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Executives

Mary Gentry - Treasurer, Director of Investor Relations

Mike Baur - Chief Executive Officer

Charlie Mathis - Chief Financial Officer, Senior Vice President

Analysts

Chris Quilty - Raymond James

Dominic Ruccella - Northcoast Research

ScanSource, Inc. (SCSC) Q2 2014 Earnings Conference Call January 30, 2014 5:00 PM ET

Operator

Welcome to the ScanSource quarterly earnings conference call. All lines have been placed in a listen-only mode until the question-and-answer session. Today's call is being recorded. If anyone has any objections, you may disconnect at this time.

I'd now like to turn the call over to Mary Gentry, Treasurer and Director of Investor Relations. Ma'am, you may begin.

Mary Gentry

Thank you, and welcome to ScanSource's earnings conference call for the quarter ended December 31, 2013. With me today are Charlie Mathis, our CFO; and Mike Baur, our CEO.

We will review operating results for the quarter and then take your questions. A slide presentation that accompanies our comments and webcast is posted in the Investor Relations section of our website. Certain statements made on this call will be forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are subject to risks and uncertainties that could cause actual results to differ materially from such statements.

These risks and uncertainties include, but are not limited to, those factors identified in the release and in ScanSource's SEC filings. Any forward-looking statements represents our views only as of today and should not be relied upon as representing our views as of any subsequent date. ScanSource undertakes no duty to update any forward-looking statements to actual results or changes in expectations.

We will be discussing both GAAP and non-GAAP results during our call and have provided reconciliation between these amounts in our press release, which can be found on our website and has also been filed with our Form 8-K.

Mike Baur will now begin our discussion with an overview of the quarterly results.

Mike Baur

Thanks Mary. And thank you for joining us today.

Let's start with Slide 3, for second quarter 2014, we reported net sales of $741 million, at the lower end of our expected range, and diluted EPS of $0.64 per share, at the upper end of our expected range. For the quarter, we had strong operating performance including higher margins and 15.9% return on invested capital.

And looking at our sales for the quarter, I would like to share a few summary points. For Worldwide Communications & Services both of our communications business units in North America, the ScanSource Communications and Catalysts units had solid year-over-year sales growth and our worldwide gross profit margin improved from last year.

In Worldwide Barcode & Security, our sales declined year-over-year. However, each of our POS & Barcode unit had sequential quarterly sales growth primarily due to better performance in our Barcode products. In Brazil, we had record sales quarter for the second quarter in a row.

As we move into the second half of our fiscal year, we are planning to return to year-over-year growth for all of our business units at value added margins. And we have a very strong balance sheet that positions us for growth. During the quarter, we continue to invest and expanding our sales force with the addition of new sales team members in many business units.

Now for an update on our ERP project. We have been evaluating a new ERP platform over the last several months to replace our existing enterprise hardware and software IT system. After careful evaluation, and taking into account our prior experiences we focused on how to achieve certainty with our goal line.

Given that we entered into agreements with SAP for both the software and implementation consulting services for a new ERP system. We have also assembled a team of experienced ScanSource employees to work on our project with a focus on business processes training and change management. With SAP, we have selected a partner with a proven solution for wholesale distribution companies similar to ScanSource plus SAP services team has assigned an experienced implementation team to deliver a successful ERP system for ScanSource. We are very pleased with the commitment from the senior executives at SAP for a successful result.

With that I will turn the call over to Charlie to discuss our second quarter financial results in more detail.

Charlie Mathis

Thanks Mike.

I will begin with Slide number 4, through 7 of the investor presentation, second quarter fiscal year 2014 results.

Net sales of $741 million decreased 0.9% from prior year. The net impacted currency a change fluctuations on the year-over-year change was minor, with higher sales from the strengthening of euro offsetting over sales and weakening of the Brazilian real.

Worldwide Barcode & Security sales were $476 million decreased 3% year-over-year primarily from slower big deal activity. Worldwide Communications & Services sales up $264 million increased 2% year-over-year.

Our North American Communications and Catalog business units’ growth was a result of growing key vendor lines and securing larger big deal projects. A consolidated gross profit margin for the second quarter 2014 was 10.4% compared to 9.9% in the prior year quarter. The Worldwide Barcode & Security gross margin for the quarter remained at 9% unchanged from the year ago quarter.

The Worldwide Communications & Services gross margin was 13.1% up from 11.6% in the prior year principally from an increase in service fee revenues and better attainment of vendor programs. This increase in gross margin for the communication segment was the driver in an overall consolidated gross margin increase.

