SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Commission File Number 0-16345
SED INTERNATIONAL HOLDINGS, INC.
(Exact Name of Registrant as Specified in Its Charter)
3505 NEWPOINT PLACE, SUITE 450, LAWRENCEVILLE, GEORGIA 30043
(Address, including zip code, of Principal Executive Offices)
(Registrant’s telephone number, including area code)
(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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the Registrant was required to submit and post such files). Yes x No ¨
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act): Yes ¨ No x
The number of shares outstanding of the Registrant’s common stock, par value $.01 per share, at November 1, 2012 was 5,109,089 shares.
SED INTERNATIONAL HOLDINGS, INC. AND SUBSIDIARIES
TABLE OF CONTENTS
PART I - FINANCIAL INFORMATION
FORWARD LOOKING STATEMENT INFORMATION
Certain statements made in this Quarterly Report on Form 10-Q are “forward-looking statements regarding the plans and objectives of management for future operations”. Such statements involve known and unknown risks, uncertainties and other factors that may cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. The forward-looking statements included herein are based on current expectations that involve numerous risks and uncertainties. Our plans and objectives are based, in part, on assumptions involving judgments with respect to, among other things, future economic, competitive and market conditions and future business decisions, all of which are difficult or impossible to predict accurately and many of which are beyond our control. Although we believe that our assumptions underlying the forward-looking statements are reasonable, any of the assumptions could prove inaccurate and, therefore, there can be no assurance that the forward-looking statements included in this report will prove to be accurate. In light of the significant uncertainties inherent in the forward-looking statements included herein particularly in view of the current state of our operations, the inclusion of such information should not be regarded as a statement by us or any other person that our objectives and plans will be achieved.
SED INTERNATIONAL HOLDINGS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except share and per share amounts)
See notes to condensed consolidated financial statements.
SED INTERNATIONAL HOLDINGS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS AND COMPREHENSIVE LOSS
(In thousands, except share and per share amounts)
See notes to condensed consolidated financial statements.
SED INTERNATIONAL HOLDINGS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
See notes to condensed consolidated financial statements.
SED INTERNATIONAL HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Tabular amounts in thousands except share and per share amounts)
1. Basis of Presentation
The accompanying unaudited condensed consolidated financial statements of SED International Holdings, Inc. and its wholly-owned subsidiaries, SED International, Inc. (“SED International”), SED International de Colombia S.A.S., and Intermaco S.R.L., (collectively, “SED” or the "Company") have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all adjustments considered necessary for a fair presentation have been included. Operating results for the three months ended September 30, 2012 are not necessarily indicative of the results that may be expected for the fiscal year ending June 30, 2013, or any other interim period. The June 30, 2012 condensed consolidated balance sheet has been derived from the audited consolidated financial statements included in SED’s Annual Report on Form 10-K for the fiscal year ended June 30, 2012 (“Annual Report”).
For further information, refer to the consolidated financial statements and footnotes thereto, including Risk Factors, included in the SED’s Annual Report, filed with the Securities and Exchange Commission (“SEC”) on September 13, 2012.
2. Earnings per Common Share
Basic earnings per share is computed on the basis of the weighted average number of shares of common stock outstanding during the period. Diluted earnings per share is computed on the basis of the weighted average number of shares of common stock plus the effect of dilutive potential common shares outstanding during the period using the treasury stock method.
Diluted earnings (loss) per common share for the three months ended September 30, 2012 and 2011 does not reflect the total of any incremental shares related to the assumed conversion or exercise of stock options due to their anti-dilutive effects. Excluded from diluted loss per share for the three months ended September 30, 2012 were the dilutive effects of options to purchase 150,000 shares of common stock and the dilutive effect of 11,944 shares of nonvested restricted stock. Also excluded from diluted loss per share for the three months ended September 30, 2011 were the dilutive effects of options to purchase 57,500 shares of common stock and the dilutive effect of 223,320 shares of nonvested restricted stock.
Components of basic and diluted earnings per share for the three months ended September 30, 2012 and 2011 were as follows:
In August 2011, SED purchased certain assets including finished goods inventories, customer and supplier lists, and intellectual property of ArchBrook Laguna LLC (“ABL”), primarily those related to its subsidiary, Lehrhoff & Co., Inc. (“Lehrhoff”), a distributor of small appliances, housewares, personal care products, and consumer electronics. Under the terms of the agreement, SED acquired the net assets for a purchase price of approximately $4.1 million in cash. SED has also employed certain personnel of Lehrhoff. For fiscal 2012, the estimated fair value of the acquired assets of $5.4 million exceeded the $4.1 million paid by SED, resulting in a gain of $1.3 million, of which $1 million was recognized in the quarter ended September 30, 2011.
