Expected Dividend Yield—because we do not currently pay dividends, our expected dividend yield is zero.

Expected Volatility in Stock Price—reflects the historical change in our stock price over the expected term of the stock option.

Risk-free Interest Rate—reflects the average rate on a United States Treasury bond with maturity equal to the expected term of the option.

Expected Life of Stock Awards—reflects the simplified method to calculate an expected life based on the midpoint between the vesting date and the end of the contractual term of the stock award.

The weighted-average assumptions used in the option pricing model for stock option grants awarded in the nine months ended March 31, 2009 were as follows:

Expected Volatility in Stock Price			26.6	%
Risk-Free Interest Rate			4.39	%
Expected Life of Stock Awards—Years			6
Weighted Average Fair Value at Grant Date		$	.00005

There were no stock option grants awarded in the nine months ended March 31, 2010.

The following table summarizes stock option activity for the nine months ended March 31, 2010:

		Shares				Weighted Average Exercise Price				Weighted Average Remaining Contractual Term
Outstanding at June 30, 2009			10,923,525,000			$	0.00075
Granted			—				—
Exercised			—				—
Canceled or expired			—				—
Outstanding at March 31, 2010			10,923,525,000			$	0.00075				7.5
Exercisable at March 31, 2010			8,563,335,000			$	0.00075				7.5
Expected to vest			2,360,190,000			$	0.00075				7.6

Stock-based compensation expense for the nine months ended March 31, 2010 and 2009 amounted to $297 and $280, respectively.  As of March 31, 2010, the aggregate intrinsic value of options outstanding and options exercisable was $0 as the Company’s market price of common stock was less than the exercise price for all options.

 

NOTE 10.

RETIREMENT PLANS

 

The Company maintains 401K Profit Sharing Plans for substantially all of its eligible employees.  The expense incurred for the three months ended March 31, 2010 and 2009 amounted to $62 and $44, respectively.  The expense incurred for the nine months ended March 31, 2010 and 2009 amounted to $178 and $114, respectively.

 

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NOTE 11.

INCOME TAXES

The Company periodically assesses its ability to realize our deferred tax assets by considering whether it is more likely than not that some portion or all of deferred tax assets will be realized.  Several factors are evaluated, including the amount and timing of the scheduled expiration and reversals of net operating loss carry forwards (NOLs) and deferred tax items, respectively, as well as potential generation of future taxable income over the periods for which the NOLs are applicable.  Certain estimates used in this analysis are based on the current beliefs and expectations of management, as well as assumptions made by, and information currently available to, management. Although the Company believes the expectations reflected in these estimates are based upon reasonable assumptions, there can be no assurance that actual results will not differ materially from these expectations.  The Company recorded a tax benefit of $0 and $900 for the three and nine month periods ended March 31, 2010, respectively, based on a re-evaluation of its valuation allowance.  The Company recorded an income tax provision of $250 and $620, respectively, for the three and nine months ended March 31, 2009, based on our estimated effective tax rate and our pretax income, which resulted in a reduction of the deferred tax asset of an equivalent amount.  The Company’s estimated effective tax rate for each period exceeds statutory rates primarily because the dividend on the Series E Preferred Stock which is classified as interest expense for book purposes may not be deductible for tax purposes.

 

NOTE 12.

SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION

The following are the payments made during the nine months ended March 31, 2010 and 2009 for income taxes and interest:

		2010				2009
Income taxes		$	108			$	25
Interest		$	3,628			$	3,248

Nine Months Ended March 31, 2010:

(1)

On February 1, 2010, the Company became obligated to issue a warrant, having a value of $1,217,  to its principal lender to purchase 2,526,480,000 shares of the Company’s common stock.

Nine Months Ended March 31, 2009:

(1)

In connection with the Tritronics acquisition transaction, the Company issued: (i) a non-cash unsecured note of $1,000 to the stockholder of Tritronics as part of the purchase price and  (ii) 2,796,233,000 shares of common stock with a value of $1,119 to the stockholder of Tritronics as part of the purchase price.

(2)

In connection with the debt financing for the acquisition of Tritronics, the Company incurred Original Issue Discounts of $265 on Series B Senior Subordinated Notes.

 

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

 

The following discussion should be read in conjunction with our condensed consolidated financial statements and the related notes and the other financial information appearing elsewhere in this report.  In addition to historical information, the following discussion and other parts of this quarterly report contain words such as “may,” "estimates," "expects," "anticipates," "believes," “plan,” "grow," "will," “could,” "seek," “continue,” “future,” “goal,” “scheduled” and other similar expressions that are intended to identify forward-looking information that involves risks and uncertainties.  In addition, any statements that refer to expectations or other characterizations of future events or circumstances are forward-looking statements.  Actual results and outcomes could differ materially as a result of important factors including, among other things, general economic conditions, the Company's ability to renew or replace key supply and credit agreements, fluctuations in operating results, committed backlog, public market and trading issues, risks associated with dependence on key personnel, competitive market conditions in the Company's existing lines of business and technological obsolescence, as well as other risks and uncertainties.  See “Risk Factors” below.

 

Executive Summary

 

As Encompass Group Affiliates, Inc., a Florida corporation, we specialize in the technology aftermarket service and supply chain known as reverse logistics. Our wholly-owned subsidiaries and principal operating units, Encompass Parts Distribution, Inc., a Delaware corporation ("Encompass Parts Distribution"), and Encompass Service Solutions, Inc. (a Delaware corporation) collectively operate businesses that, on a national level, provide parts procurement and distribution services, depot repair of consumer electronics, computer and peripheral equipment, board level repair, de-manufacturing and reclamation services for flat panel display and computer products, returns management services, and anticipates providing end-of-life cycle services for all such products.

We are a market leader in reverse logistics for the consumer electronics industry by providing original equipment manufacturers (“OEMs”), retailers, third party administrators (“TPAs”) and end-users with single-source, integrated life cycle reverse logistic professional management services for technology products.

