Caution Regarding Forward-Looking Statementsm.softchoice.com/files/pdf/about/Softchoice_MDA_2005.pdfThe words “expect,” “intend,” “anticipate” and similar expressions generally

Softchoice Corporation 2005 Management’s Discussion and Analysis

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MANAGEMENT’S DISCUSSION AND ANALYSIS

February 13, 2006 This document has been prepared to help investors understand the financial performance of the Company in the broader context of the Company’s strategic direction, the risks and opportunities as understood by management and the key metrics that are relevant to the Company’s performance. Management has prepared this document in conjunction with its broader responsibilities for the accuracy and reliability of the financial statements, as well as the development and maintenance of appropriate information systems and internal controls to ensure that the financial information is complete and reliable. The audit committee of the Board of Directors has reviewed this document and all other publicly reported financial information for integrity, usefulness, reliability and consistency. This document and the related financial statements can also be viewed on the Company’s website at www.softchoice.com and at www.sedar.com. The Company’s latest Annual Information Form is also available on these websites.

Caution Regarding Forward-Looking Statements The following discussion should be read in conjunction with the audited consolidated financial statements for the year ended December 31, 2005. This discussion contains certain forward-looking statements based on current expectations. Management bases its expectations on current market conditions and forecasts published by experts, on knowledge of observed industry trends and on internal intentions based on developed business plans or budgets. The words “expect,” “intend,” “anticipate” and similar expressions generally identify forward-looking statements. These forward-looking statements entail various risks and uncertainties that could cause actual results to differ materially from those reflected in those forward-looking statements. Certain of these risks are described under the heading “Risks” below.

Selected Annual Information The following information is provided to give a context to the broader comments elsewhere in this report.


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Year ended December 31, 2005



in Canadian $000s, except per share amountsRevenue 784,434$ 630,310$ 548,669$

Gross profit 99,743 83,974 66,170 Gross profit as a percentage of 12.7% 13.3% 12.1%revenueOperating Income 26,542 20,597 6,444

Earnings before income taxes 26,423 20,653 5,995

Net Earnings 16,052 12,837 3,523

Earnings per shareBasic 0.94$ 0.75$ 0.21$ Fully diluted 0.93$ 0.75$ 0.20$

Total Assets 205,482 128,492 152,645

Long term financial liabilities - - -

Shareholders' equity 56,043 40,836 29,638

2005 Highlights

• Revenue of $784.4 million and growth of 25 percent • Total revenue, including Imputed Revenue* of $1.1 billion and growth of 29

percent • Operating income growth of 29 percent • Net income growth of 25 percent

*See Use of Non-GAAP Measures for a description of Total revenue, including Imputed Revenue

3-Soft Group Inc. On February 25, 2005, Softchoice purchased the assets of the Software Division of 3-Soft Group Inc. (“3-Soft”). 3-Soft was a software licensing expert with a strong presence in the province of Quebec and in the academic sector, both of which provided strategic opportunities for Softchoice. The acquisition has strengthened Softchoice’s position as Canada’s largest software licensing reseller with a market share of approximately 30 percent. The acquisition added 21 full-time permanent employees to the Company and about 1,100 customers. It is not possible to segregate the impact of the acquisition on our financial results since the customers, employees and facilities have been completely


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integrated and therefore the financial impact of the acquisition has not been separately disclosed. This acquisition was financed entirely with bank debt. At the end of the year, the outstanding bank debt was $15.8 million. This debt is more reflective of short-term working capital requirements than it is the acquisition, since the bank debt has been as low as $0.8 million since the acquisition. The accounting for the acquisition is described in Note 3 to the financial statements. Strengthening EA 6.0 Sales About 48 percent of all of Softchoice’s revenue is derived from the sale of Microsoft products. EA 6.0 licenses are one type of license sold by Microsoft. For this specific license, Microsoft contracts with the customer directly and pays Softchoice an agency fee. This means that our revenue from the sale of these licenses is recognized on a net, instead of a gross basis, that the actual amount of the revenue recognized is about 10 percent of what it would have been under a gross revenue recognition arrangement and that rebates are not earned on these sales. This increasing trend means that our use of Imputed Revenue (see Non-GAAP Measures) is more relevant than ever in understanding the underlying trends beneath the reported financial results. Softchoice sells more EA 6.0 licenses agreements in the U.S. than any other reseller and ranks number 3 in EA 6.0 revenues. Strengthening EA 6.0 sales contributed in a large measure to the gross profit growth in the year of 19 percent and the Total revenue, including Imputed Revenue growth of 29 percent. (See Use Non-GAAP Measures and the revenue analysis for a description of this measure and the reconciliation between Total revenue, including Imputed Revenue and reported revenue.) Dividend Policy In December 2005, we announced that we intend to begin paying a dividend in 2006 of $0.40 per common share. On February 10, 2006 the board declared the first quarterly dividend of $0.10 per share payable on March 31, 2006 to shareholders of record on March 15, 2006.

Reporting currency Since 60 percent of our revenues are derived from sales in the United States and since the strengthening Canadian currency over the last few years has introduced added complexity to the analysis of the Company’s results, effective the first quarter of 2006, we will begin reporting our financial results in U.S. dollars. Historical financial statements for the last eight quarters will be made available in U.S. dollars on the Company’s web site.


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Business Operations Softchoice provides information technology products to North American businesses and organizations of all sizes. The services we provide make it easy and more cost-effective for customers to select, acquire and manage their technology assets. These services include the following three steps:

• Select – Softchoice helps customers find the best products to solve their business problems through our proprietary database and advanced product searching and comparative tools.

• Acquire – Softchoice helps customers identify the most effective way for them to acquire the technology through our expertise in software licensing programs and hardware volume purchasing contracts.

• Manage – Softchoice provides information and tools that help customers manage their technology assets over the course of the technology life span. These activities include assessment services in the area of IT asset management, including security and utilization.

