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Insight Enterprises, Inc. (NASDAQ:NSIT)

Q2 2013 Earnings Call

August 8, 2013 5:00 pm ET

Executives

Glynis Bryan - CFO

Ken Lamneck - President & CEO

Analysts

Brian Alexander - Raymond James

Nikhil Kumar - Stifel

Operator

Good day, ladies and gentlemen, and thank you for standing by, and welcome to the Insight Enterprises Incorporated Second Quarter 2013 Earnings Conference Call. (Operator Instructions).

As a reminder, today's conference may be recorded. It's now my pleasure to turn the floor over to Glynis Bryan. Ma'am, please go ahead. Glynis Bryan.

Glynis Bryan

Thank you. Welcome everyone and thank you for joining the Insight Enterprises' conference call. Today, we will be discussing the company's operating results for the quarter ended June 30, 2013. I am Glynis Bryan, Chief Financial Officer of Insight. And joining me is Ken Lamneck, President and Chief Executive Officer.

If you do not have a copy of the earnings release that was posted this afternoon and filed with the Securities and Exchange Commission on form 8-K, you will find it on our website at insight.com under our Investor Relations section.

Today's call, including the question-and-answer period, is being webcast live and can be accessed by the Investor Relations page of our website at insight.com. An archived copy of the conference call will be available approximately two hours after completion of the call and will remain on our website for a limited time.

This conference call and the associated webcast contain time sensitive information that is accurate only as of today, August 8, 2013. This call is the property of Insight Enterprises. Any redistribution, retransmission or rebroadcast of this call in any form without the express written consent of Insight Enterprises is strictly prohibited.

In today's conference call, we will refer to non-GAAP financial measures as we discuss the second quarter 2013 financial results. You will find a reconciliation of these non-GAAP measures to our actual GAAP results posted on our website on the investor relations page.

Finally, let me remind you about forward-looking statements that will be made on today's call. All forward-looking statements that are made in this conference call are subject to risks and uncertainties that could cause our actual results to differ materially. These risks are discussed in today's press release and in greater detail in our annual report on form 10-K for the year ended December 31, 2013.

With that, I will turn the call over to Ken to give you an overview of our second quarter 2013 operating results. Ken?

Ken Lamneck

Hello, everyone. Thank you for joining us today to discuss our second quarter 2013 operating results.

During the second quarter, we continued to see soft top-line performance, but we drove gross margin expansion through higher services sales and a strategic focus on more profitable product sales. We also maintained strict discipline around the costs in our business.

For the second quarter of 2013, consolidated net sales were down 7% year-over-year to $1.42 billion. Gross profit decreased 5%, while gross margin expanded 30 basis points to 13.5%. SG&A was relatively flat year-to-year and earnings from operations excluding severance expense decreased 17% to $47.8 million. On a GAAP basis earnings from operations decreased 19% to $44.6 million.

In North America, Hardware sales declined 10% year-over-year in line with our expectations come in to the quarter. By category, we saw stronger demand for Networking Solutions but continued to see weaker performance in Service sales.

In the Software category, net sales declined 4% year-to-year due to higher mix of software maintenance sales, which are recorded net of related costs in our financial statements. Booking trends improved throughout the second quarter in North America and we currently expect net sales in the segment will return to grow in the second half of the year.

In EMEA, net sales decreased 9% in constant currency in the second quarter. Hardware and software sales declined 19% and 6% respectively in constant currency due primarily to lower sales in notebooks, desktops and servers.

In addition to a generally weak demand environment in EMEA, our results were further affected by underperformance in the United Kingdom. While we are taking steps to improve our sales execution in this market, we currently expect this trend to continue for the balance of the year.

In Asia-Pacific, net sales decreased 2% in constant currency due to increased in sales of software products recorded net costs in our financials. Gross profit grew 5% and earnings from operations grew 6% both in constant currency. Our APAC team continues to execute very well, and the market remains healthy in the region.

I will now hand the call over to Glynis, who will discuss the second quarter 2013 financial results in more detail.

Glynis Bryan

Thank you, Ken. Starting with North America, net sales in North America were $923 million in the second quarter, down 7% year-to-year. Sales of hardware decreased 10% due primarily to lower volume in the public sector and larger enterprise space.

Software sales decreased 4% due to higher mix of sales recorded net of costs as is required for certain products such as software maintenance, and services sales were flat year-to-year.