Encompass Parts Distribution owns Vance Baldwin, Inc. and Tritronics, Inc., jointly operating as an integrated entity, and Cyber-Test, Inc. d/b/a Encompass Service Solutions, which collectively engage in the distribution of replacement parts for electronic equipment and the repair of such equipment.  Encompass Parts Distribution is headquartered in and operates out of two distribution and repair facilities located in Lawrenceville, Georgia with additional distribution, call center and administrative facilities located in Las Vegas, Nevada, Abington, Maryland and Miami, Florida.  Encompass Service Solutions had, until June 15, 2010, its headquarters and an operating facility located in Longwood, Florida, near Orlando, and now operates in one of the aforementioned Lawrenceville, Georgia facilities.  The Company operates as one segment in the reverse logistics industry serving the electronics industry.

Financial Condition

We believe that our present and future sales levels will, assuming successful discussions with our principal shareholder and our senior lender described below, generate cash flows that will be sufficient to fund our operating working capital needs, as well as capital expenditures and quarterly interest and principal payments that are required under our debt facility.  However, there can be no assurance that projected sales levels will be achieved, or such projected sales levels will be sufficient or economic conditions will improve in the near future, in which case our operations could be materially adversely affected.  We did not pay quarterly interest on our senior subordinated notes due on March 31, 2010 due to cash constraints.  Our lender has waived that failure and, pursuant to negotiations described further below, agreed to capitalize the unpaid interest as additional principal.  We have implemented and continue to implement internal growth initiatives to expand our sales levels, increase profitability, and to seek significant future business acquisitions, the latter which will likely require additional equity and additional borrowings.  Further, we have undertaken or anticipate undertaking certain actions to reduce our selling, general and administrative expenses, principally by reducing (i) compensation expense through wage and headcount reductions and (ii) occupancy expenses through downsizing and/or closing facilities to reduce overhead.  Because of these actions, our cash flow has improved.  Our debt agreement requires an annual sweep of excess cash flow (as defined therein), which may limit our ability to use operating cash flow to fund acquisitions.

 

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Critical Accounting Policies, Estimates and Judgments

 

Discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these consolidated financial statements requires us to make estimates and judgments that affect the amounts reported in the consolidated financial statements and the accompanying notes. On an on-going basis, we evaluate our estimates, including those related to revenue recognition, core charges, inventory, goodwill and intangible assets and income taxes. Actual results may differ from these estimates under different assumptions or conditions.

 

We believe the application of the following critical accounting policies used in the preparation of our consolidated financial statements requires significant judgments and estimates on the part of management.

Revenue Recognition

Revenue and related provisions for returns are significant to the Company’s results of operations.  The Company recognizes revenue upon delivery of goods, including new parts and refurbished computer equipment and related products, to a common carrier for delivery to the customer, at which point title passes and collectability is reasonably assured, at a sales price that is fixed and determinable.  Revenue for the repair of customer-owned equipment is recognized upon completion of the repair.   Revenue represents amounts billed electronically based on established price lists.  This methodology has historically been accurate and is expected to continue to be so.

Provisions for future product returns and core returns from customers are accounted for as sales reductions in the same period that the related sales are recorded, and are estimated based on historical trends, as well as specifically identified anticipated returns due to known business conditions.  While the Company’s rate of customer returns of new parts sold and defective parts, as well as cores, can vary from period to period as a percent of sales, our methodology of using historical trends as the basis for our assumptions and estimates has yielded accurate provisions and is expected to continue to do so.

Core Charges

The vendors of products distributed by the Company frequently add a "core charge" to the cost of individual replacement parts that the Company distributes as a means of encouraging the return of certain replaced components, most frequently circuit boards.  Such core charges can be significant in relation to the cost of individual replacement parts. These defective, replaced components are returned first to the Company and then to vendors and are ultimately repaired and re-enter the distribution channel.

Core charges borne by the Company associated with goods in inventory are not included in inventory as cost, but are classified separately in prepaid expenses and other current assets in the consolidated balance sheets.  Such core charges amounted to $2,249 and $1,702 as of March 31, 2010 and June 30, 2009, respectively.  Cores physically returned by customers to the Company awaiting return to vendors are included in inventory.

Customers either receive a credit from the Company for cores when returned, or are obligated to pay the billed core charge in the event a core is not returned.  Upon shipping a returned core to a vendor, the Company records an asset for the amount due from the vendor.

The Company records the appropriate assets and the appropriate liability for all core charges that it may be responsible for at any point in time.  Such amounts represent significant assets and liabilities.  The Company has no control over core pricing.  As core charges increase, our cash flow can be adversely impacted to the extent we may have to pay increased charges in advance of customer payment for the core charge following the sale of the related part or the return of the actual core from the customer.

Inventory

Inventory principally consists of OEM parts purchased for resale, and includes returned parts that are repaired and also held for resale and defective parts and cores to be returned to vendors, is valued at the lower of cost (average cost basis) or market, using the first-in, first-out (“FIFO”) method.  Management performs monthly assessments to determine the existence of obsolete and slow-moving inventory and records necessary provisions to establish reserves to reduce such inventory to net realizable value.  We believe that the current methodology used to determine excess and obsolete inventory and required reserves have been, and will continue to be, appropriate.

 

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We restated our unaudited condensed consolidated financial statements as of and for the three months ended September 30, 2009 and as of and for the three and six months ended December 31, 2009 due to overstatement of defective parts and returned core inventories.  This overstatement was principally caused by two software system problems in the Company’s enterprise-wide IT system, which have been identified and corrected.  The overstatement is not indicative of problems with our basic accounting methodology for cores.

Goodwill and Intangible Assets

The Company allocates the purchase price of its acquisitions to the tangible assets, liabilities and identifiable intangible assets acquired based on their estimated fair values.  The excess purchase price over those fair values is recorded as goodwill.  Historically, the Company included transaction costs, such as investment banking fees, accounting fees, legal fees, appraisal fees and Company-incurred direct out-of-pocket costs, as part of the purchase price of its acquisitions.  Under U.S. GAAP effective July 1, 2009, the Company is required to expense such costs as incurred.