Current Trends1 The industry has been subject to a couple of specific trends over the last few years that we believe will continue to manifest themselves in 2006. These trends are outlined below:

• Technology industry spending continues to increase gradually • Recurring software licenses are increasing • Introduction of Vista expected in late 2006

Technology Industry Spending Continues to Increase Gradually2 Just prior to 2000, many companies invested considerably in the technical resources necessary to ensure that their computer infrastructure was Y2K-compliant. Refresh rates - the time period over which a company replaces older equipment - used to be about three years; however, monitoring institutions such as International Data Corporation (IDC),now estimate that typical refresh rates have stretched to four and five years. The technology industry has not seen a significant rise in spending in the last year or two and the general consensus seems to be that there is some pent-up demand among IT managers. Management believes that companies are increasing the time period between refresh cycles so we will see only a gradual improvement in technology spending in the

1 This section includes forward-looking information. See “Caution Regarding Forward-Looking Information.” 2 This section includes forward-looking information. See “Caution Regarding Forward-Looking Information.”


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next year. IDC estimates that the growth in hardware spending through the channel will be 3 percent in 2006, 4 percent in 2007 and less than 2 percent per year in 2008 and 2009. Software sales through the channel are estimated by IDC to grow between 8 percent and 9 percent per year, between 2006 and 2009. Softchoice’s growth is expected to come more from increased market share than from significant increases in technology spending. The exception to the general gradual increase in technology spending is in corporate spending on software for security and storage, which has shown strong growth levels over the last year. Increasingly complex threats have increased corporate awareness of their vulnerabilities, causing this aggressive growth. Software vendors specializing in security, such as Symantec, Trend Micro and McAfee, have increased revenue over the past year by about 15 percent. Softchoice revenues from these product areas have increased even faster as we take market share for these vendors, and we expect continued double-digit growth from sales of these software products. Recurring Software Licenses are Increasing In the last few years, there has been a common trend among software publishers to migrate their customers away from transactional purchases of perpetual licenses to annual purchases of licenses and add-on support. The license itself allows the user to access the product, whereas the annual support or maintenance contracts allow the user access to all upgrades and patches. This changes the nature of the purchase from an episodic or transactional one to an annual subscription arrangement. This trend also tends to smooth the customers’ expenditure levels so that software purchases become another predictable cost of doing business. This shift means that software publishers are less dependent on new products to lift their revenues and more dependent on the annual payments that give users access to those new products as they are released. Customers are responding to these changes with varying levels of reception. If the customer’s corporate environment needs to be on current technology platforms, there is a tendency to embrace these annual flows since they simplify the purchasing and managing process for the corporation. If the customer prefers “good enough” computing and upgrades to current versions only after several years, the annual payment stream tends to be a more expensive alternative. The advent of increased threats from security issues increases the customers’ need for current technology and reinforces the publishers’ strategy of annual fees. In this new subscription environment, renewals of in-place agreements are of increasing focus and importance. The growth that Softchoice has had in EA 6.0 licenses is an example of this trend. We believe that the trend toward more annuity-based annual software licenses is likely to continue and expand.


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Introduction of Vista Expected in Late 20063 Microsoft has indicated that it intends to launch its new software product toward the end of 2006. Approximately 48 percent of the Company’s revenue is derived from Microsoft products. (See “Microsoft and Softchoice,” below). The impact of the Vista launch upon the industry is difficult to predict and will in part depend on the level of innovation included in the new products. Both IDC and the Gartner Group have stated that the introduction of Vista will not have a major impact on the market. Gartner has indicated that most businesses are unlikely to deploy the new software until 12 to 18 months after its release. However, we expect this product launch to affect us as outlined below. Since the product is not expected until the fourth quarter of 2006 and delays in software releases are relatively common, the impact of this product is not expected until 2007 or beyond. Software sales: To the extent that customers have purchased EA 6.0 licenses or Software Assurance, they will have access to Vista as soon as it is launched. (Software Assurance and EA 6.0 are both types of software licenses granted by Microsoft. See “Microsoft and Softchoice” for a description of these licenses). If anything, there is a risk that sales of Software Assurance products will decline after the release of Vista since the customers will have access to the product and therefore may believe that they do not need additional product releases for some time. A certain portion of customers have not purchased Software Assurance and are “license only” customers. They prefer to purchase new perpetual licenses when they feel the need to upgrade their software platforms. These customers tend to be somewhat lagging in the adoption of new technology. The increase in demand stemming from these customers would therefore be expected to be delayed for some time after the release of the new product. Hardware sales: It is expected that the memory requirements for the new software will be more extensive than most customers have for their standard PCs. Therefore the initial impact of the Vista release may be an increased demand for new hardware memory, laptops and PCs. Again, it is not expected that this trend will be manifested in 2006. As a result of the uncertainty of the timing of the product release and the potential for delays in customer acceptance and demand for the product, we have not built any expectations for enhanced sales due to the Vista release into our internal financial projections for 2006 and 2007.

Corporate Strategy and Growth Strategies The Company’s strategy comprises four key elements:

• Customer focus • Local branches • Integrated sales and marketing

3 This section includes forward-looking information. See “Caution Regarding Forward-Looking Information.”


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• Proprietary IT systems Similarly, our growth strategy has four prongs:

• To expand our customer base; • To expand our product line; • To support both expansions with stronger, more robust and more innovative sales

and IT infrastructure; and • To expand through acquisitions, where appropriate.

These strategies are described in the Company’s Annual Information Form that may be viewed on the Company’s website at www.Softchoice.com and at www.sedar.com. Microsoft and Softchoice

Microsoft is the ubiquitous provider of software worldwide. Approximately 70 percent of Microsoft’s revenue is from desktop applications and operating systems such as Windows and Office Productivity Suites. Microsoft has about 95 percent of the market share in this area with projected single-digit growth for the next few years. About 48 percent of Softchoice’s revenue is derived from the sale of Microsoft products.

Software Licenses Software licenses are used across the industry to regulate the use and ownership of all types of software products. For Microsoft products, the customer is able to buy the license alone or with an “insurance”-type product that allows the customer to obtain, free of charge, the most recent versions of the software for the term of the “insurance” product. Microsoft sells this type of product through Software Assurance and Enterprise Agreements. Customers are also able to purchase the license agreement on its own, but this gives them no rights or access to later versions of the product. To upgrade, they must repurchase the software license.

Software Assurance Software Assurance (SA) is an “insurance” or “maintenance” type of license that allows customers to upgrade to the latest technology if new applications are introduced during the period that SA is in effect. The license also entitles the customer to many different types of training and service benefits. SA licenses are renewed annually; this renewal feature increases the predictability of the Company’s revenue stream.

Enterprise Agreements 6.0 (EA 6.0) In October 2001, Microsoft began offering Enterprise Agreements (EA). With an EA, Microsoft transfers the license and bills the customers directly, paying resellers such as Softchoice an agency fee or commission on these sales. The result of these transactions is that the revenue recorded by Softchoice is reduced but the gross profit remains. Therefore, the Company’s margin on these deals is 100 percent and, as a result, they increase the Company’s overall gross margin.


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The proportion of sales of this product has risen significantly in the two last years. Meaningful year-over-year comparison of Softchoice’s revenue requires an adjustment to the EA sales that Microsoft obtains and on which Softchoice is paid an agency fee. Softchoice refers to this revenue line as Imputed Revenue (see “Use of Non-GAAP Measures”). Imputed Revenue is defined as the price paid by the customer for EA 6.0 license agreements. Total revenue, including Imputed Revenue is defined as total revenue reported by the Company plus Imputed Revenue less the agency fees included in reported revenue. The chart below shows the Total revenue, including Imputed Revenue tracked by the Company over the last three years. (In thousands of Canadian dollars) 2003 2004 2005Reported Revenue 548,669$ 630,310$ 784,434$ Agency Fees (11,420) (23,374) (30,662)Imputed Revenue 138,451 261,670 363,541 Total Revenue, including Imputed Revenue 675,700$ 868,606$ 1,117,313$

Microsoft does not pay rebates on sales of EA 6.0 agreements. As a result of the increase of these sales, rebates have begun to have a smaller impact on the overall profitability of the Company. We anticipate that this trend will continue.

Strengthening Canadian Dollar Approximately 60 percent of the Company’s revenue is from sales to U.S. customers. As a result of the increasing revenues in the U.S. and the volatility of the relative currencies, we will begin reporting our financial results in U.S. dollars, beginning with the first quarter of 2006.

There are four areas in which the strength of the Canadian dollar affects our financial results and risk profile:

1. Our net position in U.S.-dollar-denominated assets and liabilities;

2. Transactions where there are two currencies and time lags, or transaction risk;

3. The translation of the results of the U.S. subsidiary, or translation risk; and

4. The erosion of our economic advantage of having operational costs in the Canadian marketplace.

1. U.S.-dollar-denominated assets and liabilities In the Canadian Company there is usually a net liability position of U.S.-dollar-denominated assets and liabilities since the Company’s line of credit is in U.S. dollars. When we expect the Canadian-U.S. exchange rate to fluctuate significantly and when the net position is sizable, Softchoice typically hedges this exposure with forward exchange contracts. During 2005, a number of foreign exchange forward contracts were in place at various times, although none as at December 31, 2005. We expect to continue to protect the income exposure from these fluctuations through the use of foreign exchange forward contracts as the change to U.S. dollar reporting will not affect this type of foreign


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exchange risk. During 2005, the Company benefited with a net foreign exchange gain in this area in the amount of $0.4 million compared to $0.7 million in 2004.

2. Transaction risk This type of risk occurs due to currency fluctuations that take place when we buy and sell in different currencies over different time frames. For example, if a Canadian customer buys a product in Canadian dollars but we source the product in U.S. dollars, our margin on the transaction can vary depending on the exchange rate that we assume when we quote the product, when the product is purchased and when we pay for it. Generally, both sides of most transactions are in the same currency so this risk is minimal, but is monitored.

3. Translation risk This occurs when the results of the U.S. subsidiary are translated into Canadian dollars at the average rate for the period. In 2005, the average exchange rate for the Canadian dollar increased by 7 percent from US$0.76 to US$0.81. Therefore, for U.S. revenues to appear constant over the time period in Canadian dollars, sales in local currency would have had to increase by 7 percent. This has a significant impact on revenue and gross margin levels, but less of an impact on net income since most costs related to a transaction are incurred in the local currency. The chart below summarizes the impact of the strengthening Canadian dollar on reported revenue. Reporting in U.S. dollars will reduce the volatility in revenue reporting caused by foreign exchange fluctuations.

(All amounts in millions of dollars, except FX rates) FX rate 1.40 1.32 1.23Canada Revenue 173.9$ 242.5$ 313.8$ U.S. Revenue - US$ 267.7 293.6 384.0U.S. Revenue - Canadian $ 374.8 387.8 470.6Total Revenue - Canadian $ 548.7 630.3 784.4Y/Y % 15% 25%Total Revenue - constant FX using 2003 rate 548.7$ 653.5$ 851.4$ Y/Y % 19% 31%

4. Operational advantage For several years, Softchoice has enjoyed an advantage over our U.S.-based competitors because many of the costs associated with our operational infrastructure are denominated in Canadian dollars instead of the U.S.-dollar-denominated costs incurred by our competitors. However, as the Canadian dollar strengthened relative to the U.S. dollar, some of this cost advantage eroded and must be replaced with productivity gains and cost reductions.


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Seasonality Historically, the Company has followed a quarterly seasonality pattern that is typical of many companies in the information technology industry, with high sales at the end of the calendar year and low sales in the third quarter due to a lag in corporate spending during the summer months. Within the quarter, a significant level of sales usually occurs in the last two or three weeks of the quarter. The following trends have typically influenced the sales in each quarter:

• March 31 is the Canadian federal government year-end. Historically, the government tended to make purchases toward the end of its fiscal year. The effect of this buying pattern has diminished recently as the government has attempted to spread out its purchasing activities throughout the year. In addition, as the Company’s U.S. business has increased, the net impact of these sales has declined. In 2005, the Canadian government represented 7 percent of total sales.

• June 30 is Microsoft’s fiscal year-end, and Softchoice has historically benefited

from the sales and marketing drive that has been generated by Microsoft sales representatives to meet its year-end targets.

• September 30 is the U.S. federal government year-end. This date has not had an

historical impact on the Company since U.S. federal government sales are still growing and not yet significant enough to have an impact on this quarter.

• December 31 marks the fiscal year-end of much of corporate North America.

Historically, there have been increases in software revenue as our customers complete their asset purchases to meet their internal year-end requirements. In the fourth quarters of 2003 and 2005 Softchoice sold Microsoft licenses to the Internal Revenue Service (IRS) for US$29 million per year. In 2004, this contract was not recorded since the renewal slipped into early 2005.

Historically, net income for the Company has been lowest in the third quarter and highest in the fourth quarter; however, for the last two years, the impact of Microsoft’s sales at the end of the second quarter have pushed profits for that period above those realized in the fourth quarters of both 2004 and 2005.


