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PC Connection, Inc. (NASDAQ:PCCC)

Q3 2008 Earnings Call Transcript

October 30, 2008, 11:00 am ET

Executives

Stephen Baldridge – SVP, Finance & Corporate Controller

Patricia Gallup – Co-Founder, Chairman & CEO

Jack Ferguson – EVP, Treasurer & CFO

Timothy McGrath – EVP, Enterprise Group

Analysts

Brian Alexander – Raymond James

Operator

Good day, everyone, and welcome to the PC Connection third quarter 2008 financial results conference call. This call is being recorded.

At this time I would like to turn the conference over to the Senior Vice President of Finance and Corporate Controller, Mr. Stephen Baldridge. Please go ahead, sir.

Stephen Baldridge

Thank you, and good morning, everyone. This is Steve Baldridge, Senior VP of Finance and Corporate Controller. Patricia Gallup, Chairman and CEO; Jack Ferguson, Executive Vice President and CFO; and Tim McGrath, Executive Vice President, PC Connection Enterprises are also here with us today.

We're pleased to have you join us today for PC Connection's 2008 Third Quarter Conference Call. If you haven't already seen our press release, you can contact Janice Rush at 603-683-2322 and she will fax or e-mail a copy to you immediately. You can also view it on our Web site. Today's call is also being webcast and will be available from PC Connection's Web site.

I would like to inform our participants that 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 we 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 risk factors in the Company's quarterly report on Form 10-Q for the quarter-ended June 30, 2008, which is on file with the Securities and Exchange Commission.

In addition, any forward-looking statements represent our views only as of today and should not be relied upon us representing our views as of any subsequent date. While we may elect to update forward-looking statements at some point in the future, we specifically disclaim any obligation to do so even if our estimates change. Therefore, you should not rely on these forward-looking statements as representing our views as of any date subsequent to today.

I'm now going to turn the call over to our CEO, Patricia Gallup for her remarks on our quarterly results. Pat?

Patricia Gallup

Good morning. Thank you for joining us to review the results of the third quarter of 2008.

Net sales in Q3 decreased $15 million or 3% to $441 million from $456 million for the third quarter of 2007. Declines experienced in the SMB and Large Account segments were partially offset by increased public sector revenues. Net income for the third quarter of 2008 was $3.2 million or $0.12 per share compared to $7.7 million or $0.28 per share for the prior year quarter.

As stated in our press release, quarter-ended September 30th 2008 included $1.4 million of special charges related to work force reduction and management restructuring. Had these charges not been incurred, pro forma net income for the current quarter would have been $4.1 million or $0.15 per share. No special charges were incurred in the third quarter of 2007. Our press release includes a reconciliation of this pro forma amount.

I will begin by commenting on our SMB segment, our original core business. Net sales decreased by $17.4 million or 7% from the third quarter of 2007 to $217 million. Our corporate outbound sales to small and medium-sized businesses for the quarter decreased by 6% year-over-year, reflecting the industry wide slowdown in purchasing patterns from our SMB customers. Consumer sales decreased by 21% year-over-year, reflecting our continued focus on commercial account growth.

Sales to large corporate account customers reported as our Large Account segment, decreased by $12.7 million or 10% to $117 million from the corresponding prior year quarter.

Our MoreDirect subsidiary experienced decreased revenues from enterprise accounts that have curtailed IT spending in reaction to the economic instability of the past quarter. Both our SMB and Large Account segments continue to be challenged in this uncertain business environment.

Sales to government and education customers however reported as our Public Sector segment continued to be a quarterly highlight. Revenues for our federal, state and local government and education customers increased by 16% from the third quarter of 2007 to $107 million with our federal business increasing by over 40% year-over-year due to the additional sales realized under federal contract program.

Consolidated gross profit dollars decreased year-over-year in the third quarter of 2008 by 7% or $4.2 million to $53.3 million. Gross margin, representing gross profit as a percentage of net sales, was 12.1% in the third quarter of 2008 compared to 12.6% in the third quarter of 2007. Gross margin rates decreased year-over-year this past quarter due to decreases in invoice profit margin and agency fee revenues only partially offset by an increase in vendor consideration realized over the prior year quarter. We have implemented a number of gross profit improvement initiatives, including growth in the level of service calls, reduced discounting of freight revenues and improved administration of vendor rebate program.

SG&A expenses increased to $46.9 million for the third quarter of 2008 compared to $45.6 million for the third quarter of 2007, a 3% increase. The dollar increase was primarily due to investments in key strategic initiatives and sales system enhancements, which we expect will improve sales productivity beginning in 2009 and additional growth in sales personnel.

SG&A expense as a percentage of sales was 10.6% for the quarter compared to 10% for the prior year period, as a result of the weaker demand environment and previously mentioned costs.

Given the softness in customer demand, management began actions in the third quarter to reduce costs to be in line with lower sales volume. We reduced headcount in sales support areas and implemented various operating cost reduction programs that are expected to result in annualized savings of approximately $6 million.

Income from operations for the quarter was $5 million or 1.1% of net sales compared to $12 million or 2.6% for the third quarter of 2007. And as I reported earlier, pro forma net income for the quarter was $4.1 million compared to $7.7 million for the third quarter of 2007.

On a consolidated basis, average annualized sales productivity for the third quarter decreased by 6% from the prior year. Average sales productivity in our SMB segment decreased by 11% year-over-year due to the hiring of additional sales personnel. In the Large Account segment, sales productivity decreased by 4% from the third quarter of 2007. Overall sales productivity for our Public Sector segment increased by 10% due to gains achieved under a number of recently awarded federal contract vehicle and new higher education customers, partially offset by higher headcount. We ended the quarter with 666 sales representatives, up 3% from 645 representatives at the end of the prior year quarter.

Now on to Q3 product sales trends. Our largest product category was Notebook and PDA, which accounted for 16% of total sales. Video, Imaging and Sound was the second largest selling category, accounting for 15% of overall sales. And both Software and Desktop Server sales accounted for 13%.

For the second consecutive quarter our Net/Com products category showed the highest year-over-year growth rate at 22%, reflecting industry demand for total solutions sales. Average Selling Prices or ASPs for computer systems decreased year-over-year by 8% in Q3 2008 but increased by 2% compared to the second quarter of 2008. Q3 Notebook and PDA revenues decreased by 2%, and desktop and server revenues decreased by 10% year-over-year, due primarily to lower ASPs.

We continued to invest in Service Connection and Pro Connection, our services initiative, through increased levels of sales training and targeted promotion to our customer base. We believe these investments strategically position PC Connection to capture a larger portion of the services market.

We will continue to monitor our operating costs and review our spending plans and programs to enable the best possible allocation of our resources. However, we will continue to invest in the sales, marketing and technology programs we believe are necessary to ensure our future growth and prosperity.

I am sure many of you read that we were recently honored by InformationWeek Magazine. PC Connection was awarded first place in both the supply chain innovation and the retail industry categories, and we were ranked Number Eight overall in their list of the nation's top 500 business technology innovators.

And now Jack Ferguson will discuss our financial results in more detail. Jack?

Jack Ferguson

Thanks, Pat. First, the cash flow. Cash flow provided by operations for the nine months ended September 30, 2008 was $42.9 million compared to $8.9 million for the prior year period. Majority of this increase was due to a reduction in accounts receivable in 2008 which ultimately improved cash flow.

Capital expenditures in the nine months ended September 30, 2008 were higher than in the prior year period, amounting to $8.7 million in 2008 compared to $5.2 million in 2007. As noted last quarter, we completed an extensive internal desktop upgrade in Q1 of '08, which accounted for much of this increase.

Financing activities in the nine months ended September 30, 2008 represented a $1.2 million use of funds compared to a $2.4 million source of funds for the prior year period. In 2008, we purchased $1.2 million of our outstanding common stock treasury; whereas in 2007, we exercised a stock option provided $2.5 million in cash.

Our cash balance increased by approximately $33 million in the nine months ended September 30, 2008 compared to a $6 million increase in the comparable period last year. Our cash flow has remained strong with no outstanding quarter end borrowing from our credit facility.

Turning now to the balance sheet, accounts receivable as of September 30, 2008 decreased by $19 million to $183 million compared to the balance at December 31, 2007. Days sales outstanding were 43 days as of September 30, 2008, compared to 45 days as of September 30, 2007.

Inventory balances decreased by about $400,000 compared to the year-end balance. Correspondingly, inventory turns were unchanged at 22 this quarter compared to the prior year quarter. We believe inventories are in excellent condition, both in quantity and in quality.

Net sales of products drop-shipped by distributors and other vendors directly to our customers accounted for 56% of total net sales in the third quarter of 2008 compared to 52% in the third quarter last year. We continue to focus on increasing drop-shipments where appropriate and cost effective, which allows us to maintain lower overall inventory level. In summary, the balance sheet remains very healthy.

We will now entertain your questions. Operator?

Question-and-Answer Session

Operator

(Operator instructions). We do have first question from Brian Alexander with Raymond James.

Brian Alexander - Raymond James

Thanks. Good morning, guys. If you could just talk about the progression of revenue during the quarter, particularly in SMB and large corporate and to what extent those trends weakened throughout the quarter, and then into October, since we've already effectively completed the month here. Have you seen any stabilization in the SMB or the large corporate space, primarily? Thanks.

Timothy McGrath

Good morning, Brian. This is Tim, and I will take that. So, overall, the calendarization throughout the quarter was similar to what we've experienced in the past with an increasing rate of sales throughout the quarter. On a segment basis, SMB and enterprise were both soft throughout the quarter. Again, although the months did progress as you would expect, they were both soft. Public Sector, the sales demand was solid throughout the quarter. So looking into October, we are seeing still that softness in demand in both our enterprise and SMB segments. So while it's too soon to call the quarter I would say that for now this trend continues.

Brian Alexander - Raymond James

And just to make sure I understand that trend, when you look at it on a year-over-year basis for each month, did each month throughout the third quarter get progressively worse on a year-over-year basis? And has that rate of deterioration continued into October? I realize that the overall quarter was soft and you probably saw better sales in September than you did in July and August. But I'm just wondering on a year-over-year basis was there a continued deterioration over the last four months?

Timothy McGrath

So, Brian, if I understand the question correctly, in percent terms, it's fairly consistent to year-over-year in terms of percent of business done in that month. There is no doubt that it's softer and we did see in the mid month of the quarter some real softness. We did recover in September and we are off to a soft start to October.

Brian Alexander - Raymond James

Okay. So it doesn't sound like we've seen any sort of change in that trend. On the pricing front, you mentioned competitive pricing, and I'm just wondering if that was across segments, across product lines. Or was it more specific within certain product categories, certain customer sets, et cetera?

Timothy McGrath

Hi, Brian, and I will take that one as well. So I think there are probably two components that we are seeing regarding pricing and then influencing demand. First, the continued ASP decline, and we are seeing that, of course, across all three segments. But more than that, the competitive pressures that we're seeing, I think, are fairly consistent out in the competitive landscape. Customers are pushing out and delaying purchases, and when purchases are deemed to be mission critical and we are going forward, we are seeing more bidders and we are seeing a lot more competition. So I think that's fairly common in a down market. So that has put a little margin pressure on the business.

Brian Alexander - Raymond James

Okay. With respect to vendors and their rebate programs, I'm just wondering, to what extent, are they working with you, for lack of a better term, during this period? Obviously, things are tough out there for everyone. And so in this kind of environment, should we expect that the gross margin trends will get worse because you are not going to be able to reap as much from the vendor programs? Or are they working with you to reset those such that there shouldn't be any negative impact to your gross margins?

Steve Baldridge

Hi, Brian, this is Steve Baldridge. I'll make a couple of comments -- if Tim has anything to add after that. From a pricing perspective, as Tim noted, we experienced lower invoice margins across all three segments. But one of the solid or stronger points for us during the quarter was that our back end vendor consideration improved 24 basis points on a consolidated basis year-over-year. So we've experienced some positive scenarios with our vendors in terms of driving improved vendor consideration. We have done that with really new product and service certifications being driven by our Pro Connection Professional Services Group and our Product Management Group. There has been sales growth in solution categories that are highly funded by vendor programs. And finally, just execution by our team in maximizing vendor funding opportunities that are available.

In terms of what we see vendors doing, at least for the remainder of this year, while the vendors continuously update rebate and other consideration programs to enhance their market share through distribution, we have not witnessed noticeable changes in the level of rebate programs and back-end consideration for the remainder of this year. And we are working closely with our vendors for 2009 and trying to understand any changes, changes, if any that will occur and how we as an organization can continue to maximize the vendor opportunities that are outstanding.

Brian Alexander - Raymond James

And then my -- sorry I think I interrupted somebody.

Timothy McGrath

That's fine.

Brian Alexander - Raymond James

My final question would just relate to the credit environment. And I guess I'm surprised, not just on your call, but on several other calls for distributors and resellers that we haven't really witnessed any direct fall out from the credit crisis that we are going through right now. I would imagine a company like PC Connection that has a fairly high percentage of your business coming from small businesses out there that are having difficulty accessing credit, et cetera, that we would see more deterioration and ageing in bad debts. Perhaps there's more of a lag effect than maybe I'm -- than maybe I'm contemplating. So can you just kind of help me think about -- how do you guys think about the credit environment and its impact on your business and why haven't we seen any stretching of DSOs or increase in bad debt experience? Thanks.

Jack Ferguson

This is Jack. I'll take that one. We haven't really seen much of this issue so far in our credit -- in our account. We watch our credit exposure very closely and because of this current economy we've even intensified those efforts. So I think while we watch we have actually reduced credit lines for certain of our customers. I think still the quality of our current account portfolio is good. Customers are paying reasonably timely, and we believe the reserves are adequate. So while we will continue to watch that exposure I don't think we have seen that. I think we are ahead of the curve a little bit such that we don't see such a significant impact on the credit that affects sales, particularly.

Brian Alexander - Raymond James

Okay. That's it from me.

Operator

(Operator instructions). It appears there are no further questions at this time. I would like to turn things over to Patricia Gallup for any additional or closing comments.

Patricia Gallup

Thank you, operator. I'd like to thank all of our customers and vendor partners for their business and support. I would also like to thank our dedicated co-workers for their efforts and everyone listening on the call this morning. We appreciate your time and interest in PC Connection. Have a great day.

Operator

That does conclude today's conference call. Thank you for your participation. You may disconnect at this time.

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