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Insight Enterprises, Inc. (NASDAQ:NSIT)

Q4 2013 Earnings Conference Call

February 12, 2014 5:00 p.m. ET

Executives

Ken Lamneck – President and CEO

Glynis Bryan – CFO

Analysts

Matt Sheerin – Stifel Nicolaus

Jeff Koche – Raymond James & Associates

Operator

Good day, ladies and gentlemen, and welcome to the Insight Enterprises, Inc. Fourth Quarter and Full Year 2013 Earnings Conference Call. [Operator Instructions] I would now like to introduce to your host for today’s program, Glynis Bryan, Chief Financial Officer. Please go ahead.

Glynis Bryan

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 and full year ended December 31, 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 via 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, February 12, 2014. 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 fourth quarter and the full year 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 now turn the call over to Ken to give you an overview of our fourth quarter 2013 operating results. Ken?

Ken Lamneck

Hello, everyone. Thank you for joining us today to discuss our fourth quarter and full year 2013 operating results.

We are pleased with the financial results in the fourth quarter. We returned to year-over-year growth on the top line in North America and EMEA. We executed better than expected against recently announced partner program changes, and we continued to control our operating costs all leading to solid results in the quarter.

For the fourth quarter of 2013, consolidated net sales grew 4% year-over-year to $1.4 billion. Gross profit was consistent year-to-year, while gross margin declined approximately 30 basis points to 13%. SG&A decreased 1%. Earnings from operations, excluding severance and restructuring expenses, increased 5% to $40.4 million. On a GAAP basis, earnings from operations decreased 2% to $35.9 million, and diluted earnings per share excluding severance and restructuring expenses increased 16% year-over-year to $0.57. On a GAAP basis, diluted earnings per share increased 4% year-over-year to $0.48 reflecting the effective share repurchases during the year.

Within these results, the North America business delivered solid top line growth particularly in the hardware category, which grew 7% year-over-year in the quarter. We saw growth in hardware sales across all clients groups and by category, we saw continued strong demand for Networking Solutions.

In the Software category, product sales increased year-over-year but reported net sales decreased 3% year-to-year due to higher mix of software maintenance sales, which are recorded net in our financial statements.

And we saw 9% growth in our Services category driven by increased professional and managed services engagements. Gross profit grew 4% and gross margin was flat year-over-year in North America as increased services gross profit offset the adverse effects of partner program changes. Additionally, we maintained strong discipline around our cost in North America, which drove earnings from operations up 50% year-over-year in the fourth quarter excluding severance in both periods.

In EMEA, net sales increased 2% year-over-year in constant currency due to increased sales of business productivity and virtualization software in the large and mid-sized client groups.

Hardware sales were flat year-to-year in the quarter in constant currency due to increased sales of business productivity and virtualization software in the large and mid-sized client groups. Hardware sales were flat year-to-year in the quarter in constant currency. We returned to growth in mid-market as execution and sales force productivity improved.

Our EMEA team executed well in the fourth quarter to mitigate partner program changes resulted in a much lower impact than originally anticipated, but due to the residual program changes and lower services gross profit, gross profit margins during the quarter declined to 12.4% from 13.4% a year ago. The decrease in gross profit was partly offset by lower operating cost due to recent restructuring activities which led to non-GAAP earnings from operations of $4.4 million, down 70% from the fourth quarter of last year.

As we note in our last conference call, we’re highly focused on improving our results in EMEA business. Our execution is improving and we’re focused on continuing to drive improved productivity in our sales force. These efforts are expected to drive results that than more offset additional partner program changes and we believe we’ll return to positive earnings growth year-over-year in EMEA in the back half of 2014.

In Asia-Pacific, fourth quarter net sales were flat year-over-year in constant currency. Gross profit declined due to lower sales of enterprise agreements to large clients and the effect of the partner program changes in the software category, which drove earnings from operations down 20% year-to-year.

For the full year 2013, our consolidated financial results did not meet our expectations. We were proud of the improvements we saw throughout the year following a very slow start in first quarter 2013. For example, consolidated hardware sales for the full year 2013 declined 5% and we saw sequential growth each quarter beginning in Q2 and exited the year with a stronger run rate in this category.

Software product sales grew year-over-year for the full year but reported net sales declined slightly because of a higher mix of software maintenance sales which are reported net in our financial statement.

