PC Connection Inc

NASDAQ:CNXN

Earnings Call Transcript 2020-Q2

[Operator]

Good afternoon, and welcome to the Second Quarter 2020 Connection Earnings Conference Call. My name is Michelle, and I'll be the coordinator for today. At this time, all participants are in a listen-only mode. Following the 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 rebroadcast without specific permission from the company.

On the call today are Tim McGrath, President and Chief Executive Officer; and Tom Baker, Senior Vice President and Chief Financial Officer.

I will now turn the call over to the company.

[Unidentified Company Representative]

Thanks, operator. I will now read the safe harbor act.

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, 2019, as updated in the form 10-Q for the period ending June 30, 2020, each of which are on file with the Securities and Exchange Commission as well as in other documents that the company files with the commission 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 two 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 2020 comparisons are being made against the second quarter of 2019.

Today's call is being webcast and will be available on Connection's website. The earnings release will be available on the SEC website at www.sec.gov and in the Investor Relations section of our website at www.connection.com.

I would now like to turn the call over to our host, Tim McGrath, President and CEO.

[Tim McGrath, President and CEO]

Thank you. Good afternoon, everyone, and thank you for joining us today for Connection's second quarter 2020 conference call.

Let me start by stating the obvious. It was a tough quarter, after a strong first quarter, driven in part by urgent demand in March from customers transitioning their people to working from home, the pandemic's impact on our customer base and demand was significant.

While we entered Q2 with good momentum in early April demand declined later in the month and dropped significantly in May to a low point. It began to recover somewhat in June but not enough to make up for May. Fortunately, I can say at this point that July improved over June.

As noted in our press release, the second quarter was also impacted by the long planned deployment of our new ERP system. Although the new system was much needed and frankly overdue, the deployment over the last 80 days or so is difficult to say the least. But I strongly believe the pain will be worth it.

The new system will serve as a foundation for our path forward, supporting growth, greater collaboration, visibility and efficiency across our entire organization, helping with solution sales, cloud, CRM, common catalog and financials. It will also enable better customer service and give us an improved foundation for evaluating and integrating future acquisitions.

While the implementation was substantially complete by the end of the second quarter, integration team in pains unfortunately required significant focus by key employees and management as well as extra efforts by members of our sales team, which while important to protecting our customers proved to be distracting in certain circumstance.

Our customer-facing work on the system is essentially complete and some back office work has continued into the current quarter. You can be sure I'm very focused on this and I believe that our most significant difficulties on the ERP execution front are now mostly behind us.

I am confident that with this system, we are better positioned than ever to continue to assist our customers in adopting the technologies they need to drive business continuity, strengthened security, re-imagine the workplace and transform their businesses to meet the challenges of the future.

I want to give a special shout out to our incredible team which under unprecedented circumstances because of the pandemic worked tirelessly to mitigate the impact on customer service as we made the transition. I'm very grateful for their hard work and dedication.

Turning to the financials for the second quarter, revenue was $550 million, a decrease of 25.8%, while gross profit was $89 million, a decrease of 23.9% compared to Q2 of 2019. We achieved gross margin of 16.2%, which represented growth of 40 basis points compared to Q2 of 2019. Overall, we saw a strong performance in software subscriptions and we expect demand to be strong for remote work, cloud, business continuity and security going forward.

Operating income was $10.6 million, a decrease of 67.2% or 1.9% of net sales compared to $32.3 million or 4.4% of net sales in the prior year quarter. In Q2 2020, diluted earnings per share were $0.29, a decrease by 67.4% from Q2 2019. We ended Q2 with $165.9 million of cash and cash equivalents, representing an increase of $75.9 million from December 31.

Now I'd like to provide a more detailed discussion on our performance by segment. In our Business Solutions segment, Q2 net sales were $191.1 million, a decrease of 29.5% compared to $271.1 million a year ago. Gross profit in the Business Solutions segment was $37.2 million, a decrease of 29.7% from a year ago. And gross margin for this segment remained flat at 19.5% in the quarter.