4. Comprehensive Loss
Comprehensive loss is defined as the change in equity (net assets) of a business enterprise during a period from transactions or other events and circumstances from non-owner sources, and is comprised of net loss and other comprehensive loss. SED’s other comprehensive loss is comprised of changes in SED’s foreign currency translation adjustments and changes in fair value of an interest rate swap contract, including income taxes attributable to those changes.
The deferred income tax asset related to the accumulated other comprehensive loss was fully offset by a valuation allowance as of the beginning and end of the three months ended September 30, 2012 and 2011 and, therefore, the comprehensive loss for these periods had no income tax effect.
Accumulated other comprehensive loss included in shareholders’ equity totaled $3.3 million and $3.2 million at September 30, 2012 and June 30, 2012, respectively, and consisted of foreign currency translation adjustments of $3.1 million and $2.8 million, respectively, and $0.2 million and $0.4 million related to the interest rate swap contract, respectively.
5. Segment Reporting
SED operates in one business segment as a wholesale distributor of microcomputer, consumer electronics, and small appliance products. SED operates in two geographic regions, the United States and Latin America/Caribbean (combined as one in the table below). Sales of products between SED's geographic regions are made at market prices and are eliminated in consolidation. All corporate overhead is included in the results of U.S. operations.
Financial information for continuing operations by geographic region is as follows:
Sales of products between the SED’s geographic regions are made at market prices and are eliminated in consolidation. All corporate overhead is included in the results of U.S. operations.
Net sales by product category for continuing operations are as follows:
Approximately 40.1% ($20 million United States export and $30.6 million Latin America) and 38.8% ($26 million United States export, net of ($0.5) million elimination, and $34.5 million Latin America) for the three months ended September 30, 2012 and 2011, respectively, consisted of sales to customers for export principally into Latin America and the Caribbean area and direct sales to customers in Colombia and Argentina.
6. Shareholders’ Equity
Incentive Compensation Plans — In December 2009, shareholders approved SED’s 2009 Incentive Compensation Plan (the “2009 Plan”). Under the 2009 Plan, 250,000 shares of common stock are available for awards. Awards under the 2009 Plan may take the form of stock options (either incentive stock options or non-qualified options), restricted stock, or restricted stock units. As of September 30, 2012, there were 28,811 awards available for future grants.
Stock Options — At September 30, 2012, stock options for 150,000 shares were outstanding and 70,000 were exercisable with an aggregate intrinsic value of approximately $0.1 million. During the quarter ended September 30, 2012, no stock options were exercised.
Restricted Stock — SED established the 2007 Restricted Stock Plan (the “2007 Plan”) during fiscal 2008. A total of 750,000 shares of SED’s authorized and unissued shares of common stock were reserved for grants under the 2007 Plan. Generally, the awards are subject to forfeiture prior to vesting and vest in equal amounts on the second, third and fourth anniversaries of the grant date; provided, however, that at the time of vesting the holder is an employee of SED. At September 30, 2012, all shares were vested under the 2007 Plan. The value of restricted stock awards is determined using the market price of SED’s common stock on the grant date.
Non-employee director base compensation includes a per annum payment of $35,000 of restricted shares of common stock which shall be paid quarterly. The number of shares to be issued to the Directors will be determined on the last day of each quarter based upon the market price of SED’s common stock as of that date. These restricted shares of common stock vest on the date of issuance. Effective August 2012, the Chairman of the Board was elected Executive Chairman and as such, will no longer be a non-employee director and will receive a salary rather than an annual fee and restricted stock. In connection with his election, the Board awarded the Executive Chairman options to purchase 100,000 shares of common stock exercisable at $2.15 per share and subject to vesting in five equal installments beginning on August 29, 2012 and on each of next four anniversaries, provided he is a director on each anniversary date. These options were awarded from the 2009 Plan.
Nonvested restricted stock activity is as follows:
Share-based Compensation Expense — During the three months ended September 30, 2012 and 2011 share-based compensation expense was approximately $0.1 million for 2012 and 2011. At September 30, 2012, there was approximately $0.1 million of unrecognized compensation cost related to nonvested stock awards which SED expects to be recognized over the next twenty-one months. SED expects to incur approximately $84,000 of expense over the next 47 months for all unvested stock options outstanding at September 30, 2012.
7. Credit Facility and Bank Debt
SED currently maintains credit facilities with Wells Fargo Bank (USA) and with three banks in Colombia for SED’s Colombia subsidiary. Total borrowings under SED’s of credit facilities were $36.6 million at September 30, 2012 and $36.9 million at June 30, 2012.
The Wells Fargo credit agreement, as amended (“Agreement”) provides for borrowings which are collateralized by SED’s U.S. accounts receivable, inventories, and other domestic assets. The Agreement allows borrowings up to $60 million and expires in January 2015. The Agreement may be increased to $75 million in $5 million increments at SED’s discretion if certain criteria are met.
