Item 1. Business.
General
Systemax is primarily a direct marketer of brand name and private label products. Our operations are organized in three reportable business segments - Technology Products, Industrial Products and Software Solutions. Our Technology Products segment sells computers, computer supplies and consumer electronics which are marketed in North America and Europe. Except for certain personal computer (“PC”) products that we assemble ourselves and sell under the trademarks Systemax™ and Ultra™, substantially all of our products are manufactured by other companies. We also sell certain computer-related products manufactured for us to our own design under the trademark Systemax™ and Ultra™. Technology Products accounted for 92% of our net sales in 2008.
Our Industrial Products segment sells a wide array of material handling equipment, storage equipment and consumable industrial items which are marketed in North America. Substantially all of these products are manufactured by other companies. Some products are manufactured for us to our own design and marketed under the trademarks Global™, GlobalIndustrial.com™ and Nexel™. Industrial products accounted for 8% of our net sales in 2008.
Our Software Solutions segment participates in the emerging market for on-demand, web-based business software applications through the marketing of our PCS ProfitCenter Software™ application. See Note 10 to the Consolidated Financial Statements included in Item 15 of this Form 10-K for additional financial information about our business segments as well as information about our geographic operations.
The Company was incorporated in Delaware in 1995. Certain predecessor businesses which now constitute part of the Company have been in business since 1955. Our headquarter office is located at 11 Harbor Park Drive, Port Washington, New York.
Recent Developments
On January 5, 2008 the Company entered into an asset purchase agreement with CompUSA Inc. Under the agreement the Company acquired CompUSA’s e-commerce business and 16 of its retail leases and related fixtures for consideration of approximately $30.6 million. This acquisition accelerated the Company’s planned expansion into the retail market place in North America and Puerto Rico.
Products
We offer more than 100,000 brand name and private label products. We endeavor to expand and keep current the breadth of our product offerings in order to fulfill the increasingly wide range of product needs of our customers.
Our computer sales include desktops, laptops and notebooks and are primarily offerings of brand name original equipment manufacturers, as well as our own Systemax and Ultra brands. Computer supplies and consumer electronics related products include supplies such as laser printer toner cartridges and ink jet printer cartridges; media such as flash memory, recordable disks and magnetic tape cartridges; peripherals such as hard disks, CD-ROM and DVD drives, printers and scanners; memory upgrades; data communication and networking equipment; monitors; digital cameras; plasma and LCD TVs; MP3 and DVD players; PDAs; and packaged software.
We assemble our Systemax and Ultra brand PCs in our 297,000 square foot, ISO-9001:2000 certified facility in Fletcher, Ohio. We purchase components and subassemblies from suppliers in the United States as well as overseas. Certain parts and components for our PCs are obtained from a limited group of suppliers. We also utilize licensed technology and computer software in the assembly of our PCs. For a discussion of risks associated with these licenses and suppliers, see Item 1A, Risk Factors.
Our industrial products include storage equipment such as wire and metal shelving, bins and lockers; light material handling equipment such as hand carts, pallet jacks and hand trucks; ladders, furniture, small office machines and related supplies; and consumable industrial products such as first aid items, safety items, protective clothing and OSHA compliance items.
We began to market our PCS ProfitCenter Software™ suite of business applications in 2004. PCS ProfitCenter Software™ is a web-based application which is delivered as an on-demand service over the internet. The product helps companies automate and manage their entire customer life-cycle across multiple sales channels (internet, call centers, outside salespersons, etc.).
Sales and Marketing
We market our products to both business customers and individual consumers. Our business customers include for-profit businesses, educational organizations and government entities. We have developed numerous proprietary customer and prospect databases. We consider our business customers to include the various individuals who work within an organization rather than just the business itself.
We have established a multi-faceted direct marketing system to business customers, consisting primarily of relationship marketers, catalog mailings and proprietary internet websites, the combination of which is designed to maximize sales. Our relationship marketers focus their efforts on our business customers by establishing a personal relationship between such customers and a Systemax account manager. The goal of the relationship marketing sales force is to increase the purchasing productivity of current customers and to actively solicit newly targeted prospects to become customers. With access to the records we maintain of historical purchasing patterns, our relationship marketers are prompted with product suggestions to expand customer order values. In certain countries, we also have the ability to provide such customers with electronic data interchange (“EDI”) ordering and customized billing services, customer savings reports and stocking of specialty items specifically requested by these customers. Our relationship marketers’ efforts are supported by frequent catalog mailings and e-mail campaigns, both of which are designed to generate inbound telephone sales, and our interactive websites, which allow customers to purchase products directly over the Internet. We believe that the integration of our multiple marketing methods enables us to more thoroughly penetrate our business, educational and government customer base. We believe increased internet exposure leads to more internet-related sales and also generates more inbound telephone sales; just as we believe catalog mailings and email campaigns which feature our websites results in greater internet-related sales.
We continue to have strong growth in sales to individual consumers, particularly through e-commerce means. To reach our individual consumer audience, we use online methods such as website campaigns, banner ads and e-mail campaigns. We are able to monitor and evaluate the results of our various advertising campaigns to enable us to execute them in the most cost-effective manner. We combine our use of e-commerce initiatives with catalog mailings, which generate online orders and calls to inbound sales representatives. These sales representatives use our information systems to fulfill orders and explore additional customer product needs. Sales to individual consumers are generally fulfilled from our own stock, requiring us to carry more inventory than we would for our business customers. We also periodically take advantage of attractive product pricing by making opportunistic bulk inventory purchases with the objective of turning them quickly into sales. We have also successfully increased our sales to individual consumers by using retail outlet stores. As of December 31, 2008 we had 29 retail locations open in North America and Puerto Rico.
E-commerce
The worldwide growth in active internet users has made e-commerce a significant opportunity for sales growth.
The increase in our internet-related sales enables us to leverage our advertising spending. We currently operate multiple e-commerce sites, including:
Technology Products:
· www.tigerdirect.com
· www.compusa.com
· www.compusagoved.com
· www.compusabusiness.com
· www.misco.co.uk
· www.tigerdirect.ca
· www.misco.de
· www.misco.fr
· www.infotelusa.com
· www.misco.nl
· www.globalcomputer.com
· www.misco.it
· www.misco.es
· www.globalgoved.com
· www.misco.se
· www.systemaxpc.com
· www.misco.at
· www.misco.ch
· www.misco.be
· www.misco.pt
· www.misco.ie
Industrial Products:
· www.globalindustrial.com
We continually upgrade the capabilities and performance of these web sites. Our internet sites feature on-line catalogs of thousands of products, allowing us to offer a wider variety of computer and industrial products than our printed catalogs. Our customers have around-the-clock, on-line access to purchase products and we have the ability to create targeted promotions for our customers’ interests. Many of our internet sites also permit customers to purchase “build to order” PCs configured to their own specifications.
In addition to our own e-commerce web sites, we have partnering agreements with several of the largest internet shopping and search engine providers who feature our products on their web sites or provide “click-throughs” from their sites directly to ours. These arrangements allow us to expand our customer base at an economical cost.
Catalogs
We currently produce a total of 16 full-line and targeted specialty catalogs in North America and Europe under distinct titles. Our portfolio of catalogs includes such established brand names as TigerDirect.com™, Global Computer Supplies™, CompUSA, TigerDirect.ca™, Misco®, Global
Industrial™, ArrowStar™ and Nexel™. Full-line computer product catalogs offer products such as PCs, notebooks, peripherals, computer components, magnetic media, data communication, networking and power protection equipment, ergonomic accessories, furniture and software. Full-line industrial product catalogs offer products such as material handling products and industrial supplies. Specialty catalogs contain more focused product offerings and are targeted to individuals most likely to purchase from such catalogs. We mail catalogs to both businesses and individual consumers. In the case of business mailings, we mail our catalogs to many individuals at a single business location, providing us with multiple points-of-entry. Our in-house staff designs all of our catalogs. In-house catalog design helps reduce overall catalog expense and shortens catalog production time. This allows us the flexibility to alter our product offerings and pricing and to refine our catalog formats more quickly. Our catalogs are printed by third parties under fixed pricing arrangements. The commonality of certain core pages of our catalogs also allows for economies of scale in catalog production.
With the CompUSA acquisition, the distribution of our catalogs increased to 63 million in 2008, which was 9.5% more than in the prior year. In 2008, we mailed approximately 47 million catalogs in North America, a 16.2% increase from last year and approximately 16 million catalogs, or 6.5% fewer than 2007, were distributed in Europe.
Customer Service, Order Fulfillment and Support
We generally provide toll-free telephone number access for our customers. Certain of our domestic call centers are linked to provide telephone backup in the event of a disruption in phone service. In addition to telephone orders, we also receive orders by mail, fax, electronic data interchange and through the internet.
A large number of our products are carried in stock, and orders for such products are fulfilled on a timely basis directly from our distribution centers, typically on the day the order is received. We operate out of multiple sales and distribution facilities in North America and Europe. The locations of our distribution centers enable us to provide our customers next day or second day delivery. Orders are generally shipped by third-party delivery services in the United States and in Europe. The locations of our distribution centers in Europe have enabled us to market into additional countries with limited incremental investment. We maintain relationships with a number of large distributors in North America and Europe that also deliver products directly to our customers.
We provide extensive technical telephone support to our Systemax and Ultra brand PC customers. We maintain a database of commonly asked questions for our technical support representatives, enabling them to respond quickly to similar questions. We conduct regular on-site training seminars for our sales representatives to help ensure that they are well trained and informed regarding our latest product offerings.
Suppliers
We purchase substantially all of our products and components directly from manufacturers and large wholesale distributors. One vendor accounted for 12.0%, 14.4% and 12.8% of our purchases in 2008, 2007 and 2006, respectively. The loss of this vendor, or any other key vendors, could have a material adverse effect on us.
Certain private label products are manufactured by third-parties to our specifications. Many of these private label products have been designed or developed by our in-house product design and development teams.
Competition and Other Market Factors
Technology Products
The North American and European technology product markets are highly competitive, with many U.S., Asian and European companies vying for market share. There are few barriers of entry, with these
products being sold through multiple channels of distribution, including direct marketers, local and national retail computer stores, computer resellers, mass merchants, over the internet and by computer and office supply superstores. In North America, our major competitors operate in all these sales channels; in Europe, our major competitors are regional or country-specific retail and direct-mail distribution companies and internet-based resellers.
Timely introduction of new products or product features are critical elements to remaining competitive. Other competitive factors include product performance, quality and reliability, technical support and customer service, marketing and distribution and price. Some of our competitors have stronger brand-recognition, broader product lines and greater financial, marketing, manufacturing and technological resources than us. Additionally, our results could also be adversely affected should we be unable to maintain our technological and marketing arrangements with other companies, such as Microsoft®, Intel® and Advanced Micro Devices®.
With conditions in the market for technology products remaining highly competitive, continued reductions in retail prices may adversely affect our revenues and profits. Additionally, we rely in part upon the introduction of new technologies and products by other manufacturers in order to sustain long-term sales growth and profitability. There is no assurance that the rapid rate of such technological advances and product development will continue.
Current economic conditions raise additional factors as the loss of consumer confidence in the Company’s markets could result in a decrease of spending in the categories of products we sell. It is also possible that as manufacturers react to the marketplace they may reduce manufacturing capacity and create shortages of product.
Industrial Products
The market for the sale of industrial products in North America is highly fragmented and is characterized by multiple distribution channels such as retail outlets, small dealerships, direct mail distribution, internet-based resellers and large warehouse stores. We also face competition from manufacturers’ own sales representatives, who sell industrial equipment directly to customers, and from regional or local distributors. Many high volume purchasers, however, utilize catalog distributors as their first source of product. In the industrial products market, customer purchasing decisions are primarily based on price, product selection, product availability, level of service and convenience. We believe that direct marketing via catalog, the internet and sales representatives is an effective and convenient distribution method to reach mid-sized facilities that place many small orders and require a wide selection of products. In addition, because the industrial products market is highly fragmented and generally less brand oriented, it is well suited to private label products.
Software Solutions
Software Solutions offers a software application for the multi-channel commerce industry. The software distribution model in which a software application is hosted by a software vendor or a service provider and made available to customers over the internet is also known as software as a service (SaaS). Traditional software licensing is being supplemented with on-demand delivery models that increase the predictability of information technology financial expenditures while making it easier for multi-channel commerce companies to manage their customers, products and services regardless of sales channel.
The increasing replacement of obsolete software solutions by multi-channel retailers for newer technologies provides our Software Solutions business with an opportunity to market its products and services. The advantages of having a single solution, single database to manage all sales channels (eCommerce, call center, catalog, mail order, retail) with web-based accessibility and faster implementation cycles is anticipated to fuel penetration into the multi-channel software market space.
Employees
As of December 31, 2008, we employed a total of 4,452 employees, of whom 3,251 were in North America and 1,201 were in Europe.
Seasonality
Net sales have historically been modestly weaker during the second and third quarters as a result of lower business activity during those months. See Item 7, Management’s Discussions and Analysis of Financial Condition and Results of Operations; Seasonality.
