PC Connection Inc

NASDAQ:CNXN

Earnings Call Transcript 2018-Q2

[Operator]

Good afternoon, ladies and gentlemen, and welcome to the Second Quarter 2018 Connection Earnings Conference Call. My name is Jonathan, and I will be your coordinator for today. [Operator Instructions] 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 are Tim McGrath, President and Chief Executive Officer; and Steve Sarno, Chief Financial Officer.

I'll now turn the call over to Steve Sarno.

[Stephen Sarno, executive]

Thank you. I will now read our safe harbor statement for today's call, which is also on Page 2 of the webcast slides being presented today as part of our call. And slides for today's call will also be made available in the Investor Relations section of our website after the call at www.connection.com.

Any statements or references made during the conference call that are not statements of historical fact 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 these 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 other documents that the company files with the commissions from time to time.

In addition, any forward-looking statements represent management's view as of today and should not be relied upon as representing views as of any 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 these forward-looking statements as representing views as of any date subsequent to today.

During this call, GAAP and non-GAAP financial measures will be discussed. A reconciliation between the 2 is available in today's earnings release and on the company's website at www.connection.com. Please note that unless otherwise stated, all references to second quarter 2018 comparisons are being made against second quarter 2017. Today's call is being webcast and will be available on Connection's website. The earnings release along with the supplemental slides presented are also available on the website. In addition, also earlier today, we filed our Form 10-Q for the second quarter with the Securities and Exchange Commission. The Form 10-Q is available, both on the SEC website at www.sec.gov and in the Investor Relations section of our website at www.connection.com.

Before we begin today's review of our Q2 operating results, I'd like to spend a few minutes to remind you of the company's adoption of the new revenue recognition standard and how it impacts the reporting of our Q2 results.

As of January 1, 2018, we adopted the new revenue recognition standard using the modified retrospective approach, as opposed to the full retrospective approach. In other words, our Q2 2018 results are stated under the new accounting standard for revenue recognition, while our previous years are stated under the prior revenue recognition standard.

In today's earnings release, we've provided a comparison of our Q2 2018 results between the current and prior revenue recognition standards.

The main impact of adopting the new standard for Connection was the Q2 revenue, as reported, under the new revenue recognition standard was $113.2 million less than we would've reported under the prior revenue recognition standard. $108 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. This is an addition to $14.4 million mainly related to the timing of shipments delivered to customers offset by $9.2 million related to the timing of bill-and-hold transactions.

We expect Q3's new revenue standard adjustment to be similar to the $78 million adjustment that we saw in Q1. 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 historic results. We plan to provide this comparative information for our earnings releases and conference calls for the next 2 quarters.

I'll now turn the call over to Tim to provide some color on our Q2 operating results. Tim?

[Timothy McGrath, executive]

Thanks, Steve. In Q2, we executed well across all of our business segments and delivered another strong quarter. The company achieved record second quarter gross profit and record operating income. Our continued focus on profitable growth, margin improvement and operational excellence is helping us to drive these record results.

Moving to Slide 3. Net sales, as presented, for the 3 months ended June 30, 2018, were $706.6 million. Net sales prior to the impact of the new revenue standard increased by 9.3% to $819.8 million compared to $749.8 million in Q2 a year ago.

Moving to Slide 4, gross profit as presented, increased by 7.8% to $107.5 million compared to $99.7 million a year ago. Gross margin, as presented, was 15.2% compared to 13.3% in the prior year quarter. We expect our Q3 gross margins to be similar to our 2018 year-to-date levels.

Moving to Slide 5 for a more detailed discussion of our performance by segment. In our Business Solutions group, Q2 revenue, as presented, was $270 million. Prior to the impact of the new revenue standard, net sales were $311.3 million, representing an increase of 5% compared to $296.4 million a year ago. Gross margin, as presented, for this segment increased 191 basis points to 17.5% in the quarter. We continue to execute well in the Business Solutions segment. Our Business Solutions group, as presented, has 17.6% growth in net/com hardware and 8% growth in mobility and intelligent edge products. We are selling across the solution stack and seeing strong growth in advanced technologies.

Let me share with you an example of the value we provide to our customers in this segment. An energy company needed a core-to-edge network for a new high-rise office building. This was a complex project and required a deep understanding of our customers' business and their needs. We worked collaboratively to deliver unique solutions that included system hardware, software, net/com, security, supply chain support and services, enabling our customer to focus on what they do best, running an energy business.

In Public Sector Solutions, we saw a return to growth during the quarter. As presented, revenue was $135.5 million, prior to the new standard sales were $159.4 million, representing an increase of $8.1 million compared to $151.3 million a year ago. Margin, as presented, for this segment decreased by 170 basis points to 12.5%. This growth was due to strength in federal and higher education spending.

In our Enterprise Solutions segment, Q2 revenue, as presented, was $301.1 million. Prior to the new standard, sales were $349 million, an increase of 15.5% compared to $302.1 million a year ago. Gross margin, as presented, for this segment increased by 208 basis points to 14.4%.