Gross profit in North America decreased 4% year-to-year to $125 million. Gross margin increased 40 basis points to 13.5% due primarily to the effect of increases in software sales recorded on a net basis and increased vendor funding due to higher volume with strategic partners. These increases were partially offset by decrease in fees from enterprise agreements, due partly to the partner program changes.

Selling and administrative expenses for North America in the second quarter was flat year-to-year at $90.3 million. Increases in salaries and wages due to headcount investments were more than offset by lower variable compensation on lower gross profit and reduced spending in other categories.

In addition, the year-to-year comparisons are affected by a $1.2 million gain on the divestiture of certain non-core services contracts that were recorded in the second quarter of last year.

We also recorded $967 million in severance and restructuring expenses in North America in the second quarter compared to $894,000 in the same period last year. Earnings from operations in North America were $33.4 million in the second quarter of 2013, down from $39.1 million in the same quarter last year.

Moving onto to EMEA, our EMEA operating segment reported net sales of $421 million down 8% in U.S. dollars. In constant currency, net sales decreased 9%. Also in constant currency, sales of hardware decreased 19% due to lower volume across all client groups. Software sales decreased 6%, reflecting a lower demand in business productivity and creative products. Services sales grew 41% in the second quarter reflecting a net of strong quarter growth in this category.

Gross profit in EMEA decreased 8% in U.S. dollars and 9% in constant currency term with gross margins flat year-to-year at 12.9%. The positive effects of higher services sales were offset by the effect of lower overall product sales volume.

Selling and administrative expenses in EMEA in the second quarter were down 1% in U.S. dollars and on the same percent at constant currency terms. This decrease year-over-year was primarily driven by lower teammate costs resulting from recent restructuring activities and lower variable compensation on lower gross profit recorded in the quarter.

In the second quarter, we recorded net severance expense of $2.2 million in this segment, up from $1.5 million recorded in the same period last year. Earnings from operations in EMEA were $5.7 million in the second quarter, down from $10.8 million recorded last year.

In APAC, our Asia Pacific operating segment reported net sales of $72 million, down 5% year-to-year in U.S. dollars and 2% in constant currency terms. Gross profit was $12 million and gross margin was 16.6%, up from 15.3%. The decline in sales and increase in gross margins were due to a higher mix of software sales recorded net in our financial statements.

Selling and administrative expenses in APAC were up 4% year-to-year. Our APAC segment reported earnings from operations of $5.5 million, an increase of 2% year-to-year.

With regard to our tax rate, our effective tax rate in the second quarter was 39.6%, higher than our normalized range of 36% to 38% due primarily to reserves on certain foreign deferred tax assets recorded in the second quarter as a result of greater than expected operating losses in certain foreign jurisdictions. We expect our effective tax rate (inaudible) 39% for the balance of 2013 due to the same factor.

Moving onto our cash performance, in the first six months of 2013, our operations generated $88 million of cash up from $11 million last year reflecting generally low working capital needs during the first half of 2013.

We also invested $10.5 million in capital expenditures in the first half of this year down $15.9 million in the same period of 2012 reflecting low spending on our IT systems project. We spent $50 million in the first half of 2013 to repurchase approximately 2.6 million shares of our common stock.

All of this led to a cash balance of $142 million at the end of the second quarter, of which $129 million was resident in our foreign subsidiaries. And we had $52 million of debt outstanding under our debt facility. This compares to $129 million of cash and $128 million of debt outstanding as of June 30, 2013.

From a cash flow perspective, our cash conversion cycle was 18 days in the second quarter of 2013 an improvement of four days year-to-year. This decrease year-to-year was driven primarily by increases in BTO resulting from increases in our inventory financing facility for certain trade purchases in North America and from improved lender terms recently negotiated in our EMEA business.

I will now turn the call back to Ken.

Ken Lamneck

Thank you, Glynis. Just a few other updates before we get to your questions. We have recently been notified that our largest software partner intends to make changes to its channel incentive program in October, 2013. As you would expect, we are working diligently with our partner right now to finalize the details in timing of all of the changes and quantify the impact on our business.

We believe that certain other changes could become effective as multi-year contracts renew under the new program and some of the changes couldn’t become effective as early as October 1, 2013. The program is complex with many dynamic elements under review and we will determine the impact as the program details are finalized.

But at this time we anticipate that these changes will result in reduced incentives from the partner in future periods. Over the coming months we will actively work to identify actions available to us to mitigate the impact of these program changes.

