Overview

We are a distributor and provider of complete logistics solutions for traditional and e-commerce retail channels. Our solutions support both direct-to-consumer ("DTC") and business-to-business ("B2B") sales channels. We are also a publisher of computer software.

Since our founding in 1983, we have established distribution relationships with major retailers including Best Buy, Wal-Mart/Sam's Club, Apple, Amazon, Costco Wholesale Corporation, Staples, Target, Office Depot and OfficeMax, and we distribute to nearly 31,000 retail and distribution center locations throughout the United States and Canada. We believe our established relationships throughout the supply chain permit us to offer products to our internet-based and retail customers and to provide our vendors with access to broad retail channels. In order to participate in the growing revenue streams resulting from e-commerce and fulfillment services, we are expanding the business services we offer.

Our business operates through two business segments - Distribution and Publishing.

Through our distribution business, we distribute computer software, consumer electronics and accessories and video games, and provide fee-based logistical services. Our distribution business focuses on providing a range of value-added services, including electronic and internet-based ordering and gift card fulfillment. Through our publishing business, we own or license various computer software brands. Our publishing business packages, brands, markets and sells directly to consumers, retailers, third-party distributors and our distribution business. Our publishing business currently consists of Encore Software, Inc. ("Encore").

Encore publishes a variety of software products for the PC and Mac platforms. These products fall mainly into the print, personal productivity, education, family entertainment, and home and landscape architectural design software categories. In addition to retail publishing, Encore also sells directly to consumers through its e-commerce websites.

During October 2011, we implemented a series of initiatives, including a reduction in workforce and simplification of business structures and processes across the Company's operations. Substantially all restructuring activities were complete by March 31, 2012. These actions were intended to increase operating efficiencies and provide additional resources to invest in product lines and service categories in order to execute our long-term growth strategy. In conjunction with the initiatives described above, we reviewed our portfolio of businesses to identify poor performing activities and areas where continued business investments would not meet our requirements for financial returns (collectively, "Restructuring Plan"). During the six months ended September 30, 2012, cash expenditures related to the Restructuring Plan were approximately $1.9 million.

Recent events

On September 27, 2012, the Company and SpeedFC Inc., a Delaware corporation ("SpeedFC") entered into an Agreement and Plan of Merger (the "Merger Agreement") by and among Navarre, SFC Acquisition Co., Inc., a Minnesota corporation and wholly-owned subsidiary of Navarre, (the "Merger Subsidiary"), SpeedFC, the existing stockholders and optionholders of SpeedFC (together referred to herein as the "SFC Equityholders"), and Jeffrey B. Zisk, the current President and Chief Executive Officer of SpeedFC (in the capacity as SFC Equityholders' representative). The Company intends to acquire SpeedFC through a merger of SpeedFC with and into Merger Subsidiary, which shall be the Surviving Corporation (the "Merger"). On October 29, 2012, the parties entered into Amendment No. 1 to the Merger Agreement (the "Amendment").

In exchange for all of the SFC Equityholders' equity interests in SpeedFC, the Merger Agreement, as amended, states that the Company will provide initial consideration of $50.0 million in cash and shares of Navarre common stock, with additional contingent payments in cash and common stock available as described below. The initial consideration is comprised of: (i) $25.0 million to be paid in cash at closing (less certain escrow and holdback amounts, and subject to certain net working capital and post-closing adjustments); and (ii) $25.0 million worth of shares of Navarre common stock, or 17,095,186 shares, to be issued at closing. The contingent consideration is subject to the achievement of certain financial performance metrics by SpeedFC (together with its subsidiary and Merger Sub) in the 2012 calendar year, which, if met, would require: (i) the payment of up to a maximum of $5.0 million in cash consideration, with up to a maximum of $1.25 million payable in early 2013 and up to a maximum of $3.75 million (before interest of five percent per annum) payable in equal, quarterly installments beginning in late 2013 and ending on February 29, 2016 (the "Amended Contingent Cash Payment") and (ii) the issuance of up to 6,287,368 shares of our Common Stock to the SFC Equityholders, with up to 2,215,526 ("Amended First Equity Amount") shares payable in early 2013, up to 738,509 shares ("Amended Second Equity Amount") payable in late 2013 (both such share amounts being calculated based on the Average Parent Stock Price as of October 25, 2012 or $1.6926) and the original 3,333,333 shares payable at the same time as the Amended Second Equity Amount (all equity amounts together, the "Amended Contingent Equity Payment"). The Amended Contingent Cash Payment and Amended Contingent Equity Payment amounts are subject to certain escrow conditions and adjustments in connection with the measurement periods for evaluation of the achievement of financial performance metrics. As a result of the Amendment, a total of 23,382,554 shares of Navarre Common Stock could be issued in connection with the SpeedFC Merger Agreement, if all contingent amounts are fully earned.

