PC Connection Inc

NASDAQ:CNXN

Earnings Call Transcript 2019-Q4

[Operator]

Good afternoon, and welcome to the Fourth Quarter 2019 Connection Earnings Conference Call. My name is Chris, and I'll be the coordinator for today. At this time, all participants are in a listen-only mode. Following the prepared remarks, there will be 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 Tom Baker, Senior Vice President and Chief Financial Officer.

I will now turn the call over to the company.

[Unidentified Company Representative]

Thank you. I will now read the Safe Harbor Act. 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 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 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. Therefore, you should not rely on these forward-looking statements as representing views as of any date subsequent to today.

During this call, GAAP and non-GAAP financial measures will be discussed. A reconciliation between the 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 2019 comparisons are being made against the fourth quarter of 2018.

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. Please proceed sir.

[Tim McGrath, President & Chief Executive Officer]

Good afternoon, everyone, and thank you for joining us today for Connection's fourth quarter 2019 conference call. I'll be sharing a brief update on our business, including our strategic initiatives; and Tom Baker, our Chief Financial Officer will join me to provide a review of the company's fourth quarter and full year financial results.

With the start of a new decade in the beginning of our 38th year in business, I thought this would be a great opportunity to kick-off our call with a review of the items that have fueled Connection's outstanding success.

Connection's three distinct sales subsidiaries deliver a level of service and a deep understanding of our customer's environments. When combined with the expertise of our Industry Solutions Group Connection's vertical market-focused teams, we are able to deliver technology solutions customized to the specific needs of public sector organizations, small and medium-sized businesses and large enterprises.

This specialization goes beyond a different department name or a unique sales rep title. It's baked into the training, the culture and the focus of our teams. We understand our customer's needs and can collaborate with our customers to deliver specific solutions based on their needs. This level of service would not be possible without the specialization, I just mentioned. And it really grows out of our interest in the customer's environment their team and their business.

After all, Connection is a purpose-driven organization and our sales and sales support teams have done an exceptional job of living our mission. We've built a great team around our core goals of enhancing growth, elevating productivity and empowering innovation for our customers.

In addition to our public sector, business solutions and enterprise groups, I'd like to shine a spotlight on the great work that's being done by our Technology Solutions Group and our Technology Integration and Distribution Center. Our TSG team continues to drive the sales of advanced technology solutions, delivering the technical expertise and outstanding follow-through our sales teams need to exceed our customers' expectations.

The Technology Integration and Distribution Center team continues to enhance our capabilities while remaining focused on the customer experience. Just to give you a frame of reference, the TIDC team completed over 400,000 custom configurations last year. That's almost twice as many as we're able to do just a few years ago. Both teams have done great work and I look forward to seeing the innovations they'll continue to bring to the company.

It's my pleasure to announce the strongest year in our company's history. On an annual basis, we achieved record gross profits and earnings with diluted earnings per share of $3.10 or 29% higher than 2018. During our fourth quarter, revenue increased to $716.6 million and gross profit increased by 9% compared to Q4 of 2018.

During the fourth quarter, gross profit grew by 8.7% year-over-year and we achieved gross margins of 16.2%, which represented a growth of 150 basis points. Operating income increased by 12.5% to $29.6 million or 4.1% of net sales compared to $26.3 million or 3.7% of net sales in the prior year quarter.

In Q4 2019 diluted earnings per share increased by 4% from Q4 2018. Excluding restructuring charges and the favorable settlement of a contract dispute in Q4 of 2018, adjusted diluted earnings per share increased 9% from Q4 2018. We experienced strong growth in both our Business Solutions and Public Sector Solutions operating segments.

The Public Sector segment achieved 12% revenue growth in the quarter compared to Q4 2018 followed by the Business Solutions segment, which experienced growth of 5%, offset partially by a 6% decrease in our Enterprise Solutions segment. Due to our continued growth in selling cloud-based and security software for which revenue is recorded on a net basis, we believe that growth in gross profit is a better indicator of our success than revenue.

Gross profit in the fourth quarter increased by 13% in Business Solutions, 29% in Public Sector and decreased by 3% in the Enterprise Group compared to Q4 2018. We continue to benefit from a shift towards Everything-as-a-Service, hybrid cloud and the PC refresh. This led to strong growth in the mobility, desktop and software categories. We remain committed to helping our customers efficiently and intelligently build out solutions that help solve IT.

Now I'd like to provide a more detailed discussion of our performance by segment. In our Business Solutions segment, Q4 net sales increased by 5% to $262.3 million compared to $249.7 million a year ago. Gross profit in the Business Solutions segment increased 12.5% from a year ago and gross margin for this segment increased by 133 basis points to 20.1% in the quarter.

Our Business Solutions segment margins benefited from an increase in volume and in a change in customer mix. Business Solutions continue to focus on advanced technologies that have had higher margins and represented a larger percentage of revenue this quarter. In our Public Sector Solutions segment, Q4 net sales increased by 11.8% to $132.5 million compared to $118.4 million a year ago.

Sales for the federal government increased by 25.4% compared to the prior year as a result of large project wins while sales to state and local government and educational institutions increased by 3.8%. Gross profit for the Public Sector segment increased by 28.5% in the quarter and gross margins grew by 205 basis points to 15.8%, due to the double-digit growth in the modern workplace, which includes mobility and desktop solutions.

We also experienced strength in software sales. In our Enterprise segment, Q4 net sales were $321.9 million, a 5.7% decrease compared to $341.4 million a year ago. Gross profit in the quarter declined by 2.7%. As you may recall the Enterprise Group experienced 21% gross profit growth in Q4 of 2018 resulting from the timing of several large project rollouts that did not repeat in Q4, 2019.

Gross margin for the Enterprise segment increased by 41 basis points to 13.2%. Sales of cloud-based and security software had a greater financial impact on gross margin for the Enterprise segment this quarter than in the same quarter last year.

Having covered our sales and gross margin performance, 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?

[Tom Baker, Senior Vice President & Chief Financial Officer]

Thanks Tim. SG&A increased this quarter to $86.5 million from $79.5 million a year ago. The increase in SG&A was driven in part by an increase in variable compensation due to higher level of sales and gross profit achieved compared to the prior year quarter.

SG&A as a percentage of net sales increased by 86 basis points year-over-year. Our operating income increased 12.5% this quarter to $29.6 million from $26.3 million a year ago. Our Q4 effective tax rate was 26.5%, up from 26.3% in the same period a year ago.

Net income for the quarter increased 3.1% to $22 million from $21.3 million a year ago. Diluted earnings per share was $0.83, an increase of 4%. Excluding the effect of restructuring charges and the favorable contract settlement in Q4 of 2018, net income and earnings per share grew by 7.9% and 8.9% respectively.

Our trailing 12-month adjusted earnings before income taxes, depreciation and amortization or adjusted EBITDA increased 25% to $128.7 million from $102.6 million a year ago. In Q4, we declared a $0.32 per share special dividend which was paid in January of this year returning $8.4 million to shareholders.

In addition, during 2019 we repurchased 134,000 shares for $4.5 million at an average price of $33.36 per share. Between the special dividend and stock repurchase, a total of $12.9 million of cash was returned to shareholders. We ended Q4 with $90.1 million of cash and cash equivalents.

Cash flow from operations for the year ended 2019 was $36.6 million versus $86.8 million for the same period a year ago. During the quarter, our cash flow used in operations was $3.4 million. Cash flow from operations was affected by the timing of product deliveries in the fourth quarter.

Specifically in the Enterprise segment 46% of quarterly revenue was delivered in December. Across all segments, we experienced strong software sales near the end of the quarter for which the receivable is recorded on a gross basis and the revenue is reported net.

Our net cash used in investing activities of $25.7 million for the year was primarily the result of equipment purchases and capitalization of our ERP system upgrade that is in process.

The company used $12.6 million of cash for financing activities for the year ended 2019 consisting primarily of the Q1 payment of $8.5 million for our previously declared 2018 special dividend and $4.5 million of stock repurchases. As of December 31, 2019 we have $22.9 million remaining for stock repurchases under our existing stock repurchase program.

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

[Tim McGrath, President & Chief Executive Officer]

Thanks Tom. We had another quarter of solid performance in our Business Solutions and Public Sector segments, demonstrating the importance of specialization and customer segmentation. Customer success is measured in many ways and enabled by advanced technologies that are tailored to the unique needs of diverse users and environments.

As the industry continues to evolve, we'll need to accelerate our investments in certain critical areas. As our customers' needs grow and change we'll be there to help them enhance their growth, elevate their productivity and empower innovation with technology.

We will continue to invest in systems and subject matter experts that enable us to deliver the exceptional quality and service for which we are known.

Looking ahead, current industry growth expectations for IT are in the low single digits and approximate the GDP growth. Our plan is to continue to grow twice as fast as the overall market. 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] And our first question comes from the line of Adam Tindle with Raymond James. Your line is now open.

[Adam Tindle, Raymond James]

Okay. Thank you and good afternoon. Tim, I just wanted to start kind of dovetailing into that last comment that you made about growth expectations moving forward. We've just passed the expiration of Microsoft Support I think at the end of January here. And there was some fear that post this we would see some slowing in overall IT spending as that PC cycle may slow. Just curious what are you seeing in terms of impact to your backlog? Is there any evidence that we'll see some changing in IT spending growth? And just talk about your confidence to come out and talk about two times the low single-digit growth expectation given the really strong year that you're coming off of?

[Tim McGrath, President & Chief Executive Officer]

Well, Adam thanks. So there's a lot there to cover. If you think about the macroeconomic backdrop, certainly there is more uncertainty than there has been when you look at all of the events that are happening out there. So we're very conscientious of that. When you combine that with the -- certainly the slowing of spending around the Windows 10 upgrades that's really we're a little concerned. But we continue to believe that we can take market share really in any market condition and that the target of two times IT growth rate or about two times GDP is still a reasonable target for us.

[Adam Tindle, Raymond James]

Okay. And you're thinking that based on talking with customers budget expectations into 2020 that budgets are likely going to be up and we're going to see some growth in IT spending in 2020?

[Tim McGrath, President & Chief Executive Officer]

Yes definitely. We're confident of that. There's no doubt that at some point, the PC refresh will tail off but there's a number of opportunities around everything as a service and hybrid clouds.

[Adam Tindle, Raymond James]

Okay. And then maybe one for Tom. As we think about shaping up 2020 if the business mix is going to move probably away from PC and it sounds like custom solutions are accelerating, should we be expecting gross margin to be improving year-over-year in 2020?

[Tom Baker, Senior Vice President & Chief Financial Officer]

Yeah that's a loaded question. I think typically what you'd see is you'd see a little bit higher margins on that type of product. But this year, we have really benefited from the level of some of the volumes of client product that we have sold. And that's a little bit hard to predict going forward. So I think generically you sit back and you say, yeah we should see margins drift up a little. But we've got pretty decent margins on some of the higher volume product this year.

[Adam Tindle, Raymond James]

Okay. Fair enough. Yeah, so maybe some of those volume rebates don't repeat. So maybe we shouldn't get too far ahead of ourselves on gross margin. Maybe touching on operating margin and really the investments that Tim mentioned I think you said accelerating investments. Is there a way for us to think about operating margin target for the year or maybe OpEx expectations whether in dollars or a percent of revenue based on your investment plan for the year?

[Tom Baker, Senior Vice President & Chief Financial Officer]

Well, I think in Q4, we saw a little bit higher SG&A as a percentage of revenue than we did last year. We've got a couple of things going on in there. Our advertising was up and some of that does get reimbursed but that goes into the gross profit. So that's a little bit of it. The variable comp was up to the gross profit because commissions were up. And then the variable comp was up just on the relative performance of the rest of the employee group. And then also buried in there, there is some infrastructure that will be ongoing. So we have to make some investments in some systems and some other technical infrastructure going forward. So, I think if you look at this year going into next year, you might see a little bit of a drift-up in that percentage.

[Adam Tindle, Raymond James]

Okay. That makes sense. Thanks and congrats on a strong 2019.

[Tom Baker, Senior Vice President & Chief Financial Officer]

Thanks.

[Tim McGrath, President & Chief Executive Officer]

Thanks, Adam.

[Operator]

Thank you. And our last question comes from the line of Anthony Lebiedzinski with Sidoti & Company. Your line is now open.

[Anthony Lebiedzinski, Sidoti & Company]

Yes, good afternoon gentlemen, and thank you for taking the questions. So just wondering as far as your performance of the different vertical markets that you're in Tim perhaps if you could just comment on that. Then I have another question as well.

[Tim McGrath, President & Chief Executive Officer]

Great. Well Anthony thanks. So interesting quarter for vertical markets. We did really well in the health care vertical. We were up double-digits and very pleased with that across the board. We also did very well in the manufacturing vertical. In our retail vertical, a year ago in the quarter we had a very significant -- a couple of very significant large retail rollouts. So we had a very tough compare there. So health care was up, manufacturing was up and then retail was just slightly down and the financial vertical is slightly down again all based on the timing of large project rollouts.

[Anthony Lebiedzinski, Sidoti & Company]

Got it. Okay. Well that's certainly understandable. Okay. And then I guess when I look at the different segments that you provided details for the gross margin in the Business Solutions segment was certainly I think the most impressive up over -- up to 20.1% kind of. I know that was driven. Some of that was a mix shift to software, but there was -- you also called out the desktops which is lower margin. So I guess when -- how should we think about the performance of the different segments from a gross margin perspective? If you could provide any color that would be helpful.

[Tim McGrath, President & Chief Executive Officer]

Certainly. I'll start and then I'll turn it over to Tom for a little more specific financial information. What we're seeing in particular we'll start with our Business Solutions segment is the team is executing really well selling across the advanced technology and across the solution stack. So as you mentioned, we are netting more software cloud software, security software down which does push the margin rate up a little. There's certainly some of that, but we continue to see good margins and good growth in the group purely based on execution around our solutions capability.

So we're pretty confident that we can sustain that just based on the services that we offer. It's a little more difficult in Enterprise. The large projects tend to be very competitive and so we certainly saw a lot of that in the quarter. And we're also very pleased with the pickup that we've seen in our Public Sector business, driven by a large project rollouts in our Federal Group and actually good margin associated with those. So, that's kind of how I think about the margin of our three specific subsidiaries. And Tom will give you a little more on the numbers.

[Tom Baker, Senior Vice President & Chief Financial Officer]

Yes. So, I don't -- I mean I'll add a little bit more. I think, I can tell you that, we do benefit from the -- as I call it the crazy software accounting. But I can tell you, in all of our segments, absent that, we're still up a little bit year-on-year. So, I mean we're executing on real stuff not just the financials. So -- and I think, we can continue that as our product mix evolves going forward.

[Anthony Lebiedzinski, Sidoti & Company]

Okay. Got it. All right. So, even so excluding all noise associated with the netting of the software, your margins would still be up?

[Tom Baker, Senior Vice President & Chief Financial Officer]

Yes.

[Anthony Lebiedzinski, Sidoti & Company]

Okay, great. Okay. And lastly for me as far as cash flow priorities. Obviously, I know you guys paid yet another special dividend. Kind of you looking forward I mean, what's your appetite also for potential acquisitions? Has anything there -- changed there? I just wanted to get any updated thoughts on that that would be great.

[Tim McGrath, President & Chief Executive Officer]

Well thanks, Anthony. Nothing specific has changed there. As you know, we think we have the right team in place, a solid business plan. And so, we don't feel desperate to do anything. By the same token, we're always looking for opportunities that could enhance a specific solution capability or a tuck-in acquisition. So, nothing has changed. There's nothing to announce. By the same token, we remain open to all opportunities.

[Anthony Lebiedzinski, Sidoti & Company]

Okay. Great. Well, thank you, very much.

[Tim McGrath, President & Chief Executive Officer]

Thank you.

[Tom Baker, Senior Vice President & Chief Financial Officer]

Thanks, Anthony.

[Operator]

Thank you. This concludes today's question-and-answer session. I would now like to turn the call back to Tim McGrath, President and Chief Executive Officer for any closing remarks.

[Tim McGrath, President & Chief Executive Officer]

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

[Operator]

Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect.