PC Connection Inc

NASDAQ:CNXN

Earnings Call Analysis

Significant Q3 Growth Driven by Advanced Tech

Despite a net revenue decline of 10.6%, the company achieved record gross margins of 19% and an operating margin of 4.6%, emphasizing a strategic shift to higher-margin advanced technologies, which grew 6%. Coupled with efficient operations, this shift led to record earnings per share of $0.97, and a net income of $25.6 million, up 10.3%. Endpoint device sales dropped, but this decline was more than offset by growth in server storage, networking, software, and services. Cash and equivalents stood robust at $240.5 million at the end of Q3. With solid growth in AI-driven solutions expected, the company is well-prepped for a productive 2024, with enhancements in security and IT infrastructure anticipated to fuel demand.

Robust Gross Margin Expansion with Record Earnings

Investors looking into the performance of the company will note an outstanding improvement in gross margins—a record 19% in Q3, up 142 basis points from the same period the previous year. This improvement reflects a growth and transformative shift in the mix of advanced technology solutions offered, known for their higher margins compared to endpoint devices. Net income also rose to a record $25.6 million, an increase of 10.3% compared to the previous year, while diluted earnings per share grew by 10.4% to $0.97.

Strategic Reduction in Operating Costs

A reduction in Selling, General & Administrative (SG&A) expenses by $5.1 million signals the company's proactive measures in cost control. Notably, this decrease resulted from ongoing cost reduction initiatives, even as SG&A on a percentage of sales basis rose due to lower revenues. The effective tax rate also saw a downward adjustment to 26.3% from changes in state tax rates, benefiting the company's net income.

Significant Improvement in Cash Flow

Cash flow from operations for the first nine months of 2023 increased markedly by $170 million over the same period the prior year, benefiting from a decrease in accounts receivable and inventory and an increase in accounts payable. The company also strategically managed investments and financing activities, including dividends to shareholders and stock repurchases, ending Q3 with a solid $240.5 million in cash and cash equivalents.

Conservative Approach to Inventory and Receivables

While Days Sales Outstanding (DSO) edged up slightly to 71 days, inventory balances decreased significantly by $56.4 million for the first nine months of 2023 due to an improved supply chain, reflecting the company's conservative approach to capital management despite ongoing market challenges.

Anticipating Technology's Promise and Future Growth

The company shows a forward-looking approach with the expectation that current demand trends will persist into Q4 amid a challenging economic landscape. Looking ahead to 2024, executives are keenly aware of the opportunities presented by artificial intelligence (AI) and its requirement for additional infrastructure, storage, compute, and security. This technological promise leads to the anticipation of an endpoint device resurgence, driven by upgrades and AI demand, which would notably affect gross margins once materialized.

Strategic Actions to Harness AI and Security Demand

With AI not yet a significant revenue driver, the company has created a modern infrastructure center of excellence. This is part of a focused strategy on go-to-market and sales enablement for AI and related technologies. Additionally, there's an emphasis on endpoint devices and their security. By providing services to assess, design, deploy, and secure systems, the company aims to leverage technological advancements to drive future growth and help customers optimize their end-to-end IT environment.

Customer Acquisition and Market Penetration

The company is actively acquiring new customers across its sales subsidiaries and vertical markets, which promises future revenue streams. Though the competitive landscape has applied pressure, there's a notable optimism in winning new contracts, particularly in the enterprise, SMB, and public sector spaces. This success in customer acquisition suggests potential outperformance and market share gains.

Capital Allocation and Shareholder Return Focus

Management is balancing capital allocation with a commitment to returning value to shareholders through dividends and share buybacks, with over $32 million approved by the Board for future repurchases. There is also a focused pursuit of strategic tuck-in acquisitions that would expand the company's solution capabilities and be accretive to its offerings and culture.

Sales Engagement and Pipeline

The company is experiencing an increase in customer conversations, requests for proposals (RFPs), and technical engagements. Management acknowledges the uncertainty of when demand will fully recover, maintaining a cautious yet hopeful outlook for when spending will return to drive revenue growth.

Earnings Call Transcript 2023-Q3

[Operator]

Good afternoon, and welcome to the Third Quarter Connections Earnings Conference Call. My name is James, and I will be the coordinator for today.

[Operator Instructions]

As a reminder, this conference 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 Smith, executive]

Thank you, 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 facts may be deemed to be forward-looking statements. Various remarks that management may make both the company's future expectations, plans and prospects, constitute forward-looking statements for purposes of the safe harbor provision 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, 2022, 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 as required by law, even if estimates change. Therefore, you should not rely on these forward-looking statements as representing management's views 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 2023 comparisons are being made against the third quarter of 2022. 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.ir.connections.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 2023 Conference Call. I'll begin this afternoon with an overview of our third quarter results and highlights of our performance. Tom will then walk us through a more detailed look at our Q3 financials. We executed well against our strategic priorities while improving our mix of advanced technologies and integrated solutions. Record gross margins and cash flow, combined with our improved operational efficiencies enabled us to deliver record earnings per share of $0.97 during the third quarter. In broad terms, what we are experiencing is a continued shift in the mix of our product as endpoint devices continue to be a lower priority for our customers. .

In fact, sales of endpoint devices declined in the mid-teens in the quarter. This shift in customer demand aligned to our strategic initiatives to drive growth in integrated technology solutions and services across each of our segments. Advanced technologies, which includes server storage, networking, software and services grew 6% compared to the prior year and resulted in meaningful margin expansion in the quarter. We continue to believe that gross profit is a better measurement of our performance for this reason. The impact of these factors resulted in a decline of gross profit by 3.5%, while our net revenue declined by 10.6%.

Now let's discuss our Q3 performance. Consolidated net sales declined by 10.6% to $693.1 million in Q3 compared to Q3 2022. Our customers continue to prioritize investments in advanced technologies though it was not enough to offset the decrease in demand for endpoint devices. Gross profit declined 3.5% and to $131.9 million. However, gross margins were up 142 basis points to a record 19% in Q3 compared to Q3 2022. This increase in gross margin reflects the growth and the shift in mix of our advanced technology solutions, which generally have higher margins than our endpoint devices.

Operating income in Q3 was $32 million, an increase of $300,000. Operating income as a percentage of sales was a record 4.6% compared to 4.1% of net sales in the prior year quarter. Net income in Q3 was a record $25.6 million, an increase of 10.3% compared to $23.2 million in the prior year quarter. In Q3 2023, our diluted earnings per share was a record $0.97, an increase of 10.4% from $0.88 in Q3 2022.

We'll now take a little deeper look at our segment performance. In our Business Solutions segment, our Q3 net sales were $269 million, a decrease of 14.8% compared to $315.8 million a year ago. The decline in revenue is largely a result of the reduction in demand for endpoint devices. Gross profit for the Business Solutions segment was $62.7 million, a decrease of 1% from a year ago. Gross margin increased 326 basis points to 23.3% in the quarter compared to the prior year. This increase was the result of our successful execution in growing sales of integrated solutions and advanced technologies, which includes services and software that are recorded on a net basis.

In our Public Sector Solutions business, Q3 net sales were $147.5 million, a decrease of 4.4% compared to $154.4 million a year ago. Sales of endpoint devices were down 15%, offset by an increase of 31% in sales of Advanced Technology Solutions category, driven by networking, software and services. Sales to the federal government increased by 9.5% compared to the prior year quarter. Sales to state and local government and education institutions decreased by 7% compared to the prior year. Increases in higher ed and state and local were offset decreases in the K-12 market. Gross profit for the Public Sector segment was $25 million, which was consistent with the prior year. Gross margin increased by 67 basis points to a record 16.9% in the quarter. The increase in gross margin percentage was due to a higher mix of software and services, which are recorded on a net basis, in addition to growth in sales of networking, software, servers and services.

In our Enterprise Solutions segment, Q3 net sales were $276.6, a decrease of 9.5% compared to $305.5 million a year ago. The decline in revenue was due primarily to a decrease in endpoint device sales compared to the prior year. Gross profit for the Enterprise segment was $44.2 million, a decrease of 8.3% compared to the prior year quarter. Gross margin increased by 21 basis points to a record 16%. Our enterprise customers continue to prioritize software and services recorded on a net basis.

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 decreased $5.1 million compared to the prior year quarter. The decrease in SG&A was in part results from the realization of the ongoing cost reduction initiatives we have undertaken this year. On a percentage of sales basis, SG&A increased 89 basis points to 14.4% of net sales in the quarter compared to 13.5% in the prior year quarter, primarily driven by lower revenues. Q3 operating income was $32 million, an increase of 0.9% this quarter from $31.7 million a year ago. Our effective tax rate was 26.3%, down from 27.7% due to changes in state tax rates. .

Net income for the quarter was a record $25.6 million, an increase of 10.3% from $23.2 million last year. Diluted earnings per share was a record $0.97, an increase of 10.4% from the prior year period. Our trailing 12-month adjusted earnings before income taxes, depreciation and amortization or adjusted EBITDA was $127.9 million compared to $145.5 million a year ago, a decrease of 12%. In terms of returning cash to shareholders, we paid an $0.08 per share quarterly dividend in September. As of September 30, 2023, we had $32.3 million remaining for stock repurchases under our existing stock repurchase program.

Today, we announced that our Board of Directors has declared a quarterly dividend of $0.08 per share payable to shareholders of record on November 14, 2023, and payable on December 1, 2023. Cash flow generated from operations for the first 9 months of 2023 was $185.7 million, an improvement of $170 million from the same period a year ago. The increase in cash flow from operations reflects a decrease in accounts receivable and inventory and an increase in accounts payable. Our accounts receivable balance decreased $20.9 million for the first 9 months of 2023. Our DSO increased to 71 days from 70 days for the same period a year results, primarily a function of netted product sales. Our inventory balance decreased $56.4 million for the first 9 months of 2023. Improvement in the supply chain has enabled us to complete and deliver orders for which we were holding a portion of the inventory at year-end. Our accountable increased $31.6 million for the first 9 months of 2023. Our net cash used in investing activities were $56.1 million for the first 9 months of 2023 was primarily the result of $48.7 million of investment purchases and $7.4 million of IT equipment purchases. The company used $12 million of cash for financing activities during the first 9 months of 2023, consisting primarily of payments of $6.3 million of dividends to shareholders and $5.4 million of stock repurchases. We ended Q3 with $240.5 million of cash and cash equivalents.

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

[Timothy McGrath, executive]

Thanks, Tom. We expect that the trends in demand that we have seen year-to-date will continue in Q4 with this challenging economic backdrop. Looking forward to 2024, there are a number of secular factors that should drive significant growth in several of our IT solutions and product categories. The promise of genuine improvement in productivity and efficiencies driven by artificial intelligence will positively impact the demand in several areas of our business. AI solutions will require additional infrastructure, storage, compute and security. We are confident that solutions developed for AI will require investments across the IT spectrum. We also should experience an endpoint device resurgence. This will be driven by a number of factors, including the need to upgrade operating systems, the demand of AI, which will require more powerful PCs the evolution of collaboration tools, improved security as well as impending recycles for devices. .

Security continues to be a high priority as our customers need to protect their IT environment. This will continue to drive demand for hardware, software and services that will be required to properly IT environment for the foreseeable future. To address these trends, we are taking the following actions. For AI, although not a current driver of revenue, we have developed a modern infrastructure center of excellence. This will help us focus on go-to-market and sales enablement solutions with a specific focus on integrated systems to support the growth driven by AI, machine learning, data analytics, high-performance computing and edge computing. We recognize the transformative potential of artificial intelligence and its pivotal role in shaping the future of industries and customer experiences. To realize that potential, we have a team dedicated to working with our partners, focused on driving their AI solutions and developing complementary value-added services.

By making this commitment, we need to bridge the existing gaps within the market and create offerings ensuring that our customers receive unparalleled AI-driven solutions that will harness its power for successful customer innovation. For endpoint device, we're working with our customers to assess their current environment and identify upgrade opportunities to take advantage of new hardware and software that will facilitate improved security, enhanced collaboration and a platform to run AI applications. We have service offerings to assess, design, deploy and secure systems and operating systems, which will promote adoption for customers.

For security, we're continuing to develop our security catalog of offerings, including 4 key areas: modern firewall with analytics and security integration, automated network fabric provisioning, network virtualization and managed network. We believe we are well positioned to help our customers through these transformational changes when IT spending and the related demand improves. Our customers know they can count on connection to help them standardize, simplify and optimize their end-to-end IT environment and deliver their business outcomes through technology. We believe our focus in our business strategy remains well aligned with the shifting dynamics of how customers deploy, utilize and consume technology.

We continue to connect our customers with technology that enhances growth, elevate productivity and empower innovation. We help our customers expertly navigate through a complex set of choices within the technology landscape. We help Tom the confusion of IT for our customers. Our growth rates for the U.S. IT market continue to be challenging in the near term. We're encouraged by the number of new customers we're acquiring, and we believe we can outperform the market and take market share.

On that note, I'd like to take a moment to thank our extremely dedicated and valued employees for their continued and extraordinary efforts during this rapidly changing environment. We'll now entertain your questions. Operator?

[Operator]

[Operator Instructions]

Our first question comes from Anthony Lebiedzinski from Sidoti.

[Anthony Lebiedzinski, analyst]

So nice job with gross margin expansion here. So given what you're seeing right now in the business and assuming no major changes to the mix of products and services, would you say that you would expect at least near term, gross margins to be kind of sustainable from here?

[Thomas Baker, executive]

I would say, Anthony, a couple of things. If we just bridge last year to this year on our gross margins, about half of the improvement was just due to the netted product versus product. The other half was driven by product mix into more profitable categories. So I think all else being equal, we can probably hold about where we are. The thing that I would think about going forward, at some point, the device side of the business is going to come back. And when that happens, I think you will see some pressure on the margins.

[Anthony Lebiedzinski, analyst]

Understood. Okay. And I think Tim, you mentioned that you expect next year that you'll see an uptick in endpoint devices. Do you think it will be early in the year or kind of later? What's your best guess at this point?

[Timothy McGrath, executive]

Well, thanks, Anthony. There's a lot of promise around AI and technology in general for 2024. And that said, we don't know when that upgrade cycle, that refresh cycle really begins. A lot of speculation that will be in the second half. We are having more conversations with our customers relevant conversations about future projects. Our RFPs are up in number. Our technical engagements are up, but we really don't know when that demand recovers. And from our suppliers, I think the consensus is the second half.

[Anthony Lebiedzinski, analyst]

Okay. That's very helpful color. And then, Tim, I also wanted to follow up on 1 of the points that you made towards the end of your prepared remarks. So you spoke about being encouraged by the number of new customers that you're seeing. Can you give a little -- maybe a little bit more details on that maybe from we're gaining share from? And kind of -- can you share anything else? Is it across the board? Or is it more on the business solutions side or enterprise? I would love to hear some additional details on that.

[Timothy McGrath, executive]

Thanks, Anthony. So it is indeed across the board. We have an acquisition engine for each of our 3 main sales subsidiaries, and we really are doing very well with that. And on top of that, we also are doing well with acquisitions across each of our 4 vertical markets. So we'll start with enterprise in the large account sector, winning several key new logos there that will convert into legitimate revenue streams later on. It takes some of the larger customers some time to ramp up. When we look at our SMB business, we're also adding new customers. The SMB business has been under a little more pressure as you know, from the competitive landscape. We're pretty excited about that.

And finally, in the public sector space, on the federal side, it's really about contract vehicles. And on the state local K-12 and higher ed, it's about winning those new customers as well. So I'd say across the board, our acquisition engines are working really well. what we need now is that IT spend and that demand to return.

[Anthony Lebiedzinski, analyst]

Got it. Okay. And then my last question before I pass it on to others. So you have a very sizable cash and investment position now approaching $300 million. So what are your plans to do with all that cash? .

[Timothy McGrath, executive]

So when we think about capital allocation and rewarding shareholders, we are doing a quarterly dividend, as you know. We'll look at the appropriate level of share buybacks. We still have over $32 million approved by the Board for share buybacks. And finally, probably most importantly, we continue to pursue, excuse me, tuck-in acquisitions in the solutions arena that would be accretive that would have a common culture, and most importantly, that would augment or extend some of our solutions capabilities. nothing immediate to announce, but we do continue to look and we're very much committed toward that end.

[Operator]

[Operator Instructions]

Our next question comes from Jake Norrison from Raymond James.

[Jake Norrison, analyst]

So can you guys just touch on the health of the pipeline and sentiment from your sales force currently as December is typically the big corporate budget flush month. What are you anticipating there? And further, can you just touch on the real-time update on SMB and Enterprise? Are you seeing any other green shoots there other than sort of on the quoting and inquiry side of the business, as you just touched on?

[Timothy McGrath, executive]

Yes. So I'll start and then Tom, maybe you can join in. So when we think about the traditional Q4 budget flush -- right now, we're forecasting Q4 to be perhaps slightly down from Q3 to look a lot like Q3, but perhaps some low single-digit declines. So we continue to see our customers under pressure with this economic backdrop and all the reasons that you're aware of from inflation to interest rates to some geopolitical instability, all that affecting customers. So they are very cautious in the near term. That said, they're very optimistic over the long term. As I said and discussed in my prepared remarks, the promise of technology is very significant in terms of what it can do for our customers' productivity and efficiencies. Tom? .

[Thomas Baker, executive]

Yes. I mean I think Tim hit the nail on the head in terms of how Q4 is going to look. We are seeing spot where -- it looks like customers are exploring perhaps doing a little bit more next year, but it hasn't gotten to the point where we're going to be highly, highly confident that we're going to have a digit growth rate into next year. .

[Timothy McGrath, executive]

Then in conclusion, on the green shoots part of the question, we are seeing many of our customers evaluate new software operating systems and the potential of layering AI on top of that, certainly, with Windows 11 and customers piloting co-pilots and is an encouraging part of the business. And there is activity and real movement there, but nothing that we can point to as an absolute driver of demand at this point.

[Operator]

I'm showing no further questions at this time. I would now like to turn it back to Tim McGrath for closing remarks.

[Timothy McGrath, executive]

Thanks, James. I'd like to thank all of our customers vendor partners and shareholders for their continued support and, once again, our coworkers for their efforts and for their extraordinary dedication. I'd also like to thank those of you listening to the call this afternoon. Your time and interest in Connection are appreciated. Have a great evening.

[Operator]

Thank you for participation in today's conference. This does conclude the program. You may now disconnect.