ScanSource, Inc. (SCSC) Q1 2013 Earnings Report, Transcript and Summary

Welcome to the ScanSource First Quarter Earnings Conference 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 Mary Gentry, Director of Investor Relations. Thank you, ma'am, you may begin.

Thank you for joining us for the ScanSource earnings conference call for the quarter ended September 30, 2012. With me today are Rich Cleys, our CFO; Scott Benbenek, President of Worldwide Operations; and Gerry Lyons, FCP Finance and Principal Accounting Officer, Mike Baur, our CEO is joining us by phone. We will review operating results for the quarter and then take your questions. Certain statements made on this call will be forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are subject to risks and uncertainties that could cause actual results to differ materially from such statements. These risks and uncertainties include but are not limited to those factors identified in the release and in ScanSource’s SEC filings. Any forward-looking statements represent our views only as of today and should not be relied upon as representing our views as of any subsequent date. ScanSource undertakes no obligation to update any forward-looking statement to actual results or changes and expectations. We will be discussing both GAAP and non-GAAP results during our call and have provided reconciliation between these announced in our press release. Mike Baur will now begin our discussion with an overview with the quarterly results.

Thanks Mary and thank you for joining us today. For first quarter 2013 we reported net sales of $734 million and diluted EPS of $0.63. While we missed our sales forecast range, EPS exceeded our expected range. For the quarter our gross and operating profit margins were better than planned. The benefit from higher margins offset lower net sales volumes resulting in favorable bottom-line results for the quarter. Favorable customer and product mix drove the increase in our gross margins over the level for the last 2 quarters. This quarter was not a strong, big deal quarter and the average size of these deals we had were smaller. This contributed the gross margins that were higher than we planned as well as lower sales volumes. Were big deals were lower than the prior quarter our run-rate business performed well. First quarter 2013 net sales declined 5% over the last year both for North America and international. In North America we had strong year-over-year growth for communications and another record quarter for security. As expected Catalyst Telecom sales declined primarily from the termination of our distribution agreement with Juniper. And lower year-over-year sales associated with Avaya. Our international segment had good year-over-year sales growth of 8% when you exclude the impact of foreign currency. We ended the quarter with higher inventory levels than we would like in part from lower sales than planned based on our December forecast and current market conditions it will take us more than a quarter to work our inventory levels down to more appropriate levels. Turning now to our forecast for the next fiscal quarter, we believe net sales for the quarter ended December 31, 2012 could range from $745 million to $765 million and our earnings per share could range from $0.61 to $0.63 per diluted share. This reflects challenging market conditions, including competitive pressure and the impact of higher inventory levels. With that I will turn the call over to Rich to discuss our first quarter financial results in more detail.

Thanks Mike. I will start with overall sales and operating results for the September 2012 quarter as Mike pointed out we generated worldwide sales of $734 million in the first quarter of 2013, a decrease of 5% from the prior year and 3% from the fourth quarter of fiscal 2012. On a geographic basis North American sales decreased to $546 million for a 4.8% decrease from the prior year quarter. Our international segment decreased 4.6% from the prior year to $188 million largely as a result of foreign currency exchange rates. Excluding the impact of foreign currency exchange fluctuations, the international segment sales increased 7.8%. Our POS barcode and security product categories represented 62% of total sales for the quarter with the remaining 38% for communication products. Within our product lines worldwide POS barcode and security products decreased 2% over the prior year quarter. The slight decline in sales for these product lines is largely due to unfavorable exchange rates and a competitive POS and AIDC global market. Excluding the impact of foreign currency exchange, our POS barcode and security sales increased 3%. Sales for our communications units decreased 9% over the prior year quarter primarily due to lower Avaya sales and the transition of channel business related to the termination of our distribution agreement with Juniper networks. Our 10.1% gross margin decreased 18 basis points from the September 2011 quarter but increased 30 basis points sequentially. The decrease from the prior year is largely due to our international margin including increased inventory reserves on the current year. Our gross margin is up from the sequential quarter as a result of favorable products and customer mix. This was not a big deal quarter and we sold more products that typically carried higher margins. SG&A expenses in the current quarter increased to $47.1 million compared to $46.6 million in both prior year and sequential quarters. As a percentage of net sales our SG&A expense ratio totaled 6.4% an increase of 37 and 24 basis points over the prior year and sequential quarter respectively. The SG&A percentage increase is largely the result of higher ERP expenses, additional provision for bad debts in Europe and additional investment in certain growth areas. Our ERP spending included more activities such as development of training platforms which are expensed in the current period versus other activities that are capitalized. During the first quarter of 2013 SG&A expenses included approximately $2.3 million of expenses for ERP project. We remeasure our earn-out for the CDC Brasil acquisition to fair value every quarter. Quarterly remeasurement of this contingent consideration is presented separately from other SG&A expenses. In the current quarter we recorded a fair value adjustment loss of $764,000 or $0.02 per share compared to a loss of $894,000 in the prior year quarter and a gain of $1.1 million in the June 2012 quarter. As mentioned on previous calls, factors impacting the fair value adjustment can cause volatility in this line item. Operating income was $26.2 million down 17.1% from the prior year and 7.4% sequentially. Expressed as a percentage of sales operating income was 3.6% in the current quarter compared to 4.1% in the prior year at 3.8% in the June 2012 quarter. The decrease in operating income from the prior year is mainly due to lower sales volume and gross margin as previously described. The sequential decrease in operating income is primarily due to the fluctuation in the CDC Brasil earn out revaluation from a $1.1 million gain recorded in the June quarter to a $764,000 loss recorded in the current quarter, excluding the impact of the change in fair value of contingent consideration operating margin totaled 3.7% in the current quarter versus 3.6% in the June 2012 quarter. Now let’s look at operating income by segment. Operating income for the North American segment decreased 14.7% to $25 million from $29.3 million in the prior year. Operating income for the international segment decreased 47.6% to $1.2 million from $2.4 million. The decrease in North America is primarily due to lower sales volumes and gross margin as well as higher SG&A expense related to our ERP project. The decline in our international segment operating income is largely due to increased inventory reserve expense and higher provision for bad debts, partially offset by foreign exchange translation. Interest expense was $124,000 for the quarter and interest income was $633,000. In September 2011, interest income has been relatively high for the company after we transferred $22 million to our Brazilian subsidiary to prefund a portion of the future earn-out payments and finance current operations. We would expect interest income to decrease as we complete our annual earn-out payments for the purchase of CDC and as our Brazilian sales unit uses these funds for short term working capital financing. The effective tax rate was 34% this quarter compared to 34.5% in the prior year quarter. Our return on investment capital totaled 17% for the quarter compared to 18.2% for both the prior year and sequential quarters. In summary, the company had diluted earnings per share of $0.63 for the current quarter compared to $0.67 and $0.71 for the prior year and sequential quarters respectively. Moving to the balance sheet, inventory turned 5.6 times during the quarter compared to 5.8 times in the prior year quarter and 5.6 times in the sequential quarter. We had 11.9 paid for inventory days at the end of the first quarter in both the current and prior fiscal years and 7.4 paid for inventory days at June 30, 2012. There are $52.9 million in checks written but not cleared in the September accounts payable balance versus $48.2 million in our June 30, 2012 balance sheet. The change is primarily due to timing of vendor payments. Our day sales outstanding, DSO was 58 days at September 30, 2012 compared to 56 days in the prior year and sequential quarters. Cash and cash equivalents on hand totaled $38.7 million at the end of the quarter compared to $29.2 million at June 30, 2012. The company spent $2 million on capital expenditures during the quarter primarily on our investment on the new ERP system. As mentioned on previous conference calls we are on the process of designing and developing a new ERP system to standardize our processes throughout the world. Through September 30, 2012 the company has spent or accrued approximately $35.8 million on the new ERP system of which $26.9 million has been in the form of capital expenditures. As I mentioned earlier SG&A for the September 2012 quarter included $2.3 million for the ERP project. Company held $17.6 million of interest bearing debt at September 30, 2012 up from $9.7 million at June 30, 2012. The end debt was impacted by the timing of vendor payments. However average debt for the September 2013 quarter decreased to $16.6 million from $41.3 million for the June 2012 quarter. Mike will now comment specifically on a quarterly results and outlook for each of our business units.

