PC Connection Inc

NASDAQ:CNXN

Earnings Call Transcript 2018-Q1

[Operator]

Good day, ladies and gentlemen, and welcome to the First Quarter 2018 Connection Earnings Conference Call. My name is Valerie, and I will be your coordinator for today. At this time, all participants are in a listen-only mode. Following prepared remarks, there will be a question-and-answer session. As a reminder, this conference call is the property of Connection and may not be recorded or rebroadcasted without specific permission from the company.

On the call today is Tim McGrath, President and Chief Executive Officer; and Steve Sarno, Chief Financial Officer. Any statements or references made during the conference call that are not statements of historical facts may be deemed to be forward-looking statements. Various remarks that management may make about the Company’s future expectations, plans and prospects constitute forward-looking statements for purposes of the Safe Harbor provisions under the Private Securities Litigation Reform Act of 1995.

Actual results may differ materially from those indicated by those forward-looking statements as a result of various important factors, including those discussed in the Risk Factors section of the Company’s Annual Report on Form 10-K for the year ended December 31, 2017, which is on file with the Securities and Exchange Commission as well as in the documents that the company file with the commissions from time-to-time.

In addition, any forward-looking statements represent management’s views as of today and should not be relied upon as representing views as of subsequent date. While the company may elect to update forward-looking statements at some point in the future, the company specifically disclaims any obligation to do so even if estimates change. And therefore, you should not rely on those forward-looking statements as representing views as of any date subsequent to today.

During the call, GAAP and non-GAAP financial measures will be discussed. As a reconciliation between the two is available in today’s earnings release and the Company’s website. Please note that unless otherwise stated, all references to quarter 1 2018 comparisons are being made against first quarter 2017. Today’s call is being webcast and will be available on Connection’s website. The earnings release is also available on the website.

I would now like to turn the conference over to your host, Mr. Tim McGrath. Sir, please proceed.

[Tim McGrath, President and Chief Executive Officer]

Good afternoon, everyone, and thank you for joining us today to review the Company’s first quarter financial results. Connection had a strong first quarter and a great start to the year. Before we begin today’s review of our Q1 operating results, I’d like to ask our new CFO, Steve Sarno, to spend a few minutes discussing the Company’s adoption of the new revenue recognition standard and how it impacts the reporting of our Q1 results. Steve?

[Steve Sarno, Chief Financial Officer]

Thank you, Tim. We adopted the new revenue recognition standard as of January 1, 2018, using the modified retrospective approach as opposed to the full retrospective approach. In other words, our Q1 2018 results are stated under the new accounting standard for revenue recognition, while our prior periods are stated under the prior revenue recognition standard. In today’s earnings release, we’ve provided a reconciliation of our Q1 2018 results between the current and prior revenue recognition standards.

The main impact of adopting the new standard for Connection was the Q1 revenue, as reported, under the new revenue recognition standard was $75.6 million less than we would’ve reported under the prior revenue recognition standard. $78.6 million of this impact related to treating certain software arrangements, such as security software, cloud-based licenses and maintenance on a net revenue recognition basis would be offsetting $3 million mainly relating to the timing of the build-and-hold transactions.

We expect to have similar-sized adjustments when compared to prior periods for the remaining three quarters of 2018. In reviewing our financial results today, we will be referencing the term "as presented," which reflects the implementation of the new revenue recognition standard as well as amounts prior to the impact of the new standard to allow for comparability against historical results. We plan to provide this comparative information between the old and new standards in our earnings releases and conference calls for the next three quarters.

I’ll now turn the call back over to Tim to provide some color on our Q1 operating results. Tim?

[Tim McGrath, President and Chief Executive Officer]

The company achieved record first quarter operating income, gross profit and earnings per share. Our continued focus on profitable growth, margin improvement and operational excellence is driving these record results. Net sales as presented for the first three months ended March 31, 2018, were $624.9 million. Net sales prior to the impact of the new revenue standard increased by 4.5% to $700.5 million compared to $670.6 million in Q1 a year ago. Gross profit as presented for Q1 was $96.4 million. Gross profit prior to the impact of the new revenue recognition standard increased by 10.4% to $95.8 million compared to $86.7 million in Q1 a year ago. Gross margin was 15.4% as presented. Gross margin prior to the new revenue recognition standard was 13.7% compared to 12.9% in the prior year’s quarter.

In our Business Solutions group, Q1 revenue, as reported, was $263.3 million. Prior to the new revenue standard, sales were $298.7 million, representing an increase of 9.1% compared to $273.6 million earned a year ago. Gross margins for this segment increased by 229 basis points to 17.6% in the quarter. We continued to execute well and take market share in the Business Solutions segment. We’re selling across the solution stack and seeing more growth in advanced technologies, including 19% growth in server/storage and 18% growth in net/com products.

