PC Connection Inc

NASDAQ:CNXN

Earnings Call Transcript 2018-Q3

[Operator]

Good afternoon, ladies and gentlemen, and welcome to the Third Quarter 2018 Connection Earnings Conference Call. My name is Shannon, and I will be the coordinator for today. [Operator Instructions] 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 Steve Sarno, Chief Financial Officer.

I will 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. Our 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 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 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 connection.com. Please note that unless otherwise stated, all references to third quarter 2018 comparisons are being made against third 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, earlier today, we filed our Form 10-Q for the third 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 connection.com.

Before we begin today's review of our Q3 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 Q3 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 Q3 2018 results are stated under the new accounting standard for revenue recognition while our prior years are stated under the prior revenue recognition standard.

In today's earnings release, we have provided a comparison of our Q3 2018 results between the current and prior revenue recognition standards.

The main impact of adopting the new standard for Connection was that Q3 revenue, as reported under the new revenue recognition standard, was $107.8 million less than we would've reported under the prior revenue recognition standard. $103.3 million of this impact related to treating certain software arrangements, such as security, cloud-based licenses and maintenance on a net revenue recognition basis. This is an addition to $4.5 million related to the timing of bill-and-hold transactions.

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 for our earnings releases and conference calls in the next quarter as well.

I'll now turn the call over to Tim to provide some color on our Q3 operating results. Tim?

[Timothy McGrath, executive]

Thanks, Steve.

July and August results were in line with our expectations and our forecast. However, towards the end of September, we experienced some customer delays along with some supplier constraints in the small to medium business space. In addition, our health care vertical and our federal component of our Public Sector Solutions segment performed at lower levels than expected.

In the quarter, we saw a significant increase in cloud and security software. Consistent with this trend, we're seeing a greater number of project-based rollouts across all 3 of our sales subsidiaries. These project rollouts are a testament to our ability to help our customers improve their productivity, make them more secure and enhance their growth. These project rollouts ebb and flow for various reasons and in Q3, created some variability in our results. However, we're gaining market share, acquiring new customers and transforming our business while we focus on improving operational efficiencies.

Moving to Slide 3. Net sales as presented for the 3 months ended September 30, 2018, were $658.5 million. Net sales prior to the impact of the new revenue recognition standard increased by 5.1% to $766.3 million compared to $729.2 million in Q3 a year ago.

Moving to Slide 4. Gross profit as presented increased by 4.5% to $100.4 million compared to $96.1 million a year ago. Gross margin as presented was 15.3% compared to 13.2% in the prior year quarter.

Moving to Slide 5 for a more detailed discussion of our performance by segment. In our Business Solutions group, Q3 net sales as presented was $244.9 million. Prior to the impact of the new revenue standard, net sales were $294.2 million, representing an increase of 1.3% compared to $290.6 million a year ago. Gross margin as presented for this segment increased by 327 basis points to 18.2% in the quarter, which represents our highest margin on record for this segment. Our Business Solutions segment had strong growth in cloud and security software, net/com hardware and services. We're selling across the solution stack and seeing robust growth in advanced technologies. In addition, we had strong growth in the finance and manufacturing vertical markets.

In Public Sector solutions business, Q3 net sales as presented were $148.2 million. Prior to the new standard, sales were $168.5 million, representing a decrease of $2.1 million compared to $170.6 million a year ago. Gross margin as presented for this segment, increased 118 basis points to 12.1%. The decline in our federal business was partially offset by a very strong growth in state, local and education. The growth in SLED was fueled by growth in net/com and mobility products.

In our Enterprise Solutions segment, Q3 net sales as presented were $265.5 million. Prior to the new standard, sales were $303.6 million, an increase of 13.3% compared to $268 million a year ago. Gross margin as presented for this segment increased by 156 basis points to 14.3%. The Enterprise segment continue to benefit from large project refreshes, many of which have been in the retail space. This combination drove strong growth in mobility, net/com products and server/storage products, which, as presented, grew during the quarter at 26%, 13% and 12%, respectively. In addition, we continue to benefit from Windows 10, cloud and security migrations. Customers in these markets realized that technology enables competitive advantage.

Having covered our sales and gross margin performance, I will 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 along on our webcast slides, we're on Page 6 of the presentation. SG&A, as presented, increased this quarter to $81.5 million and 12.4% of net sales from $74.4 million and 10.2% of net sales a year ago. Under the prior revenue standard, our SG&A expense as a percentage of revenue would have been 10.6%. This increase in our percentage of SG&A, as presented, was primarily due to the new revenue recognition standard, which added 174 basis points. In addition, over the last 4 quarters, we have been investing in our solutions sales capabilities with an emphasis on cloud and data center solutions. In Q4, we will be focused on operational efficiencies and reducing investments in nonstrategic areas.