Environmental Matters
Under various national, state and local environmental laws and regulations in North America and Europe, a current or previous owner or operator (including the lessee) of real property may become liable for the costs of removal or remediation of hazardous substances at such real property. Such laws and regulations often impose liability without regard to fault. We lease most of our facilities. In connection with such leases, we could be held liable for the costs of removal or remedial actions with respect to hazardous substances. Although we have not been notified of, and are not otherwise aware of, any material real property environmental liability, claim or non-compliance, there can be no assurance that we will not be required to incur remediation or other costs in connection with real property environmental matters in the future.
Financial Information About Foreign and Domestic Operations
We conduct our business in North America (the United States, Puerto Rico and Canada) and Europe. Approximately 37.9% of our net sales during 2008 were made by subsidiaries located outside of the United States. For information pertaining to our international operations, see Note 10, “Segment and Related Information,” to the Consolidated Financial Statements included in Item 15 of this Form 10-K. The following sets forth selected information with respect to our operations in those two geographic markets (in thousands):
See Item 7, Management’s Discussions and Analysis of Financial Condition and Results of Operations, for further information with respect to our operations.
Available Information
We maintain an internet website at www.systemax.com. We file reports with the Securities and Exchange Commission and make available free of charge on or through this web site our annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, including all amendments to those reports. These are available as soon as is reasonably practicable after they are filed with the SEC. All reports mentioned above are also available from the SEC’s web site (www.sec.gov). The information on our web site is not part of this or any other report we file with, or furnish to, the SEC.
Our Board of Directors has adopted the following corporate governance documents with respect to the Company (the “Corporate Governance Documents”):
· Corporate Ethics Policy for officers, directors and employees
· Charter for the Audit Committee of the Board of Directors
· Charter for the Compensation Committee of the Board of Directors
· Charter for the Nominating/Corporate Governance Committee of the Board of Directors
· Corporate Governance Guidelines and Principles
In accordance with the listing standards of the New York Stock Exchange, each of the Corporate Governance Documents is available on our Company web site (www.systemax.com) and can be obtained upon request by writing to Systemax Inc., Attention: Board of Directors (Corporate Governance), 11 Harbor Park Drive, Port Washington, NY 11050.
Item 1A.
Item 1A. Risk Factors.
There are a number of factors and variables described below that may affect our future results of operations and financial condition. Other factors of which we are currently not aware or that we currently deem immaterial may also affect our results of operations and financial position.
Risks Related to the Economy and Our Industries
· Economic conditions have affected and could continue to adversely affect our revenues and profits.
Current economic conditions may cause the loss of consumer confidence in the Company’s markets which may result in a decrease of spending in the categories of products we sell. It is also possible that as manufacturers react to the marketplace they may reduce manufacturing capacity, creating shortages of product. Both we and our customers are subject to global political, economic and market conditions, including inflation, interest rates, energy costs, the impact of natural disasters, military action and the threat of terrorism. Our consolidated results of operations are directly affected by economic conditions in North America and Europe. We may experience a decline in sales as a result of poor economic conditions and the lack of visibility relating to future orders. Our results of operations depend upon, among other things, our ability to maintain and increase sales volumes with existing customers, our ability to attract new customers and the financial condition of our customers. A decline in the economy that adversely affects our customers, causing them to limit or defer their spending, would likely adversely affect us as well. We cannot predict with any certainty whether we will be able to maintain or improve upon historical sales volumes with existing customers, or whether we will be able to attract new customers.
In response to economic and market conditions, from time to time we have undertaken initiatives to reduce our cost structure where appropriate. These initiatives, as well as any future workforce and facilities reductions, may not be sufficient to meet current and future changes in economic and market conditions and allow us to continue to achieve the growth rates and levels of profitability we have recently experienced. In addition, costs actually incurred in connection
with our restructuring actions may be higher than our estimates of such costs and/or may not lead to the anticipated cost savings.
· Competitive pressures could harm our revenue and gross margin.
We may not be able to compete effectively with current or future competitors. The markets for our products and services are intensely competitive and subject to constant technological change. We expect this competition to further intensify in the future. Competitive factors include price, availability, service and support. We compete with a wide variety of other resellers and retailers, as well as manufacturers. Many of our competitors are larger companies with greater financial, marketing and product development resources than ours. In addition, new competitors may enter our markets. This may place us at a disadvantage in responding to competitors’ pricing strategies, technological advances and other initiatives, resulting in our inability to increase our revenues or maintain our gross margins in the future.
In many cases our products compete directly with those offered by other manufacturers and distributors. If any of our competitors were to develop products or services that are more cost-effective or technically superior, demand for our product offerings could decrease.
Our gross margins are also dependent on the mix of products we sell and could be adversely affected by a continuation of our customers’ shift to lower-priced products.
· State and local sales tax collection may affect demand for our products.
Our United States subsidiaries collect and remit sales tax in states in which the subsidiaries have physical presence or in which we believe nexus exists which obligates us to collect sales tax. Other states may, from time to time, claim that we have state-related activities constituting a sufficient nexus to require such collection. Additionally, many other states seek to impose sales tax collection obligations on companies that sell goods to customers in their state, or directly to the state and its political subdivisions, even without a physical presence. Such efforts by states have increased recently, as states seek to raise revenues without increasing the tax burden on residents. We rely on United States Supreme Court decisions which hold that, without Congressional authority, a state may not enforce a sales tax collection obligation on a company that has no physical presence in the state and whose only contacts with the state are through the use of interstate commerce such as the mailing of catalogs into the state and the delivery of goods by mail or common carrier. We cannot predict whether the nature or level of contacts we have with a particular state will be deemed enough to require us to collect sales tax in that state nor can we be assured that Congress or individual states will not approve legislation authorizing states to impose tax collection obligations on all direct mail and/or e-commerce transactions. A successful assertion by one or more states that we should collect sales tax on the sale of merchandise could result in substantial tax liabilities related to past sales and would result in considerable administrative burdens and costs for us and may reduce demand for our products from customers in such states when we charge customers for such taxes.
· Business disruptions could adversely impact our revenue and financial condition.
We insure for certain property and casualty risks consisting primarily of physical loss to property, business interruptions resulting from property losses, worker’s compensation, comprehensive general liability, and auto liability. Insurance coverage is obtained for catastrophic property and casualty exposures as well as those risks required to be insured by law or contract. Although we believe that our insurance coverage is reasonable, significant events such as acts of war and terrorism, economic conditions, judicial decisions, legislation, natural disasters and large losses could materially affect our insurance obligations and future expense.
· Changes in financial accounting standards may affect our results of operations.
A change in accounting standards or practices can have a significant effect on our reported results of operations. New accounting pronouncements and interpretations of existing accounting rules and practices have occurred and may occur in the future. Changes to existing rules may adversely affect our reported financial results.
Risks Related to Our Company
· Our reliance on information and communications technology requires significant expenditures and entails risk.
We rely on a variety of information and telecommunications systems in our operations. Our success is dependent in large part on the accuracy and proper use of our information systems, including our telecommunications systems. To manage our growth, we continually evaluate the adequacy of our existing systems and procedures. We anticipate that we will regularly need to make capital expenditures to upgrade and modify our management information systems, including software and hardware, as we grow and the needs of our business change. In particular, our financial and retail point of sale systems will be replaced during the coming years. The occurrence of a significant system failure, electrical or telecommunications outages or our failure to expand or successfully implement new systems could have a material adverse effect on our results of operations.
Our information systems networks, including our web sites, and applications could be adversely affected by viruses or worms and may be vulnerable to malicious acts such as hacking. Although we take preventive measures, these procedures may not be sufficient to avoid harm to our operations, which could have an adverse effect on our results of operations.
· We are dependent on third-party suppliers.
We purchase substantially all of our computer products from major distributors such as Ingram Micro Inc. and Tech Data and directly from large manufacturers such as Hewlett Packard and Acer, who may deliver those products directly to our customers. These relationships enable us to make available to our customers a wide selection of products without having to maintain large amounts of inventory. The termination or interruption of our relationships with any of these suppliers could materially adversely affect our business.
Our PC products contain electronic components, subassemblies and software that in some cases are supplied through sole or limited source third-party suppliers, some of which are located outside of the U.S. Although we do not anticipate any problems procuring supplies in the near-term, there is no assurance that parts and supplies will be available in a timely manner and at reasonable prices. Any loss of, or interruption of, supply from key suppliers may require us to find new suppliers. This could result in production or development delays while new suppliers are located, which could substantially impair operating results. If the availability of these or other components used in the manufacture of our products was to decrease, or if the prices for these components were to increase significantly, operating costs and expenses could be adversely affected.
We purchase a number of our products from vendors outside of the United States. Difficulties encountered by one or several of these suppliers could halt or disrupt production and delay completion or cause the cancellation of our orders. Delays or interruptions in the transportation network could result in loss or delay of timely receipt of product required to fulfill customer orders.
Many product suppliers provide us with co-op advertising support in exchange for featuring
their products in our catalogs and on our internet sites. Certain suppliers provide us with other incentives such as rebates, reimbursements, payment discounts, price protection and other similar arrangements. These incentives are offset against cost of goods sold or selling, general and administrative expenses, as applicable. The level of co-op advertising support and other incentives received from suppliers may decline in the future, which could increase our cost of goods sold or selling, general and administrative expenses and have an adverse effect on results of operations and cash flows.
· Goodwill and intangible assets may become impaired resulting in a charge to earnings.
The acquisition of certain assets of CompUSA resulted in the recording of significant intangible assets and goodwill. We are required to test goodwill and intangible assets to determine if the carrying values of these assets are impaired annually or on a more frequent basis if indicators of impairment exist. If any of our goodwill or intangible assets are determined to be impaired we may be required to record a significant charge to earnings in the period during which the impairment is discovered.
· We have substantial international operations and we are exposed to fluctuations in currency exchange rates and political uncertainties.
We operate internationally and as a result, we are subject to risks associated with doing business globally. Risks inherent to operating overseas include:
· Changes in a country’s economic or political conditions
· Changes in foreign currency exchange rates
· Difficulties with staffing and managing international operations
· Unexpected changes in regulatory requirements
For example, we currently have operations located in numerous countries outside the United States, and non-U.S. sales (Europe, Canada and Puerto Rico) accounted for approximately 37.9% of our revenue during 2008. To the extent the U.S. dollar strengthens against foreign currencies, our foreign revenues and profits will be reduced when translated into U.S. dollars.
· We are exposed to inventory risks.
A substantial portion of our inventory is subject to risk due to technological change and changes in market demand for particular products. If we fail to manage our inventory of older products we may have excess or obsolete inventory. We may have limited rights to return purchases to certain suppliers and we may not be able to obtain price protection on these items. The elimination of purchase return privileges and lack of availability of price protection could lower our gross margin or result in inventory write-downs.
We also take advantage of attractive product pricing by making opportunistic bulk inventory purchases; any resulting excess and/or obsolete inventory that we are not able to re-sell could have an adverse impact on our results of operations. Any inability to make such bulk inventory purchases may significantly impact our sales and profitability.
· Restrictions and covenants in our credit facility may limit our ability to enter into certain transactions.
Our United States/United Kingdom combined revolving credit agreement contains covenants restricting or limiting our ability to, among other things:
· incur additional debt
· create or permit liens on assets
· make capital expenditures or investments
· pay dividends
If we fail to comply with the covenants and other requirements set forth in the credit agreement, we would be in default and would need to negotiate a waiver agreement with the lenders. Failure to agree on such a waiver could result in the lenders terminating the credit agreement and demanding repayment, which would adversely affect our cash position and adversely affect the availability of financing to us, which could materially impact our operations.
· We have experienced rapid growth in retail stores
The acquisition of CompUSA in 2008 added 16 retail stores, more than double the then existing number of stores. The addition of these stores requires the Company to effectively manage its cost structure in order to maintain profitability including the additional inventory needs, retail point of sales IT systems, retail personnel and leased facilities. Future growth in retail will also be dependent on the ability to attract customers and build brand loyalty. The retail computer and consumer electronics business is highly competitive and has narrow gross margins. If we fail to manage our growth and cost structure while maintaining high levels of service and meeting competitive pressures adequately, our business plan may not be achieved and may lead to reduced profitability.
· Rebate Processing
Similiar to other companies in the technology products industry, we advertise manufacturers’ mail-in rebates on many products we sell and, in some cases, offer our own rebates. These rebates are processed through third party vendors and in house. If these rebates are not processed in a timely and satisfactory manner by either third party vendors or our in house operations, our reputation in the marketplace could be negatively impacted. See Item 3, Legal Proceedings.
· Gross profit margins in Technology Products are narrow and variable
The computer and consumer electronics industry is highly price competitive and gross profit margins are narrow and variable. The Company’s ability to reduce prices in reaction to competitive pressure may be limited. Additionally, gross profit margins and operating margins are affected by changes in factors such as vendor pricing, vendor rebate and or price protection programs, product return rights, and product mix. Pricing pressure was prevalent in the second half of 2008 as a result of the significant decline in economic activity in the markets we serve and we expect this to continue during this or any period of sustained economic decline. We may not be able to mitigate these pricing pressures and resultant declines in sales and gross profit margin with cost reductions in other areas or expansion into new product lines. If we are unable to proportionately mitigate these conditions our operating results and financial condition may suffer.
