PC Connection, Inc. (CNXN) Q3 2019 Earnings Report, Transcript and Summary

Good afternoon, and welcome to the Third Quarter 2019 Connection Earnings Conference Call. My name is Kylie, 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 would 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 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 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 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 third quarter 2019 comparisons are being made against the third quarter of 2018. Today's call is being webcast and will be available on Connections 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 third quarter financial results. It's our pleasure to announce another quarter strong performance, including a 75% increase in diluted earnings per share from Q3 2018. We experienced growth in all three operating segments. The Public Sector segment achieved 20% revenue growth in the quarter, followed by the business solution segment, which experienced growth of 12% and the Enterprise Solutions segment, which grew by 5%. Our success in the quarter was partially attributed to the timing of large solution-based project rollouts and strong growth in the mobility and desktop categories. The growth in these categories was due to the PC refresh, driven by the anticipated end of support for Windows 7 and technological advances in hardware that enable modern workplace solutions. In addition, we continue to see growth in our software, cloud and security businesses. We remain committed to helping our customers intelligently and efficiently build out solutions that include our focus on software-defined data center, hybrid cloud and the digital workplace. During the third quarter, the company achieved record gross profit, record gross margin and record earnings per share. Gross profit grew by 18.3% year-over-year, and we achieved gross margin of 16.3%, which represented growth of 104 basis points. The increase in both gross profit and gross margin was driven by our continued focus on our business initiatives. When all three of our sales cycles perform at these levels versus the prior year period, we experience significant operating leverage. We also saw a double-digit growth in three of our vertical markets. Net sales for the three months ended September 30, 2019, increased by 10.8% to $729.4 million, compared to $658.5 million in Q3 a year ago. Increased cloud based and security software sales continue to require us to net down more revenue, which, in effect, puts downward pressure on net sales, while benefiting gross margin. Gross profit increased by 18.3% to a record $118.9 million compared to $100.4 million a year ago. Gross margin was a record 16.3% compared to 15.3% in the prior year quarter. Operating income increased by 72.2% to $32.6 million or 4.5% of net sales compared to $19 million or 2.9% of net sales in the prior year quarter. Now I'd like to provide a more detailed discussion of our performance by segment. In our business solution segment, Q3 net sales increased by 11.8% to $273.8 million compared to $244.9 million a year ago. Gross margin for this segment increased by 83 basis points to 90% in the quarter. Our Business Solution segment benefited from the increase in volume and a change in customer mix. Business Solutions continue to focus on advanced technologies that have higher margins and represented a larger percentage of our revenue this quarter. In our Public Sector Solutions business, Q3 net sales increased by 19.7% to $177.4 million compared to $148.2 million a year ago. Sales to the federal government increased by 88.2% compared to the prior year, as a result of large project wins, while sales to state and local government and educational institutions increased by 1.5%. Gross margin for the public sector increased by 175 basis points to 13.9% due to double-digit growth in desktops, mobility, server storage and net/com categories. In the Enterprise Solutions segment, Q3 net sales were $278.3 million a 4.8% increase compared to $265.5 million a year ago. Gross margin for the segment increased by 86 basis points to 15.1%. 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 will now turn the call over to Tom to discuss additional financial highlights from our income statement, balance sheet and cash flow statement. Tom?