Our Business Solutions segment was the segment most affected by the COVID-19 pandemic. Many Business Solutions customers were forced to shutdown in the March and April time frame sharply curtailing their purchases of equipment, and other cases certain larger projects were deferred into later in the year. Margins remained strong at 19.5% in the quarter as more than half of the Business Solutions revenue was derived from advanced technologies.

In our Public Sector Solutions segment Q2 net sales were $112.2 million, a decrease of 26.2% compared to $152 million a year ago. Sales to the federal government were $26.3 million, a decrease of 40.9% compared to the prior year. Q2 of 2019 benefited from the timing of several large federal project roll-outs that did not repeat in Q2 2020.

Sales to state and local government and educational institutions was $85.9 million, a decrease of 20.1% compared to the prior year. The decrease of the flood business was largely the result of lower sales to higher ed institutions that were closed for most of the quarter. However, it is notable that we ended the quarter with a backlog double that of the prior year.

Gross profit for the Public Sector segment was $14.4 million, a decrease of 20.6% compared to Q2 2019. However, gross margins grew by 90 basis points to 12.9% as software-as-a-service became a larger component of our product mix.

In our Enterprise Solutions segment, Q2 net sales were $246.8 million, a 22.4% decrease compared to $318 million a year ago. Gross profit for the Enterprise segment was $37.3 million, a decrease of 18.5% in the quarter. Gross margin for the Enterprise segment increased by 72 basis points to 15.1%.

Enterprise saw a drop in demand for data center planning and related projects. Demand shifted to more work from home projects and software subscriptions. We are beginning to see industry leading customers take this opportunity to invest in their transformational technologies.

Having covered our sales and gross margin performance, I will now turn the call over to Tom to discuss additional financial highlights from our income statement, balance sheet and cash flow statement. Tom?

[Tom Baker, SVP and CFO]

Thanks Tim.

SG&A was $77.4 million this quarter, a decrease of 8.4% from $84.7 million a year ago. The decrease in SG&A was driven in part by a decrease in product marketing costs and variable compensation due to the lower level of sales and gross profit achieved compared to the prior year quarter.

Additionally, we incurred costs associated with the roll-out of our new ERP system of $2.8 million and we incurred $1 million of bad debt expense in the quarter versus a credit of $600,000 in the prior year quarter.

SG&A as a percentage of net sales increased by 267 basis points year-over-year, largely as a result of lower revenue. A large portion of our cost structure is variable and will scale with the business. As business conditions continue to improve, we do expect SG&A as a percentage of revenue to moderate despite some continued investment in our ERP system. We remain committed to optimizing our cost structure to scale with the demands of our business as necessary.

In Q2, we incurred $1 million of restructuring costs associated with reduction of some of our internal resources. These charges represent in a separate line in our income statement. Our operating income was $10.6 million, a decrease of 67.2% this quarter from $32.3 million a year ago. Our effective tax rate was 27.9% up from 27.2% in the same period a year ago. Net income for the quarter was $7.6 million, a decrease of 67.7% from $23.7 million a year ago.

Diluted earnings per share was $0.29, a decrease of 67% from the prior year period. Earnings per share adjusted for the restructuring and other charges were $0.32 compared to $0.89 last year. Our trailing 12-month adjusted earnings before income taxes, depreciation and amortization or adjusted EBITDA decreased 5% to $110 million from $115.7 million a year ago. We have $12.7 million remaining for stock repurchases under our existing stock repurchase program.

Cash flow from operations for the first six months of 2020 was a record $102.4 million versus $3.3 million for the same period a year ago. The change was driven primarily by a reduction in accounts receivable and an increase in accounts payable, partially offset by increases in inventory. Our net cash used in investing activities of $8.2 million in the first half of 2020 was primarily the result of equipment purchases and IT initiatives.

