Insight Enterprises Inc

NASDAQ:NSIT

Earnings Call Transcript 2018-Q3

[Operator]

Good day, ladies and gentlemen, and welcome to the Insight Enterprises Third Quarter 2018 Operating Results Conference Call. [Operator Instructions] As a reminder, today's conference is being recorded.

I would now like to turn the call over to Ms. Glynis Bryan, CFO. Ma'am, you may begin.

[Glynis Bryan, executive]

Thank you. Welcome, everyone, and thank you for joining the Insight Enterprises Earnings Conference Call. Today, we will be discussing the company's operating results for the quarter ended September 30, 2018. I'm Glynis Bryan, Chief Financial Officer of Insight, and joining me is Ken Lamneck, President and Chief Executive Officer.

If you do not have a copy of the earnings release that was posted this morning and filed with the Securities and Exchange Commission on Form 8-K, you will find it on our website at insight.com under our Investor Relations section.

Today's call, including the question-and-answer period, is being webcast live and can be accessed via the Investor Relations page of our website at insight.com. An archived copy of the conference call will be available approximately 2 hours after completion of the call and will remain on our website for a limited time.

This conference call and the associated webcast contain time-sensitive information that is accurate only as of today, November 7, 2018. This call is the property of Insight Enterprises. Any redistribution, retransmission or rebroadcast of this call in any form without the expressed written consent of Insight Enterprises is strictly prohibited.

In today's conference call, we will refer to certain non-GAAP financial measures as we discuss the third quarter 2018 financial results. When referring to non-GAAP measures, we will refer to such measures as adjusted. Non-GAAP measures to be discussed in today's call include adjusted earnings from operations, adjusted diluted earnings per share, adjusted investment -- return on invested capital and adjusted free cash flow.

You will find a reconciliation of these adjusted measures to our actual GAAP results included in the press release or the accompanying slide presentation issued earlier today. Also, please note that unless highlighted as constant currency, all amounts and growth rates discussed are in U.S. dollar terms.

Lastly, we adopted ASC 606 effective January 1, 2018, on a modified retrospective basis. As discussed on previous calls, this means that we have not re-presented the 2017 results shown in our earnings release or presentation materials issued earlier today.

Finally, let me remind you about forward-looking statements that will be made on today's call. All forward-looking statements that are made during this conference call are subject to risks and uncertainties that could cause our results -- our actual results to differ materially. These risks are discussed in today's press release and in greater detail in our annual report on Form 10-K for the year ended December 31, 2017, and other reports we file with the SEC.

With that, I will now turn the call over to Ken, and if you are following along in the slide presentation, we will begin on Slide 4. Ken?

[Ken Lamneck, executive]

Hello, everyone. Thank you for joining us today to discuss our third quarter 2018 operating results.

I'm pleased to report we delivered another quarter of strong earnings performance in the third quarter. Against a difficult comparison to our third quarter results last year, our team executed very well to hold our top line, expand gross margins and grow our bottom line results double digits.

Specifically, consolidated net sales are $1.7 billion, down less than 1% year-over-year in U.S. dollars and flat in constant currency, reflecting solid performance against the tough comparison of 26% year-over-year growth reported in third quarter of last year.

Consolidated gross profit of $235 million in third quarter was up 4% year-over-year and up 5% in constant currency. Gross margin expanded 50 basis points year-over-year to 13.4%, reflecting a higher mix of sales of cloud-based and netted software offerings in our core business and higher professional services sales with the acquisition of Cardinal Solutions completed on August 1.

Consolidated selling and administrative expenses were $184 million, up 2% year-over-year and up 3% in constant currency, largely due to the acquisition of Cardinal.

Adjusted earnings from operations were up 11% year-over-year to $51 million, and adjusted EFO margin expanded 30 basis points to 2.9% of sales. On a GAAP basis, earnings from operations were $50 million, up 21% compared to the same period last year. And adjusted diluted earnings per share was $0.91, up 25% year-over-year, and on a GAAP basis, diluted earnings per share was $0.89.