Thanks, Tim. SG&A increase this quarter to $86.2 million from $81.5 million a year ago. The increase in SG&A was driven in part by an uptick 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 decreased by 55 basis points year-over-year, demonstrating our commitment to driving operational efficiencies and managing expenses. Our operating income increased 72.2% this quarter to $32.6 million from $19 million a year ago. Of the $18.4 million increase in gross profit, $13.7 million or 74% of that increase was recognized in operating income highlighting the leverage in the business. Our effective tax rate was 27.4% down from 27.8% in the same period a year ago. Net income for the quarter increased 72.5% to $23.7 million from $13.8 million a year ago. Diluted earnings per share was $0.90, an increase of 75%. Our trailing 12 month adjusted earnings before income taxes, depreciation and amortization or adjusted EBITDA increase 30% to $129 million from $99.1 million a year ago. We repurchased 23,000 shares during the quarter for $862,000 at an average cost of $36.73 per share. We ended Q3 with $98.5 million of cash and cash equivalents. Cash flow from operations for the first nine months of 2019 was $40 million versus $81.3 million for the same period a year ago. The change was in part a result of the strong business environment we enjoyed in the third quarter compared to last year. Specifically receivables and inventory is growing support increased levels of business and accounted for most of the change in operating cash flows. During the quarter, our cash flow from operations was $36.7 million, which slightly exceeded our EBITDA for the quarter as a result of an improvement and days sales outstanding and inventory turns. Our net cash used in investing activities of $20.6 million for the first nine months of the year was primarily the result of equipment purchases and capitalization of our ERP system upgrade that is in process. The company use $12.6 million of cash for financing activities for the first nine months of 2019, consisting primarily of the Q1 payment of $8.5 million for our previously declared 2018 special dividend, and $4.4 million of stock repurchases. As of September 30 2019, we had $23 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 another quarter of solid performance across all of our business segments, resulting in strong operating leverage and demonstrating the importance of specialization and customer segmentation. We are also pleased with a double-digit in our healthcare, finance 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 customers and their environments. As our customer's needs and the industry continue to evolve, we will need to accelerate our investments in certain critical areas, which will likely result in our SG&A as a percentage of revenue migrating back closer to historical levels. 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. Looking ahead, current industry growth expectations are in the low-single-digits and approximate GDP growth. Our plan is to continue to grow twice as fast 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 Instructions] Our first question comes from Adam Tindle with Raymond James. Your line is now open.

Okay, thanks and good afternoon. I just wanted to double click on the operational aspect, obviously very impressive here, close to 20% gross profit dollar growth, but OpEx only growing mid-single-digits. So, Tim, if you could maybe just double click on what you're doing operationally. And, Tom, I think you guys alluded to this in the prepared remarks. But what ratios can we think about on the forward basis, whether it's OpEx as a percent of revenue or operating margin is kind of a more sustainable level.

Adam, thanks. So we think about our go forward strategy. So there are a lot of changes in our customer base require additional investments, more cloud engineers, more security engineers, more technical folks in general. So we look at our go forward plans. We're making some investments in systems and in personnel. And, Tom, I'll let you cover that a little more detail.

Yes. So I'll try to help you quantify what I think is happening here a little bit, Adam. If you look at us Q3 versus Q3 year-on-year, our SG&A as a percentage of revenue was gone down, I think 55 basis points. My expectation as we hit a few of those these step functions and investment, that will probably need to call back a third to a half of that amount to invest in the business and systems as these volumes continued increase.

Okay. That's helpful. And is there kind of an operating margin target that you're shooting for in 2020 and beyond? Is there something that you're kind of aspiring to?

We're always aspiring to more. But no, we haven't specifically outline, but we think that is, a lot of this is going to be, revolve around what our revenues coming at. Because as you saw this quarter, when the revenue starts to go up and starts in higher volumes. Your margins tend to accelerate a little bit disproportionately. So a lot of this is depend on how we perform year-over-year.

Got it. Okay. And Tim, I know going through the results here, PCs obviously remained very strong. I'm just curious on your view from either vendor partners or customer base on where we are in that cycle. I think, well-known that support from Microsoft expires in January. Do you think there's any -- maybe aspect of very strong PCs that you're seeing in the business has been driven by that? And if so -- it sounds like you're still talking about growth in the 2020. Do you think that's going to be headwind as we get later in the year? Thanks.

So that's a great question, one we spent a lot of time trying to answer. And I saw at the end of the day, it's anyone's guess, but if we kind of consolidate all of the views. We think the desktop refresh is going to tail off, but probably will go through Q1 of 2020. So we're optimistic about that. And as you mentioned, it's not only the end of life support for Windows 7, but we are seeing a lot of technological advances in hardware and a lot of feature sets that are important to the solutions rollout. So both of those are really positive drivers. That said, I'm sure, you're hearing this too. Across the industry, we're also getting warnings about potential shortages in processors from Intel. And although we have not experienced anything significant, today, clearly many of our suppliers are starting to point to that. So that's a little bit of a headwind out there that's going to make us feel a little bit cautious on our statements.

