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PC Connection (NASDAQ:PCCC)

Q2 2013 Earnings Call

August 01, 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

Analysts

Jared Schramm - Roth Capital Partners, LLC, Research Division

Brian G. Alexander - Raymond James & Associates, Inc., Research Division

Operator

Good afternoon, ladies and gentlemen, and welcome to the Second Quarter 2013 PC Connection, Inc. Earnings Conference Call. My name is Ben, and I'll be the coordinator for today. [Operator Instructions] As a reminder, this conference call 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 Executive Officer; and Joe Driscoll, Chief Financial Officer. Any statement or references made during the conference call that are not statements of historical facts 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 the 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, 2012, which is on file with the Securities and Exchange Commission, as well as in other documents 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 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 the 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 second quarter financial results. During the quarter, the IT market showed continued softness in overall spending trends. Despite the challenging environment, we had a solid quarter, and we delivered growth in sales, gross margin and earnings per share.

We continue to execute our core growth strategies to deliver a broad spectrum of IT solutions, increase our market share, invest in Cloud Connection, enhance our operational capabilities and drive productivity gains. Customers increasingly need our help as they work through complex IT challenges, including issues such as bring-your-own-device cloud computing and maximizing big data.

In addition, our vendor partners are increasingly looking to the channel to help them reach these customers and provide the latest products and services to solve their technology-related challenges.

As we review our results, please note that unless otherwise stated, all of our second quarter 2013 comparisons are being made against our second quarter 2012 results.

Net sales for the second quarter increased year-over-year by $14.7 million or 2.7% compared to $557 million in the prior-year quarter. Our overall commercial business, which is a combination of our SMB and Large Account segments, grew by 2.8%. Our Public Sector sales increased by 2.5%, despite the challenges in this market related to the reduced federal government spending. Our healthcare vertical continued to be strong, with 25% year over year growth.

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

Net income for the quarter increased by 4% to $9.2 million, and diluted earnings per share increased from $0.33 in 2012 to $0.35 in 2013. We increased our earnings faster than the rate of sales growth by focusing on maximizing our margins and controlling costs.

Gross profit dollars in the quarter increased by 3%, and our consolidated gross margin increased to 13.3%. We are diligent -- we are diligently managing our costs as we continue to drive sales growth. Our SG&A expense dollars increased by $1.6 million. However, our SG&A rate remained consistent at 10.5%. We are continuing to invest in our solution sales capabilities, and as a result, we expect to add to our SG&A expenses as the year progresses. However, we are highly focused on improving efficiencies and streamlining operations wherever possible.

And now, I'll discuss the quarterly results of our business segment and cover product trends. Sales for our SMB segment, which serves small to medium-sized businesses, increased by 5.5% in the quarter to $242 million.

SMB net/com sales increased by 70% -- 17% due to growth in the enterprise networking. In addition, software sales increased by 16% due to higher demand of security, virtualization and operating system software. Gross profit dollars for SMB increased by 8% in the quarter, and gross margin increased by 32 basis points to 15.8%. The segment continues to deliver strong margins, as demand for value-added services from small to medium business customers continues to increase.

Sales by our Large Account segment were relatively flat this quarter at $196 million. Gross margin decreased from 11.6% in the second quarter of 2012 to 11.2% in the current quarter due to a slight change in product mix.

Software continues to be a growth category for our Large Accounts due to the addition of our Software team that we made in 2012. This team has been very successful in winning new business in the Large Account sector with strong growth in network management, security and licensing renewals.

Quarterly sales in the Public Sector segment, which include sales to our government and education customers, increased by approximately 3%. Sales to federal government decreased by $7 million or 22% from the prior year, whereas sales to state and local governments and education customers increased by 11% year-over-year. The federal government space continues to be challenging in light of the ongoing impact of federal budget constraints that began early in 2013. Note that the federal government only represents approximately 4% of the company's total Q2 2013 sales.

Gross profit dollars for Public Sector increased from prior-year quarter by 4%, and overall Public Sector gross margin increased from 11.3% last year to 11.5% in the current quarter.

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

Joseph S. Driscoll

Thanks, Tim. In summary, our results for the quarter were solid, especially considering the continuing macro-economic concerns.

Total net sales increased by 2.7% to $557 million, despite a 22% decrease in our federal government sector. We increased adjusted LTM EBITDA to $64.1 million, an increase of 8% from the prior-year number, and we generated positive cash flow in the first half of the year through improved profitability and working capital management. Our cash balance was approximately $64 million at quarter-end, up from $40 million at year-end 2012, and we had zero bank debt outstanding.