Borrowings under the Agreement accrue interest based upon one of two interest rate options depending upon the computation of availability as defined in the Agreement. These interest rate options are (a) LIBOR, plus a margin ranging from 1.50% to 2.25%, or (b) the prime rate. SED is required to pay a commitment fee of .25% on the unused portion of the facility and pay interest and the commitment fee on a monthly basis.
The Agreement also contains certain covenants which, among other things, require that SED maintain unused availability of not less than $5 million during the term of the Agreement before SED is permitted to make advances to SED’s Latin American subsidiaries. SED’s advances to its Latin American subsidiaries are limited to $2 million under the Agreement. The Agreement also requires that if SED’s unused availability is less than 10% of the formula borrowing base ($4.6 million at September 30, 2012) at any time during the term of the Agreement, then maintenance of a minimum fixed charge coverage ratio is required. SED’s availability did not fall below this requirement during the three months ended September 30, 2012. Dividend payments are limited to $0.5 million under the Agreement. There is a $3 million stock buy-back limit permitted under the Agreement and at September 30, 2012, SED has repurchased approximately $1.8 million worth of its stock and has approximately $1.2 remaining for future purchases. As of September 30, 2012, SED determined that it was in compliance with the Agreement.
The amount available for borrowings under the Agreement at September 30, 2012 was $13.4 million, after deducting $1.5 million in reserves for outstanding letters of credit.
SED also maintains an interest rate swap contract, which expires on January 26, 2013, to reduce the impact of the fluctuations in the interest rates on $15 million notional amount of the revolving credit facility under the Agreement. The contract effectively converted the variable rate to a fixed rate of 2.95%. The fixed rates cited do not include Wells Fargo's markup of 1.75% as of September 30, 2012. SED recognizes the interest rate swap contract as either assets or liabilities on its balance sheet and measures those instruments at fair value. SED has designated its interest rate swap agreement as a cash flow hedge. Accordingly, the gains and losses associated with changes in the fair value of the interest rate swap are reported in other comprehensive income (loss) as the hedge is highly effective in achieving offsetting changes in the fair value of cash flows of the asset or liability hedged. The fair value, not in SED’s favor, of the interest rate swap was $0.1 million at September 30, 2012 and $0.2 million at June 30, 2012 and is included in accrued and other current liabilities. SED does not hold or issue derivative financial instruments for trading purposes.
The SED Colombia subsidiary currently maintains working capital lines of credit at three banks. Each line of credit is short term and maximum availability on each range from $2.5 billion to $6.6 billion pesos, which at September 30, 2012 equates to approximately $1.4 million to $3.7 million in U.S. dollars, or approximately $8.4 million dollars in the aggregate. At September 30, 2012, SED Colombia’s availability totaled $0.7 million U.S. dollars, after deducting $3.6 million U.S. dollars in reserves for outstanding letters of credit. At June 30, 2012, there were no borrowings on SED Colombia credit line facilities. As of September 30, 2012, SED Colombia determined that it was in compliance the credit facility agreements.
8. Fair Value Measurements
SED determines a fair value measurement based on the assumptions a market participant would use in pricing an asset or liability. The fair value measurement guidance established a three level hierarchy making a distinction between market participant assumptions based on (i) unadjusted quoted prices for identical assets or liabilities in an active market (Level 1), (ii) quoted prices in markets that are not active or inputs that are observable either directly or indirectly for substantially the full term of the asset or liability (Level 2), and (iii) prices or valuation techniques that require inputs that are both unobservable and significant to the overall fair value measurement (Level 3).
The carrying amounts of cash and cash equivalents, accounts receivable and accounts payable approximate fair value because of the short maturity of these items. The carrying amount of debt outstanding pursuant to revolving debt and similar bank credit agreements approximates fair value as interest rates on these instruments approximate current market rates.
SED is exposed to market risks from changes in interest rates, which may affect its operating results and financial position. SED reduces its risks from interest rate fluctuations through the use of an interest rate swap contract (see Note 6). This derivative financial instrument is used to manage risk and is not used for trading or speculative purposes. SED endeavors to utilize the best available information in measuring the fair value of the interest rate swap. The interest rate swap is classified in its entirety based on the lowest level of input that is significant to the fair value measurement. SED has determined that its interest rate swap is a Level 2 liability in the fair value hierarchy as it is valued using a discounted cash flow valuation model which includes inputs other than quoted market prices that are both observable and unobservable.
