PC Connection, Inc. (CNXN) Q2 2019 Earnings Report, Transcript and Summary

Good afternoon, and welcome to the Second Quarter 2019 Connection Earnings Conference Call. My name is Sara, and I will 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.

Thank you. I will now read the safe harbor statement. Any statements or references made during the conference call that are not statements of historical fact maybe 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 is on file with the Securities 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 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 second quarter 2019 comparisons are being made against the second quarter of 2018. Today’s call is being webcast and will be available on Connection’s website. The earnings release and the Form 10-K are both 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.

Good afternoon, everyone, and thank you for joining us today to review the company’s second quarter financial results. We are pleased to announce a 31% increase in our earnings per share from Q2 2018. This record performance was the result of strong execution by our team across all areas of the company. Our success in the quarter is attributable to our continued focus and strategic plans to help our customers intelligently and efficiently build out solutions that include our focus on software-defined data center, hyper cloud and the digital workplace. During the second quarter, the company achieved record gross profit, record gross margin, record net income and record earnings per share. Gross profit grew by 8.9% year-over-year, and we achieved gross margins of 15.8%. The increase in both gross profit and gross margins was driven by strong growth in software, including cloud subscriptions and security, mobility and desktops. Net sales for the three months ended June 30, 2019, increased by 4.9% to $741.1 million, compared to $706.6 million in Q2 a year ago. To fully appreciate our performance this quarter, I’ll remind you that cloud-based and security software and service warranties are recognized on a net basis. These products are accounted for a greater proportion of our sales than in Q2 last year, causing margins to increase while at the same time creating downward pressure on our sales growth. Gross profit increased by 8.9% to a record $117 million, compared to $107.5 million a year ago. Gross margin was a record 15.8%, compared to 15.2% in the prior-year quarter. Gross margin improved primarily due to increased sales of cloud-based and security software and improved selling margins on the balance of our product portfolio. Now I would like to provide a more detailed discussion of our performance by segment. In our Business Solutions segment, Q2 net sales slightly increased to $271.1 million, compared to $270 million a year ago. Gross margin for this segment increased by 201 basis points to a record 19.5% in the quarter. Our Business Solutions segment margins benefited from the mix of software sold and strong growth in our server/storage category. In our Public Sector Solutions business, Q2 net sales were $152 million, compared to $135.5 million a year ago. Sales to the federal government increased by 21.5%, compared to the prior year, while sales of state and local government and educational institutions increased by 8.8%. Gross margin for this segment decreased by 49 basis points to 12%, primarily due to some large wins in the federal space. In our Enterprise Solutions segment, Q2 net sales were $318 million, a 5.6% increase, compared to $301.1 million a year ago. Gross margin for this segment increased by 4 basis points to 14.4%. The Enterprise segment experienced double-digit growth in both the manufacturing and retail vertical markets. From a product category perspective, we saw good growth in mobility, desktops and accessories. In addition, we continue to benefit from cloud-based software and security sales. Having covered our sales and gross margin performance, I will now turn the call over to Tom Baker to discuss additional financial highlights from our income statement, balance sheet and cash flow statement. Tom?

Thanks, Tim. SG&A increased this quarter to $84.7 million from $82.5 million a year ago. However, SG&A as a percentage of net sales decreased by 26 basis points year-over-year demonstrating our commitment to driving operational efficiencies and managing expenses. Our operating income increased 29.6% this quarter to $32.3 million from $24.9 million a year ago. Our effective tax rate was 27.2%, down from 27.5% in the same period a year ago. Net income for the quarter increased 29.9% to $23.7 million from $18.2 million a year ago. Earnings per diluted share was $0.89, an increase of 31%. Our trailing 12-month adjusted earnings before income taxes, depreciation and amortization, or adjusted EBITDA, increased 15% to $115.7 million from $100.9 million a year ago. We repurchased 66,000 shares during Q2 for $2.2 million at an average cost of $33.49 per share. We ended Q2 with $69.7 million of cash and cash equivalents representing an increase of $1.1 million from the prior year. Cash flow from operations was $3.3 million versus $41.5 million for the same period a year ago. The change in cash flow was driven primarily by an increase in accounts receivable inventory, partially offset by an increase in accounts payable. The increase in inventory is largely a function of purchases to support customer rollouts through our state-of-the-art technology, integration and distribution center. We are utilizing this advanced configuration lab and integration center to help our customers manage large and increasingly complex rollouts. In fact, our configuration volume increased 70% during the quarter. Investing activities of $13.9 million for the year were primarily the result of equipment purchases and capitalization of our ERP system upgrade that is in process. The company yields $11.4 million of cash for financing activities for the first six months of 2019 consisting of the Q1 payment of $8.5 million for our previously declared 2018 special dividend and $3.5 million of stock repurchases. As of June 30, 2019, we had $23.9 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.