· We may be liable for misuse, loss or theft of our customers’ personal information
In processing our sales orders we often collect personal information and credit card information from our customers. The Company has comprehensive privacy and data security policies in place which are designed to prevent security breaches, however, if a third party or a rogue employee or employees are able to bypass our network security or otherwise compromise our customers’ personal information or credit card information, we could be subject to liability. This liability may include claims for identity theft, unauthorized purchases, claims alleging misrepresentation of our privacy and data security practices or other related claims.
· Increased costs associated with corporate governance compliance may impact our results of operations.
As a public company, we incur significant legal, accounting and other expenses that we would not incur as a private company. In addition, the Sarbanes-Oxley Act of 2002, as well as rules subsequently implemented by the Securities and Exchange Commission and listing requirements subsequently adopted by the New York Stock Exchange in response to Sarbanes-Oxley, have required changes in corporate governance practices of public companies. These developments have substantially increased our legal compliance, auditing and financial reporting costs and made them more time consuming. These developments may also make it more difficult and more expensive for us to obtain directors’ and officers’ liability insurance and we may be required to accept reduced coverage or incur substantially higher costs to obtain coverage, possibly making it more difficult for us to attract and retain qualified members of our board of directors, particularly to serve on our audit committee.
· Our success is dependent upon the availability of credit and financing.
We require significant levels of capital in our business to finance accounts receivable and inventory. We maintain credit facilities in the United States and in Europe to finance increases in our working capital if available cash is insufficient. The amount of credit available to us at any point in time may be adversely affected by the quality or value of the assets collateralizing these credit lines. In addition, if we are unable to renew or replace these facilities at maturity our liquidity and capital resources may be adversely affected. However, we currently have no reason to believe that we will not be able to renew or replace our facilities when they reach maturity.
· Sales to individual consumers exposes us to credit card fraud, which could adversely affect our business.
Failure to adequately control fraudulent credit card transactions could increase our expenses. Increased sales to individual consumers, which are more likely to be paid for using a credit card, increases our exposure to fraud. We employ technology solutions to help us detect the fraudulent use of credit card information. However, if we are unable to detect or control credit card fraud, we may suffer losses as a result of orders placed with fraudulent credit card data, which could adversely affect our business.
· Our income tax rate and the value of our deferred tax assets are subject to change.
Changes in our income tax expense due to changes in the mix of U.S. and non-U.S. revenues and profitability, changes in tax rates or exposure to additional income tax liabilities could affect our profitability. We are subject to income taxes in the United States and various foreign jurisdictions. Our effective tax rate could be adversely affected by changes in the mix of earnings in countries with differing statutory tax rates, changes in the valuation of deferred tax assets and liabilities, changes in tax laws or by material audit assessments. The carrying value of our deferred tax assets, which are primarily in the United States and the United Kingdom, is dependent on our ability to generate future taxable income in those jurisdictions. In addition, the amount of income taxes we pay is subject to ongoing audits in various jurisdictions and a material assessment by a tax authority could affect our profitability.
· We may encounter risks in connection with sales of our web-hosted software application.
In 2004, we introduced our web-based and hosted, on-demand software suite of products, marketed as PCS ProfitCenter Software™. We have a limited operating history with this type of product offering and may encounter risks inherent in the software industry, including but not limited to:
· failure to implement effective general and application controls
· errors or security flaws in our product
· technical difficulties which we can not resolve on a timely or cost-effective basis
· inability to provide the level of service commitment
· inability to deliver product upgrades and enhancements
· delays in development
· inability to hire and retain qualified technical personnel
· impact of privacy laws on the use of our product
· exposure to claims of infringement of intellectual property rights
Item 1B.
Item 1B. Unresolved Staff Comments.
None.
Item 2.
Item 2. Properties.
Our primary facilities, which are leased except where otherwise indicated, are as follows:
(1) For information about this facility, leased from related parties, see Item 13 -Certain Relationships and Related Transactions and Director Independence.
We also lease space for other smaller offices and retail stores in the United States, Canada, Puerto Rico and Europe and certain facilities leased by the Company are subleased to others. We believe our current facilities provide adequate capacity for our current and projected needs. We intend to renew the leases for our space which would otherwise terminate in 2009.
For further information regarding our lease obligations, see Note 9 to the Consolidated Financial Statements.
Item 3.
Item 3. Legal Proceedings.
Kevin Vukson v. TigerDirect, Inc., OnRebate.com Inc. and Systemax Inc.
On October 18, 2007, Kevin Vukson filed a national class action complaint in U.S. District Court against TigerDirect, Inc., OnRebate.com Inc. and Systemax Inc. on behalf of himself and all OnRebate customers whose rebates were denied or delayed. (OnRebate.com Inc. is a rebate processing company owned by Systemax.). Vukson’s complaint (as amended) alleges that since 2004 Systemax, TigerDirect and OnRebate engaged in a conspiracy to engage in deceptive and unfair rebate practices. Vukson alleges counts for violation of state consumer protection statutes, conspiracy, and unfair rebate practices. On February 11, 2009 the Court dismissed Vukson’s complaint with leave to file an amended complaint by February 19, 2009 but ordered that any amended complaint not include a request for punitive damages. On February 19, 2009 Vukson filed an amended complaint with no request for punitive damages, as ordered by the Court. The Company will continue to vigorously defend this case.
State of Florida, Office of the Attorney General Subpoena
On January 2, 2008 the Company received a subpoena for documents from the Florida Attorney General’s Office relating to the payment and processing of rebates by the Company. The Company received subpoenas for additional documents on January 30, 2008 and on August 25, 2008. The Company is cooperating with the Florida Attorney General’s investigation and has provided a substantial number of documents in response to the subpoenas.
Other Matters
Systemax is a party to various pending legal proceedings and disputes arising in the normal course of business, including those involving commercial, employment, tax and intellectual property related claims, none of which, in management’s opinion, is anticipated to have a material adverse effect on our consolidated financial statements.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders.
None.
PART II
Item 5.
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Systemax common stock is traded on the New York Stock Exchange under the symbol “SYX.” The following table sets forth the high and low closing sales price of our common stock as reported on the New York Stock Exchange for the periods indicated.
On January 3, 2009, the last reported sale price of our common stock on the New York Stock Exchange was $10.87 per share. As of January 3, 2009, we had 230 shareholders of record.
On March 3, 2008, the Company’s Board of Directors declared a special dividend of $1.00 per share payable on April 2, 2008 to shareholders of record on March 21, 2008. This special dividend is the second dividend we have paid since our initial public offering. Depending in part upon profitability, the strength of our balance sheet, our cash position and the need to retain cash for the development and expansion of our business, we may decide to declare another special dividend in the future.
On March 14, 2007, the Company’s Board of Directors declared a special dividend of $1.00 per share payable on April 12, 2007 to shareholders of record on April 2, 2007. This special dividend was the first dividend we have paid since our initial public offering.
In May 2008, the Company’s Board of Directors authorized the repurchase of up to 2,000,000 shares of the Company’s common stock. During 2008 the Company repurchased 475,301 common shares. Detail of those purchases is as follows:
Information regarding securities authorized for issuance under equity compensation plans and a performance graph relating to the Company’s common stock is set forth in the Company’s Proxy Statement relating to the 2009 annual meeting of shareholders and is incorporated by reference herein.
Item 6.
Item 6. Selected Financial Data.
The following selected financial information is qualified by reference to, and should be read in conjunction with, the Company’s Consolidated Financial Statements and the notes thereto, and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” contained elsewhere in this report. The selected statement of operations data for fiscal years 2008, 2007 and 2006 and the selected balance sheet data as of December 2008 and 2007 are derived from the audited consolidated financial statements which are included elsewhere in this report. The selected balance sheet data as of December 2006, 2005 and 2004 and the selected statement of operations data for fiscal years 2005 and 2004 are derived from the audited consolidated financial statements of the Company which are not included in this report.
Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Overview
Systemax is primarily a direct marketer of brand name and private label products. Our operations are organized in three reportable business segments - Technology Products, Industrial Products and Software Solutions. Our Technology Products segment sells computers, computer supplies and consumer electronics which are marketed in North America, Puerto Rico and Europe. Except for certain PC products that we assemble ourselves and sell under the trademarks Systemax™ and Ultra™, substantially all of our products are manufactured by other companies. We also sell certain computer-related products manufactured for us to our own design under the trademark Systemax™ and Ultra™. Technology products accounted for 92% of our net sales in 2008. Our Industrial Products segment sells a wide array of material handling equipment, storage equipment and consumable industrial items which are marketed in North America. Substantially all of these products are manufactured by other companies. Some products are manufactured for us to our own design and marketed under the trademarks Global™, GlobalIndustrial.com™ and Nexel™. Industrial products accounted for 8% of our net sales in 2008. In both of these product groups, we offer our customers a broad selection of products, prompt order fulfillment and extensive customer service. Our Software Solutions segment, which became a reportable segment in 2006, participates in the emerging market for on-demand, web-based business software applications through the marketing of our PCS ProfitCenter Software™ application. See Note 10 to the Consolidated Financial Statements included in Item 15 of this Form 10-K for additional financial information about our business segments as well as information about our geographic operations.
The market for computer products and consumer electronics is subject to intense price competition and is characterized by narrow gross profit margins. The North American industrial products market is highly fragmented and we compete against companies utilizing multiple distribution channels. Distribution of our technology products and industrial products is working capital intensive, requiring us to incur significant costs associated with the warehousing of many products, including the costs of leasing warehouse space, maintaining inventory and inventory management systems, and employing personnel to perform the associated tasks. We supplement our on-hand product availability by maintaining relationships with major distributors and manufacturers, utilizing a combination of stocking and drop-shipment fulfillment.
The primary component of our operating expenses historically has been employee related costs, which includes items such as wages, commissions, bonuses, employee benefits and stock option expenses. We continually assess our operations to ensure that they are efficient, aligned with market conditions and responsive to customer needs.
During the first quarter of 2008 the Company acquired CompUSA’s e-commerce business and 16 of its retail leases and related fixtures for direct consideration of approximately $30.6 million. This acquisition accelerated the Company’s planned expansion into the retail market place for Technology Products in North America and Puerto Rico.
Critical Accounting Policies and Estimates
Our significant accounting policies are described in Note 1 to the consolidated financial statements. Certain accounting policies require the application of significant judgment by management in selecting the appropriate assumptions for calculating financial estimates. By their nature, these judgments are subject to an inherent degree of uncertainty, and as a result, actual results could differ from those estimates. These judgments are based on historical experience, observation of trends in the industry, information provided by customers and information available from other outside sources, as appropriate. Management believes that full consideration has been given to all relevant circumstances that we may be subject to, and the consolidated financial statements of the Company accurately reflect management’s best estimate of the consolidated results of operations, financial position and cash flows of the Company for the years presented. We identify below a number of policies that entail significant judgments or estimates. Actual results may differ from these estimates under different conditions or assumptions.
Revenue Recognition. We recognize product sales when persuasive evidence of an order arrangement exists, delivery has occurred, the sales price is fixed or determinable and collectibility is reasonably assured. Generally, these criteria are met at the time of receipt by customers when title and risk of loss both are transferred. Sales are shown net of returns and allowances, rebates and sales incentives. Reserves for estimated returns and allowances are provided when sales are recorded, based on historical experience and current trends.
Accounts Receivable and Allowance for Doubtful Accounts. We record an allowance for doubtful accounts to reflect our estimate of the collectibility of our trade accounts receivable. We evaluate the collectibility of accounts receivable based on a combination of factors, including an analysis of the age of customer accounts and our historical experience with accounts receivable write-offs. The analysis also includes the financial condition of a specific customer or industry, and general economic conditions. In circumstances where we are aware of customer charge-backs or a specific customer’s inability to meet its financial obligations, a specific reserve for bad debts applicable to amounts due to reduce the net recognized receivable to the amount management reasonably believes will be collected is recorded. In those situations with ongoing discussions, the amount of bad debt recognized is based on the status of the discussions. While bad debt allowances have been within expectations and the provisions established, there can be no guarantee that we will continue to experience the same allowance rate we have in the past.
Inventories. We value our inventories at the lower of cost or market, cost being determined on the first-in, first-out method except in Europe and retail locations where an average cost is used. Excess and obsolete or unmarketable merchandise are written down based on historical experience, assumptions about future product demand and market conditions. If market conditions are less favorable than projected or if technological developments result in accelerated obsolescence, additional write-downs may be required. While obsolescence and resultant markdowns have been within expectations, there can be no guarantee that we will continue to experience the same level of markdowns we have in the past.
Goodwill and, Intangible Assets - We apply the provisions of Statement of Financial Accounting Standards No. 142 (“FAS 142”), “Goodwill and Other Intangible Assets,” in our valuation of goodwill and other intangible assets. FAS 142 requires that goodwill be reviewed at least annually for potential impairment. The amount of an impairment loss would be recognized as the excess of the asset’s carrying value over its fair value.
Long-lived Assets. Management exercises judgment in evaluating our long-lived assets for impairment. We believe we will generate sufficient undiscounted cash flow to more than recover the investments made in property, plant and equipment. Our estimates of future cash flows involve assumptions concerning future operating performance and economic conditions. While we believe that our estimates of future cash flows are reasonable, different assumptions regarding such cash flows could materially affect our evaluations.
Accruals. Management exercises judgment in estimating various period end liabilities such as costs related to vendor drop shipments, sales returns and allowances, cooperative advertising and customer rebate reserves, and other vendor and employee related costs. While we believe that these estimates are reasonable, any significant deviation of actual costs as compared to these estimates could have a material impact on the Company’s consolidated financial statements.
Income Taxes. We are subject to taxation from federal, state and foreign jurisdictions and the determination of our tax provision is complex and requires significant management judgment. Management judgment is also applied in the determination of deferred tax assets and liabilities and any valuation allowances that might be required in connection with our ability to realize deferred tax assets.
Since we conduct operations in numerous US states and internationally, our effective tax rate has and will continue to depend upon the geographic distribution of our pre-tax income or losses among locations with varying tax rates and rules. As the geographic mix of our pre-tax results among various tax jurisdictions changes, the effective tax rate may vary from period to period. We are also subject to periodic
examination from domestic and foreign tax authorities regarding the amount of taxes due. These examinations include questions regarding the timing and amount of deductions and the allocation of income among various tax jurisdictions. We have established, and periodically reevaluate, an estimated income tax reserve on our consolidated balance sheet to provide for the possibility of adverse outcomes in income tax proceedings. While management believes that we have identified all reasonably identifiable exposures and that the reserve we have established for identifiable exposures is appropriate under the circumstances, it is possible that additional exposures exist and that exposures may be settled at amounts different than the amounts reserved.
We recognize deferred tax assets and liabilities for the effect of temporary differences between the book and tax bases of recorded assets and liabilities and for tax loss carry forwards. The realization of net deferred tax assets is dependent upon our ability to generate sufficient future taxable income. Where it is more likely than not that some portion or all of the deferred tax asset will not be realized, we have provided a valuation allowance. If the realization of those deferred tax assets in the future is considered more likely than not, an adjustment to the deferred tax assets would increase net income in the period such determination is made. In the event that actual results differ from these estimates or we adjust these estimates in future periods, an adjustment to the valuation allowance may be required, which could materially affect our consolidated financial position and results of operations.
Restructuring charges. We have taken restructuring actions in the past and could in the future commence further restructuring activities which result in recognition of restructuring charges if events make it necessary. These actions require management to make judgments and utilize significant estimates regarding the nature, timing and amounts of costs associated with the activity. When we incur a liability related to a restructuring action, we estimate and record all appropriate expenses, including expenses for severance and other employee separation costs, facility consolidation costs (including estimates of sublease income), lease cancellations, asset impairments and any other exit costs. Should the actual amounts differ from our estimates, the amount of the restructuring charges could be impacted, which could materially affect our consolidated financial position and results of operations.
Recently Adopted and Newly Issued Accounting Pronouncements
In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 157 “Fair Value Measurements”. This statement was issued to increase consistency and comparability in fair value measurements and for expanded disclosures about fair value measurements. Effective January 1, 2008 the Company adopted the provisions of SFAS No. 157, which did not have a material impact on the Company’s consolidated financial statements.
In February 2008, the FASB issued FASB Staff Position (“FSP”) FAS 157-2, which provides for a one-year deferral of the provisions of SFAS No. 157 until fiscal years beginning after December 15, 2008 for non-financial assets and liabilities that are recognized or disclosed at fair value in the consolidated financial statements on a non-recurring basis. The Company is currently evaluating the potential impact, if any, of FSP 157-2.
In April 2008, the FASB issued FSP FAS 142-3 “Determination of the Useful Life of Intangible Assets”. FSP FAS 142-3 amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under FASB Statement No. 142, Goodwill and Other Intangible Assets. The intent of this FSP is to improve the consistency between the useful life of a recognized intangible asset and the period of expected cash flows used to measure the fair value of the asset. The standard applies prospectively to intangible assets acquired and/or recognized on or after January 1, 2009. The Company is currently evaluating the impact, if any, the adoption of this FSP may have on the Company’s consolidated financial statements.
In June 2008, the FASB issued FASB Staff Position No. EITF 03-6-1 “Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities”. This FSP was issued to clarify that instruments granted in share-based payment transactions can be participating securities prior
to the requisite service having been rendered. The guidance in this FSP applies to the calculation of Earnings Per Share (“EPS”) under Statement 128 for share-based payment awards with rights to dividends or dividend equivalents. Unvested share-based payment awards that contain non-forfeitable rights to dividends or dividend equivalents (whether paid or unpaid) are participating securities and shall be included in the computation of EPS pursuant to the two-class method. This FSP is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those years. All prior-period EPS data presented shall be adjusted retrospectively (including interim financial statements, summaries of earnings, and selected financial data) to conform with the provisions of this FSP. The Company does not expect the adoption of this FSP to have a material impact on its consolidated financial statements.
In December 2007, the FASB issued SFAS No. 141R, “Business Combinations,” which replaces FASB Statement 141. SFAS No.141R retains the requirement that the acquisition method of accounting be used for business combinations. The objective of SFAS No. 141R is to improve the relevance, representational faithfulness and comparability that reporting entities provide in their financial reports about business combinations and their effects. SFAS No. 141R establishes principles and requirements for how an acquirer 1) recognizes and measures identifiable assets acquired, the liabilities assumed and any non-controlling interest in the acquiree, 2) recognizes and measures the goodwill acquired in the combination or a gain from a bargain purchase and 3) determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination. SFAS No. 141R is effective for annual periods beginning after December 15, 2008 and will be applied prospectively for all business combinations entered into after the date of adoption. The impact of SFAS No. 141R will depend on the nature and terms of any future business combinations, if any.
In December 2007, the FASB issued SFAS No. 160, “Accounting and Reporting of Non-controlling Interest”. The objective of SFAS No. 160 is to improve the relevance, comparability and transparency of the financial information that reporting entities provide related to non-controlling interests, sometimes referred to as minority interests. SFAS No. 160 requires, among other things, that non-controlling interests be shown separately in the consolidated entity’s equity section of the balance sheet. SFAS No. 160 also establishes accounting and reporting standards for ownership interest in subsidiaries held by parties other than the parent, for presentation of amounts of consolidated net income attributable to the parent and the non-controlling interest, for consistency in accounting for changes in a parent’s ownership interest when the parent retains a controlling interest, for the valuation of retained non-controlling equity interests when a subsidiary is deconsolidated and for providing sufficient disclosure that identifies and distinguishes the interests of the parent and the interests of the non-controlling owners. SFAS No. 160 is effective beginning January 1, 2009. The Company does not expect the adoption of SFAS No.160 to have a material impact on its consolidated financial statements.
Highlights from 2008
The discussion of our results of operations and financial condition that follows will provide information that will assist in understanding our financial statements and information about how certain accounting principles and estimates affect the consolidated financial statements. This discussion should be read in conjunction with the consolidated financial statements included herein.
· Sales increase of 9% in 2008 over 2007
· CompUSA.com and CompUSA retail contributed $226.3 million in sales
· Movements in exchange rates positively impacted European and Canadian sales by approximately $13 million and $5 million, respectively
· Revenue growth slowed in the second half of 2008
Results of Operations
Key Performance Indicators (in thousands):
NET SALES
Net sales grew 9% to $3 billion driven by growth in both technology and industrial products segments. Excluding the effects of exchange rate changes, sales would have grown 8%. North American technology products sales grew 14% to $1.9 billion. Exchange rate changes did not impact full year sales growth. European technology products sales grew 1% to $940.6 million. Excluding exchange rate benefits, European sales would have been flat.
Sales increased in all three reporting business segments and in both geographies during 2008 over 2007. The Technology Products sales increase was driven by increased internet and retail store sales as the result of the acquisition of the CompUSA ecommerce business and re-opening sixteen retail stores. Sales attributable to CompUSA web and retail were $226.3 million for the year. Excluding CompUSA revenue, total Technology Products revenues increased 0.6% compared to the prior year. In the United States, Technology Products sales excluding CompUSA declined 1.0% for the year. The decline over the year is the result of slower business to business IT and consumer electronics sales as United States economy activity slowed in the second half of 2008. In Europe sales increased .9% compared to a year ago. Movements in foreign exchange rates positively impacted the European sales comparison by approximately $13 million for the year. Excluding exchange rate benefits, European sales would have been flat year over year. Sales in Canada (Other North America) increased by 13.9% compared to the prior year. Excluding exchange rate benefits, sales would have increased 10.9% for the year. The increased sales are primarily the result of the opening of one additional retail store, increased business to business and web sales and generally more stable economic conditions in Canada as compared to other locations. As in the United States, sales slowed in the second half of 2008 in Europe and Canada for both consumer and business to business sales as the result of a slowdown in economic activity.
The growth in Industrial Products sales resulted from the Company increasing its market share through aggressive acquisition of customers via web and catalog, increased web advertising by expanding and refining advertisements for existing product lines and adding new advertising for new product lines via search engines, shipping engines and vertical market sites.
In our Software Solutions segment, revenues continue to be insignificant relative to consolidated revenues. In the fourth quarter of 2008, the Company reorganized its Software business to reduce its net
loss and negative cash flow. The actions taken resulted in a charge to earnings of approximately $1.7 million. The Company expects to realize savings of approximately $2.6 million annually.
Sales increased in all three reporting business segments and in both geographies during 2007 over 2006. The growth in Technology Products sales was driven primarily by increased internet and retail store sales, private label product sales and expanded product offerings. The growth in Industrial Products sales resulted from the Company increasing its market share through competitive pricing advantages and increased internet sales. The growth in North American sales reflected the above factors in both segments. The growth in European sales was driven by strong business to business gains and by the effect of a weaker US dollar. Exchange rates positively impacted the European sales comparison by approximately $78 million in 2007 as compared to 2006. Excluding the movements in foreign exchange rates, European sales would have increased 12% from the prior year. Sales as measured in local currencies increased in all of the European markets we served in 2007. Sales in our Software segment were not material in 2007 and 2006 due to early stage of operations.
GROSS MARGIN
Consolidated gross margin remained consistent year over year at 15.3%, although in the fourth quarter of 2008 the Company’s gross margin declined to 14.4% as the Company lowered certain product prices and offered freight incentives in order to gain market share and respond to competitive pricing pressures. Gross margin is dependent on variables such as product mix, vendor price protection and other sales incentives, competition, pricing strategy, cooperative advertising funds required to be classified as a reduction of cost of sales, freight discounting and other variables, any or all of which may result in fluctuations in gross margin.
Gross margin increased 70 basis points during 2007 over 2006, due primarily to decreased competitive pricing pressures in the Technology Products segment.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES
Selling, general and administrative expenses increased in 2008 over 2007 primarily as a result of the increase in sales volume, added personnel, facility and other operating costs associated with the CompUSA acquisition, as well as increased accounting, auditing, legal and professional expenses and reorganization charges incurred in our Software segment. Significant expense increases include approximately $27.0 million of increased sales and other salaries and related costs related to the increased sales volume; rent and real estate tax increases of $10.6 million; $5.8 million of increased professional and telephone/computer maintenance costs; and $4.3 million of increased credit card fees. CompUSA operations accounted for $23.6 million of these cost increases. Included in 2007 is a gain of approximately $2.4 million from a lawsuit that was settled favorably.
Selling, general and administrative expenses increased in 2007 over 2006 primarily as a result of the increase in sales volume as well as increased accounting, auditing, legal and consulting costs related to the Company being subject to Sarbanes Oxley section 404 requirements. Significant expense increases include approximately $26 million of increased internet advertising costs, $8 million of increased sales salaries related to the increased sales volume and an increase in other salaries and related costs of approximately $15 million due to increased staff in areas such as finance, marketing and information technology.
INTEREST AND OTHER INCOME AND INTEREST EXPENSE
Interest expense was $.3 million, $1.0 million and $1.7 million in 2008, 2007 and 2006. Interest expense decreased in 2008 and 2007 as a result of decreased short-term borrowings in the United Kingdom and the Netherlands. The extinguishment of mortgage debt related to our Georgia warehouse sale in the first quarter of 2006 also contributed to the decreased interest expense. Interest and other income, net was $2.0 million, $5.5 million and $9.5 million in 2008, 2007 and 2006. The increase in other income in 2006 mainly resulted from the gain on sale of the Georgia location.
INCOME TAXES
The Company’s effective tax rate was 36.9% in 2008 as compared to 30.5% in 2007. The higher tax rate in 2008 is primarily attributed to a higher effective tax rate in the United Kingdom in 2008 as the result of the reversal of the valuation allowance in 2007. The lower effective tax rate in 2007 resulted primarily from the reversal of a valuation allowance of approximately $5.9 million against deferred tax assets in the United Kingdom partially offset by the recording of a valuation allowance of approximately $1.7 million against the deferred tax assets of Germany. The United Kingdom valuation allowance, originally recorded at $10.2 million, had been established in 2005 as the result of a cumulative loss position in the United Kingdom.
During 2008, 2007 and 2006, we did not recognize certain foreign tax credits, certain state deferred tax assets in the United States and certain benefits on losses in foreign tax jurisdictions due to our inability to carry such credits and losses back to prior years and our determination that it was more likely than not that we would not generate sufficient future taxable income in those tax jurisdictions to realize these assets. Accordingly, valuation allowances were recorded against the deferred tax assets associated with those items. If we are able to realize all or part of these deferred tax assets in future periods, it will reduce our provision for income taxes by a release of the corresponding valuation allowance.
Seasonality
Net sales have historically been modestly weaker during the second and third quarters as a result of lower business activity during those months. The 2008 amounts were impacted by the CompUSA acquisition. The following table sets forth the net sales, gross profit and income from operations for each of the quarters since January 1, 2006 (amounts in millions).
Financial Condition, Liquidity and Capital Resources
Selected liquidity data (in thousands):
Our primary liquidity needs are to support working capital requirements in our business, to fund capital expenditures, to fund the payment of interest on outstanding debt and to effect small acquisitions. We rely principally upon operating cash flow to meet these needs. In addition we have available a credit facility of approximately $120 million We believe that cash flow available from these sources will be sufficient to meet our working capital requirements, projected capital expenditures and interest and debt repayments in the foreseeable future.
Our working capital decreased in 2008 as the result of use of approximately $30.6 million cash for the purchase of certain CompUSA assets, payment of $37.1 million for a special dividend, stock repurchases of $5.8 million and an increase in inventory, primarily related to purchasing inventory for the 16 CompUSA retail stores. Accounts payable balances increased by approximately $35.7 million offset by a decrease of approximately $6.0 million in accrued expenses and a reduction in short term debt in Europe. Inventory turnover was at 9 times during 2008 and 10 times at 2007. Our accounts receivable days outstanding was at 21 in 2008 down from 24 in 2007. We expect that future accounts receivable and inventory balances will fluctuate with growth in net sales and the mix of our net sales between consumer and business customers.
We maintain our cash and cash equivalents primarily in money market funds or their equivalent. As of December 31, 2008, all of our investments mature in less than three months. Accordingly, we do not believe that our investments have significant exposure to interest rate risk.
Net cash provided by operating activities was $82.4 million, $93.1 million and $34.3 million during 2008, 2007 and 2006. The decrease in cash provided by operating activities in 2008 over 2007 resulted from a $3.3 million decrease in net income adjusted by other non-cash items, such as depreciation expense, and a decrease of $7.4 million in cash used for changes in our working capital accounts. The increase in cash provided by operating activities in 2007 over 2006 resulted from a $27.0 million increase in net income adjusted by other non-cash items, such as depreciation expense, and an increase of $31.7 million in cash used for changes in our working capital accounts.
Net cash used in investing activities was $47.7 million during 2008, primarily for the CompUSA acquisition and for capital expenditures. Net cash used in investing activities was $8.0 million during 2007, primarily for capital expenditures. Net cash provided by investing activities during 2006 consisting of proceeds from disposals of property and equipment of $18.9 million from the sale of our distribution facility in Suwanee, Georgia offset by cash used for capital expenditures of $6.7 million. Capital expenditures in 2008, 2007 and 2006 included upgrades and enhancements to our information and communications systems hardware and facilities costs for the opening of additional retail outlets stores in North America.
Net cash used in financing activities was $42.8 million during 2008. We repaid approximately $3.9 million in short-term debt, paid a special dividend of $37.1 million, and repurchased Company stock of approximately $5.8 million. Proceeds and excess tax benefits from stock option exercises and proceeds
from debt and capital leases obligations provided approximately $4.0 million of cash. Net cash used in financing activities was $42.5 million during 2007, attributable to dividends paid of $36.6 million, repayment of short term debt of $9.0 million, offset by proceeds of stock option exercises, related excess tax benefits and share repurchases of $3.1 million. Net cash of $22.1 million was used in financing activities for 2006. Repayment of short and long-term borrowings used approximately $24.8 million of cash and proceeds from stock option exercises and excess tax benefits from stock option exercises provided approximately $2.6 million of cash.
We have a $120.0 million secured revolving credit agreement (which may be increased by up to an additional $30.0 million, subject to certain conditions). The facility expires in October 2010. Borrowings under the agreement are subject to borrowing base limitations of up to 85% of eligible accounts receivable and 40% of qualified inventories and are secured by accounts receivable, inventories and certain other assets. The undrawn availability under the facility may not be less than $15.0 million until the last day of any month in which the availability net of outstanding borrowings is at least $70.0 million. The revolving credit agreement requires that we maintain a minimum level of availability. If such availability is not maintained, we will then be required to maintain a fixed charge coverage ratio (as defined). The agreement contains certain other covenants, including restrictions on capital expenditures and payments of dividends. As of December 31, 2008, the Company was in compliance with all of the covenants under the credit facility. Eligible collateral under the facility was $103.5 million, total availability was $94.4 million, outstanding letters of credit of were $9.1 million and there were no outstanding advances.
The Company’s Netherlands subsidiary maintained a 5.0 million credit facility with a local financial institution. This facility expired in November 2008 and was not renewed.
In April 2002, we entered into a ten year, $8.4 million mortgage loan on our Suwanee, Georgia distribution facility. During the first quarter of fiscal 2006, we sold this facility and repaid the remaining balance on the loan. The facility was replaced by a larger, leased distribution center in a nearby area.
We are obligated under non-cancelable operating leases for the rental of most of our facilities and certain of our equipment which expire at various dates through 2026. We have sublease agreements for unused space we lease in Wellingborough, England. In the event the sublessee is unable to fulfill its obligations, we would be responsible for rent due under the lease.
Following is a summary of our contractual obligations for future principal payments on our debt, minimum rental payments on our non-cancelable operating leases and minimum payments on our other purchase obligations as of December 2008 (in thousands):
Our purchase and other obligations consist primarily of certain employment agreements and service agreements.
In addition to the contractual obligations noted above, we had $9.1 million of standby letters of credit outstanding as of December 2008.
Our operating results have generated cash flow which, together with borrowings under our debt agreements, has provided sufficient capital resources to finance working capital and cash operating requirements, fund capital expenditures, and fund the payment of interest on outstanding debt. Our primary ongoing cash requirements will be to finance working capital, fund the payment of principal and interest on indebtedness, fund capital expenditures and fund small acquisitions. We believe future cash flows from operations and availability of borrowings under our lines of credit will be sufficient to fund ongoing cash requirements for at least the next twelve months.
We are party to certain litigation, the outcome of which we believe, based on discussions with legal counsel, will not have a material adverse effect on our consolidated financial statements.
Tax contingencies are related to uncertain tax positions taken on income tax returns that may result in additional tax, interest and penalties being paid to taxing authorities.
Off-Balance Sheet Arrangements
We have not created, and are not party to, any special-purpose or off-balance sheet entities for the purpose of raising capital, incurring debt or operating our business. We do not have any arrangements or relationships with entities that are not consolidated into the financial statements that are reasonably likely to materially affect our liquidity or the availability of capital resources.
The Company currently leases its facility in Port Washington, NY from Addwin Realty Associates, an entity owned by Richard Leeds, Bruce Leeds, and Robert Leeds, Directors of the Company and the Company’s three senior executive officers and principal stockholders.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk.
We are exposed to market risks, which include changes in U.S. and international interest rates as well as changes in currency exchange rates (principally Pounds Sterling, Euros and Canadian Dollars) as measured against the U.S. Dollar and each other.
The translation of the financial statements of our operations located outside of the United States is impacted by movements in foreign currency exchange rates. Changes in currency exchange rates as measured against the U.S. dollar may positively or negatively affect income statement, balance sheet and cash flows as expressed in U.S. dollars. Sales would have fluctuated by approximately $112 million and pre tax income would have fluctuated by approximately $2.3 million if average foreign exchange rates changed by 10% in 2008. We have limited involvement with derivative financial instruments and do not use them for trading purposes. We may enter into foreign currency options or forward exchange contracts aimed at limiting in part the impact of certain currency fluctuations, but as of December 2008 we had no outstanding forward exchange contracts.
Our exposure to market risk for changes in interest rates relates primarily to our variable rate debt. Our variable rate debt consists of short-term borrowings under our credit facilities. As of December 2008, there were no outstanding balances under our variable rate credit facility. A hypothetical change in average interest rates of one percentage point is not expected to have a material effect on our financial position, results of operations or cash flows over the next fiscal year.
Item 8.
Item 8. Financial Statements and Supplementary Data.
The information required by Item 8 of Part II is incorporated herein by reference to the Consolidated Financial Statements filed with this report; see Item 15 of Part IV.
Item 9.
Item 9. Changes In and Disagreements with Accountants on Accounting and Financial Disclosure.
None.
Item 9A.
Item 9A. Controls and Procedures.
Evaluation of Disclosure Controls and Procedures
Under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, the Company carried out an evaluation of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as of December 31, 2008. Based upon this evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that the Company’s disclosure controls and procedures are effective.
Inherent Limitations of Internal Controls over Financial Reporting
The Company’s internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. The Company’s internal control over financial reporting includes those policies and procedures that: (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the Company’s assets; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that the Company’s receipts and expenditures are being made only in accordance with authorizations of the Company’s management and directors; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets that could have a material effect on the Company’s financial statements.
Management, including the Company’s Chief Executive Officer and Chief Financial Officer, does not expect that the Company’s internal controls will prevent or detect all errors and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of internal controls can provide absolute assurance that all control issues and instances of fraud, if any, have been detected. Also, any evaluation of the effectiveness of controls in future periods are subject to the risk that those internal controls may become inadequate because of changes in business conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Management’s Report on Internal Control Over Financial Reporting
The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting. Under the supervision and with the participation of Company’s management, including the Chief Executive Officer and Chief Financial Officer, the Company evaluated the effectiveness of the design and operation of its internal control over financial reporting based on the framework established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s internal control over financial reporting was effective as of December 31, 2008.
The Company’s independent registered public accounting firm, Ernst & Young, has issued an attestation report on the effectiveness of the Company’s internal control over financial reporting as of December 31, 2008, a copy of which is included in this report.
Changes in Internal Control Over Financial Reporting
In conjunction with the Company’s Section 404 compliance efforts, the Company has continued to make improvements to its internal control over financial reporting, including remediation of the significant deficiency in the consolidation process previously noted. The nature of these improvements was incremental, and the impact was not material both individually and in the aggregate.
There have been no changes in the Company’s internal controls over financial reporting during the quarter ended December 31, 2008 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
Item 9B.
Item 9B. Other Information.
None.
PART III
Item 10.
Item 10. Directors, Executive Officers and Corporate Governance.
The information required by Item 10 of Part III is hereby incorporated by reference to the Company’s Proxy Statement for the 2009 Annual Meeting of Stockholders. (the “Proxy Statement”).
Item 11.
Item 11. Executive Compensation.
The information required by Item 11 of Part III is hereby incorporated by reference to the Proxy Statement.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.
The information required by item 12 of Part III is hereby incorporated by reference to the Proxy Statement.
Item 13.
Item 13. Certain Relationships and Related Transactions, and Director Independence
The information required by Item 10 of Part III is hereby incorporated by reference to the Proxy Statement.
Item 14.
Item 14. Principal Accounting Fees and Services.
The information required by Item 14 of Part III is hereby incorporated by reference to the Proxy Statement.
PART IV
Item 15.
Item 15. Exhibits and Financial Statement Schedules.
(a)
1.
Consolidated Financial Statements of Systemax Inc.
Reference
Reports of Ernst & Young LLP Independent Registered Public Accounting Firm
Consolidated Balance Sheets as of December 31, 2008 and 2007
Consolidated Statements of Operations for the years ended December 31, 2008, 2007, and 2006
Consolidated Statements of Cash Flows for the years ended December 31, 2008, 2007 and
Consolidated Statements of Shareholders’ Equity for the Years ended December 31, 2008, 2007 and 2006
Notes to Consolidated Financial Statements
2.
Financial Statement Schedules:
The following financial statement schedule is filed as part of this report and should be read together with our consolidated financial statements:
Schedule II - Valuation and Qualifying Accounts
Schedules not included with this additional financial data have been omitted because they are not applicable or the required information is shown in the consolidated financial statements or notes thereto.
3.
Exhibits.