9. Subsequent Event
Effective as of October 15, 2012 (the “Effective Date”), SED’s Board of Directors (the “Board”) elected Robert G. O’Malley as President and Chief Executive Officer of SED and appointed him to the Board. On the Effective Date, SED entered into employment arrangements with Mr. O’Malley providing for his full time employment as its President and Chief Executive Officer for a three-year term beginning on the Effective Date pursuant to an Employment Agreement dated September 7, 2012 (the “Employment Agreement”). Under the Employment Agreement Mr. O’Malley (i) earns an annual base salary of $350,000 (“Base Salary”); (ii) is entitled to a signing and relocation bonus in the amount of $75,000, payable on or before October 31, 2012; (iii) is entitled to receive an annual bonus of up to 100% of the Base Salary based on the achievement of specified performance targets; (iv) received a grant of: (a) stock options for 100,000 shares of the SED’s common stock (“Common Stock”) exercisable at $1.85 per share (the fair market value of a share of the Common Stock on the Effective Date) and vesting in three annual tranches; and (b) 100,000 shares of restricted Common Stock, both of which are subject to vesting upon achievement of specified performance targets; (v) is entitled to participate on the same terms as other executives in any present or future benefit plans or programs of SED; and (vi) receive a severance payment equal to the lesser of 12- months Base Salary or Base Salary for the balance of his employment term. The performance criteria for purposes of the bonus, the vesting of each option tranche and the vesting of the restricted Common Stock will be based on the achievement of specified net income per share targets in excess of that achieved in fiscal 2012 and the achievement of specified return on invested capital targets (“ROIC”) ranging from an ROIC of 10% to an ROIC of 20%, which targets will be developed in consultation between SED and Mr. O’Malley as soon as practicable after Mr. O’Malley completes his first 30 days of employment.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
SED International Holdings, Inc. (“SED”) distributes microcomputer, consumer electronic and small appliance products in the United States, Latin America and the Caribbean. SED purchases more than 17,000 products from approximately 200 vendors (directly and indirectly), including such technology market leaders as Acer, Asus, Dell, Epson, Hewlett-Packard, Kingston, Lenovo, Lexmark, Microsoft, Seagate and Western Digital; consumer electronics manufacturers such as Canon, Coby, Haier, Panasonic, Samsung, Sansui, and VuPoint; and an extensive housewares lineup, including Black & Decker, Brother, Hamilton Beach / Proctor Silex, Lasko, Norelco, Philips and Vornado. SED’s vendors generally warrant the products distributed by SED and allow the return of defective products. SED sells its products through a dedicated sales force and robust website to reseller customers in retail, e-commerce, VAR, system builder, OEM, custom install and various other reseller channels. SED also offers custom-tailored supply chain management services ideally suited to meet the priorities and distribution requirements of the e-commerce, Business-to-Business and Business-to-Consumer markets. SED distributes its products in the United States, Latin America and the Caribbean region from its strategically located warehouses in Lawrenceville, Georgia; Miami, Florida; Keasbey, New Jersey; City of Industry, California; and Plano, Texas. SED services its customers in Latin America through its wholly-owned subsidiaries SED International de Colombia S.A.S. in Bogotá, Colombia and Intermaco S.R.L. in Buenos Aires, Argentina and from its warehouse in Miami, Florida. SED and its wholly-owned subsidiary, SED International, Inc. (“SED International”) are incorporated in Georgia. As hereinafter used in this document the terms “SED,” “Company,” “we,” “our” or “us” refer collectively to SED and its wholly-owned subsidiaries.
The following discussion should be read in conjunction with the condensed consolidated financial statements of SED and the notes thereto included in this quarterly report. Historical operating results are not necessarily indicative of trends in operating results for any future period.
Results of Operations
The following table sets forth, for the periods indicated, the amounts and percentage of net sales of certain line items from SED’s condensed consolidated statements of operations:
Three Months Ended September 30, 2012 and 2011
Net sales. Net sales for the three months ended September 30, 2012 were $126.4 million, a decrease of $29.4 million or 18.9%, compared with $155.8 million for the three months ended September 30, 2011.
Comparative revenues by SED geography are summarized below:
Domestic revenues were $76.2 million for the three months ended September 30, 2012, a 20.1% decrease, compared with $95.4 million for the same period in 2011. The net decrease in domestic revenue is attributable to unit sale decreases in hard drives, PCs, notebooks, servers, and televisions which reflects similar declines within the microcomputer industry. Export revenues were $19.6 million and $26 million for the three months ended September 30, 2012 and 2011, respectively, a 24.8% decrease. Latin America sales were $30.6 million and $34.5 million for the three months ended September 30, 2012 and 2011, respectively, a decrease of 11.1% due to supply shortages in Argentina caused by government restrictions and less demand in Colombia. The Latin America sales decrease was 9.7% currency adjusted.