Thanks Rich. I will start my business unit comments with our North American segment which includes the United States and Canada and represents 74% of overall sales. In North America sales of $546 million represent a 5% decrease year-over-year and a 4% decrease sequentially. In September our 4 North American business units hosted a joint partner conference Next Is Now for our top reseller customers. It was an outstanding forum to exchange ideas and solutions and build relationship with over 700 customers and vendors attending. Our North America communications unit had double digit year-over-year growth with record quarters with Plantronics and Allworx, big deals were down however year-over-year and the average big deal size decreased. During the quarter we opened a new executive briefing center in our Lenexa, Kansas office to showcase the latest Polycom Unified Communication solutions. We will have our Polycom resellers use the briefing center for their key Polycom prospects. Catalyst Telecom had disappointing sales results compared to last year, however we achieved better margins and higher inventory returns. As we discussed previously we are working through the end of our distribution agreement with Juniper and our Juniper sales declined substantially during the September quarter. With the Avaya we saw strength in small and mid-market business customers and good results from Avaya services. Our big deals declined from previous quarters with a smaller average size. Our wireless networking business continues to be strong in part from the BYOD or bring your own device trend most businesses are facing today. As a result we also have strong sales results from Aruba and Meru wireless products which also are seasonally higher in the September quarter due to back to school systems business. The Catalyst team introduced a new pricing tool exclusively for our Avaya resellers called co-pilot which has received a great response from our customers. This tool was designed and built by Catalyst and provides a unique and efficient access for the configuration and pricing of Avaya products and services. For North America POS and barcoding our sales were down both sequential quarterly and year-over-year. Big deals were down from a record big deal quarter in June especially in our POS products. And again our average deal size was smaller. In September, we began selling NCRs, POS maintenance services to our POS resellers for the first time ever. This offer will allow resellers to profit from the resale of NCR service offerings nationwide, increasing their revenue and profitability. Our payment terminal business received another boast as we received our encryption services organization ESO certification and our performing merchant services and key injections for our resellers as part of our ScanSource payment solutions suite offering. We also introduced mobile ETC, a comprehensive mobility program to help resellers sell, deploy, and support mobile solutions from all of our mobile terminal vendors. Our security business unit achieved record sales results for the quarter with double digit year-over-year growth and strong results for the video surveillance category products. It was a seasonally strong quarter including an increase in big deals with school system business completed in the summer months and more outdoor wireless network installations. Our key security vendors with record quarters included Ruckus, Axis, Panasonic, Sony, Fargo, Exac, Samsung, OnSSI, March and DVTEL. Based on our strong results for the past year, our security team was recently named the 2012 Ruckus distributor of the year. The security team also launched a new value added offering called Snap. This is a ScanSource design web based product selection tool to help resellers easily and efficiently choose and configure the best product to fit their end user customer’s needs. Now turning to our international segment which is 26% of our overall sales this quarter. International net sales of $188 million declined 5% year-over-year but increased 2% quarter-over-quarter excluding the foreign currency translation impact net sales actually increased 8% year-over-year and 4% sequentially. Starting with POS and barcoding, sales in local currency increased year-over-year although lower than expected. Consistent with prior September quarters, our European business was seasonally slower this quarter. We had lower revenues and big deal due to lower average big deal sizes and we face competitive pricing pressure on big deals on certain markets making them hard to close. Looking across the region both UK and Eastern Europe had good quarter-over-quarter and year-over-year growth, demand was somewhat weaker in Southern Europe. In October we held our POS and barcoding partner conference in Antwerp and designed the agenda to have close interaction with our top customers and key vendors. This conference attracted record attendance and featured presentations from ScanSource and vendor executives. For Europe communications this team exceeded their internal plan with better execution and good year-over-year sales growth as measured in local currency. The sales team continues to grow our run-rate business however big deals were down both in overall volume and size on a year-over-year basis. Due to our continued success in the UK our relationship with ShoreTel which recently expanded to include Germany, Austria, Switzerland and the Benelux region. Turning to Latin America, our business there includes operations in Brazil, Mexico and Miami which serves the U.S. based exporters to Caribbean and the rest of South America. In local currency these business units had sales growth both year-over-year and quarter-over-quarter. In Brazil our team delivered strong sales results for most of our key vendors. We signed a new distribution agreement with IBM retail now operating as Toshiba TEC, and HPN, HP Hewlett Packard Networking for networking products. However, competitive pricing and certain vendor program changes are pressuring our gross margins. In August our Brazil team held a successful partner conference is Salvador with close to 400 in attendance. In Miami, we had good growth with our POS and barcode vendors and it was our first quarter with Extreme networks in Latin America. Our top countries for sales growth included Venezuela, Columbia, Peru and Costa Rica. We continue to provide successful customer trainings such as our well attended Scan Teach Event in Guatemala. Our sales in Mexico included a good quarter in barcode and POS products and during the quarter we sold products to our highest number of customers ever. We held reseller training sessions with 3 key POS and barcode vendor partners and held a security IP solutions workshop. This quarter we are adding Plantronics as a new vendor for our communications line in Mexico. At this time we will be glad to answer your questions.

