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Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


 

FORM 10-Q

 


 

(Mark One)

x Quarterly Report Pursuant to Section 13 or 15 (d) of the Securities Exchange Act of 1934 for the Quarterly Period Ended December 31, 2004

 

or

 

¨ Transition Report Pursuant to Section 13 or 15 (d) of the Securities Exchange Act of 1934 for the transition period from              to             

 

Commission File Number: 000-26926

 


 

SCANSOURCE, INC.

(Exact name of registrant as specified in its charter)

 


 

SOUTH CAROLINA   57-0965380

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

6 Logue Court, Greenville, South Carolina   29615
(Address of principal executive offices)   (Zip Code)

 

(864) 288-2432

(Registrant’s telephone number, including area code)

 

Not Applicable

(Former name, former address and former fiscal year, if changed since last report)

 


 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in rule 12b-2 of the Exchange Act).    Yes  x    No  ¨

 

As of February 1, 2005, 12,626,848 shares of the registrant’s common stock, no par value, were outstanding.

 



Table of Contents

SCANSOURCE, INC.

 

INDEX TO FORM 10-Q

December 31, 2004

 

         Page No.

PART I.   FINANCIAL INFORMATION     
    Item 1.   

Financial Statements (Unaudited):

    
        

Condensed Consolidated Balance Sheets as of December 31, 2004 and June 30, 2004

   3
        

Condensed Consolidated Income Statements for the Quarter and Six Months Ended December 31, 2004 and 2003

   5
        

Condensed Consolidated Statements of Cash Flows for the Six Months Ended December 31, 2004 and 2003

   7
        

Notes to Condensed Consolidated Financial Statements

   8
    Item 2.   

Management’s Discussion and Analysis of Financial Condition and Results of Operations

   22
    Item 3.   

Quantitative and Qualitative Disclosures About Market Risk

   30
    Item 4.   

Controls and Procedures

   31
PART II.   OTHER INFORMATION     
    Item 4.   

Submission of Matters to a Vote of Security Holders

   32
    Item 6.   

Exhibits

   33
SIGNATURES    34

 

Cautionary Statements

 

Certain of the statements contained in this Form 10-Q, as well as in the Company’s other filings with the Securities and Exchange Commission (“SEC”), that are not historical facts are forward-looking statements subject to the safe harbor created by the Private Securities Litigation Reform Act of 1995. The Company cautions readers of this report that a number of important factors could cause the Company’s activities and/or actual results in fiscal 2005 and beyond to differ materially from those expressed in any such forward-looking statements. These factors include, without limitation: the Company’s dependence on vendors, product supply, senior management, centralized functions and third-party shippers; the Company’s ability to compete successfully in a highly competitive market and to manage significant additions in personnel and increases in working capital; the Company’s ability to collect outstanding accounts receivable; the Company’s entry into new product markets in which it has no prior experience; the Company’s susceptibility to quarterly fluctuations in net sales and results of operations; the Company’s ability to manage successfully pricing or stock rotation opportunities associated with inventory value decreases; other factors such as narrow profit margins, inventory risks due to shifts in market demand, dependence on information systems, credit exposure due to the deterioration in the financial condition of our customers, a downturn in the general economy, the inability to obtain required capital, potential adverse effects of acquisitions, fluctuations in interest rates, foreign currency exchange rates and exposure to foreign markets (including the imposition of governmental controls, currency devaluations, export license requirements, restrictions on the export of certain technology, political instability, trade restrictions, tariff changes, difficulties in staffing and managing international operations, changes in the interpretation and enforcement of laws (in particular related to items such as duty and taxation), longer collection periods and the impact of local economic conditions and practices), the impact of changes in income tax legislation, acts of war or terrorism, exposure to natural disasters, potential impact of labor strikes, volatility of common stock, and the accuracy of forecast data; and other factors described herein and in other reports and documents filed by the Company with the SEC, including Exhibit 99.1 to the Company’s Form 10-K for the year ended June 30, 2004.

 

Additional discussion of these and other factors affecting our business and prospects is contained in our periodic filings with the SEC, copies of which can be obtained at the Investor Relations section of our website at www.scansource.com. We provide our annual and quarterly reports free of charge on www.scansource.com, as soon as reasonably practicable after they are electronically filed, or furnished to, the SEC. We provide a link to all SEC filings where current reports on Form 8-K and any amendments to previously filed reports may be accessed, free of charge.

 

2


Table of Contents

PART 1. FINANCIAL INFORMATION

Item 1. Financial Statements

 

SCANSOURCE, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)

(In thousands)

 

Assets


   December 31,
2004


   June 30,
2004*


Current assets:

             

Cash

   $ 1,601    $ 1,047

Trade and notes receivable:

             

Trade, less allowance of $11,817 at December 31, 2004 and $9,725 at June 30, 2004

     187,852      175,417

Other

     3,618      3,919

Inventories

     217,520      182,868

Prepaid expenses and other assets

     1,542      1,670

Deferred income taxes

     9,536      8,440
    

  

Total current assets

     421,669      373,361
    

  

Property and equipment, net

     22,822      23,663

Goodwill

     10,261      9,978

Other assets, including identifiable intangible assets

     6,768      6,190
    

  

Total assets

   $ 461,520    $ 413,192
    

  


* Derived from audited financial statements at June 30, 2004.

 

See notes to condensed consolidated financial statements (unaudited).

 

3


Table of Contents

SCANSOURCE, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)

(In thousands, except for share information)

(Continued)

 

Liabilities and Shareholders’ Equity


   December 31,
2004


   June 30,
2004*


Current liabilities:

             

Current portion of long-term debt

   $ 5,383    $ 854

Subsidiary line of credit

     950      —  

Trade accounts payable

     166,250      167,053

Accrued expenses and other liabilities

     13,413      14,803

Income taxes payable

     3,202      2,555
    

  

Total current liabilities

     189,198      185,265

Deferred income taxes

     1,727      1,058

Long-term debt

     1,644      6,584

Borrowings under revolving credit facility

     59,883      32,569

Other long-term liabilities

     673      —  
    

  

Total liabilities

     253,125      225,476
    

  

Minority interest

     931      1,072

Commitments and contingencies

             

Shareholders’ equity:

             

Preferred stock, no par value; 3,000,000 shares authorized, none issued

     —        —  

Common stock, no par value; 45,000,000 and 25,000,000 shares authorized, 12,626,848 and 12,559,689 shares issued and outstanding at December 31, 2004 and June 30, 2004, respectively

     64,196      61,856

Retained earnings

     139,286      121,288

Accumulated other comprehensive income - equity adjustment from foreign currency translation

     3,982      3,500
    

  

Total shareholders’ equity

     207,464      186,644
    

  

Total liabilities and shareholders’ equity

   $ 461,520    $ 413,192
    

  


* Derived from audited financial statements at June 30, 2004.

 

See notes to condensed consolidated financial statements (unaudited).

 

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SCANSOURCE, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED INCOME STATEMENTS (UNAUDITED)

(In thousands)

 

     Quarter ended
December 31,


    Six months ended
December 31,


 
     2004

    2003

    2004

    2003

 

Net sales

   $ 370,130     $ 288,966     $ 732,839     $ 565,440  

Cost of goods sold

     332,269       258,063       657,996       503,693  
    


 


 


 


Gross profit

     37,861       30,903       74,843       61,747  
    


 


 


 


Operating expenses:

                                

Selling, general and administrative expenses

     23,110       20,045       45,422       41,204  
    


 


 


 


Operating income

     14,751       10,858       29,421       20,543  
    


 


 


 


Other expense (income):

                                

Interest expense

     482       284       895       627  

Interest income

     (334 )     (85 )     (550 )     (246 )

Other, net

     (300 )     (64 )     (253 )     (230 )
    


 


 


 


Total other expense

     (152 )     135       92       151  
    


 


 


 


Income before income taxes and minority interest

     14,903       10,723       29,329       20,392  

Provision for income taxes

     5,719       3,935       11,201       7,524  
    


 


 


 


Income before minority interest

     9,184       6,788       18,128       12,868  

Minority interest in income of consolidated subsidiaries, net of income taxes of $20 and $45, respectively, and $16 and $45, respectively

     100       121       130       121  
    


 


 


 


Net income

   $ 9,084     $ 6,667     $ 17,998     $ 12,747  
    


 


 


 


 

See notes to condensed consolidated financial statements (unaudited).

 

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SCANSOURCE, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED INCOME STATEMENTS (UNAUDITED)

(In thousands, except per share data)

(Continued)

 

     Quarter ended
December 31,


   Six months ended
December 31,


     2004

   2003

   2004

   2003

Per share data:

                           

Net income per common share, basic

   $ 0.72    $ 0.53    $ 1.43    $ 1.03
    

  

  

  

Weighted-average shares outstanding, basic

     12,620      12,508      12,600      12,389
    

  

  

  

Net income per common share, assuming dilution

   $ 0.69    $ 0.52    $ 1.37    $ 1.00
    

  

  

  

Weighted-average shares outstanding, assuming dilution

     13,131      12,942      13,108      12,771
    

  

  

  

 

See notes to condensed consolidated financial statements (unaudited).