Management reviews and evaluates goodwill, which represents a significant asset, for impairment annually at each fiscal year end and at interim periods if events indicate that the carrying value may be impaired.  These events or circumstances would include a significant change in the business climate, legal factors, operating performance indicators, competition, sale or disposition of a significant portion of the business or other factors.  Management believes that its impairment tests have utilized reasonable assumptions which have resulted in the determination that the fair value of the reporting units was substantially in excess of carrying value; however, there can be no assurance that circumstances could not change in the future and result in an impairment charge.  The evaluation of goodwill for impairment is performed at the entity level effective July 1, 2009.

The Company’s market capitalization has been deemed to be a poor indicator of fair value because, among other reasons, the Company’s common stock is thinly traded due to concentrated ownership, a lack of institutional awareness of and interest in ownership of the Company’s common stock since it is a “penny stock,” and a lack of research coverage.  The Company’s common stock is trading in the same general price range as it did prior to the Company’s closing of (i) a recapitalization and major acquisition in August 2007 and (ii) a second major acquisition in August 2008.

Accordingly, the carrying value of goodwill is evaluated principally in relation to the operating performance, specifically historical or projected adjusted Earnings Before Interest, Taxes, Depreciation and Amortization (“EBITDA”), as appropriate in the circumstances.  The key risk factor that determines whether the carrying value of goodwill has been impaired is a significant decline in actual EBITDA realized and a significant decline in Company’s projected EBITDA in future periods based on then current business conditions.  Management bases EBITDA estimates for future years on historical adjusted EBITDA as a percentage of revenue.  This reasonableness of the EBITDA multiple is supported by recent M&A activity information.

Management reviews and evaluates purchased intangibles with finite lives, which represents a significant asset, for impairment whenever events or changes in circumstances indicate the carrying value may not be recoverable.  These events or circumstances could include the loss of one or more customers or a material portion of one or more customer’s business or the sale or disposition of a significant portion of the business or other factors.  Some of the significant unobservable inputs that would be utilized include revised projections of revenue, EBITDA and debt free cash flow, and assumptions as to discount rate and period.

Such intangible assets with finite lives are amortized based on the estimated period in which the economic benefits are consumed.  Management believes that its amortization policy has been and will continue to be appropriate unless facts and circumstances change.  In the event of a change in facts and circumstances, such as a major attrition in customers, management may alter the method and remaining period of amortization, and amortization expense could change, or an impairment charge may be incurred.

Income Taxes

Management periodically assesses the Company’s ability to realize its deferred tax asset, which is a significant asset, by considering whether it is more likely than not that some portion or all of the deferred tax asset will be realized.  Several factors are evaluated, including the amount and timing of the scheduled expiration of the Company’s net operating loss carry forwards (NOLs).  Estimates of future taxable income over the periods for which the NOLs are applicable require assumptions as to revenue and expenses, and differences between projected taxable income and book income.  Projected taxable income is expected to exceed projected book income as the dividend on Series E Preferred Stock classified as interest expense under U.S. GAAP is likely not deductible for tax purposes. Projected taxable income in any year may exceed the Company’s annual limitation under Internal Revenue Code Section 382, regarding the amount of loss carryforward that can be utilized to offset such taxable income.  Amounts below the annual limitation may be carried forward to future years.  Certain estimates used in this analysis are based on the current beliefs and expectations of management, as well as assumptions made by, and information currently available to, management.  Although management believes the expectations reflected in these estimates are based upon reasonable assumptions, there can be no assurance that actual results will not differ materially from these expectations.

 

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As part of the process of preparing our consolidated financial statements, we are also required to estimate our taxes in each of the jurisdictions in which we operate. This process involves management estimating the actual tax exposure together with assessing permanent and temporary differences resulting from differing treatment of items for tax and U.S. GAAP purposes. These differences result in deferred tax assets and liabilities, which are included within our accompanying consolidated balance sheet. We must assess the likelihood that deferred tax assets will be recovered from future taxable income and, to the extent we believe that recovery is not likely, we must establish a valuation allowance.  Correspondingly, we reduce the valuation allowance when our analysis of future taxable income indicates that it is more likely than not that the loss carryforwards will be utilized to offset taxable income.  Such reductions were recorded in fiscal 2008, 2009 and in the current fiscal year based on the Company’s projections of future taxable income. We would increase the valuation allowance when facts and circumstances reflected in our analysis of future taxable income change and indicate that there is a low probability of utilization of loss carryforwards to offset taxable income.  We believe that our estimate of a valuation allowance against the deferred tax asset is appropriate based on current facts and circumstances.

Recent Accounting Pronouncements

During the fiscal first quarter of 2010, in accordance with U.S. GAAP, the Company adopted the standards on business combinations whereby typical transaction costs such as investment banking fees, accounting fees, legal fees, appraisal fees and Company-incurred direct out-of-pocket costs incurred in business combinations must be expensed as incurred and can no longer be effectively accounted for as part of excess purchase price and intangible assets.  The requirement to expense acquisition-related transaction costs as incurred has had a material impact on results of operations in the nine months ended March 31, 2010, and will continue to do so in the event such costs are incurred in future periods.  The statement became effective for the Company as of July 1, 2009; accordingly, capitalized transaction costs associated with potential acquisitions in process and formerly included in other non-current assets in the amount of $1,111 were written off in the quarter ended September 30, 2009.  The Company does not believe that the new standard will have an impact on financial position or cash flows, lead to technical violation of debt covenants, impact the availability or cost of capital or lead to changes in business practices.

Management does not believe that any other recently issued, but not yet effective, accounting standards if currently adopted would have a material effect on the accompanying condensed consolidated financial statements.

Business Combination

On August 1, 2008, the Company acquired all of the outstanding equity interests in Tritronics, Inc., a company engaged in the distribution of replacement parts and accessories for consumer electronics products (“Tritronics”).  The results of operations for the nine months ended March 31, 2010, include Tritronics for the full period; the results of operations for the nine months ended March 31, 2009, include Tritronics only from the acquisition date through the end of the period.