Consummation of the transaction remains subject to customary conditions, including the approval of the issuance of certain of the shares in connection with the Merger by the shareholders of the Company, and the Company obtaining satisfactory financing for the transaction. At its upcoming annual meeting, the Company's shareholders will be asked to consider and vote upon, among other things, the proposal to approve the issuance of certain of the shares of the Company's common stock in connection with the Merger.

The Company and SpeedFC have made customary representations and warranties in the Merger Agreement and agreed to certain customary covenants, including covenants regarding operation of the businesses of the companies and their subsidiaries prior to the closing.

Pursuant to the Merger Agreement, the SFC Equityholders have agreed to indemnify Navarre for a number of items, including, among others, adverse consequences resulting from breaches of representations, warranties and covenants and certain identified liabilities. These indemnification obligations do not arise until the losses exceed $250,000 and the parties indemnification obligations cannot exceed a specified amount.

Additionally, the Merger Agreement provides that immediately after the closing of the Merger the Company will increase the size of its board of directors by two members and will appoint Jeffrey B. Zisk, the president and chief executive officer and a director of SpeedFC, and M. David Bryant, also a director of SpeedFC, to fill those vacancies.

The Merger Agreement contains certain termination rights for each of the Company and SpeedFC and further provides that, upon termination of the Merger Agreement in certain circumstances, either Navarre or SpeedFC may be required to pay an expense reimbursement related to the legal, accounting and other reasonable out-of-pocket costs associated with preparing, negotiating and performing the obligations in connection with the Merger.

The Merger Agreement provides that, on the closing date of the Merger, the Company will enter into a registration rights agreement (the "Registration Rights Agreement") with the SFC Equityholders which will require Navarre to provide the SFC Equityholders certain demand and piggyback registration rights with respect to registered public offerings that the Company may effect for its own account or for the benefit of other selling shareholders.

The Merger Agreement also provides that on the closing date of the Merger, the Company will enter into an employment agreement with Jeffrey B. Zisk, who will serve as president of the subsidiary Surviving Corporation.

Executive Summary

Consolidated net sales for the second quarter of fiscal 2013 decreased 2.3% to $104.1 million compared to $106.6 million for the second quarter of fiscal 2012. This $2.5 million decrease in net sales was primarily due to our transition out of the home video product category which generated $6.1 million of net sales in the second quarter of fiscal 2012. In addition, net sales increased $7.2 million for our software and publishing products (before intercompany eliminations) due to expanded distribution to existing and new customers, partially offset by a decrease in net sales in the video game category of $3.4 million compared to the second quarter of fiscal 2012.

Our gross profit decreased to $12.1 million, or 11.6% of net sales, in the second quarter of fiscal 2013 compared to $12.6 million, or 11.8% of net sales, for the same period in fiscal 2012. The $479,000 and 3.8% decrease in gross profit was principally due to a higher volume of lower gross profit margin products within the distribution segment and offset by higher gross profit margin software titles in the publishing segment.

Total operating expenses for the second quarter of fiscal 2013 were $11.3 million, or 10.9% of net sales, compared to $14.2 million, or 13.3% of net sales, in the same period for fiscal 2012. The $2.9 million decrease was primarily due to operating efficiencies resulting from the Restructuring Plan.

Net income for the second quarter of fiscal 2013 was $488,000 or $0.01 per diluted share compared to a net loss of $1.2 million or $0.03 per diluted share for the same period last year.

