Overview

ScanSource, Inc. is a leading wholesale distributor of specialty technology products, providing value-added distribution sales to resellers in the specialty technology markets. The Company distributes more than 61,700 products worldwide. The Company has two geographic distribution segments: one serving North America from the Southaven, Mississippi distribution center, and an international segment currently serving Latin America (including Mexico) and Europe from distribution centers located in Florida and Mexico, and in Belgium and the United Kingdom, respectively. The North American distribution segment markets automatic identification and data capture ("AIDC") and point-of-sale ("POS") products through the ScanSourcePOS and Barcoding sales unit; voice, data and converged communications equipment through its Catalyst Telecom sales unit; video conferencing, telephony and communications products through its ScanSource Communications sales unit; and electronic security products and wireless infrastructure products through its ScanSource Security sales unit. The international distribution segment markets AIDC, POS and Barcode products through its ScanSource Latin America and European sales units, while communication products are marketed through its ScanSource Communications sales unit in Europe.

The Company was incorporated in December 1992 and is headquartered in Greenville, South Carolina. The Company serves North America from a single, centrally located distribution center located near the FedEx hub in Southaven, Mississippi. The single warehouse and strong management information system form the cornerstone of the Company's cost-driven operational strategy. This strategy has been expanded to Latin America and Europe, with distribution centers located in Florida and Mexico, and in Belgium and the United Kingdom, respectively.

Evaluating Financial Condition and Operating Performance

The Company's management places a significant emphasis on operating income and return on invested capital ("ROIC") in evaluating and monitoring the Company's financial condition and operating performance. ROIC is used by the Company to assess its efficiency at allocating the capital under its control to generate returns. ROIC is computed by the Company as net income plus income taxes, interest expense, depreciation and amortization divided by invested capital, and then annualized.

The following table summarizes the Company's annualized return on invested capital ratio for the quarter ended September 30, 2009 and 2008, respectively:

Quarter ended September 30, 2009 2008 Return on invested capital ratio, annualized 16.0 % 20.2 %

The discussion that follows this overview explains the decrease in ROIC from the comparative period shown above. The Company uses ROIC as a performance measurement because it believes that this metric best balances the Company's operating results with its asset and liability management, excludes the results of capitalization decisions, is easily computed, communicated and understood and drives changes in shareholder value. The components of this calculation and a reconciliation to the Company's financial statements is shown below:

Reconciliation of EBITDA to net income:

                                                        Quarter Ended
                                                        September 30,
                                                     2009           2008
                                                        (in thousands)
         Net income                                $  10,935      $  12,430
         Plus: income taxes                            6,533          7,693
         Plus: interest expense                          366            579
         Plus: depreciation & amortization             1,467          1,775

         EBITDA (numerator)                        $  19,301      $  22,477


         Invested capital calculations:

                                                     2009           2008
                                                        (in thousands)
         Equity - beginning of the quarter         $ 445,446      $ 395,753
         Equity - end of the quarter                 458,566        406,703

         Average equity                              452,006        401,228
         Average debt(1)                              30,429         44,826

         Invested capital (denominator)            $ 482,435      $ 446,054

         Return on invested capital (annualized)        16.0 %         20.2 %

(1) Average debt is based upon average daily debt and is therefore not able to be represented in this format.

Results of Operations

Net Sales

The following table summarizes our net sales results (net of inter-segment
sales) for the quarters ended September 30, 2009 and 2008:



                                        Quarter ended
                                        September 30,
                                      2009        2008      $ Change       % Change
                                             (in thousands)
      North American distribution   $ 397,192   $ 444,965   $ (47,773 )       (10.7 %)
      International distribution       91,231      94,860      (3,629 )        (3.8 %)

      Net sales                     $ 488,423   $ 539,825   $ (51,402 )        (9.5 %)

On a comparative basis, consolidated worldwide net sales for the quarter ended September 30, 2009 decreased 9.5% to $488.4 million. The decrease in sales reflects weaker end-user demand which is the result of macro-economic challenges impacting both of our geographic operating segments during the current quarter. These economic challenges had not fully materialized in the prior year quarter, and therefore, our sales results were stronger in that quarter. However, the momentum in overall demand that the Company experienced late in the fourth quarter of fiscal year 2009 continued into the current quarter, and the Company experienced a 10.7% increase in consolidated revenues from that quarter. The sales results for the majority of the Company's sales units and geographic segments reflect this overall trend.

