PC Connection Inc

NASDAQ:CNXN

Earnings Call Transcript 2018-Q4

[Operator]

Good afternoon, and welcome to the Fourth Quarter 2018 Connection Earnings Conference Call. My name is Daniel, and I will be the coordinator for today. At this time, all participants are in listen-only mode. Following the prepared remarks, there will be a question-and-answer session. 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 Steve Sarno, Senior Vice President and Chief Financial Officer.

I will now turn the call over to Steve Sarno.

[Steve Sarno, SVP & CFO]

Thank you. I will now read our Safe Harbor statement for today's call, which is also on Page 2 of the webcast slides being presented today as part of our call.

Our slides for today's call will also be made available in the Investor Relations section of our website after the call at www.connection.com.

Any statements or references made during the conference call that are not statements of historical fact may be deemed to be forward-looking statements. Various remarks that management may make about the company's future expectations, plans, and prospects constitute forward-looking statements for purposes of the Safe Harbor provisions under the Private Securities Litigation Reform Act of 1995.

Actual results may differ materially from those indicated by these forward-looking statements as a result of various important factors, including those discussed in the Risk Factors section of the company's Annual Report on Form 10-K for the year ended December 31, 2018, which was filed earlier today and 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 of any date subsequent to today.

During this call, GAAP and non-GAAP financial measures will be discussed. A reconciliation between the two is available in today's earnings release and on the company's website at www.connection.com.

Please note that unless otherwise stated, all references to fourth quarter 2018 comparisons are being made against the fourth quarter of 2017. Today's call is being webcast and will be available on Connection's website. The earnings release, along with the supplemental slides presented are also available on our website. The Form 10-K is available both on the SEC website at www.sec.gov, and in the Investor Relations section of our website at www.connection.com.

Before we begin today's review of our Q4 operating results, I'd like to spend a few minutes to remind you of the company's adoption of the new revenue recognition standard and how it is impacting the reporting of our Q4 results. As of January 1, 2018, we adopted the new revenue recognition standard using the modified retrospective approach as opposed to the full retrospective approach. In other words, our Q4 2018 results are stated under the new accounting standard for revenue recognition, while our previous year's results are stated under the prior revenue recognition standard.

In today's earnings release, we have provided a comparison of our Q4 2018 results between the current and prior revenue recognition standards. The main impact of adopting the new standard to Connection was that Q4 revenue as reported under the new revenue recognition standard was $108 million less than we would have reported under the prior revenue recognition standard. $107 million of this impact related to treating certain software arrangements, such as security, cloud-based licenses, and maintenance on a net revenue recognition basis. This is in addition to $1.2 million related to the timing of bill-and-hold transactions.

In reviewing our financial results today, we will be referencing the term, as presented, which reflects the implementation of the new revenue recognition standard as well as amounts prior to the impact of the new standard to allow for comparability against historical results.

I'll now turn the call over to Tim to provide some color on our Q4 operating results. Tim?

[Tim McGrath, President & CEO]

Thanks, Steve.

We had strong performance in Q4 that was the result of our strategic focus on driving growth, operational efficiencies, and assisting our customers with advanced technology solutions.

During Q4, we saw a record gross profit of $107 million driven by 10% growth in both servers and networking products. In addition, our focus on operational improvements helped deliver strong operational income of $26.3 million, an increase of 20% from Q4 a year ago, demonstrating the power and scalability of our business model.

Lastly, we saw our fourth consecutive quarter of positive operating cash flows of $5.6 million versus the use of $9 million cash in the same period a year ago, representing a $14.6 million year-over-year improvement.

Moving to Slide 3. Net sales, as presented, for the 3 months ended December 31, 2018 were $709.5 million. Net sales prior to the impact of the new revenue standard increased by 7.3% to $817.6 million compared to $762.3 million in Q4 a year ago.

Moving to Slide 4. Gross profit, as presented, increased by 7.3% to $106.8 million compared to $99.5 million a year ago. Gross margin, as presented, was 15.1% compared to 13.1% in the prior year quarter.

We're now moving to Slide 5 to provide a more detailed discussion of our performance by segment. In our Business Solutions segment, Q4 net sales, as presented, were $249.7 million. Prior to the impact of the new revenue standard, net sales were $297.2 million, representing a decrease of 0.3% compared to $298 million a year ago. Gross margin, as presented, for the segment increased by 318 basis points to 18.7% in the quarter, which represents our highest margin on record for this segment.

Our Business Solutions segment saw a strong growth in mobility and net/com products as many of our customers are focused on digital workplace transformation.

In our Public Sector Solutions business, Q4 net sales, as presented, were $118.4 million. Prior to the new standard, sales were $128.9 million, representing a decrease of $26.5 million compared to $155.4 million a year ago. Gross margin, as presented, for the segment increased by 282 basis points to 13.7%. The majority of the decline in revenue was in our federal government group.

In our Enterprise Solutions segment, Q4 net sales, as presented, were $341.4 million. Prior to the new standard, sales were $391.5 million, an increase of 26.8% compared to $308.8 million a year ago. Gross margin, as presented, for the segment increased by 110 basis points to 12.8%.

The Enterprise segment continue to benefit from large project refreshes in vertical market solutions. This combination drove strong growth in server/storage, mobility and desktop products, which, as presented, grew during the quarter at 29%, 23% and 15%, respectively. In addition, we continue to benefit from cloud and security migrations.

Having covered our sales and gross margin performance, I'll now turn the call over to Steve to discuss additional financial highlights from our income statement, balance sheet and cash flow statement. Steve?

[Steve Sarno, SVP & CFO]

Thanks, Tim.

For those following along on our webcast slides, we're on Page 6 of the presentation. SG&A, as presented, increased this quarter to $79.5 million or 11.2% of net sales from $74.9 million and 9.8% of net sales a year ago.

Under the prior revenue recognition standard, our SG&A expense as a percentage of revenue would have been 9.7%. This increase in our percentage of SG&A, as presented, was primarily due to the new revenue recognition standard, which added 149 basis points.

In addition, over the last four quarters, we have been investing in our solution sales capabilities with an emphasis on cloud and data center solutions. In Q4, we incurred $967,000 of restructuring cost associated with reduction in some of our internal resources. These charges are presented as a separate line in our income statement.

Our operating income, as presented, increased 20.2% this quarter to $26.3 million from $21.9 million a year ago. Under the prior revenue recognition standard, our operating income would have been $26.3 million. Included in other income is a net benefit of $2.3 million resulting from a favorable resolution of a past contract dispute. The remainder of our other income is $266,000 of interest income that was earned on our cash balances during Q4.

Our Q4 effective tax rate was 26.3%, up from 5.7% in the same period a year ago. This increase is largely due to a nonrecurring benefit of $7.8 million that we recognized in Q4 a year ago due to the remeasurement of our net deferred tax liabilities as a result of the Tax Cuts and Jobs Act. Our Q4 2018 tax rate benefited from provision to return adjustments associated with our October filing of tax returns.

Net income, as presented, for the quarter increased 2.8% to $21.3 million from $20.7 million a year ago. Prior to the impact of the new accounting standard, net income also would have been $21.3 million. In addition, net income growth adjusted for nonrecurring items in each year was 39.1%.

Earnings per basic and diluted share, as presented, were $0.80, an increase of 4% compared to $0.77 per share a year ago. Prior to the impact of the new accounting standard, earnings per basic and diluted share would have increased 4% to $0.80 and 3% to $0.79, respectively.

Earnings per share adjusted for the restructuring and other charges and the resolution of a favorable contract dispute was $0.76 compared to $0.54 last year when adjusting Q4 of 2017 for the nonrecurring impact of the $7.8 million tax benefit related to the previously mentioned revaluation of our deferred tax liabilities along with $2.7 million related to a onetime cash bonus paid to all nonexecutive employees and $900,000 of restructuring and other charges.

Moving to Slide 7 of today's presentation, our trailing 12-month adjusted earnings before income taxes, depreciation and amortization or adjusted EBITDA, as presented, increased 12% to $102.6 million from $94 million a year ago. Prior to the impact of the new revenue standard, our trailing 12-month adjusted EBITDA would have increased 12% to $103.4 million.

In Q4, we declared a $0.32 per share special dividend, which was paid in January of this year, returning $8.5 million to our shareholders. In addition to the special dividend, we also repurchased 366,000 shares during Q4 for $11 million at an average cost of $30.05 per share.

During the whole of 2018, 535,000 shares were repurchased for a total of $15.4 million at an average price of $28.73 per share. Adding together, the $8.5 million of dividends declared and $15.4 million spent on stock repurchases yields a total of $23.9 million of payments accruing to the benefit of our shareholders during 2018.

Turning to the balance sheet on Slide 8, we ended Q4 with $91.7 million of cash and cash equivalents, representing an increase of $41.7 million from the prior year.

Cash flow from operations, shown on Slide 9, generated $86.8 million of cash versus $19.3 million for the same period a year ago, representing an increase of $67.5 million in cash generated. Investing activities of $21.2 million for the year were primarily the result of equipment purchases and capitalization of our system upgrade that is currently in process.

Our financing activities during the year used $23.9 million of cash, which was due to the Q1 payment of $9.1 million for our previously declared 2017 special dividend and the aforementioned $15.4 million of cash used to buy back 535,000 shares of our common stock under our previously authorized stock repurchase plans.

Please note on Slide 10 that as of December 31, 2018, we have $27.4 million remaining for stock repurchases under our existing stock repurchase program, which reflects an additional $25 million authorized by our Board of Directors, which was announced earlier in Q4.

Moving to accounts receivable, our days sales outstanding, or DSO, increased from 48 days a year ago to 51 days at the end of Q4. The entire 3-day increase is due to the impact of the new revenue standard, which resulted in the use of a lower net sales denominator in our DSO calculation.

Moving to capitalized expenditures. During Q4, we capitalized $5 million, which was mainly due to our ERP system upgrade that is currently in progress. We expect our spend, both capitalizable and expensable remaining for this project to be in the range of $6 million to $7 million over the next six to nine months.

Although we do not provide formal quarterly or annual guidance, we do expect to continue to grow during 2019 at about 200 to 300 basis points above the estimated industry average of 3%.

On a quarterly basis, we have seen slight timing differences that have had the impact of shifting revenue out of Q3 and into our fourth quarter. As a result, we believe it's reasonable to see a similar shift in 2019.

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

[Tim McGrath, President & CEO]

Thanks, Steve.

Demand for server/storage and net/com products continues to be strong in data center and intelligent edge solutions. IT product and solutions continue to evolve as customers are using technology to transform and secure their businesses. I'm pleased with our continued strong performance in our industry vertical market solutions group. We are enabling business transformation with our customers in retail, healthcare and manufacturing. The continued growth in our enterprise segment was a major contributor to our vertical market success in Q4. Customer success is measured in many ways and enabled by advanced technologies. We'll continue to invest in systems and subject matter experts in order to help our customers improve productivity, enhance growth and empower innovation. We're optimistic about the opportunities we have to assist our customers in transforming their business.

We continue to see strong growth by helping our customers create competitive advantages with technology. The company achieved record operating income this quarter. We saw a strong demand for edge, core and cloud technologies. In addition, we are pleased with the growth in our enterprise segment and in our advanced technology solutions.

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

We'll now entertain your questions. Operator?

[Operator]

Thank you. [Operator Instructions].

Our first question comes from Adam Tindle with Raymond James. Your line is now open.

[Madison Suhr, Raymond James]

Okay. Thank you. This is Madison on for Adam. I wanted to start on the 2019 outlook. A lot of confusion out there in the investment community seems to be a view that tough comps from tax reform, potential slowing PC cycle will make growth more difficult, but it seems like the distributor and reseller has seen a pretty healthy continuation of solid spend into year-end and beyond. Can you just talk about what you are hearing at the customer and partner level on expectations for 2019?

[Tim McGrath, President & CEO]

Sure. Thanks. Overall, I think there is a good amount of optimism looking at 2019. You've got a number of drivers for that, but at the end of the day, many of our customers are looking to use technology to gain competitive advantage and we talk about digital strategy and large project refresh, really driving some of their growth. Some of the enterprise space, we're pretty optimistic, we think the refresh can continue, perhaps at a slightly slower pace than we've been seeing, but we're optimistic. We still think that there is a lot of opportunity with security and software, lot of opportunity for upgrade there.

And our PC refresh and kind of edge technologies refresh has been strong. And so overall, we are committed to just what we said and as we believe, we can outpace the market rate of growth by 200 to 300 basis points, and we're pretty confident that we'll carry that through 2019.

[Madison Suhr, Raymond James]

Okay. That's helpful. And then just a follow-up I was wondering if you could touch on the cadence to whether it be operating profit dollars or EPS for fiscal year 2019. Any kind of like seasonality we should be thinking about first half, second half split? Any kind of insight there would be helpful.

[Steve Sarno, SVP & CFO]

Sure. Madison, I think we'll continue to see some of the same seasonality that we've seen in prior years with Q2 being a bit of a stronger quarter. I did mention in my remarks, Q3, I think we continue to see revenues that were in Q3 really kind of pushing towards Q4 and I think we've seen that for a couple of years now and I think that the company has obviously struggled having to preannounce in each of the last Q3s. So just not really changing the focus of the year, really, just looking to reallocate that, I think, between quarters. So I think that sort of seasonality is what we're seeing.

[Tim McGrath, President & CEO]

That's right. And historically, Q2 is a large quarter for software and now that's -- we're always showing software or a large part of the software on a net basis that does affect Q2 a little bit. Q3, traditionally, very strong for Public Sector and for SMB and enterprise and then Q4, certainly strongest quarter for our Large Account enterprise group.

[Operator]

Thank you. And our next question comes from William Gibson with ROTH Capital Partners. Your line is now open.

[William Gibson, ROTH Capital Partners]

I'm a little surprised; you're talking about gaining in cloud. Wouldn't that adversely impact server business? Or what's going on there that server is picking up? Or is that larger data center guys?

[Tim McGrath, President & CEO]

Thanks, Bill. So we think that cloud and cloud technology, there's a couple of components that we really should comment on. And absolutely, there is the pure subscription-based component and much of that is -- now is being shown on a net basis, so that business has been very strong. But what we're really seeing across our customer base is growth in two areas. One is in hybrid cloud and that really is a modified lookout cloud that it's an on-prem solution blended together with an off-prem or cloud solution, and we think a large majority of our customers end up in that category.

In addition to that, we think about the software defined space driving a lot of our business, and all of that ends up being, in one form or another, hybrid. There are workloads that can, should and will reside in cloud and there are workloads that can, should and will live out of that network edge and on-premise. And so we're seeing good growth in both areas.

[William Gibson, ROTH Capital Partners]

Good. And what about security? Is that mainly software? Or does that have a hardware element as well?

[Tim McGrath, President & CEO]

Yes, there's both elements to security. As you know, we offer the end-to-end solution. Certainly, there's a software element across many vendors and we're seeing really good growth there. And there is that hardware and appliance element as well and good growth there in our net/com category.

[William Gibson, ROTH Capital Partners]

And then just on the contract dispute that got resolved in your favor. Did you just hang onto the customer?

[Tim McGrath, President & CEO]

Yes, that contract was really about a buy-in consortium, and we did retain that contract.

[Operator]

Thank you. And our next question comes from Anthony Lebiedzinski with Sidoti. Your line is now open.

[Anthony Lebiedzinski, Sidoti]

Thank you, and good afternoon and thank you for taking the questions. So just wanted to follow-up, Tim, you talked about that 2019, you think there's a good amount of optimism out there. Is that mostly for the enterprise space? Or you're seeing that as well perhaps for the other two segments?

[Tim McGrath, President & CEO]

Well, Anthony, that's a great question. Yes, we are, again, confident. We've had great performance by our enterprise team, and as I mentioned, we're seeing large project refresh continue, and much of that is in the lines of business and about delivering a solution, but we're pretty confident that will continue but perhaps at a slightly lower pace than what we've been seeing this year in our enterprise space.

As you noted there in Q4, we had very strong growth in the enterprise. Also when it comes to our small and medium business that would be Connection's Business Solutions. In that space, we do see many of our customers looking to gain an edge with technology, especially in the vertical markets. When you think about what's happening in retail, manufacturing, healthcare, or even finance, there's many reasons to upgrade and in particular, our Business Solutions team has been doing a terrific job selling across that solution stack of advanced technologies, with almost half the revenue now coming in that arena. So we're pretty confident that will continue, because technology is offering competitive advantage.

Regarding with the public sector, we are a little more sheepish there. While we don't think the federal government shutdown had much of an effect on us in Q4, we're hoping that a further government shutdown in Q1 wouldn't delay any purchases, but if so, they should push to Q2. So we think that our government business is going to plot along. However, we think higher ed has some good rates and some good opportunity to grow in 2019, and we're optimistic about our SLED business. So when you put that altogether, though I don't want to misrepresent, we're still talking about 200 to 300 basis points above the market rate of growth and that still in the 6% region.

[Anthony Lebiedzinski, Sidoti]

Okay. So just going back to your October announcement that you guys talked about supply shortages, doesn't look like this was the case here but just wanted to just clarify to see checking on that subject. And also back then, you talked about the timing of shipments hurting Q3 performance, was wondering how much of that actually helped you in Q4, that shift and timing?

[Tim McGrath, President & CEO]

Thanks. So when we think about that in particular in Q3, we thought there was about as much as $60 million to push for one reason or another. And the reality is, across our segments, we realized about half of that, about another half of that will probably push again, but overall, we do think it smoothes out and there have been some supply chain shortages out there, but that has not had a material impact on us, and we've done some evasive moves with our inventory to try to ensure against that.

So overall, there's going to be lumpiness to the business, when we think about large enterprise as project's ebb and flow and that same lumpiness applies to the mid-market. And we define our SMB or mid-market as 2,000 seats and below, and so we think about that upper echelon of that segmentation. That too is very project oriented, and that too does have some ebb and flow. But overall, I think we're on target and would say that we've pretty much recovered in Q4.

[Anthony Lebiedzinski, Sidoti]

Got it. Okay. And also just -- now that you are done with all the 606 comparisons, I'm sure you're happy about that. How should we think about gross margins and operating margins for 2019?

[Tim McGrath, President & CEO]

Thanks, Anthony. I'll let Steve answer that and jump in by echoing your comments. Yes, we're thrilled that that's behind us.

[Steve Sarno, SVP & CFO]

Absolutely. And I think looking at gross profit first, which really isn't impacted by 606 by the new standard, certainly, helpful in some of these, in looking at how the revenues earned and looking at margins, part of what you have to do is look at how much of the software is going to continue to move to the cloud. So if that percentage is going up, you'll actually see a little bit of upward lift on margins. So we do continue to see that trend as the software that's being netted continues to inch up quarter-by-quarter and so that does have a little bit of list on gross margins. We're starting to take a look at a lot of things as a percentage of gross profit because that really allows us to levels that without that impact of netting and how that's ebbing and flowing. On operating income, a lot of the same comments and thoughts, I guess.

[Anthony Lebiedzinski, Sidoti]

Got it. Okay. And two more quick questions. As far as the restructuring that you did in the fourth quarter, how much annualized cost savings should we expect from that?

[Steve Sarno, SVP & CFO]

Sure. Several million dollars in the $3 million to $4 million range is what we modeled for that.

[Anthony Lebiedzinski, Sidoti]

Got it. Okay. And lastly, as far as --

[Steve Sarno, SVP & CFO]

Part of that is being reinvested in the business. That was -- is worth noting.

[Anthony Lebiedzinski, Sidoti]

Okay. Got it. Okay. And lastly, as far as your total CapEx expectations for 2019, do you have a number for that?

[Steve Sarno, SVP & CFO]

A little bit higher than or similar to what you saw in '18 really, as we finish up the ERP implementation project, but also add a few other projects on there in place.

[Anthony Lebiedzinski, Sidoti]

Got it. All right. Thanks so much and best of luck.

[Operator]

Thank you. And I'm not showing any further questions at this time. I would now like to turn the call back over to Tim McGrath for any further remarks.

[Tim McGrath, President & CEO]

Well, thank you, operator. I'd like to thank all of our customers, vendor partners and shareholders for their continued support and for our dedicated coworkers for their efforts. I'd also like to thank all of those -- excuse me, those of you who are listening to our call this evening. Have a great evening.

[Operator]

Ladies and gentlemen, thank you for participating in today's conference. This does conclude today's program, and you may all disconnect. Everyone, have a wonderful day.