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TESS > SEC Filings for TESS > Form 10-K on 29-May-2013All Recent SEC Filings

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Form 10-K for TESSCO TECHNOLOGIES INC


29-May-2013

Annual Report


Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.

This Management's Discussion and Analysis of Results of Operations and Financial Condition (MD&A) should be read in conjunction with the other sections of this Annual Report on Form 10-K, including Part I, "Item 1: Business," Part II, "Item 6: Selected Financial Data," and Part II, "Item 8: Financial Statements and Supplementary Data." The various sections of this MD&A contain a number of forward-looking statements, all of which are based on our current expectations and could be affected by the uncertainties and risk factors described throughout this filing, including Part I, "Item 1A: Risk Factors." Our actual results may differ materially from those described in any such forward-looking statement.

Business Overview and Environment

TESSCO Technologies Incorporated (TESSCO, we, or the Company) architects and delivers innovative product and value chain solutions to support wireless systems. Although we sell products to customers in over 100 countries, approximately 98% of our sales are to customers in the United States. We have operations and office facilities in Hunt Valley, Maryland, Reno, Nevada and San Antonio, Texas.

The Company evaluates its business and customer base in two segments - commercial and retail. The commercial segment includes: (1) public carriers, contractors, and program managers that are generally responsible for building and maintaining the infrastructure system and provide airtime service to individual subscribers; (2) private system operators and governments including commercial entities such as major utilities and transportation companies, federal agencies and state and local governments that run wireless networks for their own use; and (3) commercial dealers and resellers that sell, install and/or service cellular telephone, wireless networking, broadband and two-way radio communications equipment primarily for the enterprise market. The retail segment includes: (1) retailers, dealer agents and carriers; and (2) our Major 3PL Relationship (our largest customer, AT&T).

We offer a wide range of products that are classified into four business categories: base station infrastructure; network systems; installation, test and maintenance; and mobile devices and accessories. Base infrastructure products are used to build, repair and upgrade wireless telecommunications. Sales of traditional base station infrastructure products, such as base station radios, cable and transmission lines and antennas are in part dependent on capital spending in the wireless communications industry. Network systems products are used to build and upgrade computing and Internet networks. We have also been growing our offering of wireless broadband, network equipment, security and surveillance products, which are not as dependent on the overall capital spending of the industry. Installation, test and maintenance products are used to install, tune, and maintain wireless communications equipment. This category is made up of sophisticated analysis equipment and various frequency-, voltage- and power-measuring devices, replacement parts and components as well as an assortment of tools, hardware and supplies required by service technicians. Mobile devices and accessory products include cellular phone and data device accessories. Our customers generally have the ability to purchase any of our product categories, but base station infrastructure, network systems and installation, test and maintenance products are primarily sold into our commercial segment, while mobile device and accessories products are primarily sold into our retail segment.

Our largest customer relationship, AT&T, a Tier 1 cellular carrier purchasing phone accessories, accounted for approximately 30% of our total revenues during fiscal year 2013. In April 2012, we were notified by AT&T of their intention to transition their 3PL retail store supply chain business, which makes up the vast majority of the Company's AT&T revenues, away from TESSCO beginning in the second quarter of our fiscal 2013. As this transition continued toward completion, revenues from this relationship for the fourth quarter declined significantly, although resulting in a lesser relative impact on overall profits. This reduction in revenue for the second half of fiscal 2013 was more than fully offset by an increase in the Company's non-AT&T revenues during the fiscal year. While we expect no revenue in 2014 for the transitioned 3PL business, we do expect to continue to supply product to this customer's other programs and supply proprietary Ventev® products to AT&T retail stores. Due to the loss of this 3PL relationship, which generated $213.5 million in revenues during fiscal 2013, we do expect to have a significant decline in overall revenues in fiscal 2014.

The wireless communications distribution industry is competitive and fragmented, and is comprised of several national distributors. In addition, many manufacturers sell direct. Barriers to entry for distributors are relatively low, particularly in the mobile devices and accessory market, and the risk of new competitors entering the market is high. Consolidation of larger wireless carriers has and will most likely continue to impact our current and potential customer base. In addition, the agreements or arrangements with our customers or vendors looking to us for product and supply chain solutions are typically of limited duration and are terminable by either party upon several months or otherwise short notice. Our ability to maintain these relationships is subject to competitive pressures and challenges. We believe, however, that our strength in service, the breadth and depth of our product offering, our information technology system, our large customer base and our purchasing relationships with approximately 375 manufacturers provide us with a significant competitive advantage over new entrants to the market. Results of Operations

