UNITED STATES SECURITIES AND EXCHANGE COMMISSIONWASHINGTON, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2006
or
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from ____________ to _____________
COMMISSION FILE NUMBER 1-13792
Systemax Inc.(Exact name of registrant as specified in its charter)
11 Harbor Park DrivePort Washington, New York 11050(Address of registrant’s principal executive offices)(516) 608-7000(Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.Yes [ ] No [X]
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer (as defined in Rule 12b-2 of the Exchange Act).Large accelerated filer [ ] Accelerated filer [ ] Non-accelerated filer [X]
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act) Yes [ ] No [X]
The number of shares outstanding of the registrant’s Common Stock as of October 31, 2006 was 35,151,647.
TABLE OF CONTENTS
The filing of this Quarterly Report on Form 10-Q was delayed because of the longer-than-expected 2005 year-end closing process caused in part by the decision by the Company's former independent registered public accounting firm not to stand for re-appointment and the inability of the Company to appoint a new registered public accounting firm until December 2005.
Available Information
We maintain an internet web site at www.systemax.com. We file reports with the Securities and Exchange Commission ("SEC") 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"):
In accordance with the corporate governance rules of the New York Stock Exchange, each of the Corporate Governance Documents is available on our Company web site (www.systemax.com) or can be obtained by writing to Systemax Inc., Attention: Board of Directors (Corporate Governance), 11 Harbor Park Drive, Port Washington, NY 11050.
PART I — FINANCIAL INFORMATIONItem 1. Financial Statements
Systemax Inc.Condensed Consolidated Balance Sheets(In thousands, except share data)
See notes to condensed consolidated financial statements.
Systemax Inc.Condensed Consolidated Statements of Operations (Unaudited)(In Thousands, except per share amounts)
Systemax Inc.Condensed Consolidated Statement of Shareholders' Equity (Unaudited)(In Thousands)
Systemax Inc.Condensed Consolidated Statements of Cash Flows (Unaudited)(In Thousands)
Systemax Inc.Notes to Condensed Consolidated Financial Statements (Unaudited)
Periods ended June 30, 2005:
Revenues are attributed to countries based on the location of the selling subsidiary.
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.
This report contains forward looking statements within the meaning of that term in the Private Securities Litigation Reform Act of 1995 (Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934). Additional written or oral forward looking statements may be made by the Company from time to time, in filings with the Securities and Exchange Commission or otherwise. Statements contained in this report that are not historical facts are forward looking statements made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward looking statements may include, but are not limited to, projections of revenue, income or loss and capital expenditures, statements regarding future operations, financing needs, compliance with financial covenants in loan agreements, plans for acquisition or sale of assets or businesses and consolidation of operations of newly acquired businesses, and plans relating to products or services of the Company, assessments of materiality, predictions of future events and the effects of pending and possible litigation, as well as assumptions relating to the foregoing. In addition, when used in this discussion, the words "anticipates", "believes", "estimates", "expects", "intends", "plans" and variations thereof and similar expressions are intended to identify forward looking statements.
Forward-looking statements in this report are based on the Company's beliefs and expectations as of the date of this report and are subject to risks and uncertainties which may have a significant impact on the Company's business, operating results or financial condition. Investors are cautioned that these forward-looking statements are inherently uncertain. Should one or more of the risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual results or outcomes may vary materially from those described herein. Statements in this report, particularly in "Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations" and the Notes to Condensed Consolidated Financial Statements, describe certain factors, among others, that could contribute to or cause such differences.
Readers are cautioned not to place undue reliance on any forward looking statements contained in this report, which speak only as of the date of this report. We undertake no obligation to publicly release the result of any revisions to these forward looking statements that may be made to reflect events or circumstances after the date hereof or to reflect the occurrence of unexpected events.
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 reported amounts of assets and liabilities at the date of the financial statements, and revenues and expenses during the period. Significant accounting policies employed by the Company, including the use of estimates, were presented in the Notes to Consolidated Financial Statements of the Company's 2005 Annual Report on Form 10-K. The Company adopted SFAS 123(R), "Share-based Payment," effective January 1, 2006 to account for stock-based compensation. In accordance with SFAS 123 (R), we measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. That cost is recognized over the period during which an employee is required to provide service in exchange for the award for stock option grants. No compensation cost is recognized for equity instruments for which employees do not render the requisite service. We determine the grant-date fair value of employee share options using the Black-Scholes option-pricing model.