Moving onto our outlook for the balance of the year, we currently expect full-year 2013 earnings per share to be between $1.70 and $1.85. This outlook includes the following assumptions. The remaining 2013 adverse effect on gross profit of previously announced partner program changes in our software category, which is estimated to between $5 million and $8 million in the second half of 2013 and an effective tax rate of 39% for the balance of the year. This outlook excludes severance and restructuring expenses incurred during 2013.

Thank you for joining us today. I want to thank our teammates, clients, and partners for their dedication to Insight. That concludes my comments. We will now open the line up to your questions.

Question-and-Answer Session

Operator

Thank you, sir. (Operator Instructions). It may looks like our first question will come from the line of Brian Alexander with Raymond James. Please go ahead. Your line is now open.

Brian Alexander - Raymond James

Thanks. And I apologize, Ken. I dropped off right as you were talking about the changes in your software program. So, if you can just talk about what you were explaining there and if that's incremental to what we already knew that was going to occur this year. I know you talked about $5 million to $8 million in the back half. I'm just trying to figure out what's incremental versus what we knew before.

Ken Lamneck

Yeah, thanks for the question Brian. So, yes we were notified by a software partner that they would be going through another round of program changes. So, everything we will be incremental to what was previously discussed for those changes. The details aren’t really solid yet as we are working through many of the program elements. That’s why it’s difficult for us to give you any kind of a range what that might be. But we certainly wanted to get communication after up in changes and they could be effective as early as October 1st. But again we don’t know the full impact yet and we are working diligently right now with them to understand what the total impact will be to us and certainly at that point anything that would be significant we will certainly communicate.

Glynis Bryan

I’m sorry to answer your question. I think you are going to ask about $5 million to $8 million.

Brian Alexander - Raymond James

Yes.

Glynis Bryan

For the previous we had said that for the full year we had an impact from previously announced partner program changes was $8 million to $12 million. We are now telling you that, that $8 million to $12 million as it plays out in the back half of the year is a $5 million to $8 million impact.

Brian Alexander - Raymond James

What have you already realized in the front half of the year, and is this reflected in your updated EPS guidance?

Glynis Bryan

Yes. All of this is reflected in our updated EPS guidance. So, yes.

Brian Alexander - Raymond James

And what was the amount that you actually.

Glynis Bryan

We had about $3.5 million in the first half.

Brian Alexander - Raymond James

Okay.

Glynis Bryan

The $3.5 million and $8 million to $12 million in the first half.

Brian Alexander - Raymond James

Okay. So, it sounds like the $5 million to $8 million is incremental to the $8 million to $12 million that you had outlined before.

Glynis Bryan

No. The $5 million to $8 million is the second half impact of the $8 million to 12 million. So, it was lighter in the first half of the year. It’s only $2.5 million in the first half of the year. For the second half of the year it’s going to be $5 million to $8 million for a total of what would be $8 million to $12 million around $11 million actually.

Brian Alexander - Raymond James

So, I guess I'm struggling to understand what's changed, then, if it's consistent with what you had previously outlined.

Glynis Bryan

We are just giving you the second half impact more specifically in terms of what it was included in our guidance for the second half and even the $1.70 to the $1.85, we previously you a guidance range of $1.70 to $1.90 and told we had $8 million to $12 million impact from these partner program changes.

Ken Lamneck

For the full year

Glynis Bryan

For the full year. We are now at the midpoint of the year you know what we have incurred with regard to those partner program changes for the first half of the year. We give you guidance now that says we anticipate we're going to do $1.70 to $1.85 and included in that is the second half impact on those partner program changes, which is estimated to be between $5 million to $8 million.

Brian Alexander - Raymond James

Okay. My understanding when you first outlined this is that the changes that you talked about on this call were new, and it sounds like these are all part of what you had previously articulated.

Glynis Bryan

Correct. They are all part of what we had previously articulated. There are new changes that are coming down the pike. That's part of what Ken said at the end that you missed. However, we don’t have the quantification of those changes yet.

Ken Lamneck

The partner hasn’t given us all the specificity that we need in order to do the modeling on that, Brian. It's a pretty recent occurrence here over the last month that we have been notified. So, there are a lot of details being worked as we speak.

Brian Alexander - Raymond James

Do you think it could be comparable to the $8 million to $12 million that you saw coming for this year or would it not be that significant?