Cash flow provided by operations for the 6 months ended June 30, 2013 was $27 million. The primary sources of operating cash include $15 million generated from net income and an $11 million decrease in accounts receivable. Days sales outstanding or DSOs were 39 days as of June 30, 2013, compared to 41 days as of June 30, 2012.

We continue to efficiently utilize our inventory on hand as inventory turns for the second quarter of 2013 increased to 30 compared to 28 turns in Q2 2012. Capital expenditures in the first 6 months of 2013 totaled $4.3 million compared to $5.2 million in 2012.

Net cash provided by financing activities in the first half of 2013 totaled $1.6 million, which was primarily generated by proceeds from the exercise of stock options.

Net sales of products drop-shipped by distributors and other vendors directly to customers were 72% of total net sales in the second quarter of 2013 compared to 69% in the corresponding prior-year period. We continue to focus on increasing drop shipments where appropriate and cost-effective, which enables us to support our customers with lower inventory levels.

According to market research and announcements from other technology companies, 2013 is projected to be another challenging year. As we look to develop opportunities in 2013, we feel it is critical that we focus on our margins, cost controls and cash flow.

We will now entertain your questions. Operator?

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from the line of Jared Schramm of Roth Capital Partners.

Jared Schramm - Roth Capital Partners, LLC, Research Division

Looking at the Public Sector, you mentioned fed was down 22%, yet state, local, education was up 11%. Out of those 3 remaining in the category outside of the federal government spending, was there a bright spot there, be it state, local or education that really outshone?

Timothy J. McGrath

Jared, thanks. There was -- we did really well in the education and government space. Part of that was some category-specific growth. We did well with our solutions category very well, with networking, for example. And part of that, also, was Larger Account rollouts to some of the larger university and educational-type customers.

Jared Schramm - Roth Capital Partners, LLC, Research Division

And then looking at fed spending, looking back at the previous quarter, I think you mentioned it was down 29%, down 22% here. Your clients on the fed side, is there -- the visibility just that minimal right now you have in the back half of the year, I would assume?

Timothy J. McGrath

We don't have great visibility, but there is, obviously, the budget issues. There's no end date in sight to the challenges in the budget. However, there are some points of light out there in the market. Clearly, we're seeing some pent-up demand in some of the larger contract vehicles, and we're optimistic that we'll continue to battle through this, and vis-à-vis the competitive landscape, do pretty well.

Jared Schramm - Roth Capital Partners, LLC, Research Division

That kind of piggyback's on my next question here. Does this bring up some pent-up demand you expect to see, maybe not in Q3 here, Q4, but in maybe early 2014 when a lot of these budget issues may begin -- resolved to some degree?

Timothy J. McGrath

Yes, it's tougher to say, really. You probably have better data than we do, Jared, on that. Now there are some drivers of growth. For example, early in 2014, Windows XP, as you know, will no longer be supported, so the expiration is coming. That may be a stimulus for demand. Just simple -- by delaying projects, there may be some pent-up demand. But overall, we're very cautious with that segment of the business. As we mentioned, it is only 4% -- or in Q2, it's only 4% of our overall revenue.

Jared Schramm - Roth Capital Partners, LLC, Research Division

Looking at SMB now, margins improved 30 basis points year-over-year in that quarter there. Just primarily driven by better traction and service revenue there? Or is this just a product mixed shift across most of their existing hardware, software, et cetera?

Timothy J. McGrath

So really, we've had the centers of excellence in our practice areas, and we're seeing solution sales growth, both hardware and pure life cycle services. So that clearly is driving the growth and the margin in that sector. The bottom line is customers in that sector want and need our help. Technology becomes much more complex. They turn to us more often to help them solve that.

Jared Schramm - Roth Capital Partners, LLC, Research Division

And then another strong quarter for your healthcare business there. As far as visibility is concerned there, do you have any further back half of the year? Do you think these gains are sustainable for the rest of the year? I know that there's been some questions being raised about the implementation of Obamacare and how exactly that's going to impact your business. But any thought really on visibility for the remaining 6 months?

Timothy J. McGrath

Let me give you first a quick overview on what we are doing. So the Obamacare, or the Affordable Care Act, as it's known as, clearly reinforces tech spending. It is a driver in many areas. We focus on 6 pillars around healthcare. We have infrastructure, which is storage and cloud. We have mobility, which is BYOD and mobile device management. And we have a unique offering that we kind of created here, which is a clinical device assessment that helps with the point of care, so it helps hospitals determine the right devices for their clinicians and is really a growth area for us. But compliance is going to grow. As you know, HIPAA compliance in the omnibus is driving providers to need more security and more storage capability and document management, as well as caregiver collaborations. So these 6 areas are driving growth, and we do expect that to remain strong. We think we're taking share in healthcare, and we're doing that as a result of the programs and the teams that we have in place.

Jared Schramm - Roth Capital Partners, LLC, Research Division

You mentioned taking share there. Would you say you're taking share from a host of smaller players or the larger players in the space?

Timothy J. McGrath

It's hard to tell. I think -- and to give better numbers on the overall growth in the market, we'd defer to you. But we think that market's growing about 7% to 8%. So we do think we're taking share, and that's probably across the board in what we would call the DRC and VAR landscape.

Jared Schramm - Roth Capital Partners, LLC, Research Division

As far as the replacement and upgrade cycle there is concerned, with the customers that go into, do have some kind of rough outlook on it? Is it 10% of these hospital groups are up to speed now and there's 90% remaining. Is there some number that's a broad brush we could paint there?

Timothy J. McGrath

Yes, actually, we don't have that. We do know that by 2014, as a result of the Affordable Care Act, all -- everybody will have to be insured. And so all caregivers and medical providers are having to prepare for that. And so clearly, there's still a lot of work to be done.

Jared Schramm - Roth Capital Partners, LLC, Research Division

And then lastly here, just touching base on some potential acquisition, I know you're always looking at the market for some of the consulting or cloud companies out there. Any closer to maybe adding another one to the roster here? Or is it still taking your time at being cautious as far as acquisitions are concerned?

Joseph S. Driscoll

Yes. We're still looking. I guess, I'd say there's nothing imminent right now. There's a lot of companies for sale in that space, and we're really trying to find the right fit. So I'd say there's nothing imminent right now. We are looking to add to our services capabilities, our cloud capabilities. But it's got to be a good fit for us. So as of right now, there's nothing imminent, but there appears to be a lot of companies for sale.

Timothy J. McGrath

That's right, Jared, I think we're well positioned to compete in today's environment. And I think if we were to find the right acquisition that had a complementary business culture to ours, and it was accretive and would add customers and/or talent, we would be interested in that.

Jared Schramm - Roth Capital Partners, LLC, Research Division

Are you finding evaluations there just a little lofty, still, too, given current conditions?

Timothy J. McGrath

Absolutely. There is -- we think consolidation is going to continue, but we also think there's still a bubble around many of the cloud and net/com storage providers.

Operator

[Operator Instructions] Our next question comes from the line of Brian Alexander of Raymond James.

Brian G. Alexander - Raymond James & Associates, Inc., Research Division

I hopped on late, I was just wondering if you could, maybe, update us on how demand progressed throughout the quarter in each of your main customer segments, and what you're expecting as far as normal seasonality or linearity for the September quarter, in particular, focusing on the federal government and what impact sequestration might be having.

Timothy J. McGrath

Thanks, Brian. So actually, demand and seasonality was really normal for us. June was the strongest month in the quarter. And overall, backlogs and orders decreased nominally year-over-year. So backlog -- we finished with inventory backlog in a pretty good position. So I'd say June was the strongest month, and June ended in a pretty strong way. But it was the typical uptick that you'd expect to see. In terms of our individual segments, as I mentioned, SMB was up 5.5% in the quarter. Gov was up 2.5%, and Large Account, which includes -- which, of course, is more direct, was flat for the quarter.

Brian G. Alexander - Raymond James & Associates, Inc., Research Division

And I think, to be fair, that business had a pretty difficult compare a year ago growing 22%, I believe, in the June quarter last year. So as we look forward, would you expect to see year-over-year growth in all of your segments? And how are you thinking about federal through September?

Timothy J. McGrath

Yes. We should see growth in most of our sectors. I guess, the federal space is the one that we have the biggest question mark around right now. As you know, that ramps up in Q3 and Q4 versus the first 6 months of the year. So that would be the one area where we have some lingering questions because of the ongoing budgetary concerns out there. But other than that, we are expecting -- hoping for growth in the other segments.

Brian G. Alexander - Raymond James & Associates, Inc., Research Division

And then just any update on the pricing environment? I know that it's been a little bit more competitive in the distribution space in North America, but I'm not so sure that that's trickled down into the solution provider space. So just an update on pricing dynamics and any changes in vendor incentive programs that you think might be worth calling out.

Joseph S. Driscoll

So Brian, regarding pricing, we did, in the enterprise space, we did see a pretty competitive quarter. As you know, and as you're aware in your demand survey, that enterprise space was pretty challenged. I think there are a couple of drivers of that. I do think kind of a newer disruptive technologies have caused some of the enterprise customers to hit the pause button and to reevaluate. But I also think that's coming back around and we're a little more optimistic for the second half. But no doubt about it. It was a competitive quarter in terms of pricing. In SMB, it wasn't as competitive. Our margins are up. We did well with margins. And part of that, I think, is the value-add, our solutions and the team we have in place. In terms of what we see, as mentioned earlier, in the federal government, that's a much bigger question mark with the budget issues. So that one is much tougher to call. But as we did mention, that also is a very small part of the business.

Brian G. Alexander - Raymond James & Associates, Inc., Research Division

And then, it looks like, based on the product mix, that you had a decent bounce-back quarter, if you will, in the net/com area. I don't know if there's anything underpinning that, that you would call out. And then to your comments on enterprise being a little bit tougher, but maybe coming around more, do you get the sense that there is some pent-up demand out there from your large customers, particularly on large projects related to the data center? And do you think that, that pent-up demand is starting to get unleashed such that we could end up having a pretty good second half relative to what we would normally see?

Timothy J. McGrath

We'd like to believe that. And also, as I mentioned, the pent-up demand -- the -- as you know, companies now may be turning to growth. It's interesting, so many of the economic indicators, jobs, consumer spending, et cetera, look pretty solid. So we do hope that companies will be turning more toward growth in the second half. So we're optimistic. Also we do see some drivers, as I mentioned, some points of light with the sunsetting of Windows XP, and some of the newer technologies might be stimulating some demand. So we certainly hope that's the case.

Joseph S. Driscoll

And in terms of networking, we had really strong quarters in both the SMB and the Public Sector space. So there was some great activity there. That's really what drove the growth in that category.

Brian G. Alexander - Raymond James & Associates, Inc., Research Division

And then just finally on expenses. I know you guys have been investing in the business. And I just wanted to get an update on how to think about SG&A as we move through the back half of the year.

Joseph S. Driscoll

Sure. For the back half of the year, I mean, our revenue should be higher in the back half of the year, given the way that the Public Sector business usually flows. So just based on that, you should have an uptick in SG&A dollars in the back half of the year, just based on the variable compensation that goes along with higher sales and gross profits. So if you use the Q2 SG&A dollars as a baseline, you would expect it to be a little bit higher in Q3 and Q4 than Q2, just based on the variable compensation.

Brian G. Alexander - Raymond James & Associates, Inc., Research Division

Got it. But overall, would you expect -- I guess, final question, would you expect to see operating margins expand on a year-over-year basis? I understand they'd be up sequentially in the back half. But year-over-year, you've done a nice job of at least holding margins or expanding them a little bit this quarter. Do you think you can continue that in the back half?

Joseph S. Driscoll

Yes, but we need the revenue dollars to be there. So we really need the federal government piece to fall into place. I mean, as long as the revenue dollars are where we think they're going to be, we should be able to do a little bit better on the operating line. The way it typically has flown the last couple of years, Q3 and Q4 have had higher revenue dollars than Q2. You have a little bit less gross margin percentage because of the Public Sector having a bigger piece of the mix. And then SG&A as a percent of sales was a little bit better in Q3 and Q4 than Q2. So we're looking to try to continue the operating income expansion, certainly, for the back half of the year.

Operator

And I'm showing no further questions in queue. I'd like to turn the conference back over to Mr. McGrath for any closing remarks.

Timothy J. McGrath

Well, thank you, operator. I'm pleased with our results this quarter. We increased revenues, gross margin, operating margin and earnings per share in a challenging environment. We had solid performance in our healthcare vertical, it increased by 25%. We continue to transform our business to provide higher value technology solutions that help our customers solve their business challenges. We believe these strategies that we've put in place will position us well to gain market share and enhance long-term shareholder value. I'd like to thank all of our customers, vendor partners and shareholders for their continued support and our dedicated coworkers for their efforts. And I'd also like to thank those of you who are listening to our call this afternoon. Your time and interest in PC Connection are appreciated. Have a great evening.

Operator

Ladies and gentlemen, thank you for your participation in today's conference. This does conclude the program and you may all disconnect. Have a great rest of your day.

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