ScanSource, Inc. (SCSC) Q4 2012 Earnings Report, Transcript and Summary

Thank you for standing by, and welcome to the ScanSource Fourth Quarter and Year-End Earnings Announcement Call. [Operator instructions] Today’s call is being recorded. If anyone has any objections, you may disconnect at this time. I would now like to turn the call over to Ms. Mary Gentry, Director of Investor Relations. Thank you, ma’am, you may begin.

Thank you for joining us for the ScanSource Earnings Conference Call to discuss financial results for the quarter ended June 30, 2012. My name is Mary Gentry, Treasurer and Director of Investor Relations, and with me are Rich Cleys, our CFO; Scott Benbenek, President of Worldwide Operations; and Mike Bauer, our CEO. We will review operating results for the quarter and then take your questions. This conference call contains certain comments which are forward-looking statements that involve risks and uncertainties. These statements are subject to the Safe Harbor created by the Private Securities Litigation Reform Act of 1995. The statements made in this call are made as of today’s date. We may subsequently make these statements available on ScanSource’s website or otherwise. ScanSource does not extend any obligation to update the forward-looking statements provided to reflect events that occur or circumstances that exist after today’s date. Any number of important factors could cause actual results to differ materially from anticipated results. For more information concerning factors that could cause such a difference, please see the company’s annual report on Form 10-K for the year ended June 30, 2011, and the company’s reports on Form 10-Q filed with the Securities and Exchange Commission. We will be discussing both GAAP and non-GAAP results during our call and have provided a reconciliation between these amounts in our press release. Mike Bauer will now begin our discussion with an overview of the quarterly results.

Thanks, Mary, and thank you for joining us. We had favorable bottom line results for the fourth quarter 2012, although our net sales were lower than expected. Net sales increased 3% over the prior year fourth quarter and 7% over third quarter 2012. We missed on our sales expectations due to mixed results from our business units and to a lesser extent the impact of foreign currency translation. Sales performance for our business units was mixed: within North America, communications and security had record sales quarters while results for our POS, barcoding and Catalyst were not as strong. Within our international business we had stronger sales growth for Brazil and Latin America, while results in Europe continue to be challenging. Similarly, our big deals varied. POS and barcoding both in North America and in Europe had higher big deals while it was not a big deal quarter for either Europe communications or Brazil. As we discussed in last quarter’s conference call, we are working with our vendors to bring down inventory levels to match sales more appropriately and to set more realistic vendor program goals to allow us to reach the profitability we need to operate a value-added distribution model. We have made some progress here with lower inventory levels overall and improved inventory turns, while making sure we don’t miss any sales opportunities. Our overall working capital position improved which benefited our return on invested capital. We continue to work with our vendors on vendor program goals and are making some headway here, though it’s still a work in progress. With that, I’ll turn the call over to Rich to discuss our fourth quarter financial results in more detail.