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Summary of Quarterly Data All amounts in thousands of Canadian dollars (except earnings per share)

Q 1 Q 2 Q 3 Q 4 Q 1 Q 2 Q 3 Q 4Revenue 201,308$ 178,889$ 169,348$ 234,889$ 150,283$ 169,837$ 145,581$ 164,609$ Gross Margin 24,004 26,648 23,422 25,669 19,168 24,839 19,155 20,812Operating Income 6,618 8,227 5,013 6,684 2,210 8,372 5,374 4,641Net earnings 3,937 4,875 2,880 4,360 1,144 5,040 3,178 3,475EPS $0.23 $0.28 $0.10 $0.25 $0.07 $0.30 $0.19 $0.20

20042005

Key Performance Measures The Company presents five main key performance measures to help investors understand the underlying forces of the business. The measures reflect both the growth of the business and our productivity and are consistent with the way that management evaluates the business. We measure Gross Profit per Customer, instead of a more typical revenue measure, because the trend among our customer base toward EA 6.0 license agreements and therefore the increase in our revenue mix that is recorded on a net basis would make revenue-based analysis distorting. In prior years we have used Field Margin per Customer instead of gross profit. (Field Margin is a non-GAAP measure that deducts rebates and MDF from gross profit.) We have ceased using this measure because the trend toward EA 6.0 sales has reduced the Company’s rebate achievement, since EA 6.0 sales do not earn rebates from Microsoft. This means that the EA 6.0 fee is more properly compared to gross profit, which includes the margin that the customer pays, plus any rebate earned on the sale. Revenue or growth indicators:

Number of Customers Gross Profit per Customer

Productivity indicators

Revenue per Order Gross Profit per Sales Representative Gross Profit per Employee


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Number of Customers

Customers

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

1998 1999 2000 2001 2002 2003 2004 2005

Canada US Consolidated

In 2005, the number of customers in Canada grew by 17 percent and in the U.S. by 3 percent. In the fourth quarter alone, the number of customers in Canada grew by 24 percent and in the U.S. by 7 percent. The strong increase in Canada is partially as a result of the acquisition of the software division of 3-Soft Group early in the year. Our customer base can be segmented as follows:

.

2005 2004 2003Small - Medium 47% 48% 45%Enterprise (>2000 PCs) 20% 25% 19%Government 33% 27% 36%

Gross Profit per Customer Gross Profit per Customer needs to be analyzed in conjunction with total customer growth patterns as well. New customers tend to buy less when they first start purchasing from Softchoice and generally the amount per customer grows over time. In 2002, Microsoft stopped selling Upgrade Advantage licenses and many of our existing customers rushed to purchase the product while it was still available. As a result, the total number of customers declined in that year as we were focused on selling more to each existing customer. As those customers had no need for Microsoft products the following year, Gross Profit per Customer fell in 2003. Since that time, we have been able to balance our sales approach to increase both the number of customers served by Softchoice as well as the average amount purchased by our customers.


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Gross Profit per Customer

-

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

1998 1999 2000 2001 2002 2003 2004 2005

Canada

US

Consolidated

In 2005, Gross Profit per Customer increased by 6 percent in Canada and by 21 percent in the U.S., partially as the result of a large government renewal. On a consolidated basis, Gross Profit per Customer increased by 11 percent. Revenue per Order

Revenue Per Order

$-

$500

$1,000

$1,500

$2,000

$2,500

$3,000

$3,500

$4,000

$4,500

$5,000

1998 1999 2000 2001 2002 2003 2004 2005Calendar Year

Rev

enue

Per

Ord

er

Canada US Consolidated

In Canada, Revenue per Order has decreased by 4 percent over 2004, reflecting both the number of new customers who typically buy less and make smaller purchases when they first begin to buy from us and the result of the growth in the hardware business. In the U.S., Revenue per Order increased by 8 percent in 2005, as a result of a large government renewal. Revenue per Order is expected to decline gradually over time as the proportion of hardware orders increases. Average hardware orders are smaller than software license orders, and therefore an increase in hardware sales will reduce the average overall size of the order. This measure is monitored by management because it reflects the number of


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operational staff required to service the revenue. The consolidated decline of less than 2 percent in average order size in 2005 is less than we had anticipated. Employee Productivity During 2005, the average number of sales employees increased by 68 people, or 26 percent as a result of extensive hiring, primarily in the call centres. The average number of total employees also increased by 23 percent, or 104 people. As a result of these increases, the Gross Profit per Sales Employee and Gross Profit per Employee decreased in the year by 6 percent and 4 percent respectively. This very small decrease in productivity given the significant level of hiring in the year is a testament to the skills of our staff and the efficiency of our training programs as the employees are clearly becoming productive very quickly.

Employee Productivity

$-

$50,000

$100,000

$150,000

$200,000

$250,000

$300,000

$350,000

1998

1999

2000

2001

2002

2003

2004

2005

GP per Employee

GP per Sales Employee

Critical Accounting Policies The Company’s accounting policies are described in the “Notes to the Consolidated Financial Statements.” These policies are subject to management’s judgment in several areas, including the allowance for doubtful accounts, sales returns allowances, the accrual for rebates earned in the period and various other reserves and accruals for costs incurred in the period. In all cases, these areas of judgment represent management’s best estimate. These judgmental areas are similar for most businesses in this industry and should not expose the shareholders to unusual or unexpected trends. In particular, the Company’s accounts receivable are not concentrated in any specific industry, and the top 10 customers in 2005 accounted for 22 percent of total revenues. This ratio is much higher


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than in prior years because of the purchases of one specific customer and we expect that the accounts receivable concentration will return to lower levels in future years.4. The Company recognizes revenue when the products are shipped to a customer, FOB shipping point, or when the customer acquires the right to use or copy software under a license agreement, but in no case prior to the commencement of the license term, and when the price is fixed and determinable and collection is reasonably assured. Management estimates the level of returns of product that would normally occur after the end of the period using historical trends to predict future levels of returns. The Company generally recognizes revenue on a gross basis rather than a net basis. This revenue recognition policy means that we recognize as revenue the total cost of the product sold and invoiced to our customer and we recognize our cost from the publisher or manufacturer as cost of sales. There are three distinct reasons to support this treatment:

1. Softchoice incurs the risk of physical inventory loss once the customer has placed the order with us and we have placed the purchase order with the supplier;

2. Softchoice establishes pricing with its customers; and 3. Softchoice incurs the credit risk on its accounts receivable once the

product has been shipped.

