EACO CORP – 10-K – Management’s Discussion and Analysis of Financial Condition and Results Of Operations

Distribution Sales and Gross Margin (dollars in thousands)

                                   Year Ended August 31,            $             %                                   2011            2010         Change       Change

         Distribution sales   $    103,467      $ 91,547      $ 11,920         13.0 %          Cost of sales              74,865        67,048        (7,817 )      (11.6 )%           Gross profit         $     28,602      $ 24,499      $  4,103          Gross margin                 27.6 %        26.7 %                     (0.9 )%   Distribution sales related to the Distribution Operations segment consist primarily of sales of component parts and fasteners, but also include, to a lesser extent, kitting charges and special order fees, as well as freight charged to customers. Distribution sales generated by the Bisco division represented the substantial majority of distribution sales in both periods. The increase in distribution sales in the year ended August 31, 2011 compared to the year ended August 31, 2010 ("fiscal 2010") was largely due to increased unit sales, resulting primarily from increases in the salesperson headcount and the number of Sales Focus Teams ("SFT"). The Company uses SFTs to focus on specific markets management has identified and believes that such focus contributes to increases in sales. The Company also increased the number of offices during the year, adding three new offices in Virginia, Missouri and Georgia.  

Rental Income (dollars in thousands)

                                       Year Ended August 31,             $           %                                      2011             2010         Change      Change       Rental revenue              $    1,242        $  1,086       $   156        14.3 %       Cost of rental operations          583           1,706         1,123        65.8        Gross profit                $      659        $   (620 )     $ 1,279       Gross margin                      53.0 %         (57.0 )%                  110.0 %   Rental revenue in the Real Estate Rental Operations segment increased in fiscal 2011 due to the rental of the Deland and Orange Park Properties for all of fiscal 2011. The Orange Park Property was vacant during the first three quarters of fiscal 2010, while the Deland Property was vacant for the first two. All of the Company's rental properties are currently leased. Gross margin improved in fiscal 2011 primarily due to a decrease in the cost of rental operations. This decrease was due mainly to expenses related to the acquisition of Bisco in fiscal 2010 that did not occur again in 2011.  

Selling, General and Administrative Expense (dollars in thousands)

                                                     Year Ended August 31,             $              %                                                   2011              2010          Change        Change Selling, general and administrative expense    $    25,031        $ 21,763       $ (3,268 )       (15.0 )% Percent of distribution sales                         24.1 %          23.7 %                       (0.4 )%   Selling, general and administrative expense ("SG&A") consists primarily of payroll and related expenses for the sales and administrative staff, professional fees (including accounting, legal and technology costs and expenses), and sales and marketing costs for the Distribution Operations. SG&A expense in fiscal 2011 increased from fiscal 2010 due largely to increased headcount in sales employees and to a lesser extent to the opening of three new offices. The Company also incurred increased legal and accounting fees during fiscal 2010 due to the acquisition of Bisco in fiscal 2010 that did not occur again in fiscal 2011. As a percentage of distribution sales, SG&A increased as the Company increased the size of its sales staff with new hires, because those new hires generally do not contribute as much revenue during their first twelve months as veteran sales staff.                                           12

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Other Income (Expense), Net (dollars in thousands)

                                                                      Year Ended August 31,             $             %                                                                    2011              2010          Change        Change Other income (expense): Realized gain (loss) on sales of marketable trading securities   $     313         $ (3,481 )     $  3,794         108.9 % Unrealized gain (loss) on marketable trading securities               (172 )          1,314         (1,486 )      (113.0 ) Interest and other income                                                3               26            (23 )       (88.4 ) Interest expense, net                                                 (770 )           (796 )           26           3.2  Other income (expense), net                                      $    (626 )       $ (2,937 )     $  2,311          78.6 % Other income (expense), net as a percent of sales                     (0.5 )%          (3.1 )%                       2.6 %   Other income (expense), net primarily consists of income or losses on investments in short-term marketable equity securities of publicly-held domestic corporations. The Company's investment strategy consists of both long and short positions, as well as utilizing options to maximize return. During fiscal 2010, the Company recognized $2,167,000 in net realized and unrealized losses, which losses were primarily due to short positions the Company was holding. The Company experienced an increase of $141,000 during fiscal 2011, due mainly to holding long positions during a time of a general market increase.  

Income Tax Provision (dollars in thousands)

                                    Year Ended August 31,            $            %                                    2011             2010       Change        Change

Income tax provision $ 1,465 $ 532 $ (933 )

(175.3 )%

         Percent of net sales            1.3 %         0.5 %                 

(0.8 )%

   The provision for income taxes increased by $0.9 million in fiscal 2011 as compared to fiscal 2010, which primarily resulted from a change in the tax law for the State of California, which would further decrease the likelihood of the Company's ability to use all of its California net operating losses. In addition, in June 2011, the Company amended its state tax returns for the years ended August 31, 2007 and 2008 in accordance with the findings of a previously disclosed Internal Revenue Service audit, which resulted in a direct increase to income tax expense for fiscal 2011.  