 

RESULTS OF OPERATIONS - COMPARISON OF THE THREE MONTHS ENDED MARCH 31, 2010 TO THE THREE MONTHS ENDED MARCH 31, 2009

The following table sets forth certain selected financial data as a percentage of sales for the three months ended March 31, 2010 and 2009:

		Three Months Ended								Three Months Ended
		March 31, 2010								March 31, 2009
Net sales		$	23,580				100.00	%		$	27,148				100.00	%
Cost of sales			18,117				76.8	%			19,946				73.5	%
Gross profit			5,463				23.2	%			7,202				26.5	%
Operating expenses			5,177				22.0	%			5,234				19.3	%
Income from operations			286				1.2	%			1,968				7.2	%
Other income (expense), net			(2,933	)			(12.4	)%			(1,529	)			(5.6	)%
Income (loss) before taxes			(2,647	)			(11.2	)%			439				1.6	%
Income tax benefit (provision)			0				0.0	%			(250	)			(0.9	)%
Net income (loss)		$	(2,647	)			(11.2	)%		$	189				0.7	%

 

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Net Sales

Net sales for the three months ended March 31, 2010 amounted to $23,580 as compared to net sales of $27,148 for the three months ended March 31, 2009, a decrease of $3,568, or 13.1%.  The decrease in net sales was principally attributable to the (i) lower sales by Encompass Parts Distribution as a result of (a) the current economic downturn, (b) the loss of a key customer that began liquidation proceedings in February 2009, and (c), a higher level of shipments of Philips products in the three months ended March 31, 2009 due to the Company’s then recent appointment as authorized distributor for Philips digital replacement parts, and (ii) lower sales by Encompass Service Solutions, principally attributable to the loss of a contract with a major customer which has only partially been offset by other new business.  Such decreases were partially offset by a substantial increase in business with a major customer that commenced in February 2010, but at a lower gross margin.

 

Cost of Sales and Gross Profit

 

Our cost of sales totaled $18,117 for the three months ended March 31, 2010, as compared to $19,946 for the three months ended March 31, 2009, a decrease of $1,829, or 9.2%.  Our gross profit decreased to $5,463 for the three months ended March 31, 2010 as compared to $7,202 for the three months ended March 31, 2009, with gross margin decreasing to 23.2% from 26.5% for the comparable period in the prior year.

 

The decrease in cost of sales for the three months ended March 31, 2010 was primarily attributable to the decline in sales as described above, partially offset by the effect of lower gross margin.

 

The decrease in gross margin for the three months ended March 31, 2010 is primarily attributable to the effect of a change in product and customer mix.  Gross margin for the current quarter decreased primarily due to the aforementioned decrease in sales of higher margin Philips products, lower gross margin attributable to the incremental sales to a major customer and reduced revenue from higher margin service work performed by Encompass Service Solutions.  The level of gross margin realized in the current period may not be indicative of the level of gross margin to be achieved in future periods.

 

Operating Expenses

 

Total operating expenses for the three months ended March 31, 2010 and 2009 were $5,177 and $5,234, respectively, representing a decrease of $57, or 1.1%.  The net change was primarily attributable to due to cost reductions in light of lower sales volume offset by increased expenses related to expanded international operations.

 

Depreciation and amortization for the three months ended March 31, 2010 amounted to $532 compared to $582 for the three months ended March 31, 2009.

 

Selling, general and administrative expenses decreased to $4,645 for the three months ended March 31, 2010 from $4,652 for the three months ended March 31, 2009, for a decrease of $7, or .1%, due to cost reductions in light of lower sales volume, offset in part by the inclusion of costs associated with the Las Vegas, Canada and Mexico distribution centers in the current quarter compared to $0 in the prior year period.

 

Other Income (Expense)

 

Interest expense and other financial costs, net, for the three months ended March 31, 2010 were $2,942 compared to $1,593 for the three months ended March 31, 2009.  Included in interest expense for three months ended March 31, 2010 is $342 of non-cash interest accrued but not currently payable in connection with Series E Preferred Stock compared to $277 for three months ended March 31, 2009, and a charge of $1,217 for issuance of warrants to the Company’s principal lender for the three months ended March 31, 2010.

 

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RESULTS OF OPERATIONS - COMPARISON OF THE NINE MONTHS ENDED MARCH 31, 2010 TO THE NINE MONTHS ENDED MARCH 31, 2009

The following table sets forth certain selected financial data as a percentage of sales for the nine months ended March 31, 2010 and 2009:

		Nine Months Ended								Nine Months Ended
		March 31, 2010								March 31, 2009
Net sales		$	67,972				100.00	%		$	84,694				100.00	%
Cost of sales			51,807				76.2	%			63,802				75.3	%
Gross profit			16,165				23.8	%			20,892				24.7	%
Operating expenses			16,415				24.1	%			15,273				18.0	%
Income from operations			(250	)			(0.3	)%			5,619				6.6	%
Other income (expense), net			(6,116	)			(9.0	)%			(4,394	)			(5.2	)%
Income (loss) before taxes			(6,366	)			(9.3	)%			1,225				1.4	%
Income tax benefit (provision)			900				1.3	%			(620	)			(0.7	)%
Net income (loss)		$	(5,466	)			(8.0	)%		$	605				0.7	%

Net Sales

Net sales for the nine months ended March 31, 2010 amounted to $67,972 as compared to net sales of $84,694 for the nine months ended March 31, 2009, a decrease of $16,722 or 19.7%.  The decrease in net sales was due principally to the (i) lower sales by Encompass Parts Distribution which management attributes to (a) the 2008-2009  economic downturn,  (b) the loss of a key customer that began liquidation proceedings in February 2009, and (c)  the positive effect in the nine months ended March 31, 2009 of a short-term, high level of shipments of Philips products as the Company filled back orders following its then recent appointment as authorized distributor for Philips, which lower sales by Encompass Parts Distribution was partially offset by the inclusion of nine months of Tritronics’ results in the current nine-month period versus eight months in the comparable prior period, and (ii) lower sales by Encompass Service Solutions due principally to the loss of a contract with a major customer which has only partially been offset by other new business.

 

Encompass Parts Distribution has been awarded a substantial amount of additional business with an existing customer that commenced in February 2010, which management believes may result in approximately $2 million in monthly net sales, but at lower gross margin. However, there can be no assurance that such levels in monthly net sales will be achieved in the future.