Thanks, Tom. We had excellent performance across all of our business segments demonstrating the importance of specialization and customer segmentation. We are also pleased with our double-digit growth in our retail and manufacturing vertical markets as we continue to deliver solutions for our customers in these vertical markets that enhance productivity, improve efficiency and strengthen security. Customer success is measured in many ways and enabled by advanced technologies that are tailored to the unique needs of our diverse users and environments. We’ll continue to invest in systems and subject matter experts in order to help our customers improve productivity, enhance growth and empower innovation across their organizations. We are optimistic about the opportunities we have to assist our customers in transforming their businesses. We continue to see strong growth by helping our customers create competitive advantages with technology. 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?

Thank you. [Operator instructions] Our first question comes from the line of Adam Tindle with Raymond James. Your line is now open.

Okay. Thanks and good afternoon. Tim, I just wanted to maybe start on outlook for growth for the rest of the year. Obviously, you had a pretty healthy quarter here. We’ve heard from some of your competitors that trends are fairly stable. Your results are clearly suggesting that as well. But maybe just touch on how your conversations with customers are going in terms of the outlook for the remainder of the year?

Well, thanks, Adam. So our start to the quarter, we think, is strong and our outlook for the rest of the year is consistent I think with what we’ve been saying, which really is 200 to 300 basis points above the market rate of growth. We’re still pretty confident we can take market share through execution. And so I’d say, our outlook for the year really hasn’t changed. Like you, we’ve heard of some pockets of softness. But for the most part, we see that our solutions-based rollouts and large project rollouts can cause some lumpiness, but we’re going to stick to our estimate of 200 to 300 basis points above-market growth.

Okay. And maybe more specifically on the business performance that’s where things are pretty interesting. You’ve got some pretty healthy operating profit dollar growth and some leverage showing in the business. So maybe just touch on those trends kind of the path of profit dollar growth and the aspect of leverage, and ultimately, where you think margins can go for the business?

Yes. Adam, this is Tom. I think the leverage in our business model has really come from a couple of places this quarter. One we’re just seeing is a little bit more of the software netting. And when I kind of think about the growth of the business, I kind of look at the growth in gross profit. And when you look at the increase on the margin rate, I would say, roughly a third of that increase in the gross margin rate is due to products other than software and two-thirds of that improvement is due to the increase in software sales. The other things happening, we’re just continuing to really manage our operating expenses tightly. So our SG&A as a percentage of revenues continues to drop. So that’s really where it’s coming from. In terms of the margin outlook, I think we’re probably going to be – the trajectory will probably be about where it’s been.

Okay. Meaning the – where it’s been in Q2? Or meaning slightly earlier?

Yes.

Okay. Got it. Maybe just one…

It’s just really hard to figure that out with some of the accounting rules that are now – we’re now dealing with.

Understood. I think maybe one way to neutralize for that is kind of just looking at gross profit dollar and operating profit dollar growth where trends are also quite healthy for the business regardless of the netting aspect of it.

As I said, we completely agree with that.

One final one maybe for Tim. Just kind of high level. There was, obviously, a major acquisition in the space with Insights’ purchase of PCM this quarter. Just touch on maybe how this changes the competitive landscape, if it all? And then remind us of your acquisition strategy given your net cash position? Thank you.