 

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Table of Contents

SCANSOURCE, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

(In thousands)

 

     Six Months Ended
December 31,


 
     2004

    2003

 

Cash flows from operating activities:

                

Net income

   $ 17,998     $ 12,747  

Adjustments to reconcile net income to net cash provided by (used in) operating activities:

                

Depreciation

     2,434       2,490  

Amortization of intangible assets

     235       112  

Allowance for accounts and notes receivable

     1,997       1,267  

Impairment of capitalized software

     30       —    

Deferred income tax benefit

     (437 )     (109 )

Tax benefit of stock option exercises

     1,124       882  

Minority interest in income of subsidiaries

     130       (121 )

Changes in operating assets and liabilities, net of acquisitions:

                

Trade and notes receivables

     (13,635 )     (17,836 )

Other receivables

     309       1,283  

Inventories

     (32,602 )     (197 )

Prepaid expenses and other assets

     186       9  

Other noncurrent assets

     (215 )     (1,084 )

Trade accounts payable

     (2,541 )     (4,523 )

Accrued expenses and other liabilities

     (786 )     (24 )

Income taxes payable

     611       1,333  
    


 


Net cash used in operating activities

     (25,162 )     (3,771 )
    


 


Cash flows used in investing activities:

                

Capital expenditures

     (1,577 )     (1,209 )

Cash paid for business acquisitions

     (521 )     (277 )
    


 


Net cash used in investing activities

     (2,098 )     (1,486 )
    


 


Cash flows from financing activities:

                

Advances on revolving credit, net

     26,977       1,234  

Exercise of stock options

     1,207       2,316  

Repayments of long-term debt borrowings

     (411 )     (431 )
    


 


Net cash provided by financing activities

     27,773       3,119  
    


 


Effect of exchange rate changes on cash

     41       309  
    


 


Increase (decrease) in cash

     554       (1,829 )

Cash at beginning of period

     1,047       2,565  
    


 


Cash at end of period

   $ 1,601     $ 736  
    


 


 

See notes to condensed consolidated financial statements (unaudited).

 

7


Table of Contents

SCANSOURCE, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

(1) Basis of Presentation

 

The accompanying unaudited condensed consolidated financial statements of ScanSource, Inc. (the “Company”) have been prepared by the Company’s management in accordance with generally accepted accounting principles for interim financial information and applicable rules and regulations of the Securities Exchange Act of 1934, as amended. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles in the United States for annual financial statements. The unaudited condensed consolidated financial statements included herein contain all adjustments (consisting of normal recurring adjustments) which are, in the opinion of management, necessary to present fairly the financial position as of December 31, 2004 and June 30, 2004, the results of operations for the quarter and six month periods ended December 31, 2004 and 2003 and statement of cash flows for the six month periods ended December 31, 2004 and 2003. The results of operations for the quarter and six month periods ended December 31, 2004 and 2003 are not necessarily indicative of the results to be expected for a full year. These financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 2004.

 

(2) Business Description

 

The Company is a leading distributor of specialty technology products, providing value-added distribution sales to resellers in the specialty technology markets. The Company has two geographic distribution segments: one serving North America from the Memphis, Tennessee distribution center, and an international segment currently serving Latin America (including Mexico) and Europe. The North American distribution segment markets automatic identification and data capture (“AIDC”) and point-of-sale (“POS”) products through its ScanSource sales unit; voice, data and converged communications equipment through its Catalyst Telecom sales unit; voice, data and converged communications products through its Paracon sales unit; and electronic security products through its ScanSource Security Distribution unit. The international distribution segment markets AIDC and POS products through its ScanSource sales unit.

 

3) Summary of Significant Accounting Policies and Accounting Standards Recently Issued

 

Consolidation Policy

 

The consolidated financial statements include the accounts of the Company and all wholly-owned and majority-owned subsidiaries. All significant inter-company accounts and transactions have been eliminated.

 

Minority Interest

 

Minority interest represents that portion of the net equity of majority-owned subsidiaries of the Company held by minority shareholders. The minority shareholders’ share of the subsidiaries’ income or loss is listed separately in the Consolidated Income Statements. Effective July 1, 2004, the Company acquired an additional 12% of Outsourcing Unlimited, Inc. (“OUI”) and an additional 8% of Netpoint International, Inc. (“Netpoint”). The Company now owns 88% of OUI, and 76% of Netpoint.

 

Use of Estimates

 

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. On an ongoing basis, management evaluates its estimates, including those related to the allowance for uncollectible accounts receivable and inventory reserves to reduce inventories to the lower of cost or market. Management bases its estimates on historical experience and on various other assumptions that management believes to be reasonable under the circumstances, the results of which form a basis for making judgments about the carrying value of assets and liabilities that are not readily available from other sources. Actual results may differ from these estimates under different assumptions or conditions; however, management believes that its estimates, including those for the above described items, are reasonable and that the actual results will not vary significantly from the estimated amounts.

 

8


Table of Contents

SCANSOURCE, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

The following significant accounting policies relate to the more significant judgments and estimates used in the preparation of the consolidated financial statements:

 

(a) Allowances for Accounts and Notes Receivable

 

The Company maintains an allowance for uncollectible accounts receivable for estimated losses resulting from customers’ failure to make payments on accounts receivable due to the Company. Management determines the estimate of the allowance for uncollectible accounts receivable considering a number of factors, including: (1) historical experience, (2) aging of the accounts receivable and (3) specific information obtained by the Company on the financial condition and the current credit worthiness of its customers. If the financial condition of the Company’s customers were to deteriorate and reduce the ability of the Company’s customers to make payments on their accounts, the Company may be required to increase its allowance by recording additional bad debt expense. Likewise, should the financial condition of the Company’s customers improve and result in payments or settlements of previously reserved amounts, the Company may be required to record a reduction in bad debt expense to reverse the recorded allowance. In addition, the Company maintains an allowance for credits to customers that will be applied against future purchases.

 

(b) Inventory Reserves

 

Management determines the inventory reserves required to reduce inventories to the lower of cost or market based principally on the effects of technological changes, quantities of goods on hand, and other factors. An estimate is made of the market value, less costs to dispose, of products whose value is determined to be impaired. If these products are ultimately sold at less than estimated amounts, additional reserves may be required. Likewise, if these products are sold for more than the estimated amounts, reserves may be reduced.

 

Cash and Cash Equivalents

 

The Company considers all highly liquid investments with original maturities of three months or less to be cash equivalents. Book overdrafts of $7,915,000 and $8,953,000 as of December 31, 2004 and June 30, 2004, respectively, are included in accounts payable.

 

Derivative Financial Instruments

 

The Company’s foreign currency exposure results from purchasing and selling internationally in several foreign currencies. In addition, the Company has foreign currency risk related to debt that is denominated in currencies other than the U.S. Dollar. The Company may reduce its exposure to fluctuations in foreign exchange rates by creating offsetting positions through the use of derivative financial instruments or multi-currency borrowings. The market risk related to the foreign exchange agreements is offset by changes in the valuation of the underlying items hedged. The Company currently does not use derivative financial instruments for trading or speculative purposes, nor is the Company a party to leveraged derivatives.

 

Derivative financial instruments are accounted for on an accrual basis with gains and losses on these contracts recorded in income in the period in which their value changes. These contracts are generally for a duration of 90 days or less. The Company has elected not to designate its foreign currency contracts as hedging instruments. They are, therefore, marked to market with changes in their value recorded in the Consolidated Income Statement each period. The underlying exposures are denominated primarily in British Pounds, Euros, and Canadian Dollars. Summarized financial information related to these derivative contracts and changes in the underlying value of the foreign currency exposures follows:

 

     Quarter ended
December 31,


  

Six months ended

December 31,


     2004

    2003

   2004

    2003

Foreign exchange derivative contract losses, net of gains

   $ (175,000 )   $ —      $ (363,000 )   $ —  

Foreign currency transactional and remeasurement gains, net of losses

     433,000       74,000      586,000       296,000
    


 

  


 

Net foreign currency transactional and remeasurement gains

   $ 258,000     $ 74,000    $ 223,000     $ 296,000
    


 

  


 

 

9


Table of Contents

SCANSOURCE, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

The Company had no currency forward contracts outstanding as of December 31, 2004. At June 30, 2004, the Company had one currency forward contract outstanding with a net liability under this contract of $21,000 which was included in accrued expenses and other liabilities. The following table provides information about the outstanding foreign currency derivative financial instrument as of June 30, 2004:

 

June 30, 2004


   Notional
Amount


   Weighted Average
Contract Rate


   Estimated Fair
Market Value


 

US Dollar functional currency

                    

Forward contracts - purchase US Dollar, sell Euro

   $ 4,848,000    1.2120    $ (21,000 )

 

The notional amount of forward exchange contracts is the amount of foreign currency to be bought or sold at maturity. Notional amounts are indicative of the extent of the Company’s involvement in the various types and uses of derivative financial instruments and are not a measure of the Company’s exposure to credit or market risks through its use of derivatives. The estimated fair value of derivative financial instruments represents the amount required to enter into similar offsetting contracts with similar remaining maturities based on quoted market prices.

 

Inventories

 

Inventories (consisting of AIDC, POS, business phone, converged communications equipment, and electronic security system products) are stated at the lower of cost (first-in, first-out method) or market.

 

Vendor Programs

 

Funds received from vendors for marketing programs and product rebates have been accounted for as a reduction of selling, general and administrative expenses (“SG&A”) or product cost according to the nature of the program, in accordance with Emerging Issues Task Force (“EITF”) No. 02-16, Accounting for Cash Consideration Received from a Vendor.

 

Product Warranty

 

The Company’s vendors generally warrant the products distributed by the Company and allow the Company to return defective products, including those that have been returned to the Company by its customers. The Company does not independently warrant the products it distributes. However, to maintain customer relations, the Company facilitates vendor warranty policies by accepting for exchange, with the Company’s prior approval, most defective products within 30 days of invoicing.

 

Long-Lived Assets

 

Property and equipment are recorded at cost. Depreciation is computed using the straight-line method over estimated useful lives of 3 to 5 years for furniture and equipment, 3 to 5 years for computer software, 40 years for buildings and 15 years for building improvements. Leasehold improvements are amortized over the shorter of the lease term or the estimated useful life. Maintenance, repairs and minor renewals are charged to expense as incurred. Additions, major renewals and betterments to property and equipment are capitalized.

 

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Table of Contents

SCANSOURCE, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

For long-lived assets other than goodwill, if the sum of the expected cash flows, undiscounted and without interest, is less than the carrying amount of the asset, an impairment loss is recognized as the amount by which the carrying amount of the asset exceeds its fair value.

 

The Company reviews its long-lived assets for impairment whenever events or circumstances indicate that the carrying amount of an asset may not be recoverable or may be impaired. The Company recognized charges of $0 and $30,000 for the quarter and six months ended December 31, 2004, respectively, and $0 and $0 for the quarter and six months ended December 31, 2003, respectively, in operating expenses for the impairment of certain capitalized software for the North American distribution segment. This software was no longer functional based on current operational needs.

 

Goodwill and Other Identifiable Intangible Assets

 

Goodwill represents the excess of the purchase price over the fair value of the identifiable net assets acquired in acquisitions accounted for using the purchase method. With the adoption of Statement of Financial Accounting Standards (“SFAS”) No. 142, Goodwill and Other Intangible Assets, on July 1, 2001, the Company discontinued the amortization of goodwill. During fiscal year 2004 and 2003, the Company performed its annual test of goodwill to determine if there was impairment. These tests included the determination of each reporting unit’s fair value using market multiples and discounted cash flows modeling. No impairment was required to be recorded related to the Company’s annual impairment testing under this pronouncement.

 

The Company reviews the carrying value of its intangible assets with finite lives, which includes customer lists and non-compete agreements, as current events and circumstances warrant to determine whether there are any impairment losses. If indicators of impairment are present in intangible assets used in operations, and future cash flows are not expected to be sufficient to recover the assets’ carrying amount, an impairment loss is charged to expense in the period identified. These assets are included in other assets. The customer lists are amortized using the straight-line method over a period of 5 years. The non-compete agreements are amortized over their expected life, and the debt issue costs are amortized over the term of the credit facility (see Note 7).

 

Fair Value of Financial Instruments

 

The fair value of financial instruments is the amount at which the instrument could be exchanged in a current transaction between willing parties. The carrying values of financial instruments such as accounts receivable, accounts payable, accrued liabilities, borrowings under the revolving credit facility and the subsidiary lines of credits approximate fair value, based upon either short maturities or variable interest rates of these instruments.

 

Contingencies

 

The Company accrues for contingent obligations, including estimated legal costs, when it is probable that a liability is incurred and the amount is reasonably estimable. As facts concerning contingencies become known, management reassesses its position and makes appropriate adjustments to the financial statements. Estimates that are particularly sensitive to future changes include tax, legal, and other regulatory matters, which are subject to change as events evolve and as additional information becomes available during the administrative and litigation process.

 

Revenue Recognition

 

Revenue is recognized once four criteria are met: (1) the Company must have persuasive evidence that an arrangement exists; (2) delivery must occur, which happens at the point of shipment (this includes the transfer of both title and risk of loss, provided that no significant obligations remain); (3) the price must be fixed and determinable; and (4) collectibility must be reasonably assured. A provision for estimated losses on returns is recorded at the time of sale based on historical experience.

 

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SCANSOURCE, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

The Company has service revenue associated with configuration and marketing which is recognized when work is complete and all obligations are substantially met. Revenue from multiple element arrangements is allocated to the various elements based on the relative fair value of the elements, and each revenue cycle is considered a separate accounting unit with recognition of revenue based on the criteria met for the individual element of the multiple deliverables. The Company has arrangements in which it earns a service fee determined as a percentage of the value of products shipped on behalf of the manufacturer, who retains the risk of credit loss. In the event of termination of the arrangements, the Company has the right to return certain inventory to the manufacturer. Such service fees earned by the Company are included in net sales and were less than 1% of net sales for each of the quarters and six months ended December 31, 2004 and 2003.

 

Shipping Costs

 

Shipping revenue is included in net sales and related costs are included in cost of goods sold.

 

Advertising Costs

 

The Company defers advertising related costs until the advertising is first run in trade or other publications or in the case of brochures, until the brochures are printed and available for distribution. Advertising costs, included in marketing costs, after vendor reimbursement, were not significant in the quarters ended December 31, 2004 or 2003. Deferred advertising costs at December 31, 2004 and 2003 were not significant.

 

Foreign Currency

 

The currency effects of translating the financial statements of the Company’s foreign entities that operate in their local currency are included in the cumulative currency translation adjustment component of accumulated other comprehensive income. The assets and liabilities of these foreign entities are translated into U.S. Dollars using the exchange rate at the end of the respective period. Sales, costs and expenses are translated at average exchange rates effective during the respective period.

 

Foreign currency transactional and re-measurement gains and losses are included in other expense (income) in the Condensed Consolidated Income Statement.

 

Income Taxes

 

Income taxes are accounted for using the liability method. Deferred taxes reflect tax consequences on future years of differences between the tax bases of assets and liabilities and their financial reporting amounts. Valuation allowances are provided against deferred tax assets in accordance with SFAS No. 109, Accounting for Income Taxes. Federal income taxes are not provided on the undistributed earnings of foreign subsidiaries because it has been the practice of the Company to reinvest those earnings in the business outside of the United States.

 

Stock-Based Compensation

 

The Company has three stock-based employee compensation plans and a plan for its non-employee directors. The Company has adopted the disclosure provisions of SFAS No. 148, Accounting for Stock-Based Compensation—Transition and Disclosure, which amends SFAS No. 123, Accounting for Stock-Based Compensation. SFAS No. 148 allows for continued use of recognition and measurement principles of Accounting Principles Board (“APB”) Opinion No. 25 and related interpretations in accounting for those plans. The Company applies the recognition and measurement principles of APB Opinion No. 25, and related interpretations in accounting for those plans. No stock-based employee compensation expense is reflected in net income as all options

 

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SCANSOURCE, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions to stock-based employee compensation. Such disclosure is not necessarily indicative of the fair value of stock options that could be granted by the Company in future fiscal years or of the value of all options currently outstanding.

 

    

Quarter ended

December 31,


  

Six months ended

December 31,


     2004

   2003

   2004

   2003

Net income, as reported

   $ 9,084,000    $ 6,667,000    $ 17,998,000    $ 12,747,000

Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects

     529,000      313,000      1,028,000      623,000
    

  

  

  

Pro forma net income

   $ 8,555,000    $ 6,354,000    $ 16,970,000    $ 12,124,000
    

  

  

  

    

Quarter ended

December 31,


  

Six months ended

December 31,


     2004

   2003

   2004

   2003

Earnings per share:

                           

Income per common share, basic, as reported

   $ 0.72    $ 0.53    $ 1.43    $ 1.03
    

  

  

  

Income per common share, basic, pro forma

   $ 0.68    $ 0.51    $ 1.35    $ 0.98
    

  

  

  

Income per common share, assuming dilution, as reported

   $ 0.69    $ 0.52    $ 1.37    $ 1.00
    

  

  

  

Income per common share, assuming dilution, pro forma

   $ 0.65    $ 0.49    $ 1.29    $ 0.95
    

  

  

  

 

For the quarter and six months ended December 31, 2004, the number of options exercised for shares of common stock were 8,556 and 67,159, respectively. For the quarter and six months ended December 31, 2003, the number of options exercised for shares of common stock were 87,334 and 183,627, respectively.

 

Comprehensive Income

 

Comprehensive income is comprised of net income and foreign currency translation. The foreign currency translation gains or losses are not tax-effected because the earnings of foreign subsidiaries are considered by Company management to be permanently reinvested. For the quarter and six months ended December 31, 2004, comprehensive income consisted of net income of the Company of $9.1 million and $18.0 million, respectively, and net translation adjustment gains of $486,000 and $482,000, respectively. For the quarter and six months ended December 31, 2003, comprehensive income consisted of net income of the Company of $6.7 million and $12.7 million, respectively, and net translation adjustment gains of $1.1 million and $1.3 million, respectively.

 

Accounting Standards Recently Issued

 

In January 2003, the FASB issued Interpretation No. 46 (“FIN 46”), Consolidation of Variable Interest Entities. FIN 46 clarifies the application of Accounting Research Bulletin No. 51, Consolidated Financial Statements, to certain entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 applies immediately to variable interest entities (“VIEs”) created after January 31, 2003, and to VIEs in which an enterprise obtains an interest after that date. In December 2003, the FASB published a revision to FIN 46 to clarify some of the provisions and to exempt certain entities from its requirements. Under the new guidance, special effective date provisions apply to enterprises that have fully or partially applied FIN 46 prior to issuance of the revised interpretation. Otherwise, application of Interpretation 46R (“FIN 46R”) is required in financial statements of public

 

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SCANSOURCE, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

entities that have interests in structures that are commonly referred to as special-purpose entities (“SPEs”) for periods ending after December 15, 2003. Application by public entities, other than small business issuers, for all other types of VIEs other than SPEs is required in financial statements for periods ending after March 15, 2004. The Company has completed its evaluation of all potential VIEs relationships existing prior to February 1, 2003. The Company did not create or obtain any interest in a variable interest entity during the period February 1, 2003 through December 31, 2004. However, changes in the Company’s business relationships with various entities could occur which may impact its financial statements under the requirements of FIN 46R. The Company has concluded that these relationships do not meet the requirements under the provision and therefore, there is no effect of these relationships on the Company’s consolidated financial position or results of operations as of December 31, 2004.