10.9
Form of 1995 Stock Plan for Non-Employee Directors* (incorporated by reference to the Company’s registration statement on Form S-1) (Registration No. 333-1852)
10.10
Employment Agreement entered into on October 12, 2004 but effective as of June 1, 2004 between the Company and Gilbert Fiorentino* (incorporated by reference to the Company’s report on Form 8-K dated October 12, 2004)
10.11
Restricted Stock Unit Agreement entered into on October 12, 2004 but effective as of June 1, 2004 between the Company and Gilbert Fiorentino* (incorporated by reference to the Company’s report on Form 8-K dated October 12, 2004)
10.12
Amended and Restated Credit Agreement, dated as of October 27, 2005, between JPMorgan Chase Bank, N.A. and affiliates, General Electric Capital Corporation, and GMAC Commercial Finance LLC (as Lenders) with the Company and certain subsidiaries of the Company (as Borrowers) (the “Amended and Restated JP Morgan Chase Loan Agreement”) (incorporated by reference to the Company’s report on Form 8-K dated October 27, 2005)
10.13
Amendment No. 1, dated as of December 19, 2005, to the Amended and Restated JP Morgan Chase Loan Agreement (incorporated by reference to the Company’s annual report on Form 10-K for the year ended December 31, 2005)
10.14
Lease agreement, dated December 8, 2005, between the Company and Hamilton Business Center, LLC (Buford, Georgia facility) (incorporated by reference to the Company’s annual report on Form 10-K for the year ended December 31, 2005)
10.15
First Amendment, dated as of June 12, 2006, to the Lease Agreement between the Company and Hamilton Business Center, LLC (Buford, Georgia facility) (incorporated by reference to the Company’s annual report on Form 10-K for the year ended December 31, 2005)
10.16
First Amendment, dated as of February 1, 2006, to the Naperville Illinois Facility Lease between the Company and Ambassador Drive LLC (current landlord) (incorporated by reference to the Company’s annual report on Form 10-K for the year ended December 31, 2005)
10.17
Employment Agreement, dated as of January 17, 2007, between the Company and Lawrence P. Reinhold*(incorporated by reference to the Company’s annual report on Form 10-K for the year ended December 31, 2006).
10.18
Form of 2006 Stock Incentive Plan for Non-Employee Directors*(incorporated by reference to the Company’s annual report on Form 10-K for the year ended December 31, 2006).
10.19
Form of 2005 Employee Stock Purchase Plan* (incorporated by reference to the Company’s annual report on Form 10-K for the year ended December 31, 2006).
10.20
Second Amendment to Lease Agreement dated September 20, 1988 between the Company and Addwin Realty Associates (Port Washington facility) (incorporated by reference to the Company’s annual report on Form 10-K for the year ended December 31, 2007).
10.21
Asset Purchase Agreement between the Company and CompUSA dated January 5, 2008 (incorporated by reference to the Company’s annual report on Form 10-K for the year December 31, 2007).
10.22
Amendment to Asset Purchase Agreement between the Company and CompUSA dated February 14, 2008 (incorporated by reference to the Company’s annual report on Form 10-K for the year ended December 31, 2007).
Corporate Ethics Policy for Officers, Directors and Employees (revised as of March 30, 2005) (incorporated by reference to the Company’s report on Form 8-K dated March 30, 2005)
Subsidiaries of the Registrant (filed herewith)
Consent of Independent Registered Public Accounting Firm (filed herewith)
31.1
Certification of the Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2
Certification of the Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1
Certification of the Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2
Certification of the Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
99.1
Charter of the Audit Committee of the Company’s Board of Directors, as revised February 23, 2009 (filed herewith)
99.2
Charter of the Compensation Committee of the Company’s Board of Directors, as revised February 23, 2009 (filed herewith)
99.3
Charter of the Nominating/Corporate Governance Committee of the Company’s Board of Directors, as revised February 23, 2009 (filed herewith)
* Management contract or compensatory plan or arrangement
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
SYSTEMAX INC.
By: /s/ RICHARD LEEDS
Richard Leeds
Chairman and Chief Executive Officer
Date: March 18, 2009
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
Signature
Title
Date
/s/ RICHARD LEEDS
Chairman and Chief Executive Officer
March 18, 2009
Richard Leeds
(Principal Executive Officer)
/s/ BRUCE LEEDS
Vice Chairman and Director
March 18, 2009
Bruce Leeds
/s/ ROBERT LEEDS
Vice Chairman and Director
March 18, 2009
Robert Leeds
/s/ LAWRENCE P. REINHOLD
Executive Vice President, Chief Financial Officer
March 18, 2009
Lawrence P. Reinhold
and Director
(Principal Financial Officer)
/s/ THOMAS AXMACHER
Vice President and Controller
March 18, 2009
Thomas Axmacher
(Principal Accounting Officer)
/s/ GILBERT FIORENTINO
Chief Executive, Technology Products Group
March 18, 2009
Gilbert Fiorentino
and Director
/s/ ROBERT D. ROSENTHAL
Director
March 18, 2009
Robert D. Rosenthal
/s/ STACY DICK
Director
March 18, 2009
Stacy Dick
/s/ ANN R. LEVEN
Director
March 18, 2009
Ann R. Leven
Report of Independent Registered Public Accounting Firm
The Board of Directors and Shareholders of Systemax Inc.
We have audited the accompanying consolidated balance sheets of Systemax Inc. as of December 31, 2008 and 2007, and the related consolidated statements of operations, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2008. Our audits also included the financial statement schedule listed in the index at Item 15(a). These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Systemax Inc. at December 31, 2008 and 2007, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2008, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
As discussed in Note 8 to the consolidated financial statements, the Company adopted Financial Accounting Standards Board Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an Interpretation of FASB Statement No. 109 as of January 1, 2007.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Systemax Inc.’s internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 16, 2009 expressed an unqualified opinion thereon.
Report of Independent Registered Public Accounting Firm
The Board of Directors and Shareholders of Systemax Inc.
We have audited Systemax Inc.’s internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Systemax Inc.’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, Systemax Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2008 based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Systemax Inc. as of December 31, 2008 and 2007 and the related consolidated statements of operations, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2008 of Systemax Inc. and our report dated March 16, 2009 expressed an unqualified opinion thereon.
SYSTEMAX INC. CONSOLIDATED BALANCE SHEETS (in thousands, except for share data)
See notes to consolidated financial statements.
SYSTEMAX INC. CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
See notes to consolidated financial statements.
SYSTEMAX INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
See notes to consolidated financial statements.
SYSTEMAX INC. CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
(in thousands)
See notes to consolidated financial statements.
SYSTEMAX INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation - The accompanying consolidated financial statements include the accounts of Systemax Inc. and its wholly-owned subsidiaries (collectively, the “Company” or “Systemax”). All significant intercompany accounts and transactions have been eliminated in consolidation.
Reclassifications - Certain balances have been reclassified among current assets and current liabilities in prior year to conform to current year presentation on the consolidated balance sheets. Foreign exchange loss (gain) has been reclassified from selling, general and administrative expense to its own separate income statement account in prior years to conform to current year presentation on the consolidated statements of operations.
Use of Estimates In Financial Statements - The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates.
Fiscal Year - Effective the fourth quarter of 2007, the Company changed its fiscal year end from a calendar year ending on December 31 to a fiscal year ending at midnight on the Saturday closest to December 31. Fiscal years will typically include 52 weeks, but every few years will include 53 weeks which was the case in 2008. For clarity of presentation herein, all fiscal years are referred to as if they ended on December 31. The fiscal year will be divided into four fiscal quarters that each end at midnight on a Saturday. Fiscal quarters will typically include 13 weeks, but the fourth quarter will include 14 weeks in a 53 week fiscal year. For clarity of presentation herein, all fiscal quarters are referred to as if they ended on the traditional calendar month.
Foreign Currency Translation - The Company has operations in numerous foreign countries. The functional currency of each foreign country is the local currency. The financial statements of the Company’s foreign entities are translated into U.S. dollars, the reporting currency, using year-end exchange rates for assets and liabilities, average exchange rates for the statement of operations items and historical rates for equity accounts. Translation gains or losses are recorded as a separate component of shareholders’ equity.
Cash and Cash Equivalents - The Company considers amounts held in money market accounts and other short-term investments, including overnight bank deposits, with an original maturity date of three months or less to be cash equivalents.
Inventories - Inventories consist primarily of finished goods and are stated at the lower of cost or market value. Cost is determined by using the first-in, first-out method except in Europe and retail locations where an average cost is used. Allowances are maintained for obsolete, slow-moving and non-saleable inventory.
Property, Plant and Equipment - Property, plant and equipment is stated at cost. Depreciation of furniture, fixtures and equipment, including equipment under capital leases, are depreciated using the straight-line or accelerated method over their estimated useful lives ranging from three to ten years. Depreciation of buildings is on the straight-line method over estimated useful lives of 30 to 50 years. Leasehold improvements are amortized over the lesser of the useful lives or the term of the respective leases.
Evaluation of Long-lived Assets - Long-lived assets are evaluated for recoverability whenever events or changes in circumstances indicate that an asset may have been impaired. In evaluating an asset for recoverability, the Company estimates the future cash flows expected to result from the use of the asset and eventual disposition. If the sum of the expected future cash flows (undiscounted and without interest charges) is less than the carrying amount of the asset, an impairment loss, equal to the excess of the carrying amount over the fair market value of the asset is recognized.
Goodwill and intangible assets - Goodwill represents the excess of the cost of acquired assets over the fair value of assets acquired. The Company tests goodwill and indefinite lived intangibles for impairment annually or more frequently if indicators of impairment exist. In addition, goodwill is required to be tested for impairment after a portion of the goodwill is allocated to a business targeted for disposal. The Company’s identifiable intangible assets consist of trademarks, trade and domain names, retail leases and customer lists (See Note 2).
Accruals - Management makes estimates and assumptions that affect amounts reported in the consolidated financial statements and accompanying notes. These estimates are based upon various factors such as the number of units sold, historical and anticipated results and data received from third party vendors. Actual results could differ from these estimates. Our most significant estimates include those related to the costs of vendor drop shipments, sales returns and allowances, cooperative advertising and customer rebate reserves, and other vendor and employee related costs.
Product Warranties - Provisions for estimated future expenses relating to product warranties for the Company’s assembled PCs are recorded as cost of sales when revenue is recognized. Liability estimates are determined based on management judgment considering such factors as the number of units sold, historical and anticipated rates of warranty claims and the likely current cost of corrective action. The changes in accrued product warranties were as follows:
Income Taxes - Deferred tax assets and liabilities are recognized for the effect of temporary differences between the book and tax bases of recorded assets and liabilities and for tax loss carry forwards. The realization of net deferred tax assets is dependent upon our ability to generate sufficient future taxable income. Where it is more likely than not that some portion or of the deferred tax asset will not be realized, we have provided a valuation allowance. If the realization of those deferred tax assets in the future is considered more likely than not, an adjustment to the deferred tax assets would increase net income in the period such determination is made.
The Company provides for uncertain tax positions and related interest and penalties based upon management’s assessment of whether a tax benefit is more likely than not to be sustained upon examination by tax authorities. To the extent the Company prevails in matters for which a liability for an unrecognized tax benefit is established or is required to pay amounts in excess of the liability, the Company’s effective tax rate in a given financial statement period may be affected.
Revenue Recognition and Accounts Receivable - The Company recognizes sales of products, including shipping revenue, when persuasive evidence of an order arrangement exists, delivery has occurred, the sales price is fixed or determinable and collectability is reasonably assured. Generally, these criteria are met at the time the product is received by the customers when title and risk of loss have transferred. Allowances for estimated subsequent customer returns, rebates and sales incentives are provided when revenues are recorded. Costs incurred for the shipping and handling of its products are recorded as cost of sales. Revenue from extended warranty and support contracts on the Company’s assembled PCs is deferred and recognized over the contract period. The Company evaluates collectability of accounts receivable based on numerous factors, including past transaction history with customers and their credit rating and provides a reserve for accounts that are potentially uncollectible. Trade receivables are generally written off once all collection efforts have been exhausted. Accounts receivable are shown in the consolidated balance sheets net of allowances for doubtful collections and subsequent customer returns.
Advertising Costs - Expenditures for internet, television and local radio advertising are expensed in the period the advertising takes place. Catalog preparation, printing and postage expenditures are amortized over the period of catalog distribution during which the benefits are expected, generally one to six months.
Net advertising expenses were $40.0 million, $47.2 million and $37.4 million during 2008, 2007 and 2006, respectively and are included in the accompanying Consolidated Statements of Operations. The Company utilizes advertising programs to support vendors, including catalogs, internet and magazine advertising, and receives payments and credits from vendors, including consideration pursuant to volume incentive programs and cooperative marketing programs. The Company accounts for consideration from vendors as a reduction of cost of sales unless certain conditions are met showing that the funds are used for specific, incremental, identifiable costs, in which case the consideration is accounted for as a reduction in the related expense category, such as advertising expense. The amount of vendor consideration recorded as a reduction of selling, general and administrative expenses totaled $60.4 million, $42.6 million and $39.6 million during 2008, 2007 and 2006, respectively.
Prepaid expenses as of December 2008 and 2007 include deferred advertising costs of $4.1 million and $3.9 million which are reflected as an expense during the periods benefited, typically the subsequent fiscal quarter.