North American Distribution

North American distribution sales include sales to technology resellers in the United States and Canada from our Southaven, Mississippi distribution center. For the quarter ended September 30, 2009, net sales decreased over the comparative prior year period by $47.7 million, or 10.7%.

The Company's North American POS, bar-coding, and security product categories saw revenues decrease by 13.8% in comparison to the prior year quarter. As discussed previously, sales of substantially all of our major vendors and product lines were down and we saw fewer of the larger deals than in the prior year quarter. The exception to this trend was our security product lines, which experienced strong quarter over quarter and sequential sales growth through several big deals and new customers. Specifically, video surveillance and card printer product lines showed significant sales growth for this sales unit. In our POS & bar-coding product lines, the Company experienced a significantly more competitive environment since the quarter ended June 30, 2009. This resulted in a significant increase in the number of deals closed during the quarter with special pricing incentives designed to aggressively pursue market share. As a result, the Company was able to increase revenues in the majority of these product categories on a sequential basis.

The Company has two North American sales units that sell communications products to our customers - the Catalyst Telecom sales unit and the ScanSource Communications sales unit. The combined sales of these units were 6.8% lower in the current quarter versus the prior year quarter. Despite the quarter over quarter decrease in revenues, Catalyst Telecom continues to gain momentum and post strong sales results on a sequential quarter basis. In addition, Catalyst did experience some product shortages at the end of the quarter which delayed some orders into next quarter. In the ScanSource Communications sales unit, there were a number of big deals and strong results from our video and voice product lines which resulted in record revenues for the current quarter. Accordingly, ScanSourceCommunications experienced both sequential and quarter over quarter sales growth.

International Distribution

The international distribution segment includes sales to Latin America (including Mexico) and Europe from the ScanSource POS and Barcoding sales units and in Europe through the ScanSource Communications sales unit. For the quarter ended September 30, 2009, net sales for this segment decreased by $3.6 million, or 3.8%. On a constant exchange rate basis, the sales decrease was less than 1%. In all of our international geographies, sales continue to be lower on a year over year basis as both Europe and Latin America continue to recover from the economic recession and, to a lesser extent, currency devaluations in certain countries. However, on a sequential basis, we did see sales growth across the majority of our product categories. We attribute a portion of this growth to a number of large deals that were closed during the quarter in addition to a more aggressive pursuit of market share and channel shift.

Gross Profit

The following tables summarize the Company's gross profit for the quarter ended
September 30, 2009 and 2008, respectively:



                                            Quarter ended                                       % of Sales
                                            September 30,                                     September 30,
                                           2009       2008     $ Change       % Change       2009        2008
                                                 (in thousands)
North American distribution              $ 40,446   $ 43,653   $  (3,207 )        (7.3 %)     10.2 %      9.8 %
International distribution                 10,972     11,849        (877 )        (7.4 %)     12.0 %     12.5 %

Gross profit                             $ 51,418   $ 55,502   $  (4,084 )        (7.4 %)     10.5 %     10.3 %

North American Distribution

Gross profit for the North American distribution segment decreased 7.3% or $3.2 million for the quarter ended September 30, 2009, as compared to the comparative prior year period. The decrease in gross profit is primarily the result of lower sales volume in all of our sales units, as previously discussed. Gross profit as a percentage of net sales for the North American distribution segment increased slightly to 10.2% for the quarter ended September 30, 2009, as there were significantly fewer larger deals in the current quarter and a more favorable mix of sales within our sales units, as compared to the prior year results. However, on a sequential basis, the Company is experiencing lower gross margins as a percentage of sales, as the Company pursues market share through more competitive pricing, especially in our POS & bar-coding sales unit.