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Results of Operations

The following tables summarize the results of our operations for fiscal years 2013, 2012 and 2011:

(Dollars in
thousands, except
per share data)                                          2012 to 2013                                2011 to 2012
                        2013           2012        $ Change       % Change         2011        $ Change       % Change
Segment Revenues
 Commercial
Segment:
Public Carriers,
Contractors &
Program Managers      $ 111,146     $   73,824     $  37,322           50.6 %    $  87,010     $ (13,186 )        (15.2 %)
Private &
Government System
Operators               121,313        129,129        (7,816 )         (6.1 %)     108,520        20,609           19.0 %
Commercial Dealers
& Resellers             138,737        125,431        13,306           10.6 %      117,213         8,218            7.0 %
 Total Commercial
Revenues                371,196        328,384        42,812           13.0 %      312,743        15,641            5.0 %

Retail Segment:
Retailers,
Independent Dealer
Agents & Carriers       167,895        153,803        14,092            9.2 %      137,676        16,127           11.7 %
Major 3PL
relationship            213,474        251,203       (37,729 )        (15.0 %)     154,800        96,403           62.3 %
 Total Retail
Revenues                381,369        405,006       (23,637 )         (5.8 %)     292,476       112,530           38.5 %

Total Revenues        $ 752,565     $  733,390     $  19,175            2.6 %    $ 605,219     $ 128,171           21.2 %


(Dollars in
thousands, except
per share data)                                          2012 to 2013                                2011 to 2012
                         2013           2012       $ Change       % Change          2011       $ Change       % Change
Segment Gross
Profit
 Commercial
Segment:
Public Carriers,
Contractors &
Program Managers      $  24,183     $   17,101     $   7,082           41.4 %    $  20,139     $  (3,038 )        (15.1 %)
Private &
Government System
Operators                33,596         35,860        (2,264 )         (6.3 %)      28,978         6,882           23.7 %
Commercial Dealers
& Resellers              38,345         35,393         2,952            8.3 %       31,717         3,676           11.6 %
 Total Commercial
Gross Profit             96,124         88,354         7,770            8.8 %       80,834         7,520            9.3 %

Retail Segment:
Retailers,
Independent Dealer
Agents & Carriers        35,903         33,421         2,482            7.4 %       29,947         3,474           11.6 %
Major 3PL
relationship             15,012         26,881       (11,869 )        (44.2 %)      22,500         4,381           19.5 %
 Total Retail Gross
Profit                   50,915         60,302        (9,387 )        (15.6 %)      52,447         7,855           15.0 %

Total Gross Profit    $ 147,039     $  148,656     $  (1,617 )         (1.1 %)   $ 133,281     $  15,375           11.5 %

Selling, general
and administrative
expenses                117,821        121,652        (3,831 )         (3.1 %)     117,305         4,347            3.7 %
Income from
operations               29,218         27,004         2,214            8.2 %       15,976        11,028           69.0 %
Interest, net               224            293           (69 )        (23.5 %)         421          (128 )        (30.4 %)
Income before
provision for
income taxes             28,994         26,711         2,283            8.5 %       15,555        11,156           71.7 %
Provision for
income taxes             11,200         10,274           926            9.0 %        5,537         4,737           85.6 %
Net income            $  17,794     $   16,437     $   1,357            8.3 %    $  10,018     $   6,419           64.1 %

Diluted earnings
per share             $    2.15     $     2.03     $    0.12            5.9 %    $    1.27     $    0.76           59.8 %

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Fiscal Year 2013 Compared to Fiscal Year 2012

Revenues. Revenues for fiscal year 2013 increased 2.6% as compared to fiscal year 2012, due to a 13.0% increase in commercial segment revenues partially offset by a 5.8% decrease in retail segment revenues. The increase in commercial segment revenues was due to a significant increase in our public carrier, contractor and program manager market, a smaller increase in our commercial dealers and resellers market, and was partially offset by a decline in sales to our private and government system operators market. The retail reduction in sales was a result of a 15.0% decrease in sales to our Major 3PL relationship, AT&T, partially offset by 9.2% sales growth in our retailers, independent dealer agents and carriers market. As noted above, in April 2012, we were notified by AT&T of their intention to transition their 3PL retail store supply chain business, which made up the vast majority of the Company's historical AT&T revenues, away from TESSCO beginning in the second quarter of our fiscal 2013. This transition was completed by the close of our fiscal 2013.

