PC Connection Inc

NASDAQ:CNXN

Earnings Call Transcript 2022-Q3

[Operator]

Good afternoon, and welcome to the Third Quarter 2022 Connection Earnings Conference Call. My name is Justin, 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.

[Unidentified Company Representative]

Thanks, operator, and good afternoon, everyone. I will now read our cautionary note regarding forward-looking statements. 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 and 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, 2021, 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 other than required by law even if estimates change. And therefore, you should not rely on these forward-looking statements as representing management's view as of any date subsequent to today.

During this call, non-GAAP financial measures will be discussed. A reconciliation between any non-GAAP financial measure discussed and its most directly comparable GAAP measure 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 2022 comparisons are being made against the third quarter of 2021. 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, President and CEO]

Thank you, Samantha. Good afternoon, everyone, and thank you for joining us today for Connection's Q3 2022 conference call. I'll begin this afternoon with an overview of our third quarter results, highlights of our performance and share our updated thoughts on our business and the remainder of 2022. Tom will then walk us through a more detailed look at our financials.

We delivered another strong quarter as we continue to execute well against our strategic objectives. During the quarter, our customers focus started to shift from rollouts of endpoint devices and related technology to digital transformation, data center modernization, cloud optimization and security solutions. More than ever before, customers look at Connection to solve their complex technology needs and guide them through their technology initiatives with our broad-based capabilities.

Gross profit grew 13.2% year-over-year as a result of the shift in customer demand, while net sales grew 3.2% over a previous record revenue performance in the third quarter of 2021. Our gross margins grew 155 basis points to a record 17.6% in the quarter compared to 16.1% in the prior year. These results demonstrate the continued execution of our business strategy to connect our customers with technology that enhances their growth, elevate their productivity and empower their innovation.

The technology and solutions that we provide are highly valued by our customers. As we look forward, we believe that these products and services will continue to be essential in helping our customers to achieve their business objectives with technology and automation. The Business Solutions segment grew 12.2%, while the Enterprise and Public Sector segment declined 1.4% and 3.7%, respectively. Our Enterprise and Public Sector segment experienced an increased level of sales of software and services recognized as revenue on a net basis which placed downward pressure on net sales.

As we've pointed out in the past, we believe gross profit is the best indicator of our true growth. Gross profit improved 13.2% on a consolidated basis compared to the prior year quarter. We achieved a record gross margin rate in the quarter of 17.6% compared to 16.1% in the prior year quarter. Our focus and ability to execute our plans to drive more advanced technology solutions contributed to this 155 basis point margin improvement.

As customers complete their build-out of endpoint solutions, budgets are now being allocated more heavily toward data center, software and services. We continue to invest in our managed service capabilities, and we are experiencing a strong growth for our solutions as customers are focused on the need to improve security, increase productivity, manage costs and modernize their infrastructure. We also experienced strong growth in our vertical markets, and we delivered strong double-digit revenue growth in our finance and health care markets with growth rates of 40% and 14%, respectively.

During the quarter, we saw improvements in our supply chain, which resulted in a decrease in our backlog compared to last year as well as sequentially. However, our backlog remains elevated. We expect some challenges will remain through at least the balance of the year and into 2023.

Now let's discuss our Q3 performance in a little greater detail. Operating income in Q3 was $31.7 million, an increase of 16.1% or 4.1% of net sales compared to $27.3 million or 3.6% of net sales in the prior year quarter. In Q3 2022, our diluted earnings per share was $0.88, an increase of 15.4% from $0.76 in Q3 2021. We ended Q3 with $116.2 million in cash and cash equivalents.

Now we'll look a little deeper into segment performance. In our Business Solutions segment, our Q3 net sales of $315.8 million, an increase of 12.2% compared to $281.4 million a year ago. Gross profit in the Business Solutions segment was $63.3 million, an increase of 15.7% from a year ago. Gross margin increased 60 basis points to 20% in the quarter compared to the prior year, primarily due to an increase in demand for software and services recognized as revenue on a net basis.

We saw an increase in demand for software, networking and data center products. The increase in software and services demand is a result of more customers shifting their business to subscription services, cybersecurity and off-premise cloud solutions, along with other cost-saving technologies. In our Public Sector Solutions business, Q3 net sales were $154.4 million, a decrease of 3.7% compared to $160.2 million a year ago. Sales to state and local government and education institutions were $130.3 million, a decrease of 2.6% compared to the prior year, while sales for the federal government decreased 9.1% year-over-year.

Gross profit for the Public Sector segment was $25.1 million, an increase of 23.3% compared to Q3 '21. Gross margin increased by 356 basis points to 16.3% in the quarter. As our customers transition from on-premise solutions to off-premise and cloud solutions, the recognition of revenue on a net basis puts downward pressure on revenue while generating increased gross margins. In our Enterprise Solutions segment, Q3 net sales were $305.5 million, a decrease of 1.4% compared to $309.7 million a year ago.

Gross profit for the Enterprise segment was $48.3 million, an increase of 5.7% compared to the prior year quarter. Gross margin increased by 106 basis points to a record 15.8%, primarily driven by enterprise customers' business-driven need for cloud and data center solutions. 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, SVP and CFO]

Thanks, Tim. SG&A increased 110 basis points to 13.5% of net sales in the quarter compared to 12.4% in the prior year quarter. Approximately 75% of the increase in this rate is solely due to the increase in sales of products, which are recognized as revenue on a net basis. On a dollar basis, SG&A increased $11.5 million compared to the prior year quarter. In addition to the impact inflation continues to have on wages, there was also incremental increase in SG&A resulting from increased variable compensation due to higher levels of gross profit.

We have also continued to make investments in incremental headcount focused on building our technical and sales organization as well as increased marketing spend. Q3 operating income was $31.7 million, up 16.1% this quarter from $27.3 million a year ago. Our effective tax rate was 27.6%, up from 26.6% in the same period a year ago. Net income for the quarter was $23.2 million, an increase of 15.8% from $20 million a year ago.

Diluted earnings per share was $0.88, an increase of 15.4% from the prior year period. Our trailing 12-month adjusted earnings before income taxes, depreciation and amortization or adjusted EBITDA, was $145.5 million compared to $102.4 million a year ago, an increase of 42%. Cash flow generated from operations for the first 9 months of 2022 was $15.7 million compared to $8.8 million in the same period a year ago. The increase in cash flow from operations reflect higher levels of earnings offset by increases in both accounts receivable and inventory as well as a decrease in accounts payable.

I'd like to take a moment to discuss a few components of our working capital trends in the past quarter. DSO increased to 69 days from 64 days at the end of 2021. The increase is a function of netted products recorded in accounts receivable on a gross basis, while the revenue is reported on a net basis. Inventories increased by $3.1 million versus the end of 2021. This increase was driven by our Enterprise segment, which has purchased inventory in advance of large project rollouts, offset by our ongoing inventory reduction plan. Our accounts payable balance declined $23.3 million for the first 9 months of 2022. Our net cash used in investing activities of $7 million for the first 9 months of 2022 was primarily the result of equipment purchases and IT initiatives that will drive future efficiencies.

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

[Timothy McGrath, President and CEO]

Thanks, Tom. I want to take a few moments to review some of the highlights of our business. Our growth in Q3 is largely attributable to the customized IT solutions that we integrate and deliver on behalf of our customers as they continue to work through their digital transformation and efforts to gain competitive advantage with technology.

Our customers look to Connection to integrate and deliver these innovative solutions. Toward that end, we continue to leverage our managed services capability as customers turn their attention toward data centers, infrastructure and digital transformation initiatives. Our years of experience with supply chain optimization and our ability to deliver custom integrated solutions continue to be an important component of our growth and a competitive differentiator for us.

Our growth was also attributed to our expertise in delivering customized solutions to our vertical markets. For example, in the finance vertical, we grew revenue 40% year-over-year and 12% sequentially as our customers were upgrading legacy hardware and focusing on securing their environment. Manufacturing revenue grew 3% year-over-year as clients focus on increasing automation and process integration as well as long-term investment in new technologies to support cybersecurity, risk reduction and growth opportunities.