 

On December 16, 2004, the FASB issued FASB Statement No. 123 (revised 2004), Share-Based Payment, which is a revision of FASB Statement No. 123, Accounting for Stock-Based Compensation. Statement 123(R) supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and amends FASB Statement No. 95, Statement of Cash Flows. Generally, the approach in Statement 123(R) is similar to the approach described in Statement 123. However, Statement 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative. Statement 123(R) must be adopted no later than July 1, 2005. Early adoption will be permitted in periods in which financial statements have not yet been issued. We expect to adopt Statement 123(R) on July 1, 2005. Statement 123(R) permits public companies to adopt its requirements using one of two methods: (1) A “modified prospective” method in which compensation cost is recognized beginning with the effective date (a) based on the requirements of Statement 123(R) for all share-based payments granted after the effective date and (b) based on the requirements of Statement 123 for all awards granted to employees prior to the effective date of Statement 123(R) that remain unvested on the effective date. (2) A “modified retrospective” method which includes the requirements of the modified prospective method described above, but also permits entities to restate based on the amounts previously recognized under Statement 123 for purposes of pro forma disclosures either (a) all prior periods presented or (b) prior interim periods of the year of adoption. The Company is currently evaluating the adoption alternatives and expects to complete its evaluation by June 30, 2005. As permitted by Statement 123, the company currently accounts for share-based payments to employees using Opinion 25’s intrinsic value method and, as such, generally recognizes no compensation cost for employee stock options. Accordingly, the adoption of Statement 123(R)’s fair value method may have a significant impact on our result of operations, although it will have no impact on our overall financial position. The impact of adoption of Statement 123(R) cannot be predicted at this time because it will depend on levels of share-based payments granted in the future. However, had we adopted Statement 123(R) in prior periods, the impact of that standard would have approximated the impact of Statement 123 as described in the disclosure of pro forma net income and earnings per share in Note 3 to our consolidated financial statements. Statement 123(R) also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after adoption. While the company cannot estimate what those amounts will be in the future (because they depend on, among other things, when employees exercise stock options), the amount of operating cash flows recognized in prior periods for such excess tax deductions were $882,000, $3.5 million, and $1.5 million in 2004, 2003 and 2002, respectively. The amount of operating cash flows recognized for such excess tax deductions in the six month period ended December 31, 2004 was $1.1 million.

 

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SCANSOURCE, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

(4) Earnings Per Share

 

Basic earnings per share are computed by dividing net income by the weighted-average number of common shares outstanding. Diluted earnings per share are computed by dividing net income by the weighted-average number of common and potential common shares outstanding.

 

    

Net

Income


   Shares

   Per Share
Amount


Quarter ended December 31, 2004:

                  

Income per common share, basic

   $ 9,084,000    12,620,000    $ 0.72
                

Effect of dilutive stock options

     —      511,000       
    

  
      

Income per common share, assuming dilution

   $ 9,084,000    13,131,000    $ 0.69
    

  
  

Six months ended December 31, 2004:

                  

Income per common share, basic

   $ 17,998,000    12,600,000    $ 1.43
                

Effect of dilutive stock options

     —      508,000       
    

  
      

Income per common share, assuming dilution

   $ 17,998,000    13,108,000    $ 1.37
    

  
  

Quarter ended December 31, 2003:

                  

Income per common share, basic

   $ 6,667,000    12,508,000    $ 0.53
                

Effect of dilutive stock options

     —      434,000       
    

  
      

Income per common share, assuming dilution

   $ 6,667,000    12,942,000    $ 0.52
    

  
  

Six months ended December 31, 2003:

                  

Income per common share, basic

   $ 12,747,000    12,389,000    $ 1.03
                

Effect of dilutive stock options

     —      382,000       
    

  
      

Income per common share, assuming dilution

   $ 12,747,000    12,771,000    $ 1.00
    

  
  

 

For the quarter and six months ended December 31, 2004, there were 12,700 shares excluded from the computation of diluted earnings per share because their effect would have been antidilutive. For the quarter and six months ended December 31, 2003, there were 14,000 shares excluded from the computation of diluted earnings per share because their effect would have been antidilutive.

 

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Table of Contents

SCANSOURCE, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

(5) Revolving Credit Facility and Subsidiary Lines of Credit

 

At December 31, 2004, the Company had a $100 million multi-currency revolving credit facility with its bank group, which matures on July 31, 2008. The new credit facility was entered into on July 16, 2004. This facility has an accordion feature that allows the Company to increase the revolving credit line up to an additional $50 million, the first $30 million of which is committed with the existing bank group and the remaining $20 million is subject to syndication. The facility bears interest at either the 30-day LIBOR rate of interest in the United States or the 30, 60, 90 or 180-day LIBOR rate of interest in Europe. The interest rate is the appropriate LIBOR rate plus a rate varying from .75% to 1.75% tied to the Company’s funded debt to EBITDA ratio ranging from 0.00:1.00 to 2.50:1.00 and a fixed charge coverage ratio of not less than 1.50:1. The effective weighted average interest rate at December 31, 2004 was 3.26% and the outstanding borrowings were $59.9 million on a calculated borrowing base of $100 million, leaving $40.1 million available for additional borrowings. The facility is collateralized by domestic assets, primarily accounts receivable and inventory. The agreement contains other restrictive financial covenants, including among other things, total liabilities to tangible net worth ratio and capital expenditure limits. The Company was in compliance with its covenants at December 31, 2004.

 

At June 30, 2004, the Company’s former revolving credit facility with its bank group had a borrowing limit of the lesser of (i) $80 million or (ii) the sum of 85% of eligible accounts receivable plus the lesser of (a) 50% of eligible inventory or (b) $40 million. The interest rate was the 30-day LIBOR rate of interest plus a rate varying from 1.00% to 2.50% tied to the Company’s funded debt to EBITDA ratio ranging from 2.50:1 to 4.25:1 and a fixed charge coverage ratio of not less than 2.75:1. The effective interest rate at June 30, 2004 was 2.13% and the outstanding balance was $32.6 million on a calculated borrowing base of $80 million, leaving $47.4 million available for additional borrowings. The revolving credit facility was collateralized by accounts receivable and eligible inventory. The credit agreement contained various restrictive covenants, including among other things, minimum net worth requirements, capital expenditure limits, maximum funded debt to EBITDA ratio and a fixed charge coverage ratio. The Company was in compliance with its covenants at June 30, 2004 and at the restatement date of the credit agreement.

 

At December 31, 2004, Netpoint, doing business as ScanSource Latin America, had an asset-based line of credit with a bank that was due on demand and had a borrowing limit of $1 million (increased from $600,000 as of August 27, 2004). The facility matures on August 27, 2005 and is collateralized by accounts receivable and eligible inventory. The facility contains a restrictive covenant which requires an average deposit of $50,000 at the bank. The Company has guaranteed 76% of the balance on the line, while the remaining 24% of the balance was guaranteed by Netpoint’s minority shareholder. The facility bears interest at the bank’s prime rate minus one percent. At December 31, 2004, the effective interest rate was 4.25%. At December 31, 2004 the outstanding balance was $950,000 and the outstanding standby letters of credit totaled $40,000, leaving $10,000 available for borrowings. Netpoint was in compliance with its covenant at December 31, 2004.

 

At June 30, 2004, Netpoint had an asset-based line of credit agreement with a bank that was due on demand. The borrowing limit on the line was the lesser of $600,000 or the sum of 75% of domestic accounts receivable and 50% of foreign accounts receivable, plus 10% of eligible inventory (up to $250,000). The interest rate was the bank’s prime rate minus one percent, which was 3.00% at June 30, 2004. All of Netpoint’s assets collateralized the line of credit. The Company had guaranteed 68% of the balance on the line, while the remaining 32% of the balance was guaranteed by Netpoint’s minority shareholder. At June 30, 2004, there were no outstanding borrowings on the line of credit. However, outstanding standby letters of credit totaled $40,000 leaving $560,000 available for additional borrowings. Netpoint was in compliance with its covenants at June 30, 2004.

 

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SCANSOURCE, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

(6) Long-term Debt

 

Long-term debt consists of the following at December 31, 2004 and June 30, 2004:

 

     December, 31
2004


   June 30,
2004


Note payable to a bank, secured by distribution center land and building; monthly payments of principal and interest of $65,000; 3.71% and 2.53% variable interest rate, respectively at December 31, 2004 and June 30, 2004; maturing in fiscal year 2006 with a balloon payment of approximately $4,826,000

   $ 5,221,000    $ 5,528,000

Note payable to a bank, secured by office building and land; monthly payments of principal and interest of $15,000; 9.19% fixed interest rate at December 31, 2004 and June 30, 2004; maturing in fiscal 2007 with a balloon payment of approximately $1,458,000

     1,530,000      1,549,000

Note payable to a bank, secured by motor coach; monthly payments of principal and interest of $7,000; 3.71% and 2.53% variable interest rate, respectively at December 31, 2004 and June 30, 2004; maturing in fiscal 2006 with a balloon payment of approximately $147,000

     234,000      274,000

Capital leases for equipment with monthly principal payments ranging from $33 to $1,903 and effective interest rates ranging from 7.60% to 23.82% at December 31, 2004 and June 30, 2004, respectively

     42,000      87,000
    

  

       7,027,000      7,438,000

Less current portion

     5,383,000      854,000
    

  

Long-term portion

   $ 1,644,000    $ 6,584,000
    

  

 

The notes payable secured by the distribution center and the motor coach contain certain financial covenants, including minimum net worth, capital expenditure limits, and a maximum debt to tangible net worth ratio, and prohibit the payment of dividends. The Company was in compliance with the various covenants at December 31, 2004.