The Enterprise group continued to benefit from large project refresh and by the adoption of Windows 10. In addition, we are leveraging our global capabilities through our GlobalServe division. This combination drove strong growth in mobility and server/storage products, which, as presented, grew during the quarter at 37% and 27%, respectively.

Let me share with you an example of the power that GlobalServe and our Enterprise team bring to our customers who have international operations. Our Enterprise team recently helped a global provider of pharmaceutical and medical devices to design and deliver a new software platform and successfully rollout tens of thousands of devices in over 50 countries. GlobalServe and our OneSource portal enabled consistent delivery, reporting, pricing and logistics for our customers, thus providing our customers with a unique and efficient solution.

Having covered our 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?

[Stephen Sarno, executive]

Thanks, Tim. For those following online on our webcast slides, we're on Page 6 of the presentation.

SG&A, as presented, increased this quarter to $82.5 million and 11.7% of net sales from $77.2 million and 10.3% of net sales a year ago. Under the prior revenue recognition standard, our SG&A expense as a percentage of revenue would have been 10.1% versus 10.3% a year ago. This increase in our percentage of SG&A, as presented, was due to the new revenue recognition standard, which added 157 basis points. We expect SG&A as a percentage of revenue in Q3 to be similar to our 2018 year-to-date levels.

Our operating income, as presented, increased this quarter to $24.9 million or 3.5% of net sales from $22.4 million or 3% of net sales in Q2 a year ago. Under the prior revenue standard, our operating income as a percentage of revenue would have been 3.2%. The 54 basis point increase in the operating income percentage, as presented, was due to the new revenue recognition standard, which added 36 basis points and due to business performance, which added 18 basis points, almost entirely driven by improvement in SG&A.

Our Q2 effective tax rate was 27.5%, down from 39.5% in the same period a year ago, as a result of the Tax Cuts and Jobs Act, which became effective for Connection in Q1 of this year. The impact of the act was a decrease in our federal tax rate 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 rate for the year to be in the range of 27% to 29%. The lower tax rate contributed approximately $3 million or $0.11 per share during Q2 of 2018.

Net income, as presented, for the quarter, increased 34% to $18.2 million from $13.6 million a year ago. Prior to the impact of the new accounting standard, net income would have increased 39.9% to $19 million a year ago.

Earnings per basic and diluted share, as presented, increased 33% to $0.68 compared to $0.51 a year ago. Prior to the impact of the new accounting standard, EPS for basic and diluted share would have increased 39% to $0.71.

Moving to Slide 7. Earnings before income taxes, depreciation and amortization or EBITDA, as presented, our trailing 12-month adjusted EBITDA increased 7% to $100.9 million from $94 million a year ago. Prior to the impact of the new revenue standard, our trailing 12-month adjusted EBITDA would have increased 8% to $101.5 million.

Turning to balance sheet on Slide 8. We ended Q2 with $68.7 million of cash and cash equivalents, representing an increase of $18.7 million from December 31.

Cash flow from operations, shown on Slide 9, generated $41.5 million of cash versus a use of cash of $9.8 million for the same period a year ago, representing an increase of $51.3 million in cash generated.

Investing activities of $9.9 million for the first half of 2018 were primarily the result of equipment purchases and capitalization of our system upgrade.

Our financing activities during the first 6 months of 2018 used $12.9 million of cash, which was due to the Q1 payment of $9.1 million from our previously declared special dividend and $4.4 million of cash used to buy back 169,000 shares of our common stock at an average price of $25.87 per share under our previously authorized stock repurchase plans. This combined use of $13.5 million was partially offset by $600,000 generated through the issuance of stock for our employee stock purchase plan.

Please note on Slide 10 that as of June 30, 2018, we have $13.4 million remaining for stock repurchases under our existing stock repurchase program.

Moving to accounts receivable. Our day sales outstanding, or DSO, increased from 47 days a year ago to 53 days at the end of Q2. The entire 6-day increase is due to the impact of the new revenue standard, which resulted in the use of a lower sales denominator in our DSO calculation.

Moving to capitalized expenditures. During Q2, we capitalized $3.4 million, which was mainly due to our ERP system upgrade that is currently in progress. We expect our spend, both capitalizable and expansible remaining for this project to be in the range of $10 million to $12 million over the next 12 to 15 months. Our goal is to maximize shareholder value, while maintaining financial flexibility, which allows us to continue to assess M&A opportunities and other capital allocations, such as dividends and stock buybacks.

I will now turn the call back over to Tim to discuss current market trends.

[Timothy McGrath, executive]

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 margins, cash flow and earnings.

We will remain focus on helping our customers drive their success with improved technology solutions. Our goal is to grow faster than the market by taking share in this robust IT-demand environment. Consistent with industry trends, the IT market is estimated to grow at approximately 3-plus percent, and our goal is to double this rate of growth. Customer success is measured in many ways and enabled by advanced technologies. We'll continue to invest in complex areas of our business in order to help our customers improve productivity and empower innovation. Our Software business continues to grow, including cloud, virtualization and security. In addition, we're seeing strong growth in server/storage and net/com. We're also seeing continued growth in our vertical markets, financial services, health care, manufacturing and retail. For example, we're seeing strong demand in the retail space as our customers look to gain competitive advantage with upgraded technology solutions. 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]

[Operator Instructions] Our first question comes from the line of Adam Tindle from Raymond James.

