contingencies. During the ordinary course of business, contingencies arise resulting from an existing condition, situation, or set of circumstances involving uncertainty as to possible gain, a gain contingency, or loss contingency, that will ultimately be resolved when one or more future events occur or fail to occur. Resolution of the uncertainty may confirm the acquisition of an asset or the reduction of a liability or the loss or impairment of an asset or the incurrence of a liability. When loss contingencies exist, such as, but not limited to, pending or threatened litigation, actual or possible claims and assessments, collectability of receivables or

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obligations related to product warranties and product defects or statutory obligations, the likelihood of the future event or events occurring generally will confirm the loss or impairment of an asset or the incurrence of a liability. The Company accounts for such contingencies in accordance with the provisions of Statement of Financial Accounting Standards No. 5.

Bad Debt. The Company maintains allowances for doubtful accounts for estimated losses resulting from the inability of its customers to make required payments. On a monthly basis the Company applies a reserve calculation based on the agings of its receivables and either increases or decreases its estimate of doubtful accounts accordingly. If the financial condition of the Company’s customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. The Company maintains credit insurance for its significant customers.

Inventory. Inventories are stated at the lower of cost (first-in, first-out method) or market Most of the Company’s vendors allow for either return of goods within a specified period (usually 90 days) or for credits related to price protection. However, for other vendor relationships and inventories, the Company is not protected 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 our 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 or price protection programs were discontinued in the future, or if vendors were unable to honor the provisions of certain contracts which protect the Company from inventory losses, the risk of loss associated with obsolete and slow moving inventories would increase.

Foreign Currency Translation. The assets and liabilities of foreign operations are translated at the exchange rates in effect at the balance sheet date, with related translation gains or losses reported as a separate component of shareholders’ equity. The results of foreign operations are translated at the weighted average exchange rates for the year. Gains or losses resulting from foreign currency transactions are included in the statement of earnings.

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Results of Operations

The following table sets forth for the periods indicated the percentage of net sales represented by certain line items from the Company’s consolidated statements of operations: