PC Connection Management Discusses Q4 2013 Results - Earnings Call Transcript

Jan.30.14 | About: PC Connection, (PCCC)

PC Connection (NASDAQ:PCCC)

Q4 2013 Earnings Call

January 30, 2014 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

Justin Patterson

Prabhakar Gowrisankaran - Canaccord Genuity, Research Division

Operator

Good afternoon, ladies and gentlemen, and welcome to the Fourth Quarter 2013 PC Connection Incorporated Earnings Conference Call. My name is Karen, 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 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 views 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 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. Good afternoon, everyone, and thank you for joining us today to review the company's fourth quarter financial results. We're pleased with our fourth quarter performance. Net sales grew at 4% despite another difficult quarter for our federal business. Gross margins improved by 19 basis points over the prior year quarter, which helped us to grow earnings per share by 12% to $0.37 per share. Operating income increased to 2.8% of net sales for the quarter, and we also paid a special dividend for the third consecutive year.

We continued to execute our core growth strategies to deliver a broad spectrum of IT solutions, increase our market share, invest in our cloud capabilities, enhance operational efficiencies and maximize growth opportunities in higher margin advanced technology solutions. Our vendor partners look to us as a key resource to reach customers who are seeking the latest products and services.

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

Consolidated net sales for the quarter increased year-over-year by $22.3 million or 4% to $579 million compared to the prior year quarter.

Gross profit dollars in the quarter increased by 6%, and our consolidated gross margin increased to 13.1% 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 in the following key areas: Data center, software, mobility, storage, net/com, cloud and life cycle services. These investments have led to increases in SG&A. Our SG&A dollars increased by $2.3 million compared to the prior year quarter. However, SG&A as a percentage of net sales remained flat.

Variable SG&A generated part of the increase in dollars due to higher sales and gross profit. In addition, SG&A in the fourth quarter now includes approximately $500,000 of depreciation related to our Customer Master Data Management project.

Fixed SG&A will increase in 2014 due to planned additions in our sales team, a full year of depreciation on the MDM project and additions to our technical resources, including engineers, focused on the data center and cloud solutions.

Net income for the quarter increased by 11% to $9.8 million, and diluted earnings per share increased from $0.33 in 2012 to $0.37 in 2013.

We increased our earnings faster than our rate of sales growth by focusing on maximizing our margins and controlling fixed costs.

And now I'll turn the call 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 4.9% in the quarter to $240 million, with double-digit percentage increases in the storage, net/com and software categories in this segment.

Gross profit dollars for SMB increased by almost 10% in the quarter, and gross margin increased by 70 basis points to 15.3%. 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 7.8% this quarter to $218 million. Consistent with the SMB segment, the Large Account segment had excellent growth in the higher value categories of storage, net/com and software.

Total gross profit dollars grew 10% for Large Accounts, and gross margin increased from 11.2% in the fourth quarter of 2012 to 11.4% in the fourth quarter of 2013.

Our overall commercial sales, which is the combination of our SMB and Large Account segments, grew by 6.2% over the prior year quarter.

Quarterly sales in the Public Sector segment, which includes sales to government and education customers, decreased by 3.6%. Sales to the federal government decreased by $15 million or 23% from the prior year quarter, whereas sales to state and local governments and education customers increased by $10 million or 17% year-over-year.

Note that we continue to experience unfavorable headwinds due to constrained federal spending as we had double-digit percentage decreases in our federal business in all 4 quarters of 2013. Sales to the federal government are expected to continue to be under pressure for, at least, the first half of 2014.

For fiscal year 2013, federal government sales represented 6% of our consolidated revenue. Gross profit dollars for the Public Sector segment decreased from the prior year quarter by 10%, and gross margin decreased from 12.5% in the fourth quarter of 2012 to 11.7% in the fourth quarter of 2013.

Our health care vertical, which is represented in each of our 3 segments, only increased sales by 2% due to large projects in 2012, which did not repeat.

