PC Connection Inc

NASDAQ:CNXN

Earnings Call Transcript 2021-Q3

[Operator]

Good afternoon, and welcome to the Third Quarter 2021 Connection Earnings Conference Call. My name is Laurie, 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 Tom Baker, Senior Vice President and Chief Financial Officer.

I will now turn the call over to the company.

[Samantha Tracy;Microsoft Business Development Specialist, executive]

Thank you, operator, and good afternoon, everyone. I will now read our 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 the 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, 2020, 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 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 third quarter 2021 comparisons are being made against the third quarter of 2020.

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?

[Timothy McGrath, executive]

Thank you, Samantha. Good afternoon, everyone, and thank you for joining us today for Connection's Q3 2021 Conference Call. I'll begin this afternoon with an overview of our third quarter results, highlights of our performance and then share our updated thoughts on the balance of the year. Tom will walk us through a more detailed look at our financials and our capital allocation strategy.

We are excited to announce record Q3 revenue and gross profit for both our enterprise and our Business Solutions segment. These results demonstrate the continued execution of our business strategy to connect our customers with technology that enhances growth, elevate productivity and empowers innovation. A number of factors combined to improve our results, including strong performance in our manufacturing and health care vertical markets, along with growth in mobility, desktops, displays, storage and services. These results were driven by the continued trends of work from anywhere and the need for services and security.

On a consolidated basis, Q3 organic revenue grew by 15.1% compared to last year's third quarter. Looking at our segments, Business Solutions grew 21.8%. The Enterprise segment grew 19.2%, while the Public Sector segment declined 1.1%. In Q3, demand was again greater than supply, and lead times extended in several areas. Our team continued to leverage our capabilities and scale to navigate the ongoing supply constraints on behalf of our customers. However, the supply chain has yet to recover to the point that it can consistently fulfill demand on a timely basis.

In fact, our backlog has increased once again to record levels. We anticipate some of these challenges will persist for the balance of the year and into 2022. We're continuing to work with our partners and customers on a daily basis to manage these issues. In addition, a number of our customers are asking us to secure and store product in an effort to support planned rollouts, which is driving higher inventory levels than usual. Our loyal customers know that we have the expertise, scale and capacity, so they rely on us for these services.

Looking forward, our customers will continue to need help with their digital transformation, remote work, hybrid cloud and security. And this has driven our backlog to even higher levels at the end of October.

Looking at our vertical markets during the quarter. Manufacturing grew 24% year-over-year. Our manufacturing customers want solutions that include industrial infrastructure, IoT, security, cloud and workplace productivity. In addition, our health care vertical experienced double-digit growth year-over-year. We did see recovery in large projects and security, the top concern for our health care clients.

Demand was also a function of our customers' need to improve operational efficiencies, the patient experience and long-term care. We are also seeing continued growth in telehealth and noncontact patient monitoring.

Now let's discuss our Q3 performance in a little greater detail. Third quarter revenue was up 15.1% to $751.4 million from 2020, while gross profit was up 11.9% to $120.7 million. Gross margins were 16.1%, down 46 basis points from Q3 2020. The decrease in margin is primarily due to a shift in our product mix to more client-based devices. It is notable that our gross margin on client-based devices was actually up meaningfully year-over-year. However, the share volume of this mix shift reduced overall margins. We view this shift as temporary. As the supply chain constraints in data center products ease, we expect our margins will normalize.

Operating income in Q3 was $27.3 million, an increase of 29.7% or 3.6% of net sales compared to $21.1 million or 3.2% of net sales in the prior year quarter. In Q3 2021, diluted earnings per share was $0.76, an increase of 18.1% from $0.64 in Q3 2020. We ended Q3 with $89.7 million of cash and cash equivalents.

We'll now look a little deeper into segment performance. In our Business Solutions segment, our Q3 net sales were $281.4 million, an increase of 21.8% compared to $231 million a year ago. Gross profit in the Business Solutions segment was $54.7 million, an increase of 17.5% from a year ago. Gross margin decreased by 73 basis points to 19.4% in the quarter compared with 20.2% in the prior year. Customer spending in this segment was comprised of a larger-than-normal mix of mobility solutions that tend to have slightly lower margins.

In our Public Sector Solutions business, Q3 net sales were $160.2 million, a decrease of 1.1% compared to $162 million a year ago. Sales to state and local government and educational institutions were $133.7 million, an increase of 2.5% compared to the prior year. Sales to the federal government were $26.5 million, a decrease of 15.8% compared to the prior year, primarily due to a reduction in large software projects that did not repeat this quarter. The federal sector is experiencing delays with several large contract vehicles as much of a stimulus funding remains unallocated at the contract level.

Gross profit for the Public Sector segment was $20.3 million, a decrease of 10.8% compared to Q3 20. Gross margin decreased by 138 basis points to 12.7%, primarily due to a reduction in software sales and a product mix that was more heavily weighted towards lower-margin client devices such as Chromebooks.

In our Enterprise Solutions segment, Q3 net sales were $309.7 million, an increase of 19.2% compared to $259.8 million a year ago. Gross profit for the Enterprise segment was $45.6 million, an increase of 18.7% in the quarter. Gross margin for the quarter decreased by 6 basis points to 14.7%. Gross margins were favorably affected by increased sales of software sold on a net basis, offset by a greater mix of mobility products.

We've continued to see strong demand in the Enterprise Solutions segment, especially in the manufacturing and health care verticals, both of which achieved double-digit growth.

I'll 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 was $93.4 million this quarter, an increase of 7.6% from $86.8 million a year ago. As a percentage of net sales, this represented a decrease of 86 basis points year-over-year. The year-over-year Q3 increase in SG&A was primarily driven by an increase in variable compensation and increases in marketing costs.

Q3 operating income was $27.3 million, up 29.7% this quarter from $21.1 million a year ago. Our Q3 effective tax rate was 26.7%, up from 19.6% in the same period a year ago. As you may recall, in the prior year quarter, we recorded some onetime tax credits that favorably affected our tax rate.

Net income for the quarter was $20 million, an increase of 18.4% from $16.9 million a year ago. Diluted earnings per share was $0.76, an increase of 18.1% from the prior year period. Our trailing 12-month adjusted earnings before income taxes, depreciation and amortization, or adjusted EBITDA, was $102.4 million compared to $99.3 million a year ago.

Cash flow from operations for the first 9 months of 2021 was $8.8 million versus $46.3 million for the same period a year ago. In the year ago quarter, we generated significant cash as business activity dropped off and partners extended terms. Cash flow from operations for the first 9 months was driven by a decrease in accounts receivable as DSO improved by 9 days since December.

As we stated earlier, customers are placing orders in advance to mitigate the risk of product shortages, which has resulted in a higher-than-normal inventory levels, negatively affecting our cash flow. A decrease in payables also negatively impacted cash flow from operations for the first 9 months of 2021.

Our net cash used in investing activities of $5.6 million in the first 9 months of 2021 was primarily the result of equipment purchases and IT initiatives, offset by proceeds from life insurance. The company used $9.2 million of cash for financing activities during the first 9 months, consisting primarily of the Q1 payment of our 2020 special dividend.

We expect to exit 2021 with approximately 10% growth. Based on our confidence in the business and our desire to return cash to our shareholders, we are announcing that our Board of Directors has approved a special dividend of $1 per share payable on December 3 to shareholders of record on November '18. Our strong balance sheet allows us to pay this dividend while maintaining the ability to continue to grow the business.

Let me remind you, we also have $12.7 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. I want to take a few moments to review some of the highlights in our business. In Q3, Connection continued to experience significant demand in products and solutions that enable our customers to be productive from anywhere. We expect this trend will continue into the first half of 2022. In addition, continued growth across our vertical markets. Manufacturing saw revenue growth of 24% year-over-year and 7% sequentially compared to Q2 2021 as manufacturers look to augment the available workforce, automate and invest in new technologies to address both short-term and long-term workforce challenges stemming from the COVID-19 and workforce skills shortages.

Health care experienced revenue growth of 10% year-over-year as a result of organizations expanding and securing infrastructure to support a surge in employee remote access and telemedicine activity as well as improving the patient and provider experience.

Our Technology Solutions Group saw strong demand and growth for managed services, cybersecurity and network transformation services. Our services business grew more than 23% year-over-year. In addition, we achieved Microsoft Azure Expert Managed Service Provider certification. As an Azure Expert MSP, we offer customers access to in-demand hyperscale cloud solutions and resources.

Connection has demonstrated industry-leading technical capabilities and offers end-to-end support across Azure cloud environments through our Microsoft Center of Excellence.

Looking at the balance of 2021, and assuming that supply chain constraints don't further deteriorate, we believe we can deliver long-term growth rates that are 300 basis points above the IT industry. We are focused on helping our customers enable their post-COVID hybrid workforce, accelerate their digital transformation and empower their innovation.

We'll now entertain your questions. Operator?

[Operator]

[Operator Instructions] We have a question from Adam Tindle of Raymond James.

[Catherine Huntley, analyst]

This is Catherine on for Adam. And let me add my congratulations to your results. Tim, you talked about backlog and lean times continuing to grow. Could you dive into the composition of this backlog? And is it more concentrated in a product category or consumer vertical? And taking that a step further, even though manufacturing and health were up strong double digits year-over-year, was demand limited by supply in these areas?

[Timothy McGrath, executive]

Well, thanks, Catherine. So there's a lot to cover there. When we think about our backlog, clearly, in the quarter, as you hear, we had significant growth in mobility. And so the backlog for devices is strong. But there's also additional backlog for net/com products, backlog for storage and some of the data center products. So the backlog -- while we expect some of that will be reduced in Q4, we really need to see that end-to-end supply chain improve to help our overall margins. But we're pretty confident that will happen. And so we think that we'll see a good margin recovery here in Q4 and continue to see good growth.

When it comes to the manufacturing health care vertical, yes, I'd say, overall, not just our business, certainly, throughout the competitive landscape, backlog and supply constraint has been a challenge. And we did see constraints pretty much across the board.

Tom, what would you add to that?

[Thomas Baker, executive]

No, I would just say the product mix probably had the biggest impact on our gross margins. So I think we said we were down 46 basis points. That is exclusively due to shifts in product mix. And in fact, as I mentioned in the call, if you look at the client base -- the client devices, we were actually able to improve margins there pretty reasonably well. So it's a little bit of softness in software. Client devices were better, but it is -- the totality of the mix is really what affected the margins.

[Catherine Huntley, analyst]

Okay. That was very helpful. And Tom, on the margins on a go-forward basis, you said that they would moderate a little bit in client devices over time. And we can expect operational improvement in the second half of 2022.

[Thomas Baker, executive]

Yes. So I think what you should see is probably a little bit more of a shift back towards a richer software mix and a richer data center mix. And notebooks and mobility comprise 40% of our revenue this quarter. I think it was an 8- or 9-point increase. So that should moderate, maybe not completely next quarter, but certainly over the next couple of quarters.

And then in terms of the operational improvements, I think our G&A was 12.4% of revenues this quarter. That should also moderate a little as the revenues go up.

[Operator]

And there are no further questions at this time. I will turn the call over back to the company for closing remarks.

[Timothy McGrath, executive]

Well, thank you, Laurie. I want to thank all of our customers, vendor partners and shareholders for their continued support and once again, our dedicated coworker. I also want to thank those of you listening to our call this afternoon. Your time and interest in Connection are appreciated. Have a great evening.

[Operator]

This concludes today's conference call. Thank you for participating. You may now disconnect.