Microcomputer product sales were $109.1 million for the three months ended September 30, 2012, a decrease of 22.2% over similar product sales of $140.3 million reported for the same period in 2011. The decreases in the microcomputer product sales were primarily attributable to lower sales in the notebook, hard drives, and software product categories. Sales of microcomputer products represented approximately 86.3% of SED’s first quarter net sales compared to 90% for the comparable period in 2011.
Consumer electronics sales, all of which were in the U.S., for the three months ended September 30, 2012 were $10.2 million, a decrease of 27.1% compared to $14 million for the comparable period in 2011. Sales of consumer electronics products accounted for approximately 8.1% of SED’s first quarter net sales compared to 9% for the comparable period in 2011. This decrease was from a decline in the sales of televisions predominantly caused by price drops and less units sold.
Small appliance and housewares sales, all of which were in the U.S., for the three months ended September 30, 2012 were $7.1 million, an increase of 373.3%, compared to $1.5 million in the same period in 2011. The increase was primarily due to the additional product categories acquired from ArchBrook Laguna LLC (“ABL”). Sales of small appliances and housewares accounted for approximately 5.6% of net sales for the first quarter compared to 0.9% for the comparable period in 2011.
Gross Profit Margins. Gross profit for the three months ended September 30, 2012 was $7.0 million, a decrease of $0.5 million or 6.8% compared with $7.5 million for the same period in 2011. Gross Profit declined as a result of lower sales offset by higher gross margins. Gross margin improved, as a percentage of sales, to 5.6% for the quarter ended September 30, 2012 from 4.8% for the same period in 2011. The increased gross profit percent is attributable to higher margins earned on small appliance and housewares products and an increase in margins in SED’s foreign subsidiaries in Latin America. The improvement in gross margins in Latin America was a result of Argentine governmental import restrictions causing tighter inventory supply which increased pricing and margins.
Selling, General and Administrative Expenses. Selling, general and administrative expenses were $8.3 million for the three months ended September 30, 2012, an increase of 4.7% compared with $7.9 million for the same period in 2011. The increase was attributable to consulting services for improving certain operational efficiencies, professional fees related to acquisition activities, and expenses related to various legal matters.
Depreciation and Amortization. Depreciation and amortization was $0.2 million for the three months ended September 30, 2012 compared with $0.1 million for the same period last year. The increase in depreciation is attributable to the capital expenditures during fiscal 2012 associated with the opening of the New Jersey facility and move of the Atlanta distribution centers and corporate headquarters.
Foreign Currency Transaction. SED has U.S. dollar denominated liabilities recorded in its subsidiaries in Argentina and Colombia to meet certain vendor payment requirements. The revaluation/devaluation of the peso in Colombia and Argentina versus the U.S. dollar resulted in a net foreign currency transaction expense totaling $0.1 million for the three months ended September 30, 2012 as compared to expense of $0.7 million for the same period in 2011.
Acquisition-related cost. There were no acquisition costs in the three months ended September 30, 2012. Acquisition-related expenses associated with the acquisition of the Lehrhoff assets from ABL (the “Lehrhoff Assets”) for the three months ended September 30, 2011 were approximately $0.4 million and consisted primarily of professional and legal fees associated with the transaction. There were no acquisition costs in the three months ended September 30, 2012.
Operating Loss. For the three months ended September 30, 2012, SED reported operating loss of $1.6 million compared with operating loss of $1.5 million for the comparable period in 2011. The loss reported in operating income is attributable to the decrease in volume sales which was partially offset with higher margins. SED continues to focus on increasing sales while reducing recurring operating expenses.
Gain from Acquisition. There was no gain from acquisition in the three months ended September 30, 2012. During the three months ended September 30, 2011, we acquired certain items including finished goods inventories, customer and supplier lists, and intellectual property of Lehrhoff. For fiscal 2012, the estimated fair value of the acquired assets of $5.4 million exceeded the $4.1 million cash consideration paid resulting in a bargain purchase gain of $1.3 million of which $1 million was recognized for the three months ended September 30, 2011.
Interest Expense. Interest expense, net of interest income, was $0.3 million for the three months ended September 30, 2012 and 2011.
Provision for Income Taxes. Income tax expense was $0.2 million for the three months ended September 30, 2012, compared to an income tax benefit of $10,000 in the same period last year. The provision is primarily attributed to income generated by SED’s Latin American subsidiaries as SED in the U.S. has the benefit of a tax loss carryforward for Federal and all but two state tax jurisdictions. The increase in income tax expense in the period ended September 30, 2012, was attributable to the increase in taxable income generated in our Latin America subsidiaries.
