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PC Connection (NASDAQ:PCCC)

Q3 2013 Earnings Call

October 24, 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

Robert Burleson - Canaccord Genuity, Research Division

Operator

Good afternoon, ladies and gentlemen, and welcome to the Third Quarter 2013 PC Connection, Inc. Earnings Conference Call. My name is Mary, 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 statements 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 and 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 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 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

Thank you, Mary. Good afternoon, everyone, and thank you for joining us today to review the company's third quarter financial results. I'm pleased with the third quarter performance. Net sales grew at 3.4% despite another difficult quarter for our federal business. We improve gross margins by 23 basis points over the prior year quarter, which helped us to grow earnings per share by 8%, to $0.40 per share. Operating income increased to 3% of net sales for the quarter, and we also increased our cash balance to $77 million.

We continue to execute our core growth strategies, to deliver a broad spectrum of IT solutions, increase our market share, invest in our cloud capabilities, enhanced operational efficiencies and maximized growth opportunities, particularly, in high margin advanced solutions.

We are transforming our business investing in key areas to help our customers solve increasingly complex IT problems. In addition, our vendor partners, continue to look us as a key resource to reach customers who are seeking the latest products and services and to assist those customers in solving complex technology problems. As we review our results, please note that otherwise stated, all of our third quarter 2013 comparisons are being made against third quarter 2012.

Consolidated net sales for the third quarter increased year-over-year by $19.1 million or 3.4% to $580 million, compared to the prior year quarter. Gross profit dollars in the quarter increased by 6%, and our consolidated gross margin increased to 13.2%, from 12.9% in the prior year quarter, which is a result of our strategy to focus on delivering higher margin, advanced technology solutions to our customers.

We continue to invest in and focus on improving our operations and expanding our solution sales capabilities. Our Center of Excellence include data center, software, mobility, storage, Net/Com and life cycle services. These investments have led to an increase in SG&A.

Our SG&A dollars increased by $3.1 million compared to the prior-year quarter. Variable SG&A generated part of the increase due to higher sales and gross profit. Looking ahead our SG&A will increase by approximately $500,000 per quarter starting in Q4 2013, as we begin to depreciate the customer master data management project that was recently put into service.

As our business continues to evolve to meet increasingly complex IT needs, our SG&A may increase to fuel future growth opportunities.

Net income for the quarter increased by 7% to $10.6 million and diluted earnings per share increased from $0.37 in 2012, to $0.40 in 2013. We increased our earnings faster than a rate of sales growth by focusing on maximizing our margins, and controlling fixed costs.

Now, I will turn the conference over to Joe Driscoll to discuss the results of our business segments and financial highlights. Joe?

Joseph S. Driscoll

Thanks, Tim. Sales for our SMB segment, which serves small-to-medium-size businesses, increased by 7.3% in the quarter to $235 million with double digit percentage increases in the notebook tablet, desktop server and software categories.

Gross profit dollars for SMB increased by 8% in the quarter, and gross margin increased by 15 basis points to 15.6%. This segment continues to deliver strong margins as demand for our value-added services from small and medium business customers continues to increase.

Sales by our Large Account segment, increased by 0.2% this quarter to $193 million. Total gross profit dollars grew 5% for large accounts, and gross margin increased from 11.5% in the third quarter of 2012 to 12.1% in the third quarter of 2013, partly due to an increase in storage sales.

Our overall commercial sales, which is the combination of our SMB and Large Account segments, grew by 4% over the prior-year quarter.

Quarterly sales in the public sector segment, which includes sales to government and education customers, increased by approximately 2%. Sales to the federal government decreased by $10 million or 18% from the prior year quarter, whereas sales to state and local governments and education customers increased by $12 million or 13% year-over-year.

Note that we continue to experience headwinds due to constraint federal spending as this is the third quarter in a row with double-digit percentage decreases in our federal business.

On a year-to-date basis, federal government sales represent 6% of our consolidated revenue. Gross profit dollars for the public sector increased from the prior year quarter by 2% and gross margin remained consistent year-over-year at 10.8%.

Our healthcare vertical, which is represented in each of our 3 segments, only increased by 1.2% in sales, due to some large projects in 2012, which did not repeat.

However, gross margin for our healthcare sales, increased by 38 basis points, which generated a 6% increase in gross profit dollars. We expect healthcare to continue to be an important vertical for us in future periods.

Overall, our financial performance was solid. In addition to increasing EPS to $0.40 per share, we also increased our trailing 12-month EBITDA to approximately $66 million, and our quarter end cash balance totaled $77 million, up from $64 million at the end of June.

Cash flow continues to be strong driven by our growth in earnings plus strong working capital metrics. On a year-to-date basis, total positive cash flow equals $37 million.