 

Cost of Sales and Gross Profit

 

Our cost of sales totaled $51,807 for the nine months ended March 31, 2010, as compared to $63,802 for the nine months ended March 31, 2009, a decrease of $11,995, or 18.8%.  Our gross profit decreased to $16,165 for the nine months ended March 31, 2009 as compared to $20,892 for the nine months ended March 31, 2009, with gross margin decreasing to 23.8% in the nine months ended March 31, 2010 from 24.7% in the comparable period in the prior year.

 

The decrease in cost of sales for the nine months ended March 31, 2010 was attributable to the decline in sales as described above, partially offset by the effect of lower gross margin.

 

The decrease in gross margin for the nine months ended March 31, 2010 is primarily attributable to the effect of a change in product and customer mix.  Gross margin for the nine months ended March 31, 2010 decreased primarily due to the aforementioned decreased sales of higher margin Philips products and reduced revenue from higher margin service work performed by Encompass Service Solutions, which were offset by higher gross margins from certain business activities associated with a strategic contractual relationship into which the Company entered in the first quarter of the current fiscal year.  The level of gross margin experienced in the current period may not be indicative of the level of gross margin to be achieved in future periods.

 

Operating Expenses

 

Total operating expenses for the nine months ended March 31, 2010 and 2009 were $16,415 and $15,273, respectively, representing an increase of $1,142 or 7.5%.  The net change was primarily attributable to a write off of deferred transaction costs to conform to U.S. GAAP that became effective in the first quarter of the current fiscal year, which resulted in the Company recording a non-cash expense in the amount of $1,111.  This charge reduced operating income, but did not have an impact on liquidity or financial condition.

 

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Depreciation and amortization for the nine months ended March 31, 2010 amounted to $1,641 compared to $1,538 for the nine months ended March 31, 2009.  The slight increase is attributable to higher amortization expense in the current period associated with intangible assets recorded in connection with the Tritronics acquisition.

 

Selling, general and administrative expenses decreased to $13,663 for the nine months ended March 31, 2010 from $13,735 for the nine months ended March 31, 2009, for a decrease of $72, or .5%, due to cost reductions in light of lower sales volume.  Selling, general and administrative expenses for the nine months ended March 31, 2010 were inflated over expenses in the comparable prior period because they included such expenses of Tritronics for all nine months and costs associated with the Las Vegas and Georgia returns and distribution centers for all nine months.   Selling, general and administrative expenses for the nine months ended March 31, 2009 included only eight months of such expenses of Tritronics following its acquisition and only eight months of such costs for the Georgia returns center and $0 of such costs for the Las Vegas distribution center.

 

Other Income (Expense)

 

Interest expense and other financial costs, net, for the nine months ended March 31, 2010 was $6,122 compared to $4,536 for the nine months ended March 31, 2009, an increase of $1,586.   This increase was due principally to a charge of $1,217 for the issuance of warrants to the Company’s principal lender. Interest expense includes $1,044 of non-cash interest accrued but not currently payable in connection with Series E preferred stock.

 

LIQUIDITY AND CAPITAL RESOURCES

 

At March 31, 2010, the Company had cash and cash equivalents of $2,776 available to meet its working capital and operational needs.  Since concluding a series of transactions in August 2007 and August 2008, to, among other things, effect a recapitalization and complete two major acquisitions, the Company’s cash flows have historically been consistent and stable from quarter to quarter based on the level of net earnings and EBITDA generated by our operating units.  The bankruptcy filing and liquidation of a major parts customer that occurred in the third quarter of our prior fiscal year, and the loss of a large laptop service contract with a major parts and service customer, negatively impacted the amount, but not the certainty, of our cash flows.  While these two events have had an impact on sales, operating income and cash flows the Company’s overall liquidity and financial condition nonetheless was sufficient.  Working capital needed to fund increases in inventory and accounts receivable or capital expenditures has been provided by operations.

The above notwithstanding, during the quarter ended March 31, 2010, and in the ensuing months, the Company has experienced a decrease in available cash due principally to an increase in accounts receivable arising in connection with the substantial increase in sales to one of its major customers.   The Company did not pay quarterly interest on the senior subordinated notes due on March 31, 2010 due to cash constraints.    In light of these circumstances, the Company, its principal shareholder and its senior lender have entered into discussions to provide $2,500 of working capital through (i) the purchase of additional preferred stock in the amount of $1,250 and (ii) the deferral and capitalization of interest on the senior subordinated notes in the aggregate amount of $1,250, $938 for the three month period ended March 31, 2010 and $312 for the three month period ending June 30, 2010.   Further, in connection with these discussions, the Company’s senior lender will waive certain financial covenants set forth in the Company’s debt agreement for the periods ending June 30, 2010 through December 31, 2010, and will revise them for future periods.  The Lender has also waived the Company’s non-payment of interest on its senior subordinated notes for the three months ended March 31, 2010, as well as all loan covenant violations as of March 31, 2010 and for any prior periods.

The Company expects to complete the equity infusion and amendment to its existing debt agreement before June 30, 2010; however, there is no assurance that the parties will reach agreement upon financing on such terms.  In the unlikely event that our majority shareholder or senior lender is unwilling to provide the necessary working capital funding on terms acceptable to us, we would seek to obtain this funding from other financing sources if available.  If we are unable to obtain such funding from either our existing majority shareholder or another source acceptable to us, our operations will be materially adversely affected.

We have undertaken or anticipate undertaking certain actions to reduce our selling, general and administrative expenses, principally by reducing (i) compensation expense through wage and appropriate headcount reductions and (ii) occupancy expenses through downsizing and/or closing facilities to reduce overhead. Because of actions taken to date, our cash flow has improved.