Overall, this quarter we received some end of the year vendor incentive and unusually high service fee income that is not expected in the March quarter.

SG&A expenses totaled $49.3 million or 6.7% of net sales relatively unchanged from a year ago quarter. SG&A for the second quarter 2014 included a severance payment as previously disclosed in an 8-K filed in November. Also as you may recall, our second quarter 2013 included a $2.1 million charge for Belgium tax compliance and personnel replacement cost in our European entity.

As Mike previously mentioned, we recently signed contracts with SAP to provide a software platform as well as SAP services to implement the new enterprise software. The project kicked-off in January. Although, we did not expect significant operating expenses in the current quarter related to our new ERP project, we will discuss the overall project cost and timing of the rollout in greater detail as we finalize the blueprint stage in the next few months.

In the second quarter 2014, the fair value remeasurement of our earn-out for the CDC Brazil acquisition was a charge of $499,000 as expected inline with a year ago quarter. Second quarter 2014 operating income was $27.5 million with an operating margin of 3.71%. The operating margin increased from 3.27% from second quarter 2013 or 3.55% excluding the $2.1 million for the Belgium tax compliance and personnel replacement cost.

Our effective tax rate for the quarter was 34.2% inline with our expected range of 34% to 34.5% for the remaining quarters of fiscal year 2014.

Second quarter 2014 net income was $18.3 million or $0.64 per diluted share. Diluted EPS totaled $0.59 for the second quarter 2013 or $0.64 per share excluding the Belgium tax compliance and personnel replacement cost. Return on investment capital totaled 15.9% for the quarter compared to 15.2% for the year ago quarter.

Now, let me discuss the balance sheet which you will find on Slide 8 of the presentation. Cash and cash equivalents totaled $157.1 million at December 31, 2013, compared to $148.2 million at June 30, 2013. But, down from $193.8 million in the prior quarter, which I discussed last quarter. For the trailing 12-month period, we have generated $140 million in cash from operating activity. I will discuss how we can use the cash a little later.

Our day sales outstanding, DSO was 53 days in December 31, 2013, compared to 55 in the sequential quarter and 54 days in the prior year quarter. The increase in the allowance for doubtful accounts contributed to lower day sales outstanding.

We continue to execute well and remain disciplined in managing appropriate inventory levels. Although inventory has increased approximately $65 million since our fiscal year end due to increased demand inventory turn 5.9x during the quarter compared to 5.6x with prior year. We have 11.3 paid for inventory days at the end of December 2013, compared to 2.2 paid for inventory days at the end of September 2013 and 17.8 days at the end of December 2012.

We had $5.4 million of debt as of December 31, 2013, compared to $27.8 million at December 31, 2012. During the past year we have borrowed very little under our credit facility. Nevertheless, in the quarter we extended our $300 million facility for an additional two years with essentially the same terms as the previous facility. We have significant resources and capital to grow the company in the future while maintaining high ROIC. Our top priorities on allocating capital are consistent with how the company has created shareholder value in the past.

First, we looked in depth in the organic business to ensure growth. This means decisions on the range of opportunities such as investing in inventory on existing and our new vendor lines, extending credit terms to newer existing customers, opening new markets, as well as investing and maintaining our own infrastructure for the future. And second, we look to make acquisitions, acquisitions that meet our strategic and financial goal. The company has made over 20 acquisitions since its inception adding a strategic geographic area, a strategic vendor and our customers, our new technology and as done so at a reasonable multiple valuation. We continue to focus on these top two priorities.

Turning now to our next quarter, a quarter in which we expect to see year-over-year revenue growth. We expect net sales for the quarter ended March 31, 2014 to range from $700 million to $720 million and earnings per share to range from $0.53 to $0.55 per diluted share.

With that I'll turn the call back over to Mike.

Mike Baur

Thanks Charlie.

Let me start with our Worldwide Barcode & Security, summarized on Slide 9, it represents 64% of overall sales for this quarter. Worldwide Barcode & Security sales up $476 million increased 6% sequential and decreased 3% year-over-year. We had sequential quarter growth for each of our POS & Barcode units across all geographies including a record sales quarter in Brazil. This quarter-over-quarter increase reflects better performance with elite vendors. Similar to the last few quarters slowness in big deals continue with larger projects being broken up into small pieces.

So sales were down year-over-year, our POS & Barcode team in North America had solid sequential quarter growth lead by mobile computing and scanning. Big deals were down from last quarter and last year including fewer big point-of-sale deals. We continue to have good growth with our small and mid-sized vendors and our payment processing sales were up significantly.

In Europe our POS & Barcode business unit exceeded the sales plan, strong growth in our scanner business and better achievement of vendor rebates. We had good growth in certain regions including Eastern Europe, Germany, France and Belgium. We recently expanded our U.S. relationship with CODE, a new vendor for us Barcode readers to include Europe geography.

We are very pleased to report that our team in Brazil had a record quarter for the second quarter in a row where sales grew across all product categories point-of-sale, Barcode, AIDC and Communications. Even with currency fluctuations that's a growth headwind. Net sales in Brazil grew 15% year-over-year. Our team in Brazil execute well growing faster in the market keeping margins at planned levels and accelerating inventory turns. In the past year, our team won two sales growth awards from HP Networking in Brazil.

We named Yvette McKenzie, who joined ScanSource in 2000, President of ScanSource Latin America and Mexico. Since May, Yvette has been leading our Latin America and Mexico business units helping our teams execute best practices, building vendor and reseller partner relationships to our business and adding new team members.

Economic struggles in countries like Venezuela and Argentina continue to impact our business there. However, we had good growth in Chile, Ecuador and Guatemala. Our Latin America and Mexico business is very project driven and we are working there to grow our run rate business. This quarter, we are launching motion computing and projects [ph] as new vendors in Latin America and Mexico.

Our Security sales in the U.S. and Canada declined from weak sales in our networking infrastructure and card printers offsetting good year-over-year growth in video surveillance and access control. Big deal volume was down which contributed to a 4% year-over-year sales decline for the Security business unit. We had record quarter, however, with four of our top six vendors and higher margins from the sales mix and better achievement of vendor programs. This quarter we are adding Cisco's Meraki products to a wireless infrastructure offering and access control products.

Now turning to Worldwide Communications & Services on Slide 10, which is 36% of overall sales this quarter. Worldwide Communications & Services net sales of $264 million decreased 6% sequentially an increase of 2% year-over-year.

Both of our business units in North America had solid year-over-year growth and higher big deals. This increase was partially offset by lower sales in Europe communications. ScanSource Communications in North America had year-over-year sales growth including record quarters with Polycom and AudioCodes. We continued to have good growth with our voice-over-IP telephone resellers and the service provider customer segments.

For ScanSource Catalyst, a significant increase in big deals drove the year-over-year sales growth. In addition, we had good growth with our mid-market voice and another quarter of double-digit growth from our wireless vendors here. We are building out a value-added support model to grow our Cisco collaboration business. In October, we held our catalyst partner conference branded fuel with great business building opportunities for our reseller and vendor partners.

Sales for ScanSource Communications in Europe declined in both of our biggest countries in U.K. and Germany. In U.K., timing of business had an impact on sales results. During the quarter, we launched AudioCodes as a new vendor in our U.K. market. In Germany, sales declined largely from competitive pressures with some changes to our sales team.

We saw business start to pick-up in France with quarter-over-quarter growth. ScanSource Services group provide education and training, network assessments, customer configuration, marketing and a similar partnership community principally in North America. We had a record operating income quarter for our marketing service offer with increases in both the number of projects and our billable hours. We continued to have good demand for our configuration services with exceptionally high-quality metrics and for training classes as an authorized training partner for Avaya, Polycom and ShoreTel.

At this time, we will be glad to answer your questions.

Question-and-Answer Session

Operator

Thank you. We will now begin the question-and-answer session. (Operator Instructions) The first question comes from Chris Quilty of Raymond James. Your line is open.

Chris Quilty - Raymond James

Thanks gentlemen. Just wanted to follow-up just to make sure I got it, you were saying for the fiscal third quarter or for all of calendar 2014, you expect revenues to be up by product line and business segment?

Mike Baur

What we are saying, Chris, this is Mike. What we are saying is that we expect for the calendar year. So we are saying that we expect growth in all of our business units to occur this year. So we are obviously only giving guidance out for one quarter. What we believe based on the investments we have made in 2013 and some of the indicators we are getting from either vendors or customers that we think for calendar year and certainly the last half of this fiscal year will show growth to our company year-over-year in all of our business units.

Chris Quilty - Raymond James

That's great. And is there a particular business unit that you and if you've to rank order of where you feel best about?