Our operating income, as presented, decreased this quarter to $19 million from $21.7 million a year ago. Under the prior revenue recognition standard, our operating income would have been $19.2 million. Our effective tax rate was 27.8%, down from 39.6% in the same period a year ago as a result of the Tax Cut 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 tax rate was partially offset by an average state rate that rose from 5% to 6.5% due to changes in individual state income apportionate. We expect our rate for the year to be in the range of 27% to 29%. The lower tax rate contributed approximately $2.3 million or $0.08 per share during Q3 of 2018.

Net income as presented for the quarter, increased 5% to $13.8 million from $13.1 million a year ago. Prior to the impact of the new accounting standard, net income would have increased 6.2% to $13.9 million. Earnings per basic and diluted share, as presented, increased 6% and 4% to $0.52 and $0.51, respectively, compared to $0.49 a year ago. Prior to the impact of the new accounting standard, earnings per basic and diluted share would have increased 6% to $0.52.

Moving to Slide 7 of today's presentation. Earnings before income taxes, depreciation and amortization or EBITDA, as presented. Our trailing 12-month adjusted EBITDA increased 7% to $99.1 million from $92.4 million a year ago. Prior to the impact of the new revenue standard, our trailing 12-month adjusted EBITDA would have increased 8% to $99.9 million.

Turning to the balance sheet on Slide 8. We ended Q3 with $102.2 million of cash and cash equivalents, representing an increase of $52.3 million from December 31, 2017.

Cash flow from operations, shown on Slide 9, generated $81.3 million of cash versus $28.4 million for the same period a year ago, representing an increase of $52.9 million in cash generated. Investing activities of $15.6 million for the 9 months of 2018 were primarily the result of equipment purchases and capitalization of our system upgrade that's currently in progress.

Our financing activities during the first 9 months of 2018 used $13.4 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.

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

Moving to accounts receivables. Our day sales outstanding, or DSO, increased from 43 days a year ago to 50 days at the end of Q3. The entire 7-day increase is due to the impact of the new revenue standard, which resulted in the use of a lower net sales denominator in our DSO calculation.

Moving to capitalized expenditures. During Q3, we capitalized $4.1 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 $8 million to $9 million over the next 9 to 12 months.

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 continue to evolve as customers are using technology to transform and secure their businesses. It's good to see continued growth and execution in the retail, manufacturing and financial vertical markets. I'm also pleased with the growth and execution in our enterprise and SLED businesses. We remain focused on helping our customers drive their success with improved technology solutions. Our goal is to grow faster than the market by taking market share in this evolving IT environment.

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, enhance growth and empower innovation. Our software business continues to grow, including cloud, virtualization and security. In addition, we're seeing strong growth in mobility, servers, storage and net/com. We were also pleased with our strong operating cash flow. 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. We remain focused on gross margin improvements, operating expense management and our strategic plan to help our customers solve their business challenges with technology solutions.

We'll now entertain your questions. Operator?

[Operator]

[Operator Instructions] Our first question comes from Adam Tindle with Raymond James.

[Adam Tindle, analyst]

Tim, I just wanted to start just kind of from the ground up listening to your sales reps and vendor commentary. Could you just maybe talk about what you're hearing on the overall demand environment moving forward? Are you seeing any indications of moderation in growth, what the customer budget and IT growth look like in 2019. Just what's your hearing from sales reps and vendor commentary would be helpful.

[Timothy McGrath, executive]

Well, thanks, Adam. And I think it's slightly different for each subsidiary. But overall, as we mentioned on the call, we are seeing a transformation happen in the business. We are seeing the business sort of gravitate toward project rollout or solution-based rollouts. And as I mentioned, those can ebb and flow. With that said, we're seeing a really good growth in cloud and security. And the -- as you know, when you're involved in those type of upgrades, you're also looking at several other components to enable that transformation. So I think that's a trend that continues to happen. We are seeing more customers look toward project rollouts. And with those upgrades, they're looking more than ever before to drive their return on investment or their improvements in productivity. So we don't see demand slowing down. But we do note in the macroeconomic environment, there are still some challenges and some questions out there like the -- sort of like everybody else in our environment, we're not really sure what effect the tariffs may have on us. They haven't -- they've had a minimal effect to date and nothing significant in Q4 either. The -- some of the jitters that have happened with Wall Street may have a slight effect. But again, nothing significant. So enterprise -- to sum it up, enterprise will be very strong, has a full funnel and we're confident in Q4 and beyond. We did see SMB, the Business Solutions, moderating a little bit. But we're still pretty confident there that this will continue to perform. And then with Public Sector, we see good growth in SLED. But we are cautious on fed as the federal government is cutting their budgets under the Trump administration. So we'll see a slight pullback there. So we're on to Q4. We're confident in where we're headed and that we don't see anything major out in front of us.

[Adam Tindle, analyst]

Okay. That's helpful. And as the business shifts more towards the solutions and stuff like that, you -- would we expect to see gross margin change? Or would we kind of maintain at this mid-15% level? Or should it move up as we move more towards the solutions area?