 

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Assuming we are able to secure additional working capital in the short term, we intend in the long-term to continue to seek significant business acquisitions and to continue the expansion of our product and service offerings as well as our international operations.  Such potential acquisitions and anticipated future business and international expansion activities will require significant additional working capital, which we anticipate obtaining from our majority shareholder and/or existing lender.  We expect that such form of further investment on the part of our principal shareholder or lender would be a combination of additional equity or senior indebtedness, but there is no assurance that we could obtain financing on such terms. In the unlikely event our majority shareholder or our senior lender are unwilling to provide the necessary working capital or acquisition funding on terms acceptable to us, the Company anticipates obtaining this growth capital from other financing sources.  If we are unable to obtain growth capital from either our existing majority shareholder or another source acceptable to us, we would be unable to aggressively expand our business operations and/or make one or more significant acquisitions.

The interest rate on the Company’s senior subordinated notes, which has a floor of 13% and a ceiling of 17%, is determined by the Company’s maximum EBITDA leverage ratio, as defined, on the first day of each quarter.  For the quarter ended June 30, 2009, this ratio was less than 3.50:1:00 for the initial time; accordingly, the interest rate on the senior subordinated notes decreased to 15% from 17% for the quarters ended September 30, 2009 through March 31, 2010.  For the quarter ended June 30, 2010, the rate will increase to 17%.  We anticipate that this rate will remain at that level thereafter, assuming we reach agreement with our senior lender on such terms in the aforementioned on-going negotiations.

Our debt agreement requires an annual sweep of excess cash flow, as defined in the debt agreement, which may limit our ability to use operating cash flow to fund acquisitions.  For the fiscal year ended June 30, 2009, although no payment was required under the definition of a cash flow sweep in the debt agreement, the Company agreed pursuant to an amendment to such agreement to pay a one-time, additional $1,000 principal payment.  This Company paid this additional principal on October 2, 2009.  The Company currently does not believe that a payment will be required for fiscal 2010 under the cash flow sweep in the debt agreement.

Net cash used in operating activities of  $969 for the nine months ended March 31, 2010 was principally attributable to a net loss of $5,466 and an increase  in accounts receivable of $1,825 (which was due to an increase in revenue with major customer late in the quarter), partially offset by an increase in accounts payable and accrued expenses of $2,014 attributable to inventory purchases, and  non-cash charges of $4,371, principally consisting of depreciation and amortization, deferred income taxes, the aforementioned one-time write off of deferred transaction costs and aforementioned financial costs in connection with the warrant issuance to our senior lender.  Net cash used in operating activities of $2,500 for the nine months ended March 31, 2009 was principally due to an increase in accounts receivable and inventory of $3,339 and $5,978, respectively, attributable to the growth in the business, partially offset by net income of $605 and an increase in accounts payable and accrued expenses of $4,510 also attributable to the growth in the business.

Net cash used in investing activities of $391 for the nine months ended March 31, 2010 was attributable to capital expenditures of $391 for property and equipment.  Net cash used in investing activities of $9,932 for the nine months ended March 31, 2009 was attributable to the acquisition of Tritronics for $8,296, net of cash acquired, plus related transaction costs in the amount of $865 and capital expenditures of $771 for property and equipment.

Net cash used in financing activities of $1,400 for the nine months ended March 31, 2010 was attributable entirely to principal payments.   Net cash provided by financing activities of $15,845 for the nine months ended March 31, 2009 was attributable to proceeds of $4,167 and $13,000 from the sale of Series E Preferred Stock and senior and subordinated notes, respectively, in connection with the acquisition of Tritronics and the Philips transactions, offset by payments of principal on notes and capital lease payments of $742 and redemption of common stock of $308.  In addition, financing costs of $272 were incurred in connection with the debt issuance.

Off-Balance Sheet Arrangements

There are no off-balance sheet arrangements between the Company and any other entity that have, or are reasonably likely to have, a current or future effect on the Company’s financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures, or capital resources.  The Company does not have any non-consolidated special purpose entities.

 

RISKS FACTORS

 

In addition to the other information included in this Quarterly Report on Form 10-Q, you should carefully review and consider the factors discussed in Part I, Item 1A - Risk Factors of our Annual Report on Form 10-K for the year ended June 30, 2009, certain of which have been updated below. These factors materially affect our business, financial condition or future results of operations. The risks, uncertainties and other factors described in our Annual Report on Form 10-K and below are not the only ones facing our company. Additional risks, uncertainties and other factors not presently known to us or that we currently deem immaterial may also impair our business operations, financial condition or operating results. Any of the risks, uncertainties and other factors could cause the trading price of our common stock to decline substantially.

 

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Failure To Meet Certain Financial Covenant Tests required By Our Debt Agreements Would Result In An Event Of Default.

Our ability to meet certain financial covenants will depend on our ability to generate sufficient earnings from our operations in the future. This, to a certain extent, is subject to general economic, financial, competitive, legislative, regulatory and other factors that are beyond our control.  On February 1, 2010, we failed to satisfy a certain EBITDA leverage ratio covenant under our debt agreement, which required us to issue to our principal lender a warrant to purchase 2,526,480,000 shares of our common stock for no additional or nominal consideration.  At March 31, 2010, we failed to meet certain financial covenant tests, each of which our principal lender waived.  We cannot provide any assurances that we will have sufficient earnings to meet our financial covenant tests or that our principal lender will grant us further waivers.

Our Disclosure Controls and Procedures for Financial Reporting Are Subject to Certain Limitations and Have Required Remediation.

Management has concluded that as of the period ended March 31, 2010, our disclosure controls and procedures were effective. Such controls and procedures, however, may not be adequate to prevent or identify existing or future internal control weaknesses due to certain limitations, including, but not limited to, our dependence on our enterprise-wide IT system for inventory management.  As an example, we concluded the our disclosure controls and procedures were not effective to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for the periods ended September 30, 2009 and December 31, 2009 because of the identification of a material weakness relating to the proper carrying value of certain components of inventory and the result of a certain key controls in place not operating effectively.  The material misstatement of inventory was not prevented or detected on a timely basis due to lack of adequate testing of perpetual inventory records for the subject components of inventory and the failure of entity level controls in place, such as the analyses of balance sheet account balance fluctuations, gross profit and gross margin, which were designed to detect the overstatement of inventory and gross profit.  As a result, we restated our consolidated financial statements for the periods ended September 30, 2009 and December 31, 2009. We believe that we have remediated the material weakness described above and will continue to do so in future periods by performing periodic verification of the accuracy of the perpetual records by cycle counting quantities of the subject components of inventory reported as being on hand and conducting more in-depth analyses of all the various factors impacting balance sheet account balance fluctuations, monthly gross profit and gross margin. Despite our remediation efforts, however, certain limitations remain and there is a risk that material misstatements in results of operations and financial condition may not be prevented or detected on a timely basis by our internal controls over financial reporting and may require us to restate our financial statements in the future. This could, in turn, adversely affect the trading price of our common stock and there is a risk that repeated restatements could result in an investigation by the SEC.