Mike Baur

For us it's always a challenge because when we look at the businesses, we're trying to manage the portfolio and sometimes we'll miss based on our quarterly basis how much one of the units can grow based on some of these big deals. I would say that's probably the negating factor in some of what we're saying is, we saw big deals come back this time, our Communication business but not in our Barcode POS business, which historically we saw some significant point-of-sale deals into December quarter in North America and because of the change in one of our vendors this year that didn't happen. So we may see more Barcode POS big deals now move into the March quarter than the December quarter. So we're not really going to prioritize it for you, but we feel good about each one of these business units and their opportunities.

Chris Quilty - Raymond James

Got you. And are there any underlying technology or market changes and either Communications, Barcode or Security that are worth highlighting as growth drivers and I'm just thinking of the top of my head something like target getting burned with your POS terminals and some articles in the journal about jeez may be we shall move to back to smart card readers to try to mitigate some of that either that or some other end market specific drivers?

Mike Baur

Well, that particular comment around the data breaches in the retailers for sure is a topic of discussion in point-of-sale industry. And one of the things that we highlighted for the last year or so is that we continue to add some vendors in the payment processing terminal arena. We have good relationships with key vendors now. We've added this capability in our distribution center where we can configure payment processing terminals that means you mean what's called a key injection process for our customers. So we've added the capability and the right vendors and so if that market starts to accelerate, which if you read trade press and listen to the stories one of the drivers that could help solve some of the data breaches is to adopt, the U.S. to adopt a chip and PIN technology that Europe uses.

And that chip and PIN or EMV Technology is something that has been predicted; few happened in the U.S. and if it happens it will require based on everything we've seen a replacement of the existing payment processing terminals and readers out in the market as you're saying. So we do see that as a potential driver, we just don't know like any of these technologies how fast that be adopted because that's going to be a significant cost for someone to bear whether that's the retailer or it's the banks not sure right. But that is a potential driving force in our technologies. Having said all of that that's not why you're feeling good about work [ph] for this year that would be more upside to what we're thinking.

Chris Quilty - Raymond James

Got you. Charlie, some of the foreign exchange fluctuations that have happened in the past week, do you expect that to impact revenues in anyway?

Charlie Mathis

Well, we didn't see a lot of that in the prior quarter because we had it going both ways euro would strength and Brazilian real was weakening they pretty much offset each other. So now, we don't really anticipate a big impact to that.

Chris Quilty - Raymond James

Got you. And did you mention at some point in the script that you increased the allowance for doubtful accounts and can you just talk about whether you're seeing a deteriorating or improving situation with receivables?

Charlie Mathis

Yes. I did mention that and allowance doubtful -- reserve did go up. There were some customer specific issues in there that we felt we needed to reserve for. So I think that was the primary thing that was driving it other than overall deterioration in the portfolio.

Chris Quilty - Raymond James

Got you. And can you elaborate a little bit more specifically, I mean the performance in Brazil was -- it was pretty outstanding given the economic backdrop there. Is there something specific driving the business either just the addition of vendors, is it taking market share or some other driver?

Mike Baur

Yes. I think what we saw -- this is Mike again Chris. I think what we saw is better execution by the ScanSource team in an improving markets. So our team told us that the overall demand for our products has improved in the last few quarters and then we're executing better against that.

One of our largest vendors down there is a company called Bematech; they're Brazilian printer company that sells other Point-of-Sale equipment as well. And we're seeing better performance in our Bematech portfolio down there. I would say they're representative, if you will, of the overall market. And so we believe that Bematech's business getting better has been good for ScanSource Brazil.

And I think there is some cases where we're taking some market share. We've got a - still a very early stage business in our Brazil Communications business. We referenced HP Networking as one of our couple of vendors; we don't have a real significant vendor yet in that marketplace. We don't have the Avayas or Polycoms in that marketplace. We would certainly hope that our Communication business will start to develop over the next year. And we did some nice growth in those networking products in Brazil that we had not. So that was kind of an upside as well for us in the quarter.

Chris Quilty - Raymond James

Got you. And final question on the M&A, I think you mentioned geography and one other priority, was it product line?

Charlie Mathis

Well, historically the company has made acquisitions to expand strategically in geographic areas and vendor product lines and new technologies and that's continually where we're focused on.

Chris Quilty - Raymond James

Okay. And I mean, historically you've said that when you look at the Asia Pacific region where you don't have a presence, it simply too vulcanized. And so I'm assuming your M&A efforts would be more focused on beefing up some of your existing markets, is that a fair assumption?