 

The note payable secured by the distribution center land and building matures on September 5, 2005 with a balloon payment of approximately $4.8 million. The Company has ample borrowing capacity under its existing credit facility and is reviewing its various financing options to satisfy its obligations with respect to such payment. As of December 31, 2004, the $5.2 million balance was classified as current debt. As of June 30, 2004, the current portion of the debt was $647,000 and the long-term portion was $4.9 million.

 

17


Table of Contents

SCANSOURCE, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

(7) Goodwill and Identifiable Intangible Assets

 

In accordance with SFAS No. 142, Goodwill and Other Intangible Assets, the Company performs its annual test of goodwill at the end of each fiscal year to determine if impairment has occurred. This testing includes the determination of each reporting unit’s fair value using market multiples and discounted cash flows modeling. At the end of fiscal year 2004, no impairment charge was recorded. During the first quarter of fiscal year 2005, the Company acquired additional goodwill through the acquisition of an additional 12% interest in OUI and an additional 8% interest in Netpoint. Changes in the carrying amount of goodwill and other intangibles assets for the six months ended December 31, 2004, by operating segment, are as follows:

 

     North
American
Distribution
Segment


   International
Distribution
Segment


   Total

Balance as of June 30, 2004

   $ 5,719,000    $ 4,259,000    $ 9,978,000

Excess of cost over fair value of acquired net assets, net

     27,000      256,000      283,000
    

  

  

Balance as of December 31, 2004

   $ 5,746,000    $ 4,515,000    $ 10,261,000
    

  

  

 

Included within other assets are identifiable intangible assets as follows:

 

     As of December 31, 2004

   As of June 30, 2004

     Gross
Carrying
Amount


   Accumulated
Amortization


  

Net

Book
Value


   Gross
Carrying
Amount


   Accumulated
Amortization


  

Net

Book
Value


Amortized intangible assets:

                                         

Customer lists

   $ 338,000    $ 201,000    $ 137,000    $ 338,000    $ 167,000    $ 171,000

Debt issue costs

     532,000      55,000      477,000      —        —        —  

Non-compete agreements

     425,000      396,000      29,000      425,000      250,000      175,000
    

  

  

  

  

  

Total

   $ 1,295,000    $ 652,000    $ 643,000    $ 763,000    $ 417,000    $ 346,000
    

  

  

  

  

  

 

The customer lists are amortized using the straight-line method over a period of 5 years. The non-compete agreements are amortized over their expected life and the debt issue costs are amortized over the term of the credit facility. Amortization expense for the quarter and six months ended December 31, 2004 was $79,000 and $235,000, respectively. Amortization expense for the quarter and six months ended December 31, 2003 was $51,000 and $103,000, respectively. Amortization expense is estimated to be approximately $363,000 for fiscal year 2005, $200,000 for fiscal year 2006, $170,000 for fiscal year 2007, $133,000 for fiscal year 2008 and $12,000 for fiscal year 2009.

 

18


Table of Contents

SCANSOURCE, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

(8) Segment Information

 

The Company is a leading distributor of specialty technology products, providing value-added distribution sales to resellers in the specialty technology markets. Based on geographic location, the Company has two segments for distribution of specialty technology products. The measure of segment profit is income from operations, and the accounting policies of the segments are the same as those described in Note 2 to the audited consolidated financial statements contained in the Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 2004. Beginning with the first quarter of fiscal 2004, the ChannelMax segment has been restructured into the North American Distribution segment.

 

North American Distribution

 

North American Distribution offers products for sale in four primary categories: (i) AIDC and POS equipment sold by the ScanSource sales unit, (ii) voice, data and converged communications equipment sold by the Catalyst Telecom sales unit, (iii) voice, data and converged communications products sold by the Paracon sales unit, and (iv) electronic security products through its ScanSource Security Distribution sales unit. These products are sold to more than 11,000 resellers and integrators of technology products that are geographically disbursed over the United States and Canada in a pattern that mirrors population concentration. No single account represented more than 7% of the Company’s consolidated net sales during the quarter and six month periods ended December 31, 2004 and 2003.

 

International Distribution

 

International Distribution sells to two geographic areas, Latin America (including Mexico) and Europe, and offers AIDC and POS equipment to approximately 4,000 resellers and integrators of technology products. This segment began during fiscal 2002 with the Company’s purchase of a majority interest in Netpoint and the start-up of the Company’s European operations. Of this segment’s customers, no single account represented 1% or more of the Company’s consolidated net sales during the quarter and six month periods ended December 31, 2004 and 2003.

 

The Company evaluates segment performance based on operating income. Inter-segment sales consist of sales by the North American Distribution segment to the International Distribution segment. All inter-segment revenues and profits have been eliminated in the accompanying consolidated financial statements.

 

19


Table of Contents

SCANSOURCE, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

Selected financial information of each business segment are presented below:

 

    

Quarter ended

December 31,


   

Six months ended

December 31,


 
     2004

    2003

    2004

    2003

 

Sales:

                                

North American distribution

   $ 327,683,000     $ 263,006,000     $ 660,642,000     $ 518,218,000  

International distribution

     47,218,000       28,962,000       79,684,000       52,615,000  

Less intersegment sales

     (4,771,000 )     (3,002,000 )     (7,487,000 )     (5,393,000 )
    


 


 


 


     $ 370,130,000     $ 288,966,000     $ 732,839,000     $ 565,440,000  
    


 


 


 


Depreciation and amortization:

                                

North American distribution

   $ 1,155,000     $ 1,121,000     $ 2,403,000     $ 2,313,000  

International distribution

     139,000       211,000       266,000       289,000  
    


 


 


 


     $ 1,294,000     $ 1,332,000     $ 2,669,000     $ 2,602,000  
    


 


 


 


Operating income:

                                

North American distribution

   $ 13,807,000     $ 10,132,000     $ 28,387,000     $ 19,831,000  

International distribution

     944,000       726,000       1,034,000       712,000  
    


 


 


 


     $ 14,751,000     $ 10,858,000     $ 29,421,000     $ 20,543,000  
    


 


 


 


Capital expenditures:

                                

North American distribution

   $ 1,130,000     $ 421,000     $ 1,364,000     $ 1,036,000  

International distribution

     111,000       136,000       213,000       173,000  
    


 


 


 


     $ 1,241,000     $ 557,000     $ 1,577,000     $ 1,209,000  
    


 


 


 


 

Assets for each business unit are summarized below:

 

     December 31,
2004


  

June 30,

2004


Assets:

             

North American distribution

   $ 399,193,000    $ 373,101,000

International distribution

     62,327,000      40,091,000
    

  

     $ 461,520,000    $ 413,192,000
    

  

 

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SCANSOURCE, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

(9) Special Charges

 

The Company incurred special charges of $2.3 million during the quarter ended September 30, 2003 related to the restructuring of the ChannelMax business segment into the North American Distribution segment. Effective July 1, 2003, the Company reassigned the ChannelMax segment to become a part of the North American Distribution segment. The Company consolidated the information services and operational staff into the Company’s corporate group. These charges primarily consisted of costs associated with employee severance for 9 employees of the operations management and programming groups and ChannelMax option settlement costs associated with the segment. These charges are included in operating expenses on the Company’s Condensed Consolidated Income Statements.

 

(10) Commitments and Contingencies

 

Contingencies – The Company received an assessment for a sales and use tax matter for the three calendar years ended 2001. Based on this assessment, the Company has determined a probable range for the disposition of that assessment and for subsequent periods. Although the Company is disputing the assessment, it accrued a liability of $1.4 million at December 31, 2004 and June 30, 2004. Although there can be no assurance of the ultimate outcome at this time, the Company intends to vigorously defend its position.

 

21


Table of Contents

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Results of Operations

 

Net Sales

 

The following tables summarize the Company’s net sales results (net of inter-segment sales):

 

    

Quarter ended

December 31,


  

Difference


  

Percentage

Change


 
     2004

   2003

     
     (In thousands)       

North American distribution

   $ 322,912    $ 260,004    $ 62,908    24.2 %

International distribution

     47,218      28,962      18,256    63.0 %
    

  

  

  

Net sales

   $ 370,130    $ 288,966    $ 81,164    28.1 %
    

  

  

  

    

Six months ended

December 31,


  

Difference


  

Percentage

Change


 
     2004

   2003

     
     (In thousands)       

North American distribution

   $ 653,155    $ 512,825    $ 140,330    27.4 %

International distribution

     79,684      52,615      27,069    51.4 %
    

  

  

  

Net sales

   $ 732,839    $ 565,440    $ 167,399    29.6 %
    

  

  

  

 

North American Distribution

 

North American distribution sales include sales to technology resellers in the United States and Canada from the Company’s Memphis, Tennessee distribution center. Sales to technology resellers in Canada account for less than 5% of total net sales for the quarter and six month periods ended December 31, 2004 and 2003. The 24.2% increase in North American Distribution sales for the quarter ended December 31, 2004, as compared to the same period in the prior year, was due primarily to gain in market share. The 27.4% increase for the six months ended December 31, 2004, as compared to the same period in the prior year, was due to an increase in large orders and a gain in market share.

 

Sales of the AIDC and POS product categories for the North America distribution segment increased 22.4% as compared to the prior year quarter and 23.4% as compared to the prior year six month period. The ScanSource selling unit benefited from the aforementioned larger orders and market share gain.

 

Sales of converged communications products increased 26.0% as compared to the prior year quarter and 32.1% as compared to the prior year six month period. Both Catalyst Telecom, which distributes small and medium business (SMBS) and enterprise (ECG) products, and Paracon, which distributes communication products, experienced growth from the recruitment of additional resellers and to larger orders for the six month period ended December 31, 2004.

 

The ScanSource Security Distribution sales unit was created during the quarter ended December 31, 2004. Sales were immaterial for the quarter and six months ended December 31, 2004.