Ken Lamneck

It’s hard to state right now until we understand all the elements that help us remediate what the takeaways might be on that. So, a little bit difficult for us to guesstimate right now.

Brian Alexander - Raymond James

Okay. You talked about seeing better bookings I think in North America, specifically in the second quarter. Can you just drill down a little bit more on where you saw that by customer segment and what product areas? And as I heard your comments about returning to revenue growth in North America in the second half, clearly your comparisons are a bit easier. And I'm just wondering does that imply that you're expecting better than seasonal growth in the second half sequentially or is it basically normal seasonal growth gets us to year-over-year growth?

Ken Lamneck

I would say it’s probably the latter, Brian, that you mentioned. But as far as where the growth is coming from pretty good across the board. And regards to the client set that we're talking about, good growth, certainly in the enterprise clients that we're seeing as far as the bookings trends, as well. And then categories, the networking segment continues to do well for us certainly overall. I think everybody is pretty much seeing that consistently with type of growth. And other segments I think are pretty much as you have been seeing them.

Brian Alexander - Raymond James

And then just when do you think, like, when do you think total revenue could return to growth? Is that something that you think on a consolidated basis can occur in the second half, or is that more 2014?

Ken Lamneck

No, we would say that in the second half.

Brian Alexander - Raymond James

Okay. All right, I'll get back in the queue.

Operator

Thank you, sir. (Operator Instruction). And our next question will come from Nikhil Kumar with Stifel.

Nikhil Kumar - Stifel

Nik Kumar for Matt Sheerin. Just want to get a sense of like a lot of your competitor talked about, like pricing pressure. So, what you are seeing when you are, like talking to the clients, are you seeing same kind of pricing pressure or is it different for you guys?

Ken Lamneck

Yes, Nik thanks for the question. I would say that we are seeing consistent pricing pressure certainly in the velocity products, certainly more, but I think it’s been pretty consistent. So I don't think anything really out of the norm in that regard. And we're trying to be more diligent as well and chasing the right elements of the business for us versus trying to play completely in the pricing game.

Nikhil Kumar - Stifel

And are you seeing any like impact from, like push-out from federal sequester concern, or nothing as of now?

Ken Lamneck

Yeah, I would say that we certainly saw the public sector space was certainly lighter in the quarter for us as far as the results I think there is certainly some impact to that. A little hard for us completely quantify that, but when we look certainly at the year-to-year results on the federal space, we definitely saw a negative growth rate there and that’s part of the market.

Nikhil Kumar - Stifel

Okay, perfect. And, lastly, just an update on like last quarter you talked about some issue with IT integration and [seriously are]. So, are you still seeing a hangover from them on those issues or it's pretty much over now?

Ken Lamneck

Yeah, I would say that much less so, yes, the integration on SAP in North America has gone very smoothly. We have a very small amount of clients that we will actually get migrated here during the Q3. Most of the works it’s really been done. So, now it just a real focus on optimizing the platform to get the efficiencies that we need.

On the European space, very similar circumstance, so we're completely through the full migration there, as well in focused on optimizing. So, as you look in Q3 and beyond we see certainly a lot of good stabilization, and now the focus really is on just enhancing and improving the productivity of the systems.

Operator

Our next question will come from the line of Brian Alexander with Raymond James.

Brian Alexander - Raymond James

Okay, I'm back. Ken, maybe a little bit more on what's going on in Europe, significant decline in hardware this quarter, and I think you alluded to the UK having some issues, and I know you're going through a leadership transition in Europe overall. So, I'm just wondering if you can kind of tie those things together. And it didn't sound like you thought that the UK business was going to get turned around here in the near-term. So, just help us understand exactly what's going on there.

Ken Lamneck

Yeah, in the hardware we did see as we reported and certainly significant decline in hardware sales related to a few big enterprise clients, but that push some business out. As far as the prospect there as we estimated we think we probably take the back half of the year to really get that corrected. We think the leadership team that's running the UK business is really a solid team. We've had some people, one specific individual, that was out on maternity leave that runs that business for us is back in the business now running that business for us. So, we expect to see certainly improvements there over the next couple of quarters.

In regards to Stuart Fenton, who's our President of EMEA business, he still running the business. He is still actively involved day today in all aspects of the business. The search for his replacement is going in accordance to plan, and we expect to have that completed by the end of this year. So, all things are pretty much according to plan in that front.