Thanks, Mike. I’ll start with overall sales and operating results for the June 2012 quarter. As Mike pointed out, we generated worldwide sales of $754 million in fourth quarter of 2012, an increase of 3% over the prior year and a 7% increase over the third quarter of 2012. On a geographic basis, North American sales increased to $570 million or a 4.9% increase over the prior year. Our international segment decreased 3.8% from the prior year to $184 million. Excluding the impact of foreign exchange fluctuations, international segment sales grew 8.1%. Our prior year fourth quarter revenues included CDC Brasil results from April 15, 2011, the acquisition date. Within our product lines we experienced a 1.4% increase in worldwide POS, barcode, and security products over the prior-year quarter. The relatively flat growth rate in these product lines is largely due to a competitive POS and AIDC global market, weaker economic conditions in Europe, and unfavorable foreign exchange rate variances. Sales in our security product lines have continued to perform well. Our POS, barcode and security product categories represent 60% of our total sales for the quarter with the remaining 40% in communications products. Our communications sales unit experienced an increase of 4.6% over the prior year quarter. Our reported 9.8% gross margin decreased 33 basis points from the June, 2011 quarter and remained flat sequentially. The decrease from the prior year is largely due to certain vendor program changes in our international business which adversely impacted our gross margin and increased inventory reserves in our international communications business. SG&A expenses in the current quarter increased to $46.6 million compared to $45.3 million in the prior year, and decreased slightly from $46.7 million in the March quarter. As a percent of net sales, our SG&A expense ratio remained constant at 6.2% from the prior year. From the sequential quarter, SG&A expenses decreased 42 basis points as a percent of net sales. The sequential decrease in SG&A percentage is largely attributable to increased sales over a seasonally lower March quarter. As a reminder, we have an earn-out for CDC Brasil that is required to be re-measured to fair value every quarter. The quarterly re-measurement of this contingent consideration is presented separately from other SG&A expenses. In the current quarter we recorded a fair value adjusted gain of $1.1 million or $0.03 per share versus a $1.1 million loss sequentially and a $128,000 gain in the prior year quarter. As mentioned on previous calls, factors impacting the fair value adjustment can cause volatility over time in this line item. The gain in the current quarter is largely due to our revised projections as the Brazilian market has begun to soften compared to previous expectations. For the year, contingent consideration has no impact on earnings per share. Operating income was $28.3 million, down 3.2% from the prior year but up 31.8% sequentially. Expressed as a percentage of sales, operating income was 3.8% in the current quarter compared to 4.0% in the prior year and 3.0% sequentially. The decrease in operating income from the prior year is mainly due to lower gross margin as previously described, partially offset by the fair value gain on the CDC earn-out. The increase of operating income sequentially is primarily due to the increased volume over the prior quarter and the fair value gain on the CDC earn-out of $1.1 million versus a $1.1 million loss in the third quarter. Operating income for the North American segment increased 10% over the prior year period to $26.5 million whereas the international segment decreased 65% to $1.8 million, which includes the benefit of the $1.1 million fair value gain for the quarter. The decline in our international segment operating income was driven by the change in certain vendor programs which lowered margins and from higher inventory reserve expense on relatively flat operating expense. Interest expense was $150,000 for the quarter; interest income was $653,000 for the quarter. Interest income in the current year was higher than previous years as we transferred $22 million to our Brazilian subsidiary in September 2011. [Audio Gap] pre-fund a portion of future earn-out payments. We would expect interest income to decrease as we complete our annual Brazilian earn-out payments for the purchase of CDC. The effective tax rate was 31% this quarter compared to 32% in both the prior year and sequential quarters. We expect the fiscal year 2013 effective tax rate to be approximately 34%. Our return on invested capital was 18.2% for the quarter compared to 19.9% for the prior year quarter and 13.5% for the March quarter. In summary, the company has fully diluted earnings per share of $0.71 for the current and prior year quarters. The current quarter earnings per share included a $0.03 benefit from the fourth quarter earn-out of fair value re-measure. Moving to the balance sheet. Inventory turned 5.6x during the quarter compared to 6.1x in the prior year quarter and 5x in the sequential quarter. We had 7.4 paid-for inventory days at June 30, down from 8.3 days at the same time last year and 14.8 days at the end of the third quarter. Inventory levels are down $26.5 million from the March quarter, however levels are still up $8 million from the prior year. There are $48.2 million in checks written but not cleared in the June accounts payable balance versus $73.6 million for the prior year. The decrease is largely due to timing of vendor payments. Our days sales outstanding, DSO, was 56 days at June 30, 2012, compared to 57 days in the prior year and sequential quarter which is within our normal expected range. The company had cash and cash equivalents on hand of $29.2 million at June 30, 2012, compared to $28.7 million at June 30, 2011. The company spent $2.6 million and $12.8 million on capital expenditures during the quarter and year-to-date respectively primarily on our investment in a new ERP system. As mentioned on previous calls, we are in the process of designing and developing a new ERP system to standardize our processes throughout the world. During the third quarter, we received a project study from a third-party service provider which indicated that the project would take longer to implement and exceed our previous cost estimates, which at the high end was $38.5 million. We anticipate implementing the new system in calendar 2013. Through June 30, 2012, the company spent approximately $33.5 million on the new ERP system, of which $26.8 million has been in the form of capital expenditures. Anticipated future capital expenditures on the project are estimated to be between $9 million and $15 million. All future capital expenditures are anticipated to occur in fiscal 2013. The company held $9.7 million of interest-bearing debt at June 30, 2012, down from $60.1 million at the prior year-end. Our funded borrowing decreased $37.2 million from March as we reduced inventory levels during fourth quarter and benefited from timing of [ph] payments to our vendors. Mike will now comment specifically on quarterly results and outlook for each of our business units.