 

Item 3. Quantitative and Qualitative Disclosure about Market Risk

 

As a smaller reporting company, we have elected scaled disclosure reporting obligations and therefore are not required to provide the information in this Item 3.

 

Item 4.  Controls And Procedures

 

(A)  Evaluation Of Disclosure Controls And Procedures

 

Prior to the filing of this Quarterly Report on Form 10-Q, an evaluation was performed under the supervision of and with the participation of the Company’s management, including the Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), of the effectiveness of the Company’s disclosure controls and procedures. Based on the evaluation, the CEO and CFO have concluded that, as of the end of the period covered by this report, the Company’s disclosure controls and procedures are effective to ensure that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act, is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms, and is accumulated and communicated to the Company’s management, as appropriate, to allow timely decisions regarding required disclosure. It should be noted that the design of any system of controls 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, regardless of how remote.

 

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(B)  Changes In Internal Control Over Financial Reporting

 

There were no changes in the Company's internal control over financial reporting  (as defined in Section 13a-15(f) or 15d-15(f) of the Exchange Act) during our fiscal quarter ended March 31, 2010 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

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PART II

OTHER INFORMATION

 

Item 1.  Legal Proceedings

 

None.

 

 Item 1A.  Risk Factors

 

In addition to the other information included in this Quarterly Report on Form 10-Q, you should carefully review and consider the factors discussed in Part I, Item 1A - Risk Factors of our Annual Report on Form 10-K for the year ended June 30, 2009 and filed with the SEC on September 28, 2009.  These factors materially affect our business, financial condition or future results of operations. The risks, uncertainties and other factors described in our Annual Report on Form 10-K are not the only ones facing our company. Additional risks, uncertainties and other factors not presently known to us or that we currently deem immaterial may also impair our business operations, financial condition or operating results. Any of the risks, uncertainties and other factors could cause the trading price of our common stock to decline substantially.

 

Item 2.  Unregistered Sales of equity Securities And Use Of Proceeds

 

As a result of the Company failing to meet a certain EBITDA leverage ratio covenant test as of February 1, 2010 under the debt agreement with Sankaty Advisors, LLC, the Company’s principal lender, Sankaty earned and was granted on February 1, 2010 a warrant to purchase 2,526,480,000 shares of the Company’s common stock for no additional or nominal consideration.   The warrant has a one-year term.  The issuance of the warrant was exempt from registration under the Securities Act in reliance upon Section 4(2) thereof.  The Company believes Sankaty is an “accredited investor” as that term is defined in Rule 501(a) of Regulation D under the Securities Act. The warrant will include a legend to indicate that it is restricted. The issuance of the warrant did not involve the use of underwriters, and no commission was paid in connection therewith.

 

Item 3. Defaults Upon Senior Securities

 

The Company did not make the interest payment on the senior subordinated debt due as of March 31, 2010, and did not meet certain financial covenants as of that date.  Subsequent to that date the lender waived all such defaults.

 

Item 4. [Removed and Reserved.]

 

Item 5. Other Information

 

None.

 

Item 6. Exhibits

 

Exhibits are incorporated herein by reference or are filed with this quarterly report as set forth in the Exhibit Index beginning on page 28 hereof.

 

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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.

 

	Encompass Group Affiliates, Inc.
Date:      June 22, 2010	By:	/s/ Wayne I. Danson
	Name:	Wayne I. Danson
	Title:	President, Chief Executive Officer (Principal Executive Officer) and Director
Date:      June 22, 2010	By:	/s/ John E. Donahue
	Name:	John E. Donahue
	Title:	Vice President and Chief Financial Officer (Principal Accounting Officer)

 

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Exhibit No.		Description		Location (1)
2.1		Asset Purchase Agreement dated May 27, 2004, by and between Cyber-Test, Inc., a Delaware corporation, and Cyber-Test, Inc., a Florida corporation.		Incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed with the SEC on June 18, 2004
2.2		Stock Purchase Agreement entered into by and between Encompass Group Affiliates, Inc. and Fred V. Baldwin, dated as of August 17, 2007		Incorporated by reference to Exhibit 2.1 to the Company’s Current Report on Form 8-K filed with the SEC on August 21, 2007
2.3		Stock Purchase Agreement entered into by and between Encompass Group Affiliates, Inc., a Florida corporation, Encompass Group Affiliates, Inc., a Delaware corporation, Tritronics, Inc., Tritronics, LLC and the members of Tritronics, LLC listed on Schedule 2 thereto, dated as of August 1, 2008		Incorporated by reference to Exhibit 2.1 to the Company’s Current Report on Form 8-K filed with the SEC on August 7, 2008
3(i)(a)		Restated Articles of Incorporation of Advanced Communications Technologies, Inc.		Incorporated by reference to Exhibit 3(i) to the Company’s Annual Report on Form 10-KSB filed with the SEC on September 28, 2007
3(i)(b)		Articles of Amendment to the Articles of Incorporation of Advanced Communications Technologies, Inc. filed with the Secretary of State of Florida on May 6, 2008		Incorporated by reference to Exhibit 3(i)(b) to the Company’s Annual Report on Form 10-KSB filed with the SEC on September 28, 2007
3(i)(c)		Articles of Amendment to the Articles of Incorporation of Advanced Communications Technologies, Inc. filed with the Secretary of State of Florida on August 1, 2008		Incorporated by reference to Exhibit 3.1 to the Company’s Current Report on Form 8-K filed with the SEC on August 7, 2008
3(ii)		Amended Bylaws of Advanced Communications Technologies, Inc.		Incorporated by reference to Exhibit 3(ii) to the Company’s Current Report on Form 8-K filed with the SEC on August 21, 2007
4.1		Form of Exchange Agreement, dated June 24, 2004, by and among Advanced Communications Technologies, Inc. and certain debenture holders of Hy-Tech Technology Group, Inc.		Incorporated by reference to Exhibit 10.40 to the Company’s Annual Report on Form 10-KSB filed with the SEC on November 3, 2004
4.2		Form of Convertible Promissory Note issued in connection with Exhibit 2.2		Incorporated by reference to Exhibit 4.1 to the Company’s Current Report on Form 8-K filed with the SEC on August 21, 2007