The company used $18.3 million of cash for financing activities during the first half of 2020, consisting primarily of the Q1 payment of $8.4 million for our previously declared 2019 special dividend and $10.2 million of stock repurchases. While it is impossible to predict how long or how severe the economic impact of the COVID-19 pandemic will be, near the end of June and through July, we started to experience a rebound in order activity, which we believe will continue

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

[Tim McGrath, President and CEO]

Thanks Tom.

For the second half of 2020, we expect to see an acceleration of public cloud adoption, growth in collaboration tools and demand for digital e-commerce platforms and digital health technologies.

As our customers are adjusting to challenges brought about by the COVID-19 pandemic, we are focused on supporting them during this difficult time with technological solutions and services. For example, we continue to help our customers define their work from home and remote work strategies.

We're also helping customers stabilize and secure their businesses with infrastructure support and cloud optimization. In addition, our Lifecycle Services team is assisting customers with managing expenses by helping them maximize their existing IT assets through warranty contracts and managed services.

As our customers' needs grow and change, we will be here to help them enhance growth, elevating productivity and empower innovation with technology. As stated earlier, it's not possible to predict what impact the global pandemic will have on our business, but as Tom said, we do believe that revenues will continue to be adversely affected in the near term. However, we did see a significant improvement in July. We also believe that disruptions resulting from the deployment of our new ERP system are largely behind us.

During the pandemic, we invested in our business and strengthening our management team with the addition of several key leaders. Our financial strength and position in the market will permit us to make further opportunistic investments in our business. As we've navigated these challenging times, our highest priorities have been to ensure the safety and well-being of Connection's workforce and to support the immediate business needs of our customers. We've employed rigorous safety protocols at our Technology Integration and Distribution Center, which remains staffed and fully operational.

While the reality of a world post COVID-19 remains unclear, one thing is certain. Technology offers the innovation and safety we need to move forward. I want to thank our team for their passion and extraordinary efforts through the most difficult quarter in recent history. We are confident that our financial strength, dedicated workforce, constant pursuit of innovation and strong customer relationships will drive our growth.

We'll now entertain your questions. Operator?

[Operator]

[Operator Instructions] Our first question comes from Anthony Lebiedzinski with Sidoti & Company. Your line is open.

[Anthony Lebiedzinski, Sidoti & Company]

So, first, I just wanted to start off with, as far as the new ERP system implementation, do you have an estimate as to how much your revenue was impacted and also which areas of the business that the ERP system implementation hit the most?

[Tim McGrath, President and CEO]

So, with a lot of moving pieces to the quarter obviously with the pandemic and obviously a rough quarter, there's no doubt about it, our ERP implementation was bumpy. As I said in the prepared remarks, we think it's the right path forward for us. We see a lot of benefits to the new ERP system, but it was really distracting in the quarter, because there is also the backdrop of the pandemic, we felt like that might be a good time to make this implementation and to complete it, because we felt that would be the best time to have the least impact on our customer base.

So with that, it's really hard to break out those dollars succinctly. But we think a good estimate, and this only is an estimate, we don't know with certainty, but would be sort of look at what the competitive landscape has been doing around declines because of the pandemic, and you see that we were a little south of that, and that delta we think is the result of our people being distracted focusing on our customers and making sure we got them squared away in the quarter. So, no doubt, it hurt us. We don't have an exact percentage, but I'd say the delta between the average in the market and where we're at, is a good surrogate.

[Anthony Lebiedzinski, Sidoti & Company]

And then in terms of the - as you just stated, second part of my first question was as far as the - which areas of business - I mean, do you think it was across the board or did you see perhaps more of a hiccup because of this, let's say, an Enterprise versus the Business Solution or is it - just wanted to get a little bit more color about the impact?

[Tim McGrath, President and CEO]

I think, any way you slice it, our Business Solutions team, our SMB Group was the hardest hit. They have the large number of - we have the largest number of buying customers there and also the largest number of customers who were impacted by the pandemic.