Critical accounting policies are those that are most important to the presentation of our financial condition and results of operations, require management's most difficult, subjective and complex judgments, and involve uncertainties. The accounting policies that have been identified as critical to our business operations and understanding the results of operations pertain to revenue recognition, net accounts receivable, inventories, long-lived assets, income taxes and restructuring charges and accruals. The application of each of these critical accounting policies and estimates was discussed in Item 7 of the Company's Annual Report on Form 10-K for the year ended December 31, 2005. There have been no significant changes in the application of critical accounting policies or estimates during 2006. Management believes that full consideration has been given to all relevant circumstances that we may be subject to, and the condensed 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 periods presented. Because of the uncertainty in these estimates, actual results could differ from estimates used in applying the critical accounting policies. We are not aware of any reasonably likely events or circumstances which would result in different amounts being reported that would materially affect its financial condition or results of operations.
We are a direct marketer of brand name and private label products. Our operations are organized in two primary reportable segments – Computer Products and Industrial Products. Our Computer Products segment markets personal desktop computers, notebook computers and computer related products in North America and Europe. We assemble our own PCs and sell them under our own trademarks, which we believe gives us a competitive advantage. We also sell personal computers manufactured by other leading companies, such as Hewlett Packard, E-Machines and Sony. Our Industrial Products segment markets material handling equipment, storage equipment and consumable industrial items in North America. We offer more than 100,000 products and continuously update our product offerings to address the needs of our customers, which include large, mid-sized and small businesses, educational and government entities as well as individual consumers. We reach customers by multiple channels, utilizing relationship marketers, e-commerce web sites, mailed catalogues and retail outlet stores. We also participate in the emerging market for on-demand, web-based software applications through the marketing of our PCS Profitability Suite™ of hosted software, which we began during 2004, and in which we have not yet recognized any revenues and have incurred considerable losses to date. Computers and computer related products account for 92% of our net sales, and, as a result, we are dependent on the general demand for information technology products.
The market for computer products 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 multiple distribution channels. Distribution of information technology and our 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, and employee benefits. We have made substantial reductions in our workforce and closed or consolidated several facilities over the past several years. With evidence of a prolonged economic downturn in Europe, we took measures to align our cost structure with expected potentially lower revenues and decreasing gross margins, initiating several cost reduction plans there during 2004 and 2005. We will continue to monitor our costs and evaluate the need for additional actions.
The discussion of our results of operations and financial condition that follows will provide information that will assist in understanding our financial statements, the factors that we believe may affect our future results and financial condition as well as information about how certain accounting principles and estimates affect the consolidated financial statements. This discussion should be read in conjunction with the condensed consolidated financial statements included herein.
Net sales for the six months ended June 30, 2006 increased 7.5% to $1.12 billion compared to $1.04 billion in the year-ago period. Net sales in the first six months of 2006 included approximately $390.9 million of internet-related sales, a 30.8% increase from $298.9 million of internet-related sales in the prior year's first six months. North American sales were $766.8 million, an increase of 11.5% from $687.4 million in the prior year. European sales decreased to $355.4 million (representing 31.7% of worldwide sales) compared to $356.6 million (34.2% of worldwide sales) in the year-ago period. Movements in foreign exchange rates negatively impacted the European sales comparison by approximately $25.1 million in 2006. Excluding the movements in foreign exchange rates, European sales would have increased 6.7% from the prior year. Sales as measured in local currencies in all but two of the European markets we serve increased in the first six months of 2006. The increase in our North American sales resulted from sales growth in both our computer and industrial products groups. Sales of computer products were $672.1 million, an 11.6% increase from $602.1 million of sales in the prior year. This increase was primarily a result of our continuing internet initiatives and expansion of our product offerings. Sales of industrial products increased 11.0% to $94.7 million from $85.3 million in the prior year.
Gross profit, which consists of net sales less product cost, shipping, assembly and certain distribution center costs, was $168.1 million compared to $151.1 million in the year-ago six months, an increase of $17.0 million. The gross profit margin was 15.0% in the current period, compared to 14.5% in the year-ago period. The increase in the gross profit margin resulted from a favorable change in product mix, increased consideration from vendors and reduced warehouse costs for staff and supplies.