For the first 9 months of 2018, our business has delivered top line growth of 8% and gross profit growth of 8%, which, combined with continued expense discipline, has driven adjusted earnings from operations up 21% compared to the same period last year. These results are particularly impressive when compared to the 32% in adjusted earnings growth delivered in the first 9 months of 2017.

At the same time, we have improved our cash flow generation and deployed capital toward strategic acquisitions with the addition of Cardinal in August of this year.

Moving to Slide #5. We continue to be pleased with our year-over-year improvement in cash flow generation. In addition to our adjusted return on [ invested ] capital performance, adjusted free cash flow was $152 million in the first 9 months of this year as compared to our use of cash of $294 million for the first 9 months of the prior year. Strong cash management and higher earnings performance, combined with our new lower tax rate in 2018, also drove adjusted return on invested capital to 15.8%, up 160 basis points year-over-year.

Moving on to Slide 6. In North America in the third quarter, hardware sales decreased 1% year-over-year compared to a 48% increase in hardware sales produced by the business in Q3 last year. Services sales increased 24%, including higher sales of cloud offerings and the acquisition of Cardinal. Software sales decreased due to a higher mix of software sales now reported net and now included in our services category following the adoption of ASC 606 and lower volume with public sector clients compared to the same period last year.

Gross profit in North America was up 2% year-over-year and gross margin improved 60 basis points, reflecting the increased mix of services sales in the business. In addition, we focused on controlling costs, which allowed us to grow adjusted earnings from operations 3% year-over-year to $45 million.

Against the tough comparison year-over-year, our North America business delivered solid results in the third quarter. We began to see trends soften in September as compared to the first 2 months of the quarter. We attribute this softness partly to the maturing refresh cycle within our large enterprise client base and the completion of the deferral of certain client-specific projects.

While we do not believe shortages of certain device components or tariffs to be imposed against imported goods from China affected our Q3 performance in any material respects, we're cautiously monitoring this situation with our clients and partners over the balance of this year.

Moving on to the third quarter results in EMEA on Slide 7. Net sales in EMEA grew 11% year-over-year and 12% in constant currency. In addition, gross profit grew 13% as reported and 15% in constant currency. Our team executed very well in the third quarter, driving growth in both net sales and gross profit dollars across each of the hardware, software and services categories.

Top line growth in EMEA, combined with a 40 basis point increase in gross margin and effective cost control, led to an adjusted earnings from operations growth in excess of 200% in the third quarter.

Moving to Slide 8. In APAC, net sales in the third quarter decreased 10% year-over-year in U.S. dollars and 5% in constant currency due to an increased mix of cloud and software maintenance sales recorded net. Gross profit was largely consistent at $8.4 million year-over-year, and effective cost control helped drive expenses down 6%, which led to earnings from operations growth of 47% year-over-year.

To the next slide. Before I hand the call back to Glynis, as part of our effort to educate you on our 4 solution areas' go-to-market strategy, I wanted to highlight an example of a win in one of our solution areas called Connected Workforce. As you may recall, this is our practice focused on workforce productivity and collaboration and is a strategic priority for our future growth.

We recently helped a long-standing large enterprise client with an upgrade to their global server infrastructure following a system security incident that they had. As a result of that engagement, we were rewarded another opportunity to help the client improve the security of its global device platform.

Our team architected a solution that transitioned more than 200,000 of the client's devices from Windows 7 to the Microsoft modern desktop architecture utilizing Windows 10, Office 365 and Microsoft System Center. This is just one of the many examples of how our Connected Workforce solution brings deep technical skills around cloud technologies to help clients solve complex business issues on a global basis.

Our thought leadership in this area was also recently recognized by Microsoft when we were named Microsoft's 2018 Worldwide Modern Desktop Partner of the Year.

I will now hand the call over to Glynis.

[Glynis Bryan, executive]

Thank you, Ken. As Ken noted earlier, we're pleased with the progress we have made so far this year to deliver strong top and bottom line results, improve our cash flow generation and make strategic investments in our business that will help position us to compete in the future.

Let me break down our year-to-date financial results in a bit more detail on Slide 11. Consolidated net sales of $5.3 billion in the first 9 months of 2018 are up 8% compared to the same period last year and include growth in each of our geographic operating segments.

In North America, net sales are up 6% year-over-year, driven by higher hardware and services volume. Net sales in EMEA and APAC are up 18% -- are each up 18%, reflecting growth across each of our hardware, software and services categories.

In 2018, as a result of the adoption of 606, we're seeing a higher mix of software sales which are recorded net, specifically security software, because we're now deemed the agent in these transactions. As a result, the gross profit is now reflected in net sales and is now reported in the services category in our P&L.

For the first 9 months of 2018, our top line results are lower than would have been reported under the previous standard by approximately $76 million due to the increase in software sales reported net.

Consolidated gross profit for the first 9 months of 2018 was $740 million, up 8% year-over-year. Gross margin was 13.9%, flat year-over-year in the first 9 months of this year.

Lower product margins in the hardware and software categories due to product and client mix have been offset by the increased mix of cloud and services gross profit in the total business.

As we have discussed before, we are actively engaged in helping our clients migrate to the cloud. And year-to-date, gross profit earned from cloud sales represents 17% of our consolidated gross profit, up from 13% for the same period last year.

And on the SG&A front, consolidated selling and administrative expenses were $562 million, up 4% year-to-date. This increase was driven primarily by investments in headcount in North America and EMEA, the addition of Cardinal beginning in August and higher variable compensation on improved earnings results, partly offset by lower depreciation and amortization expense.

We recorded severance and restructuring expense of $2.7 million in the first 9 months of this year compared to $6.2 million in the same period in 2017. And we incurred expenses related to the acquisition of Cardinal of approximately $282,000 in the first 9 months of this year compared to $3.3 million spent on the Caase and Datalink acquisitions in the first 9 months of 2017.

And finally, we recorded a loss in our business in Russia on the sale of our business in Russia in the third quarter of 2017 with no similar transactions this year. This all led to adjusting (sic) [ adjusted ] earnings growth from operations of $178 million in the first 9 months of 2018, up 21% year-over-year. GAAP earnings from operations increased 31% for the first few quarters of 2018.

In addition, our effective tax rate year-to-date through September 30 was 26%, down from 36% last year, due primarily to the U.S. tax reform enacted at the end of 2017.

Diluted earnings per share on an adjusted basis are $3.31 so far this year compared to $2.42 earned in the first 3 quarters of 2017, an increase of 36%. GAAP diluted earnings per share were $3.24, up from $2.21 -- $2.11 last year.

Moving on to Slide 12. As reported on our last call, we adopted ASC 606 effective January 1, 2018, on a modified retrospective basis. This means that we have not re-presented the 2017 results presented in our materials issued today. In our 10-Q, we will provide a reconciliation from the results under the new 606 rules to the previously issued accounting standard -- previously used accounting standard.

As expected, the adoption of 606, ASC 606, did not have a material impact on our consolidated bottom line results reported in the first 9 months of 2018. However, the impact on net sales and certain balance sheet lines was more notable. Specifically, for the 9 months ended September 30, 2018, as a result of the adoption of the new standard, we accelerated the recognition of certain software sales that under the previous standard would have been reported in future periods. We also recorded some of these sales net because we're now the agent in the transaction.

As a result, accounts receivable increased $115 million, while net sales decreased $76 million following adoption of the new standard.

With respect to our cash flow efficiency metrics overall, our cash conversion cycle was 38 days in the third quarter of 2018, up 1 day year-over-year, due to the increase in accounts receivable as a result of the adoption of 606. Without a similar effect on sales, this is adversely impacting our cash conversion cycle by 4 days.

Rounding out our cash flow performance. In the first 9 months of 2018, our operations generated $247 million of cash compared to a use of cash of approximately $324 million last year. Our cash flow results -- our strong cash flow results this year reflect our enhanced focus on reducing aged accounts receivable balances, minimizing general and client-specific inventory investments and optimizing our payables arrangements. For the full year, we expect cash flow from operations will be between $200 million and $250 million.

In the first 9 months, we invested approximately $13 million in capital expenditures, down 18% year-over-year, and we used $22 million to repurchase approximately 641,000 shares of our common stock.

Cardinal Solutions was acquired in the third quarter for approximately $79 million net of cash acquired and including estimated final working capital and tax gross-up adjustments. For comparison, we used $181 million to acquire Datalink in the first quarter of last year.

All of this led to a cash balance of $113 million at the end of the quarter of which $94 million was resident in our foreign subsidiaries. And we had $266 million of debt outstanding under our financing facilities. This compares to $240 million of cash and $550 million of debt outstanding at the end of Q3 2017.

I will now turn the call back to Ken to review the 2018 outlook. Ken?

[Ken Lamneck, executive]

Thank you, Glynis. We're pleased with our execution in the first 9 months of the year. I believe our business is healthy across each of the markets in which we compete.

With respect to our full year 2018 outlook, we expect to deliver sales growth in the mid-single-digit range compared to 2017. We also expect adjusted diluted earnings per share for the full year of 2018 to be between $4.40 and $4.45.

This outlook assumes an effective tax rate of 15% to 18% for the fourth quarter of 2018, capital expenditures of $15 million to $20 million for the full year and an average share count for the full year of approximately 36 million shares.

This outlook does not reflect the repurchase of any additional shares that may be made under our currently authorized share repurchase program, assumes no current-year acquisition-related expenses and excludes severance and restructuring expenses incurred during the first 9 months of 2018 and those that may be incurred during the balance of 2018.

Thank you for joining us today. I want to thank our teammates, clients and partners for their dedication to Insight and for their hard work this year.

That concludes my comments, and we'll now open your line up for your questions.

[Operator]

[Operator Instructions] Our first question comes from the line of Matt Sheerin with Stifel.

Our next question comes from the line of Kara Anderson of B. Riley FBR.

[Kara Anderson, analyst]

I'm just wondering if you can talk about the quarter's results as compared to your internal expectation, your -- talk about the biggest differential and how much of the guide down here is attributable to 3Q versus your 4Q outlook.

[Glynis Bryan, executive]

So I think -- when we look at Q3, we had some assumptions in our Q3 on the second half of the year that didn't materialize and we saw some softness, as we mentioned, in September. The biggest driver of the difference between Q3 and Q4 today relative to what we would have said back in May or in July is related to differences that we're seeing in our large enterprise clients primarily. So those larger enterprise clients, we're seeing a little bit of a slowdown as it relates to devices. We had a large deal that we assumed was going to transact in the second half of the year that has moved into the first half of the year, a known deal that has moved into the first half of next year. And those 2 are the primary drivers of the difference in our results that we saw in Q3 and ultimately in Q4 based on the guidance that we gave.

[Kara Anderson, analyst]

Got it. That's helpful. Just one more on -- with the hardware slowing and sort of the inclusion of Cardinal, can you speak to expectations for gross margins going forward?

[Glynis Bryan, executive]

I think that you saw some improvement in our gross margin this quarter, 50 basis points in our -- improvement in our gross margin this quarter. So we -- when we had guided, given guidance in the first half in July or August, we had said that we would anticipate that it was going to slow. Second half was going to be slower because we have very tough compares in the second half of the year, specifically as it relates to hardware, and that we would see an improvement in our gross margin related to the change in the product mix as well as more services in the portfolio. We saw that occurring in Q3. We anticipate seeing something similar going into Q4 because we had the same dynamics on client mix changing, et cetera, and we would envision that we're on a track to get to more that 3, 3.5%. I'm not saying 3.5% in 2019, to be clear, but we're on a trajectory to get to our -- get closer to that 3.5% goal we've had out there.

[Operator]

And our next question comes from the line of Adam Tindle of Raymond James.

[Madison Suhr, analyst]

Yes, this is Madison on for Adam. Just one quick one here. I'm just wondering if you could update us on what you're hearing from customers or seeing around tariffs. I know you mentioned it didn't have an impact here in Q3. But what are customers saying? Is there any kind of slowdown embedded in guidance? Or are you seeing any pauses in spending? Just some more clarity around there would be helpful.

[Ken Lamneck, executive]

Yes, Madison, it's obviously a very current topic. As we've said, we didn't really said any real impact in Q3. And we're monitoring it very closely. Of course, we're in sort of a cost plus environment. So to us, we completely pass that on, of course, to our clients. And we have got, obviously, good systems and tools to ensure that occurs. So for us, it obviously would not affect the gross margin percentage, but it certainly would lead to more increased gross profit dollars.

As far as what that's doing to demand, it's sort of a little bit of a mixed bag. We've seen a little bit of both. We've seen some clients sort of hunker down a little bit in regards to should I continue to buy at these inflated sort of prices. And then we've seen other clients come in and say, "Jeez, if the tariffs are 10% and going to 25% in January, maybe I should accelerate." So it's a little bit of a mixed bag. Hard to call right now exactly what's going to flush out during the next couple of months.

[Operator]

[Operator Instructions] Our next question comes from the line of Alvin Park of Stifel.

[Alvin Park, analyst]

Yes, on behalf of Matt Sheerin. Just wanted to follow up on the -- what were your primary causes for weakness in Q4? You mentioned that there's a push-out that -- in the second half that was going to be deferred to the first half, and there's a bit of a slowdown regarding devices on another customer. Could we just get more details on that?

[Glynis Bryan, executive]

Oh, so...

[Ken Lamneck, executive]

There was one that...

[Glynis Bryan, executive]

I think it was more detail on devices and more detail on the push-out of a client, yes?

[Alvin Park, analyst]

Yes, yes. The magnitude -- yes, please.

[Glynis Bryan, executive]

So, yes. So I am not sure what I'm talking about the magnitude. We wouldn't mention it unless it was significant. So we had assumed it was going to occur for us in the second half. We now know for certainty that it's occurring in Q1. So I can't give you the magnitude, but I can say that because we're calling it out it is significant with regard to the impact on revenue and on profitability overall.

And as it relates to devices, when you look back at our hardware performance in the second half of the year in Q3, hardware grew in 2017 by 48%, as Ken mentioned in his comments. And in Q4, hardware grew by 26%. So the magnitude of growth that we had in the second half of the year as it related specifically to hardware, we didn't envision we were going to see that level of growth on a go-forward basis. And hence, when we did our guidance at the end of the second quarter, we had said we anticipated that growth was going to be a little bit lower. We're seeing that Q3 was a little bit lower than we had anticipated. Q4 is probably in line from a growth perspective with what we had anticipated, except for the shift that we have in the second half related to this one large client.

So I don't think that it's a negative trend. We just knew that, based on the magnitude of growth that we had experienced in 2017, that it was going to be tough to grow with that compare. Going into 2019, the compares get a little bit easier, again, because we don't have that magnitude of growth in any one quarter, except possibly for the first quarter, but we're not concerned about that.

[Alvin Park, analyst]

I see. And...

[Glynis Bryan, executive]

Did that answer your question, Alvin?

[Alvin Park, analyst]

Yes, that makes sense. Yes.

[Operator]

[Operator Instructions]

I'm not showing any further questions at this time. Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program, and you may all disconnect. Everyone, have a great day.