LQDT

Business Context and Reporting Period

Liquidity Services, Inc. (LSI) is a leading online auction marketplace for wholesale surplus and salvage assets, operating marketplaces such as liquidation.com and govdeals.com. The company serves corporate and government sellers, including the U.S. Department of Defense (DoD), by managing the disposition of excess assets. This Form 10-Q covers the quarterly period ended June 30, 2009, and the nine months ended June 30, 2009.

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue Decline: Revenue decreased 18.8% ($13.5 million) for the quarter and 10.4% ($20.2 million) for the nine months compared to the prior year. This was primarily driven by a 40.7% decrease in the scrap business due to falling commodity prices.
• Profitability: Net income decreased 11.6% for the quarter and 42.7% for the nine months. Despite lower revenue, operating margins improved slightly in the quarter (10.8% vs 8.6%) due to a significant reduction in profit-sharing distributions to the DoD.
• Profit-Sharing Distributions: Distributions to the DoD dropped 66.6% for the quarter and 49.4% for the nine months. This reduction is attributed to the wind-down of the original Surplus Contract and the transition to a new Surplus Contract (effective Dec 2008) which utilizes a purchase model with no profit-sharing provision.
• Cash Flow: Net cash provided by operating activities fell significantly to $4.1 million for the nine months ended June 30, 2009, compared to $16.6 million in the prior year period, largely due to changes in working capital and lower net income.

Outlook, Risks, and Management Commentary

• Contract Transition: The quarter ended June 30, 2009, was the first full quarter under the new DoD Surplus Contract. While the company received a significant volume of property, this created temporary operational inefficiencies and constrained throughput at primary facilities in Columbus, Ohio, and Oklahoma City, Oklahoma.
• Commercial Business: The commercial business faced headwinds from the economic downturn, including reduced retailer volume in the U.S. and U.K. A major U.K. client reorganization caused a material decrease in volume, though management has initiated cost-saving measures and leadership changes to address this.
• Guidance: Management expects operational inefficiencies related to the new DoD contract to persist into the next quarter as the company works through high inventory levels. The U.K. business is expected to remain a drag on earnings in the near term.
• Liquidity: The company maintains a $30.0 million senior credit facility with $21.4 million available (as of June 30, 2009). Management believes existing cash and investments are sufficient for the next 12 months.
• Risks: Key risks include the impact of the economic downturn on commercial GMV, operational capacity constraints at DoD facilities, and the potential for litigation regarding the original Surplus Contract (a $1.5 million claim by KGP, which the company believes is meritless).

Investor Verification Checklist

• Verify the timeline for resolving operational bottlenecks at the Columbus and Oklahoma City facilities under the new DoD Surplus Contract.
• Monitor the recovery of the U.K. commercial business following the reorganization of the major client and the implementation of new management.
• Track the status of the $1.5 million litigation claim filed by Kormendi/Gardener Partners (KGP) regarding the original Surplus Contract.
• Confirm the company's ability to maintain compliance with the EBITDA covenants of its $30 million senior credit facility as revenue fluctuates.
• Assess the impact of the transition from profit-sharing to purchase models on future gross margins and working capital requirements.