Well, thanks. So obviously, we’re aware of the acquisition and it’s interesting for us, given our market position in our segments, SMB, enterprise, et cetera, looking at the acquisition, I think we had to stay focused on our business plans and what is right for our company. We feel very confident as we go into the balance of the year. We have the right strategies in place. That said, we also remain open to adding solutions capabilities and tuck-in acquisitions that would enhance us in specific areas and continue our improvement in the overall solutions side of our business. So we’re open to that. And as you know, we’re in pretty good position to do that should the right opportunity arise. But we don’t feel any sense of burning need or desperation to move at this time, but we’ll be very selective.

Thank you. Our next question comes from the line of Anthony Lebiedzinski with Sidoti & Company. Your line is now open.

Great. Thank you very much. Thanks for taking the questions, gentlemen. So certainly encouraging to hear that the trends so far in this quarter are off to a good start. I’m just wondering if you could just kind of drill down look at the three separate segments. Are you seeing that kind of across the board? Or you are seeing, for example, Public Sector was quite a bit better than what we had modeled here for the quarter? I know you’ve touched on some large Federal wins, but kind of if you just look at more specifically at each of the three segments, kind of, what are your – what are you seeing there so far?

Well, thanks, Anthony. So we’ll start with Public Sector, since you mentioned it. So it’s good to see the momentum that we have in our public sector business. I think the team is doing a nice job executing there. We saw really good growth on the Federal side and that is project-dependent. And we also are very strong on the SLED side of our business. We’ve got some new authorizations that I think will help drive that. So we’re pretty confident now that we’ve got some momentum in public sector that will carry through to the rest of the year. When it comes to our business solutions team, again, what you’re seeing there is really good execution selling across the solution stack in a very good margin profile. I think the outlook there remained strong. We’re pretty confident in that team. As Tom mentioned earlier, with the software netting, it sometimes puts pressure on that growth line. But overall, I think business solutions is very strong, and we’ve got a good outlook for the rest of the year. And finally, the enterprise team, which you know have been executing extraordinarily well with above-industry growth, I think, has a bright outlook for the rest of the year as well. Enterprise, we’re starting to hear out in the competitive landscape that there’s some pullback, some pockets of pause, but that really hasn’t affected us. And while it is Large Account rollout-dependent and that can be a little lumpy, we’re very confident in our forecast for the rest of the year.

Okay. That’s great to hear. And just wondering as far as all the noise with the tariffs, I know some of the – that there has been uncertainty in the marketplace. I’m just generally speaking as far as the tariffs, it doesn’t sound that there was anything meaningful as far as impact in the second quarter. Just wondering, with the newly announced tariffs just this afternoon by the President of 10% on, I think, List 4. Would that have any impact at all on your company?

Yes. That’s a great question. And the answer is, it could have. At the end of the day, if the tariffs affect our suppliers and our customers, we are impacted. There was – I’d say, the concerns prior to this maybe were a little overblown. We didn’t have the negative effect in demand that we thought we might have, but we remain guarded on the point. We’ll have to watch that closely. So I don’t have a specific outlook regarding tariffs.

And lastly, as far as the inventory, Tom, I know you touched on this in your prepared remarks about it. But how should we think about inventory by the end of the year?

Well, you know, the increase in the inventories related to products staged at our advanced technology and integration center, where we did a – in fact, we did a record number of configurations in the quarter. All this inventory is backed by – all the increase is backed by firm POs, and we’re not speculating on anything there. What you’re seeing is about $60 million of inventory for four specific rollouts that are scheduled to go over the next quarter or so. So my expectation is that that balance is going to go back down to around historical levels, unless we continue to do a lot more through the technology and distribution center than we have historically. So my expectation is it drifts down over time unless this spike in business continues.

Okay. Thanks very much, and best of luck.

Thank you.

Thank you. [Operator instructions] There are no further questions in the queue at this time. I would now like to turn the call back to Tim McGrath for closing remarks.

Thank you, operator. 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.

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