So that combination was tough and certainly magnified by our ERP implementation. Behind that would be government, in particular our federal business had a very tough quarter. Our Enterprise is probably the least affected simply because of our marketplace technology and our go-to-market strategy there. So I'd say, clearly Business Solutions was the most affected. Tom?

[Tom Baker, SVP and CFO]

Yes, I think that's - I think, Tim [indiscernible] a point there just because of the way the businesses operate, Enterprise was dependent on the ERP.

[Anthony Lebiedzinski, Sidoti & Company]

And Tim you also talked about the trends that you were seeing in July. We saw in July that they were better than June, what about versus a year ago, how would you say those trends were in July?

[Tim McGrath, President and CEO]

So we are - we did start to see a recovery in July. If we take a benchmark probably year-over-year for July would be probably still low single-digit declines in July. Tom how would - what you think?

[Tom Baker, SVP and CFO]

Yes. Somewhere in that range.

[Anthony Lebiedzinski, Sidoti & Company]

And then you talked about - we believe, Tim, you mentioned about the higher backlog being doubled from last year. So can you perhaps quantify that?

[Tim McGrath, President and CEO]

Yes. Anthony, we don't typically disclose our backlog. You know, I think that backlog is really a function of two things. And the backlog we were talking about that was specifically for flood. And I think what we're seeing there is, one, a little bit of resurgence in some of the higher education institution starting to buy, so that business is coming back. There was a few product shortages that affected part of the government business; and then three, we probably a little bit behind processing some orders because of the ERP. So - but 2x is a pretty healthy backlog in that business.

[Anthony Lebiedzinski, Sidoti & Company]

And then last question from me. As far as bad debt expense, I think, Tim, you mentioned there was a $1 million impact in the quarter. How should we think about that for the rest of the year?

[Tim McGrath, President and CEO]

I honestly believe that assuming nothing really bad happens in the macro environment between now and then accelerates the pandemic. I think we're pretty well covered, and I think we probably shouldn't have to experience those levels of charges going forward.

[Operator]

Our next question comes from Adam Tindle from Raymond James. Your line is open.

[Adam Tindle, Raymond James]

Tim, I just want to start on some of the demand commentary. I think you just said that the month of July just had low single-digit declines. And that's a pretty significant uptick versus down over 20% for the full June quarter. Maybe if you could give us a little bit of color on where you're seeing that uptick? And then secondly, as you sit here, while I look a little bit of time under you in the month of August, have you seen that trend continue to where we might even see year-over-year growth in the month of August, just some color on that trajectory following that July uptick would be helpful?

[Tim McGrath, President and CEO]

Well, thanks, Adam. So, first off, I'd love to focus on where we're going perhaps to where we've been. But as I said, Q2 was tough, and so for Q3, as you know, we have a seasoned team. We have some extraordinary employees who really know the business. We just had to get the system in place to support that. And when it comes to the customer-facing aspect, we are there, and so we now are really looking forward to getting back to business and to driving growth.

That said the pandemic is still out there and so we think about Q3 maybe overall and we don't have a great barometer but maybe negative 10% for the quarter year-over-year, be a much better benchmark than where we were in Q2. Tom, what would you add?

[Tom Baker, SVP and CFO]

Yes. And I think, I mean, I look at the numbers every day. We had five business days in August so far, because you specifically at the August. I think what we're seeing in July appears to be continuing. So I - again we're five days into it, but it doesn't look like July was an aberration.

[Adam Tindle, Raymond James]

And do you think any of that is like an aspect of like backlog that you had entering Q3? You had an ERP issue, obviously we understand, where there like unfilled quarters that you're now filling in July and August or is this uptick what you're seeing pure actual end customer demand?

[Tom Baker, SVP and CFO]

So, I guess, I should have been more specific, Adam. When I was talking about the numbers in July and August, I was actually talking about net orders, net bookings so, because that's our best leading indicator.

[Adam Tindle, Raymond James]

Right.