Thanks, Rich. I’ll start my business unit comments with our North America segment, which includes the United States and Canada and represents 76% of overall sales. In North America, sales of $570 million represent a 5% increase year-over-year and an 8% increase sequentially. While at the low end of our normal increase for the March to June quarters, each of our North American business units had positive sequential quarter growth. Our North American communications unit had a record quarter with double-digit growth both year-over-year and sequentially. Almost all of our top vendors in this unit had outstanding results including record quarters with Polycom, ShoreTel and Plantronics. We also had a strong services quarter, a plus for the margin. After a softer quarter in March, Polycom video and infrastructure came in very strong. Big deals doubled from the preceding quarter, ending up in line with our expectations. With ShoreTel, we had another record quarter, as we saw revenue growth from existing resellers and from new resellers that we recruited and launched for ShoreTel. We’ve enhanced our ShoreTel quoting tool to make it easier to sell and configure voice over IP solutions, reducing complexity and saving time for our customers. For Catalyst Telecom, sales declined year-over-year and missed our internal sales plan. Despite missing the top line number, we saw the mix shift back to more value-added business where we can earn higher margins. We had our biggest quarter ever with Aruba and Meru, and Extreme networks gained traction quarter-over-quarter. We had a strong finish at quarter-end with Avaya, mostly from SMB and data networking products. We made progress and gained both average and ending inventory levels down, and saw meaningful improvement in inventory turns. We introduced a new version of Catalyst Fast Quote and in June added a new vendor for headsets, Jabra. Effective September 30, we are ending our distribution agreement with Juniper. When we originally created the agreement it was to add networking products to support our voice-oriented vendors and customers. Now, Catalyst and Juniper have decided to go in different directions. Our Juniper business was about $41 million this past quarter. North America POS and barcoding had a record quarter for big deals despite slower than expected overall growth. The month of June was unusually slow for us and we had some deals that were pushed out into future quarters. Our point of sale systems business performed very well with double-digit growth both year-over-year and quarter-over-quarter. We had strong results with IBM, NCR, Datalogic, Cisco, POS-X and ID TECH. In early August, the Retail Solution Providers Association, RSPA, awarded ScanSource its Gold Award of Excellence in the Technology Distributor category for the third year in a row. This award is the highest award a distributor can earn and is voted on by members of the RSPA for excellence in sales, service, and support of the retail channel. Our security business unit achieved record quarterly sales results with double-digit growth sequentially and year-over-year. We had record quarters with 5 of our top 10 vendors, with Ruckus, Axis, Sony, Arecont and Exacq Tech. We also had strong results from newer vendors such as Mobotex, ACTe [ph] ACTi, and record quarters with PureWave, Milestone and Interlogix. We’ve brought down inventory levels and realized better inventory turns while keeping our position as the go-to security distributor. Our big deals were in line with expectations and included an uptick in wireless deals where we gained some market share. We’re making some good progress with the national security integrators including several big deals this quarter, and the team benefited from some direct to indirect shifts with certain vendors, such as March Networks and PureWave. Now, turning to our international segment which is 24% of our overall sales this quarter. Net sales of $184 million declined 3.8% year-over-year, increased 3.5% quarter-over-quarter, however. Excluding the foreign currency translation impact, net sales increased 8.1% year-over-year and 7.3% sequentially. As a reminder, our acquisition of CDC Brasil closed last year on April 15, 2011. Europe continues to be a challenging environment with economic uncertainty, pricing pressures, and more cautious customers. We are working with our vendors and customers to make sure our value-added model is important to the channel and ensuring that we are able to earn appropriate profit