The provision for income taxes differs from the amount which would result from applying the statutory Federal income tax rate due to: (a) taxes imposed on the foreign subsidiaries and (b) the anticipated changes in the valuation allowance for the year. At September 30, 2012, SED has a total net operating loss carry forward for Federal tax purposes of approximately $62.2 million and for state tax purposes of approximately $52.5 million, expiring at various dates through 2029. SED has recorded valuation allowances principally for all deferred tax assets, except for those relating to Intermaco S.R.L. (Intermaco) and SED International de Colombia S.A.S. (SED Colombia), as at this time it is not considered more likely than not that these assets will be realized. SED continues to monitor this assertion quarterly.
Net Loss. SED’s net loss for the three months ended September 30, 2012 was $2.1 million compared with a net loss of $0.8 million in the same period last year. The net loss in the three months ended September 30, 2011 was inclusive of a gain from acquisition in the amount of $1 million and a net loss incurred by Lehrhoff of $0.9 million including acquisition related expenses. Excluding Lehrhoff, SED’s net loss for the three months ended September 30, 2011 was $0.9 million.
Critical Accounting Policies and Estimates
Allowance for Doubtful Accounts. An allowance for doubtful accounts has been established based on collection experience and an assessment of the collectability of specific accounts. Management evaluates the collectability of accounts receivable based on a combination of factors. Initially, management estimates an allowance for doubtful accounts as a percentage of accounts receivable based on historical collections experience. This initial estimate is periodically adjusted when management becomes aware of a specific customer’s inability to meet its financial obligations (e.g., bankruptcy filing) or as a result of changes in the overall aging of accounts receivable. The overall determination of the allowance also considers credit insurance coverage and deductibles, which SED has maintained from time to time. SED maintains credit insurance, which protects the Company from credit losses exceeding certain deductibles for certain domestic sales and certain export shipments from the United States. SED maintains credit insurance in many Latin American countries (subject to certain terms and conditions).
Inventories — Slow Moving, Obsolescence, and Lower of Cost or Market. Certain SED vendors allow for either return of goods within a specified period (usually 45-90 days) or for credits related to price protection. However, for other vendor relationships and inventories, SED is not protected by vendors from the risk of inventory loss. Therefore, in determining the net realizable value of inventories, the Company identifies slow moving or obsolete inventories that (1) are not protected by vendor agreements from risk of loss, and (2) are not eligible for return under various vendor return programs. Based upon these factors, the Company estimates the net realizable value of inventories and records any necessary adjustments as a charge to cost of sales. If inventory return privileges were discontinued in the future, or if vendors were unable to honor the provisions of certain contracts, which protect SED from inventory losses, including price protections, the risk of loss associated with obsolete, slow moving or impaired inventories would increase.
Revenue Recognition. Revenue is recognized once four criteria are met: (1) SED must have persuasive evidence that an arrangement exists; (2) delivery must occur, which generally happens at the point of shipment (this includes the transfer of both title and risk of loss, provided that no significant obligations remain which is usually the case); (3) the price must be fixed or determinable; and (4) collectability must be reasonably assured. Shipping revenue is included in net sales while the related costs, including shipping and handling costs, are included in the cost of sales. SED allows its customers to return product for exchange or credit subject to certain limitations. A provision for such returns is recorded based upon historical experience.
Financial Instruments.SED’s principal financial instruments consist of cash and cash equivalents, accounts receivable, accounts payable and revolving credit facilities. The carrying value of these financial instruments approximate fair value based upon the short-term nature of the instruments, and the variable rates on credit facilities.
The functional currency for SED’s international subsidiaries is the local currency of the country in which the subsidiaries own their primary assets. The translation of the applicable currencies into U.S. dollars is performed for balance sheet accounts using exchange rates in effect at the balance sheet date and for revenue and expense accounts using a weighted average exchange rate during the period. Any related translation adjustments are recorded directly to stockholders’ equity as a component of accumulated other comprehensive income (loss). It is SED’s policy not to enter into derivative contracts for speculative trading purposes. SED conducts business in countries outside of the United States, which exposes SED to fluctuations in foreign currency exchange rates. SED may enter into short-term forward exchange or option contracts to reduce this risk. At September 30, 2012, SED held approximately $9.0 million of short-term forward exchange contracts, which mature over the next quarter. The fair value of these contracts is recorded in accrued and other current liabilities.
SED’s revolving credit facility is currently a variable rate facility. SED has entered into an interest rate swap contract, which expires on January 26, 2013, to reduce the impact of the fluctuations in the interest rate on $15 million notional amount of the obligation under its revolving credit facility with Wells Fargo.
Inflation and Price Levels. Inflation has not had a significant impact on SED’s overall business because of the typically decreasing costs of products sold by SED and the fact that we also receive price protection from vendors for a significant portion of our inventory. In the event a vendor or competitor reduces its prices for goods purchased by SED prior to SED’s sale of such goods, we generally have been able either to receive a credit from the vendor for the price differential or to return the goods to the vendor for credit.