If we were to record revenue on a net basis, after deducting the cost of the product, the financial statements would indicate revenue at much lower levels, but there would be no impact on net income or earnings per share. The recognition of gross revenue is consistent with the Company’s public competitors.

The exception to the recognition of revenue on a gross basis is for Microsoft EA 6.0 license agreements. In this instance, Microsoft sells the software directly to the end user and pays Softchoice an agency fee, or commission. In this case, Softchoice does not incur credit risk and it does not have a direct contractual relationship with the customer.

Changes in Accounting Policies In June 2003, the Canadian Institute of Chartered Accountants ("CICA") issued Accounting Guideline No. 15 ("ACG-15") "Consolidation of Variable Interest Entities." AcG-15 addresses the consolidation of variable interest entities ("VIEs"), which are entities that have insufficient equity at risk to finance their operations without additional subordinated financial support and/or entities whose equity investors lack one or more of the specified essential characteristics of a controlling financial interest. AcG-15 provides specific guidance for determining when an entity is a VIE and who, if anyone, should consolidate the VIE. The guideline was effective for the Company for its interim period

4 This sentence includes forward-looking information. See “Caution Regarding Forward-Looking Information.”


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beginning January 1, 2005. As the Company did not and does not currently hold any variable interests, the adoption of AcG-15 did not have any impact on its consolidated balance sheet, results of operations and cash flows.

Critical Accounting Estimates Financial statements prepared in accordance with Canadian generally accepted accounting principles (“GAAP”) require us to make estimates and assumptions that affect the reported amount of assets and liabilities at the date of the financial statements, disclosure of contingent assets and liabilities and reported amounts of revenue and expenses during the reporting period. Significant accounting policies and methods used in preparation of the financial statements are described in Note 2 to the consolidated financial statements. We evaluate our estimates and assumptions on a regular basis, based on historical experience and other relevant factors. Included in our consolidated financial statements are estimates used in determining doubtful accounts, sales returns allowances and rebates receivable. These estimates are made with management’s best judgment given the information available at the time and as much relevant historical data as is available. Actual results could differ from these estimates and assumptions. At the date of this report, Softchoice did not have any significant contingent liabilities or large or unusual reserve items that would expose these financial statements to unusual risk regarding estimates.

Use of Non-GAAP Measures In our financial reporting, we refer to Imputed Revenue or Total revenue, including Imputed Revenue, which are non-GAAP terms. Imputed Revenue and Total revenue, including Imputed Revenue do not have any standardized meanings under GAAP and are therefore unlikely to be comparable to similar measures by other users.

Imputed Revenue is defined as the price paid by the customer to Microsoft for EA 6.0 license agreements that are transacted through Softchoice sales representatives (see “Microsoft and Softchoice”). Total revenue, including Imputed Revenue reflects Imputed Revenue, plus reported revenue, less any agency fees included in reported revenue. Microsoft pays Softchoice an agency fee or commission for EA 6.0 sales, and therefore Softchoice does not record the total revenue for these transactions. Imputed Revenue allows for better comparability between fiscal periods since an increase in the product mix of EA 6.0s would make it appear that Softchoice is selling less, when that would not be the case. The use of Imputed Revenue also aids in comparison with our competitors. This measure is not likely to be used by any competitors in the industry for two reasons:

1. Public competitors all sell hardware as well as software and, typically, software revenue is only about 20 percent of total revenue. The impact of the EA 6.0 license is therefore much less significant; and

2. Softchoice has sold a greater portion of EA 6.0 license agreements than our competitors since we believe that the agreement often provides a more cost-


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effective solution for our customers, particularly in the Small Medium Business (SMB) market.

Disclosure Controls and Procedures With the supervision and participation of our management team, including the President and the Chief Financial Officer, we have evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Multilateral Instrument 52-109), as of December 31, 2005. Based on that evaluation, we have concluded that our disclosure controls and procedures are sufficiently effective to provide reasonable assurance that material information relating to the Company is made know to management and disclosed in accordance with the applicable securities regulations. Financial Statement Analysis Revenue Revenue for the year was $784.4 million - an increase of 25 percent from the revenue of $630.3 million reported in 2004. There are several factors that affected the revenue growth.

• Factors that enhanced revenue growth: o The acquisition of the Software Division of 3-Soft in February 2005; o A major U.S. customer purchased two annual software license renewals in

2005 due to a delay in signing its 2004 annual renewal); and o The growth in hardware revenue of 61 percent over 2004.

• Factors that depressed revenue growth: o The increased mix of EA 6.0 sales; and o The strengthening of the Canadian dollar relative to the U.S. dollar.

The table below outlines the impact of the Canadian dollar and the EA 6.0 fees over the last two years. (In thousands of Canadian dollars) 2004 2005Reported Revenue 630,310$ 784,434$ Agency Fees* (23,374) (30,662)Imputed Revenue 261,670 363,541 Total Revenue, including Imputed Revenue 868,606 1,117,313 Canadian Dollar - 55,779 Total Revenue, including Imputed Revenue, Adjusted to 2004 Exchange Rates 868,606$ 1,173,092$ *Agency fees are included in reported revenue. The Canadian dollar impact is calculated on Total revenue, including Imputed Revenue. (See “Use of Non-GAAP Measures”)


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When the comparative results are adjusted for the strengthening Canadian dollar and the impact of Imputed Revenue, the result indicates an underlying growth rate of the business of 35 percent. (In thousands of Canadian dollars) 2005 2004 $ Variance Y/Y %Canada $ $ $Total revenue, inluding Imputed Revenue 380,843 283,559 97,284 35%Imputed Revenue 71,955 44,478 27,477 62%Agency Fees* (4,938) (3,382) (1,556) 46%Reported Revenue 313,826 242,463 71,363 30% *Agency fees are included in reported revenue. The Canadian dollar impact is calculated on Total revenue, including Imputed Revenue. (See “Use of Non-GAAP Measures”) It is not possible to isolate the impact of the 3-Soft acquisition on the growth in Canada since the employees and customers have been fully integrated into the Softchoice environment. It is possible, however, to review the growth in revenue over the last several years in Canada alone to see that the growth trend in 2005 is consistent with prior years. In 1998 we began our expansion of the Canadian business into the United States. It has become evident that the growth of the Canadian business has also been a spin-off benefit of the investment in more sophisticated sales management that was required for the U.S. expansion.

Revenue in Canada

$-

$50,000,000

$100,000,000

$150,000,000

$200,000,000

$250,000,000

$300,000,000

$350,000,000

1998 1999 2000 2001 2002 2003 2004 2005


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United States 2005 2004 $ Variance Y/Y %

(In thousands of Canadian dollars) $ $ $Total revenue, including Imputed Revenue 599,493 442,699 156,794 36%Imputed Revenue 236,375 164,182 72,193 44%Agency Fees* (20,874) (15,124) (5,750) 38%Reported Revenue 383,992 293,641 90,351 31% *Agency fees are included in reported revenue. The Canadian dollar impact is calculated on Total revenue, including Imputed Revenue. (See “Use of Non-GAAP Measures”) Growth in the United States in 2005 was positively affected by two renewals in the amount of US$29.0 million each by the IRS. In 2002 and 2003 this contract was renewed in the last quarter of the year. In 2004, the renewal was delayed and was not signed until the first quarter of 2005. The normal renewal scheduled has now resumed and, as a result, this renewal revenue was again received in the fourth quarter of 2005. If the first renewal is reclassified into 2004 results or if the renewal trend is normalized, the growth in the U.S. revenue would have been 10 percent for the year. Total revenue, including Imputed Revenue growth would have been 21 percent. Reported revenue growth in 2005 continues to be consistent with that posted in prior years.

Revenue in U.S.

-

50,000,000

100,000,000

150,000,000

200,000,000

250,000,000

300,000,000

350,000,000

400,000,000

450,000,000

1998 1999 2000 2001 2002 2003 2004 2005

US


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Product Mix

Hardware Sales In the fourth quarter of 2002, Softchoice began the sale of hardware products to its customers. The table below outlines the growth in revenue in the new product line. (In thousands of Canadian dollars) 2002 2003 2004 2005Hardware Revenue - $'s millions 1.2$ 40.3$ 88.7$ 142.8$ Growth 3,258% 120% 61%% of Total Revenue 7.3% 14.1% 18.2% Hardware as a percentage of total revenue is below our targets set for 2005; however, this is the result of higher software sales, rather than a lower performance of hardware revenue. In addition, more than 34 percent of the Company’s customers have purchased hardware products from the Company this year.

Software Sales Softchoice sales of Microsoft products, excluding EA 6.0 licenses, increased in both Canada and the U.S. by 11 percent and 31 percent, respectively. The sales of other Microsoft products are the product lines that historically have generated the rebates recorded by the Company. Sales of other software include products by such publishers as Symantec, McAfee (or NAI), Adobe, Novell, IBM, etc. Sales of these products rose by 8 percent in Canada, 12 percent in the U.S. and 10 percent on a consolidated basis. Gross Profit

Gross profit includes the profit that we make when we sell the product to the customer, plus any benefits earned as a result of reductions in product costs due to volume rebates and marketing development funds earned in the period. The gross margin for the year ended December 31, 2005, was 13 percent compared to 13 percent for the year ended December 31, 2004. Gross profits grew at 19 percent over 2004. This growth comprised 25 percent growth at the product sales level, a small increase in market development costs and a reduction in earned rebates of about 10 percent. The rebate reduction is in spite of earning rebates on the large government renewal that occurred twice in the U.S. during 2005. Rebates are largely earned on Microsoft products, and the decline in the year reflects the impact of the switch in customer buying preferences toward the EA 6.0 license agreement. Rebates


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are now less than 2 percent of revenue, and management expects that they will continue to decline until they reach about 1 percent of total revenue.5 In Canada, gross profit grew by 24 percent, comprising an increase of product margins of about 33 percent and a decline of about 14 percent in rebates earned in the year. In the U.S., the margin on product sales increased by about 32 percent and rebate revenue declined only marginally for the year. Expenses Expenses in 2005 have increased by $9.8 million, or 16 percent. Expenses are outlined below as a percentage of Total revenue, including Imputed Revenue (see “Use of Non-GAAP Measures”) for two reasons: this ratio analysis aids when comparing our financial results with those of our competitors and with prior years since it eliminates the impact of the product switch toward EA 6.0 licenses. The overall increase of 16 percent is primarily as a result of increased investment in our sales staff during the year and should be analyzed in comparison with the gross profit increase of 19 percent and the increase in Total revenue, including Imputed Revenue of almost 30 percent. Expenses Thousands of Canadian dollars

$ % of Total revenue, including Imputed Revenue

$ % of Total revenue, including Imputed Revenue

Salaries and benefits 44,804 4.0% 37,828 4.4%Selling, general and administrative 23,403 2.1% 20,562 2.4%Amortization of property, plant and equipment 3,451 0.3% 3,525 0.4%Amortization of software 1,543 0.1% 215 0.0%Write-down of software - 0.0% 1,247 0.1%

73,201 6.5% 63,377 7.3%

2005 2004

Expenses as a percentage of Total revenue, including Imputed Revenue fell from 7.3 percent in 2004 to 6.6 percent. We believe that the improvement in this expense ratio reflects the productivity improvements that have been achieved at the same time that we hired new staff.



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Salaries and Benefits Salaries and benefits increased in the year by $7.0 million, or 18 percent. The average number of employees throughout 2005 was 554 compared to an average in 2004 of 450. At the end of the year, there were 604 employees at Softchoice, compared to 463 at the end of 2004. The increase in compensation costs is strictly related to the increased staff levels. Average compensation per person declined slightly as a result of the change in employee mix. We anticipate that we will not continue hiring at this level in 2006 and that there will be only modest increases in the size of the employee base this year.6

Selling, General and Administrative Expenses Selling, general and administrative expenses (“SG&A”) have increased in the year by $2.8 million, or 14 percent. The majority of this increase was incurred in the Canadian operation. SG&A costs increased in Canada by $2.6 million compared to the prior year, primarily in cost areas related to the new personnel, such as recruiting, training and travel costs. There were also increases in professional fees as a result of the activities of the Strategic Planning Committee. These increases in costs were offset by declines in bad debt expense, repair costs, rent and other miscellaneous expenses.