Selling, general and administrative expenses for the first six months decreased $3.1 million, or 2.2%, to $136.7 million compared to $139.8 million in the first six months of 2005. Selling, general and administrative costs in Europe declined approximately $10.0 million in the first six months of 2006 primarily the result of the restructuring actions we took in Europe in 2005 and $2.9 million of decreased costs due to the effects of changes in foreign exchange rates. The European decreases were partially offset by increased spending in North America on salaries and employee related expenses of approximately $5.5 million and increased advertising costs net of rebates of approximately $.6 million and higher credit card processing fees related to the higher sales volume of approximately $1.4 million. Selling, general and administrative expenses also include $0.7 million of stock compensation expense in 2006 as a result of the adoption of SFAS 123(R). The Company used the modified prospective transition method at adoption and accordingly, financial statement amounts for prior periods presented in this Form 10-Q have not been restated to reflect the fair value method of recognizing compensation cost relating to non-qualified stock options. Selling, general and administrative expenses as a percentage of net sales was 12.2% in the current six month period compared to 13.4% in the year-ago period.
During the first quarter of 2005 we implemented plans to streamline and restructure the activities of our European computer businesses, resulting in the elimination of approximately 200 positions. We incurred $2.9 million of restructuring costs associated with these actions in the first six months of 2005 for staff severance and benefits for terminated employees.
We had income from operations for the current six months of $31.5 million compared to $8.3 million in the year-ago period. We had income from operations of $23.7 million in North America in the current year compared to income from operations of $15.8 million last year. We had income from operations in Europe of $7.7 million in the first six months of 2006, compared to a loss from operations of $7.5 million in the year-ago period.
During the first quarter of 2006 we sold our distribution facility in Suwanee, Georgia and recognized a gain of approximately $6.7 million net of a prepayment penalty incurred upon the repayment of the underlying mortgage loan, which is included in "Other non-operating (income) expense, net." The facility was replaced by a larger, leased building in the same geographic area.
Interest income and expense, net includes interest expense of $1.0 million in the first six months of 2006 and $1.4 million in 2005. The decrease resulted from lower average European short-term borrowings. Interest income earned on invested funds increased in 2006 as a result of an increase in funds available for investment.
Income tax expense was $13.6 million in the first six months of 2006 and $3.1 million in the year-ago period. The effective income tax rate was 35.5%, compared to 42.5% in the year ago period. The effective income tax rate was lower in 2006 primarily as a result of income earned in the United Kingdom for which the tax provision has been offset by the reversal of a deferred tax valuation allowance previously recorded against the deferred tax asset for our United Kingdom carryforward losses. Changes in the mix of U.S. and non-U.S. earnings over the balance of the year and changes in the valuation of deferred tax assets could have a significant impact on the effective tax rate for the year.
Net income for the first six months was $24.7 million, or $.71 per basic share and $.67 per diluted share, compared to $4.2 million, or $.12 per basic and $.11 per diluted share, in the first six months of 2005.
Net sales for the three months ended June 30, 2006 increased 8.1% to $547.2 million compared to $506.1 million in the year-ago quarter. Revenues in the quarter were reduced by an adjustment of approximately $1.9 million for sales returns and allowances related to prior periods. Net sales in the second quarter of 2006 included approximately $191.0 million of internet-related sales, a 29.2% increase from $147.8 million of internet-related sales in the prior year's second quarter. North American sales were $375.8 million, an increase of 12.4% from $334.2 million in the prior year. European sales decreased 4%, to $171.4 million (representing 31.3% of worldwide sales) compared to $172.0 million (34.0% of worldwide sales) in the year-ago quarter. Movements in foreign exchange rates negatively impacted the European sales comparison by approximately $4.1 million in 2006. Excluding the movements in foreign exchange rates, European sales would have increased 2.0% from the prior year. Sales as measured in local currencies in all but one of the European markets we serve increased in the second quarter of 2006. The increase in our North American sales resulted from sales growth in both our computer and industrial products groups. Sales of computer products were $325.8 million, a 12.6% increase from $289.4 million of sales in the prior year. This increase was primarily a result of our continuing internet initiatives and expansion of our product offerings. Sales of industrial products increased 11.9% to $50.0 million from $44.7 million in the prior year, and continue to grow in line with the favorable economic conditions in the United States.
Gross profit, which consists of net sales less product cost, shipping, assembly and certain distribution center costs, was $77.4 million compared to $71.4 million in the year-ago quarter, an increase of $6.0 million. The gross profit margin was 14.1% in the current period and 14.1% in the year-ago period.