Argentina and Colombia have experienced high rates of inflation and hyperinflation from time to time in the past. SED has experienced higher operating costs related to government mandated wage increases in those countries. At this time, management believes that inflation may have a material impact on SED’s Latin American business operations in the immediate future.
Net Operating Tax Loss Carry Forwards. SED has accumulated net operating loss carry forwards for Federal income tax purposes of approximately $62.2 million and for state tax purposes of approximately $52.5 million, which expire in fiscal years 2019 through 2029. These losses are available to offset taxable income generated through those dates. The ultimate realization of these deferred tax assets is dependent upon the generation of sufficient future taxable income during the periods in which these carryforwards may be utilized.
Liquidity and Capital Resources
At September 30, 2012, SED had cash and cash equivalents totaling $3.5 million and working capital of approximately $18.1 million. SED has financed its liquidity needs largely through internally generated funds, credit facilities, and vendor lines of credit. SED’s principal source of liquidity is its cash, cash equivalents, trade receivables, inventories and amounts available under its lines of credit with vendors and its revolving credit facilities. Consolidated net borrowings under the SED’s credit facilities decreased to $36.6 million at September 30, 2012, compared to $36.9 million at June 30, 2012. At September 30, 2012, SED’s global availability under its bank credit facilities was approximately $14.1 million, after deducting $5.1 million in reserves for outstanding letters of credit.
Cash used in operating activities was $0.4 million for the three months ended September 30, 2012, an increase of $4.6 million as compared to approximately $5 million used in operating activities for the same period last year. The $4.6 million increase in operating activities is primarily attributable to decreases in inventories and trade receivables. Changes in operating assets and liabilities during the three months ended September 30, 2012 are as follows:
Net trade receivables were $52.5 million at September 30, 2012 and $54 million at June 30, 2012. Average day’s sales outstanding for the quarter were approximately 39 days at September 30, 2012 and 38 days at September 30, 2011. Certain large retail customers acquired with the Lehrhoff Assets have extended terms which has led to the increase in days sales outstanding.
Inventories decreased $6.1 million to $55.7 million at September 30, 2012 from $61.8 million at June 30, 2012. The decrease can be attributed to lower sales volume. Inventory turns for the quarter ended September 30, 2012 and 2011 were approximately 8.1 and 9.0, respectively.
Other current assets increased to $12.9 million at September 30, 2012 from $8.1 million at June 30, 2012. This was primarily due to an insurance claim related to a warehouse theft at the Atlanta distribution center location in September 2012.
Trade accounts payable decreased by $2.3 million to $60.8 million at September 30, 2012 compared to $63.1 million at June 30, 2012.
Accrued and other current liabilities increased to $9.4 million at September 30, 2012 from $8.7 million as of June 30, 2012.
SED’s cash flows are affected by changes in exchange rates in Argentina and Colombia. Exchange rate changes had the effect of using $20,000 in cash for the three months ended September 30, 2012, compared to using $0.2 million in cash for the same period last year.
SED also maintains an interest rate swap contract to reduce the impact of fluctuations in the interest rates on $15 million notional amount of the revolving credit facility under the Wells Fargo Agreement which expires on January 26, 2013. The fair value, not in SED’s favor, of the interest rate swap was $0.1 million and $0.5 million as of September 30, 2012 and 2011, respectively, and is included in accrued and other current liabilities. SED does not hold or issue derivative financial instruments for trading purposes.
While SED has historically derived a material portion of its operating income and cash flows from its foreign subsidiaries, management believes that if there were to be deteriorating economic conditions in Argentina or Colombia or a devaluation of the peso in either country it may have a negative effect on our foreign subsidiaries’ net income and the ability to generate cash flows from operations. The movement of cash from SED’s foreign subsidiaries may be restricted at times due to governmental restrictions, domestic banking agreements, international monetary restrictions, and other restrictions from time to time, therefore movement of cash may be uncertain. Currently there are no such restrictions.
The domestic and global economic downturn created several risks relating to SED’s financial results, operations and prospects. SED has experienced a rapid decline in demand for the products it sells resulting in a more competitive environment and increased pressure to reduce the cost of operations. The benefits from cost reductions will take longer to fully realize and may not fully mitigate the impact of the reduced demand. The recent economic downturn may also result in changes in vendor terms and conditions, such as rebates, cash discounts and cooperative marketing efforts, which may result in further downward pressure on SED’s sales and gross margins. Deterioration in the financial and credit markets heightens the risk of customer bankruptcies and delays in payment. Deterioration in the credit markets in Latin America and the United States have resulted in reduced availability of credit insurance to cover customer accounts. This has resulted in a reduction of the credit lines SED provides to its customers, thereby having a negative impact on its sales. Also, volatile foreign currency exchange rates increase SED’s risk related to products purchased in a currency other than the currency in which those products are sold. The realization of any or all of these risks would likely have a significant adverse effect on SED’s future financial results.