Also in the software category, we mitigated the effects of expected partner program changes through stronger execution with the $4 million decline in incentives to our largest partner due to program changes compared to our initial expected range of $8 million to $12 million. And we grew our services sales 3% year-to-year in 2013 at higher gross margins than we saw in 2012.

As we headed to 2014, the foundation of our business is stronger. Integration of our IT systems in North America and EMEA is complete. Our management team is in place including Wolfgang Ebermann who recently joined as president of EMEA. Market demand is improving particularly North America, our largest segment. With a healthy balance sheet to support growth and our operating trends are improving across all the markets we do business in.

Industry analysts expect low single-digit growth in hardware sales in 2014 and mid-single digit growth in software and services sales. Our plans for 2014 are focused on driving growth and access [ph] to the market across our operating segments. We will also continue to focus on our account level profitability initiatives, optimize our performance with strategic partners, expand our capabilities in the Cloud and tightly manage discretionary costs in our business while growing our sales force.

In North America in 2013, we worked to refine our go-to-markets model, organizing our field and inside sales resources to focus on key vertical markets and client groups across specific cities in North America.

In 2014, we plan to continue to invest in sales resources in these markets to drive new business growth. We also expect to add additional technical sales support for strategic categories such as software services, networking and storage to bring more value-added solutions to our clients, and we will continue to execute our profit improvement plan at the accountant partner level which we believe will help mitigate the effect of previously announced program changes in the software category.

In EMEA, we plan to invest modestly in our sales teams and we continue to focus on improving the productivity of our existing sales resources which we believe will result in improved financial performance of 2014. Our plans include returning to growth in the hardware category in key geographic markets, while managing through partner program changes in the software category. We’ll continue to tightly manage our newly reduced cost structure as well and we believe that this focus will lead to improved earnings and performance for the full year.

Finally, in Asia-Pacific, we’re almost entirely a software business. Our plans are focused on continued penetration of the mid-sized and public sector markets and the development of more specialized software services capability. We also expect to integrate our Asia-Pacific business into our North America IT platform in mid-2014.

I will now hand the call over to Glynis who will discuss our full year 2013 financial results in more detail.

Glynis Bryan

Thank you, Ken. For the full year 2013, consolidated net sales were $5.1 billion, down 3% year-to-year.

North America net sales declined a 4% primarily due to lower hardware sales to large clients. North America software sales declined due to higher mix of software maintenance sales to public sector clients which are recorded net on our financial statements.

In EMEA, net sales were flat year-to-year as lower hardware sales across all client groups were offset by increased software and services sales.

In Asia-Pacific, net sales declined 3% due to lower software sales volume with large clients. Full year 2013 consolidated gross profit was approximately $700 million, down 3% and gross margin of 13.6% was flat year-over-year. Gross margin expanded in North America due to strong execution on the partner program and partner incentive program and higher services gross profit. These offset the adverse effects of partner program changes and lower hardware sales in EMEA. As Ken noted earlier, partner program changes by our largest software partner resulted in approximately $4 million of lower incentives in the software business primarily in our EMEA operating segment.

Selling and administrative expenses for the full year of 2013 were $565 million, flat year-to-year. In North America, SG&A expenses increased $2.7 million year-over-year. Investments in sales and services resources were offset by lower margin and variable compensation expense. Also please recall that our 2012 SG&A results were favourably impacted by $2.2 million from the sale of certain services contracts and the recovery of legal fees from a third party.

In EMEA, SG&A expenses declined approximately $2 million year-to-year in US dollars and $3.8 million in constant currency in 2013 due to restructuring actions taken during the year. And in Asia-Pacific, expenses declined $1.1 million year-to-year due to lower variable compensation expense. As a result of significant restructuring activities in EMEA and the continued review of resource moves in North America, we recorded severance and restructuring expense of $12.7 million in 2013 compared to $6.3 million in 2012. We do not expect to incur this level of severance expense in 2014. All of these led to earnings from operations of $121 million in 2013, a decrease of 18% from 2012. Excluding severance expenses, earnings from operations were $134 million, down 13% in each year.

Our expected tax rate in 2013 was 38% compared to 35.9% in 2012. The increase was primarily due to the effects of an increased valuation allowance against certain foreign deferred tax assets during 2013. And finally, net earnings in 2013 was $71 million, down 23% year-to-year, and excluding severance expenses, net earnings were $80.8 million in 2013, down 15% from 2012.