Selling, general and administrative expenses for the quarter decreased $.3 million to $66.8 million compared to $67.1 million in the second quarter of 2005. Selling, general and administrative costs in Europe declined approximately $4.9 million in the second quarter of 2006 primarily the result of the restructuring actions we took in Europe in 2005 and $.5 million of decreased costs due to the effects of changes in foreign exchange rates. The European decreases were offset in part by increased spending in North America on salaries and employee related expenses of approximately $3.1 million, increased professional fees of approximately $.8 million and higher credit card processing fees related to the higher sales volume of approximately $.6 million. Selling, general and administrative expenses also include $0.4 million of stock compensation expense in 2006 as a result of the adoption of SFAS 123(R). The Company used the modified prospective transition method at adoption and accordingly, financial statement amounts for prior periods presented in this Form 10-Q have not been restated to reflect the fair value method of recognizing compensation cost relating to non-qualified stock options. Additionally an adjustment of approximately $1.2 million was recorded in the second quarter to lower accounts receivable reserves as the result of lower than expected write offs from prior periods. Selling, general and administrative expense as a percentage of net sales was 12.2% in the current quarter compared to 13.3% in the year-ago quarter.
During the first quarter of 2005 we implemented plans to streamline and restructure the activities of our European computer businesses, resulting in the elimination of approximately 200 positions. We incurred $1.1 million of additional restructuring costs associated with these actions during the second quarter of 2005 for staff severance and benefits for terminated employees.
We had income from operations for the current quarter of $10.6 million compared to $3.2 million in the year-ago quarter. We had income from operations of $7.4 million in North America in the second quarter compared to income from operations of $4.9 million last year. We had income from operations in Europe of $3.2 million in the second quarter of 2006, compared to a loss from operations of $1.8 million in the year-ago quarter.
Interest income and expense, net includes interest expense of $0.5 million in the second quarter of 2006 and $0.7 million in 2005. The decrease resulted from lower average European short-term borrowings. Interest income earned on invested funds increased in 2006 as a result of an increase in funds available for investment.
Income tax expense was $3.6 million in the second quarter of 2006 and $1.1 million in the year-ago quarter. The effective income tax rate for the second quarter of 2006 was 33.7%, compared to 42.5% in the year ago period. The effective income tax rate was lower in 2006 primarily as a result of income earned in the United Kingdom for which the tax provision has been offset by the reversal of a deferred tax valuation allowance previously recorded against the deferred tax asset for our United Kingdom carryforward losses. Changes in the mix of U.S. and non-U.S. earnings over the balance of the year and changes in the valuation of deferred tax assets could have a significant impact on the effective tax rate for the year.
Net income for the second quarter was $7.1 million, or $.20 per basic share and $.19 per diluted share, compared to $1.5 million, or $.04 per basic and diluted share, in the second quarter of 2005.
Our primary liquidity needs are to support working capital requirements in our business and to fund capital expenditures. We rely principally upon operating cash flow and borrowings under our credit facilities to meet these needs. 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 was $202.8 million at June 30, 2006, an increase of $33.0 million from $169.8 million at the end of 2005. This resulted from a $5.3 million increase in accounts receivable, a $28.0 million increase in inventories, a $7.9 million increase in prepaid expense and other current assets, a $3.7 million decrease in short-term borrowings, a $9.0 million decrease in accounts payable and other accrued expenses offset by a $2.2 million decrease in deferred tax assets and a $18.7 million decrease in cash and cash equivalents. Inventory levels increased $28.7 million in North America, primarily in our computer products segment and inventories in Europe decreased $.7 million. Our inventory turnover decreased slightly to 8.7 times from 9.3 times at the end of 2005. The increase in our accounts receivable occurred in Europe, as local currency sales in some of our larger markets increased from the fourth quarter. Accounts receivable in North America decreased slightly from the end of the prior year. Future accounts receivable and inventory balances will continue to fluctuate with changes in sales volume and the mix of our net sales between consumer and business customers.
Our cash balance decreased to $52.2 million during the six months ended June 30, 2006 from $70.9 million at the end of 2005. Net cash used in operating activities was $20.6 million for the first six months of 2006, compared to net cash provided by operating activities of $9.7 million in the same period of 2005. The decrease in cash provided by operations in 2006 resulted from changes in our working capital accounts, which used $46.4 million in cash compared to $3.1 million of cash used in 2005. The reduction resulted primarily from a $25.2 million increase in inventories in the first six months of 2006 compared to an $16.4 million decrease for the same period of the prior year, an increase in prepaids and other current assets of $6.2 million compared to a reduction of $1.6 million for the same period in 2005 and a decrease in accounts payable, accrued expenses and other current liabilities in the first six months of 2006 of $16.1 million compared to a $13.4 million increase for the same period of the prior year. Cash generated from net income adjusted by other non-cash items provided $25.8 million in 2006 compared to $12.8 million provided by these items in 2005, primarily as a result of the increase in our net income.
We maintain our cash and cash equivalents primarily in money market funds or their equivalent. As of June 30, 2006, 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.
We had $15.4 million of cash provided by investing activities in 2006. This consisted of $18.6 million of proceeds from the sale of our Suwanee, Georgia distribution facility, offset by $3.2 million of capital expenditures. Capital expenditures in 2006 included facilities costs and equipment for the replacement distribution facility we leased and upgrades and enhancements to our information and communications systems hardware. In 2005, we used $2.7 million in investing activities, principally for the purchase of property, plant and equipment. Capital expenditures in 2005 consisted primarily of upgrades and enhancements to our information and communications systems hardware and facilities costs for the opening of new retail outlet stores.
Net cash of $13.0 million was used in financing activities in 2006. We used cash of $8.0 million to repay long-term debt obligations, primarily for the mortgage on our Georgia distribution facility, and we used $5.5 million to repay short-term borrowings in Europe. Exercises of stock options provided $0.3 million of cash in 2006. Cash of $0.7 million was provided by financing activities in 2005. Cash of $0.4 million was provided by short-term borrowings under our European credit facilities. We used cash of $0.3 million for payments under long-term borrowing and capital lease agreements. Exercises of stock options provided $0.6 million of cash in 2005.
Under our $120 million (which may be increased by up to $30 million, subject to certain conditions) secured revolving credit agreement for borrowings in the United States and United Kingdom, as of June 30, 2006, eligible collateral was $108.0 million and total availability was $79.4 million. There were outstanding letters of credit of $10.6 million and there were outstanding advances of $18.0 million (all in the United Kingdom) as of June 30, 2006. The borrowings are secured by all of the domestic and United Kingdom accounts receivable, the domestic inventories of the Company, general intangibles and the Company's shares of stock in its domestic subsidiaries and the Company's United Kingdom headquarters building. The credit facility expires and the outstanding borrowings thereunder are due on October 26, 2010. The revolving credit agreement contains certain financial and other covenants, including maintaining a minimum level of availability and restrictions on capital expenditures and payments of dividends. We were in compliance with all of the covenants as of June 30, 2006, except for the required timely submission of financial statements, for which we have obtained a waiver.
Under our Netherlands €5 million ($6.4 million at the June 30, 2006 exchange rate) credit facility, at June 30, 2006 there were €3.6 million ($4.6 million) of borrowings outstanding under this line with interest payable at a rate of 5.0% per annum. This facility expires in August 2007.
We also have certain obligations with various parties that include commitments to make future payments. Our principal commitments at June 30, 2006 consisted of repayments of borrowings under our credit agreements, payments under operating leases for certain of our real property and equipment and payments under employment and other service agreements. In connection with the sale of our Suwanee, Georgia distribution facility, the Company repaid the related mortgage loan which was secured by the land and building.
The Company has not created, and is not party to, any special-purpose or off-balance sheet entities for the purpose of raising capital, incurring debt or operating the Company's business. The Company does not have any arrangements or relationships with entities that are not consolidated into the financial statements that are reasonably likely to materially affect the Company's liquidity or the availability of capital resources.
In July 2006, the FASB issued Interpretation No. 48 (FIN 48), "Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109." FIN 48 clarifies and sets forth consistent rules for accounting for uncertain tax positions taken or expected to be taken in accordance with SFAS 109, "Accounting for Income Taxes." FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company is currently evaluating the impact that adoption of FIN 48 may have on its consolidated results of operations or financial position.
In June 2006, the FASB ratified the consensus reached by the EITF on Issue No. 06-3, "How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (That Is, Gross versus Net Presentation)." The consensus requires disclosure of either the gross or net presentation, and any such taxes reported on a gross basis should be disclosed in the interim and annual financial statements. This Issue is effective for financial reports beginning after December 15, 2006. The Company does not expect to change its presentation of such taxes, as its sales are currently recorded net of tax.
In September 2006, the SEC issued Staff Accounting Bulletin No. 108 ("SAB 108") "Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements". SAB 108 provides interpretative guidance on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a current year misstatement. The SEC staff believes that registrants should quantify errors using both a balance sheet and an income statement approach and evaluate whether either approach results in quantifying a misstatement that, when all relevant quantitative and qualitative factors are considered, is material. This pronouncement is effective for fiscal years ending after November 15, 2006. The Company is currently evaluating the provisions of SAB 108.