In our Enterprise Solutions segment, Q1 revenue, as reported, was $257.2 million prior to the new standard. Sales were $290.2 million, an increase of 14.7% compared to $252.9 a year ago. Gross margins for this segment increased by 176 basis points to 14.3% in the quarter. The Enterprise group continued to benefit from large project refresh and by Windows 10 option. In a different – excuse me, in addition, we’re leveraging our growth capabilities through our GlobalServe division. This combination drove strong growth in mobility and server/storage products, which grew during the quarter at 27% and 13%, respectively.

In Public Sector Solutions, Q1 revenue, as reported, was $104.4 million prior to the new standard. Sales were $111.6 million, representing a decline of $32.4 million compared to $144 million a year ago. The majority of the decline was due to a large federal project rollout that did not repeat this year and was previously disclosed on our prior calls.

Gross margin for this segment increased by 364 basis points to 12.9% in the quarter. Having covered sales and gross margin performance, I’ll now turn the call over to Steve to discuss additional financial highlights from our income statement, balance sheet and cash flow statement. Steve?

[Steve Sarno, Chief Financial Officer]

Thanks, Tim. SG&A, as reported, increased this quarter to $80.9 million or 12.9% of net sales from $75.3 million or 11.2% of net sales a year ago. Under the prior revenue recognition standard, our SG&A expense as a percentage of revenue would have been 11.5% compared to 11.2% a year ago. This increase in percentage was primarily due to the new revenue recognition standard, which added 140 basis points. The remaining 30 basis point increase was primarily due to higher variable compensation associated with our increased gross profit performance.

Moving to operating income. Our operating income increased this quarter to $15.5 million with 2.5% of net sales during Q1 from $11.5 million or 1.7% of net sales in Q1 a year ago. Under the prior revenue recognition standard, our operating income as a percentage of revenue would have been 2.1%. This increase in percentage was primarily due to the new revenue recognition standard, which added 40 basis points. The additional 40 basis points of improvement was primarily due to the higher level of gross profit earned, partially offset by our increase in SG&A.

Moving to our tax rate. Our Q1 effective tax rate was 27.5%, down from 35.2% in the same period a year ago as a result of the Tax Cuts and Jobs Act, which became effective at the Connection in Q1 of this year. The impact of the tax act was a decrease in our federal rates from approximately 35% to 21%. This decrease in the federal rate was partially offset by an average state rate that rose from 5% to 6.5% due to there being less federal taxes to deduct for state tax purposes. We expect our tax rate for the remainder of 2018 to be in the range of 27% to 29%.

Moving on from taxes to net income. Our net income, as presented, for the quarter increased to $11.3 million, up 52% from a year ago. Under the prior standard, our net income would have been $10.9 million, an increase of 47% from the prior year’s quarter’s net income. Earnings per basic and diluted share, as presented, increased to $0.42, up 50% from $0.28 last year. Prior to the impact of the new accounting standard, basic and diluted EPS would have been $0.41 per share. In addition, our trailing 12-month adjusted EBITDA increased to $98.6 million.

Turning to the balance sheet. We ended Q1 with $71 million of cash, representing an increase of $21 million from December 31. Cash flow from operations was $37.2 million versus $25.4 million for the same period a year ago. Investing activities for Q1 were primarily the result of equipment purchases of $5 million, while our financing activities used $11.3 cash due to the Q1 payment of $9.1 million for our previously declared special dividend and $3 million of cash used to buy back 116,000 shares of our common stock at an average price of $25.78 per share under our previously authorized stock repurchase plans.

As of March 31, we had $14.8 million remaining for buybacks. In addition, we generated cash of $900,000 due to the use of our line of credit. The $900,000 was subsequently repaid in April making us debt-free as of today. Moving to accounts receivable. Our days sales outstanding, or DSO, increased from 48 days a year ago to 53 days at the end of Q1.

The entire five-day increase is due to the impact of the new revenue recognition standard, which resulted in lower net sales, which translates into a smaller day sales denominator being used in our DSO calculation. Moving to capital expenditures. During Q1, we capitalized $2 million for our new ERP system upgrade that is in process. We expect our spend, both capitalizable and expensable remaining for this project, to be in the range of $12 million to $14 million over the next six quarters.

Our goal is to maximize shareholder value, while maintaining financial flexibility. We continue to assess M&A opportunities and other capital allocations, such as dividends and stock buybacks.

I’ll now turn the call back over to Tim to discuss current market trends. Tim?

