PC Connection Inc

NASDAQ:CNXN

Earnings Call Transcript 2019-Q3

[Operator]

Good afternoon, and welcome to the Third Quarter 2019 Connection Earnings Conference Call. My name is Skyler, and I'll 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 Tom Baker, Vice President and Chief Financial Officer.

I would now turn the call over to the company.

[Unknown Executive]

Thank you. I will now read the safe harbor statement. 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, 2018, 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 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 third quarter 2019 comparisons are being made against the third quarter of 2018.

Today's call is being webcast and will be available on Connection's website. The earnings release and the Form 10-K are both 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. Please proceed, sir.

[Timothy McGrath, executive]

Good afternoon, everyone, and thank you for joining us today to review the company's third quarter financial results. It's our pleasure to announce another quarter of strong performance, including a 75% increase in diluted earnings per share from Q3 2018. We experienced growth in all 3 operating segments. The Public Sector segment achieved 20% revenue growth in the quarter, followed by the Business Solutions segment, which experienced growth of 12%, and the Enterprise Solutions segment, which grew by 5%.

Our success in the quarter was partially attributed to the timing of large solution-based project rollouts and strong growth in the mobility and desktop categories. The growth in these categories was due to the PC refresh, driven by the anticipated end of support for Windows 7 and technological advances in hardware that enable modern workplace solutions.

In addition, we continue to see growth in our software, cloud and security businesses.

We remain committed to helping our customers intelligently and efficiently build out solutions that include our focus on software-defined data center, hybrid cloud and the digital workplace.

During the third quarter, the company achieved record gross profit, record gross margin and record earnings per share. Gross profit grew by 18.3% year-over-year, and we achieved gross margin of 16.3%, which represented growth of 104 basis points. The increase in both gross profit and gross margins was driven by our continued focus on our business initiatives.

When all 3 of our sales segments perform at these levels versus the prior year period, we experience significant operating leverage. We also saw double-digit growth in 3 of our vertical markets.

Net sales for the 3 months ended September 30, 2019, increased by 10.8% to $729.4 million compared to $658.5 million in Q3 a year ago.

Increased cloud-based and security software sales continue to require us to net down more revenue, which, in effect, puts downward pressure on net sales, while benefiting gross margin.

Gross profit increased by 18.3% to a record $118.9 million compared to $100.4 million a year ago. Gross margin was a record 16.3% compared to 15.3% in the prior year quarter.

Operating income increased by 72.2% to $32.6 million or 4.5% of net sales compared to $19 million or 2.9% of net sales in the prior year quarter.

Now I'd like to provide a more detailed discussion of our performance by segment.

In our Business Solutions segment, Q3 net sales increased by 11.8% to $273.8 million compared to $244.9 million a year ago. Gross margin for this segment increased by 83 basis points to 19% in the quarter.

Our Business Solutions segment benefited from an increase in volume and a change in customer mix. Business Solutions continued to focus on advanced technologies that have higher margins and represented a larger percentage of our revenue this quarter.

In our Public Sector Solutions business, Q3 net sales increased by 19.7% to $177.4 million compared to $148.2 million a year ago.

Sales to the federal government increased by 88.2% compared to the prior year as a result of large project wins, while sales to state and local government and educational institutions increased by 1.5%. Gross margin for the Public Sector increased by 175 basis points to 13.9%, due to double-digit growth in desktops, mobility, server storage and net/com categories.

In the Enterprise Solutions segment, Q3 net sales were $278.3 million, a 4.8% increase compared to $265.5 million a year ago. Gross margin for this segment increased by 86 basis points to 15.1%. Sales of cloud-based and security software had a greater financial impact on gross margin for the enterprise segment this quarter than in the same quarter last year.

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?

[Thomas Baker, executive]

Thanks, Tim. SG&A increased this quarter to $86.2 million from $81.5 million a year ago. The increase in SG&A was driven in part by an uptick in variable compensation due to higher level of sales and gross profit achieved compared to the prior year quarter.

SG&A as a percentage of net sales decreased by 55 basis points year-over-year, demonstrating our commitment to driving operational efficiencies and managing expenses.

Our operating income increased 72.2% this quarter to $32.6 million from $19 million a year ago.

Of the $18.4 million increase in gross profit, $13.7 million or 74% of that increase was recognized in operating income, highlighting the leverage in the business.

Our effective tax rate was 27.4%, down from 27.8% in the same period a year ago.

Net income for the quarter increased 72.5% to $23.7 million from $13.8 million a year ago.

Diluted earnings per share was $0.90, an increase of 75%.

Our trailing 12-month adjusted earnings before income taxes, depreciation and amortization or adjusted EBITDA increased 30% to $129 million from $99.1 million a year ago.

We repurchased 23,000 shares during the quarter for $862,000, at an average cost of $36.73 per share.

We ended Q3 with $98.5 million of cash and cash equivalents.

Cash flow from operations for the first 9 months of 2019 was $40 million versus $81.3 million for the same period a year ago.

The change was in part a result of the strong business environment we enjoyed in the third quarter compared to last year.

Specifically, receivables and inventories grew in support of increased levels of business and accounted for most of the change in operating cash flows.

During the quarter, our cash flow from operations was $36.7 million, which slightly exceeded our EBITDA for the quarter as a result of an improvement in days sales outstanding and inventory turns.

Our net cash used in investing activities of $20.6 million for the first 9 months of the year was primarily the result of equipment purchases and capitalization of our ERP system upgrade that is in process. The company used $12.6 million of cash for financing activities for the first 9 months of 2019, consisting primarily of the Q1 payment of $8.5 million for our previously declared 2018 special dividend and $4.4 million of stock repurchases. As of September 30, 2019, we had $23 million remaining for stock repurchases under our existing stock repurchase program.

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

[Timothy McGrath, executive]

Thanks, Tom. We had another quarter of solid performance across all of our business segments, resulting in strong operating leverage and demonstrating the importance of specialization and customer segmentation.

We are also pleased with our double-digit growth in our health care, finance and manufacturing vertical markets as we continue to deliver solutions for our customers in these vertical markets that enhance productivity, improve efficiency and strengthen security.

Customer success is measured in many ways and enabled by advanced technologies that are tailored to the unique needs of our diverse customers and their environments. As our customer's needs and the industry continue to evolve, we will need to accelerate our investments in certain critical areas which will likely result in our SG&A as a percentage of revenue migrating back closer to historical levels.

We'll continue to invest in systems and subject matter experts in order to help our customers improve productivity, enhance growth and empower innovation across their organizations.

Looking ahead, current industry growth expectations are in the low single digits and approximate GDP growth. Our plan is to continue to grow twice as fast as the overall market.

We believe that our team and the strategies that we have in place position us well to gain market share and increase long-term shareholder value.

We'll now entertain your questions. Operator?

[Operator]

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

[Adam Tindle, analyst]

I just wanted to double-click on the operational aspect, obviously, very impressive here, close to 20% gross profit dollar growth, but OpEx only growing mid-single digits. So Tim, if you could maybe just double-click on what you're doing operationally? And Tom, I think you guys alluded to this in the prepared remarks, but what ratios can we think about on a forward basis, whether it's OpEx as a percent of revenue or operating margin is kind of a more sustainable level?

[Timothy McGrath, executive]

Well, Adam, thanks. So when we think about our go-forward strategies, there are a lot of changes in our customer base that require additional investments, more cloud engineers, more security engineers, more technical folks in general. So when we look at our go-forward plans, we are making some investments in systems and in personnel. And Tom, I'll let you cover that in a little more detail.

[Thomas Baker, executive]

Yes. So I'll try to help you quantify what I think is happening here a little bit, Adam. If you look at Q3 versus Q3 year-on-year, our SG&A as a percentage of revenue has gone down, I think, 55 basis points. My expectation, as we hit a few of these step functions and investment, that we'll probably need to claw back 1/3 to 1/2 of that amount to invest in the business and systems as these volumes continue to increase.

[Adam Tindle, analyst]

Okay, that's helpful. And is there kind of an operating margin target that you're shooting for in 2020 and beyond? Is there something that you're kind of aspiring to?

[Thomas Baker, executive]

We're always aspiring to more. But no, we haven't specifically outlined what we think that is. A lot of this is going to be revolved around what our revenues come in at because as you saw this quarter, when the revenue starts to go up and start hitting higher volumes, your margins tend to accelerate a little bit disproportionately. So a lot of it is just going to depend on how we perform year-over-year.

[Adam Tindle, analyst]

Got it. Okay. And Tim, I know going through the results here, PC has, obviously, remained very strong. I'm just curious on your view from either vendor partners or customer base on where we are in that cycle. I think, well-known that support from Microsoft expires in January. Do you think there's any maybe aspect of very strong PCs that you're seeing in the business that's being driven by that? And if so, it sounds like you're still talking about growth into 2020? Do you think that's going to be a headwind as we get later in the year?

[Timothy McGrath, executive]

So, Adam, that's a great question. And one we spend a lot of time trying to answer, and I suppose at the end of the day, it's anyone's guess, but if we kind of consolidate all of the views, we think the desktop refresh is going to tail off, but probably will go through Q1 of 2020. That -- so we're optimistic about that. And as you mention, it's not only the end-of-life support for Windows 7, but we are seeing a lot of technological advances in hardware and a lot of feature sets that are important to the solutions rollout. So both of those are really positive drivers. That said, and I'm sure you're hearing this too, across the industry, we're also getting warnings about potential shortages in processors from Intel. And although we have not experienced anything significant to date, clearly, many of our suppliers are starting to point to that. So that's a little bit of a headwind out there that's going to make us be a little bit cautious on our statements.

[Adam Tindle, analyst]

And congrats on the very strong results.

[Timothy McGrath, executive]

Thank you.

[Operator]

And our next question comes from Anthony Lebiedzinski with Sidoti & Company.

[Anthony Lebiedzinski, analyst]

So other than the issue with Intel, is there anything else that you can perhaps point to as to why fourth quarter may not be as good as your Q3? Or -- I mean, just wanted to get any sort of thoughts as to how you're thinking about the rest of the year?

[Timothy McGrath, executive]

Well, Anthony, thanks. So when you think about Q3, we did have a large federal government business as we look at September being the end of the federal government buying season, and so clearly, that federal business probably won't repeat in Q4. Big question remains, what will we see around the enterprise budget cycles and that traditional budget flush, and I think on the enterprise side, we're seeing a little more cautionary notes out there as well. So nothing definitive, but when we look at our funnels and our forecast, the enterprise of all 3 segments is the one that probably has the most uncertainty.

[Thomas Baker, executive]

The only other thing I'd add to that, Anthony, is if you go back and look at last quarter, our inventories have kind of spiked a little. And we had talked about the fact that we had some rollouts that would roll into Q3. So we got kind of a bit of a tailwind from that. And if you compare that to the same quarter last year, I think we experienced some supply chain issues, which kind of depressed the revenues a little. So year-on-year, you got to -- this year, we got a little bit of a tailwind, last year, we had a little bit of headwind.

[Anthony Lebiedzinski, analyst]

Got it. Okay. Thanks for that clarification. And you talked also about the changes in customer mix for your SMB and Public Sectors impacting or helping your gross margin. Can you just maybe give us more detail about that?

[Timothy McGrath, executive]

Sure. So in the Public Sector space, we really had strong growth in the federal arena, and that was really a positive for us in Q3. Also in our small to medium business, our Business Solutions group, they did a really good job. We did a good job selling across the solution stack, selling a lot of advanced technologies to customers that tend to be higher margin and a little stickier. And so as you know, that was a 19% gross margin business. So that was very positive. Contributing to that and another was the lack of a couple of large projects that we had prior year in the quarter that didn't repeat. And so we didn't have as much margin pressure there. So that ends up being a little bit of a benefit.

[Anthony Lebiedzinski, analyst]

Got it. Okay. And lastly, as far as your balance sheet, you are sitting in on a lot of cash at the moment. You have certainly had a strong balance sheet for quite some time. So as far as your priorities for cash flow usage and any updated thoughts on potential acquisitions?

[Thomas Baker, executive]

Well, I can't really talk about potential acquisitions, Anthony. But I think as we kind of discussed in the past, opportunities to grow the business and invest in assets that will accelerate our growth are our top priority. And absent that, I think you'll see our capital deployed kind of in the same way we've done historically.

[Timothy McGrath, executive]

But I also want to add, Anthony, we really are confident in our business plan and our team and our strategy, so we don't feel any undue pressure to go do an acquisition, but we'll remain open to anything that could round out our solution set or be accretive to our company and our culture.

[Operator]

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

[William Gibson, analyst]

You referenced the backlog of product shipped in the quarter. I assume that's out of your advanced configuration center. How is that operating now? Is it still staying at a high level or was that a onetime flush?

[Timothy McGrath, executive]

Well, Bill, thanks. So we really do feel that our advanced configuration center offers great value for our customer base. So we have been very busy. It does bring real value to our solutions rollout. The volumes continue to rise there. And we expect that to continue in the future. So we're seeing really good growth in our advanced configuration business. And we think it's a real value-add.

[William Gibson, analyst]

Good. And then you mentioned double-digit growth in 3 verticals, and you went over them, but I missed -- healthcare, finance, and what was the third?

[Timothy McGrath, executive]

The third was manufacturing. So we're seeing good growth across all 3 of those vertical markets. Retail has been strong, but a year ago in the quarter, we had some very large retail rollout. So we had a tough compare there. So the three are finance, healthcare and manufacturing.

[Operator]

And at this time, I'm showing no further questions. I'd like to turn the call back over for any 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 also like to thank all of those listening to the calls 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.