margins and return on invested capital. We’re disappointed with the financial results of both our European sales units and will be working to improve this situation. Earlier this year we named Xavier Cartiaux as President of International Operations, a new position for us. Xavier is responsible for leading the strategic direction and management of our international business units and is based in Greenville, South Carolina now. With Xavier’s new role we promoted Maurice Van Rijn, who joined ScanSource more than a decade ago, to Managing Director to lead our ScanSource Europe POS and barcoding. Starting with the Europe POS and barcoding unit, our sales in local currency were down slightly to the year-ago level. Big deals were higher, however, than last quarter including delayed projects from the March quarter, but in line with prior year levels. Most countries were up quarter-over-quarter. With our vendors we saw some market share gains and strong year-over-year growth from Honeywell, Intermec, ELO, Epson and our Services group. In June, ScanSource Europe received the Honeywell Scanning and Mobility Award for the Highest Growth pan-EMEA Distributor 2011. We recently announced a new partnership with Wincor Nixdorf, a retail systems vendor to offer their ePOS solutions across Europe with our initial focus being on the U.K. For Europe communications we had sequential quarter growth following a disappointing March quarter. Our communications business is focused primarily on Germany and the U.K., and certain select markets like France, Austria, Switzerland, and Belgium for some vendors. We started our communications business in Europe in 2008 and have focused on a few key vendors including Avaya, Extreme [ph], ShoreTel, Plantronics, LifeSize and Juniper. Recently we’ve added Polycom in Germany while losing Juniper as we said earlier. Avaya has continued to be our largest communications vendor in Europe just as they are in North America. We have record results from Avaya IP Office, also Extreme [ph] and Avaya Data as well as good results with Polycom, Plantronics and AudioCodes. Gaining vendor support in other countries outside of Germany and the U.K. has taken longer than we expected, which is lengthening the investment period for this business unit. Year-over-year results were roughly flat in local currency. For the second quarter in a row, large projects declined with investment slowdown from postponements, splitting projects into smaller parts, and reduced project sizes. Our customers continue to be more cautious in their purchasing decisions. We had record quarters in the U.K. where we have more run rate business and in Switzerland. We also had strong results in Austria and France while Germany, with a more project-driven customer base, was slower. We recently delivered technical workshops around Avaya’s new Unified Communications Module for IP Office and we were the first in the U.K. to do so. For the second year in a row, ScanSource U.K. was recognized as the Distributor of the Year by the readers of Comms Business Magazine. Our Latin America business includes Brazil, Mexico and Miami which serves U.S.-based exporters to Caribbean and the rest of South America. In Brazil we completed our first year with CDC Brasil. Excluding the foreign currency translation impact, we had strong growth, both year-over-year and sequentially although it did not meet our expectations. Run rate business drove the growth in the June quarter. It was not a good quarter for big deals as some of these deals were put on hold because of the strong dollar valuation. Our team delivered good results from Bematech, Motorola, Honeywell, HP, and Daruma. In Miami, we had double-digit growth both year-over-year and sequentially. We had excellent results with Motorola, Honeywell, NCR, Datamax and Zebra including greater success with vendor program attainment. Sales were led by good results in Chile, Colombia, Ecuador, Peru and Puerto Rico, as well as U.S. exporters serving the rest of Latin America. Our sales in Mexico rebounded after a slow March quarter. We had strong growth from Motorola, Zebra, NCR and Intermec in our barcode and POS unit, from Polycom in our communications and from Zebra Card in security. So turning now to our next fiscal quarter, we believe net sales for the quarter ended September 30, 2012, could range from $740 million to $760 million and our earnings per share could range from $0.58 to $0.60 per diluted share. At this time, we’ll be glad to answer your questions.