International Distribution

In our international distribution segment, gross profit decreased by 7.4% or $0.9 million for the quarter ended September 30, 2009, as compared to the same period in the prior year. The decrease in gross margin percentage in Europe and Latin America from the comparative quarter reflects a more favorable customer and product mix in the prior year quarter. In addition, it also reflects a more competitive environment in which the Company is aggressively pursuing market share at the expense of lower gross margins.

Operating Expenses

The following table summarizes our operating expenses for the quarters ended September 30, 2009 and 2008, respectively:

Quarter ended % of Sales September 30, September 30, 2009 2008 $ Change % Change 2009 2008

Operating expenses decreased by 3.3%, or $1.1 million for the quarter ended September 30, 2009, as compared to the same period in the prior year. The decrease in operating expenditures for the current quarter is primarily attributable to our compensation programs which are variable in nature and declined in correlation with our sales volume and profitability. And to a lesser extent, we continue to benefit from various cost reduction initiatives implemented in the prior fiscal year in response to lower sales volumes.

Partially offsetting these expense reductions in the current quarter was a $1.5 million increase in bad debt expense over the prior year quarter. The increase in bad debt expense reflects the weakened financial profiles of certain of our customers and their end-users due to the prevailing economic conditions of the last 12 months. Accordingly, the credit needs and associated risks of these customers have also changed. The increase in bad debt expense reflects the adjustment of our allowance for doubtful accounts to capture the risks associated with this pool of customers.

Operating expenses as a percentage of sales increased to 6.9% for the quarter ended September 30, 2009, which was slightly higher than the comparative, prior year period. This increase is largely attributable to the increase in bad debt expense and an overall decline in sales volumes for our consolidated operations between the two periods.

Operating Income

The following table summarizes our operating income for the quarters ended
September 30, 2009 and 2008, respectively:



                                            Quarter ended                                       % of Sales
                                            September 30,                                     September 30,
                                           2009       2008     $ Change       % Change       2009        2008
                                                 (in thousands)
North American distribution              $ 14,931   $ 17,725   $  (2,794 )       (15.8 %)      3.8 %      4.0 %
International distribution                  2,756      2,903        (147 )        (5.1 %)      3.0 %      3.1 %

                                         $ 17,687   $ 20,628   $  (2,941 )       (14.3 %)      3.6 %      3.8 %

Operating income decreased 14.3% or $2.9 million for the quarter ended September 30, 2009 to $17.7 million. The decrease in operating income for both segments is primarily attributable to lower sales volumes and related gross profit generated during the current quarter, as previously discussed.

Total Other Expense (Income)

The following table summarizes our total other expense (income) for the quarter
ended September 30, 2009 and 2008, respectively:



                                             Quarter ended                                           % of Sales
                                             September 30,                                         September 30,
                                            2009        2008        $ Change       % Change       2009        2008
                                                     (in thousands)
Interest expense                           $  366      $  579      $     (213 )       (36.8 %)      0.0 %      0.1 %
Interest income                              (263 )      (351 )            88         (25.1 %)      0.0 %     -0.1 %
Net foreign exchange losses                   219         327            (108 )       (33.0 %)      0.0 %      0.1 %
Other, net                                   (102 )       (50 )           (52 )       104.0 %       0.0 %      0.0 %

Total other expense, net                   $  220      $  505      $     (285 )       (56.4 %)      0.0 %      0.1 %

Interest expense reflects interest paid on borrowings on the Company's revolving credit facility and long-term debt. Interest expense for the quarter ended September 30, 2009 was $0.4 million. The decrease in interest expense is primarily the result of lower average debt balances between the respective periods, and, to a lesser extent, lower interest rates experienced between the comparative periods.

Interest income for the quarter ended September 30, 2009 was slightly lower than the comparative prior year periods. The Company generates interest income on longer-term interest bearing receivables, and, to a lesser extent, interest earned on cash and cash-equivalent balances on hand.

Net foreign exchange gains and losses consist of foreign currency transactional and functional currency re-measurements, offset by net foreign currency exchange contract gains and losses. Foreign exchange losses and gains are generated as the result of fluctuations in the value of the Euro versus the British Pound and the U.S. Dollar versus other currencies. While the Company utilizes foreign exchange contracts and debt in non-functional currencies to hedge foreign currency exposure, our foreign exchange policy prohibits us from entering into speculative transactions.

Provision for Income Taxes

Income tax expense was $6.5 million for the quarter ended September 30, 2009, reflecting an effective income tax rate of 37.4%. Income tax expense was $7.7 million for the quarter ended September 30, 2008, reflecting an effective income tax rate of 38.2%. The decrease in the effective tax rate in the current quarter is attributable to the Company receiving a favorable tax ruling in December 2008 from a state taxing jurisdiction that had the effect of decreasing our effective tax rate for subsequent periods.

Net Income

The following table summarizes our net income for the quarters ended September 30, 2009 and 2008, respectively:

Quarter ended % of Sales September 30, September 30, 2009 2008 $ Change % Change 2009 2008

The decrease in net income for the current quarter is attributable to the changes in operations, as discussed above.

Liquidity and Capital Resources

The Company's primary sources of liquidity are cash flow from operations, borrowings under the revolving credit facility, secured and unsecured borrowings, and borrowings under the subsidiary's line of credit. The Company's cash and cash equivalent balance totaled $87.8 million at September 30, 2009, compared to $127.7 million at June 30, 2009. The Company's working capital increased to $414.2 million at September 30, 2009 from $399.6 million at June 30, 2009. The $14.6 million increase in working capital is primarily due to higher inventory and accounts receivable balances between the two periods, offset by lower cash balances. As of September 30, 2009, there is no outstanding balance on the Company's revolving line of credit facility.

The number of days sales in receivables (DSO) was 58 at September 30, 2009, compared to 59 days at June 30, 2009 and 58 days at March 31, 2009.

Inventory turnover increased to 7.2 times in the current quarter versus 6.9 times in the comparative, prior year quarter. This increase is largely the function of lower average inventory balances.

Cash used in operating activities was approximately $40.1 million for the quarter ended September 30, 2009, compared to $31 million of cash provided by operating activities for the comparative prior year period. The $71 million swing in cash flow was driven primarily by the overall improvement in demand discussed previously. This resulted in a significant increase in accounts receivable and inventory balances during the current quarter. In addition, during the current quarter the Company took advantage of early payment discounts with one of our largest vendors which had the effect of accelerating approximately $40 million of cash payments to this vendor. While the Company's cash reserves have increased over the past few quarters, these assets earn little return based on current interest rates. As a result, the Company has chosen to take advantage of favorable payment terms from certain vendors.

Cash used in investing activities for the quarter ended September 30, 2009 was $0.1 million, compared to $1.6 million used in the comparative prior quarter. For both periods, this reflects net capital expenditures purchased in the ordinary course of business.

In the current quarter, cash provided by financing activities amounted to $0.1 million, in comparison with cash used of $28 million in the comparative prior year quarter. In the current quarter, there was minimal activity in terms of financing activities. The Company did not have an outstanding balance on its revolving credit facility at any point during the quarter and the Company had cash on hand of $87.8 million at September 30, 2009. In contrast, in the comparative prior quarter, the Company was in the process of reducing its outstanding debt balances.

The Company has a revolving credit facility secured by the assets of its European operations and guaranteed by the Company. This facility was amended on May 14, 2008 to increase the borrowing limit to €6.0 million for the Company's European operations. At September 30, 2009, there was no outstanding balance on this facility.