 

22


Table of Contents

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

International Distribution

 

The international distribution segment includes sales to Latin America (including Mexico) and Europe from the ScanSource selling unit. Sales for the overall international segment increased 63.0% or $18.3 million for the quarter ended December 31, 2004 and 51.4% or $27.1 million for the six month period as compared to the same periods in the prior year. The favorable Euro versus U.S. Dollar exchange rate accounts for approximately $2.8 million and $4.8 million of the increase for the quarter and six months ended December 31, 2004. Without the benefit of the foreign exchange rates, the increase for the quarter and six month periods ended December 31, 2004 would have been 53.4% or $15.5 million and 42.3% or $22.3 million, respectively. The increase in sales was primarily attributable to obtaining additional market share in Europe and Latin America.

 

Gross Profit

 

The following tables summarize the Company’s gross profit:

 

    

Quarter ended

December 31,


  

Difference


  

Percentage

Change


    Percentage of Sales
December 31,


 
     2004

   2003

        2004

    2003

 
     (In thousands)                   

North American distribution

   $ 32,895    $ 26,934    $ 5,961    22.1 %   10.2 %   10.4 %

International distribution

     4,966      3,969      997    25.1 %   10.5 %   13.7 %
    

  

  

  

 

 

Gross profit

   $ 37,861    $ 30,903    $ 6,958    22.5 %   10.2 %   10.7 %
    

  

  

  

 

 

     Six months ended
December 31,


  

Difference


  

Change


    Percentage of Sales
December 31,


 
     2004

   2003

        2004

    2003

 
     (In thousands)                   

North American distribution

   $ 66,024    $ 54,681    $ 11,343    20.7 %   10.1 %   10.7 %

International distribution

     8,819      7,066      1,753    24.8 %   11.1 %   13.4 %
    

  

  

  

 

 

Gross profit

   $ 74,843    $ 61,747    $ 13,096    21.2 %   10.2 %   10.9 %
    

  

  

  

 

 

 

North American Distribution

 

Gross profit for the North American Distribution segment increased 22.1% and $6.0 million for the quarter ended December 31, 2004 and 20.7% and $11.3 million for the six month period as compared to the same periods in the prior year. The increase in gross profit for the quarter and six months ended December 31, 2004 is a result of increased sales volume of the segment.

 

Gross profit as a percentage of net sales for the North American Distribution segment decreased compared to same periods in the prior year. The decrease is a result of product sales mix, including a greater percentage of large orders with a low value-add requirement, and changes in vendor purchasing programs which had the effect of increasing unit costs. The change in vendor purchasing programs is a combination of decreased program benefits and higher year on year sales volume with fixed dollar incentives on certain programs.

 

International Distribution

 

Gross profit for the international distribution segment increased 25.1% and $1.0 million for the quarter ended December 31, 2004 and 24.8% and $1.8 million for the six month period as compared to the same periods in the prior year. The increase was primarily due to increased distribution sales volume as the segment gained additional resellers and market share.

 

23


Table of Contents

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Gross profit, as a percentage of net sales, which is typically greater than the North American Distribution segment, decreased for the quarter and six month periods ended December 31, 2004. The decrease was due to changes in vendor purchasing programs, a greater percentage of large orders for all international geographies, and to the inclusion of additional freight costs for the European business.

 

Operating Expenses

 

The following table summarizes the Company’s operating expenses:

 

     Period ended
December 31,


  

Difference


  

Percentage

Change


    Percentage of Sales
December 31,


 
     2004

   2003

        2004

    2003

 
     (In thousands)                   

Quarter

   $ 23,110    $ 20,045    $ 3,065    15.3 %   6.2 %   6.9 %

Six months

   $ 45,422    $ 41,204    $ 4,218    10.2 %   6.2 %   7.3 %

 

For the quarter ended December 31, 2004, operating expenses included an $800,000 increased profit sharing contribution, a $250,000 charitable contribution, and an increase in marketing related expenses compared to the prior year quarter. Operating expenses as a percentage of net sales decreased for the quarter ended December 31, 2004 due to the accrual of $1.25 million, or $775,000 net of $475,000 tax benefit, in the prior year for the disposition of a sales and use tax matter and to greater economies of scale in selling, general and administrative expenses as the sales volume increased.

 

The Company continues to invest in infrastructure in Europe and Latin America to expand coverage due to its growth potential. In Europe, the Company has expanded geographically and increased employee headcount. In Latin America, the Company has increased employee headcount in Miami and Mexico City in order to serve an expanding customer base. In North America, an expansion project was begun during the quarter ended December 31, 2004 to increase the capacity of the Memphis, Tennessee distribution center by 50%. Related to this, the Company entered into an operating lease and incurred approximately one month of operating expense. This project was completed in January 2005 and is expected to meet the current and near-term growth of the North American business. The Company also opened an additional Canadian sales office in Toronto in order to increase the focus on current and potential AIDC and POS resellers in eastern Canada. The Company has maintained a western Canadian sales office in Vancouver since 1998.

 

For the six months ended December 31, 2004, operating expenses included a $2.6 million discretionary profit sharing contribution, a $750,000 charitable contribution, $700,000 of additional bad debt expense over the same period in the prior year, and additional infrastructure investments in Europe and Latin America that occurred throughout the six month period. The six month period ended December 31, 2004 also reflects the costs associated with the aforementioned expansion of the Memphis, Tennessee distribution center and the Canadian sales office in Toronto. Operating expenses for the six months ended December 31, 2003 included $2.3 million of restructuring costs for the ChannelMax segment, a discretionary profit sharing contribution of $1.8 million, and a $1.65 million, or $1.023 million net of $627,000 tax benefit, accrual for the disposition of a sales and use tax matter.

 

Operating Income

 

The following table summarizes the Company’s operating income:

 

     Period ended
December 31,


  

Difference


  

Percentage

Change


    Percentage of Sales
December 31,


 
     2004

   2003

        2004

    2003

 
     (In thousands)                   

Quarter

   $ 14,751    $ 10,858    $ 3,893    35.9 %   4.0 %   3.8 %

Six months

   $ 29,421    $ 20,543    $ 8,878    43.2 %   4.0 %   3.6 %

 

24


Table of Contents

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Operating income increased 35.9% and $3.9 million for the quarter ended December 31, 2004 and 43.2% and $8.9 million for the six month period ended December 31, 2004 as compared to the same periods in the prior year. The increase in operating income for the quarter ended December 31, 2004 compared to the prior year quarter is a result of increased sales volume, the accrual of $1.25 million in the prior year for the disposition of a sales and use tax matter, and to greater economies of scale in operating expenses as sales volume increased, partially offset by an increased profit sharing contribution. The increase in operating profit for the six month period ended December 31, 2004 was due to the same reasons mentioned above for the quarter and also to $2.3 million ChannelMax restructuring costs in the prior year.

 

Operating income as a percentage of net sales increased compared to same periods in the prior year. The increase is primarily due to decreased operating expenses as a percentage of net sales discussed above.

 

Total Other Expense (Income)

 

The following table summarizes the Company’s total other expense (income):

 

     Quarter ended
December 31,


   

Difference


   

Percentage

Change


    Percentage of Sales
December 31,


 
     2004

    2003

        2004

    2003

 
     (In thousands)                    

Interest expense

   $ 482     $ 284     $ 198     69.7 %   0.1 %   0.1 %

Interest income

     (334 )     (85 )     (249 )   292.9 %   -0.1 %   0.0 %

Net foreign exchange (gains) losses

     (258 )     (74 )     (184 )   248.6 %   -0.1 %   0.0 %

Other, net

     (42 )     10       (52 )   -520.0 %   0.0 %   0.0 %
    


 


 


 

 

 

Total other expense

   $ (152 )   $ 135     $ (287 )   -212.6 %   0.0 %   0.0 %
    


 


 


 

 

 

     Six months ended
December 31,


   

Difference


   

Percentage

Change


    Percentage of Sales
December 31,


 
     2004

    2003

        2004

    2003

 
     (In thousands)                    

Interest expense

   $ 895     $ 627     $ 268     42.7 %   0.2 %   0.2 %

Interest income

     (550 )     (246 )     (304 )   123.6 %   -0.1 %   -0.1 %

Net foreign exchange (gains) losses

     (223 )     (296 )     73     -24.7 %   -0.1 %   -0.1 %

Other, net

     (30 )     66       (96 )   -145.5 %   0.0 %   0.0 %
    


 


 


 

 

 

Total other expense

   $ 92     $ 151     $ (59 )   -39.1 %   0.0 %   0.1 %
    


 


 


 

 

 

 

Interest expense reflects interest paid on borrowings on the Company’s line of credit and long-term debt. Interest expense for the quarter and six months ended December 31, 2004 was $482,000 and $895,000, respectively. Interest expense for the quarter and six months ended December 31, 2003 was $284,000 and $627,000, respectively. The increased expense for the current year was due to higher interest rates and higher average borrowings on the Company’s line of credit over the prior year.

 

Interest income principally represents interest collected from customers. Interest income for the quarter and six months ended December 31, 2004 was $334,000 and $550,000, respectively. Interest income for the quarter and six months ended December 31, 2003 was $85,000 and $246,000, respectively. The increase from the prior year was a result of increased interest income from certain customer financing arrangements.

