ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
The following discussion and analysis of financial condition and results of operations of Manchester should be read in conjunction with our condensed consolidated financial statements and notes thereto included elsewhere in this Quarterly Report on Form 10-Q and with our Annual Report on Form 10-K. This discussion and analysis contains certain forward-looking statements within the meaning of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, which are not historical facts, and involve risks and uncertainties that could cause actual results to differ materially from the results anticipated in those forward-looking statements. These risks and uncertainties include, but are not limited to, those set forth below, those set forth in the Company's Annual Report on Form 10-K for the year ended July 31, 2000, and those set forth in the Company's other filings from time to time with the Securities and Exchange Commission.
General
We are an integrator and reseller of computer hardware, software and networking products, primarily for commercial customers. We offer our customers single-source solutions customized to their information systems needs by integrating analysis, design and implementation services with hardware, software, networking products and peripherals from leading vendors. To date, most of our revenue has been derived from product sales. We generally do not develop or sell software products. However, certain computer hardware products sold by us are loaded with prepackaged software products.
The computer industry is characterized by a number of potentially adverse business conditions, including pricing pressures, evolving distribution channels, market consolidation and a potential decline in the rate of growth in sales of personal computers. Heightened price competition among various hardware manufacturers may result in reduced per unit revenue and declining gross profit margins. As a result of the intense price competition within our industry, we have experienced increasing pressure on our gross profit and operating margins with respect to our sale of products. Our inability to compete successfully on the pricing of products sold, or a continuing decline in gross margins on products sold due to adverse industry conditions or competition, may have a material adverse effect on our business, financial condition and results of operations.
An integral part of our strategy is to increase our value-added services revenue. These services generally provide higher operating margins than those associated with the sale of products. This strategy requires us, among other things, to attract and retain highly skilled technical employees in a competitive labor market, provide additional training to our sales representatives and enhance our existing service management system. We can't predict whether we will be successful in increasing our focus on providing value-added services, and the failure to do so may have a material adverse effect on our business, results of operations and financial condition.
Our strategy also includes expanding our presence in the New York metropolitan area by increasing our sales and service capabilities in our New York City office and enlarging our sales, service and training capabilities at our Long Island headquarters as well as expanding geographically into growing business centers in the eastern half of the United States. We can't assure you that the expansion of our New York metropolitan area operations will increase profits generated by such operations, that the opening of new offices will prove profitable, or that these expansion plans will not substantially increase future capital expenditures or other expenditures. The failure of this component of our strategy may materially adversely affect our business, results of operations and financial condition.
To date, our success has been based primarily upon sales in the New York Metropolitan area. Our strategy, encompassing the expansion of service offerings, the expansion of existing offices and the establishment of new regional offices, has challenged and will continue to challenge our senior management and infrastructure. We can't predict our ability to respond to these challenges. If we fail to effectively manage our planned growth, there may be a material adverse effect on our business, results of operations and financial condition.
In addition, the success of our strategy depends in large part upon our ability to attract and retain highly skilled technical personnel and sales representatives, including independent sales representatives, in a very competitive labor market. Our ability to grow our service offerings has been somewhat limited by a shortage of qualified personnel, and we can't assure you that we will be able to attract and retain such skilled personnel and representatives. The loss of a significant number of our existing technical personnel or sales representatives, difficulty in hiring or retaining additional technical personnel or sales representatives, or reclassification of our sales representatives as employees may have a material adverse effect on our business, results of operations and financial condition.
The computer industry is characterized by intense competition. We directly compete with local, regional and national systems integrators, value-added resellers and distributors as well as with certain computer manufacturers that market through direct sales forces and/or the Internet. The computer industry has recently experienced a significant amount of consolidation through mergers and acquisitions, and manufacturers of personal computers may increase competition by offering a range of services in addition to their current product and service offerings. In the future, we may face further competition from new market entrants and possible alliances between existing competitors. In addition, certain suppliers and manufacturers may choose to market products directly to end users through a direct sales force and/or the Internet rather than or in addition to channel distribution, and may also choose to market services, such as repair and configuration services, directly to end users. Some of our competitors have or may have, greater financial, marketing and other resources, and may offer a broader range of products and services, than us. As a result, they may be able to respond more quickly to new or emerging technologies or changes in customer requirements, benefit from greater purchasing economies, offer more aggressive hardware and service pricing or devote greater resources to the promotion of their products and services. We may not be able to compete successfully in the future with these or other current or potential competitors.
Our business is dependent upon our relationships with major manufacturers and distributors in the computer industry. Many aspects of our business are affected by our relationships with major manufacturers, including product availability, pricing and related terms, and reseller authorizations. The increasing demand for personal computers and ancillary equipment has resulted in significant products shortages from time to time, because manufacturers have been unable to produce sufficient quantities of certain products to meet demand. We can't predict that manufacturers will maintain an adequate supply of these products to satisfy all the orders of our customers or that, during periods of increased demand, manufacturers will provide products to us, even if available, or at discounts previously offered to us. In addition, we can't assure you that the pricing and related terms offered by major manufacturers will not adversely change in the future. Our failure to obtain an adequate supply of products, the loss of a major manufacturer, the deterioration of our relationship with a major manufacturer or our inability in the future to develop new relationships with other manufacturers may have a material adverse effect on our business, financial condition and results of operations.