Mike Baur

I would say Chris that we're probably not looking at Asia Pacific, I mean that's fair. But as Charlie said, we would be looking at our existing market plus new technologies.

Chris Quilty - Raymond James

Got you. And is that primarily on the Barcode & Security or Communications?

Mike Baur

Could be something new -- something that's separate from both of them.

Chris Quilty - Raymond James

So, a new leg to the story?

Mike Baur

Correct. Yes, that's right.

Chris Quilty - Raymond James

Very good. It's been, what a decade, well that's not true Security.

Mike Baur

Yes, that's right 2004 when we started Security, yes, yes, you are right on.

Chris Quilty - Raymond James

It was a decade.

Mike Baur

Yes.

Chris Quilty - Raymond James

All right. Very good. Interested to see what you have in the pipeline and --

Mike Baur

Yes. Stay tuned, more to come on that.

Chris Quilty - Raymond James

Great. Thank you.

Mike Baur

Thanks Chris.

Operator

The next question comes from Dominic Ruccella for Keith Housum of Northcoast Research. Your line is open.

Dominic Ruccella - Northcoast Research

Thank you very much. Thank you for taking my call. Just a few question where guys on the quarter. Did you guys see any type of competitive benefit from Westcon’s troubles with their ERP?

Mike Baur

This is Mike. We did hear that from many of our team members. We certainly sympathized with A1 that has the ERP challenges, we certainly had ours, unless you are trying to live. But no, I would say no one in our team said, hey, we were able to steal some business or take some market share because of challenges with that. It's generally especially in the Communication business where we've got larger customers. They really -- they make some really long-term decisions when they choose distribution partners. So I think that one is less transactional oriented frankly than some of our other businesses. And so I would say no, we didn't see that in the quarter.

Dominic Ruccella - Northcoast Research

Okay. All right, fair enough. Thank you. For Avaya's new channel programs, what are you guys initial thoughts, positive, negative for you guys, I know you guys mentioned that a little bit earlier in the script.

Mike Baur

Well, in general for us, we're really reflecting on just a normal development of vendor programs as they go. We try to shy away from talking about any specific vendors, if we can. And so I don't think I said Avaya's program. So I was talking about our vendor programs and that really encompasses lots of them. But in general, if we have problems with programs where we believe would provide value-added services and not being compensated, we'll call that out.

And if we didn't we feel good about our vendor programs right now, they seem to be and maybe that's the point, is we seem to see improvement I would say more broadly with our programs. Having said that, as you heard from Charlie still had some unexpected gains from a margin perspective in the quarter because we got some program benefits that we don't believe we can forecast will happen again in March.

Dominic Ruccella - Northcoast Research

Okay, all right. Thank you very much. And then for the – and kind of keeping with your outlook on the vendor programs, any type of gut feeling right now and if any changes from Motorola or Zebra or any other large vendors coming down the pipe, do you have any foresight on that?

Mike Baur

Well, it’s kind of early days because these guys are all calendar year oriented programs, so I would say it’s too early to call anything for the year. I would say the way we exited the calendar year with our key vendors, we feel better about that whole situation that we did a year ago. But it feels you know, we got to sit down and work with them March being the first quarter for all these vendors and it's our fiscal third. It's always the quarter where they are trying to figure out what do they really want from their team and expect from the channel. Then they got to figure out what they are going to expect from ScanSource team.

So it's still too early to call for the year, but we will certainly be able to report a lot more on the vendor programs for you in April, when we report our next quarter results.

Dominic Ruccella - Northcoast Research

Okay, great. And then, I'm sorry, simple on Avaya, is that – is it safe to assume that's less than 29% of your business now, the relationship with Avaya?

Mike Baur

Well, we haven't reported a percentage. I think we talk about them being a significant vendor and we talked about them a lot but we don't have a specific number that we are out there with. So –

Dominic Ruccella - Northcoast Research

Okay.

Mike Baur

We view that has as proprietary information.

Dominic Ruccella - Northcoast Research

Okay. Fair enough. And okay. Well, I think that just going to take care all of my questions. Thank you very much.

Mike Baur

Great. Thanks. Take care.

Dominic Ruccella - Northcoast Research

You too.

Operator

(Operator Instructions) We are showing no further questions at this time.

Mike Baur

Great. Thank you so much for joining us today. Our next conference call to discuss our March 31st quarterly earnings is expected to be on May the 1st, 2014. Thank you very much.

Operator

That concludes today's conference. Thank you for participating. You may disconnect at this time.

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