Revenue in Healthcare grew 14% year-over-year, driven by post-pandemic technology refreshes and new investments in traditional and new patient care delivery models.

Looking forward to the remainder of 2022, we believe customers want to manage costs while leveraging technology for greater efficiency and as an enabler for competitive advantage. We expect our customers will continue to focus on data center, security and cloud transformation. We anticipate this trend will continue in the near term and will put pressure on top line revenue growth as it did this quarter. Last quarter, we indicated that year-over-year growth rates would be moderating, which they did. We expect that trend to continue for the near term. These expectations are in part due to record results recorded in the prior year period. Additionally, our customers are telling us that they're being more deliberate in sending and are being more restrictive on budget in the face of increasing economic uncertainty.

That being said, we believe we'll end the year with growth at 3% to 5% above the IT industry growth rate, and we will continue to take market share. We remain focused on helping our customers achieve their productivity and efficiency goals while keeping them secure and connected in this uncertain economic environment. I'd like to take a moment to thank our valued employees for their continued effort and extraordinary dedication during this rapidly changing environment. We will now entertain your questions.

[Operator]

[Operator Instructions] And our first question comes from Adam Tindle from Raymond James.

[Adam Tindle, Raymond James]

Tim, I want to maybe start with the last comments that you were making there. That was very helpful. When you say 3% to 5% above the IT industry for 2022, could you help us with what you're thinking of as the IT industry growth rate and maybe even simpler, I think it's going to imply that Q4 revenues might be down year-over-year. I just want to make sure that we're getting the model right based on the commentary you're making on Q4.

[Timothy McGrath, President and CEO]

Yes. Well, thanks, Adam. Yes, I think that's right. I think that, obviously, if you look at our growth rate year-to-date, we've had a pretty good year. We do see that moderating a little bit in Q4, and we think we can take some market share. So I think exiting the year at 3% to 5% above market is still well within our reach.

[Thomas Baker, SVP and CFO]

Yes. And if we baseline that, I think we're thinking 3% to 4% base growth rate, so you're kind of looking at 8%, 9% for the full year.

[Adam Tindle, Raymond James]

Got it. Okay. That's helpful. And Tom, as we experienced maybe some of this slowing here, I'm wondering what -- how we think about margins moving forward, particularly as we try to model 2023. Sounds like we might have some continued challenges on top line. You're going to roll into some really difficult comparisons in Q1 and Q2, and I would imagine top line might even be flat or down in Q1 and Q2. If so, feel free to clarify if that's not the case. But if so, how we think about the margin trajectory moving forward as well.

[Thomas Baker, SVP and CFO]

I mean there's a few moving pieces in there, right? The growth in the services and cloud has certainly had a material effect on our margins this quarter, right? So question 1 is, how does that continue going forward? If you just look at the margin percentage, that's why we continue to try to stay focused on what's our gross profit growth rate because that's kind of the important thing.

Now that being said, if you take the mix out of it, I think we should be able to hold our historical margins on hardware. As you can see from the numbers, the endpoint spending was down a little this quarter compared to last year. And I think we kind of expect that to continue at least into Q4. And as we roll into next year, I'm thinking we can probably hold our historical margin rates on the endpoint equipment and the data, the storage. But it's going to -- it's really going to be the wildcard in terms of reported margins is how do those services in cloud and that 100% margin product roll through the P&L.

[Timothy McGrath, President and CEO]

We're pretty optimistic on that. We're seeing incredibly strong growth rates in our cloud, our CSP and our software business in general, that's quarters on a net basis, which does drive that margin rate up.

[Adam Tindle, Raymond James]

Got it. Just one more for me. Tim, as you look at your pipeline and hear from your sales force as we're sitting here in November, we've got the month of December coming out, it typically tends to be the corporate budget flush month. And I'm just wondering what you're hearing qualitatively or anything that you could support with the metrics that you look at on what the budget flush might ultimately look like in 2023.

[Timothy McGrath, President and CEO]

So that is a great question, Adam. We are a little conservative on that. Just talked to a number of customers who, in some cases, they're still waiting for data center equipment and some of the advanced technology solutions. So to the extent that, that is still constrained, a lot of that could be pushed into 2023. And as you know, endpoints are slowing down. But generally speaking, many of the projects that we're involved in now are truly mission critical, and we feel pretty confident that we're going to meet our expectation and deliver our forecast.

[Operator]

And our next question comes from Anthony Lebiedzinski from Sidoti.

[Anthony Lebiedzinski, Sidoti]

So first in terms of the implied 4Q sales projections that you have, I mean how much of that is because of the mix of business shifting more toward software users or the impact of netting versus just the impact from slower demand because of the macro environment?

[Timothy McGrath, President and CEO]

Well, thanks, Anthony. It's good to hear from you. So Tom?

[Thomas Baker, SVP and CFO]

I would say, I mean we're clearly seeing a little bit of a pullback in some of the hardware categories, Anthony, especially on the endpoint devices. So there is some of that, I think, baked in there. And we did have a really nice Q4 last year. But the vast majority of the pressure is coming from all the software and services coming through on a net basis. So it's I think it's more of the accounting and the net software, but there is some underlying demand softness coming.

[Timothy McGrath, President and CEO]

Anthony, what that looks like for us is our mid-market and commercial business has been very strong with our enterprise business. We are hearing as you're hearing out there in the industry that customers are, in some cases, asking for an additional signature. In some cases, they're delaying. But at the end of the day, we still feel very confident.

[Anthony Lebiedzinski, Sidoti]

Got it. Okay. So overall, I think to your point, it sounds like your gross profit should certainly increase, I guess, in Q4, even though the reported revenue will be maybe not as good because of all this netting. So is that fair to say that you would expect your gross profit dollars to be up in the fourth quarter?

[Timothy McGrath, President and CEO]

Okay, I'll start and then I'll let Tom jump in. But clearly, we're seeing that mix shift into integrated solutions, and we're seeing as a part of that, a lot of cloud, a lot of cybersecurity and a lot of software. And as you know, all of that is -- most of that is recorded on a net basis and that, of course, does drive gross margins up.

[Thomas Baker, SVP and CFO]

Yes. I think to answer your question directly, Anthony, I think the jury is still out on that. It's going to be nip and tuck, I think.

[Anthony Lebiedzinski, Sidoti]

Can you hear me guys?

[Timothy McGrath, President and CEO]

Yes, we can hear you now.

[Anthony Lebiedzinski, Sidoti]

Okay. Sorry, there's a long pause there. Okay. And I guess my last question, I guess, is obviously, you made progress with your inventories versus your second quarter, so cash flow improved. So what would you say is your reasonable goal for your year-end inventories? And if you could just also touch on your cash flow priorities, that would be great.

[Thomas Baker, SVP and CFO]

So I think on the inventory, Anthony, a lot of it's just going to depend on how the supply chain frees up. We did see an improvement this quarter, and our goal is to continue to drive that number down. Now that being said, we do have a couple of very large projects that are coming up. And I think a lot of it is going to depend on how that inventory comes in right at the end of the year. We can push it out to Q1. I think it's 1 thing, we're talking $30 million, $40 million here. So it's going to depend on the timing of the supply chain. But all else being equal, we should be able to drive down another $10-ish million, I think.

[Timothy McGrath, President and CEO]

And also to put that in perspective, Anthony, our inventory levels are lower than last year, as we mentioned. But compared to ordinary levels, they're significantly elevated.

[Anthony Lebiedzinski, Sidoti]

Right. And then in terms of your cash flow priorities?

[Timothy McGrath, President and CEO]

Yes. So we're kind of sticking to our guns there, Anthony. We are -- have an approved share buyback in place, and we'll be looking at that. We also have made some upgrades to our system. We've made some upgrades to our senior staff. And as you know, our balance sheet is clean and our powder is dry and we're also continually looking at additional opportunities that could tuck in and enhance our capabilities and specific solution areas. Right now, I'm open to the idea of doing tuck-in acquisitions.

[Operator]

And I am showing no further questions. I would now like to turn the call back over to Tim McGrath for closing remarks.

[Timothy McGrath, President and CEO]

Thanks, Justin. I'd like to thank all of our customers, vendor partners for their 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]

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