Certain manufacturers offer market development funds, cooperative advertising and other promotional programs to systems integrators, distributors and computer resellers. We rely on these funds for many of our advertising and promotional campaigns. In recent years, manufacturers have generally reduced their level of support with respect to these programs, which has required us to increase spending of our own funds to obtain the same level of advertising and promotion. If manufacturers continue to reduce their level of support for these programs, or discontinue them altogether, we would have to further increase our advertising and promotion spending, which may have a material adverse effect on our business, financial condition and results of operations.
Our profitability has been affected by our ability to obtain volume discounts from certain manufacturers, which has been dependent, in part, upon our ability to sell large quantities of products to computer resellers, including value added resellers. Our sales to resellers have been made at profit margins generally less favorable than our sales directly to commercial customers. Our inability to sell products to computer resellers and thereby obtain the desired volume discounts from manufacturers or to expand our sales to commercial customers sufficiently to offset our need to rely on sales to computer resellers may have a material adverse effect on our business, financial conditions and results of operations.
The markets for our products and services are characterized by rapidly changing technology and frequent introduction of new hardware and software products and services. This may render many existing products and services noncompetitive, less profitable or obsolete. Our continued success will depend on our ability to keep pace with the technological developments of new products and services and to address increasingly sophisticated customer requirements. Our success will also depend upon our abilities to address the technical requirements of our customers arising from new generations of computer technologies, to obtain these new products from present or future suppliers and vendors at reasonable costs, to educate and train our employees as well as our customers with respect to these new products or services and to integrate effectively and efficiently these new products into both our internal systems and systems developed for our customers. We may not be successful in identifying, developing and marketing product and service developments or enhancements in response to these technological changes. Our failure to respond effectively to these technological changes may have a material adverse effect on our business, financial condition and results of operations.
Rapid product improvement and technological change characterize the computer industry. This results in relatively short product life cycles and rapid product obsolescence, which can place inventory at considerable valuation risk. Certain of our suppliers provide limited price protection to us, which is intended to reduce the risk of inventory devaluation due to price reductions on current products. Certain of our suppliers also provide stock balancing to us pursuant to which we are able to return unsold inventory to a supplier as a partial credit against payment for new products. There are often restrictions on the dollar amount of inventory that we can return at any one time. Price protection and stock balancing may not be available to us in the future, and, even if available, these measures may not provide complete protection against the risk of excess or obsolete inventories. During fiscal 2000, certain manufacturers reduced the period for which they provide price protection and stock balancing rights. Although we maintain a sophisticated proprietary inventory management system, we can't assure you that we will continue to successfully manage our existing and future inventory. Our failure to successfully manage our current or future inventory may have a material adverse effect on our business, financial conditions and results of operations.
Our strategy envisions that part of our future growth will come from making acquisitions consistent with our strategy. There can be no assurance that we will be able to identify suitable acquisition candidates and, once identified, to negotiate successfully their acquisition at a price or on terms and conditions favorable to us, or to integrate the operations of such acquired businesses with our operations. Certain of these acquisitions may be of significant size and may include assets that are outside our geographic territories or are ancillary to our core business strategy.
Our quarterly revenue and operating results have varied significantly in the past and are expected to continue to do so in the future. Quarterly revenue and operating results generally fluctuate as a result of the demand for our products and services, the introduction of new hardware and software technologies with improved features, the introduction of new services by us and our competitors, changes in the level of our operating expenses, competitive conditions and economic conditions. In particular, we have increased certain of our fixed operating expenses, including a significant increase in personnel, as part of our strategy to increase our focus on providing systems integration and other higher margin and value added services. As a result, we believe that period-to-period comparisons of our operating results should not be relied upon as an indication of future performance. In addition, the results of any quarterly period are not necessarily indicative of results to be expected for a full fiscal year.
As a result of the rapid changes which are taking place in computer and networking technologies, product life cycles are short. Accordingly, our product offerings change constantly. Prices of products change with generally higher prices early in the life cycle of the product and lower prices near the end of the product's life cycle. The computer industry has experienced rapid declines in average selling prices of personal computers. In some instances, we have been able to offset these price declines with increases in units shipped. There can be no assurance that average selling prices will not decline or that we will be able to offset declines in average selling prices with increases in units shipped.
Most of the personal computers we sell utilize operating systems developed by Microsoft Corporation. The United States Department of Justice has brought a successful antitrust action against Microsoft, which could delay the introduction and distribution of Microsoft products. The potential unavailability of Microsoft products could have a material adverse effect on our business, results of operations and financial condition.
We lease certain warehouses and offices from entities that are owned or controlled by our majority shareholder. Each of the leases with related parties has been amended effective with the closing of our initial public offering in December 1996 to reduce the rent payable under that lease to then current market rates.