Liquidity and Capital Resources

  The accompanying financial statements include the financial position and results of operations of Bisco for all periods presented. As a result of Mr. Ceiley having majority voting control over both entities during all periods presented, the consolidated financial statements were prepared in accordance with ASC 805-50, Transactions Between Entities Under Common Control, which specifies that in a combination of entities under common control, the entity that receives the assets or the equity interests shall initially recognize the assets and liabilities transferred at their historical carrying amounts at the date of transfer ("as-if pooling-of-interests" accounting). The financial statements of the receiving entity shall also report the results of operations for the period, the financial position and other financial information as though the transfer of net assets or exchange of equity interests had occurred at the beginning of the period. Financial statements and financial information presented for prior years have been retrospectively adjusted to furnish comparative historical information for periods during which the entities were under common control. The Distribution Operations segment consists of the operations of Bisco.  The Company's Distribution Operations have historically generated positive cash flow from its operations and/or by trading in marketable domestic equity securities. In addition, the Company has a revolving credit agreement with Community Bank, which currently provides for borrowings of up to $10.0 million and bears interest at either the 30, 60 or 90 day LIBOR (the 90 day LIBOR at August 31, 2011 and 2010 was 0.38% and 0.29%, respectively) plus 1.75% and/or the bank's reference rate (3.25% at August 31, 2011 and 2010). Borrowings are secured by substantially all assets of the Company's Distribution Operations and are                                           13 

-------------------------------------------------------------------------------- guaranteed by the Company's Chief Executive Officer and Chairman of the Board, Glen F. Ceiley. The original agreement, as amended in April 2008, expired in October 2010, but was extended to and renewed in March 2011. The new credit agreement expires in March 2013. The amount outstanding under this line of credit as of August 31, 2011 and 2010 was $8,500,000 and $8,900,000, respectively. Availability under the line of credit was $1,500,000 and $1,100,000 at August 31, 2011 and 2010, respectively.  The Company's Real Estate Rental Operations are funded by rents received from the tenants of its five rental properties. Any cash requirements in excess of the rental income required by the Real Estate Rental Operations have historically been funded by the Distribution Operations. These borrowings and related interest have been eliminated in the accompanying consolidated financial statements.  

Cash Flows from Operating Activities

The Company's principal uses of cash during fiscal 2011 was the payment of the Company's operating expenses.

  During the year ended August 31, 2011, the Company used $712,000 in net cash from its operating activities. This was due mainly to increases in both accounts receivable and inventory during fiscal 2011 combined with paying down accounts payable. This was offset by the Company's income for the year and changes in the deferred tax asset resulting from the Company's ability to use its net operating losses to decrease payments due to the Internal Revenue Service.  During the year ended August 31, 2010, the Company generated $879,000 in net cash from its operating activities. This was due mainly to an increase in accounts payable resulting from extending credit terms and checks held at the end of the period.  

Cash Flows from Investing Activities

  Net cash flow provided by investing activities was $114,000 for the year ended August 31, 2011. This was due to the release of restricted cash required as part of the Company's self-insured worker's compensation program by Florida SIGA and an increase in the sales of the Company's investments during the year. These were offset by the Company's purchase of equipment relating to its Distribution Operations segment.  Net cash flow used by investing activities was $1,032,000 for the year ended August 31, 2010. This was due to required repurchases of securities sold, not yet purchased and an increase in purchases of the Company's investments not related to its short positions. This was offset by the release of restricted cash related to the liabilities for short sales and a reduction in the collateral requirement regarding the Company's self-insured worker's compensation program by Florida SIGA.  

Cash Flows from Financing Activities

  For the year ended August 31, 2011, net cash generated by financing activities was $791,000. This was due to the Company's payment in fiscal 2011 of $228,000 in dividends on the Company's preferred stock that had been in arrears and the increase in the Company's bank overdraft in fiscal 2011, due to a higher volume of outstanding checks at year end. Additionally, the Company borrowed $1,000,000 in long term debt, which was used to partially pay down the Company's revolving credit facility.  

Cash used in financing activities for the year ended August 31, 2010 was $432,000 mainly due to the Company's settlement of a capital lease obligation relating to the Deland Property.

Off-Balance Sheet Arrangements

  The Company has no off-balance sheet arrangements that are reasonably likely to have a current or future effect on the financial position, revenues, results of operations, liquidity or capital expenditures.                                           14

--------------------------------------------------------------------------------Contractual Financial Obligations

  In addition to using cash flow from operations, the Company finances its operations through the issuance of debt, and previously by entering into leases. These financial obligations are recorded in accordance with accounting rules applicable to the underlying transactions, with the result that some are recorded as liabilities in the balance sheet while others are required to be disclosed in the Notes to the accompanying financial statements and Management's Discussion and Analysis of Financial Condition and Results of Operations in the Annual Report on Form 10-K for the year ended August 31, 2011.