[Operator instructions] And our first question comes from Tony Kure with KeyBanc.

A couple of quick questions. On the vendor programs, obviously we talked about this last quarter and it’s going on this quarter. And I think what we talked is that you’re expecting some relief. I was just wondering if there’s any, as the quarter passes now, is there any line of sight into when that relief might come on the margin side?

Let me -- the vendor programs, we alluded to the vendor programs in our international business. We had a number of vendor program issues. For example, one of the things that occurred in one of our international businesses is we went from a fee-based arrangement on a major vendor to a full purchase and sale. So on the fee-base you reflect only the margin as revenues and as the overall gross margins, so you have 100% gross margin on that product. We’re now purchasing that product and taking on the receivable risk to the inventory we carry and we have more of a typical margin. So that’s impacted the overall international margins just as an example.

So obviously you talked about, and Mike, you alluded to the fact that you want to negotiate or it sounds like you said negotiate with them to have a more profitable enterprise there over in Europe. I mean is that something that should happen in fiscal 2013 or in the next couple of quarters? I’m just trying to get some sort of line of sight there.

Yes, so typically we have annual programs and then we have quarterly updates. We have a quarterly business review with each of our key vendors and at that interval in time we sit down together and say “Hey, how’s it working, Are we meeting our plans? Is ScanSource happy? Are we happy, the vendor?" So we generally have these intervals to update and change throughout the year. So it doesn’t mean it’s a year away. It doesn’t mean it happens in the exact quarter that we want it to happen into. But generally we don’t have to wait a year, Tony.

Okay. And then inventory reserves were also cited as an impact. Could you maybe scale those relative to the vendor programs? Are they as big of an impact, bigger or smaller?

In the overall margin, the inventory reserves was the largest factor; and those inventory reserves are reflective of lower-than-expected sales and also some purchasing with a number of vendors where we’re trying to get some increase, especially in our European business. So per our policy as this inventory ages out we have to set up reserves for what amounts to that excess, so that was the biggest single factor in our overall margin.

Okay. And then I guess from the outlook perspective just 2 quick questions. First, the revenue guidance. I mean, is it fair to say that with Juniper going away, about $40 million last quarter I think you said. I mean, is it fair to say that your revenue guidance could have been $40 million higher if you had Juniper still -- that relationship going?

Well, I think it’s fair to say we included the loss of Juniper in our guidance.

Okay. And then on the last one is just on that note. Was Juniper a higher margin business? Because for a flat revenue and if I go to the midpoint of your guidance, your operating margins come down sequentially. So is it fair to say that was a higher margin business or is there something else in the September quarter that’s impacting margins?

Yes, I wouldn’t read the forecast margin expectation from the modeling you’re doing there to be the result of Juniper.

Our next question comes from Keith Housum with Northcoast Research.

Staying on the topic of your guidance, as you back into it as Tony said, you’re at like 3.25% operating margin versus I think roughly 3.60% excluding the Brazil item in this quarter. Can you speak about the margin degradation a little bit further? I mean is there something on the horizon that says it’s not going to continue, where you’re at -- the 3.6% is not going to continue?

Well, first of all, remember we’ve got this fair value adjustment, and our fair value adjustment -- if all is equal in our projections you end up having additional expense because you’re getting closer to the payout. So in our guidance, it implies a fair value expense. I think last quarter we forecasted about $1 million of expense and we ended up with income; it would be fair to model a similar number for this upcoming quarter. So that I think is a big change coming off of the fourth quarter.

Okay, so you'd say, or at least you're saying right now, the $1 million you would model for the first quarter?

Yes, I think that would be a fair estimate.

Okay. And that certainly gets you some of that gap, but any other color on what perhaps may fill in the additional gap?

Well, we are -- there is with the ERP project, we are carrying some internal folks and some external consultants where those expenses are not capitalized. So we do have additional carry. We had for instance, for the last fiscal year, our expense load for the ERP project for consultants and internal labor that was not capitalized was about $5 million for the year.

Gotcha, so that number will be increasing here in FY '13 as you guys make a push toward the implementation.

That would be a reasonable assumption.

Okay, got it, got it. Okay, and then in terms of FX, you guys disclosed the impact in terms of overall sales. Any of that drop into the bottom line or is it because of the high nature of the cost of goods sold, it kind of filters out to an immaterial number?

Well [indiscernible] dropped to the bottom line. If you assume even a 10% margin and then say a 6% SG&A, you’re going to have 4% of whatever that top line is, show up as lower U.S. dollars. So in the local currency you’ve got the same result but when you translate into dollars, it’s going to affect you by call it 4% or thereabouts.

Got it. And finally with Juniper, did you say the contract ends, or the distribution agreement ends, September 30 or June 30?

September 30. We worked with Juniper on making sure there was no change in the business through June 30 but it’s already been announced to customers at the beginning of July. So customers are already aware of it. So we’ve got a contract in place, just to frankly help both of us transition any inventory issues, any returns, all that kind of stuff.