Results of Operations
The following table sets forth, for the periods indicated, information derived from our Condensed Consolidated Statements of Income expressed as a percentage of related revenue or total revenue.
Percentage of Revenues
Three Months Ended
October 31,
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2000 1999
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Product Sales ................ 98.0% 97.1%
Services ..................... 2.0 2.9
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Total revenue ........... 100.0 100.0
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Cost of Product Sales ........ 88.4 85.6
Cost of Services ............. 67.9 69.6
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Cost of revenue ......... 88.0 85.1
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Product Gross Profit ......... 11.6 14.4
Services Gross Profits ....... 32.1 30.4
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Gross Profit ............ 12.0 14.9
Selling, general and
administrative expenses ... 10.9 12.3
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Income from operations ....... 1.1 2.6
Interest and other income, net 0.2 0.2
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Income before income taxes ... 1.3 2.8
Provision for income taxes ... 0.5 1.1
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Net income ................... 0.8% 1.7%
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Three Months Ended October 31, 2000 Compared to Three Months Ended October 31, 1999
Revenue.
Our revenue increased $15.8 million (24.1%) from $65.4 million for the three months ended October 31, 1999 to $81.1 million for the three months ended October 31, 2000. Product revenue increased by $16.1 million (25.3%) due primarily to increases in shipments of monitors and displays as well as increases in shipments of computers partially offset by lower average selling prices for personal computers. Service revenue decreased $285,000 (14.9%) due primarily to lower revenues generated by our permanent and temporary staffing division.
Gross Profit. Cost of revenue includes the direct costs of products sold, freight and the personnel costs associated with providing technical services, offset in part by certain market development funds provided by manufacturers. All other operating costs are included in selling, general and administrative expenses. Gross profit increased $14,000 (0.1%) from $9.7 million for the first quarter of fiscal 1999 to $9.8 million for the most recent fiscal quarter. Gross profit from the sale of products increased by $73,000 while gross profit from the sale of services decreased by $59,000. The changes in gross profit primarily result from the changes in revenue discussed above. As a percentage of revenue, gross profit decreased to 12.0% in the first quarter of fiscal 2001 as compared to 14.9% in fiscal 2000. Increased competitive pressures, changes in types of products and services sold, reductions in volume incentives available from manufacturers all contributed to the reduction in gross profit margins despite the increase in revenues discussed above.
Selling, General and Administrative Expenses. Selling, general and administrative expenses increased $866,000 or 10.8% from $8.0 million in the first quarter of fiscal 2000 to $8.9 million in the first quarter of fiscal 2001. This increase is principally a result of higher salaries, personnel and commission costs as well as higher bad debt expense and depreciation and amortization expense partially offset by lower insurance costs.
Interest and Investment Income.Interest and investment income increased by $78,000 due to higher cash balances available for investments as well as higher interest rates.
Provision for Income Taxes. The effective income tax rate decreased slightly to 40.3% of pretax income in the current period compared to 41.0% of pretax income in the prior year’s period.
Liquidity and Capital Resources
Our primary sources of financing have been internally generated working capital from profitable operations and a line of credit from financial institutions.
For the three months ended October 31, 2000, cash used in operating activities was $5.9 million consisting primarily of increases in inventory and, a decrease in accounts payable and accrued expenses, partially offset by net income, depreciation and amortization and a decrease in prepaid income taxes. Our accounts receivable and accounts payable and accrued expenses, balances as well as our investment in inventory can fluctuate significantly from one period to the next due to the receipt of large customer orders or payments or variations in product availability and vendor shipping patterns at any particular date. Generally, our experience is that increases in accounts receivable, inventory and accounts payable and accrued expenses will coincide with growth in revenue and increased operating levels. In addition, during the three months ended October 31, 2000 we used approximately $207,000 for capital expenditures, and $574,000 to repurchase and retire common stock.
We have an available line of credit with financial institutions in the aggregate amount of $15.0 million. No amounts were outstanding under this line as of October 31, 2000.
We believe that our current balances in cash and cash equivalents, expected cash flows from operations and available borrowings under the line of credit will be adequate to support current operating levels for the foreseeable future, specifically through at least the end of fiscal 2001. We currently have no material commitments for capital expenditures. Future capital requirements include those for the growth of working capital items such as accounts receivable and inventory and the purchase of equipment and expansion of facilities as well as the possible opening of new offices and potential acquisitions.
New Accounting Pronouncements
Effective August 1, 2000, we implemented t he provisions of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended. The adoption of this new standard did not have a material impact on our consolidated financial statements.
PART II - OTHER INFORMATION
Item 6. Exhibits and Reports
(a) Exhibits
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Exhibit No. Description
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27 Financial Data Schedule
(b) Reports on Form 8-K
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None
MANCHESTER EQUIPMENT CO., INC.
Signatures
Pursuant to the requirements 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.
MANCHESTER EQUIPMENT CO., INC. BR>.
(Registrant)
DATE: December 12, 2000 /s/ Barry Steinberg
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Barry Steinberg
President and Chief Executive Officer
DATE: December 12, 2000 /s/ Joseph Looney
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Joseph Looney
Chief Financial Officer