For the full year, health care sales grew 9% over 2012. Most of the year-over-year gains occurred in the first half of 2013. We expect health care to continue to be an important vertical for us in future periods. However, there is some uncertainty in the market due to ongoing changes in government regulations, including the rollout of the Affordable Care Act. Program reimbursements for health care could be impacted, which may result in delays in IT investments.

Overall, our financial performance was solid, especially considering the challenging economic and political environment. In addition to increasing EPS to $0.37 per share, we also increased our trailing 12-month adjusted EBITDA to $67.4 million.

In recognition of our shareholders for their continued support, we paid a special dividend of $10.5 million or $0.40 per share during the fourth quarter of 2013. While we are pleased to be in the position to pay a special dividend, any declaration of future cash dividends will depend upon our financial position, strategic plans and general business conditions.

For fiscal year 2013, we generated $13 million of positive cash flow prior to the special dividend payment. The year-end cash balance of $42.5 million is lower than our Q3 balance due to the Q4 dividend payment, plus seasonal working capital fluctuations.

We regularly assess how to best deploy our excess cash. Some transactions we have executed in prior years include acquisitions, dividends and stock repurchases. Our goal is to maximize shareholder value while maintaining financial flexibility, and to achieve that goal, 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, servers, data center and related areas. We continue to make progress on this initiative, especially in our software and net/com product categories.

Our SMB and Large Account software sales teams continued to be effective in the fourth quarter, which resulted in strong double-digit sales growth in these segments. Our overall software category grew 14% in Q4 over the prior year. Demand in software sales has been driven by an increased need for security, virtualization, office productivity and operating system software.

The networking and communication category had a strong quarter with overall growth of 9%. We experienced double-digit growth in SMB, Large Account and SLED, offset by a decline in Federal. Our focus on the data center has helped to drive solid gains in this critical category.

I'd like to make a few comments on our full year 2013 results. 2013 was another successful year for PC Connection. We increased sales, net income and earnings per share for the fourth consecutive year, while we continued our transition into being a national solutions provider.

Total revenues increased by 2.9% to $2.22 billion. All of our sales subsidiaries had growth, with the exception of our federal government channel. Gross margin improved to 13.19% from 13.07% in 2012, which continues the positive trend over the past several years.

Net income increased by 8% to $35.7 million, and earnings per share increased from $1.24 in 2012 to $1.35 in 2013.

As we look ahead to 2014, the overall market is currently undergoing significant changes. A number of large technology companies have announced 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 reductions in some of our partner funding programs for 2014, particularly in software.

In order to maximize channel incentives and our overall profitability, we need to continue to transition our business and invest in these emerging technologies, which will increase our SG&A.

As change in the market continues to unfold, we feel it is critical that we manage our growth appropriately with a focus on expanding margins, investing in solution capabilities and keeping our balance sheet strong. We also believe that our balanced portfolio of customers, suppliers and products and solutions has helped us to deliver solid results, our goal is to continue to deliver sustained and consistent performance as we move into our 32nd year.

And now, we'll entertain your questions. Operator?

Question-and-Answer Session

Operator

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

Jared Schramm - Roth Capital Partners, LLC, Research Division

First question. Looking at software, up 14% year-over-year in the quarter, as it relates to operating system software, did you see any direct benefit from Microsoft sunsetting Windows XP?

Timothy J. McGrath

Jared, it's a great question. We're starting to see some projects roll as a result of that. And as you know, we have a couple of months left to continue to drive that transition. So I think we are seeing some positive tailwinds from that.

Jared Schramm - Roth Capital Partners, LLC, Research Division

And you mentioned growing the sales team in the upcoming quarters will likely drive SG&A a little higher. What areas in particular do you look to add sales force in as far as personnel is concerned? And typically, what's your anticipated time for ramp as far as productivity is concerned?

Timothy J. McGrath

So each of our sales subsidiaries has a plan to add salespeople this year. And each segment actually has kind of a different strategy. So our Large Account segment, those are mainly field-based personnel. They're spread out all over the country, calling on larger accounts. And then the small and medium business in the public sector is a combination of call center-based people, as well as field people. So each segment is going to add salespeople. We believe that's one way to grow the top line, obviously, is to touch more customers. And there is a different ramp-up period for each of those segments as well. So you're -- if you hire somebody today, they might not be fully productive for a year or 2 years, but they will produce some results in the near term. So it's kind of different for every segment. And as you add more sales people, what we also look to do is add more technical people to support those salespeople. So we want to get more into selling things like storage and data center products. So you need the technical people to support those new salespeople as well.

Jared Schramm - Roth Capital Partners, LLC, Research Division

And looking at the direct salespeople, I realize that varies across each segment individually. But are you typically trying to recruit kind of higher end, more experienced sales folks? Or are you just looking to bring them in at an entry level, teach them the business the way you want to look at it and then let them ramp-up from there?

Timothy J. McGrath

So Jared, again, it's different by our customer focus, by our segmentation strategy. But clearly, in the Enterprise and the Large Account space, we look for experienced people. We also look for experienced people in our Public Sector. We do have a pretty effective training program, PC Connection University, so we are able to hire some junior people in our SMB division and try to give them a career track to work from.

Jared Schramm - Roth Capital Partners, LLC, Research Division

And then I know potential acquisitions are always something you take a look at. Where do you think you stand today as far as being able to make an acquisition? And I didn't realize that cloud, everything that touched the word cloud was asking for kind of a very elevated multiple. Is that an arena you're maybe going to continue to look at right now as far as acquisitions are concerned? Are there other areas you may be more inclined to be aggressive in as far as making an acquisition?

Timothy J. McGrath

So we think we have a really solid plan. We think we have the right strategy and the right team. So we don't feel any urgent need to do an acquisition, but as you know, our balance sheet's pretty strong. And we always are open to opportunities. So if we saw the right company that was accretive or that would give us, round out our solutions capability, a tuck-in acquisition, clearly, that would be of interest to us. But really, there are no plans at this time.

Joseph S. Driscoll

Yes. And we're also looking for something that we can scale on a national level. So there are a lot of $20 million and $30 million companies out there that we've taken a peek at, and it's difficult to scale some of these businesses. That's been one of our challenges.

Jared Schramm - Roth Capital Partners, LLC, Research Division

And then turning into health care side, you said, up 2% year-over-year. It's coming out with some difficult comps to the year prior, obviously. You mentioned that the Affordable Care Act was creating some degree of uncertainty. As far as visibility in the health care segment, has that largely been put on hold as ACA gets implemented and people actually find out the impact of that from an IT spending level? Some color on that would be helpful.

Timothy J. McGrath

Sure. So Jared, we don't really see -- we see 4 main drivers of growth in the sector, and we do feel like we're positioned very well for the challenging landscape in 2014. We do think that our investments there have really paid off, and will continue to do so for many years as evidenced by the fact that one of our large suppliers has chosen us as their health care partner of the year, and we did just win a very large contract for an additional 3 years, one of the largest contracts in the U.S. So we are positioned very well. That said, there are really 4 drivers of change in the industry, as you know. And as you mentioned, the Affordable Care Act, or ObamaCare, does mean that many more patients will be coming into the health care system, and our health care customers will need to manage that process. And so there is some opportunity there. But also under the high-tech meaningful use Stage II program, many of the large accounts have already converted, but many of the SMB accounts, we think about 40%, have not. So that's sort of a double-edged sword. Some of the enterprise comps have gone. The SMB still yet to go. And we also think there's an opportunity to help our customers who are dealing with HIPAA and Omnibus to help them get ready for their audits and for that process. And then finally, ICD-10, as you know, that conversion must be done by October. And so we do see many of our customers who are holding back cash, wondering about their payment cycles. And it does cause a lot of confusion. So it's a mixed bag. There's confusion, but there's opportunity. But clearly, the confusion is causing a lot of customers that are going to offer a long-term growth trajectory to us are kind of hitting the pause button right now.

Jared Schramm - Roth Capital Partners, LLC, Research Division

And my last question here in regards to federal spend. Obviously, the company is performing well in spite of what's been a difficult federal market for the last several quarters here. Is Q2 of this coming year of 2014, where you look to start anniversary-ing some of the difficult year-over-year comps you've been seeing in federal spend, given the back half of the year in a much of an easier platform to jump off on a year-to-year comparison basis with looking at federal spending?

Timothy J. McGrath

Yes. I mean, definitely, the comps are much easier in 2014. I think when we started seeing -- the first drop-off was kind of March of 2013, that was sort of the first month that sort of had a significant drop. And then that continued on the remainder of the year. So I think, yes, Q2 -- a full Q2 will have an easier comp, I guess, versus 2013.

Operator

And our next question comes from the line of Brian Alexander from Raymond James.

Justin Patterson

This is Justin Patterson in for Brian. I guess, I'll kind of add on to that last federal question some more. So in terms of the public segment, you've had tremendous growth and SLED lately. I think it actually accelerated in 4Q versus where you are -- where you were in 3Q. Could you talk about how you see the public segment trending with that headwind from federal kind of lessening in 2Q? And SLED, obviously, having quite a bit of momentum behind it.

Timothy J. McGrath

Yes, Justin. So we are seeing great momentum with the SLED business. We're seeing that kind of across the -- that's a mixed bag across the SLED business. We're seeing good growth in higher ed. We're seeing good growth in -- around the state. The federal business though, is still much more of a question mark. We were really, it's just not clear that we're at all out of the woods with the federal budget. So that, I think, will continue to be a question mark and a headwind going into the balance of 2014.

Justin Patterson

Okay. And just a quick clarification. Did you say that federal was 6% of revenue for the full year earlier?

Timothy J. McGrath

Yes, that's correct. Little shy of 6%.

Justin Patterson

Little shy of 6%. Okay, I can kind of triangulate off of that. As far as SG&A goes, obviously, that's been brought up several times on the call today. If I look back at SG&A, it's been about 10.5% of consolidated revenue in 2012 and 2013. I know it's going up on a dollar basis, but as a percentage of revenue, how were you thinking about that for 2014?

Joseph S. Driscoll

So percentage of revenue should be in that ballpark, I guess. The way we're looking at it is, we want to grow the top line. We want to grow our margins. But we also want to continue to invest in the business in order to keep the sales and margin going in the right direction. So there's a lot of technical people we would want to add. There's a lot of salespeople we want to add. So I think we're trying to stay somewhere around that same percent of sales, but if we are really exceeding our sales and margin budget, we are likely going to plow that extra money back into hiring more technical people, so that we can continue to fuel future growth. In addition, we have depreciation on our Master Data Management project, just started in Q4 of 2013, it was about $500,000. So you're going to continue to see that in Q1, Q2 and Q3 being sort of a year-over-year unfavorable SG&A number. And then by the time you get to Q4 of next year, it will be anniversaried.

Justin Patterson

Got it. And then from just kind of a product perspective, could you talk about anything that came across as either better or worse than expected for the period?

Timothy J. McGrath

So I'm pleased to say that we had really good growth in net/com, in mobility and in software, and that's important because it's congruent with our strategic initiatives. We talk about the customers transitioning to social, mobile, cloud, analytics, and big data and security. We had growth in all of those areas, and we had some good growth in storage as well. So we do expect those trends to continue.

Justin Patterson

Right. And it looks like gross margin's been expanding pretty nicely as those categories have been growing, so I think that kind of speaks to your overall strategy here. And then, I guess, for kind of a final question, looking at the IT market for 2014, what type of growth are you factoring in at this point in time? And how do you think about taking share against the overall market?

Timothy J. McGrath

So, of course, the latest GDP numbers are out this afternoon. But in general, we're kind of consistent with the view of your firm and others in that we've seen mid single-digit growth, but our strategy has been to grow the bottom line faster than the top line and to grow significantly ahead of the GDP rate. And so we saw, as you've predicted, about 50% better growth than the GDP, and that clearly is a trend that we'd like to continue.

Joseph S. Driscoll

But I think, overall, if you're looking from 3% to 5% growth or something like that for next year, I guess, that's probably a reasonable expectation. We do have the federal number that we need to continue to keep an eye on. So that all adds in to the overall growth rate for us.

Operator

And our next question comes from the line of Prab Gowrisankaran from Cannacord.

Prabhakar Gowrisankaran - Canaccord Genuity, Research Division

Just a quick update on your operating margin targets. I know in the last call, you mentioned you were trying to target a 3% level. I know you talked about increased SG&A spend with the sales hires. If you can talk through it, what do you think you expect for the year?

Joseph S. Driscoll

Yes. So the 3% number that we've talked about, we're not there yet, obviously, and we're going to continue to move in that direction by trying to increase the top line, increase our gross margins and try to hold the SG&A as a percent of sales. So we believe in 2014, we're going to continue to move in that direction. I'm not sure we're going to get there for the full year, but that's really the game plan is to keep moving into the higher value-added solutions where we can generate more margin dollars. But that does come with a bit more SG&A, obviously.

Prabhakar Gowrisankaran - Canaccord Genuity, Research Division

Okay, yes. And on the federal side, I know you -- it's been tough to predict where the segment will grow. But as the comps get easier, do you see like the Windows XP expiring, some of that other stuff to still benefit through the first half and then maybe other things pick up in the second half? How do you see the federal recovering from here?

Joseph S. Driscoll

Hard to say.

Timothy J. McGrath

It's a great question. We just don't have great visibility. Some of the federal spend will recover, but that may not be on IT, and so we just -- we're just not confident that we can say that we're going to see a recovery there. And I think our major consistent -- we're consistent with our major suppliers on that view. I think we're all kind of in the same place.

Prabhakar Gowrisankaran - Canaccord Genuity, Research Division

Yes, and the last question I have was, in terms of the higher value solutions and services like net/com and software and big data and mobility. Where do you see the mix going towards, of your revenues? Do you see it shifting drastically? How do you see it trending? I know you're gaining, there's a lot more growth there. Do you still -- selling older stuff? So I'm just trying to get some macro level view on how you think it'll trend.

Timothy J. McGrath

Yes. So one of our internal goals is to try to get 50% of our sales from higher value-added solutions. We're not at that number yet, but I think every year, we can continue to move in that direction. So right now we're probably about 40% of our total revenues coming from software, storage, net/com, sort of the higher value-added areas. And that is up from last year, but I think it's going to be a gradual move in that direction. We still have a large business that sells things like traditional workstations, notebooks, et cetera. So you'll see, I think, a gradual move in that direction where we're going to sell another 1% or 2% every year sort of in that higher margin stuff.

Operator

And that concludes our question-and-answer session for today. I would like to turn the conference back to Mr. Tim McGrath for any concluding remarks.

Timothy J. McGrath

Well, thank you operator. We're pleased with PC Connection's result this quarter. The company increased revenue, gross margin, operating margin and earnings per share in a challenging economic environment. As a national solution provider, we're continually working to enhance our capabilities to deliver high-value technology solutions to help our customers solve their business challenges. We believe the team and the strategy that we have in place position PC Connection well to gain market share and increase long-term shareholder value. I'd like to thank all of our customers, vendor partners and shareholders for their continued support, and our dedicated co-workers for their efforts. I'd also like to thank those of you 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. Everyone, have a good day.

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PC Connection, Inc. (PCCC): Q4 EPS of $0.37 beats by $0.01. Revenue of $578.6M (+4.0% Y/Y) beats by $3.67M.