[Tim McGrath, President and Chief Executive Officer]

Thanks, Steve. Demand for IT products and solutions has been strong, as our customers are using technology to transform and shape their future. It’s good to see our continued strength and execution in gross margin and earnings. Our goal is to grow faster in the market by taking market share in this robust IT demand environment. Consistent with industry trends, the IT market is estimated to grow at approximately 3%, and our goal is to double that rate of growth. We remain focused on advanced technologies and continue to invest in complex areas of our business in order to help our customers drive their business outcomes.

Our software business continues to grow, including cloud, virtualization and security. In addition, we’re seeing strong growth in server/storage, net/com and hyperconverged infrastructure. We’re off to see robust growth in the vertical markets, retail, manufacturing, health care and financial services. We believe in the strength of our business model, and remain focused on our strategic initiatives to deliver sustained and predictable performance.

We’ll now entertain your questions. Operator?

[Operator]

Thank you. [Operator Instructions] Our first question comes from Anthony Lebiedzinski from Sidoti. Your line is open.

[Anthony Lebiedzinski, Sidoti]

Yes. Good afternoon and welcome Steve to Connection. So I just had a few quick questions. So first of all, with the Large Account, the sales were particularly strong once adjusted for the new revenue recognition method. Just wondering about the sustainability of that? And also, Tim, you mentioned that you’ve gained share, I assume, from the smaller bars. Just wanted also to get a sense as to how sustainable you think these trends are?

[Tim McGrath, President and Chief Executive Officer]

Well, Anthony thanks. So our Business Solutions grew – our large enterprise – excuse me, large enterprise grew, prior to the adjustment, grew at about 14.8%, a little under 15%. So really good growth. That growth is outpacing the market. And when we look at the funnel and the forecast, we see many project refreshes coming. We think that there’s good growth and sustainable growth happening in that segment of the market. I think our competitors are seeing growth as well, they have very strong growth. So we’re optimistic.

There are a number of drivers of that. We think the refresh will continue. We think Windows 10 adoption will continue. We’re seeing very strong growth in device and mobility segment. So overall, we’re pretty bullish on this segment. As you know, we are dependent on the economy, and we’re cautiously optimistic. But of our three subsidiaries, our Enterprise group, clearly, has the strongest funnel throughout 2018.

Our Business Solutions group is also very strong. They are at about 9.2%. And so exciting there is they are selling across the solution stack. We’re really getting great penetration with the advanced technologies. Server/storage looks good. And I think that business is going to be fairly consistent. But as you know, our Public Sector business has been a little more challenged. We had a really tough compare. And moving forward now, I think our growth there is going to be dependent upon those large contract vehicles and some of the large federal projects. So blended, we remain focused on our goal and that’s to grow twice as fast as the rate of growth in our industry. And right now, we still see that growth at around 3%.

[Anthony Lebiedzinski, Sidoti]

Got it, okay. Thanks for that. And also – so looking back at 2017, I think, Tim, you had described it as hypercompetitive. I mean look at the first quarter numbers normalizing for the revenue recognition standard. Looks like your gross margin was up roughly 80 basis points adjusting, again, for the revenue recognition. So are we kind of past the worst of the hypercompetitiveness in your opinion?

[Tim McGrath, President and Chief Executive Officer]

I think that growth in large enterprise is going to continue to be very competitive. I think that’s sort of the new world that we live in. But I do think some of the margin – and if you look at margin analysis across all 3 sectors, we have seen growth in all three sectors, and some of that’s fairly significantly. So as part of our business plan, we’re going to be very focused on that. And we’re going to be very diligent at that process with a number of internal initiatives. So I hope the worse is behind, yes, but that remains to be seen.

[Anthony Lebiedzinski, Sidoti]

Got it, okay. And lastly, I didn’t notice and also if you called out you did buy some shares. It looks like this is the first time since 2012 that you bought back some stock. Just wondering about how you’re thinking about future share repurchases?

[Tim McGrath, President and Chief Executive Officer]

Sure, happy to take that, Anthony. We definitely remain – have some funds available and remain open to the thought about doing some additional purchases. And in fact, we have already done some in the month of April.

[Anthony Lebiedzinski, Sidoti]

Got it. Okay, thank you.

[Tim McGrath, President and Chief Executive Officer]

Thank you.

[Operator]

Thank you. [Operator Instructions] I am showing no further questions at this time. I’d like to turn the conference back over to the company for any closing remarks.

[Tim McGrath, President and Chief Executive Officer]

Well, thank you, Valerie. And I’d like to thank all of our customers, vendor partners and shareholders for their continued support and our dedicated coworkers for their efforts. I’d also like to thank all of you listening to the call this afternoon. Your time and interest in Connection are appreciated. Have a great evening.

[Operator]

Thank you. Ladies and gentlemen, this does conclude today’s conference. Thank you for your participation. Have a wonderful day. You may all disconnect.