Consolidated net sales for the six months ended September 30, 2012 decreased 7.2% to $195.4 million compared to $210.6 million for the first six months of fiscal 2012. This $15.2 million decrease in net sales was primarily due to our transition out of the home video product category which generated $16.4 million of net sales in the first six months of fiscal 2012. In addition, net sales increased $9.5 million (before intercompany eliminations) for our consumer electronics and accessories products and due to the distribution of new products to existing and new customers, partially offset by a decrease in net sales in the software and video games categories of $8.1 million (before intercompany eliminations) compared to the first six months of fiscal 2012.

Our gross profit decreased to $22.2 million, or 11.3% of net sales, for the first six months of fiscal 2013 compared to $26.4 million, or 12.5% of net sales, for the same period in fiscal 2012. The $4.2 million and 16.0% decrease in gross profit was principally due to a higher volume of lower gross profit margin products within the distribution segment.

Total operating expenses for the first six months of fiscal 2013 were $21.9 million, or 11.2% of net sales, compared to $28.6 million, or 13.6% of net sales, in the same period for fiscal 2012. The $6.7 million decrease was primarily due to operating efficiencies resulting from the Restructuring Plan.

Net loss for the first six months of fiscal 2013 was $83,000 or zero per diluted share compared to net loss of $1.9 million or $0.05 per diluted share for the same period last year.

Working Capital and Debt

Our business is working capital intensive and requires significant levels of working capital primarily to finance accounts receivable and inventories. We finance our operations through cash and cash equivalents, funds generated through operations, accounts payable and our revolving credit facility. The timing of cash collections and payments to vendors may require usage of our revolving credit facility in order to fund our working capital needs. "Checks written in excess of cash balances" can occur from time to time, including period ends, and represent payments made to vendors that have not yet been presented by the vendor to our bank, and therefore a corresponding advance on our revolving line of credit has not yet occurred. On a terms basis, we extend varying levels of credit to our customers and receive varying levels of credit from our vendors. During the last twelve months, we have not had any significant changes in the terms extended to customers or provided by vendors which would have a material impact to the reported financial statements.

On November 12, 2009, we entered into a three year, $65.0 million revolving credit facility (the "Credit Facility") with Wells Fargo Foothill, LLC as agent and lender, and a participating lender. On December 29, 2011, the Credit Facility was amended to eliminate the participating lender, reduce the revolving credit facility limit to $50.0 million, provide for an additional $20.0 million under the Credit Facility under certain circumstances and extend the maturity date to December 29, 2016. The Credit Facility is secured by a first priority security interest in all of our assets, as well as the capital stock of our companies. Additionally, the Credit Facility, as amended, calls for monthly interest payments at the bank's base rate (as defined in the Credit Facility) plus 1.25%, or LIBOR plus 2.25%, at our discretion.

At both September 30, 2012 and March 31, 2012 we had zero outstanding on the Credit Facility. Amounts available under the Credit Facility are subject to a borrowing base formula. Changes in the assets within the borrowing base formula can impact the amount of availability. Based on the facility's borrowing base and other requirements at such dates, we had excess availability of $29.4 million and $30.4 million at September 30, 2012 and March 31, 2012, respectively. At September 30, 2012, we were in compliance with all covenants under the Credit Facility and we currently believe that we will be in compliance with all covenants during the next twelve months.

In association with, and per the terms of the Credit Facility, we also pay and have paid certain facility and agent fees. Weighted-average interest on the Credit Facility was 4.25% at both September 30, 2012 and March 31, 2012. Such interest amounts have been, and continue to be, payable monthly.

Forward-Looking Statements / Risk Factors

We make written and oral statements from time to time regarding our business and prospects, such as projections of future performance, statements of management's plans and objectives, forecasts of market trends, and other matters that are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Statements containing the words or phrases "will likely result," "are expected to," "will continue," "is anticipated," "estimates," "projects," "believes," "expects," "anticipates," "intends," "target," "goal," "plans," "objective," "should" or similar expressions identify forward-looking statements, which may appear in documents, reports, filings with the SEC, including this Quarterly Report on Form 10-Q, news releases, written or oral presentations made by officers or other representatives made by us to analysts, shareholders, investors, news organizations and others and discussions with management and other representatives. For such statements, we claim the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995.

Our future results, including results related to forward-looking statements, involve a number of risks and uncertainties. No assurance can be given that the results reflected in any forward-looking statement will be achieved. Any forward-looking statement made by or on behalf of us speaks only as of the date on which such statement is made. Our forward-looking statements are based on assumptions that are sometimes based upon estimates, data, communications and other information from suppliers, government agencies and other sources that may be subject to revision. Except as required by law, we do not undertake any obligation to update or keep current either (i) any forward-looking statement to reflect events or circumstances arising after the date of such statement, or
(ii) the important factors that could cause our future results to differ materially from historical results or trends, results anticipated or planned by us, or which are reflected from time to time in any forward-looking statement which may be made by or on behalf of us.

In addition to other matters identified or described by us from time to time in filings with the SEC, there are several important factors that could cause our future results to differ materially from historical results or trends, results anticipated or planned by us, or results that are reflected from time to time in any forward-looking statement that may be made by or on behalf of us. Some of these important factors, but not necessarily all important factors, include the following: our revenues being derived from a small group of customers; our dependence on significant vendors and manufacturers and the popularity of their products; technological developments, particularly software as a service application, electronic transfer and downloading could adversely impact sales, margins and results of operations; inability to adapt to evolving technological standards; some revenues are dependent on consumer preferences and demand; our restructuring efforts may have unpredictable outcomes, including the possibility of us incurring additional restructuring charges; a deterioration in businesses of significant customers could harm our business; the seasonality and variability in our business and decreased sales could adversely affect our results of operations; growth of non-U.S. sales and operations could increasingly subject us to additional risks that could harm our business; the extent to which our insurance does not mitigate the risks facing our business or our insurers are unable to meet their obligations, our operating results may be negatively impacted; increased counterfeiting or piracy may negatively affect demand for our home entertainment products; we may not be able to protect our intellectual property rights; the failure to diversify our business could harm us; the loss of key personnel could affect the depth, quality and effectiveness of the management team; our ability to meet our significant working capital requirements or if working capital requirements change significantly; product returns or inventory obsolescence could reduce sales and profitability or negatively impact our liquidity; the potential for inventory values to decline; impairment in the carrying value of our assets could negatively affect consolidated results of operations; our credit exposure or negative product demand trends or other factors could cause credit loss; our ability to adequately and timely adjust cost structure for decreased demand; our ability to compete effectively in distribution and publishing, which are highly competitive industries; our dependence on third-party shipping and fulfillment for the delivery of our product; our reliance on third-party subcontractors for certain of our business services; developing software is complex, costly and uncertain and operational errors or defects in such products could result in liabilities and/or impair such products' marketability; our dependence on information systems; future acquisitions or divestitures could disrupt business; future acquisitions could result in potentially unsuccessful integration of acquired companies; interruption of our business or catastrophic loss at any of our facilities could curtail or shutdown our business; future terrorist or military activities could disrupt our operations or harm assets; we may be subject to one or more jurisdictions asserting that we should collect or should have collected sales or other taxes; our ability to use net operating loss carryforwards to reduce future tax payments may be limited; we may be unable to refinance our debt facility; our debt agreement limits operating and financial flexibility; we may incur additional debt; changes to financial standards could adversely affect our reported results of operations; our e-Commerce business has inherent cybersecurity risks that may disrupt our business; fluctuations in stock price could adversely affect our ability to raise capital or make our securities undesirable; the exercise of outstanding options could adversely affect our stock price; our anti-takeover provisions, our ability to issue preferred stock and our staggered board may discourage takeover attempts beneficial to shareholders; we do not intend to pay dividends on common stock, thus shareholders should not expect a return on investment through dividend payments; and our directors may not be personally liable for certain actions which may discourage shareholder suits against them.

A detailed statement of risks and uncertainties is contained in our reports to the SEC, including, in particular, our Annual Report on Form 10-K for the year ended March 31, 2012 and other public filings and disclosures. Investors and shareholders are urged to read these documents carefully.

Critical Accounting Policies

We consider our critical accounting policies to be those related to revenue recognition, allowance for doubtful accounts, goodwill and intangible assets, impairment of long-lived assets, inventory valuation, share-based compensation, income taxes, restructuring charges, and contingencies and litigation. There have been no material changes to these critical accounting policies as discussed in greater detail under this heading in Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the year ended March 31, 2012.

Reconciliation of GAAP Net Sales to Net Sales Before Inter-Company Eliminations

In evaluating our financial performance and operating trends, management considers information concerning our net sales before inter-company eliminations of sales that are not prepared in accordance with generally accepted accounting principles ("GAAP") in the United States. Management believes these non-GAAP measures are useful because they provide supplemental information that facilitates comparisons to prior periods and for the evaluation of financial results. Management uses these non-GAAP measures to evaluate its financial results, develop budgets and manage expenditures. The method we use to produce non-GAAP results is not computed according to GAAP, is likely to differ from the methods used by other companies and should not be regarded as a replacement for corresponding GAAP measures. Net sales before inter-company eliminations has limitations as a supplemental measure, and you should not consider it in isolation or as a substitute for analysis of our results as reported under GAAP.

The following table represents a reconciliation of GAAP net sales to net sales before inter-company eliminations:

                                                Three Months Ended           Six Months Ended
                                                   September 30,               September 30,
                                                    (Unaudited)                 (Unaudited)
                                                2012          2011          2012          2011
Net sales:
Distribution                                  $ 101,671     $ 104,037     $ 190,721     $ 205,771
Publishing                                        7,081         6,315        12,499        13,522
Net sales before inter-company eliminations     108,752       110,352       203,220       219,293
Inter-company sales                              (4,620 )      (3,784 )      (7,816 )      (8,709 )
Net sales as reported                         $ 104,132     $ 106,568     $ 195,404     $ 210,584

Results of Operations



The following table sets forth for the periods indicated the percentage of net
sales represented by certain items included in our Consolidated Statements of
Operations and Comprehensive Loss.



                                              Three Months Ended              Six Months Ended
                                                 September 30,                 September 30,
                                                  (Unaudited)                   (Unaudited)
                                              2012           2011            2012          2011
Net sales:
Distribution                                     97.6 %         97.6 %          97.5 %        97.6 %
Publishing                                        6.8            5.9             6.5           6.4
Inter-company sales                              (4.4 )         (3.5 )          (4.0 )        (4.0 )
Total net sales                                 100.0          100.0           100.0         100.0
Cost of sales, exclusive of depreciation         88.4           88.2            88.7          87.5
Gross profit                                     11.6           11.8            11.3          12.5

Operating expenses
Selling and marketing                             4.4            4.7             4.3           4.8
Distribution and warehousing                      1.7            2.3             1.8           2.3
General and administrative                        4.0            5.4             4.2           5.6
Depreciation and amortization                     0.8            0.9             0.8           0.9
Total operating expenses                         10.9           13.3            11.1          13.6
Income (loss) from operations                     0.7           (1.5 )           0.2          (1.1 )
Interest income (expense), net                   (0.2 )         (0.3 )          (0.1 )        (0.3 )
Other income (expense), net                       0.1           (0.2 )          (0.1 )        (0.1 )
Income (loss)- before taxes                       0.6           (2.0 )             -          (1.5 )
Income tax benefit                               (0.3 )          0.8               -           0.6
Net income (loss)                                 0.3 %         (1.2 )%            - %        (0.9 )%

The distribution segment distributes computer software, consumer electronics and accessories and video games and provides fee-based distribution logistics services.

Fiscal 2013 Second Quarter Results Compared To Fiscal 2012 Second Quarter

Net Sales (before inter-company eliminations)

Net sales before inter-company eliminations for the distribution segment decreased $2.3 million, or 2.3%, to $101.7 million for the second quarter of fiscal 2013 compared to $104.0 million for the second quarter of fiscal 2012. Net sales in the software product group increased $6.4 million to $83.9 million during the second quarter of fiscal 2013 from $77.5 million for the same period last year due to increased demand for our software products. Consumer electronics and accessories net sales increased with net sales of $15.7 million . . .