On January 2, 2008, the Company entered into a $25 million promissory note with a financial institution. This note payable accrues interest on the unpaid balance at a rate per annum equal to the 30 day LIBOR plus 0.65% and matures on September 28, 2012. The terms of the note payable allow for payments to be due and payable in consecutive monthly payment terms of accrued interest only, commencing on January 31, 2008, and continuing on the last day of each month thereafter until fully paid. In any event, all principal and accrued interest will be due and payable on September 28, 2012. The note may be prepaid in whole or in part at any time without penalty. The effective interest rate was 0.91% as of September 30, 2009. Due to cross-default provisions within this loan agreement, the Company was not in compliance with certain covenants as of September 30, 2009 and all other periods impacted by the non-compliance associated with the revolving credit facility agreement. Accordingly, the Company obtained a waiver from the lender on November 4, 2009, which cures this violation as of September 30, 2009 and any other prior periods.

On January 4, 2008, the Company entered into an interest rate swap with a notional amount of $25 million and designated this instrument as a cash flow hedge of our exposure to variability in future cash flows associated with this note payable. Under the terms of the swap, the Company pays a fixed rate of 3.65% plus a fixed spread of 0.65% on the $25 million notional amount and receives payments from a counterparty based on 30 day LIBOR plus a fixed spread of 0.65% for a term ending on September 28, 2011.

On September 28, 2007, the Company entered into a $250 million multi-currency revolving credit facility with a syndicate of banks that matures on September 28, 2012. The facility is guaranteed by the Company and certain of its subsidiaries and is secured by substantially all of the domestic assets of the Company and its domestic subsidiaries. The facility bears interest at a rate equal to a spread over the applicable LIBOR or prime rate, as chosen by the Company. This spread is dependent on the Company's ratio of funded debt to EBITDA (as defined in the credit facility) and ranges from 0.50% to 1.25% for LIBOR-based loans, and from 0.00% to 0.25% for prime rate-based loans. The spread in effect as of September 30, 2009 was 0.50% for LIBOR-based loans and 0.00% for prime rate-based loans. There were no outstanding borrowings on this facility as of September 30, 2009. As a result, the Company had $250 million available for additional borrowings on this facility. This agreement subjects the Company to certain non-financial and financial covenants, including minimum fixed charge and leverage ratio covenants. On October 30, 2009, the Company entered into an amendment and waiver to its $250 million Revolving Credit Facility after it was determined that the Company was not in compliance with a specific intercompany loan covenant within the agreement since June 30, 2008. This default was due to a technical misunderstanding of the underlying legal agreement which was immediately waived and the agreement amended to allow for such transactions in the future.

On August 1, 2007, the Company entered into an agreement with the State of Mississippi in order to provide financing for the acquisition and installation of certain equipment to be utilized at the Company's Southaven, Mississippi distribution facility, through the issuance of an industrial development revenue bond. The bond matures on September 1, 2032 and accrues interest at the 30-day LIBOR rate plus a spread of 0.85%. The terms of the bond allow for payment of interest only for the first 10 years of the agreement, and then, starting on September 1, 2018 through 2032, principal and interest payments are due until the maturity date or the redemption of the bond. The outstanding balance on this facility was $5.4 million as of September 30, 2009, and the effective interest rate was 1.11%. Due to cross-default provisions within the agreement, the Company was not in compliance with certain covenants as of September 30, 2009 and all other periods impacted by the non-compliance associated with the revolving credit facility agreement. Accordingly, the Company obtained a waiver from the bondholder and trustee on November 4, 2009, which cures this violation as of September 30, 2009, and any other prior periods.

The Company believes that its existing sources of liquidity, including cash resources and cash provided by operating activities, supplemented as necessary with funds under the Company's credit agreements, will provide sufficient resources to meet the Company's present and future working capital and cash requirements for at least the next twelve months.

Accounting Standards Recently Issued

See Note 3 to our Condensed Consolidated Financial Statements.