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PC Connection (NASDAQ:PCCC)

Q4 2012 Earnings Call

January 31, 2013 4:30 pm ET

Executives

Timothy J. McGrath - Chief Executive Officer and President

Joseph S. Driscoll - Chief Financial Officer, Senior Vice President and Treasurer

Operator

Good afternoon, ladies and gentlemen, and welcome to the Fourth Quarter 2012 PC Connection Inc. Earnings Conference Call. My name is Sean, and I will be the coordinator for today. [Operator Instructions] As a reminder this conference call is being recorded and is the property of PC Connection and may not be recorded or rebroadcasted without specific permission from the company.

On the call today is Tim McGrath, President and Chief Financial -- Chief Executive Officer; and Joe Driscoll, Chief Financial Officer.

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 Factor section of the company's annual report on Form 10-K for the year ended December 31, 2011, which is on file with the Securities and Exchange Commission, as well as in the 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. If you have not already seen the press release, you can contact Janice Rush at (603) 683-2322, and she will e-mail a copy to you. You can also view it on the company's website. Today's call is being webcast and will be available on PC Connection's website.

I would now like to turn the call over to Tim McGrath. Please proceed, sir.

Timothy J. McGrath

Good afternoon, everyone, and thank you for joining us today to review the company's fourth quarter and annual 2012 financial results.

During the quarter, the IT market continued to be challenging due to ongoing tough market conditions. Concerns related to potential tax increases, federal spending cuts and the overall softness in the economy resulted in customers delaying IT investment spending. 2013 is projected to be a slightly improved growth environment for IT spending, but still in the low single-digit range.

We will continue to execute our core strategies, delivering a broad spectrum of IT solutions, increasing our market share and investing in our cloud computing practice, Cloud Connection, enhancing our operational capabilities and driving productivity gains. Our company-wide focus on these goals resulted in a solid Q4 and annual performance.

As we review our results, please note that unless otherwise stated, all of our fourth quarter 2012 comparisons are being made against our fourth quarter 2011 results.

Net sales for the quarter increased year-over-year by 1% to $556 million. Sales to our Public Sector and Large Account customers increased year-over-year by 9% and 3%, respectively. Sales to our small and medium-sized business increased 1% year-over-year, however, weakness in our consumer sales resulted in an overall year-over-year decrease of 5% in the SMB segment.

Our Healthcare business remains strong as revenue increased 23% over the prior year quarter. We are taking market share in this strategically important component of our business.

We continue to invest in and focus on improving our operations and expanding our solution sales capabilities. Our standards of excellence include data center, software, mobility, storage, Net/Com and life cycle services. We expect to continue to invest in these important practice areas, which are part of our branding and strategy for Cloud Connection.

Our adjusted EBITDA increased 25% in Q4 versus the prior year quarter. Net income for the quarter increased by 19% to $8.9 million and diluted earnings per share increased from $0.28 per share in 2011 to $0.33 per share in 2012.

We continue to strive to increase earnings per share at a faster rate than the growth in sales by focusing on improving gross margins and controlling costs. Gross profit dollars in the quarter increased by $3 million or 4% to $71.7 million. Gross margin increased to 12.9% compared to 12.4% in the prior year quarter. Our strategic focus on solution selling has resulted in 10 straight quarters of year-over-year margin growth.

We are managing our costs as we expand our gross margins. Due to tight cost controls, our total SG&A for the quarter remained relatively flat year-over-year in both dollars and as a percentage of net sales.

As you know from our previous calls, we are implementing our Customer Master Data Management or MDM project. We're confident that this initiative will enhance our capabilities to better serve our customers and provide a platform for additional opportunities to sell more products and services.

The project will be implemented in 2013 and we expect depreciation expense for this project to add approximately $2 million in annual SG&A expenses.

On an annual basis, demand was affected by softness in the macroeconomic IT environment and concerns about potential tax increases on the horizon.

Sales growth rates for the industry are projected be in the low single digits in 2013 as these issues continue to impact IT spending. 2012 net sales increased 3% over 2011 to $2.2 billion. Increased sales to our small and medium businesses, Large Account customers and government and education customers contributed to the revenue increase.

Our Large Account segment had the highest increase with 2012 sales increasing by 9% over the prior year. Our Public Sector sales increased by 3% in 2012 over the prior year, with higher sales to both federal and state and education customers contributing to the increase.

Sales for our small and medium businesses increased by 3%, however, this increase is offset by a decline in consumer revenues, resulting in an overall decrease of 2% in 2012 for the SMB segment.

Annual gross profit dollars increased by 6% to $282 million in 2012 compared to 2011. Each of our segments improved gross margins and as a result, margin increased year-over-year by 50 basis points to 13.1%.

We've continued to look for ways to drive growth and expand margins, primarily by focusing on higher-end solution sales.

SG&A expenses increased as a percentage of net sales from 10.3% in 2011 to 10.5% in 2012. The increase was due primarily to investments in our service, support and solution selling areas, as well as higher variable compensation related to increased sales.

Included in our 2012 results were pre-tax charges of $1.1 million related to retirement and severance benefits. Our adjusted EBITDA, which is adjusted for stock-based compensation and the special charges, increased by 16% in 2012 to $63.3 million. Pro forma net income, excluding special charges, increased 19% to $33.8 million or $1.27 per share in 2012 compared to $1.07 per share in 2011.

And now I'll discuss the quarter results for our business segments and cover some product trends.

The top product trends in the industry are mobility, cloud, big data and software. We're focused on delivering solutions that help our customers execute their business strategies in these critical areas with customized IT products and services.

Net sales for the SMB business segment were $228 million in the fourth quarter of 2012. Sales of small and medium businesses increased by 1% year-over-year, however, when combined with a lower consumer sales, the overall segment decreased by 5%. Gross margin for SMB increased by 60 basis points, resulting in a 14.6% margin. Our SMB segment continues to have the highest gross margin of our 3 business segments.

Sales by our Large Account segment increased this quarter by 3% to $202 million. Gross profit dollars increased by 6% and the margin rate increased from 10.8% to 11.2% during the quarter as a result of our strategic focus on improving results through higher margin sales.

Quarterly sales in the Public Sector, which consists of sales for government and education customers, increased by 9% to $125 million. We gained share in the quarter in a challenging Public Sector environment. Sales to local government and education customers increased by 7.5% and sales to the federal government increased by 10.7% year-over-year.

Gross margin for the Public Sector increased by 60 basis points compared to Q4 of last year. We continue to increase gross margin in the segment with 8 straight quarters of year-over-year margin improvement due to our focus on higher-margin solution sales.

In each of our business segments, we continue to invest in people, systems and infrastructure to fuel future sales growth and improve operational efficiencies. We are focused on developing and maximizing service capabilities and our Cloud Connection practice area in order to drive growth in this strategically important market.

And now Joe Driscoll will discuss our financial results in more detail. Joe?

Joseph S. Driscoll

Thanks, Tim. In summary, our bottom line results for the quarter were solid, especially considering the continuing macroeconomic concerns.

Earnings per share increased from $0.28 to $0.33 per share in the quarter, an increase of 18%. On a year-to-date basis, pro forma EPS increased 19%. This is our third straight year of double-digit earnings growth. Gross margins were well above the prior-year period and we generated significant positive cash flow in 2012 from improved profitability and working capital management. Our cash balance was approximately $40 million and we had 0 bank debt outstanding at December 31, 2012.

We had 2 significant cash transactions in the fourth quarter. The first was a $10.1 million special dividend. This was the second year in a row that the company has paid a special dividend. We believe this transaction was a significant reward for our shareholders, especially given potential changes in tax laws related to dividends.

The second transaction was the purchase of a total of 600,000 shares of common stock from the 2 large shareholders for approximately $6.3 million. This transaction will be accretive to future earnings as it will reduce diluted shares outstanding to approximately $26 million from $26.6 million.

The company had sufficient cash on hand to execute the dividend and the purchase of treasury shares as evidenced by the year-end cash balance of approximately $40 million. We will continue to look for ways to enhance shareholder value in the future as opportunities present themselves.

Cash flow provided by operations for the year ended December 31, 2012, was $69.7 million compared to cash used of $5.3 million in 2011. The primary driver for the increase was a $26 million decrease in accounts receivable.

Days sales outstanding or DSOs were 41 days as of December 31, 2012, compared to 47 days as of December 31, 2011. In addition, inventory levels decreased by $8 million from December 2011 due to tighter working capital management.

Capital expenditures in 2012 totaled $9.3 million compared to $10.9 million in 2011. These expenditures were primarily related to our Customer Master Data Management project, which we expect to place into service in 2013.

According to market research and announcements from other technology companies, 2013 is projected to be a slightly improved growth environment in IT spending. As we look to develop opportunities in the coming year, we feel it is critical that we maintain a strong core and focus on margin improvement, cost controls and cash flow.

We will now entertain your questions. Operator?

Question-and-Answer Session

Operator

[Operator Instructions] I have a question from Brian Alexander with Raymond James.

Unknown Analyst

It's actually Arry [ph] on the call for Brian today. So last -- this last quarter and this quarter, you mentioned that both state and local education as well as federal were strong and just with what's kind of swirling around about federal budgets. Do you kind of think that, that momentum can continue? Do you think you can continue to take share even as the budget declines?

Timothy J. McGrath

Yes, obviously, we're watching what's happening with the federal government and certainly, that could have a potential effect on us, but we do think that we're well positioned. We've got a number of contract vehicles in place and we think that in this marketplace, we can continue to take share.

Unknown Analyst

Got you. And how much -- if you'd be able to quantify, how much is Healthcare of that because it's a strong burn segment?

Timothy J. McGrath

Actually, that's a great question. As I mentioned, it's a really important vertical that's growing for us, but we don't include Healthcare in the Public Sector subsidiary, in GovConnection. Healthcare is booked over all 3 subsidiaries. We have an overlay company, HealthConnection, that helps provide support in marketing to all of our divisions to help drive Healthcare and serve of our customers.

Joseph S. Driscoll

Yes, so that the fastest-growing piece of our Healthcare is actually in the Large Account space.

Unknown Analyst

Got you. If I may have another. Just wondering, your outlook for IT spending, you're saying low double digits now, this year.

Joseph S. Driscoll

Low single digits.

Unknown Analyst

I'm sorry, low single digits, excuse me. Now this year, probably see that clocking at less than 2%, so do you think that you guys will still be able to grow faster than the market in 2013?

Timothy J. McGrath

Yes, I do. So you're right, this year, I think our guidance said about 1.7% before the year ended up for IT spending and, of course, the GDP announced today, down at about 2% and our goal has always been to try to grow it at about double the rate of the GDP and IT spending. So we think that the low- to mid-single digit is about the right range for us to target.

Unknown Analyst

Got you. And now just turning to the gross margin. I've noticed that average order size has been kicking up over the past few quarters. Is that kind of what you were talking about, you'd focus on more solution selling?

Timothy J. McGrath

Yes, so as we focus on the advanced technologies and really helping the customers solve their business problems with IT solutions, it tends to be a much more comprehensive approach and they are higher-margin products. So it's a mix issue and the storage systems, the servers, the software are higher margin for us.

Unknown Analyst

Got you. And then, again on, I guess on that issue, you mentioned servers and, I guess, you called that in the press release that those were weak again, and probably what -- Gartner data probably is saying it's going to be down at 1% to 2% on the year. Do you guys feel that, that market might be stabilizing a little bit, or what's your general sense from your customers?

Timothy J. McGrath

So I -- really, first, I have to put it in perspective. We're looking at -- in Q4, we're looking at year-over-year comp. In Q4, we had a pretty tough comparable with some very large server rollouts in Q4 '11 as compared to '12. So that, of course, is the driver. And then we look at the growth that we're seeing in cloud and virtualization and some of the other trend data and, of course, that's the driver. But we did execute forward with strong backlog. We are seeing some points of light with our customer projects and we do anticipate that our data center practice area, combined with some of the market trends will start to bring the server mind back certainly. You'll also note that we combined desktops and servers in the category and now we have terrific growth with the notebook category, desktops and servers were a little below that, but desktops also weighed on that category.

Operator

[Operator Instructions] I have another question from Brian Alexander.

Unknown Analyst

It's Arry [ph] again. Just wondering if you could speak a little bit more about your Cloud Connection platform and how is that -- how are you really using that to kind of address some of the trends that you mentioned, mobility, big data, especially big data, I guess?

Timothy J. McGrath

So thanks, Arry [ph]. What we're doing is we have 6 major practice areas that we call ProConnection. They are data center, lifecycle, storage, Net/Com and software. And so I think that was all 6. And so what we find is that overlaying solution architects and experts over the top of all of the practice areas who can also help with specific cloud issues are really -- have been very beneficial. So that's a program that we started last quarter and we're rolling out in full force this quarter. But for example, if you're engaging a customer and helping them with their IT needs, you might be having a data center conversation, which quickly turns into a virtualization and software or security conversation, which may turn into storage or power and cooling. So we find that we need solution architects who can speak to all of those areas in a very technical and confident way to help our customers navigate through. So we will help our customers enable their clouds, whether that's a private cloud or a hybrid strategy, and through Cloud Connection, we're aggregating cloud services and Software-as-a-Service together to offer very select partners to our customers based on their specific needs.

Unknown Analyst

I see. Another question, I guess which kind of has come up in some of distributors who I imagine you are their customer. They've had issues implementing these new ERP systems and I was wondering, would you say that your MDM system is something kind of like that and Tech Data, for example, has had trouble executing in the U.S. because of the difficulty in implementing that system and getting the sales force ramped up on that. So if you could just kind of maybe talk to how -- is this MDM system kind of similar to what they're -- what they implemented?

Timothy J. McGrath

Thanks, Arry, it's a great question. MDM stands for Master Data Management, and really, what we're doing is we're consolidating all of our databases together. So as you know, we have some subsidiaries. We have an e-commerce business, we have a customer database, an operating database. By bringing all the data together, it really becomes a foundation, and it is absolutely the database layer. It is not as you compare it to distributors and ERP rollout. So better data gives us better marketing capabilities, gives us a much better approach to our customers using analytics, to be more proactive to their needs and start to predict some of those needs. But it is not an ERP solution. It is very much a database layer and a foundational solution. So we don't see that there's any risk to interrupting any business with our customers because it really is not that type of a system upgrade.

Unknown Analyst

So it's not like a CRM or anything like that?

Timothy J. McGrath

No. So we have a -- CRM systems and you could layer CRM on top of it, but ERP is -- excuse me, MDM is strictly Master Data Management and a database upgrade, not CRM and not ERP.

Unknown Analyst

I see. Okay, okay. And then I guess maybe the biggest question, like you said, 10 straight quarters of gross margin expansion. It's -- what do you see as kind of the long-term goal for that, like where do you see like the -- maybe if you kind of have a target goal or maybe like a plateau level that you'd like to reach?

Timothy J. McGrath

Sure. So I'll kind of lead it off, and then I'll have Joe just kind of follow it up. If you look at our business plans, we're very focused on top line growth and bottom line profitability. And as you know, finding that balance sometimes is tricky. We have found that transitioning into solutions and providing more solutions to our customers does yield some higher margins, but we're very conscientious of that balance between growth and margin expansion, and so we've done a nice job expanding margin, but growth is also on the agenda.

Joseph S. Driscoll

We're not giving any specific guidance. We would love gross margins to keep going up and up. We don't have a specific target in mind, but I'm going to echo what Tim said, there is a balance there. If you grow faster, it's quite possible that the margin percentage would not grow at the same rate if you take on more larger deals, which might be more competitively bid out. Your margin doesn't necessarily go up on deals like that. So there's a balance there. We are absolutely striving to grow the margin, but I'm not sure we're going to project it or predict it at this time.

Operator

I'm not showing any other questions in the queue. I'd like to turn it back over to Tim McGrath for closing comments.

Timothy J. McGrath

Thank you, operator. So during the fourth quarter, we continued to drive gross margin improvement and double-digit earnings growth while facing soft demand due to the macroeconomic environment.

Overall, 2012 was a strong year for the company as evidenced by our 19% growth and pro forma earnings per share and the $70 million in cash we generated from operating activities.

Our performance enabled us to pay a special dividend to shareholders for the second year in a row, fund our capital expenditures related to enhancing internal IT systems and purchase common stock at an accretive transaction.

In 2013, we're focused on top line growth and improved bottom-line performance to enhance earnings and shareholder value.

Thank you for joining us for our 2012 year-end earnings call. I'd like to extend a special thanks to all of our customers, vendor partners and shareholders for their continued support and our dedicated coworkers for their efforts. Your time and interest in PC Connection are appreciated. Have a good evening.

Operator

Thank you. Ladies and gentlemen, thank you for your participation in today's conference. This does conclude the conference. You may now disconnect. Good day.

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