DSOs at December 30 were 37 days, an annualized inventory turns were 27 times. We currently estimate that the December 31, cash balance will be lower than the September 30 balance due to normal working capital fluctuations. We regularly assess how to best deploy our excess cash, some transactions we have executed in prior years include acquisitions, stock repurchases and special dividends. Our goal is to maximize shareholder value while maintaining financial flexibility. So we will continue to review all options available to us.

I will now turn the call back over to Tim to discuss current market trends.

Timothy J. McGrath

Thanks, Joe. One of our internal goals is to significantly increase sales in advanced technology categories, such as networking, software, storage, services, data center and related areas. We continue to make progress on this initiative. Especially in our Net/Com software and server categories.

Net/Com product sales increased by 8% year-over-year accounting for 10% of our consolidated net sales. Our public sector networking sales were particularly strong this quarter with growth in enterprise networking, security appliances, wireless access and switches.

Software sales increased by 7% year-over-year, due to higher demand in security, virtualization, office productivity and operating system software. Both our SMB and Large Account software teams continued to succeed in maximizing growth opportunities in 2013. SMB grew software sales by 18% compared to the prior-year quarter with sales in virtualization being notably strong during the quarter.

The overall market is currently undergoing significant changes. Many large technology companies have announced major restructuring plans, which involve reductions in legacy businesses, in order to find investments in cloud computing, mobility, big data and security. These changes in market conditions have resulted in adjustments to some of our partners' programs. For example, a large software provider has implemented changes in their challenge centers, which could impact our profitability from that product category in 2014.

Other suppliers are also assessing changes to their channel programs. In order to maximize channel incentives, and add -- excuse me, in order to maximize channel incentives and our overall productivity and profitability, we need to continue to transform our business and invest in these emerging technologies.

In addition to technology changes, and funding pressures that have impacted some of our end user customers, specifically federal government spending continues to be an issue. Although, it's less than 10% of our overall sales, the double-digit percentage decreases in sales that we experienced this year have been a drag on our overall growth.

It's not clear what the 2014 outlook is in this market space. Also, enterprise projects for some of our larger customers, have been delayed as companies carefully evaluate their alternatives in this complex IT environment.

As we look to the fourth quarter and opportunities that are emerging for 2014, we feel it's critical that we manage our growth appropriately and focus on expanding margins, increases-- excuse me, investing in solutions capabilities and keeping our balance sheet strong. Our goal is to continue to deliver sustained and consistent performance as we move into our 32nd year of operation.

We'll now entertain your questions. Operator?

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Jared Schramm from Roth capital.

Jared Schramm - Roth Capital Partners, LLC, Research Division

Looking at the public sector, so you're still a decent quarter in light of what you are seeing with the federal government there, could you just segregate a little bit what you're seeing at the state and local education side, what's driving the growth there? And then your part 2 of this question would be, am I little too optimistic to think that there's some pent up demand at this federal level that will eventually show its face here some time in 2014?

Timothy J. McGrath

Thanks, Jerry. That's a good question. So to begin with to kind of put in perspective, we actually did have a really good quarter in SLED for Q3. In fact, our SLED business was about 71% of our total public-sector in the quarter and our fed business was 29%. And as Joe mentioned, the federal business was down for us and it's interesting that we are seeing good growth in SLED, but clearly have that downward pull from the fed. Now looking forward to 2014, we just don't have really good visibility. We don't know when the budget issues are going to be resolved. We understand that there could be some pent up demand, but I also think these budget issues are fairly significant and wide sweeping. So we are just very cautious on the year when it comes to the public sector.

Jared Schramm - Roth Capital Partners, LLC, Research Division

Okay. And then looking to Large Account there is 60 basis points jump in gross margin in the quarter, could you provide a little more color on what drove that?

Joseph S. Driscoll

Yes. I mean, really it was continued focus on sort of the higher margin technologies, the more advanced solutions, the Large Account space, sometimes you can get some major projects that are at sharp margins. And this year, we actually didn't see a lot of those kinds of projects. We saw a lot more of smaller deals, but those smaller deals generally come at better margins. So we are continuing to push deeper into software and storage, sort of those higher margin categories. So that was-- that's really what kind of carried the day there.

Jared Schramm - Roth Capital Partners, LLC, Research Division

And then turning to healthcare, you mentioned that there were some large projects in the year ago period which made a difficult comp in this quarter, are we going to return to that kind of mid-teen, low 20s year-over-year growth in Q4 there, were there some larger projects in Q4, which will drag into this quarter as far as the comps concerned.

Timothy J. McGrath

Yes, so Jerry, I think there are really 2 parts to the question. First is we did have some very large project rollout that did not repeat, but they were-- they are multi-quarters , so they are very large and expand 2, actually 3 quarters in some cases. So that is behind us. However, looking forward, we think that with our pillar strategy, we are getting some tractions, but in the healthcare space, I think, we probably underestimated 2 significant drivers, 1 is in both of them not matter of fact, a matter of law, the legislative changes that have happened, the first is the ICD 10 change, which I am sure you read a lot about, that really is very significant because all healthcare providers have to get their billing and their coding in order, and they have a year to do that or they frankly can't bill or collect revenue. And so when we talked to CIOs in the healthcare community, they kind of liking this change to Y2K and that's is sweeping and it's all encompassing. Now, with all of these changes there are our technology components that could be very helpful. But for right now, I think the entire industry is hunkered-down trying to get through ICD 10 and the meaningful use, 2 components from the high-tech legislation. So both of those are very significant. However, we do see opportunity to think about what's happening in the business, clearly mobility is really important factor for our customer base point of care, compliance, infrastructure, all of these with several million more customers coming into healthcare systems storage is really an opportunity. So we are optimistic, but the Legislature and the changes are so significant, we kind of agree with what IDC and the other analysts are saying that the healthcare growth is probably going to be low single digit for the foreseeable future or the next few quarters.

Jared Schramm - Roth Capital Partners, LLC, Research Division

Okay. That's helpful and then vendor specific, you see any shift and stove going private you got more legs behind in now they are actually in acting steps to take that forward?

Timothy J. McGrath

We were seeing some project change, but really nothing significant, nothing we could point to.

Jared Schramm - Roth Capital Partners, LLC, Research Division

Okay. And then lastly, you had a your cash balance gives up there $ 77 million, I know the last couple of quarters on we spoken, you mentioned that a lot of the cloud companies is the multiple that they are asking from an acquisition standpoint a little lofty, in the acquisition space on the services side is anything you are getting closer to as far as completing acquisition are you thinking evaluation to still a little too aggressive as far as what they're requesting?

Timothy J. McGrath

Jerry, we always-- we remain open to the idea, we are pretty confident in the business plans that we have. We think we are well poised in the market, to continue to grow, and to continue to take share. We think we got a really strong team here behind us, but that said we're always looking for opportunities in our consolidating space, should they be accretive and should they be a tuck end that would enhance our solutions capability, certainly will be open to that, so I think we are open in all areas.

Operator

[Operator Instructions] Our next question comes from Bob Burleson from Canaccord.

Robert Burleson - Canaccord Genuity, Research Division

Couple of quick questions on the federal side, do you see any catch-up from the shutdown showing up in Q4 or do you see it sliding further in Q4? Then I have a follow-up.

Timothy J. McGrath

Bob this is Tim, thanks for joining us today. It's really tricky and that there are a number of drivers out there and consistent with our major suppliers, would say and have said on their calls, things like the Windows XP expiring and some of the other changes that are happening in the e-commerce space and in the security space. We are optimistic that mobility in security and big data are in fact going to stimulate some demand, however we don't see an end in sight to the budgetary issues. So we don't want to misrepresent it that we think there would be anything new coming. We have seen nothing to indicate that the last 3 quarters of performance that we have seen are going to change in Q4.

Robert Burleson - Canaccord Genuity, Research Division

Okay. And the other question I had in terms of the IT spending, it looks like people are expecting a better year in 2014, 3%, 4% growth, what do you see and what do you see as drivers for '14?

Timothy J. McGrath

Bob, so again, I think there are some drivers. We seeing some of the functional areas we have invested here ourselves we think big data, is important and as customers and our customers want to know as much as they can about their customers, and so big data has clearly been a driver mobility is a driver security, is an absolute driver in the space, and overall, we think that there are some points of light out there. And we are kind of accept sort of the market rate of growth if you will, but everything we are seeing, the IT spend is going to be add or a little above the GDP rate of growth.

Robert Burleson - Canaccord Genuity, Research Division

Okay. Great. And the last question on operating margins I see expanded, do you think you can in 2014 expand beyond or get to 3% level for the year?

Joseph S. Driscoll

Yes, I'm not sure about for the full-year, but we're happy to get 3% for this quarter that was a good starting point for us. Really, our near term goal is to get 3% operating income for a full year, is that be our challenge for the next year, but I'm not sure I would model that just yet, but we need to continue to grow the top line, we need to continue to increase gross margins, and we need to hold the line on costs and then that will all found a place. But certainly it is our goal to get 3% operating income and beyond over the next few years.

Operator

[Operator Instructions] I show no further questions at this time. And we would like to turn the conference back to you Mr. Tim McGrath for closing remarks.

Timothy J. McGrath

Thank you, Mary. I'm pleased with our results this quarter. We increased revenues, gross margin, operating margin and earnings per share, while improving our overall working capital metrics in a challenging environment. We continue to transform our business to provide higher value technology solutions, it help our customers to solve their business challenges. We believe the strategies that we have put in place will position us well to gain market share and enhance long-term shareholder value. I would like to thank all of our customers, vendor partners and shareholders for their continued support and our dedicated coworkers for their efforts. I would 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 now disconnect at this time.

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