[Operator Instructions]. And our first question comes from Anthony.

Just wanted to talk a little bit about the guidance as we look forward. And if I sort of take at the mid-point of the revenue guidance and then the mid-point of the EPS it sort of implies -- or does imply a sequential downturn at least a little bit on the operating margin line and then I’m guess just trying to parse out is that the anticipation there more on the gross margin or is it may be a step up in SG&A from maybe the ERP spending if you can maybe parse that out a little bit and see if you could just add a little color there.

This is Rich I’ll take that one. As far as the guidance goes for the mid-point as you point out it's about $0.62 and you can model that to be in the neighborhood of about 3.5% operating profit. So that is at 3.5%, your question is "is it SG&A, is it gross margin". I think Mike mentioned in his comments that we continue to see some pressure in competitive pressure in the marketplace as well as the inventory levels that we have got, it will take a little bit of time to bring those inventory levels down from a policy point of view we reserve for excess inventories based upon aging. So the margin that would imply would be down from the margin that we just reported. SG&A probably you would model it to be similar to the kind of SG&A spend that we just had.

So to clarify on your SG&A comment that you mean the spend level in dollars should be about the same correct?

Yes.

So it sounds like the inventory levels is sort of the culprit again -- or the biggest culprit, I think last quarter we talked about how that was maybe the biggest downside driver or pressure on margins. Does that remain the case here as we look at to the December quarter here?

I think it's a combination of the inventory levels as well as the competitive environment. We have some pretty good product mix this quarter that help us on the margin. The environment is a little bit more competitive across the board and that would impact us.

Yes, Tony this is Mike. Let me just put a little more color on that, I think the revenue that our mid-point guidance implies is not really exciting as far as we have been used to so it's suggesting that the growth is not there in all of our businesses like we have been used to in the past. So in these conditions we are just assuming that our customers are going to be more demanding on pricing when it comes to any deals of any size because there is more people chasing fewer deals right now. So I think that’s a piece of this in addition to the inventory.

Okay and I guess that sort of leads into my next question implies about 3% sequential. Could you just remind me what you kind of think about as far as what it's tough to think about what a normal world is these days but what is normally the December quarter sequential increase would you say?

You know over the years it seem like -- and this was pre-us acquiring Brasil. It seemed like we would always have like a 10% sequential uptick quarter-to-quarter rough numbers not -- 7% to 10% and that was generally driven by if we would have a big deal quarter or not and the big deals typically in the December quarter were led by point of sale and barcode and as you heard on the call our big deals were not only fewer but the average size of the big deal was less than it has been in prior year. So that’s why we are somewhat cautious of the top line. It implies not a significant improvement in big deal activity so there is a sequential increase as you can see at the mid-point we are sequentially up $20-some-odd million but on a normalized -- again to your question on normalized I would have expected that to be higher but again in this environment as everybody knows we don’t have a backlog, every day we have to start over and when big deals are fewer then we have even less visibility than we have normally which is almost none.

Okay and then I guess my last question is just maybe you can talk about any progress with the discussions with your vendors as it relates to resetting the bar for the program goals maybe you can talk about the margin impact there and maybe when you might get some relief from that?

We certainly continue to have these conversations. I would say we have had some assistance from some of our vendors. Most of them are stuck themselves in this budget challenge in their companies and they said we got a number, we gave you your share of our number and you need to deliver, we’ll work with you but I think we won't see any additional help or any significant and so implied in our guidance is no significant help. We would hope at January would change that.

We can go on to our next question. Goes to Michael Sonoey [ph] with Oppenheimer.

Within the communication segment, I was wondering if you can just go a little deeper in what areas you expect to do well in the December quarter and then what some of the negative offsets will be excluding the Juniper transition.

Sure. This is Mike. Normally for us in the December quarter, again if and it's hard to say what normal is anymore. We have established like everybody else has, it's very, very difficult to estimate what the market will be but if you look back at our company we have in the communication side in the December quarter typically seeing somewhat of a down quarter from September and that was led historically by what changes with the Avaya who is our principal supplier there and a Avaya typically would have a much higher September quarter and that would lead to a lower December quarter which was traditionally their first fiscal quarter. They have I would say that trend has smooth out over the last couple of years but we don’t see the big swings in September to December. So we don’t expect that to be an impact. We have seen throughout this year good results from Polycom. We have had good results there and as you know I think that we added ShoreTel in the U.S. over a year ago and so we benefited from that ShoreTel business that they transition resellers to us, that transition has mostly happened and we are not working with these new customers that we have been recruiting for ShoreTel successfully. The new customers have to ramp up and so they will be if you’re looking for the “negative” there will be less ShoreTel business growth year-over-year because now we are competing against the year-ago quarter where we had the transition business already established in our numbers. Does that make sense?