Okay. Make sense. And congrats on the very strong results.

Thank you.

And our question comes from Anthony Lebiedzinski with Sidoti & Company. Your line is now open.

Good afternoon, gentlemen. Thank you for taking the question. So, other than the issue with Intel, is there anything else that you can perhaps point to us to why fourth quarter may not be as good as your Q3 or just wanted to get any sort of thoughts as to how you're thinking about the rest of the year?

Anthony, thanks. So when we think about Q3, we did have a large federal government business as we look at September being the end of the federal government buying season. And so, clearly that that federal business probably won't repeat in Q4, big question remains, what will we see around the enterprise budget cycles in the traditional budget flush. And I think in the enterprise side, we're seeing little more cautionary notes out there as well. So nothing definitive, but when we look at our funnels and our forecast, the enterprise of all three segments is the one that probably has the most uncertainty.

The only other thing I'd add to that, Anthony, is if you go back and look at last quarter. Our inventories are kind of spice a little and we had talked about the fact that we had some rollouts that would roll into Q3. So we got kind of a bit of a tailwind from that. And you can compare that to the same quarter last year. I think we experienced some supply chain issues, which kind of depress the revenues a little. So year-on-year, you've -- this year, we got a little bit of tailwind, last year, we had a little bit of headwind.

Got it. Okay. Thanks for that clarification. And you talked also about the changes in customer mix for your SMB and public sectors impacting or helping your gross margin. Can you just maybe give us more detail about that?

Sure. So in the public sector space, we really had strong growth in the federal arena, and that was really a positive for us in Q3. Also in our small to medium business, our Business Solutions group, they did a really good job, we did a good job selling across the solution stack, selling a lot in advanced technologies to customers, they tend to be higher margin and little stickier. So as you know, that was a 19% gross margin business, so that that was very positive. Contributing to that and another was the lack of -- a couple of large projects that we had prior year in the quarter that didn't repeat. And so we didn't have as much margin pressure there. So that ended up being a little bit of a benefit.

Got it. Okay. And lastly, as far as your balance sheet, you are sitting in on a lot of cash at the moment. I know, you have certainly had a strong value for quite some time. So as far as your priorities for cash flow usage and any updated thoughts, some potential acquisitions?

Well, I can't really talk about potential acquisitions, Anthony. But I think, as we kind of discussed in the past. Opportunities to grow the business and invest in assets that will accelerate our growth or our top priority. And absent that I think you'll see our capital deployed kind of in the same way we've done historically.

But I also want to add, we really are confident in our business plan, in our team and our strategy. So we don't feel any undue pressure to go do an acquisition. But we'll remain open to anything that could round out our solution set, or be accretive to our company and our culture.

Got it. All right. Thank you very much and best of luck.

Thank you.

Our next question comes from William Gibson with ROTH Capital Partners. Your line is now open.

Thank you. You reference the backlog of product shipped or in the quarter, I assume that's out of your advanced configuration center. How's that operating now? Is it still stain of a high level? Or was that a one-time flush?

Well, Bill, thanks. So, we really do feel that our advanced configuration center offers great value for our customer base. So we have been very busy. It does bring real value to our solutions rollout, the volumes continue to rise there and we expect that to continue in the future. So we're seeing really good growth in our advanced configuration business and we think it's real value add.

Good. And then you mentioned double-digit growth in 3 verticals and you went over him, but I missed healthcare, financial and what was in the third?

The third was manufacturing. So we're seeing good growth across all 3 of those vertical markets. Retails been strong, but a year ago in the quarter we had some very large retail rollout. So we had a tough compare there.

Okay. Thanks.

So the 3 are finance, healthcare and manufacturing.

Yes. Sounds good.

Thank you.

And at this time, I'm showing no further questions. I'd like to turn the call back over for any closing remarks.

Well, thank you, operator. I'd like to thank all of our customers, vendor partners and shareholders for their continued support, and our dedicated co-workers for their efforts. I'd also like to thank all of those listening to the call this afternoon. Your time and interest in Connection or appreciated. Have a great evening.

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