Amortization of Property, Plant and Equipment Amortization of property, plant and equipment decreased by $0.1 million, or 2 percent. As we continue to expand our business and reinvest in our computer equipment, amortization expenses should remain relatively consistent in future years. We expect ongoing capital expenditures of about $4.0 million.7

Amortization of Intangible Assets Intangible assets first arose when the Company acquired Beyond.com in 2002 and $2.4 million was recorded as intangible assets at that time, primarily related to expected profits on specific contracts that were purchased. By December 2004, all but $0.1 million of that balance had been amortized. The remaining balance of intangible assets relative to the Beyond.com acquisition was amortized in 2005. In February of 2005, we purchased the assets of the Software Division of 3-Soft Group. This acquisition, created additional intangible assets of $8.6 million. Of this balance, $1.5 million was amortized in 2005.

6 This sentence includes forward-looking information. See “Caution Regarding Forward-Looking Information.” 7 This sentence includes forward-looking information. See “Caution Regarding Forward-Looking Information.”


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The remaining balance is expected to be amortized over the next five years. The goodwill on the balance sheet can be identified as follows: (in thousands of Canadian dollars) Purchase of the minority interest of the U.S. subsidiary $7,853 Goodwill arising on the purchase of Beyond.com 3,141 Impact of foreign exchange, 2003 (334) Impact of foreign exchange, 2004 (327) Impact of foreign exchange, 2005 (75) Goodwill arising on the purchase of 3-Soft 6,414 Balance as at December 31, 2005 $16,672 In 2000, the U.S. subsidiary was 90 percent owned by the Canadian parent. Over 2001 and 2002, the Company purchased the remaining 10 percent of the shares in exchange for common shares of the Canadian parent. The purchase consideration for these step acquisitions was determined using the fair market value of the Softchoice common shares given as purchase consideration. As the liabilities acquired were in excess of the assets acquired, the full amount of the purchase consideration was allocated to goodwill. Goodwill balances related to Beyond.com’s Government Systems Group, the U.S. subsidiary and the 3-Soft acquisition are examined at the end of each reporting period for any deterioration in the value of the underlying business. As at December 31, 2005, management believes that no such deterioration exists.

Write-Down of Software In the first quarter of 2004, the Company wrote off software costs in the amount of $1.2 million related to licenses for an Oracle ERP system that we decided not to implement. There were no write-downs of capital assets in 2005. Operating Income Operating income grew by 29 percent over the prior year. The year-over-year increase in operating income is consistent with the increase in Total revenue, including Imputed Revenue (see “Use of Non-GAAP Measures”). Operating income as a percentage of revenue and as a percentage of Total revenue, including Imputed Revenue has remained relatively consistent with the prior year at 3.4 percent and 2.4 percent, respectively. Interest expense remained consistent with the prior year; however, interest in 2005 was primarily incurred because the operating line of credit was used to finance the $14.9 million acquisition of 3-Soft. Other income includes interest revenue generated from bank interest and various accounts receivable charges. In 2004 other income included a gain on the realization of an amount receivable from Electron Bank JSC in the amount of $0.5 million. This receivable was acquired by the Company as part of the reverse takeover transaction


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completed in 2002. The receivable had been discounted by the Company due to potential collection risks. This balance has now been collected in full and no further amount remains receivable. Earnings Earnings for the year of $16.1 million have increased by 25 percent over the earnings of $12.8 million reported for the year ended December 31, 2004. The Company’s income is fully taxable in both Canada and the U.S. at an effective tax rate of 39 percent. Fourth Quarter Thousands of Canadian dollars 2005 2004 $ % $ % Revenue 234,889 100.0% 164,609 100.0% Gross profit 25,669 10.9% 20,812 12.6% Expenses Salaries and benefits 12,293 5.2% 9,675 5.9% Selling, general and administrative 5,717 2.4% 5,624 3.4% Amortization of property, plant and equipment 862 0.4% 821 0.5% Amortization of intangible assets 113 0.5% 52 0.0% 18,985 8.0% 16,172 9.8% Operating Income 6,684 2.8% 4,640 2.8% Earnings before income taxes 6,988 2.9% 4,769 2.9% Net earnings for the period 4,360 1.8% 3,475 2.1% EPS $ 0.25 $ 0.20

Revenue increased by 43 percent in the quarter compared to the prior year. About half of the increase in the year is due to a government renewal of a software license in the amount of US$29.0 million that historically occurred in the fourth quarter of the year. In 2004, the finalization of this renewal was delayed until early in 2005, but in this quarter, the original schedule was resumed. A portion of the increase in Canada is due to the acquisition of 3-Soft, but the precise effect of this acquisition cannot be determined since the operations of 3-Soft have been integrated into the business of the Company. When the revenue in the quarter is adjusted to reflect Imputed Revenue (see “Use of Non-GAAP Measures”) and the strengthening Canadian currency, the underlying revenue growth for the quarter increases to 48 percent.


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(In thousands of Canadian dollars) 2004 2005Reported Revenue 164,609$ 234,888$ Agency Fees (5,899) (7,660)Imputed Revenue 60,407 86,526 Total Imputed Revenue 219,117 313,754 Canadian Dollar - 8,678 Total Imputed Revenue, Adjusted to 2004 Exchange Rates 219,117$ 322,432$ Gross profit increased by about 24 percent compared to the fourth quarter of 2004. The fact that this growth rate is significantly lower than the overall revenue growth rate indicates the decline in gross margin in percentage terms. The gross margin declined to 10.9 percent of revenue from 12.6 percent in the prior year. In the U.S. this decline is as a result of a large government renewal. In Canada the decline is due partially to some large IBM deals that were signed in the fourth quarter and to a reduction in rebates earned. Rebates in the fourth quarter declined by about $0.6 million compared to the same period in the prior year. This decline reflects the continued shift of product sales away from Microsoft Select licenses toward EA 6.0 licenses, particularly in Canada. Rebates in the U.S. were significantly higher than fourth quarter of 2004 as a result of the large government renewal. The strength of the Canadian dollar mitigated against the contribution that the strong US rebate performance had on the company as a whole. Expenses during the quarter increased by $2.8 million, or 17 percent, over the same period in the prior year. This increase includes a foreign exchange loss of $0.2 million compared to a small loss in the prior year. Salaries and benefits increased by $2.6 million, or 27 percent, as a result of increased hiring discussed above. Compensation expenses in Canada increased by $1.3 million. About 60 percent of this increase is due to higher staffing levels, and the balance is due to bonuses and commissions paid as a result of the strong results in the quarter. SG&A costs in Canada were about $0.8 million higher than in the prior year. Salaries and benefits the U.S. increased by US$1.3 million; approximately $0.1 million of this increase is due to additional staff, and the balance reflects bonuses and commission paid on sales results. SG&A costs in the U.S. were about $0.5 million lower than in the prior year. Amortization of property, plan and equipment increased by about 5 percent over the prior quarter, at a level that management thinks is reasonable to reflect ongoing investment in the capital assets of the business. The amortization of intangible assets increased by $61 thousand as a result of the acquisition of 3-Soft. Operating income for the quarter increased by $2.0 million or about 44 percent. The effective income tax rate was approximately 39 percent in 2005.


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Liquidity and Capital Resources The Company has available to it a credit facility of US$30.0 million with availability under this facility subject to a formula based on eligible accounts receivable. The interest charged on the facility fluctuates with the bank prime rate, plus or minus 0.75 percent. The term of the facility expires on March 31, 2006. We expect this facility to be renewed prior to that date without significant changes to the terms of the facility. The Company’s cash and loan balances fluctuate dramatically during a typical month, with the cycle of vendor payments concentrated at month-end. At the end of the year, the Company had outstanding $15.8 million of the available US$30.0 million credit facility. Additional needs for cash are not foreseen by management, and the Company has no immediate plans to raise capital in the equity markets.8 Accounts receivable balances reflect days sales outstanding (DSO) of 44 days as at December 31, 2005, compared with 43 days outstanding as at December 31, 2004. In a typical quarter, a larger percentage of sales for the quarter are recognized in the last two weeks of the quarter. This causes DSO to decline at month-end and quarter-end, compared with the rest of the intervening periods. Days payable outstanding (DPO) remained consistent with the prior year at 45 days. Payables to Microsoft typically lag other payables by up to 15 days due to our payment terms with Microsoft. As Microsoft sales decline as a percentage of overall revenue, the positive influence on DPO will also decline. In previous years, the Company has been able to cite the positive gap between payables and receivables as evidence that the Company could continue to expand without the need of additional capital to finance working capital. This gap has narrowed, but during 2005 we were able to maintain an average gap of two days between payables and receivables. Management expects this spread to be maintained, but there is no assurance that days payable will not continue to decline and put capital pressure on the Company’s forecasted growth. Management believes that the existing credit facility will be sufficient to handle increases in cash requirements caused by these changes.9 Softchoice earns revenue and incurs expenses in U.S. dollars in its U.S. subsidiary and in Canadian dollars in the parent Company. The expansion costs in the U.S. have been financed by U.S.-dollar-denominated debt, thereby reducing Softchoice's exposure to foreign exchange losses on this debt. Softchoice has available to it a foreign exchange facility of $4.0 million. This facility is used to purchase foreign currency forward contracts to protect the Company against currency fluctuations on U.S.-dollar-denominated assets and liabilities and against transaction risk when appropriate. During the fourth quarter of 2005, the Company purchased a U.S. dollar forward contract in the

8 This sentence includes forward-looking information. See “Caution Regarding Forward-Looking Information.” 9 This sentence includes forward-looking information. See “Caution Regarding Forward-Looking Information.”


27

amount of $10.0 million to protect the value of U.S.-dollar-denominated assets and liabilities. The contract expired at the end of December 2005. Management will continue to use such financial instruments when appropriate.

Softchoice has the following contractual obligations, excluding leases for premises, outstanding as at the end of December 2005.

Contractual Obligations

(In thousands of Canadian dollars.) Less than 1 year 1-3

years After 4 years Operating Leases $ 24.7 $89.7 $20.7

The Company has no long-term debt, capital lease obligations, purchase obligations or off-balance-sheet arrangements. Annual expenditures on capital assets were $3.0 million in the year compared with $1.7 million in 2004. We expect capital expenditures to be around $4.0 million per year on an ongoing basis.10

Share Capital The Company had 17,166,499 common shares outstanding at the end of 2005. In addition, a number of employees have stock options outstanding totaling 464,294 options that are exercisable into common shares for prices ranging between $2.50 and $8.10. Of these options 447,627 were vested as of December 31, 2005. During 2005, 67,620 options were exercised. The continuity of shares and an explanation of the weighted average number of common shares outstanding in the year are included in note 11 to the consolidated financial statements.

Facilities

Softchoice has 32 offices in North America with operating leases that run between three and 10 years in length. The Company is obligated to make future minimum annual lease payments under operating leases for office equipment and premises as follows:

Operating Lease Commitment Schedule

(in thousands of Canadian dollars) Amount 2006 $ 4,409 2007 4,132 2008 3,673 2009 2,915 2010 2,090

Thereafter 1,902 Total $ 19,121



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Cash Flow Cash on hand as at December 31, 2005, remained virtually constant with a minor decrease of less than $0.04 million compared to the cash at the end of 2004. However, the Company increased its borrowings under the credit facility in the amount of $13.4 million to finance the acquisition of the Software division of 3-Soft Group Inc. These changes reflect cash available from operations in the amount of $4.4 million. Cash from operating activities increased from $15.8 million in 2004 to $19.6 million in 2005; however, working capital requirements at the end of the year reduced cash flow by $15.0 million compared to a reduction of $4.0 million the prior year. The major difference over these two years is in the increase in accounts receivable due to higher sales at the end of the quarter. As long as the Company is in a net borrowing position, it is our practice to minimize cash balances as much as is practical. This objective is balanced by the need to have available cash in both U.S. and Canadian currencies to meet short-term payment obligations.

Related-Party Transactions There were no related-party transactions in the year with the exception of directors fees paid to directors who are also shareholders of the Company in connection with their remuneration as directors.

Risks The identification and management of risk is the overall responsibility of management, reporting to the Audit Committee. The mandate of the Audit Committee gives it specific responsibility to review, at least annually, significant risk-management strategies and exposure. At this time, the Company does not follow a specific risk model, but rather includes risk-management analysis in all levels of strategic and operational planning. Management has identified the risks as those specific to the Company in the upcoming year and has described these risks in the Annual Information Form. This form may be obtained on the Company’s website at www.softchoice.com or at www.sedar.com.

Documents

Caution Regarding Forward-Looking Statementsm.softchoice.com/files/pdf/about/Softchoice_MDA_2005.pdfThe words “expect,” “intend,” “anticipate” and similar expressions generally