PC Connection Inc

NASDAQ:CNXN

Earnings Call Analysis

Connection's Q3 Earnings: Growth in Sales Amid Cautious IT Spending

In Q3 2024, Connection reported record net income of $27.1 million and earnings per share of $1.02, a 5.4% increase from last year. Overall sales rose by 4.6% to $724.7 million, fueled by a 17% increase in notebook and desktop sales from client refresh initiatives. However, demand for advanced technology declined by 11% due to ongoing IT challenges amid AI adoption uncertainties. Looking ahead, the company anticipates a muted demand environment through 2024, expecting to outperform market growth by 200 basis points. Costs related to strategic investments in sales capabilities and AI initiatives may impact near-term margins.

Overview of Q3 Performance

In Q3 2024, Connection reported consolidated net sales of $724.7 million, marking a 4.6% increase compared to the same quarter last year. The company also achieved a record net income of $27.1 million, up 5.7% from Q3 2023, alongside a record diluted earnings per share of $1.02, a 5.4% rise from $0.97 in the prior year. Despite these positive results, gross profit grew modestly by 2.7% to $135.4 million, with gross margins down 30 basis points to 18.7%.

Segment Analysis

Dividing the performance by business segments, the Business Solutions segment saw net sales decline by 6.1% to $252.6 million, primarily due to a 20% drop in advanced technology product sales, despite a 4% increase in endpoint device sales. In contrast, the Public Sector Solutions segment flourished with an 18.7% increase in sales to $175.1 million, bolstered by significant sales growth in federal government contracts. Lastly, the Enterprise Solutions segment grew by 7.4%, reaching $297 million, supported by a 14% increase in endpoint device sales.

Advanced Technology Challenges and Opportunities

The advanced technology sector faced challenges with an overall decline of 11%, largely attributed to a 32% decrease in networking solutions. This setback stemmed from tougher comparisons to the previous year's performance when supply chain issues were resolved. However, the software category, which encompasses cloud and cybersecurity solutions, posted an impressive 11% growth. Despite these impediments, the company remains optimistic about demand for technology in 2025, driven by device upgrades and AI initiatives.

Operating Expenses and Profitability

Operating income in Q3 decreased by 6.2% to $30 million, with a corresponding decline in operating margins from 4.6% to 4.1% of sales. The rise in selling, general and administrative expenses (SG&A) by 5.6% to 14.5% of net sales indicates increased investments in sales and technical capabilities. Management expressed their commitment to operational improvements utilizing AI, a strategy that could yield efficiencies moving forward.

Market Outlook and Strategic Investments

Looking ahead, the company anticipates that IT spending will remain conservative through the remainder of 2024, primarily due to macroeconomic uncertainties and the upcoming elections. However, they project that demand will recover and accelerate in 2025, influenced by the expiration of Windows 10 and a renewed focus on security and efficiency in manufacturing, healthcare, and retail sectors which showcased impressive growth rates of 20% and 23%, respectively. Investments are also being channeled into AI initiatives to support customer infrastructure modernization.

Cash Flow and Return to Shareholders

In terms of financial health, the company generated $148.6 million in cash flow from operations in the first three quarters of 2024. They maintained a strong cash position with $429.1 million in cash, cash equivalents, and short-term investments as of September 30, 2024. Connection also returned value to shareholders with a quarterly dividend of $0.10 per share and share repurchases amounting to $3.9 million. The dividend is payable to shareholders on November 29, 2024, illustrating the company's commitment to rewarding its investors.

Challenges in Advanced Technology and Future Expectations

Despite positive performance in some areas, advanced technology sales remain a concern due to customer hesitancy regarding the adoption of AI and infrastructure investment amidst economic uncertainties. Management indicated that the expected recovery could take longer than initially anticipated, placing the timing of advanced technology engagements into the latter part of 2024 and early 2025. Nonetheless, they remain optimistic about future growth.

Conclusion

Overall, while Connection has shown resilience in its earnings and segments, there are significant challenges ahead, particularly in advanced technology sales. Investors should monitor developments relating to demand recovery and the strategic utilization of AI, looking towards 2025 as potentially pivotal for growth and profitability. The company's efforts in maintaining cash flow and returning capital to shareholders are positive indicators of its financial stability and commitment to investor interests.

Earnings Call Transcript 2024-Q3

[Operator]

Good afternoon, and welcome to the Third Quarter 2024 Connection Earnings Conference Call. My name is Antoine, and I will be your 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, we have 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]

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 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, 2023, 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. And 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 2024 comparisons are being made against the third quarter of 2023. 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.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 2024 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 are in a period of rapid innovation. Technology advancements are happening at an unprecedented pace. The promise of digital transformation enabled by hybrid AI has never been greater. We are confident that as demand recovers, we have the right strategy to help our customers navigate through this challenging IT environment. Connection achieved record net income and earnings per share of $1.02 for the third quarter of 2024. In addition, we experienced moderate growth in gross profit in each of our business segments while making strategic investments to better position ourselves for the evolving technology landscape and what lies ahead for our industry.

We saw some evidence of our recovery year-over-year in select areas of our business in Q3. We experienced notebook mobility and desktop revenue growth of 17%, driven by PC refresh initiatives by our customers. Approximately 25% of those PCs were AI-enabled. However, demand for advanced technology has been negatively affected by our customers' ongoing struggle with our IT road map in the face of AI uncertainty. This resulted in a recovery that has been delayed longer than we anticipated. We believe our customers may continue to maintain this conservative approach for their IT spending for the balance of the year.

In terms of advanced technology, our software category, which includes cloud and cybersecurity, had strong growth of 11%. This increase was offset by a 32% decline in networking solutions. This decrease in networking was in part the result of a tough compare against results in the prior year, which benefited from the resolution of supply chain issues, impacting networking equipment that have been backlogged. This contributed to an 11% decline in overall advanced technology revenue compared to the prior year quarter.

Now let's discuss our Q3 performance. Consolidated net sales were $724.7 million, an increase of 4.6% compared to last year. Gross profit increased 2.7% to $135.4 million. Gross margins were down 30 basis points to 18.7% in Q3 compared to the prior year quarter. Operating income in Q3 was $30 million, a decrease of 6.2% compared to Q3 2023. Operating income as a percentage of sales was 4.1% compared to 4.6% of net sales in the prior year quarter. Net income in Q3 was a record $27.1 million, an increase of 5.7% compared to $25.6 million in the prior year quarter. In Q3 2024, our diluted earnings per share was a record $1.02, an increase of 5.4% from $0.97 in Q3 2023.

We'll now look a little deeper into our segment performance. In our Business Solutions segment, our Q3 net sales were $252.6 million, 6.1% lower than a year ago as we experienced a 20% decrease in sales of advanced technology products, partially offset by an increase of 4% in endpoint device sales. Gross profit for the Business Solutions segment was $63.1 million, an increase of 0.7%. Gross margin increased 170 basis points compared to the prior year quarter to a record 25%. Our net sales and gross margins were favorably affected by customer mix, an increase in cybersecurity and software sales.

In our Public Sector Solutions business, Q3 net sales were $175.1 million, 18.7% higher than a year ago. Sales for federal government increased by $25.6 million, while sales to state and local government and education institutions increased by $2 million. Gross profit for the Public Sector segment was $26.1 million, an increase of 4.4% compared to Q3 '23. Gross margin decreased by 200 basis points to 14.9% for the quarter compared to the prior year. The revenue increase in margin decline resulted from a few large project rollouts in Q3 2024 that were at lower margins.

In our Enterprise Solutions segment, Q3 net sales were $297 million, 7.4% higher than a year ago as we experienced a 14% increase in sales of endpoint devices. Gross profit for the Enterprise segment was $46.2 million, 4.4% higher than the prior year quarter. Gross margin decreased by 40 basis points to 15.6% for the quarter. The margin decrease was a result of lower software license fees and product mix.

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 increased by 5.6% compared to the prior year quarter. The increase in SG&A was primarily due to an increase in investments and resources to strengthen our sales, technical sales and service capabilities. In addition, we spent an incremental $1.5 million on targeted technical marketing events for our customers.

On a percentage of sales basis, SG&A increased 14 basis points to 14.5% of net sales in the quarter compared to 14.4% in the prior year quarter. Interest income for Q3 amounted to $4.9 million compared to $2.7 million last year, an increase of $2.2 million. Included in other income is $1.7 million of income from a legal settlement received during the quarter.

Our effective tax rate was 26%, down from 26.3%. Net income for the quarter was $27.1 million, an increase of 5.7% from $25.6 million last year, and diluted earnings per share was $1.02, an increase of 5.4%. Adjusted diluted earnings per share remained flat at $0.97. Our trailing 12-month adjusted earnings before interest, income taxes, depreciation and amortization or adjusted EBITDA was $123.6 million compared to $121.3 million a year ago, an increase of 2%. In terms of returning cash to shareholders, we paid a $0.10 per share quarterly dividend in August and we repurchased shares having an aggregate purchase price of $3.9 million in the quarter at an average price of $66.02 per share.

As of September 30, 2024, we had $64.6 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 $0.10 per share. The dividend is payable to shareholders of record on November 12, 2024, and payable on November 29, 2024. Cash flow generated from operations for the first 9 months of 2024 was $148.6 million. Our accounts receivable balance decreased $20.9 million for the first 9 months of 2024. Our DSO decreased to 67 days from 71 days for the same period a year ago. Our inventory balance decreased $10.5 million for the first 9 months of 2024.

Our accounts payable balance increased $29.1 million for the first 9 months of 2024, largely due to the timing of payments at the end of the quarter. Cash used in investing activities of $109.7 million was a result of $255.1 million of investment purchases offset by $150.6 million of investment maturities. We used $16.4 million of cash from financing activities during the first 9 months of 2024, consisting primarily of the payment of dividends to shareholders of $7.9 million in aggregate stock repurchases of $7.7 million. We ended Q3 with $429.1 million of cash, cash equivalents and short-term investments.

In terms of capital allocation, we remain committed to growing the business and have an ongoing program focused on investing in both organic and inorganic opportunities. Furthermore, as announced above, we have continued to return cash to shareholders in the form of a quarterly dividend and plan to continue to repurchase stock in a disciplined manner.

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

[Timothy McGrath, executive]

Thanks, Tom. We have customized our go-to-market approach for each of our verticals, resulting in consistent growth across our key market sectors. While large deals continue to contribute to accelerating this momentum, we attribute our continued success to the strength of our vertical focus, which underpins our sustained performance and strong execution throughout all levels of the business. Health care revenue increased 20% year-over-year as our health care customers continue to prioritize software and system upgrades. Also, we did have success with large client electronic health record system refreshes.

Retail revenue increased 23% year-over-year as a number of our large retail customers began their device refresh. The strong revenue growth in retail in both our Business Solutions and Enterprise Solutions Group was the result of multiple large customer deployments of endpoint solutions. Manufacturing revenue increased 1% year-over-year. Software endpoint device, networking and cybersecurity continue to be a heavy focus for manufacturers as they look for productivity gains while keeping their businesses secure.

We believe that many of our manufacturing customers are facing the need to modernize their facilities and technology infrastructure in support of the integration of intelligent digital technologies in manufacturing and in industrial processes. And many manufacturers continue to be targets of cybersecurity threats.

Financial Services increased 5% year-over-year, in part to address cybersecurity, flexibility and interoperability between IT systems. We continue to make good progress in our Solutions business, driven by ongoing investments in technology, talent and tools. This has resulted in strong growth in cloud, cybersecurity and our managed services business. AI remains a focus of investment as many of our customers assess their AI strategies. We continue to strengthen our AI capabilities through the Connection Helix initiatives.

The Connection Helix Center for Applied AI and robotics is foundational to our AI capabilities and fostering innovation for our customers. Through focused collaboration with key partners, we've developed specialized programs and vertical strategies, positioning us as a provider of AI infrastructure and solutions. Our early investments are setting the foundation for future growth as our customers refine their AI strategies and objectives. Our Connection Helix Center and the technology services team stands ready to support our clients.

In Q3, we faced similar headwinds to those that we saw in Q2. Customers continue to navigate their IT road maps in the face of AI and certainty, Windows 10 exploration and infrastructure changes. Additionally, uncertainty around the November 5 election has caused customers to remain guarded and we believe that will continue for the balance of 2024. We expect that device demand will improve in 2025 overall. IT demand may continue to be impacted by deal scrutiny and cautious investments in infrastructure due to the macroeconomic backdrop. In terms of profitability, device refresh and the assumed change in product mix will continue to produce downward pressure on gross margins.

As a result, for the remainder of 2024, we anticipate demand to remain somewhat muted. We are confident that we can outperform the IT market growth by 200 basis points. We remain committed to stay at the forefront of the technology curve, ensuring that our integrated solutions effectively meet the evolving needs of our customers. We believe our focus and business strategy remain 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 calm the confusion of IT for our customers. We know that in this complex world of technology, change happens and expertise wins.

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 Adam Tindle from Raymond James.

[Adam Tindle, analyst]

Okay. Tim, I just wanted to start, I noticed that gross margin was down 30 basis points and understand that PC mix may be driving some of that. But I wanted to ask on the competitive environment as well. One of your main competitors this morning cited an increasingly competitive environment. So just wondering what you're seeing from that standpoint in the quarter and how you're expecting that to evolve going forward?

[Timothy McGrath, executive]

Well, thanks, Adam. I would say, really, our gross margin pressure was the result of large project rollouts for big contract wins that we had in particular, with the federal government and in enterprise. Those were the main drivers. However, no doubt about it, in this economic backdrop, customers are cautious. They're really -- they've been very concerned about what that IT budget is going to look like next year, how they adopt AI and where that fits into the budget. And that has made the market more competitive as customers evaluate their options.

[Adam Tindle, analyst]

Got it. Okay. And Tom, Tim had mentioned that the device refresh is going to continue to mix down and put pressure on the gross margin line, which makes sense. Just wondering how you're thinking about the impact to operating margin and ability to grow earnings. Any initiatives that you're considering to sort of offset that gross margin pressure and how we should think about operating margin and ability to grow earnings?

[Thomas Baker, executive]

Yes. So I think what you're seeing is just a few things. One, if we get a pickup in the device and the endpoint device market, which I think pretty much everyone agrees is going to happen 2025. We'll see up on some margin rate compression, but we should see overall gross profit growth. So we'll grow the dollars. Frankly, the kind of the struggle we had this quarter, I wouldn't say necessarily struggle, but in our operating, our SG&A was up. And we've been investing. We've had the opportunity to hire some people, and we've been taking advantage of it. We're trying to improve our technical sales capabilities. And those things just take a time -- a little bit of time to manifest themselves into improved profit. But we're really trying to get set up for next year. So I think that's kind of where we're at.

[Adam Tindle, analyst]

Got it. Okay. One last one, Tim, just kind of near term as we think about Q4 trends. I think you mentioned that the advanced tech segment has been negatively impacted by AI pausing and you're expecting a delayed recovery that's going to continue for 2024. I know that category tends to be important for budget flush in Q4. Just how you're thinking about the trends in Q4 and expectations for budget plus based on the pipeline that you're seeing? And Tom, any parameters that you might want to give us from a modeling standpoint for Q4, just so we are on the same page.

[Timothy McGrath, executive]

Well, thanks. That is a great question. There's been a lot of speculation around what might happen after November 5 in the election. But if we look at kind of where the quarter has started, it feels an awful lot like Q3 and still -- we're optimistic that in 2025, advanced technologies will be a real driver of growth. We believe that on-prem technology, edge technologies will be a driver of growth. But we're just not seeing that for Q4. Q4, everything has kind of remained in that, I think, use term AI Fog. That AI Fog is out there in our customer environment. We do have, as you know, the drivers in 2025, including the Windows 10 expiration. But for the balance of the year, we think it's a lot like what we've been seeing.

[Thomas Baker, executive]

Yes. I think, Adam, for -- coming back and look from 2019 to today with the sequential growth Q3 to Q4. And it's -- you can't really defer any patterns. What I would tell you is kind of the way Q4 has started out, it's probably going to be a little bit on the weaker side. That's the way it's looking. In terms of modeling, I think you should see -- I wouldn't expect to see a huge change in the gross margin rate. SG&A should be down a little because we kind of -- we're going to pull out some of those onetime events that we had this quarter. So I think on the next kind of going to look like Q3, like Tim said.

[Operator]

Our next question comes from Anthony Lebiedzinski from Sidoti & Co.

[Anthony Lebiedzinski, analyst]

So I guess just a follow up on the previous comment about the strategic investments in terms of AI readiness, technical sales and customer engagement. I guess when would it be reasonable for you guys to start to see the benefits of that spending? Would it be Q1 or later? I mean just any sort of ballpark estimate would be helpful just for us to gauge as far as when we could expect tangible benefits from that?

[Timothy McGrath, executive]

Well, thanks, Anthony. So I think there are a couple of different components that really make up that. And so I do think that in 2025, you'll see continued uptick in the AI device side of the ecosystem. Again, a lot of that is just driven by the aging installed base in the Windows 10 and the need to refresh. But we do think that AI at the edge, at the PC level is going to be a continued driver. However, the AI applications and the proof of concepts and a lot of the on-prem AI implementations, we think are pushed more to the back half of the year. There are longer-term engagements. They require a lot of study, a lot of proof of concept and customers are still cautious as they really look at what the ROIs will be.

So the irony is probably the greatest promise for technology in our industry that we've seen since the advent of the Internet, yet the timing of that, I think, does remain a little delayed.

[Thomas Baker, executive]

Yes. I think, Anthony, the investments we've made in technical sellers technical sales people and the sales people that we've hired over the past year, those are starting to take hold now. I mean, we have a tremendous amount of activity going on in terms of hiring to win new logos and expand our wallet share. It just takes a little bit of time. So to answer your question directly, hopefully, Q2, we'll start seeing some of the stuff come through. Q1 is usually a pretty light quarter to begin with. But I think that's probably -- Q2, Q3, I think, is where we're seeing some tangible results.

[Anthony Lebiedzinski, analyst]

Got you. Okay. Well, that's good to hear. And as far as -- I mean -- so looking at the quarter, obviously, even with the tough macro environment, your sales were up in 2 out of the 3 segments. In terms of just the Business Solutions, which was down, how should we think about the recovery for that segment? You think it will be delayed until next year? Like just what are your thoughts just on Business Solutions?

[Timothy McGrath, executive]

Yes. Again, a good question, Anthony. So we're seeing our Enterprise customers really start to plan for the future. So we're seeing an uptick in RFPs, in requests for quotation. So the Enterprise business is really starting to move. We're also seeing some continued growth in the federal space. But in our SMB space, our customers have been more cautious. And we talked about endpoint upgrades. And the reality is a lot of windows upgrades are being done on current devices rather than new devices, and we didn't expect that. Not to the level that we're seeing that. And that SMB customer, I think, is more dependent on the macroeconomic backdrop. Very concerned about the outcome of the election and just cautious overall. So we don't see that SMB customer coming back with the speed or the velocity that we think that enterprise customer will be coming on.

[Thomas Baker, executive]

Yes. The revenue was down in SMB, but the gross profit was up. I mean, that's pretty impressive actually.

[Anthony Lebiedzinski, analyst]

Yes, indeed. And that's actually -- just to actually follow up on the SMB gross margin. So this is even with a bit of, I guess, headwind right as far as the -- I think you used to have a 4% increase in endpoint devices and business solutions. So what drove that gross margin percentage increase? Is it just a favorable mix shift? Or what else is behind the scenes there?

[Thomas Baker, executive]

I had a couple of large customers that didn't buy a lot and we have cloud sales, cloud and software. Cloud software [ site ].

[Anthony Lebiedzinski, analyst]

Got you. Okay. That's helpful. Okay. And then just touching based on the balance sheet that you guys made further progress with your inventory. And obviously, that's a nice -- had a nice impact on cash flows. I mean, do you think you're tapped out with inventory reductions? Or do you think you can make some further progress there?

[Thomas Baker, executive]

I think we're probably about as low as we're going to go for the time being. And because once the device ecosystem starts picking up, that's going to probably put $20 million of inventory in play pretty quickly. So I think maybe make a little more headway with our receivables, although our DSOs probably as soon as it's been in 3 or 4 years. So that part of the business is actually kind of clicking pretty well for us. So, yes.

[Timothy McGrath, executive]

But I'll add, Anthony, that we do have a big focus on operational efficiencies, and we're using AI to drive efficiencies internally and very focused on getting better there. So there should be some continuous improvement, as you would expect with our business.

[Anthony Lebiedzinski, analyst]

Got you. Right. And it's helpful to hear the comment about your AR. So despite the uncertainties in the macro environment, it sounds like, generally speaking, people are paying their bills on time. So that's good to hear. So thanks very much, and best of luck.

[Operator]

Thank you. I'm showing no further questions at this time. I will turn it over to Tim McGrath for closing remarks.

[Timothy McGrath, executive]

Well, thank you, Antoine. 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 extraordinary dedication. I'd also 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]

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