PC Connection Inc

NASDAQ:CNXN

Earnings Call Transcript 2022-Q4

[Operator]

Good afternoon and welcome to the Fourth Quarter 2022 Connection Earnings Conference Call. My name is Cherie, and I’ll be the coordinator for today. [Operator Instructions] As a reminder, this conference call is the property of Connection and may not be recorded or rebroadcast without specific permission from the company.

On the call today are Tim McGrath, President and Chief Executive Officer and Tom Baker, Senior Vice President and Chief Financial Officer. I will now turn the call over to the company.

[Samantha Tracy, Investor Relations]

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 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, 2021 which is on file with the Securities and Exchange Commission as well as in other documents that the company files with the Commission from time-to-time.

In addition, any forward-looking statements represent management’s view as of today and should not be relied upon as representing views as of any subsequent date. While the company may elect to update forward-looking statements at some point in the future, the company specifically disclaims any obligation to do so other than 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 fourth quarter 2022 comparisons are being made against the fourth quarter of 2021. Today’s call is being webcast and will be available on Connection’s website. The earnings release will be available on the SEC website at www.sec.gov and in the Investor Relations section of our website at www.connection.com.

I would now like to turn the call over to our host, Tim McGrath, President and CEO. Tim?

[Tim McGrath, President and Chief Executive Officer]

Thank you, Samantha. Good afternoon, everyone and thank you for joining us today for Connection’s Q4 2022 conference call. I’ll begin this afternoon with an overview of our fourth quarter results, highlights of our performance and share our thoughts on business in 2023. Tom will then walk us through in more detail in our Q4 financials.

We are seeing increased demand for advanced technology solutions, including data center modernization, cloud, software optimization and security solutions. This shift away from endpoint devices means our customers have to be aligned with a partner they can trust to deliver on more complex integrated solutions and services. Our strategic initiatives were developed to support the evolution in customer priorities around advanced technologies and integrated solutions. We’ve continued to make investments in tools, resources and training in order to further expand and align our offerings with the needs of our customers as we enable their digital transformation.

We believe our business strategy remains well aligned to the shifting dynamics of how customers deploy, utilize and consume technology. We continue to connect our customers with technology that enhances growth, elevates productivity and empowers their innovation. We help our customers expertly navigate through a complex set of choices within the technology landscape with dynamic and constantly evolving technology choices around core infrastructure, on-prem and off-prem cloud, security and software. We help calm the confusion of IT for our customers.

Now let’s discuss our Q4 performance. We have had great success since the pandemic began, helping our customers to navigate through hybrid work and hybrid learning solutions. During Q4, the endpoint device categories experienced nearly a 15% decline in revenue as customers have shifted their priorities and become more cautious with their overall IT spending in this uncertain economic environment. As a result, net sales declined by 8.5% to $732.5 million compared to Q4 2021.

Gross profit declined 2.1% to $124.3 million. However, gross margins were up 110 basis points to 17% in Q4 compared to Q4 2021. This increase in gross margin is a reflection of the shift in product mix, including more solutions recognized on a net basis.

Operating income in Q4 was $23.9 million, a decrease of 23.6% or 3.3% of net sales compared to $31.3 million or 3.9% of net sales in the prior year quarter. Net income in Q4 was $18.8 million, a decrease of 15.9% compared to $22.4 million in the prior year quarter. In Q4 2022, our diluted earnings per share was $0.71, a decrease of 16.2% from $0.85 in Q4 2021.

During the quarter, we saw a continued improvement in the supply chain, although pockets of constraints still exist with a few suppliers. For the full year, we delivered record results, including an 8% increase in net sales to $3.1 billion, 13.3% growth in gross profit to $526.2 million and diluted earnings per share of $3.37, which represents a 27.2% increase compared to 2021 full year results.

We will now look a little deeper into our performance. In our Business Solutions segment, our Q4 net sales were $280.7 million, a decrease of 7.5% compared to a record and tough compare of $303.5 million a year ago. In spite of this decrease in net sales, our gross profit in the Business Solutions segment was $60 million, an increase of 3.6% from a year ago.

Gross margin increased 229 basis points to 21.4% in the quarter. This increase was driven by strong demand for higher-margin data center products, including software, networking and servers during the fourth quarter of 2022. This is in line with our expectation of the shifting technology mix and customer spend.

In our Public Sector Solutions business, Q4 net sales were $117.3 million, a decrease of 9.4% compared to $129.4 million a year ago. Sales to the federal government increased 46% year-over-year compared to the prior year, while sales to state and local government and educational institutions were $79.6 million, a decrease of 23.2% compared to the prior year. Gross profit for the Public Sector segment was $17 million, a decrease of 8.8% compared to Q4 ‘21. Gross margin increased by 10 basis points to 14.5% in the quarter.

In our Enterprise Solutions segment, Q4 net sales were $334.5 million, a decrease of 8.9% compared to $367.3 million a year ago. Gross profit for the Enterprise segment was $47.3 million, a decrease of 6.2% compared to the prior year quarter. Gross margin increased by 41 basis points to 14.1% primarily driven by an increase in sales of servers and services during the fourth quarter of 2022.

Our vertical market focus continues to deliver customer value. In our finance vertical market, revenue grew 13% year-over-year as customers modernize their environment with a focus on security and software. In addition, gross profit increased 22% year-over-year. Retail revenue grew 11% year-over-year as customers relied on technology to enable automation and improve the retail experience.

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?

[Tom Baker]

Thanks, Tim. SG&A increased 175 basis points to 13.7% of net sales in the quarter compared to 12% in the prior year quarter primarily driven by lower revenues. On a dollar basis, SG&A increased by $4.7 million compared to the prior year quarter as a result of an increase in the cost of labor and ongoing investment in resources to strengthen our sales, technical sales and services organization. Looking forward, we intend to continue to invest in technical resources while focusing on improving our efficiency in light of what we perceive to be continued economic headwinds in 2023.

In the first quarter of 2023, we launched an initiative intended to reduce our current cost structure by $8 million to $10 million annually. Implementations cost reduction initiatives started this month and will be fully implemented by Q4. Q4 operating income was $23.9 million, down 23.6% this quarter from $31.3 million a year ago. Our Q4 effective tax rate was 23.7%, down from 28.5% in the same period a year ago due to a reduction of state income tax expense.

Net income for the quarter was $18.8 million, a decrease of 15.9% from $22.4 million a year ago. Diluted earnings per share was $0.71, a decrease of 16.2% from the prior year period. Our trailing 12-month adjusted earnings before income taxes, depreciation and amortization or adjusted EBITDA was $139.3 million compared to $113 million a year ago, an increase of 23%.

In terms of returning cash to shareholders, we announced an increase in our stock repurchase program of $25 million in Q4, in addition to a $0.34 per share special annual dividend paid in December. Additionally, we are pleased to announce that our Board of Directors have declared a quarterly dividend of $0.08 per share payable to shareholders of record on February 21, 2023, and payable on March 10, 2023. Our goal is to maximize shareholder value while maintaining financial flexibility. We continue to assess M&A opportunities and other capital allocations such as dividends and stock buybacks. We have approximately $37 million in previously authorized share repurchases.

Cash flow generated from operations for the year ended 2022 was $34.9 million compared to $57.8 million for the same period a year ago. The decrease in cash flow from operations reflects an increase in accounts receivable as our DSO increased to 70 days from 65 days at the end of 2021. This increase in DSO was primarily a function of netted products recorded in accounts receivable on a gross basis, while the revenue was recorded on a net basis.

Our accounts payable balance declined $49.1 million for the year ended 2022, while accrued expenses and other liabilities declined $14.7 million due to the timing of product received and associated payments. Our net cash used in investing activities of $9.1 million in 2022 was primarily the result of equipment purchases and IT initiatives that we believe will drive future efficiencies. The company used $11.2 million of cash for financing activities during the year ended 2022, of which $8.9 million was returned to shareholders in the form of dividends. We ended Q4 with $122.9 million of cash and cash equivalents.

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

[Tim McGrath, President and Chief Executive Officer]

Thanks, Tom. I want to take a few moments to update you on our strategic plans. As stated earlier, we’re seeing increased demand in advanced technologies, and we’re focused on keeping our customers secure, productive and competitive with technology. Now in our 41st year, we remain committed to our trhee main pillars of growth: cloud and data center transformation, workplace transformation and supply chain optimization. To help us accomplish these initiatives, we’ve made enhancements to our business plans and have hired several world-class leaders in sales, technical sales and services. As our customers continue to transform their businesses, they look toward connection to integrate and deliver on more complex and innovative solutions.

Looking at the first half of 2023, we believe that demand for endpoint devices will continue to be challenged as they were in Q4. Additionally, our customers continue to tell us that they are more deliberate in spending and are being more restrictive on budget in the face of economic uncertainty. We do expect our customers will continue to shift their priorities towards hybrid data center, cybersecurity and cloud transformation, which should partially offset weakness in the endpoint market. In addition, we expect our customers to extend the life of their technology assets more than they normally would. This means that services and advanced technology should be a growth driver for Connection as clients will look to help offset their continued need for technical resources and solutions.

As we navigate through 2023, we will remain very focused on improving our operational efficiency, managing our costs and scaling our expenses appropriately. Consistent with analysts’ predictions for the second half of 2023, we believe that the overall IT market should recover as the macroeconomic environment improves. Great companies can take market share in any economic environment, and we expect to end the year with growth that is 2% above the IT industry growth rate.

I’d like to take a moment to thank our valued employees for their continued effort and extraordinary dedication during this rapidly changing environment.

We will now entertain your questions. Operator?

[Operator]

Thank you. [Operator Instructions] First question will come from Anthony Lebiedzinski with Sidoti. Please go ahead.

[Unidentified Analyst]

Good afternoon, guys. How are you?

[Tim McGrath, President and Chief Executive Officer]

Great. Thanks, Anthony. How are you?

[Unidentified Analyst]

This is Stefan actually. This is Stefan in for Anthony Lebiedzinski. I apologize. My first question is given the slower economy, are you seeing any meaningful customer cancellations or postponements for certain IT projects?

[Tim McGrath, President and Chief Executive Officer]

So thanks. So, clearly, the economy, the economic backdrop does have an effect on many of our customers. We are seeing it probably the most in our enterprise space right now. But overall, we continue to add customers overall. So, our acquisition engine is working very well. And our current customers, some that have taken a pause, it’s largely as I mentioned on the call in the device arena. And when you think about that, if you think about Q4 ‘21 versus Q4 ‘22, there is an extraordinary difference in the overall device ecosystem for us. It was over 75 million. And so that really is the story for the quarter. We have got tremendous loyal long-term customers. They are going to continue to buy from us. Many of them have taken a pause in device – devices specifically. But that said, we are really excited about where headed – where we are headed as a company. We have really made a transition to focus more on those advanced technologies, have put a number of plans in place around training initiatives, leadership focus and especially the tools to drive all that. So, we are pretty optimistic about where we are headed and don’t think that our customers are doing anything other than as you indicated, trying to get through this uncertain economic time. We are here to help them through that and overall, pretty bullish. Tom?

[Tom Baker]

Yes. I think to-date, we haven’t seen any meaningful cancellations of POs or orders that have been placed. There have been a few projects that have pushed a bit. But I wouldn’t say those are significant at this time.

[Tim McGrath, President and Chief Executive Officer]

Thanks.

[Unidentified Analyst]

Alright. Thank you. My second question is also given the current macro environment, are you seeing or are you expecting any meaningful pricing pressure? And if yes, you have got across the board or only in some of your vertical markets?

[Tim McGrath, President and Chief Executive Officer]

So, I don’t think – clearly, there have been pricing increases from our suppliers over the pandemic and over the probably the last 18 months, but nothing meaningful. Any price increases that we have had, we have been able to successfully move along. And we are not seeing any extraordinary pressure the other way from our customer base, frankly, because I think they see the technology and the integrated solutions that we deliver as being mission-critical and impactful to their business. So, we have not had that pressure.

[Unidentified Analyst]

Thank you so much. And my follow-up, how should we think about like the PC cycle playing out this year? And if you could talk about that in terms of your expectations for your three main segments, that would be great, please.

[Tim McGrath, President and Chief Executive Officer]

So, clearly, what we saw with the PC cycle, as you know from following our industry, is that, from the pandemic through late Q3 of ‘22 and certainly into Q4 – let me correct that. During the pandemic, of course, PC was essential, and purchases were accelerated. In fact, we saw great acceleration in the device market overall. And as a result of that, I think many of our customers did indeed accelerate purchases of endpoint device and all the related ecosystem and products that go along with that. We did see a slowing of that, it started late in Q3 and certainly continued into Q4. And we now expect that, that slowness in device will be around at least for the first half of 2023. There are meaningful drivers of growth coming, I think after that. And we think that 3-year upgrade cycle will return to normal and really start to pick up in the second half of the year. Does that answer your question?

[Unidentified Analyst]

Yes. Can you give more details about your backlog and the composition of backlog?

[Tom Baker]

Yes. I would say during the quarter, our backlog is down a little bit. But as we mentioned in our prepared remarks, there are still pockets in the supply chain where supply is constrained. So, backlog still is a little bit elevated, and it has been easing through the quarter.

[Unidentified Analyst]

Thank you so much for taking my questions. I will jump back in the queue.

[Tim McGrath, President and Chief Executive Officer]

Thank you.

[Operator]

And one moment for our next question, that will come from the line of Jake Norrison with Raymond James. Your line is open.

[Jake Norrison, Raymond James]

Hey guys. This is Jake on for Adam. I was just hoping you guys could provide me with more color on sort of the demand trends you are seeing in SMB compared to enterprise. Obviously, discussed customers getting a little more cautious in scrutinizing IT budgets more, but are you seeing that sort of index more towards SMB or enterprise? Can you just dive into that a little further, please?

[Tim McGrath, President and Chief Executive Officer]

Thanks Jake. So, really, we have been seeing it across the board, and there are some pockets of opportunity, and I will outline those. But clearly, our large enterprise customers, many of them are going through reductions and certainly budget reductions. And as a result, the enterprise has probably been hit the hardest. We do believe that is temporary. They hit the hardest when it comes to device, but they are investing in the advanced technology side of their business. And so there is a great opportunity there. As you said, the SMB business is forecasted to be down in device as we go through 2023. But again, our SMB customers have been pretty resilient and do look to us to provide a lot of those IT solutions. And so enterprise and SMB have been down about the same. And that is also true for the K-12 and with the SLED business. However, there are some drivers on the horizon there as the ECF funding has been continued through the end of 2023. We do expect that will be a driver of demand. And then finally, with our Federal business, we are seeing really strong growth right now. That is large project dependent. But we have a good view of those large projects. We think they will last throughout 2023. So, we are optimistic there. So, I would say we are kind of down in all three subsidiaries. We see some pockets of growth in Fed. We see a return to growth coming with K-12 a little later in the year as ECF works its way through. And with the enterprise and SMB, we think the first half will be infrastructure and advanced technology. In the second half, we will see that device start to kick in again.

[Jake Norrison, Raymond James]

Prefect. Thank you so much. I appreciate your time.

[Tim McGrath, President and Chief Executive Officer]

Thank you.

[Operator]

And speakers, I am showing no further questions in the queue at this time. I would now like to turn the call back over to Mr. Tim McGrath for any closing remarks.

[Tim McGrath, President and Chief Executive Officer]

Thank you, Cherie. I would like to thank all of our customers, vendor partners and shareholders for their continued support and once again, our dedicated coworkers for their efforts and extraordinary dedication through these times. I would also like to thank all of those – excuse me, thank all of you who are listening to the call this afternoon. Your time and interest in Connection are appreciated. Have a great night.

[Operator]

Thank you all for participating. This concludes today’s program. You may now disconnect.