Gross Profit. Gross profit decreased 1.1% in fiscal year 2013 compared to fiscal year 2012, due to a 15.6% decrease in our retail segment partially offset by an 8.8% increase in our commercial segment. Within the retail segment, our Major 3PL relationship market showed a decrease in sales, with a larger decrease of 44.2% in gross profit due to the transition of the AT&T third party logistics retail supply chain business. This decrease in gross profit was partially offset by a 7.4% increase in the retailers, independent dealer agents and carriers market. The increase in our commercial segment was driven by increases in our public carrier, contractor and program manager market and our commercial dealers and resellers, and was partially offset by a decline from our private and government system operators market. Overall gross profit margin decreased to 19.5%, compared to 20.3% in fiscal year 2012, primarily driven by the continued decline in AT&T gross margin. Excluding our Major 3PL relationship, gross profit margin decreased from 25.4% in fiscal year 2012 to 24.5% in fiscal year 2013, due in part to higher dollar, lower margin public carrier, contractor and program manager market sales. We account for inventory at the lower of cost or market, and as a result, write-offs/write-downs occur due to damage, deterioration, obsolescence, changes in prices and other causes.

Our ongoing ability to earn revenues and gross profits from customers and vendors looking to us for product and supply chain solutions is dependent upon a number of factors. The terms, and accordingly the factors, applicable to each relationship often differ. Among these factors are the strength of the customer's or vendor's business, the supply and demand for the product or service, including price stability, changing customer or vendor requirements, and our ability to support the customer or vendor and to continually demonstrate that we can improve the way they do business. In addition, the agreements or arrangements on which our customer and vendor relationships are based are typically of limited duration, typically do not include any obligation in respect of any specific product purchase or sale and are terminable by either party upon several months or otherwise short notice. Our customer relationships could also be affected by wireless carrier consolidation or the global financial crisis.

Selling, General and Administrative Expenses. Total selling, general and administrative expenses decreased by 3.1% during fiscal year 2013 as compared to fiscal year 2012. Total selling, general and administrative expenses as a percentage of revenues decreased from 16.6% in fiscal year 2012 to 15.7% in fiscal year 2013, due to a decrease in selling, general and administrative expenses, partially offset by the slight increase of revenues as discussed above.

The largest factors contributing to the overall decrease in total selling, general and administrative expenses were decreased AT&T market development expenses and decreased pay for performance bonus expense, partially offset by increased corporate support expenses.

Marketing expenses decreased by $2.7 million, or 32.7%, in fiscal year 2013 as compared to fiscal year 2012, primarily related to a decrease in AT&T market development expenses, which are completely variable to sales units.

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Pay for performance bonus expense (including both cash and equity plans) decreased by $5.1 million in fiscal year 2013 as compared to fiscal year 2012. Our bonus programs are all based on annual performance targets. The relationship between expected performance and actual performance led to lower bonus accruals in fiscal 2013 than in fiscal 2012.

As previously reported, effective November 27, 2012, David M. Young ceased to serve as TESSCO's Chief Financial Officer. In connection with his departure, Mr. Young was paid 1.65 times his base salary, or $499,125, and the sum of $102,424, as the prorated amount of any Value Share incentive compensation due for the current fiscal year. Additionally, in accordance with the terms of the applicable agreements, all of Mr. Young's earned but not yet vested PSU shares (30,563 shares) vested and were issued. The impact of these payouts and accelerated vesting, net of previously accrued bonus and PSU amortization that was reversed, was approximately $550,000.

Corporate support expense increased approximately $1.4 million, or 21.5%, in fiscal year 2013 as compared to the fiscal year 2012. This increase was primarily related to slightly higher bad debt expense in addition to higher new product development costs related to our proprietary power product line.

We continually evaluate the credit worthiness of our existing customer receivable portfolio and provide an appropriate reserve based on this evaluation. We also evaluate the credit worthiness of prospective and current customers and make decisions regarding extension of credit terms to such customers based on this evaluation. Accordingly, we recorded a provision for bad debts of $1,197,300 and $458,700 for fiscal year 2013 and fiscal year 2012, respectively. Bad debt expense during fiscal year 2012 was unusually low due to significant bad debt recoveries, with fiscal year 2013 being much more representative of our historical bad debt expense levels.

Interest, Net. Net interest expense decreased from $292,900 in fiscal year 2012 to $224,200 in fiscal year 2013, primarily due to decreased average borrowings on our revolving credit facility as well as the repayment in full of a loan from the Maryland Economic Development Corporation.

Income Taxes, Net Income and Diluted Earnings Per Share. The effective tax rates in fiscal year 2013 and 2012 were 38.6% and 38.5%, respectively. As a result of the factors discussed above, net income and diluted earnings per share for fiscal year 2013 increased 8.3% and 5.9%, respectively, compared with fiscal year 2012.

Commercial Segment. Revenues in our commercial segment totaled $371.2 million in fiscal year 2013, compared to $328.4 million in the prior year, a 13.0% increase. Gross profit totaled $96.1 million, an 8.8% increase as compared to last year. Within this segment, the public carrier, contractor and program manager market grew revenues by 50.6% and gross profits by 41.4%. This growth was primarily driven by a need by our customers to increase bandwidth and upgrade their infrastructure to accommodate increasing wireless traffic. The need for increased bandwidth was echoed in our commercial dealers and resellers market, with revenue growth of 10.6% and gross profit growth of 8.3%. We continue to see strong opportunities for our proprietary and customized solutions in this market, as these customers continue to build and enhance their own private wireless applications. The private and government system operators market revenue declined 6.1% and gross profit declined by 6.3%, due to economic uncertainties as well as government spending cuts.

Our direct expenses in this segment totaled $42.8 million, a 3.2% increase compared to the fiscal year 2012. Therefore, total segment net profit contribution (see Note 9 to the Consolidated Financial Statements) was $53.3 million, a 13.7% increase over the prior year.

Retail Segment. Revenues in our retail segment totaled $381.4 million in fiscal year 2013, representing a 5.8% decrease from the prior year. Gross profit totaled $50.9 million, a 15.6% decrease. These decreases are due to the transition of our Major 3PL relationship, AT&T, which showed a 15.0% revenue decrease and a 44.2% gross profit decrease. Revenues in our retailer, dealer agent and carrier market increased as compared to last year, up 9.2%, with a 7.4% increase in gross profit as a result of increased sales from independent agents and dealers.

Our direct expenses in this segment totaled $27.7 million in fiscal year 2013, a 7.5% decrease over the prior year period, primarily due to decreased market development expenses for AT&T, which are completely variable to sales. Therefore, total segment net profit contribution was $23.2 million for fiscal year 2013, a 23.5% decrease over the prior year period.

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Table of Contents

Fiscal Year 2012 Compared to Fiscal Year 2011

Revenues. Revenues for fiscal year 2012 increased 21.2% as compared to fiscal year 2011, due to a 38.5% increase in retail segment revenues and a 5.0% increase in commercial segment revenues. The retail sales growth was largely a result of a 62.3% increase in sales to our Major 3PL relationship, AT&T, which had expanded their relationship with us during the third quarter of fiscal 2012, but also due to an 11.7% increase in sales to our retailers, independent dealer agents and carriers market. As noted above, in April 2012, we were notified by AT&T of their intention to transition their third party logistics retail store supply chain business, which makes up the vast majority of the Company's AT&T revenues, away from TESSCO beginning in the second quarter of our fiscal 2013. The increase in commercial segment revenues was due to a significant increase in our private and government system operators market, a smaller increase in our commercial dealers and resellers market, and was partially offset by a decline in sales to our public carrier, contractor and program manager market. During fiscal year 2012, sales of our proprietary products increased 4.2%, as compared to the prior year. However, due to the significant increase in overall sales, and the fact that proprietary product sales represented only a small percentage of the increased AT&T sales on a dollar basis, proprietary product sales decreased to 8.6% of total sales compared to 10.0% of total sales in the prior year. Because our proprietary products generally carry higher gross margins than our other non-proprietary third party products, the increased sales of proprietary products on a dollar basis contributed to the margin growth we experienced during the year in sales to other than our Major 3PL relationship customer (see detailed explanation below).

Gross Profit. Gross profit increased 11.5% in fiscal year 2012 compared to fiscal year 2011, due to a 15.0% increase in our retail segment and 9.3% increase in our commercial segment. Within the retail segment, our Major 3PL relationship market showed a considerable increase in sales, but the impact on overall gross profit was lessened by the lower margins we experienced in sales to AT&T resulting from the business relationship expansion. The increase in our commercial segment gross profit was driven by increases in our private and government market and our commercial dealers and resellers, and was partially offset by a decline from our public carrier, contractor and program manager market. Overall gross profit margin decreased to 20.3%, compared to 22.0% in fiscal year 2011, driven by the expanded lower margin AT&T business. However, excluding our Major 3PL relationship market, gross profit margin increased from 24.6% in fiscal year 2011 to 25.3% in fiscal year 2012, due in part to pricing adjustments, product mix and lower excess and obsolete inventory writeoffs.

Selling, General and Administrative Expenses. Total selling, general and administrative expenses increased by 3.7% during fiscal year 2012 as compared to fiscal year 2011. Total selling, general and administrative expenses as a percentage of revenues decreased from 19.4% in fiscal year 2011 to 16.6% in fiscal year 2012, due to the increase of revenues as discussed above, offset by a less significant increase in selling, general and administrative expenses.

The largest factors contributing to the overall increase in total selling, general and administrative expenses were increased AT&T market development expenses and increased pay for performance bonus expense, partially offset by decreased compensation and benefits, freight out, and sales promotion expenses.

Marketing expenses increased by $1.8 million, or 27.4%, in fiscal year 2012 as compared to fiscal year 2011, primarily related to an increase in AT&T market development expenses, which are completely variable to sales.

Pay for performance bonus expense (including both cash and equity plans) increased by $8.9 million in fiscal year 2012 as compared to fiscal year 2011. Because our reward programs are performance based, our strong results during fiscal year 2012 resulted in increased bonus expense.

Compensation and benefits expense decreased approximately $3.8 million in fiscal year 2012 compared to fiscal year 2011. This decrease was primarily related to position consolidations made during the fourth quarter of fiscal year 2011.

Freight expense decreased by approximately $1.7 million, or 11.4%, in fiscal year 2012. This was a result of more efficient operational flow and fewer pounds shipped as compared to fiscal year 2011.

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Sales promotions declined by $1.1 million, or 35.8%. This was primarily a result of decreased travel and trade shows expense.

We recorded a provision for bad debts of $458,700 and $1,050,500 for fiscal year 2012 and fiscal year 2011, respectively. During fiscal year 2012, we experienced lower bad debt expense in part due to recoveries of amounts previously reserved or written off as well as better collection experience.

Interest, Net. Net interest expense decreased from $420,600 in fiscal year 2011 to $292,900 in fiscal year 2012, primarily due to decreased average borrowings on our revolving credit facility as well as a lower variable rate on our term loan.

Income Taxes, Net Income and Diluted Earnings Per Share. The effective tax rates in fiscal year 2012 and 2011 were 38.5% and 35.6%, respectively. The lower than normal tax rate in fiscal year 2011 was primarily attributable to a one-time reduction in our uncertain tax position reserve as a result of a lapse in the applicable statute of limitations. Absent this one-time adjustment, the tax rate for fiscal year 2011 would have been 38.2%. As a result of the factors discussed above, net income and diluted earnings per share for fiscal year 2011 increased 64.1% and 59.8%, respectively, compared with fiscal year 2011.

Commercial Segment. Revenues in our commercial segment totaled $328.4 million in fiscal year 2012, compared to $312.7 million in the prior year, a 5.0% increase. Gross profit totaled $88.4 million, a 9.3% increase as compared to last year. Within this segment, the commercial dealers and resellers market grew revenues by 7.0% and gross profits by 11.6%. The private system operator and government market grew revenues by 19.0% and gross profits by 23.7%. We continue to see strong opportunities for our proprietary and customized solutions in this market, as these customers continue to build and enhance their own private wireless applications. The public carrier, contractor and program manager market revenue declined 15.2% and gross profit declined by 15.1%, as carriers continued to delay significant network builds.

Our direct expenses in this segment totaled $41.5 million, an 11.9% decline compared to the fiscal year 2011, due to a decrease in compensation and marketing expenses. Therefore, total segment net profit contribution (segment gross profit less segment direct expenses) was $46.9 million, a 38.9% increase over the prior year.

Retail Segment. Revenues in our retail segment totaled $405.0 million in fiscal year 2012, representing a 38.5% increase from the prior year. Gross profit totaled $60.3 million, a 15.0% increase. These increases are primarily due to significantly higher sales to our Major 3PL relationship market (AT&T), which showed a 62.3% revenue increase and a 19.5% gross profit increase, both resulting from the previously discussed expansion of this relationship. Revenues in our retailer, dealer agent and carrier market also increased as compared to last year, up 11.7%, with a 11.6% increase in gross profit, a result of changes in product and customer mix, pricing adjustments and lower inventory write-offs.

Our direct expenses in this segment totaled $30.0 million in fiscal year 2012, a 4.8% decrease over the prior year period, a result of lower compensation and freight costs, partially offset by increased market development expenses for AT&T, which are completely variable to sales. Therefore, total segment net profit contribution was $30.3 million for fiscal year 2012, a 44.7% increase over the prior year period.

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