Yes that does make sense. What about on the networking side, you mentioned strong sales from Aruba. So I guess on the enterprise level but more on the networking side what’s really doing well and what’s I guess going to be an offset in December.

Yes sure. So what’s interesting about the wireless networking products at ScanSource and what’s different about them too is -- we sell the wireless networking products across almost all of our business unit. So we house them in specific ones so as we said Ruckus is housed in our security business unit, Aruba in our Catalyst business unit. The customers buying these are our customers across barcode, POS, security and communications and what they are doing and what we are hearing is due to the smartphones and tablet trends that are happening and in addition to other devices coming into workforce, we are seeing that our customers are been asked to come in and replace the existing wireless infrastructure to accommodate more bandwidth, more devices, faster throughput, new technology. So because we represent the premier brands in wireless we found that our success with those brands is significant and we have been participating with them in the growth in that part of the business so that has been growing somewhat independently of the other products we sell in those product lines. So if we are not selling a lot of barcode scanners it doesn’t mean we are not selling a lot of wireless networking because that’s the hot market right now for our customers.

Okay and then just lastly, going through your transcripts I think you quantified the Juniper impact being $41 million last quarter. I’m just trying to figure out if you back out Juniper kind of what the run rate revenue growth or decline is looking like going into the next quarter.

Well we indicated that the relationship was ending at the end of September and it was announced that it would end at the end of September in the end of the June quarter. So, it was announced on our last call, it didn’t happen during the quarter that the business moved away from us. The customers that were buying from us, are either buying other networking products from us or they're buying Juniper products from a different distributor. So we saw a significant decline in that $41 million. We are not going to quantify it at the call today but in our forecast we have almost no Juniper revenue in the forecast.

Our next question comes from Keith Housum with Northcoast Research.

This is actually John Barta online for Keith. And I guess the question I had was over the course of last year, we have seen a lot of vendors increase their service-based revenue and as we go forward and see you know hardware as a service or software as a service type offerings. I was wondering what type of opportunities you know there are for ScanSource as a business.

I will tackle that. We have had inquiries from our customers for over 2 years and we have modeled an offering that would require a third party financial institution to actually acquire the asset, though we are viewing this as a more a traditional sales fill for ScanSource. So we would still sell the hardware like we would in the past, we would then sell that product through a third party financial company let’s say for simple purposes a leasing company, they would then own the asset and the reseller would pay ScanSource back through the leasing company and then the end customer when we get billed by the leasing company on a monthly basis. So in that sense it's still a straight sale, normal revenue recognition for our company. We don’t see any change today in how we would do business in hardware as a service. We believe our customers business is going to be dramatically impacted and we know some of our customers are asking us as the distributor to carry the asset and bill the customer monthly but we don’t believe that’s the proper role for a distributor with our balance sheet.

And then I guess a follow-up I had, did you mention on the call you’re opening an office with Polycom like a partner office or something along those lines? And I guess what is that do for you there?

Sure sorry about that John, let me be clear, we have an office already Lenexa, Kansas. It's our office that we acquired when we bought a company called T2 Supply in 2006. This is where we have a strong and large presence of our internal Polycom sales team and Polycom did not have within that geographic region of the Midwest a local executive briefing center where they can send their customers and their resellers to showcase Polycom video equipment and they worked with ScanSource, we had some extra space in our building and we agreed to house this equipment, provide an area for resellers to entertain, their end users. It has a separate entrance into our area but we are going to be able to use this as a way for our team to see how customers react to Polycom’s latest and greatest products and it will be a great place for Polycom to send customers. We think it's a win-win for ScanSource, Polycom and then of course for our reseller customers. So it's a demo center, where resellers can bring their customers to a live demonstration between 1 office say in Kansas and they could hook up to the Polycom headquarters out in California.

Okay does that kind of tie in within their new video conferencing as a service model?

It's not as a result of that but it certainly will be additional help to how they are going to go forward with that offer yes.

[Operator Instructions]. It doesn’t look like we have any questions at this time.

Okay. Thanks operator. Thank you everyone for joining us. Our next conference call to discuss the December 31, quarterly earnings is expected to be on January 24, 2013. Thank you.

Thank you for participating in today’s conference. You may disconnect at this time.