 

25


Table of Contents

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Foreign exchange gains and losses consist of foreign currency transactional and functional currency re-measurements, offset by net foreign currency exchange contract losses. Net foreign exchange gains for the quarter and six months ended December 31, 2004 were $258,000 and $223,0000, respectively. Net foreign exchange gains for the quarter and six months ended December 31, 2003 were $74,000 and $296,000, respectively. The change in foreign exchange gains and losses for the quarter ended December 31, 2004 as compared to the prior year is primarily the result of fluctuation in the value of the Euro versus the British Pound, and to a lesser extent, the U.S. Dollar versus other currencies. The foreign exchange gains and losses for the six months ended December 31, 2004 are comparable to the prior year period. It continues to be our goal to minimize the impact of foreign currency exchange fluctuations through an effective hedging program. The Company’s foreign exchange policy prohibits entering into speculative transactions.

 

Provision For Income Taxes

 

Income tax expense was $5.7 million and $11.2 million for the quarter and six months ended December 31, 2004, respectively, reflecting an effective income tax rate of 38.4% and 38.2%, respectively. Income tax expense was $3.9 million and $7.5 million for the quarter and six months ended December 31, 2003, respectively, reflecting an effective income tax rate of 36.7% and 36.9%, respectively. The effective income tax rate for the prior full fiscal year was 38.3%.

 

Minority Interest in Income of Consolidated Subsidiaries

 

The Company consolidates two subsidiaries that have a minority ownership interest. Minority interest income reflects the minority interest earnings of these subsidiaries for the respective periods. For the quarter and six months ended December 31, 2004, the Company owned 88% of OUI and 76% of Netpoint. For the quarter and six months ended December 31, 2003 the Company owned 76% of OUI and 68% of Netpoint.

 

Net Income

 

The following table summarizes the Company’s net income:

 

     Period ended
December 31,


  

Difference


  

Percentage

Change


   

Percentage of Sales

December 31,


 
     2004

   2003

        2004

    2003

 
     (In thousands)                   

Quarter

   $ 9,084    $ 6,667    $ 2,417    36.3 %   2.5 %   2.3 %

Six months

   $ 17,998    $ 12,747    $ 5,251    41.2 %   2.5 %   2.3 %

 

The increase in the amount of net income is attributable to the changes in operating profits and provision for income taxes discussed above.

 

26


Table of Contents

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Liquidity and Capital Resources

 

The Company’s primary sources of liquidity are cash flow from operations, borrowings under the revolving credit facility, and, to a lesser extent, borrowings under the subsidiary’s line of credit, and proceeds from the exercise of stock options.

 

The Company’s cash balance totaled $1.6 million at December 31, 2004 compared to $1.0 million at June 30, 2004. Domestic cash is generally swept on a nightly basis to pay down the Company’s line of credit under the revolving credit facility. The Company’s working capital increased to $232.5 million at December 31, 2004 from $188.1 million at June 30, 2004. The increase in working capital resulted primarily from a $12.4 million increase in the Company’s trade and notes receivable and a $34.7 million increase in inventories offset by a $4.5 million increase in the current portion of long-term debt. The increase in receivables and inventory is due to levels necessary to support worldwide growth of the Company.

 

The increase in the amount of trade and notes receivable is attributable to an increase in sales during the quarter. The number of days sales outstanding (DSO) in ending trade receivables remained comparable at December 31, 2004 and June 30, 2004, at 46 and 47 days, respectively. Inventory turnover improved to 6.6 times for the quarter ended December 31, 2004 from 6.5 times for the quarter ended June 30, 2004. The company decreased accounts payable due to quarter end timing of domestic bi-weekly payments as well as a more linear pattern of purchases of inventory, which in turn accelerates traditional accounts payable payment patterns.

 

Cash used in operating activities was $25.2 million for the six months ended December 31, 2004 compared to $3.8 million for the six months ended December 31, 2003. The increase in cash used in operating activities was primarily attributable to changes in current assets and liability accounts for each respective period referenced above.

 

Cash used in investing activities for the six months ended December 31, 2004 was $2.1 million, which included $1.6 million for capital expenditures and $521,000 primarily for additional ownership interest in one of the Company’s majority-owned subsidiaries (Netpoint). The Company’s capital expenditures included $617,000 related to the expansion of the Memphis, Tennessee distribution center, as well as purchases of software, furniture and equipment.

 

Cash used in investing activities for the six months ended December 31, 2003 was $1.5 million, which included approximately $1.2 million for capital expenditures, $277,000 for additional ownership interests in two of the Company’s majority-owned subsidiaries (Netpoint and OUI), and the remaining 10% minority interest of ChannelMax. The Company’s capital expenditures resulted from purchases of software for financial reporting, web-based software for product ordering and configuration, as well as furniture and equipment.

 

At December 31, 2004, the Company had a $100 million multi-currency revolving credit facility with its bank group, which matures on July 31, 2008. The new credit facility was entered into on July 16, 2004. This facility has an accordion feature that allows the Company to increase the revolving credit line up to an additional $50 million, the first $30 million of which is committed with the existing bank group and the remaining $20 million is subject to syndication. The facility bears interest at either the 30-day LIBOR rate of interest in the United States or the 30, 60, 90 or 180-day LIBOR rate of interest in Europe. The interest rate is the appropriate LIBOR rate plus a rate varying from .75% to 1.75% tied to the Company’s funded debt to EBITDA ratio ranging from 0.00:1.00 to 2.50:1.00 and a fixed charge coverage ratio of not less than 1.50:1. The effective weighted average interest rate at December 31, 2004 was 3.26% and the outstanding borrowings were $59.9 million on a calculated borrowing base of $100 million, leaving $40.1 million available for additional borrowings. The facility is collateralized by domestic assets, primarily accounts receivable and inventory. The agreement contains other restrictive financial covenants, including among other things, total liabilities to tangible net worth ratio and capital expenditure limits. The Company was in compliance with its covenants at December 31, 2004.

 

At June 30, 2004, the Company’s former revolving credit facility with its bank group had a borrowing limit of the lesser of (i) $80 million or (ii) the sum of 85% of eligible accounts receivable plus the lesser of (a) 50% of eligible

 

27


Table of Contents

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

inventory or (b) $40 million. The interest rate was the 30-day LIBOR rate of interest plus a rate varying from 1.00% to 2.50% tied to the Company’s funded debt to EBITDA ratio ranging from 2.50:1 to 4.25:1 and a fixed charge coverage ratio of not less than 2.75:1. The effective interest rate at June 30, 2004 was 2.13% and the outstanding balance was $32.6 million on a calculated borrowing base of $80 million, leaving $47.4 million available for additional borrowings. The revolving credit facility was collateralized by accounts receivable and eligible inventory. The credit agreement contained various restrictive covenants, including among other things, minimum net worth requirements, capital expenditure limits, maximum funded debt to EBITDA ratio and a fixed charge coverage ratio. The Company was in compliance with its covenants at June 30, 2004 and at the restatement date of the credit agreement.

 

At December 31, 2004, Netpoint, doing business as ScanSource Latin America, had an asset-based line of credit with a bank that was due on demand and had a borrowing limit of $1 million (increased from $600,000 as of August 27, 2004). The facility matures on August 27, 2005 and is collateralized by accounts receivable and eligible inventory. The facility contains a restrictive covenant which requires an average deposit of $50,000 at the bank. The Company has guaranteed 76% of the balance on the line, while the remaining 24% of the balance was guaranteed by Netpoint’s minority shareholder. The facility bears interest at the bank’s prime rate minus one percent. At December 31, 2004, the effective interest rate was 4.25%. At December 31, 2004 the outstanding balance was $950,000 and the outstanding standby letters of credit totaled $40,000, leaving $10,000 available for borrowings. Netpoint was in compliance with its covenant at December 31, 2004.

 

At June 30, 2004, Netpoint had an asset-based line of credit agreement with a bank that was due on demand. The borrowing limit on the line was the lesser of $600,000 or the sum of 75% of domestic accounts receivable and 50% of foreign accounts receivable, plus 10% of eligible inventory (up to $250,000). The interest rate was the bank’s prime rate minus one percent, which was 3.00% at June 30, 2004. All of Netpoint’s assets collateralized the line of credit. The Company had guaranteed 68% of the balance on the line, while the remaining 32% of the balance was guaranteed by Netpoint’s minority shareholder. At June 30, 2004, there were no outstanding borrowings on the line of credit. However, outstanding standby letters of credit totaled $40,000 leaving $560,000 available for additional borrowings. Netpoint was in compliance with its covenants at June 30, 2004.

 

Cash provided by financing activities for the six months ended September 30, 2004 totaled $27.8 million, including $27.0 million in advances under the Company’s credit facility and $1.2 million in proceeds from stock option exercises offset by $411,000 in payments on long-term debt. Cash provided by financing activities for the six months ended December 31, 2003 totaled $3.1 million, including $1.2 million in advances under the Company’s credit facility and $2.3 million in proceeds from stock option exercises offset by $431,000 in payments on long-term debt.

 

The note payable secured by the distribution center land and building matures on September 5, 2005 with a balloon payment of approximately $4.8 million. The Company has ample borrowing capacity under its existing credit facility and is reviewing its various financing options to satisfy its obligations with respect to such payment. As of December 31, 2004 the $5.2 million balance was classified as current debt. As of June 30, 2004, the current portion of the debt was $647,000 and the long-term portion was $4.9 million.

 

The Company believes that it has sufficient liquidity to meet its forecasted cash requirements for at least the next fiscal year.