[Adam Tindle, analyst]

Tim, I just wanted to start, revenue growth was certainly higher than 2 larger publicly traded peers that reported over the past few days. And gross margin was flattish, so it wouldn't appear to be aggressive pricing. So maybe start by talking about what enabled you to presumably gain some share in the quarter?

[Timothy McGrath, executive]

Well, Adam, thanks. We've been very focused on solution side of the business. And I think that our revenue growth primarily was led by the Enterprise segment with a good growth across the board, but led by Enterprise with the larger project rollouts. So really, it's -- larger count has been the driver of the additional growth.

On the margin side of the business, as you know, large accounts are often fairly competitive, and we're very pleased with the margins that we're seeing on the SMB business solution side of the business at 17-plus percent. We think they are industry-leading margins in that space, so we're part of that. And across the board, we think we are more in line with our peer group with Enterprise and Public Sector.

[Adam Tindle, analyst]

Okay. And some of those peers also provide a guidance for the back half of this year to see more modest year-over-year revenue growth, somewhere kind of in the mid-single-digit range. Can you maybe talk about what you're seeing for Connection, is that the right way to think about back half of the year?

[Timothy McGrath, executive]

Yes, thanks, Adam. So I think a few of competitors were using the term muted for the second half. And when we look out at that, we're going to stick to our forecast, which is in that 6-plus percent growth range and for right now that's the best visibility that we have.

[Operator]

Our next question comes from the line of Anthony Lebiedzinski from Sidoti & Company.

[Anthony Lebiedzinski, analyst]

So I guess first just on the Enterprise Solutions space. Obviously, that was your best-performing segment. Just wondering about the sustainability of that, sort of a follow-up to the previous question. Just wanted to get a sense as to how we should think about that segment, specifically?

[Timothy McGrath, executive]

Well, Anthony, thanks. And we are seeing consistently strong demand for large enterprise projects. We're certainly optimistic that, that demand will carry through the rest of the year. Naturally, we don't have a crystal ball, but at this point, we don't see any letting up in that enterprise. As you also know, large projects can be somewhat spotty, depending on year-over-year comps. And so again, we kind of stick by our forecast that will be high single-digit growth.

[Anthony Lebiedzinski, analyst]

Got it, okay. And then I was just wondering if you could comment on your outlook and appetite for potential acquisitions.

[Timothy McGrath, executive]

Thanks, again. So we -- obviously, we're watching the market closely. I think the competitive landscape has done a lot in the M&A space. And as you know, our balance sheet is clean, our powder is dry. We feel pretty comfortable with our business plan. So we don't feel a specific need to move in any direction, but we are, optimistically, always looking for opportunities that would be accretive and that would round out our solutions capability.

[Anthony Lebiedzinski, analyst]

Got it, okay. And then lastly, just looking at the cash flows. So Steve, as you pointed out, nice improvement there. Looks like accounts payable was the predominant driver there. Is this a timing issue? Or is there something else going on, specifically to accounts payable?

[Stephen Sarno, executive]

No. Actually I thought within -- when you look within the accounts payable year-over-year, we certainly generated some improvement there, in that I think accounts payable only grew about 2% on the balance sheet, while revenue grew at 9%. So some of that is certainly timing of the heavy Q2 at the end of the quarter. But certainly, when you look at it from a year-over-year perspective, I think we've done a better job of managing the balance sheet as well as generating more net income than we did a year ago.

[Operator]

[Operator Instructions] Our next question comes from the line of William Gibson from Roth Capital Partners.

[William Gibson, analyst]

Tim, I know you had record gross margins in the quarter, but given it's the end of Microsoft's year in the second quarter, I'm surprised it wasn't even maybe a little higher. How is your business with them?

[Timothy McGrath, executive]

So thanks, Bill. Good to hear from you. We have been very strong with Microsoft and very strong with software overall. In fact, in the quarter -- in Q2, software was 24% of our revenue. So nearly a quarter of our revenue. And as you know, we are netting down a large percentage of that. That said, when you look at the changes in some of our publishers' programs, we think that our margin has been very consistent there, but we didn't see a specific spike in that regard.

[William Gibson, analyst]

Okay, good. And actually, I was pleasantly surprised by the growth in the public sector is -- I guess, I'm a little surprised that maybe margins weren't under more pressure.

[Timothy McGrath, executive]

Thanks. We're pleased that we returned to growth there and now we need to carry that momentum forward. As you know, we had a really good growth in the federal space, and we also had some growth in the educational space and the combined growth, it was about 5%. So we're optimistic that we can carry that forward.

[Operator]

This does conclude the question-and-answer session of today's program. I'd like to hand the program back to Tim McGrath for any further remarks.

[Timothy McGrath, executive]

Thank you, operator. 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, for your participation in today's conference. This does conclude the program. You may now disconnect. Good day.