Business Context and Reporting Period
Company: Scan Source, Inc.
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: March 31, 2007
Business Overview: A leading wholesale distributor of specialty technology products, including automatic identification and data capture (AIDC), point-of-sale (POS), voice/data communications, video conferencing, and electronic security products. Operations are divided into North American and International (Latin America and Europe) distribution segments.
Key Financial Metrics
| Metric | Quarter Ended Mar 31, 2007 | Nine Months Ended Mar 31, 2007 |
|---|---|---|
| Net Sales | $492.7 million | $1,462.6 million |
| Gross Profit | $51.0 million | $155.7 million |
| Gross Margin | 10.4% | 10.6% |
| Operating Income | $17.2 million | $54.6 million |
| Net Income | $10.1 million | $31.3 million |
| Diluted EPS | $0.38 | $1.19 |
| Cash and Equivalents | $3.0 million | (N/A - Balance Sheet Item) |
| Working Capital | $365.3 million | (N/A - Balance Sheet Item) |
| Revolving Credit Facility Used | $112.4 million | (N/A - Balance Sheet Item) |
| Operating Cash Flow (9 Months) | (N/A) | ($49.2 million) used |
Material Changes vs. Prior Period
- Revenue Growth: Net sales increased 21.5% for the quarter and 21.4% for the nine-month period compared to the prior year. North American sales grew 18.2% (quarter) and 17.7% (nine months), while International sales grew 41.6% (quarter) and 46.9% (nine months).
- Profitability: Operating income increased 19.4% for the quarter and 23.1% for the nine months. Net income rose 11.8% for the quarter and 16.2% for the nine months.
- Restatement Impact: Financial statements for the prior year (2006) have been restated due to a review of historical stock option grant practices. The restatement resulted in additional non-cash stock-based compensation expense of approximately $5.3 million cumulatively from 1995 to 2006. For the quarter ended March 31, 2006, restated net income was $9.0 million (down from $9.4 million previously reported).
- Acquisitions: The acquisition of T2 Supply, LLC (video conferencing and telephony) in July 2006 contributed significantly to sales and operating income growth in the current period.
- Operating Expenses: Increased by 26.0% for the quarter, driven primarily by $3.0 million in special committee investigation costs, increased headcount, and higher bad debt expense.
Guidance, Outlook, Risks, and Unusual Items
- Restatement and Controls: The Company identified a material weakness in internal controls over financial reporting related to stock option granting practices. A Special Committee review concluded that measurement dates for certain options were incorrect. Management has implemented new policies and procedures to remediate this weakness.
- Legal Proceedings: Two derivative lawsuits were filed in late 2006 and early 2007 alleging violations of securities laws and breach of fiduciary duty regarding stock option grants. The Company intends to vigorously defend these actions. Insurance carriers have indicated the claims appear to be within coverage, though costs for the Special Committee review are not yet recognized as covered.
- Liquidity: Operating cash flow was negative ($49.2 million used) for the nine months ended March 31, 2007, primarily due to increased working capital requirements (receivables and inventory) to support growth and the T2 Supply acquisition. The Company increased borrowings under its revolving credit facility to $112.4 million. On April 20, 2007, the credit facility commitment was increased from $150 million to $200 million.
- Unusual Items: Operating expenses included $3.0 million (quarter) and $7.9 million (nine months) in direct costs associated with the Special Committee review of stock options.
- Outlook: Management believes it has sufficient liquidity to meet forecasted cash requirements for at least the next fiscal year. The Company continues to invest in customer training, new technologies, and international expansion.
Investor Verification Checklist
- Restatement Details: Verify the full impact of the stock option restatement on historical earnings and the specific adjustments made to the 2006 fiscal year.
- Legal Exposure: Monitor the status of the derivative lawsuits and the final determination of insurance coverage for legal defense costs and potential damages.
- Working Capital Trends: Review the sustainability of the increased Days Sales Outstanding (DSO) and inventory levels, which contributed to negative operating cash flow.
- Debt Covenants: Confirm continued compliance with financial covenants, noting the waivers received regarding the delivery of quarterly information during the investigation period.
- Acquisition Integration: Assess the ongoing performance and integration of the T2 Supply acquisition and its contribution to future margins.