Moving on to our cash flow performance. For the year ended December 31, 2013, our operations generated $76 million of cash, up approximately 13% year-over-year. We invested $19 million in capital expenditures in 2013, down from $30 million in 2012 reflecting lower IT spending as we completed our EMEA and North American IT system projects. And we spent $58 million in 2013 to repurchase approximately 2 million shares of our common stock.

In 2014, we expect to spend between $15 million to $20 million in capital expenditures and in the first half of the year to repurchase up to $42 million of our common stock under previously announced authorization. We ended the 2013 year with a cash balance of $127 million of which $111 million was resident [ph] in our foreign subsidiaries and $66.5 million of debt outstanding under our debt facilities. This compares to $152 million of cash and $80 million of debt outstanding at the end of 2012. And from a cash flow efficiency perspective, our cash conversion cycle was 27 days in fourth quarter of 2013, an increase of three days year-to-year as a result of lower CPOs in North America driven by the timing of payment due to suppliers in the quarter. I will now turn the call back to Ken.

Ken Lamneck

Thank you, Glynis. Moving onto our outlook for 2014. For the full year 2014 we expect the global IT market to grow on a low- to mid-single digit range. We expect our business to grow slightly faster than the market. As a result, we expect earnings per share for the full year 2014 to be between $1.97 to $2.07. This outlook reflects the adverse effects on gross profit of previously announced partner program changes in the software category of between $15 and $20 million, an effective tax rate of 38% to 39%; the completion of our current share repurchase program of up to $42 million in the first half of the year; and capital expenditures of $15 million to $20 million. This outlook does not reflect severance and restructuring expenses.

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

Question-and-Answer Session

Operator

[Operator Instructions] And our first question comes in the line of Matt Sheerin from Stifel.

Matt Sheerin – Stifel Nicolaus

Ken, just regarding your outlook for the year, sort of backing into the number I'm given -- mid-single-digit revenue growth. It looks like gross margin could be down a little bit for reasons you stated. But operating margins should be up to get to that number, that EPS number. Is that going to come from SG&A leverage? And what should we be thinking about margin expansion in North America and Europe? Europe, obviously, you're off of a lower base; but what should be we thinking about margin expansion in both of those regions?

Ken Lamneck

Thanks, Matt. Let me start and then Glynis will add as well. Yeah. As we indicated that we do expect of course to see growth of some of that, obviously growth that we’ll see in the profit line will come from the top line revenue growth. We will certainly be controlling SG&A. There will be some increases to it all related to sales and technical head count and again you’ll see an acceleration for us planning in some key areas like services, of course it’s coming at higher margin profiles for us. So that’s pretty much what we see in regards to what we’ll see that and now that will certainly more than offset the program impact changes that we talked about on the software side. Glynis, do you want to add a little bit more to that?

Glynis Bryan

Sure. Matt, so what we will also see the $15 million to $20 million impact that we indicated we’d have from the partner program changes translate roughly to about 25- to 50-basis point reduction ultimately in our gross margin. And when you flow that through at the EFO line, you should anticipate that our EFO or earnings from operation margin would be relatively flat on a year-over-year basis after absorbing that impact and controlling our SG&A.

Ken Lamneck

The margin percent line, that obviously gross –

Glynis Bryan

Gross dollars.

Matt Sheerin – Stifel Nicolaus

Got you. Flat gross margin, higher dollars on the volumes. But are you then looking to offset some of that margin pressure from the vendor relationships by continuing to add to your services business? Or is it hard to get a sense of how much that's going to move the needle at this point?

Ken Lamneck

We certainly expect that we’ll increase our plan to certainly to increase and accelerate the services business. To help offset that, that’s a big part of the plan.

Matt Sheerin – Stifel Nicolaus

Okay. And it sounds like in your comments regarding Europe, it sounds like you're looking at either down of your profitability, down year-over-year for the first couple of quarters from where you were, and then improve that in the second half of the year. Is that coming primarily, Ken, from the volumes that are expected to improve? Or do you also have cost-cutting initiatives and other organization initiatives to improve that?

Ken Lamneck

Yeah. I think you coined it exactly right. Matt, that’s exactly what we expect to happen. So again in the first half we don’t expect to have increases year-over-year at the EFO line but we certainly expect to have that in the back half and lot of that of course is through acceleration with the team in place that we’ll start to see them, we’re confident from that perspective. And then we basically will be very, very focused on how we drive and continue to drive more of the remediation efforts as well on this one software program change.

Glynis Bryan

One other – Matt, to expand a little bit on Ken’s comments. One of the other things that we anticipate is that we would see some recovery in the UK. We were… we didn’t have a very strong 2013 performance in UK. So one of the elements that’s going to aid the recovery in Europe is the recovery in the UK, which has a full complement of hardware, software and services in that regard.

Matt Sheerin – Stifel Nicolaus

And just in terms of the demand environment, it sounds, you sound relatively upbeat about the demand outlook, you’re calling for above market growth. And I think last year, you were little below market for various reasons. What gives you confidence that you can grow faster than the market? And what are the key demand drivers that you see happening this year?

Ken Lamneck

I think certainly we have some of the headwinds that we were looking at last year this time in regards to still completing the SAP migration here and then of course our ERP integration in Europe. So we have those completed. And then last year we did continue to invest in sales resources, on both continents and we expect to certainly start to see that result and we didn’t see that of course in the Q4 results. So we see that continuing.

Matt Sheerin – Stifel Nicolaus

And then in terms of demand drivers just overall?

Ken Lamneck

I think that – when you talk to the segments that we see – that are, I think, doing well. The networking segment continues to grow, we think very strongly from what we can see in all the -- our participation as well as the data that we analyze. Storage, we certainly continue to see that to grow. We do think we will start to see some rebound on the service side this year and that was a pretty tough market overall from a market perspective, last year we do think that we’d start to see that rebounding. And desktop and notebooks continue to actually increase in volume even with all the discussion about it when you look at the NPV data it shows clearly that in the channel desktop notebooks as a category [indiscernible].

Operator

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

Jeff Koche – Raymond James & Associates

Hey guys, it's Jeff Koche in for Brian. Real quick -- a little surprised by the weakness in the gross margin. I know you guys -- it sounded like you didn't have quite as much pressure from the change in the vendor program, and you're obviously benefiting from the change to net in the software side, or selling more net -- recording that more on a net basis. And I'm just wondering, so what drove the gross margin decline this quarter?

Glynis Bryan

Partly is the – while the program changes may not have been as severe as we initially anticipated, there was a $4 million impact in the fourth quarter primarily in EMEA and it was a 100% margin. So the impact on the margin line is greater than the impact on the dollar line, if you want to think about it that way. That’s why we are also seeing when you look at the $15 million to $20 million impact that we say we are going to have in 2014 from the partner program changes that we anticipate is going to be an impact on the margin also of the 25 to 60 basis points.

Jeff Koche – Raymond James & Associates

So to be clear, it’s not like the – the competitive environment is getting –

Glynis Bryan

It’s not the competitive environment, not at all.

Jeff Koche – Raymond James & Associates

And then you said that the gross margin, the 25 to 50 bp is the headwind you're facing. Can you give us a little -- what's your outlook for a year-on-year change? Should we expect you guys can offset that completely? Or should we expect that gross margin will be down?

Glynis Bryan

I don’t think we should anticipate that, there will be some softness in gross margin which we will make up ultimately through SG&A control. We are going to invest in the sales and technical resources but we will control other SG&A such that we anticipate being relatively flat at the EFO margin line.

Jeff Koche – Raymond James & Associates

And then can you just talk about demand improvement in North America? And maybe break it down by customer segment and product segment?

Ken Lamneck

Yes, we definitely saw a nice increase in the quarter in the large enterprise space. We saw that to be strong and we saw a good participation at the SMB side as well for us. And we had good growth, pretty much in all the categories in regards to public sector, and some key verticals like healthcare, K2-12 and so forth as well. So I think there wasn’t any – it wasn’t completely robust but all categories certainly participated in growth.

Jeff Koche – Raymond James & Associates

And then last night, actually, there was a press release that CDW is partnering or training [ph] their relationship with Google. Do you guys see any potential or possibility for you guys to expand relationships with some of, maybe, Microsoft's competitors?

Ken Lamneck

Yeah we are certainly always looking – for us of course it’s always based upon what our clients are demanding. So we’ve got to be able to afford our clients’ needs. We’re certainly always out looking at all the alternatives there. In that regard we do a Chromebook offering, and that we do have signed – so we do have the appliance there for Chromebooks. We don't currently sell the Google apps if that’s what you are referring to and the announcement I saw as well that CDW does – we are currently not doing that.

Operator

(Operator Instructions) And that does conclude the question and answer session of today’s program and this does conclude the conference call for today’s program. Thank you ladies and gentlemen for your participation in today’s conference. You may now disconnect. Good day.

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