TMCNet:  SED INTERNATIONAL HOLDINGS INC - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

[November 09, 2012]

SED INTERNATIONAL HOLDINGS INC - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(Edgar Glimpses Via Acquire Media NewsEdge) Overview SED International Holdings, Inc. ("SED") distributes microcomputer, consumer electronic and small appliance products in the United States, Latin America and the Caribbean. SED purchases more than 17,000 products from approximately 200 vendors (directly and indirectly), including such technology market leaders as Acer, Asus, Dell, Epson, Hewlett-Packard, Kingston, Lenovo, Lexmark, Microsoft, Seagate and Western Digital; consumer electronics manufacturers such as Canon, Coby, Haier, Panasonic, Samsung, Sansui, and VuPoint; and an extensive housewares 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.

10 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 2011 $ % $ % $ % Change Change Net sales 126,365 100.00 % 155,839 100.00 % (29,474 ) (18.9 )% Cost of sales 119,354 94.45 % 148,320 95.18 % (28,966 ) (19.5 )% Gross profit 7,011 5.55 % 7,519 4.82 % (508 ) (6.8 )% Operating expenses: Selling, general and administrative 8,284 6.56 % 7,915 5.08 % 369 4.7 % Depreciation and amortization 217 .17 % 125 .08 % 92 73.6 % Foreign currency transaction loss 129 .10 % 651 .42 % (522 ) (80.2 )%Acquisition-related costs 0 0 % 370 .24 % (370 ) (100.0 )% Total operating expenses 8,630 6.83 % 9,061 5.82 % (431 ) (4.8 )% Operating loss (1,619 ) (1.28 )% (1,542 ) (1.00 )% (77 ) (5.0 )% Interest expense, net 284 (.22 )% 296 (.18 )% (12 ) (4.1 )% Gain on acquisition 0 0 % (998 ) .64 % 998 (100.0 )% Loss before income taxes (1,903 ) (1.50 )% (840 ) (.54 )% (1,063 ) 126.5 % Income tax expense (benefit) 201 .16 % (10 ) (.01 )% 211 (2110.0 )% Net loss (2,104 ) (1.66 )% (830 ) (.53 )% (1,274 ) 153.5 % 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: Three Months Ended September 30, Change 2012 2011 Amount Percent United States Domestic $ 76,181 $ 95,358 $ (19,177 ) (20.1 )% Export 19,575 26,031 (6,456 ) (24.8 )% Total U.S. 95,756 121,389 (25,633 ) (21.1 )% Latin America 30,609 34,450 (3,841 ) (11.1 )% Consolidated $ 126,365 $ 155,839 $ (29,474 ) (18.9 )% 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 decreasewas 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.

11 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 andless 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.

12 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 withWells 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.

13 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 thereare no such restrictions.

14 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.

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