 

Accounting Standards Recently Issued

 

In January 2003, the FASB issued Interpretation No. 46 (“FIN 46”), Consolidation of Variable Interest Entities. FIN 46 clarifies the application of Accounting Research Bulletin No. 51, Consolidated Financial Statements, to certain entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 applies immediately to variable interest entities (“VIEs”) created after January 31, 2003, and to VIEs in which an enterprise obtains an interest after that date. In December 2003, the FASB published a revision to FIN 46 to

 

28


Table of Contents

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

clarify some of the provisions and to exempt certain entities from its requirements. Under the new guidance, special effective date provisions apply to enterprises that have fully or partially applied FIN 46 prior to issuance of the revised interpretation. Otherwise, application of Interpretation 46R (“FIN 46R”) is required in financial statements of public entities that have interests in structures that are commonly referred to as special-purpose entities (“SPEs”) for periods ending after December 15, 2003. Application by public entities, other than small business issuers, for all other types of VIEs other than SPEs is required in financial statements for periods ending after March 15, 2004. The Company has completed its evaluation of all potential VIEs relationships existing prior to February 1, 2003. The Company did not create or obtain any interest in a variable interest entity during the period February 1, 2003 through December 31, 2004. However, changes in the Company’s business relationships with various entities could occur which may impact its financial statements under the requirements of FIN 46R. The Company has concluded that these relationships do not meet the requirements under the provision and therefore, there is no effect of these relationships on the Company’s consolidated financial position or results of operations as of December 31, 2004.

 

On December 16, 2004, the FASB issued FASB Statement No. 123 (revised 2004), Share-Based Payment, which is a revision of FASB Statement No. 123, Accounting for Stock-Based Compensation. Statement 123(R) supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and amends FASB Statement No. 95, Statement of Cash Flows. Generally, the approach in Statement 123(R) is similar to the approach described in Statement 123. However, Statement 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative. Statement 123(R) must be adopted no later than July 1, 2005. Early adoption will be permitted in periods in which financial statements have not yet been issued. We expect to adopt Statement 123(R) on July 1, 2005. Statement 123(R) permits public companies to adopt its requirements using one of two methods: (1) A “modified prospective” method in which compensation cost is recognized beginning with the effective date (a) based on the requirements of Statement 123(R) for all share-based payments granted after the effective date and (b) based on the requirements of Statement 123 for all awards granted to employees prior to the effective date of Statement 123(R) that remain unvested on the effective date. (2) A “modified retrospective” method which includes the requirements of the modified prospective method described above, but also permits entities to restate based on the amounts previously recognized under Statement 123 for purposes of pro forma disclosures either (a) all prior periods presented or (b) prior interim periods of the year of adoption. The Company is currently evaluating the adoption alternatives and expects to complete its evaluation by June 30, 2005. As permitted by Statement 123, the company currently accounts for share-based payments to employees using Opinion 25’s intrinsic value method and, as such, generally recognizes no compensation cost for employee stock options. Accordingly, the adoption of Statement 123(R)’s fair value method may have a significant impact on our result of operations, although it will have no impact on our overall financial position. The impact of adoption of Statement 123(R) cannot be predicted at this time because it will depend on levels of share-based payments granted in the future. However, had we adopted Statement 123(R) in prior periods, the impact of that standard would have approximated the impact of Statement 123 as described in the disclosure of pro forma net income and earnings per share in Note 3 to our consolidated financial statements. Statement 123(R) also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after adoption. While the company cannot estimate what those amounts will be in the future (because they depend on, among other things, when employees exercise stock options), the amount of operating cash flows recognized in prior periods for such excess tax deductions were $882,000, $3.5 million, and $1.5 million in 2004, 2003 and 2002, respectively. The amount of operating cash flows recognized for such excess tax deductions in the six month period ended December 31, 2004 was $1.1 million.

 

Impact of Inflation

 

The Company has not been adversely affected by inflation as technological advances and competition within specialty technology markets has generally caused prices of the products sold by the Company to decline. Management believes that any price increases could be passed on to its customers, as prices charged by the Company are not set by long-term contracts.

 

29


Table of Contents

Item 3. Quantitative and Qualitative Disclosures about Market Risk

 

The Company’s principal exposure to changes in financial market conditions in the normal course of its business is a result of its selective use of bank debt and transacting business in foreign currencies in connection with its foreign operations. The Company has chosen to present this information below in a sensitivity analysis format.

 

The Company is exposed to changes in interest rates primarily as a result of its borrowing activities, which include revolving credit facilities with a group of banks used to maintain liquidity and fund the Company’s business operations. The nature and amount of the Company’s debt may vary as a result of future business requirements, market conditions and other factors. The definitive extent of the Company’s interest rate risk is not quantifiable or predictable because of the variability of future interest rates and business financing requirements, but the Company does not believe such risk is material. A hypothetical 100 basis point increase or decrease in interest rates on borrowings on the Company’s revolving line of credit, variable rate long term debt and subsidiary line of credit for the quarter and six months ended December 31, 2004 would have resulted in an approximately $121,000 and $208,000 decrease or increase, respectively, in pre-tax income. The Company does not currently use derivative instruments or take other actions to adjust the Company’s interest rate risk profile.

 

The Company is exposed to foreign currency risks that arise from its foreign operations in Canada, Mexico and Europe. These risks include the translation of local currency balances of foreign subsidiaries, inter-company loans with foreign subsidiaries and transactions denominated in non-functional currencies. Foreign exchange risk is managed by using foreign currency forward and option contracts to hedge these exposures. The Company’s Board of Directors has approved a foreign exchange hedging policy to minimize foreign currency exposure. The Company’s policy is to utilize financial instruments to reduce risks where internal netting cannot be effectively employed and not to enter into foreign currency derivative instruments for speculative or trading purposes. The Company monitors its risk associated with the volatility of certain foreign currencies against its functional currencies and enters into foreign exchange derivative contracts to minimize short-term currency risks on cash flows. The Company continually evaluates foreign exchange risk and may enter into foreign exchange transactions in accordance with its policy. Foreign currency gains and losses are included in other expense (income).

 

The Company has elected not to designate its foreign currency contracts as hedging instruments, and therefore, the instruments are marked to market with changes in their values recorded in the Consolidated Income Statement each period. The underlying exposures are denominated primarily in British Pounds, Euros, and Canadian Dollars. At December 31, 2004, the Company had no currency forward contracts outstanding. At June 30, 2004, the Company had one currency forward contract outstanding with a net liability under the contract of $21,000.

 

The Company does not utilize financial instruments for trading or other speculative purposes, nor does it utilize leveraged financial instruments. On the basis of the fair value of the Company’s market sensitive instruments at December 31, 2004 and June 30, 2004, the Company does not consider the potential near-term losses in future earnings, fair values and cash flows from reasonably possible near-term changes in interest rates and exchange rates to be material.

 

30


Table of Contents

Item 4. Controls and Procedures

 

Evaluation of Controls and Procedures

 

The Company maintains disclosure controls and procedures designed to ensure that information required to be disclosed in reports filed or submitted under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. As of the end of the period covered by this report, the Company’s Chief Executive Officer and Chief Financial Officer evaluated, with the participation of management, the effectiveness of the Company’s disclosure controls and procedures as required by Rule 13a-15 or 15d-15 of the Exchange Act. Based on the evaluation, which disclosed no significant deficiencies or material weaknesses, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective. There were no changes in the Company’s internal control over financial reporting identified in connection with the evaluation required by paragraph (d) of Rule 13a-15 or 15d-15 of the Exchange Act, that occurred during the Company’s most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

Limitations on the Effectiveness of Controls

 

The Company maintains a system of internal accounting controls to provide reasonable assurance that assets are safeguarded and that transactions are executed in accordance with management’s authorization and recorded properly to permit the preparation of financial statements in accordance with accounting principles generally accepted in the United States. However, the Company’s management, including the CEO and CFO, does not expect that the Company’s disclosure controls or internal controls will prevent all errors and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty. Breakdowns in the control systems can occur because of a simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.

 

31


Table of Contents

PART II. OTHER INFORMATION

 

Item 4. Submission of Matters to a Vote of Security Holders

 

The Company’s annual meeting of shareholders was held on December 2, 2004. At the annual meeting, the shareholders (i) elected six directors who constitute all the directors continuing on the Board after the meeting, (ii) amended the Company’s Amended and Restated Articles of Incorporation to increase the number of authorized shares of Common Stock of the Company from 25,000,000 to 45,000,000 shares, and (iii) ratified the appointment of independent auditors for fiscal 2005. Votes on each matter presented at the annual meeting were as follows:

 

(i) Election of directors:

 

     Number of Shares

Nominees


   For

   Withheld

Michael L. Baur

   10,652,765    541,297

Steven R. Fischer

   8,623,239    2,570,823

James G. Foody

   8,629,975    2,564,087

Michael J. Grainger

   11,084,783    109,279

Steven H. Owings

   10,977,025    217,037

John P. Reilly

   8,623,089    2,570,973

 

(ii) Proposal to amend the Company’s Amended and Restated Articles of Incorporation to increase the number of authorized shares of Common Stock of the Company from 25,000,000 to 45,000,000 shares:

 

     Number of Shares

For

   10,342,814

Against

   845,628

Abstain

   5,620

Broker Non-Votes

   —  

 

(iii) Proposal to ratify the appointment of Ernst & Young as the Company’s independent auditors for the fiscal year ending June 30, 2005:

 

     Number of Shares

For

   7,558,781

Against

   3,632,811

Abstain

   2,470

 

 

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Table of Contents

Item 6. Exhibits

 

Exhibits

 

3.1   Articles of Amendment Amending the Amended and Restated Articles of Incorporation of the Registrant dated December 2, 2004.
31.1   Certification Pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934, as amended.
31.2   Certification Pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934, as amended.
32.1   Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2   Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

 

33


Table of Contents

SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

SCANSOURCE, INC.

/s/ MICHAEL L. BAUR


MICHAEL L. BAUR
President and Chief Executive Officer
(Principal Executive Officer)

/s/ RICHARD P. CLEYS


RICHARD P. CLEYS
Vice President and Chief Financial Officer
(Principal Financial Officer)

 

Date: February 2, 2005

 

 

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