Okay, but the expectation is since customers know about it they’re going to start working their way to other distributors and that’s why [indiscernible].

Yes, for a product like this it’s available at other distributors, so we anticipate that will happen, yes.

Our next question comes from Chris Quilty with Raymond James.

Rich, if I can just check with you, what was that number for the Juniper revenue? Was it $31 million, I wrote?

$41 million of revenue in the quarter.

Gotcha. The security business, have you picked up any new vendors’ line card expansion or was the double-digit growth just more business going through the same vendors?

Yes, Chris, this is Mike. It is pretty much the same vendors. Yes, same guys we’ve had. No real dramatic changes there. I referenced a little bit of shift from a couple of vendors -- March Networks and PureWave -- but no real new names there, right.

And are you looking to expand the line card still?

I would say there’s maybe a handful of vendors that we’d be looking for to add. It would be a very low number. We’re frankly looking more at reducing some of the vendors we have. We have more vendors in the security business than we do for any other of our units, and it’s one of those conundrums where we started adding them early on to make sure we had the right ones. But I would say other than literally less than 5, we would be looking to add in the near term.

Okay. Actually back to Juniper, does the break in the relationship there leave you missing anything in your product offering that you might look to fill with another vendor?

Well, I think what has happened here is, and what I was trying to indicate in my comments was when we added Juniper, this was before Avaya acquired Nortel and so there was a gap there for our Catalyst teams both here and in Europe that we didn’t have necessarily the complete solution. But after Avaya acquired Nortel, it became obvious for the Avaya resellers that they would be promoting Nortel, frankly, over any other brand and there were incentives to do that. So we did recruit some customers for Juniper that were not buying Avaya. We felt like that was sort of some customer relationships and, frankly, sales that we would have rather not lost to be honest. But they’ve got a different direction and we do, too, especially with our focus on Avaya. But no, there’s no gaping hole I would say at this point.

Okay. It sounds like a real strong quarter coming out of Miami for Latin America/Central America. What’s the difference between the strength in Miami and underperformance in Brazil?

Well, just -- and again, I’ve got to be fair. Brazil had a strong quarter in local currency. We just have, as everybody knows, high expectations for that market. When we bought the company a year ago, we had frankly some ideas and projections from them and internally that said we’d have a bigger first year than we did. And so I would say some of that’s due to the Brazil economy slowing down last year. There are some other issues going on in Brazil, too, that relative to taxes that affect the distribution of products that impacted us during the year so we’re frankly a year smarter now about what is possible in Brazil. But I think it’s fair to say that Brazil did okay, but we had higher goals. Now, there’s no difference in the other markets, like in Mexico and in Miami, those markets are really just somewhere where we have a chance there to gain some market share and we’ve just got a better team in place right now that’s doing that. That’s more execution than it is the market.

Okay. And vendor programs. I know you started a process last quarter of trying to renegotiate some of the program goals. Typically, is this a 6-month process, which seems to be what you’re implying, in order to roll out some new programs? And if we do in the next 3 or 4 months get new programs in place, are benefits felt immediately or is there a delay for inventory issues to work through?

Well, normally these programs are recognized as the inventory sells through. So there is a delay; even if we started it last quarter, we wouldn't have -- and if we would have overachieved in the June quarter, we wouldn’t have seen necessarily all the benefits in the June quarter. That’s correct. So there is a subsequent impact on future quarters of attainment, but in general these are things that everyone wants to not over steer. And so I would say a vendor will first say “Well come on, you guys can do a better job than that. We’ll help you and so let’s don’t move the numbers a lot because everyone’s trying to hit annual numbers." I would say it’s harder that first conversation to make meaningful changes. I think after we have another quarter under our belt like we just had, I think the conversations will be more clear to the vendors and to ScanSource.

[Operator instructions] And we’re showing no further questions.

Well great, thanks a lot and thank you for joining us today. Our next conference call to discuss September 30th quarterly earnings is expected to be on October 25, 2012. Thank you very much.

Thank you. That does conclude today’s call. Thank you all for participating. You may disconnect your lines at this time.