[Timothy McGrath, executive]

So it's a great question. I think that likely, we'll maintain. These large projects tend to be planned months in advance. And they tend to be fairly competitive. We do kind of beat them out, but I'm going to ask Steve to give us kind of a quick review on our gross margin by segment.

[Stephen Sarno, executive]

Adam, on this -- it also depends -- we're seeing a good growth in enterprise, which has a slightly lower gross margins than what we have in the Business Solutions group. And then I think we've seen a little bit more challenge in the public sector space. So depending on what mix we see not only amongst product, but also amongst the segments can influence it slightly.

[Operator]

Our next question comes from William Gibson with Roth Capital Partners.

[William Gibson, analyst]

Tim, you mentioned you're still taking share in these complex areas. Is that mainly from the small regional competitors? Or are you getting anything from the big guys as well?

[Timothy McGrath, executive]

I think mainly, it is the small competitors. You do have to look by segment. Our enterprise team grew at over 13% in the quarter. In that segment, I think we are more head to head with the larger players in our industry. But across-the-board, clearly, we're taking share, growing faster than the IT market. And a lot of that is from the smaller VARs.

[William Gibson, analyst]

Okay. And I know you mentioned you remain positive on the SMB segment. But is there a little more color there as to -- do you think there's something just due to the environment that could be changing for smaller companies?

[Timothy McGrath, executive]

No. I really don't because, as you know, technology does help to drive competitive advantage. And many companies are looking to us for help with that. And in particular, what we saw happening in our Business Solutions, or SMB, group during the quarter, as we mentioned, strong July and August and then toward the end of September, we saw some orders push. But if we look into a detailed analysis on those orders, the majority of them will be recaptured in Q4. And based on the environment and the complexity of project rollouts, we don't know what will happen in the end of Q4, but we do not see a real pullback happening. We think that business will maintain.

[Operator]

Our next question comes from Anthony Lebiedzinski with Sidoti & Company.

[Anthony Lebiedzinski, analyst]

So in your October 18 press release, you guys talked about supply shortages as well as the timing of shipments affecting your third quarter performance. Can you guide us or perhaps, you quantify the impact of those 2 and whether the -- and what's the situation now as far as the supply shortages and also as far as the timing of shipments? Is that already transferred over to Q4?

[Timothy McGrath, executive]

Well, this is Tim. I'll start that and then Steve, you can help out. But in Q3, specifically, we did see some product constraint. It was really limited to just a couple of million dollars. It was in the net/com space, and it caused us to hold off some projects. We do think that has resolved itself. And we do not think that, that will be an issue going forward. So it really was networking that held up a large project. But that has resolved itself. And we're not hearing too much more about supply shortages. Steve, did I miss anything?

[Stephen Sarno, executive]

No. I would just add that -- 2 pieces to -- a couple of pieces to that. One is yes, it was a couple million worth of networking product, and I can confirm that, that did ship within Q4. And we've not seen any significant shortages to date in Q4. I think this was something that just happened to happen and hit us right at the end of the quarter, of course. And then in regards to -- I think the other part of your question was in regards to the delays that we experienced. We have seen a portion of that already shipped within Q4, and then there was a small piece that moved to Q1. Everything else is expected to go in Q4. And none of it has gone away.

[Anthony Lebiedzinski, analyst]

Got it. Okay. And also, I know it's still early in the fourth quarter, but could you guys perhaps give some guidance? Or how we should think about the impact of 606 on Q4 sales?

[Stephen Sarno, executive]

Sure. So predicting the impact of 606 is very much due to whatever the mix is, particularly on software that's cloud-based and security-based as well as maintenance. So obviously, we had some difficulty predicting that within Q3. And I think like others, we saw a lot of movement more than we expected to the cloud and to security products. We actually think that that's good news. But I think we've kind of started to look at this from more of a gross profit perspective, which is not as susceptible to 606. No material differences there. And we do see growth in gross profit for the fourth quarter.

[Anthony Lebiedzinski, analyst]

Got it. Okay. Well, you only have 1 more quarter to go through the 606 noise.

[Timothy McGrath, executive]

And one of it is happening at the...

[Stephen Sarno, executive]

[ From beyond ].

[Anthony Lebiedzinski, analyst]

Right. Okay. And then kind of wrapping up. So you ended the quarter with over $100 million of cash. You didn't buy back any stock in the quarter. Kind of like when you're looking at capital allocation, how are you guys thinking about that going forward?

[Timothy McGrath, executive]

Thanks, Anthony. So as you know, we -- our partners try, so we are always looking at possible opportunities out in the marketplace. But we have -- we are clearly looking at -- and we'll evaluate share buybacks as well as dividends. So I'd say, all options are in play. But at the end of the day, assessing dividends and buybacks are clearly on our agenda.

[Operator]

Thank you. And I'm currently showing no further questions at this time. I would like to turn the call back over to Tim McGrath for closing remarks.

[Timothy McGrath, executive]

Well, 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 like -- also like to thank all of those -- excuse me, I'd like to thank those of you who are 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. Thank you for your participation. Have a wonderful day.