Stock based compensation - The Company records share-based payment awards exchanged for employee services at fair value on the date of grant and expenses the awards in the consolidated statement of operations over the requisite employee service period. Stock-based compensation expense includes an estimate for forfeitures and is recognized over the expected term of the award on a straight-line basis. The Company recorded, as a component of selling, general and administrative expenses, amortization of stock-based compensation of $3,220,000, $3,435,000, and $1,756,000 in 2008, 2007 and 2006, respectively. (See Note 7)
Net Income Per Common Share - Net income per common share basic is calculated based upon the weighted average number of common shares outstanding during the respective periods presented. Net income per common share diluted is calculated based upon the weighted average number of common shares outstanding and included the equivalent shares for dilutive securities outstanding during the respective periods, where the effect is anti-dilutive. The dilutive effect of outstanding options issued by the Company is reflected in net income per share - diluted using the treasury stock method. Under the treasury stock method, options will only have a dilutive effect when the average market price of common stock during the period exceeds the exercise price of the options. Equivalent common shares of 941,000, 1,087,000, and 989,000
in 2008, 2007 and 2006, respectively were included for the diluted calculation. The weighted average number of stock options outstanding excluded from the computation of diluted earnings per share was 622,000, 0, and 36,000 in 2008, 2007 and 2006, respectively due to their antidilutive effect.
Comprehensive Income - Comprehensive income consists of net income and foreign currency translation adjustments and is included in the Consolidated Statements of Shareholders’ Equity. Comprehensive income was $34,214,000, $74,011,000 and $51,435,000 in 2008, 2007 and 2006, respectively.
Employee Benefit Plans - The Company’s U.S. subsidiaries participate in a defined contribution 401(k) plan covering substantially all U.S. employees. Employees may invest 1% or more of their eligible compensation, limited to maximum amounts as determined by the Internal Revenue Service. The Company provides a matching contribution to the plan, determined as a percentage of the employees’ contributions. Aggregate expense to the Company for contributions to such plans was approximately $730,000, $614,000 and $514,000 in 2008, 2007 and 2006, respectively.
Fair Value of Financial Instruments - Financial instruments consist primarily of investments in cash and cash equivalents, trade accounts receivable, accounts payable and debt obligations. The Company estimates the fair value of financial instruments based on interest rates available to the Company and by comparison to quoted market prices. At December 31, 2008 and 2007, the carrying amounts of cash and cash equivalents, accounts receivable, income taxes receivable and payable and accounts payable are considered to be representative of their respective fair values due to their short-term nature.
Concentration of Credit Risk - Financial instruments that potentially subject the Company to concentrations of credit risk consist of cash, cash equivalents and accounts receivable. The Company’s excess cash balances are invested with money center banks such as Wachovia and JP Morgan Chase. Concentrations of credit risk with respect to accounts receivable are limited due to the large number of customers and their geographic dispersion comprising the Company’s customer base. The Company also performs on-going credit evaluations and maintains allowances for potential losses as warranted.
Recent Accounting Pronouncements
In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 157 “Fair Value Measurements”. This statement was issued to increase consistency and comparability in fair value measurements and for expanded disclosures about fair value measurements. Effective January 1, 2008 the Company adopted the provisions of SFAS No. 157, which did not have a material impact on the Company’s consolidated financial statements.
In February 2008, the FASB issued FASB Staff Position (“FSP”) FAS 157-2, which provides for a one-year deferral of the provisions of SFAS No. 157 until fiscal years beginning after December 15, 2008 for non-financial assets and liabilities that are recognized or disclosed at fair value in the consolidated financial statements on a non-recurring basis. The Company is currently evaluating the potential impact, if any, of FSP 157-2.
In April 2008, the FASB issued FSP FAS 142-3 “Determination of the Useful Life of Intangible Assets”. FSP FAS 142-3 amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under FASB Statement No. 142, Goodwill and Other Intangible Assets. The intent of this FSP is to improve the consistency between the useful life of a recognized intangible asset and the period of expected cash flows used to measure the fair value of the asset. The standard applies prospectively to intangible assets acquired and/or recognized on or after January 1, 2009. The Company is currently evaluating the impact, if any, the adoption of this FSP may have on the Company’s consolidated financial statements.
In June 2008, the FASB issued FASB Staff Position No. EITF 03-6-1 “Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities”. This FSP was issued to clarify that instruments granted in share-based payment transactions can be participating securities prior to the requisite service having been rendered. The guidance in this FSP applies to the calculation of Earnings Per Share (“EPS”) under Statement 128 for share-based payment awards with rights to dividends or dividend equivalents. Unvested share-based payment awards that contain non-forfeitable rights to dividends or dividend equivalents (whether paid or unpaid) are participating securities and shall be included in the computation of EPS pursuant to the two-class method. This FSP is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those years. All prior-period EPS data presented shall be adjusted retrospectively (including interim financial statements, summaries of earnings, and selected financial data) to conform with the provisions of this FSP. The Company does not expect the adoption of this FSP to have a material impact on its consolidated financial statements.
In December 2007, the FASB issued SFAS No. 141R, “Business Combinations,” which replaces FASB Statement 141. SFAS No.141R retains the requirement that the acquisition method of accounting be used for business combinations. The objective of SFAS No. 141R is to improve the relevance, representational faithfulness and comparability that reporting entities provide in their financial reports about business combinations and their effects. SFAS No. 141R establishes principles and requirements for how an acquirer 1) recognizes and measures identifiable assets acquired, the liabilities assumed and any non-controlling interest in the acquiree, 2) recognizes and measures the goodwill acquired in the combination or a gain from a bargain purchase and 3) determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination. SFAS No. 141R is effective for
annual periods beginning after December 15, 2008 and will be applied prospectively for all business combinations entered into after the date of adoption. The impact of SFAS No. 141R will depend on the nature and terms of any future business combinations, if any.
In December 2007, the FASB issued SFAS No. 160, “Accounting and Reporting of Non-controlling Interest”. The objective of SFAS No. 160 is to improve the relevance, comparability and transparency of the financial information that reporting entities provide related to non-controlling interests, sometimes referred to as minority interests. SFAS No. 160 requires, among other things, that non-controlling interests be shown separately in the consolidated entity’s equity section of the balance sheet. SFAS No. 160 also establishes accounting and reporting standards for ownership interest in subsidiaries held by parties other than the parent, for presentation of amounts of consolidated net income attributable to the parent and the non-controlling interest, for consistency in accounting for changes in a parent’s ownership interest when the parent retains a controlling interest, for the valuation of retained non-controlling equity interests when a subsidiary is deconsolidated and for providing sufficient disclosure that identifies and distinguishes the interests of the parent and the interests of the non-controlling owners. SFAS No. 160 is effective beginning January 1, 2009. The Company does not expect the adoption of SFAS No.160 to have a material impact on its consolidated financial statements.
2. ACQUISITION
On January 5, 2008, the Company, through various subsidiaries, entered into an asset purchase agreement with CompUSA Inc., a Delaware corporation. Pursuant to the Purchase Agreement, the Company acquired certain assets and liabilities related to the e-commerce business of CompUSA Inc., certain intellectual property rights owned by CompUSA, and the E-Commerce Business for $18.9 million in cash. The Company completed its acquisition of the E-Commerce Business on January 10, 2008. Pursuant to the Purchase Agreement, the Company also acquired sixteen retail leases from CompUSA Inc. and certain fixtures located at these locations. The closing of the acquisition of each lease was subject to the receipt of the consent of the landlord, if required, under the terms of a lease. During February and March 2008 the Company completed the acquisition of these 16 store leases and fixtures for an aggregate purchase price of approximately $11.7 million. This acquisition accelerated the Company’s planned expansion into the retail market place in North America and Puerto Rico. A final purchase price allocation based on the fair market value of acquired assets has been completed and the Company has recorded assets of approximately $17.0 million for Trademarks and Trade Names, $8.0 million for Domain Names, $3.4 million for Retail Store Leases, $0.4 million for Client Lists, $0.9 million for fixed assets and $0.9 million for Goodwill. These assets were recorded in the Company’s Technology Products business segment. The Company expects to amortize its Retail Store Leases over the remaining weighted average life of the leases, 12.9 years, the Client Lists over a 5 year period and depreciate its fixed assets over a similar period. All other intangible assets are indefinite lived. All of the Company’s goodwill at December 31, 2008 is deductible for tax purposes on a straight line basis over 15 years. The gross carrying amount and accumulated amortization for amortizable intangible assets at December 31, 2008 was as follows (in thousands):
The aggregate amortization expense was approximately $0.3 million in 2008. The estimated amortization for future years ending December 31 is as follows (in thousands):
3. PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment, net consist of the following (in thousands):
Included in property, plant and equipment are assets under capital leases, as follows (in thousands):
Depreciation charged to operations for property, plant and equipment in 2008, 2007, and 2006 was $10.1 million, $8.8 million and $8.2 million, respectively.
4. CREDIT FACILITIES
The Company maintains a revolving credit agreement with a group of financial institutions at an amount of $120 million (which may be increased by up to $30 million, subject to certain conditions). The borrowings are secured by all of the domestic and United Kingdom accounts receivable, the domestic inventories of the Company, the Company’s United Kingdom headquarters building and the Company’s shares of stock in its domestic and United Kingdom subsidiaries. The credit facility expires and outstanding borrowings thereunder are due on October 26, 2010. The borrowings under the agreement are subject to borrowing base limitations of up to 85% of eligible accounts receivable and up to 40% of qualified inventories. The interest on outstanding advances is payable monthly, at the Company’s option, at the agent bank’s base rate (at December 31, 2008) plus 0.25% or the bank’s daily LIBOR rate (at December 31, 2008) plus 1.25% to 2.25%. The undrawn availability under the facility may not be less than $15 million until the last day of any month in which the availability net of outstanding borrowings is at least $70 million. The facility also calls for a commitment fee payable quarterly in arrears of 0.375% of the average daily unused portions of the facility. The revolving credit agreement requires that a minimum level of availability be maintained. If such availability is not maintained, the Company will be required to maintain a fixed charge coverage ratio (as defined). The agreement contains certain other covenants, including restrictions on capital expenditures and payments of dividends. We were in compliance with all of the covenants as of December 31, 2008. As of December 31, 2008, eligible collateral under the agreement was $103.5 million and total availability was $94.4 million. There were outstanding letters of credit of $9.1 million and there were no outstanding advances.
The Company’s Netherlands subsidiary maintained a 5 million credit facility with a local financial institution. Borrowings under the facility were secured by the subsidiary’s accounts receivable and are subject to a borrowing base limitation of 85% of the eligible accounts. The facility expired during 2008. At December 31, 2007 there was 2.6 million ($3.9 million) of borrowings outstanding under this line with interest payable at a rate of 7.05%.
The weighted average interest rate on short-term borrowings was 5.1%, 7.5%, and 7.8% in 2008, 2007 and 2006.
5. ACCRUED EXPENSES AND OTHER CURRENT LIABILITIES
Accrued expenses and other current liabilities consist of the following (in thousands):
6. LONG-TERM DEBT
Long-term debt consists of (in thousands):
The aggregate maturities of long-term debt outstanding at December 31, 2008 are as follows (in thousands):
7. SHAREHOLDERS’ EQUITY
Stock based compensation plans
The Company currently has four equity compensation plans which reserve shares of common stock for issuance to key employees, directors, consultants and advisors to the Company. The following is a description of these plans:
The 1995 Long-term Stock Incentive Plan - This plan, adopted in 1995, allowed the Company to issue qualified, non-qualified and deferred compensation stock options, stock appreciation rights, restricted stock and restricted unit grants, performance unit grants and other stock based awards authorized by the Compensation Committee of the Board of Directors. Options issued under this plan expire ten years after the options are granted. The ability to grant new awards under this plan ended on December 31, 2005 but awards granted prior to such date continue until their expiration. A total of 762,688 options were outstanding under this plan as of December 31, 2008.
The 1995 Stock Option Plan for Non-Employee Directors - This plan, adopted in 1995, provides for automatic awards of non-qualified options to directors of the Company who are not employees of the Company or its affiliates. All options granted under this plan will have a ten year term from grant date and are immediately exercisable. A maximum of 100,000 shares may be granted for awards under this plan. The ability to grant new awards under this plan ended on October 12, 2006 but awards granted prior to such date continue until their expiration. A total of 39,000 options were outstanding under this plan as of December 31, 2008.
The 1999 Long-term Stock Incentive Plan, as amended (“1999 Plan”) - This plan was adopted on October 25, 1999 with substantially the same terms and provisions as the 1995 Long-term Stock Incentive Plan. The Company increased the number of shares that may be granted under this plan to a maximum of 7.5 million from 5.0 million shares. The maximum number of shares granted per type of award to any individual may not exceed 1,500,000 in any calendar year and 3,000,000 in total. The Company extended the expiration date under this plan that no grants shall be granted under this plan after December 31, 2010. The original date was after December 31, 2009. Restricted stock grants and common stock awards reduce stock options otherwise available for future grant. A total of 1,385,896 options and 600,000 restricted stock units were outstanding under this plan as of December 31, 2008.
The 2006 Stock Incentive Plan For Non-Employee Directors - This plan, adopted by the Company’s stockholders on October 11, 2006, replaces the 1995 Stock Option Plan for Non-Employee Directors. The Company adopted the plan so that it could offer directors of the Company who are not employees of the Company or of any entity in which the Company has more than a 50% equity interest (“independent directors”) an opportunity to participate in the ownership of the Company by receiving options to purchase shares of common stock at a price equal to the fair market value at the date of grant of the option and restricted stock awards. Awards for a maximum of 200,000 shares may be granted under this plan. A total of 15,000 options were outstanding under this plan as of December 31, 2008.
Shares issued under our share-based compensation plans are usually issued from shares of our common stock held in the treasury.
Adoption of SFAS 123(R)
Effective January 1, 2006, the Company adopted the provisions of SFAS 123(R), using the modified-prospective-transition method. Under that transition method, compensation cost recognized for the year ended December 31, 2006 includes: (a) compensation cost for all share-based payments granted prior to, but not yet vested as of January 1, 2006, based on the grant-date fair value estimated in accordance with the original provisions of SFAS 123, and (b) compensation cost for the vested portion of share-based payments granted subsequent to January 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of SFAS 123(R).
The fair value of employee share options is recognized in expense over the vesting period of the options, using the graded attribution method. The fair value of employee share options is determined on the date of grant using the Black-Scholes option pricing model. The Company has used historical volatility in its estimate of expected volatility. The expected life represents the period of time (in years) for which the options granted are expected to be outstanding. The Company used the simplified method for determining expected life as permitted in SEC Staff Accounting Bulletin 107 for options qualifying for treatment (“plain-vanilla” options) due to the limited history the Company currently has with option exercise activity. The risk-free interest rate is based on the U.S. Treasury yield curve.
Compensation cost related to non-qualified stock options recognized in operating results (selling, general and administrative expense) for 2008, 2007 and 2006 was $3,220,000, $3,435,000, and $1,756,000 respectively. The related future income tax benefits recognized for 2008, 2007 and 2006 were $1,219,000, $1,147,000 and $599,000, respectively.
Stock options
The following table presents the weighted-average assumptions used to estimate the fair value of options granted in 2008, 2007 and 2006:
The following table summarizes information concerning outstanding and exercisable options:
The total intrinsic value of options exercised and share based payments made was $4,088,000, $6,517,000 and $3,501,000, respectively, for 2008, 2007 and 2006.
The following table summarizes information about options vested and exercisable or nonvested that are expected to vest (nonvested outstanding less expected forfeitures) at December 31, 2008:
The aggregate intrinsic value in the tables above represents the total pretax intrinsic value (the difference between the closing stock price on the last day of trading in 2008 and the exercise price) that would have been received by the option holders had all options been exercised on December 31, 2008. This value will change based on the fair market value of the Company’s common stock.
The following table reflects the activity for all unvested stock options during 2008:
At December 31, 2008, there was approximately $2,810,000 of unrecognized compensation costs related to unvested stock options, which is expected to be recognized over a weighted average period of 1.21 years. The total fair value of stock options vested during 2008, 2007 and 2006 was $2,981,000, $671,000 and $1,502,000, respectively.
Restricted Stock and Restricted Stock Units
In October 2004, the Company granted 1,000,000 restricted stock units under the 1999 Plan to a key employee who is also a Company director. A restricted stock unit represents the right to receive a share of the Company’s common stock. The restricted stock units have none of the rights as other shares of common stock until common stock is distributed, other than rights to cash dividends. The restricted stock unit award was a non-performance award which vests at the rate of 20% on May 31, 2005 and 10% per year on April 1, 2006 and each year thereafter. The share-based expense for restricted stock awards was determined based on the market price of the Company’s stock at the date of the award. Compensation expense related to the restricted stock award was approximately $574,000 in each of 2008, 2007 and 2006. Share-based compensation expense for restricted stock issued to Directors was $75,000 in each of 2008, 2007 and 2006.
Share repurchase plan
In May 2008, the Company’s Board of Directors authorized the repurchase of up to 2,000,000 shares of the Company’s common stock. During 2008 the Company repurchased 475,301 common shares at a cost of approximately $5.8 million, an average of $12.25 per share. Theses shares are included in Common stock in treasury at cost in the Company’s consolidated balance sheet.
8. INCOME TAXES
The components of income before income taxes are as follows (in thousands):
The provision for income taxes consists of the following (in thousands):
Income taxes are accrued and paid by each foreign entity in accordance with applicable local regulations.
A reconciliation of the difference between the income tax expense and the computed income tax expense based on the Federal statutory corporate rate is as follows (in thousands):
The deferred tax assets and liabilities are comprised of the following (in thousands):
The Company has not provided for federal income taxes applicable to the undistributed earnings of its foreign subsidiaries of approximately $39.6 million as of December 31, 2008, since these earnings are considered indefinitely reinvested. The Company has foreign net operating loss carryforwards which expire through 2022 except for carryforwards in the United Kingdom which have no expiration. The Company records these benefits as assets to the extent that utilization of such assets is more likely than not; otherwise, a valuation allowance has been recorded. The Company has also provided valuation allowances for certain state deferred tax assets and net operating loss carryforwards where it is not likely they will be realized.
In the fourth quarter of 2007 the Company’s United Kingdom subsidiary emerged from its cumulative loss position and the previously established valuation allowance against the deferred tax assets of the United Kingdom of approximately $5.9 million was reversed. In the fourth quarter of 2007 the Company recorded a valuation allowance of approximately $1.7 million against the deferred tax assets of its German subsidiary as the result of the German subsidiary entering a cumulative loss position and uncertainty as to whether or not future earnings will be sufficient to enable utilization of those assets.
As of December 31, 2008, the valuation allowances of approximately $8.4 million related to net operating loss carryforwards in foreign jurisdictions of $6.4 million, $2.0 million for state net operating loss carryforwards and $0.2 million for other state deductible temporary differences. During 2008, valuation allowances increased $1.4 million as a
result of additional losses incurred in foreign and state jurisdictions. Valuation allowances decreased $.7 million in 2008 for carryforward losses utilized for which valuation allowances had been previously provided. As of December 31, 2007, the valuation allowances of $7.4 million included $6.0 million related to net operating loss carryforwards in foreign jurisdictions, $1.2 million for state net operating loss carryforwards and $0.2 million for other state deductible temporary differences. During 2007, valuation allowances decreased $10.5 million primarily as a result of the reversal of the valuation allowance in the United Kingdom, utilization of net operating losses and timing differences in the United Kingdom and utilization of state net operating loss deductions in the United States. During 2006, valuation allowances increased $2.6 million as a result of additional losses incurred in certain state jurisdictions and adjustments of prior year’s allowances in foreign jurisdictions.
The Company is routinely audited by federal, state and foreign tax authorities with respect to its income taxes. The Company regularly reviews and evaluates the likelihood of audit assessments and believes it has adequately accrued for exposures for tax liabilities resulting from future tax audits. To the extent the Company would be required to pay amounts in excess of reserves or prevail on matters for which accruals have been established, the Company’s effective tax rate in a given period may be materially impacted. The Company’s federal income tax returns for fiscal years 2005 and 2006 are currently under audit by the Internal Revenue Service. The Company does not expect the outcome of the audit to have a material impact on the Company’s consolidated financial statements. The Company has not signed any consents to extend the statute of limitations for any subsequent years. The Company’s significant state tax returns have been audited through 2005. The Company considers its significant tax jurisdictions in foreign locations to be the United Kingdom, Canada, France, Italy and Germany. The Company remains subject to examination in the United Kingdom for years after 2001, in
Canada for years after 2000, in France for years after 2004, in Italy for years after 2002. Audits are currently ongoing in the Netherlands for 2006 and in Germany for 2005 and 2006.
Effective January 1, 2007, the Company adopted the provisions of FASB Interpretation 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”). FIN 48 clarifies the accounting and reporting for uncertainties in income tax law. This interpretation prescribes a comprehensive model for the financial statement recognition, measurement, presentation and disclosure of uncertain tax positions taken or expected to be taken in income tax returns. For those benefits to be recognized, a tax position must be more-likely-than-not to be sustained upon examination by taxing authorities. At January 1, 2007, the Company had a liability for unrecognized tax benefits of $3,379,000 (including interest and penalties of $731,000) of which $283,000 was charged to retained earnings at January 1, 2007. Of this total, $2,586,000 (net of the federal benefit on state issues) represents the amount of unrecognized tax benefits that, if recognized, would favorably affect the effective income tax rate in any future periods. At December 31, 2007 the Company had a liability for unrecognized tax benefits of $1,547,000 (including interest and penalties of $631,000). Of this total, $1,467,000 (net of the federal benefit on state issues) represents the amount of unrecognized tax benefits that, if recognized, would favorably affect the effective income tax rate in any future periods. The following table details activity of the Company’s uncertain tax positions during 2008 and 2007:
Interest and penalties of approximately $46,000 and $69,000 related to unrecognized tax benefits were expensed in 2008 and 2007 and are included in income tax expense. Additionally, included in income tax expense in 2008 is an interest and penalty reserves reversal of approximately $399,000 related to a state tax audit that was settled favorably. Within the next twelve months the Company believes it reasonably possible that these tax positions, related to foreign tax audits, will be reduced.
9. COMMITMENTS, CONTINGENCIES AND OTHER MATTERS
Leases - The Company is obligated under operating lease agreements for the rental of certain office and warehouse facilities and equipment which expire at various dates through September 2026. The Company currently leases its headquarters office/warehouse facility in New York from an entity owned by the Company’s three principal shareholders and senior executive officers. The Company believes that these payments were no higher than would be paid to an unrelated lessor for comparable space. The Company also acquires certain computer and communications equipment pursuant to capital lease obligations.
At December 31, 2008, the future minimum annual lease payments for capital leases and related and third-party operating leases were as follows (in thousands):
Annual rent expense aggregated approximately $24,993,000, $14,760,000 and $13,198,000 in 2008, 2007 and 2008, respectively. Included in rent expense was $860,000, $612,000, and $612, 000 in 2008, 2007 and 2006, respectively, to related parties.Rent expense is net of sublease income of $355,000, $853,000 and $937,000 for 2008, 2007 and 2006, respectively.
Litigation -
Kevin Vukson v. TigerDirect, Inc., OnRebate.com Inc. and Systemax Inc.
On October 18, 2007, Kevin Vukson filed a class action complaint in U.S. District Court (E.D.N.Y.) against TigerDirect, Inc., OnRebate.com Inc. and Systemax Inc. on behalf of himself and all OnRebate customers whose rebates were denied or delayed. (OnRebate.com Inc. is a rebate processing company owned by Systemax.) Vukson’s Complaint alleges that since 2004 Systemax, TigerDirect and OnRebate have conducted a deceptive and unlawful enterprise by failing to pay rebates that should have been paid and delaying unnecessarily the payment of other rebates that were paid. Vukson alleges claims arising under Florida’s Unfair, Deceptive Trade Practice Act, the federal RICO statute, along with claims for breach of contract, conspiracy to commit fraud and unjust enrichment. On February 11, 2009 the Court dismissed Vukson’s complaint with leave to file an amended complaint by February 19, 2009 but ordered that any amended complaint not include a request for punitive damages. On February 19, 2009 Vukson filed an amended complaint with no request for punitive damages, as ordered by the Court. The Company intends to vigorously defend this case.
State of Florida, Office of the Attorney General Subpoena
On January 2, 2008 the Company received a subpoena for documents from the Florida Attorney General’s Office relating to the payment and processing of rebates by the Company. The Company received subpoenas for additional documents on January 30, 2008 and on August 25, 2008. The Company is cooperating with the Florida Attorney General’s investigation and has provided a substantial number of documents in response to the subpoenas.
Other matters
The Company has also been named as a defendant in other lawsuits in the normal course of its business, including those involving commercial, tax, employment and intellectual property related claims. Based on discussions with legal counsel, management believes the ultimate resolution of these lawsuits will not have a material effect on the Company’s consolidated financial statements.
10. SEGMENT AND RELATED INFORMATION
The Company operates and is internally managed in three operating segments, Technology Products, Industrial Products and Software Solutions. The Company’s chief operating decision-maker is the Company’s Chief Executive Officer. The Company evaluates segment performance based on income from operations before net interest, foreign exchange gains and losses, restructuring and other charges and income taxes. Corporate costs not identified with the disclosed segments and restructuring and other charges are grouped as “Corporate and other expenses.” The chief operating decision-maker reviews assets and makes significant capital expenditure decisions for the Company on a consolidated basis only. The accounting policies of the segments are the same as those of the Company described in Note 1.
Financial information relating to the Company’s operations by reportable segment was as follows (in thousands):
Financial information relating to the Company’s operations by geographic area was as follows (in thousands):
Net sales are attributed to countries based on location of selling subsidiary.
11. QUARTERLY FINANCIAL DATA (UNAUDITED)
Quarterly financial data is as follows (in thousands, except for per share amounts):
(1) During the fourth quarter of 2007 the Company recorded a write down of certain assets in Europe of approximately $6.7 million and a reversal of certain liabilities in a domestic location of approximately $3.9 million.
SYSTEMAX INC.
SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
For the years ended December:
(in thousands)
(1) Charges to expense are net of reductions resulting from changes in deferred tax assets due to changes in tax laws.