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 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 sales, gross margins, operating expenses and retained earnings as expressed in U.S. dollars. 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 June 30, 2006 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 includes short-term borrowings in Europe under our credit facilities. As of June 30, 2006, the balance outstanding on our variable rate debt was approximately $22.6 million. Based on our market sensitive instruments as of June 30, 2006, 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 for the fiscal year.
The Company establishes and maintains disclosure controls and procedures that are intended to provide reasonable assurance that information required to be disclosed by the Company in the reports it files under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms. Disclosure controls are also intended to provide reasonable assurance that such information is accumulated and reported to management, including the Chief Executive Officer and the Chief Financial Officer, to allow timely decisions regarding required disclosure.
Our management, including our CEO and CFO, does not expect that our disclosure controls and procedures will prevent 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 control systems, misstatements due to error or fraud may occur and not be detected. These limitations include the circumstances that breakdowns can occur as a result of error or mistake, the exercise of judgment by individuals or that controls can be circumvented by acts of misconduct. 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.
As of the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our management, including the Chief Executive Officer and the Chief Financial Officer, of the effectiveness of the design and the operation of our disclosure controls and procedures pursuant to Exchange Act Rules 13a-15 and 15d-15 of the Securities Exchange Act of 1934.
Based on their evaluation, as of June 30, 2006, the Chief Executive Officer and the Chief Financial Officer have concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended) were not effective to ensure that the information required to be disclosed by us in this quarterly report on Form 10-Q was recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms. This conclusion is based on our identification of three material weaknesses in our internal controls over financial reporting as of June 30, 2006. The material weaknesses are:
As a result of this determination and as part of the work undertaken in connection with this report, we have applied compensating procedures and processes as necessary to reasonably ensure the reliability of our financial reporting. Accordingly, management believes, based on its knowledge, that (i) this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which they were made, not misleading with respect to the period covered by this report and (ii) the financial statements, and other financial information included in this report, fairly reflect the form and substance of transactions and fairly present in all material respects our financial condition, results of operations and cash flows as at, and for, the periods presented in this report.
As reported in our Annual Report on Form 10-K for the year ended December 31, 2005, management was unable to conclude that the Company's internal controls over financial reporting were then effective, as a result of the three material weaknesses described above. Ernst & Young LLP, our independent registered public accounting firm, issued a material weakness letter to the Company which addressed these material weaknesses. These matters have been discussed among management, the audit committee and our independent registered public accountants.
During 2006, we have taken the following actions to date to address the material weaknesses:
While progress is being made to remediate the material weaknesses identified, we are continuing to monitor these processes to further improve our procedures.
We are not yet subject to the internal controls certification and attestation requirements of Section 404 of the Sarbanes-Oxley Act of 2002 because we are not an accelerated filer. Based on SEC implementing regulations in effect as of June 30, 2006, at the end of fiscal year 2007 Section 404 of the Sarbanes-Oxley Act of 2002 will require that management provide an assessment of the effectiveness of the Company's internal control over financial reporting and the Company's independent registered public accounting firm will be required to audit that assessment beginning with fiscal year 2008.
We are continuing to work to achieve compliance with the requirements of Section 404. We have dedicated substantial time and resources to documentation and review of our procedures, including the hiring of additional internal audit staff in both the United States and in Europe. We will also evaluate the need to engage outside consultants to assist us. We have not completed this process or its assessment, due to the complexities of our decentralized structure and the number of accounting systems in use. We have not completed our assessment of our internal control over financial reporting. In addition to the three material weaknesses as of June 30, 2006 discussed under the caption "Disclosure Controls and Procedures," we have identified a number of internal control significant deficiencies, including controls in the information technology area, that may affect the timeliness and accuracy of recording transactions and which, individually or in the aggregate, could become material weaknesses in future periods if not remediated. While the Company does not believe that the following are currently material weaknesses, they are designated as significant deficiencies as of June 30, 2006:
We have a significant amount of work to do to remediate the items we have identified. In the course of completing our evaluation and testing we may identify further deficiencies and weaknesses that will need to be addressed and will require remediation. We may not be able to correct all such internal control deficiencies in a timely manner and may find that a material weakness or weaknesses continues to exist. As a result, management may not be able to issue an unqualified opinion on the effectiveness of the Company's internal control over financial reporting as of December 31, 2007.
Our management is not aware of any changes in internal control over financial reporting other than those described above that occurred during the quarter ended June 30, 2006 that materially affected, or were reasonably likely to materially affect, our internal control over financial reporting.
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