Historically, SED has financed its liquidity needs largely through internally generated funds, borrowings under the Wells Fargo credit facility, subsidiary bank credit agreements, and vendor lines of credit. There can be no assurance that any or all of the aforementioned sources of capital will be available to SED when needed. For example, SED’s creditors may tighten their lending standards and SED may find it necessary to tighten credit availability standards to its customers due to the general weakening of the economic environment. However, SED believes that funds generated from operations, together with its Wells Fargo credit facility, subsidiary bank credit agreements, vendor credit lines, and current cash and cash equivalents will be sufficient to support its working capital and liquidity requirements for at least the next 12 months.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
As a smaller reporting company, SED is not required to provide the information required by this item.
ITEM 4. CONTROLS AND PROCEDURES
Our management, with the participation of our chief executive officer and chief financial officer, carried out an evaluation of the effectiveness of our “disclosure controls and procedures” (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)), as of the end of the period covered by this report (the “Evaluation Date”). Based upon that evaluation, our chief executive officer and chief financial officer concluded that as of the Evaluation Date, our disclosure controls and procedures are effective to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act (i) is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms and (ii) is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate to allow timely decisions regarding required disclosure.
There were no changes in our internal controls over financial reporting that occurred during the quarter ended September 30, 2012 that have materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
PART II – OTHER INFORMATION
ITEM 1. Legal Proceedings
On September 13, 2012 SED learned that a complaint by the Chamber of Industry Wuppertal-Solingen-Remscheid, a German trade association, seeking statutory damages, treble damages, an accounting and injunctive relief for defendants’ sale of products allegedly infringing the “Solingen” certification mark was initiated. The Complaint names SED and various other parties as defendants and was filed in the United States District Court for the Southern District of Florida. The Plaintiff contends that it has not served any of the defendants in the case and therefore no defendant is required to answer the suit at this time. At the appropriate time SED intends to deny liability and vigorously defend this lawsuit.
ITEM 1A. Risk Factors
As a smaller reporting company, SED is not required to provide the information required by this item.
ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds
Effective August 29, 2012, the Chairman of the Board was elected Executive Chairman and began receiving a salary for services rendered by him after August 29, 2012. In connection with his becoming Executive Chairman, the Board awarded to him stock options to purchase 100,000 shares of Common Stock exercisable at $2.15 per share and subject to vesting in five equal installments beginning on August 29, 2012 and on each of next four anniversaries of August 29, 2012, provided he is a director on each such anniversary date. These options were awarded from SED’s 2009 Incentive Compensation Plan.
On October 1, 2012, SED issued an aggregate of 16,042 shares of restricted common stock from its 2009 Incentive Compensation Plan, with a market value of approximately $32,000, to the non-management members of the Board as director compensation for the quarter ended September 30, 2012. Shares are issued quarterly under the SED director compensation plan.
Effective as of October 15, 2012, the Board awarded to Mr. O’Malley: (a) options to purchase 100,000 shares of Common Stock exercisable at $1.85 per share and vesting in three annual tranches and (b) 100,000 shares of restricted Common Stock, both of which are subject to vesting upon achievement of specified performance targets. The performance criteria for purposes of the vesting of each option tranche and the vesting of the restricted Common Stock will be based on the achievement of specified net income per share targets in excess of that achieved in fiscal 2012 and the achievement of specified ROIC ranging from an ROIC of 10% to an ROIC of 20%, which targets will be developed in consultation between SED and Mr. O’Malley as soon as practicable after Mr. O’Malley completes his first 30 days of employment.
The aforementioned shares of restricted Common Stock were issued in reliance upon the exemption from the registration requirements of the Securities Act of 1933, as amended (“Act”) pursuant to Sections 4(2) and 4(5) of the Act. Appropriate restrictive legends were imprinted on the back of each issued stock certificate.
Company Purchases of its Equity Securities
Since the adoption of the SED share repurchase plan in August 2009 continuing through September 30, 2012, SED repurchased an aggregate of 481,925 shares of Common Stock at an average cost of approximately $3.79 per share or $1.8 million in the aggregate. SED did not repurchase shares of Common Stock under our repurchase plan during the three months ended September 30, 2012.
ITEM 6. Exhibits
**Filed herewith. In accordance with Rule 406T of Regulation S-T, the information in these exhibits shall not be deemed to be “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, or otherwise subject to liability under that section, and shall not be incorporated by reference into any registration statement or other document filed under the Securities Act of 1933, as amended, except as expressly set forth by specific reference in such filing.
(1) Filed as an exhibit to the Company’s Current Report on Form 8-K filed with the SEC on October 18, 2012 and incorporated herein by reference.
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.