SCANSOURCE, INC. annual report, FY2014

ScanSource, Inc. 2014 Form 10-K Summary

Reporting period: Fiscal year ended June 30, 2014; the filing also reports fourth-quarter results for the three months ended June 30, 2014. The company is an international wholesale distributor of specialty technology products serving approximately 28,000 resellers and approximately 290 vendors across North America, Latin America, and Europe.

Business Context and Reporting Structure

• Operations are organized into two technology-focused segments: Worldwide Barcode & Security and Worldwide Communications & Services.
• Products include automatic identification and data capture, point-of-sale, physical security, communications, networking, video conferencing, and related professional services.
• The company added 3D-printing solutions during fiscal 2014 and continued investing in security, communications, services, and ERP capabilities.
• Motorola, Avaya, and Honeywell each represented more than 10% of fiscal 2014 net sales, creating vendor concentration risk. No customer represented more than 5% of sales.

Financial Performance and Key Metrics

Metric	FY 2014	FY 2013	Change
Net sales	$2.914 billion	$2.877 billion	+1.3%
Gross profit	$301.1 million	$292.9 million	+2.8%
Gross margin	10.3%	10.2%	+0.1 percentage point
SG&A	$192.5 million	$191.2 million	+0.7%
Operating income	$121.8 million	$51.0 million	+138.6%
Operating margin	4.2%	1.8%	+2.4 percentage points
Net income	$81.8 million	$34.7 million	+135.9%
Diluted EPS	$2.86	$1.24	+130.6%
Operating cash flow	$47.7 million	$129.4 million	Down $81.7 million

Fiscal 2014 fourth-quarter net sales were $758.1 million, gross profit was $74.0 million, and net income was $27.1 million, compared with a fourth-quarter net loss of $13.3 million in fiscal 2013. Fourth-quarter diluted EPS was $0.94 versus a loss of $0.48 in the prior-year quarter.

• Barcode & Security: Sales increased 2.5% to $1.873 billion; gross profit was essentially flat at $168.2 million, with margin declining to 9.0% from 9.2%; operating income increased 48.6% to $51.5 million.
• Communications & Services: Sales declined 0.8% to $1.040 billion; gross profit increased 6.5% to $132.9 million, and margin improved to 12.8% from 11.9%; operating income increased 22.8% to $54.8 million.
• Adjusted net income, excluding the legal recovery in 2014 and selected unusual items in 2013, was $72.0 million versus $69.3 million; adjusted diluted EPS was $2.52 versus $2.47.
• ROIC declined to 15.4% from 16.0%, primarily because of higher average equity from retained earnings.

Liquidity, Capital Resources, and Balance Sheet

• Cash and cash equivalents were $194.9 million at June 30, 2014, compared with $148.2 million a year earlier.
• Working capital increased to $715.9 million from $614.4 million, primarily due to higher cash, accounts receivable, and inventory.
• Accounts receivable were $464.4 million, with a $26.3 million allowance; inventories were $504.8 million, up from $402.3 million.
• Debt totaled $5.4 million, consisting primarily of an industrial revenue bond. There were no borrowings under the $300 million revolving credit facility, leaving the full facility available; the facility matures in November 2018 and includes a potential $150 million accordion feature.
• The company was in compliance with its debt covenants and stated that existing liquidity should fund working capital and other requirements for at least the next twelve months.
• Cash flow was pressured by a $31.9 million increase in accounts receivable and a $99.2 million increase in inventories. Inventory turnover declined to 5.6 times in the fourth quarter from 6.2 times in the prior-year quarter.
• Fiscal 2014 capital expenditures were $11.2 million, including $13.2 million of ERP-related capital expenditures; fiscal 2015 capital spending was expected to range from $17 million to $22 million, primarily for the ERP system.

Material Changes, Unusual Items, and Outlook

• The major favorable variance in fiscal 2014 resulted from a $15.0 million cash settlement with former ERP implementation partner Avanade. After attorney fees and reversal of $2.0 million of accrued liabilities, the company recorded a $15.5 million net legal recovery.
• Fiscal 2013 included a $28.2 million pretax non-cash impairment of the discontinued Microsoft Dynamics AX ERP project and $20.6 million of goodwill impairments related to Brazilian POS & Barcode and European Communications. No goodwill impairment was recorded in fiscal 2014.
• The company began developing a replacement ERP system using SAP in January 2014 after abandoning the prior Microsoft Dynamics AX project.
• The company expects fiscal 2015 effective tax rates of approximately 33% to 34%.
• At June 30, 2014, the company had $11.1 million of CDC acquisition contingent consideration recorded, including $5.9 million due August 31, 2014. Total future undiscounted earnout payments were estimated at approximately $12.0 million.
• In August 2014, the company entered into a binding letter of intent to acquire Brazil-based Network1. The initial purchase price was approximately $70.4 million, with estimated total consideration of approximately $135.4 million including a four-year earnout, subject to closing conditions and due diligence.
• The board authorized up to $120 million for common-stock repurchases. The company has never paid a cash dividend, and its credit facility restricts dividend payments.
• The company also announced a non-binding letter of intent to acquire Imago Group plc for an initial payment of approximately $41.0 million plus earnout payments.

Risks and Contingencies

• ERP implementation remains a significant execution, cost-overrun, delay, and business-disruption risk.
• International operations expose the company to foreign-exchange volatility, economic and political instability, tax and regulatory changes, trade-compliance requirements, and greater credit and collection risk.
• Venezuela presented heightened collectability risk: $2.3 million of receivables were outstanding at June 30, 2014, with 87% specifically reserved.
• Latin American goodwill was considered more sensitive than other reporting units; estimated fair value exceeded carrying value by only 10.2%, and future impairment remains reasonably possible if projected margins, working capital, or discount rates deteriorate.
• Vendor concentration, short-term distribution agreements, potential vendor consolidation, product shortages, price reductions, and reduced rebates could pressure revenue and narrow gross margins.
• Rapid product obsolescence, inventory accumulation, customer credit losses, cyber-security incidents, reliance on centralized facilities, and third-party logistics providers could adversely affect results.
• The company had approximately $89.5 million of undistributed foreign earnings considered permanently reinvested; estimated tax upon repatriation was approximately $14.9 million after foreign tax credits.
• Ordinary-course litigation was not expected to be material based on information available at filing, and the Avanade litigation was settled.

Investor Verification Checklist

• Verify whether the SAP ERP implementation remained on budget, on schedule, and free of operational disruption.
• Track inventory turnover, working-capital growth, accounts-receivable aging, Venezuela exposure, and operating cash conversion.
• Assess whether Communications & Services sales stabilized and whether improved gross margins were sustainable.
• Monitor vendor concentration, particularly Motorola, Avaya, and Honeywell, and any effects from the proposed Zebra-Motorola enterprise-business transaction.
• Reconcile reported earnings with adjusted earnings and separately evaluate the recurring economics excluding the $15.5 million legal recovery.
• Review the financing, funding, and integration implications of the proposed Network1 and Imago acquisitions and the $120 million share-repurchase authorization.
• Test the sensitivity of Latin American goodwill and CDC contingent consideration to foreign exchange, earnings forecasts, and discount rates.