 

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4.3.1		Note Purchase Agreement, dated as of August 17, 2007, by and among Encompass Group Affiliates, Inc. as Issuer, and Advanced Communications Technologies, Inc., Cyber-Test, Inc., Vance Baldwin, Inc., Hudson Street Investments, Inc. and SpectruCell, Inc. as Guarantors, the Note Purchasers listed therein, and Sankaty Advisors, LLC		Incorporated by reference to Exhibit 4.2 to the Company’s Current Report on Form 8-K filed with the SEC on August 21, 2007
4.3.2		Form of Senior Note issued in connection with Exhibit 4.3.1		Incorporated by reference to Exhibit 4.3 to the Company’s Current Report on Form 8-K filed with the SEC on August 21, 2007
4.3.3		Form of Subordinated Note issued in connection with Exhibit 4.3.1		Incorporated by reference to Exhibit 4.4 to the Company’s Current Report on Form 8-K filed with the SEC on August 21, 2007
4.3.4		First Lien Pledge and Security Agreement, dated as of August 17, 2007, between Encompass Group Affiliates, Inc., Advanced Communications Technologies, Inc., SpectruCell, Inc., Hudson Street Investments, Inc., Cyber-Test, Inc., Vance Baldwin, Inc. and Sankaty Advisors, LLC		Incorporated by reference to Exhibit 4.5 to the Company’s Current Report on Form 8-K filed with the SEC on August 21, 2007
4.3.5		Second Lien Pledge and Security Agreement , dated August 17, 2007, between Encompass Group Affiliates, Inc., Advanced Communications Technologies, Inc., SpectruCell, Inc., Hudson Street Investments, Inc., Cyber-Test, Inc., Vance Baldwin, Inc. and Sankaty Advisors, LLC		Incorporated by reference to Exhibit 4.6 to the Company’s Current Report on Form 8-K filed with the SEC on August 21, 2007
4.4		Form of Subordinated Promissory Note issued in connection with Exhibit 2.3		Incorporated by reference to Exhibit 4.1 to the Company’s Current Report on Form 8-K filed with the SEC on August 7, 2008
4.5.1		Amended and Restated Note Purchase Agreement, dated as of August 1, 2008, by and among Encompass Group Affiliates, Inc., a Delaware corporation as Issuer, Encompass Group Affiliates, Inc., a Florida corporation, Tritronics, Inc., Cyber-Test, Inc., Vance Baldwin, Inc., Hudson Street Investments, Inc. and SpectruCell, Inc. as Guarantors, the Note Purchasers listed therein, and Sankaty Advisors, LLC.		Incorporated by reference to Exhibit 4.2 to the Company’s Current Report on Form 8-K filed with the SEC on August 7, 2008
4.5.2		Form of Series B Subordinated Note issued in connection with Exhibit 4.5.1.		Incorporated by reference to Exhibit 4.3 to the Company’s Current Report on Form 8-K filed with the SEC on August 7, 2008

 

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4.5.3		Amended and Restated First Lien Pledge and Security Agreement, dated as of August 1, 2008, between Encompass Group Affiliates, Inc., a Delaware corporation, Encompass Group Affiliates, Inc., a Florida corporation, Tritronics, Inc., SpectruCell, Inc., Hudson Street Investments, Inc., Cyber-Test, Inc., Vance Baldwin, Inc. and Sankaty Advisors, LLC		Incorporated by reference to Exhibit 4.4 to the Company’s Current Report on Form 8-K filed with the SEC on August 7, 2008
4.5.4		Amended and Restated Second Lien Pledge and Security Agreement, dated August 1, 2008, between Encompass Group Affiliates, Inc., a Delaware corporation, Encompass Group Affiliates, Inc., a Florida corporation, Tritronics, Inc., SpectruCell, Inc., Hudson Street Investments, Inc., Cyber-Test, Inc., Vance Baldwin, Inc. and Sankaty Advisors, LLC.		Incorporated by reference to Exhibit 4.5 to the Company’s Current Report on Form 8-K filed with the SEC on August 7, 2008
4.5.5		Amendment No. 1 to the Amended and Restated Note Purchase Agreement, dated as of August 1, 2008, by and among Encompass Group Affiliates, Inc., a Delaware corporation as Issuer, Encompass Group Affiliates, Inc., a Florida corporation, Tritronics, Inc., Cyber-Test, Inc., Vance Baldwin, Inc., Hudson Street Investments, Inc. and SpectruCell, Inc. as Guarantors, the Note Purchasers listed therein, and Sankaty Advisors, LLC, dated January 12, 2009.		Incorporated by reference to Exhibit 4.5.5  to the Company’s Quarterly Report on Form 10-Q filed with the SEC on February 13, 2009
31.1		Certification by Principal Executive Officer pursuant to Sarbanes-Oxley Section 302		Filed herewith
31.2		Certification by Principal Financial Officer pursuant to Sarbanes-Oxley Section 302		Filed herewith
32.1		Certification by Chief Executive Officer pursuant to 18 U.S.C. Section 1350		Filed herewith
32.2		Certification by Chief Financial Officer pursuant to 18 U.S.C. Section 1350		Filed herewith

(1) In the case of incorporation by reference to documents filed by the Company under the Exchange Act, the Company’s file number under the Exchange Act is 000-30486.

 

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