Brian Alexander - Raymond James

So there's nothing really operationally that's new in that region that caused you to see some sales slippage this quarter? It sounded like maybe there was just a little bit of, I guess, personnel absenteeism that will get addressed this quarter, you should be back on track, and there shouldn't be anything lingering beyond that?

Ken Lamneck

Yeah, I think there were certainly some execution issues. And I think again with the leader coming back after being out of the business for a year, which certainly have really I think a very positive impact and being well received by the team. So I think it's just going to take a little bit of time to her to get her feet under her a little bit and we get things back in motion and building those pipelines of business. But, yes, no fundamental bigger shifts than that occurring in the UK business for U.S.

Brian Alexander - Raymond James

Okay. And then just over again the gross margin improvement you saw, Glynis, in North America specifically, up 40 basis points year-on-year, how much of that was related to mix versus other factors, either vendor incentives or product margin?

Glynis Bryan

I think it was a combination of mix to some extend related to certain categories of product and the getting some thresholds with two partners that actually have more lucrative incentives I guess I would say. So, I think the team performed well. We have been targeting our networking category that worked out very well for us in Q2 in North America specifically.

So, most of the benefit and the improvement that we saw in North America came from execution against a couple of key categories and increased incentives related to that by virtue of overachieving the volume threshold.

Brian Alexander - Raymond James

It's been a while since I think you guys have talked about deal registration as a potential catalyst for gross margins. I know this was something that you had highlighted a few quarters ago as an opportunity, particularly on enterprise deals. So, where are you in that initiative, and how is it going relative to your expectations?

Ken Lamneck

Yeah, that continues to be an important part of the elements that we are tracking on a daily basis. So, I get reports daily in regards to how we are doing number of deal registrations each day. So that continues to see the attention. I think we'll continue to gain traction, maybe not as fast as we'd like, but it still it’s an important element of what we’re doing. Again very focused on how do we drive more solution selling for our partners and of course they in turn willing to pay us more for that type of effort with the deal registration. So, that continues to more along nicely and we will continue to try to accelerate it.

Brian Alexander - Raymond James

And then just on the cash flow, it was very strong this quarter, and it was very strong for the first six months of the year. And I just wanted to know how sustainable we should think about this working capital performance, in particular. The trade cycle looked pretty low. It looked largely driven by payables, which I know could just be a moment in time. So, as we look at the operating cash flow year-to-date, how should we think about that for the full year relative to the earnings guidance that you gave?

Glynis Bryan

I think for the full year you should anticipate we're going to be performing in the normal range on a full year basis, which in the $80 million to $110 million category in terms of cash flow from operations. We do really well with regard to our BPO it’s specifically as related to the inventory financing facility that we were able leverage.

As I said, our EMEA operation also negotiated some better terms with lenders. But I think you should anticipate that we’re going to be in that on the higher end of that $82 million to $110 million range that we've typically seen over the years for the full year.

Brian Alexander - Raymond James

Okay. So, obviously very frontend-loaded cash flow. It would put back half cash flow somewhere around $20 million to $30 million?

Glynis Bryan

Yeah, there is some seasonality frontend on that seasonality this year, yes.

Brian Alexander - Raymond James

And then, I guess, final one, as I look at the earnings guidance for the full year, and if I back out what you achieved in the first half, it would imply the second half is roughly flat, maybe down slightly if I use the midpoint from an EPS standpoint versus the first half. Would you consider that kind of a typical balance for the year, or I'm just trying to get a sense for why the second half wouldn't be a little bit better than the first half, given the challenges that you had, particularly in Q1.

Glynis Bryan

Well, I mean the second quarter is historically has been our biggest quarter with regard to the Microsoft effect that occurs in the second quarter. So, I would anticipate that we are not 50:50 would be great in terms of our first half, second half. This year our second half is also impacted by the underperformance that that we're seeing in EMEA. So, our North America operations is going to be doing a little bit better in the second half than they did in the first half. However, what normalizes for that is the issues that we had specifically in the UK and then in EMEA that we talked about with regard to the second half performance.

Brian Alexander - Raymond James

Okay. That's it for me.

Operator

Thank you, sir. (Operator Instructions). Presenters at this time I’m showing no additional phone line questions at this time. Ladies and gentlemen, that does conclude our time our questions and we will also conclude our conference for today. Thank you for your participation and have a wonderful day. Attendees you may now disconnect.

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