[Tim McGrath, President and CEO]

I don't think it was a hangover or a carryover backlog. It is different for each of our segments. And again the hardest hit segment would be our Business Solutions or SMB team and we do need to see a tailwind, a little market recovery there as many of our customers were greatly affected. Q3 is a big quarter for public sector.

So we're also expecting that we'll see the seasonal pickup there. Perhaps, again year-over-year will be a tough compare, but we're certainly gaining momentum. Then also in our Enterprise Group, as you know, that is large project dependent, but we have momentum going into Q3 with the Enterprise team as well.

[Adam Tindle, Raymond James]

And Tim, I guess - so it sounds like the ERP missed orders or just kind of loss to the competitive landscape in Q2 and not necessarily going to be an uptick in Q3. But I guess the bigger question when you kind of look at those customers, are you - how do you prevent losing customers to that competitive landscape? Are you seeing customer defections or anything in the face of the ERP? Or is this just kind of one-time transactional device sales that got lost to the competitive landscape and the customers will still be retained?

[Tim McGrath, President and CEO]

Thanks, Tindle. We are not seeing customer defections. That's the good news. We did a lot of things to shore up customers, and a lot of that was - took a lot of people and a lot of manual effort in Q2. But I'm pleased to say we did not lose any customers.

As you know, we're in our 38th year. We've got a very loyal customer base and that's a real tribute to our sales team that holds down those relationships. So for us going forward, we do have to make sure that we execute. And as I said, Q2 was rough, but that is behind us. And I do not believe we will see customer defections.

[Tom Baker, SVP and CFO]

Yes, I think to be honest with you, Adam, just given the orders will flow smoothly through the system proved to be the big challenge, so I think if anything, we probably just built a little backlog or built some backlog versus net losses.

[Adam Tindle, Raymond James]

Maybe last one for me, Tom, I wanted to clarify some of the OpEx comments. So, if I remember correctly entering this year, and I know a lot has obviously changed. But you had thought that this would be a year where SG&A as a percent of revenue was going to potentially drift up a little bit. But I think if I heard you right in the prepared remarks, you now said that you're expecting it to come down a little bit. Could you maybe just clarify that just because that about $3 million expense on the ERP comes out in Q3 or is this like core SG&A as a percent of rev is coming down for some reason?

[Tom Baker, SVP and CFO]

Yes. So Adam, so when I'm thinking about this, I'm thinking about SG&A as a percentage of revenue, and I think we were at 14.1% this quarter all in, and I think we were at 13% last quarter all in. I think going forward, what you're going to see, again a lot of it's dependent upon the revenues bouncing back some, but I think what we're going to see going forward is an SG&A profile that might be a little bit further north, what was last year just because of some of the investments we're doing.

But for instance, if you take our Q1 and you back out the $2.8 million of additional bad debt expense we had, I think you kind of get to like a 12.5-ish percent, and that's kind of in the near term, where I would expect this to fall in.

[Adam Tindle, Raymond James]

Anything notable on gross margin to think about then as we kind of think about modeling the rest of the year?

[Tom Baker, SVP and CFO]

Yes. I think, I was actually very pleasantly surprised with the margins, just given what happened with revenues. And the thing I would tell you is our partner programs hold up a little bit better than I thought. I was expecting to take a little bit more of a hit there. So we did a really nice job executing on those programs.

[Adam Tindle, Raymond James]

Right. And mix was out of your favor because software declined more than anything else, so it was pretty...

[Tim McGrath, President and CEO]

Again, you're right. Software did decline, but remember, you're also seeing a migration to software-as-a-service netted software as well. So that actually does help margins a little bit too.

[Operator]

There are no further questions. I'd like to turn the call back over to Tim McGrath for any closing remarks.

[Tim McGrath, President and CEO]

Thank you, Michelle. 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 in extraordinary dedication through this time. I'd also like to thank those of you listening to our call this afternoon. Your time and interest in Connection are appreciated. Have a great evening.

[Operator]

Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect.