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Connect Group: Press release : Annual results 2010

Management discussion and analysis of the results

Connect Group NV (Euronext Brussels: CONN) reports a sales increase from EUR 33.7 million in the 3rd quarter to EUR 37.1 million in the 4th quarter. This strong revenue improvement was partly the result of gaining control of the component problems that resulted in first half sales falling significantly below expectations (H1 2010 sales of EUR 62.6, H2 sales of EUR 70.8 million).

The operating result before the recording of certain customer provisions in the 4th quarter was far from bad, with a profit of EUR 1,966 k, representing a profit margin of 5.3 percent of sales.

However, not only Connect Group was hit by the crisis in recent years. Two customers have also run into difficulties and are currently unable to meet their financial obligations towards Connect Group. The good operating results from fourth quarter were undone by the need to record a provision for possible losses from these customers.
These customers are currently being delivered on a cash basis. It is clear that on the one hand payment from these customers is far from certain, but that on the other hand right now the receivables should not yet be considered as lost, as these customers continue to operate actively in the market, purchase their goods from Connect Group on a cash basis and are negotiating with investors to strengthen their capital structure. Given the uncertainty surrounding the continued existence of these customers, Connect Group has opted to record a general provision covering 50 percent of the outstanding receivables from these customers.  This provision amounts to EUR 1,625,000 and has been charged in full to the income statement. If these customers ultimately would not pay, the group will need to write off an additional EUR 1,625,000. If full payment is obtained, the provision of EUR 1,625,000 will have to be reversed.

For the full year 2010, sales amounted to EUR 133.4 million from the continuing contract manufacturing activity compared with EUR 121.3 million in 2009. The operating result from continuing operations was a loss of EUR 167 k for the year as a whole, compared with an operating loss of EUR 1,947k in 2009.

The following factors had a significant negative impact on the 2010 annual results:

o Shortages on the components market during the first half of 2010 meant that production lagged behind expectations; resulting in an undercoverage of fixed costs. The impact on the results is not calculable but is significant;
o Several restructuring operations were undertaken to improve operational efficiency. The direct cost of the restructuring is included in cost of sales and amounted to EUR 1,181k;
o Given that a significant portion of production takes place in Romania and the Czech Republic and a portion of the components are purchased in dollars, the company is sensitive to exchange rate fluctuations. In 2010 foreign exchange losses of EUR 527k were recorded (US dollar, Romanian lei and the Czech koruna).
o As mentioned above, a provision for doubtful customer receivables was recorded in an amount of EUR 1,625 k. This provision was included in the income statement under “other expenses”.
 
The following elements had a important positive impact on the net result of 2010:

In 2009, at the time of disposal of the automation business (discontinued activity) a provision was set up for a major claim on an Automation customer, the risk on which had remained with the Connect Group after the sale. Ultimately this receivable was paid in full.

At the end of 2009, on selling the automation activity, the company recorded a gross receivable of EUR 2 million against the buyer of this business. When initially recording this receivable at the end of 2009, the Board decided to recognize it at its estimated market value based on the underlying value of the Connect Group shares (700,000 shares with a market value at that time of € 1,500,000) obtained as security, taking into account the buyer's financial structure and its other outstanding obligations towards Connect Group. In 2010, the buyer of the automation activities met all its financial obligations towards Connect Group and has informed that it will show a profit.  Based on this new information, the Board has decided to record the receivable at its nominal value reduced by the interest charge for one year, given that the loan is still interest-free in 2011 and becomes interest-bearing from 2012.  The gain resulting from this valuation is recognized as income from the discontinued activity.
The income statement for 2010 of the discontinued activity otherwise contains no operating results, given that all operations from 1 January to 3 March 2010 have been treated as being for the buyer’s account.
In this way the discontinued activity has a positive impact of EUR 1,495 k on the result.

The order book rose to EUR 71.2 million at the end of 2010 (EUR 55 million at end-2009), an increase of 30%.

In the 4th quarter the company succeeded in eliminating partly the delay in order deliveries that had arisen during the first half as a result of components shortages. Although there is still pressure on the availability of certain components, the initiatives taken have had the effect of minimizing the impact on customer deliveries.

Given the component shortages, we have for several months now been taking initiatives with our customers to order critical components in advance. This involves obtaining more accurate and longer
forward forecasts to enable us to place orders earlier with our suppliers. A disadvantage is that inventory has risen to EUR 38.0 million at end-2010 (vs. EUR 29.5 million at end-2009).

The increase in trade receivables reflects both increased turnover in the 4th quarter and the failure by one customer to respect payment conditions (EUR 3 million impact at year-end).

The EUR 2 million investment in the new SAP software package had been included in the end-2009 balance sheet in property, plant and equipment under 'work in progress' as no delivery had yet occurred. In early 2010 the package was brought into use and the investment included in intangible assets.

An analysis of the company’s risk management can be found in the annual report and is available on the internet (www.connectgroup.com).

The most significant risks for the company are:
1. The production is completeley dependent on the availability of all components at the moment that production starts up. If component availability slows down, sales too will be delayed.
2. Currency risk:
• The group buys a portion of its components in dollars/yen, the exchange rate risk on which is only partially covered in the selling price.
• Production takes place partly in Romania and the Czech Republic: large fluctuations of these currencies against the Euro can impact costs.
• Since foreign currency needs cannot be accurately timed, the group does not cover its foreign currency positions.
3. The group has a credit agreement with its bankers that includes a minimum solvency ratio covenant, equity and cash flow. For year-end the group obtained a waiver for not meeting the established solvency ratio from its bankers.
4. Customer insolvency can have a major impact on the results

Significant events in 2010

On 2 March 2010 the automation activity was definitively sold to its former founders, Huub Baren and Vladimir Dobosch.

On 27 April 2010 the Extraordinary General Meeting approved a EUR 5 million subordinated convertible bond on the following conditions: suspension of general preferential rights, a minimum investment of EUR 50,000, a term of 6 years, an interest rate of 6 percent payable semi-annually, and a twice-yearly conversion option (following publication of annual and half-yearly figures). The bonds will be convertible at the lower of: (i) 70% of the average highest independent bid price for a Connect Group share, in the central order book of Euronext, over the 30 trading days preceding the date of exercise and (ii) EUR 2.00.

The issuance of this subordinated loan in an amount of EUR 5,000,000 considerably improves the Connect Group’s financial position. This improvement of both the quasi-equity and the cash position was necessary, following the divestment of the automation activity at the end of 2009. 

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