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PC Connection, Inc (NASDAQ:PCCC)

Q1 2014 Earnings Conference Call

May 1, 2014 04:30 PM ET

Executives

Tim McGrath - President and CEO

Joe Driscoll - CFO

Analysts

Jared Schramm - Roth Capital Partners

Prab Gowrisankaran - Canaccord Genuity

Jeff Koche - Raymond James & Associates

Operator

Good afternoon, ladies and gentlemen, and welcome to the First Quarter 2014 PC Connection Incorporated Earnings Conference Call. My name is Andrew, and I'll be the coordinator for today. At this time all participants are in listen only - mode. Following the prepared remarks there will be a question-and-session. 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, 2013, 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 web site. Today's call is being webcast and will be available on PC Connection's web site.

I would now like to turn the call over to Tim McGrath. Please proceed, sir.

Tim McGrath

Good afternoon everyone and thank you for joining us today to review the company’s first quarter financial results. We’re pleased with the strong first quarter performance. Net sales grew by 10.8% led by sales growth of 26% in our public sector business. Through a significant research activity in the quarter due to the Windows XP expiration, we also generated strong sales in Chromebook, software and networking. The change in product mix is a result of Windows XP expiration resulted in a lower gross margin but we’re still able to grow earnings faster than sales as net income and earnings per share both increased by 17%.

We continue to execute our core growth strategies to deliver broad spectrum of IT solutions. Our goal is to increase market share, best in class capabilities, enhance operational efficiencies and maximize growth opportunities particularly in targeted vertical markets and higher margin solutions.

As we review our results please note otherwise stated all of our first quarter 2014 comparisons are being made against our first quarter 2013. Consolidated net sales increased year-over-year by $54 million or 10.8% to $560 million.

Gross profit dollars in the quarter increased by 9% to $73 million consolidated gross margin decreased 21 basis points to 13% as a result of the product mix shift to lower margin product such as notebooks and desktops.

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, security, cloud and life cycle services. These investments have led to an increase in SG&A expense. Our SG&A dollars increased by $4.4 million however SG&A as a percentage of net sales was favorable by 31 basis points.

Variable SG&A accounted for part of the increase in dollars due to higher sales. In addition SG&A in the first quarter of 2014 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 17% to $7.1 million, and diluted earnings per share increased from $0.23 to $0.27. We increased our earnings faster than our rate of sales growth by leveraging our fixed cost over higher net sales.

And now I'll turn the call over to Joe Driscoll to discuss the results of our business segments and financial highlights. Joe?

Joe Driscoll

Thanks, Tim. Sales for our SMB segment, which serves small to medium-sized businesses, increased by 7.5% to $253 million, with double-digit percentage increases in the notebook, desktop and software categories in this segment.

Gross profit dollars for SMB increased by 6%, however gross margin decreased by 19 basis points to 14.9%. The decrease in gross margin was due to increased demand for lower margin products such as notebooks and desktops.

Sales by our Large Account segment increased by 7.8% to $201 million. We experienced double-digit percentage sales growth in both notebooks and desktops. Total gross profit dollars grew by 12% and gross margin increased from 11.5% to 12%.

Our overall commercial sales, which is the combination of our SMB and Large Account segments, grew by 7.7% over the prior year quarter. Quarterly sales in the Public Sector segment, which includes sales to government and education customers, increased by 26%. 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 29% whereas sales to the federal government were up 20%.

Federal government sales represented 5% of our consolidated revenue in Q1. Gross profit dollars for the Public Sector segment increased by 11%, and gross margin decreased from 11.9% to 10.5%, the decrease in margin is attributable the significant increase in sales of lower margin notebooks and Chromebooks during the quarter.

Our healthcare vertical, which is represented in each of our three segments, increased in sales by 4%. We expect healthcare to continue to be an important vertical for us in future periods. However, there is continued uncertainty in the market due to ongoing changes in government regulations. Program reimbursements for healthcare could be impacted which may result in delays in IT investments.

Overall, our financial performance was solid. In addition to increasing EPS to $0.27 per share, we also increased our trailing 12-month adjusted EBITDA to $69.5 million. During the first quarter we generated 22 million of positive cash flow the Q1 2014 cash balance of 64.9 million is higher than our 2013 year-end cash balance due to seasonally lower working capital requirements.

We regularly assess how to best deploy our excess cash. And our goal is to maximize shareholder value while maintaining financial flexibility.

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

Tim McGrath

Thanks Joe. We’re pleased with PC Connections’s results this quarter. Our long standing customer relationships puts us in position to benefit from the Windows XP expiration drove significant re-productivity in categories such as notebooks and desktops. In addition we increased sales of our more complex areas especially software and networking. As we continued transformation into a national provider of the advance IT solutions focused on helping our customers solve their business challenges.

The overall IT market continues to undergo significant changes, some of these market changes have resulted in reduction in certain partner funding programs for 2014 particularly in software. In order to maximize channel incentives and our overall profitability, we need to continue to transform our business and invest in emerging technologies which will increase our SG&A expenses.

As we look out to the balance of the year, we believe that sales growth will return to level of their consistent with industry expectations. We experienced substantial growth in quarter from several areas that are not likely to continue to grow at the same rate for the rest of 2014. One area was the expiration of Windows XP, there could be additional Windows XP activity for the next couple of quarters but it is not expected to be at the Q1 levels.

Our SLED business grew 29% in Q1. We expect to have a growth in SLED for the balance of the year but it sounds like we continue at the Q1 rate of growth since the year-over-year comparisons will be much more difficult for the rest of 2014. Our federal business was 20% in Q1 but the sales growth was mainly attributed to several large deals that had relatively low margins. We expect that for the rest of the year federal sales growth rates will be in the low single-digit range which is consistent with industry expectations for the federal space.

In addition to these factors, our customers in all sales segments continue research new disruptive technologies for their data centers. And are also evaluating cloud alternatives which has resulted in lengthening a decisions in some complex solution category. Industry experts have projected overall IT growth rates in the 4% range for 2014, which we believe are reasonable. As changes in the market continue unfold we feel it’s critical that we manage our growth appropriately with focus on expanding margins, investing in solution capabilities and keeping our balance sheet strong.

We also believe that our balanced portfolio of customers, suppliers, products and solutions has helped us to deliver solid results. Our goal is to continue to deliver sustained and consistent performance.

We’ll now entertain your questions. Operator.

Question-and-Answer Session

Operator

(Operator Instructions) We have a question from the line of Jared Schramm from Roth Capital Partners. Your line is open.

Jared Schramm - Roth Capital Partners

Looking on the federal government side, obviously, a nice -- see a bounce-back quarter there. Tim, you talked about some moderate growth going forward at the federal level here. Is it safe to say that the difficult period we saw for the previous couple quarters are now behind you?

Tim McGrath

Yeah. It’s really tough to make that call. So we think about Q1, 27% of our business was in the federal space and 73 in the SLED space. As you see pretty good growth in the SLED space, Federal space we did see a good recovery and you know we are optimistic but we’re just not confident that we can say that with slowdown is behind us and we feel projecting sort of at mid single digit growth range.

Jared Schramm - Roth Capital Partners

Looking on the acquisition side, how active do you anticipate being in this market for the remainder of 2014? In particular, anything on the higher margin consulting side being attracted you of recent?

Tim McGrath

So, we’ve been looking at potential deals, fairly regularly large deals come across our desk, really right the valuation have been the biggest problem that, some of these higher end bars who are focused on datacenter or storage, they really expecting a big multiple for their businesses. So we are absolutely looking at deals all the time. It’s truly been a question finding the right one that we can get at the right price.

Joseph Driscoll

In addition Jared, I’d like to add that, we are up very confident in our business plan and our people we are we think taking share and growing up some key category, so while we are instant in valuating opportunity and we do think the market is going to continue to consolidate, we don’t feels it, there is a sense of urgency to do, we’re going to be very selective in the process.

Jared Schramm - Roth Capital Partners

Tim, you mentioned that purchasing decisions seem to be lengthening. Any metric you can provide there? Is this a matter of three months going to nine months? Six months going to a year?

Tim McGrath

Well, probably not. I do review the finals and we look at that in and as you know Jared, just most of technology is more complex specially the datacenter arena and there are several new and disrupted technologies coming in to play and so that just makes the decision harder for our customer base that they really evaluate what’s best for them. So the upside of that is, that makes our proposition a little strong for them as we help them through that process. So I don’t have any specific data that say, it’s sales cycle have moved to 90 day to 120 days, but I can’t tell you, clearly there’s more technology that makes the decision harder for them.

Jared Schramm - Roth Capital Partners

And then, lastly, looking at the Windows XP expiration. Obviously got a nice bump up from that this quarter. You mentioned that you expect this will drag out for the next several months. Is that to date, so far -- I guess two-part question -- April? Was that still a pretty solid benefit you expect this to carry on for the rest of 2014?

Tim McGrath

Sure, clearly there’s going to be some carry over yes, but that’s not if the rates that we saw in Q1 and we saw some really significant growth rates in Q1. And you know we’ve talked a little about the effect that had on the margin I think about notebooks in a particular Chrome books in the public sectors those are slightly margin program than the advance technology sweeter products. So we saw really good growth in Q1, we think that’s going to continue but it’s going to tail-off. So we’re going to be right back, we think fairly quickly that to normal growth rates,

Operator

Thank you. Our next question comes from the line of Prab Gowrisankaran from Canaccord. Your line is open.

Prab Gowrisankaran - Canaccord Genuity

Thanks for taking my question and congrats on the quarter. A couple quick questions on -- in terms of as you see the Windows XP refresh tail off, I'm assuming you would expect gross margins to pick back up? Or do you expect Chromebook and others to keep it at these levels? If you can provide some color just on what the trend you think will be the rest of the year.

Tim McGrath

Yeah. So I think you’re going to see some windows XP activity for the next couple of quarters it won’t be a significant as Q1 but really there is almost a direct relationship, the more you have in those categories, the lower our overall gross margin is going to be, so it adds as the Windows XP thing flushes out, you’re going to see hopefully our margins kick back up again. So it’s kind of earnings gross relationship there.

Prab Gowrisankaran - Canaccord Genuity

Okay. And another question I had was if you can talk about the sales in your higher value segments? You talked about software and networking being strong. How about storage in other segments? And if you can provide any color on where you see it going?

Tim McGrath

So, there’s actually a table in our earnings release that breaks out the exact numbers. Software was very strong this quarter with 40% growth and that’s going to be a mix bag, security and virtualization and regular office software. So that’s been a continuing growth story for us the last several quarters and we expect that to be strong for the rest of year. Networking was very good in the quarter with 8% so those two categories were some of the more complex area that we did really well. And on storage, was actually down 5% year-over-year and really that gets back to what Tim was talking about sort of a lengthening cycle in the decision process. So, that’s what we found is that people are taking more time on some of these bigger decisions. And so it hasn’t been strong for us this past quarter, but we are highly focused on growing that category.

Prab Gowrisankaran - Canaccord Genuity

Okay, great. And one last question, just on the overall growth rate, just based off the strong start, do you expect -- I know you talked about maybe the 4% level; do you see getting over that -- higher than that, just based on this Windows XP refresh?

Tim McGrath

You know 4% is rough and tough where the industry experts have; I have estimated the growth for the year or so. We think maybe we’ll be slightly above that number but once again they kind of, the higher we get above that number, you’re probably going to see and office into some extent in our gross margin percentage. So that be that, the one thing I would caution you on as you are building your model.

Operator

Thank you. Our next question comes from the line of Jeff Koche from Raymond James. Your line is open.

Jeff Koche - Raymond James & Associates

It's Jeff in for Brian. Really quick question. I think you -- I mean you said that the Chromebooks were really strong. And it sounds like that's going to be tied to the public. You are not seeing any adoption on the enterprise or other -- or the small or the large businesses, are you?

Tim McGrath

Nothing is significant, Jeff. So, thanks. We are seeing really significant growth in the education space and that’s what [Indiscernible].

Jeff Koche - Raymond James & Associates

Was that -- is that tied, do you think, to the expiration of XP? Or is it…?

Tim McGrath

No it’s really more tied to sort of K3 12 education space where a lot of school districts are implementing things like common for and or, a computer for every kid in the school and that’s really where we’re seeing a lot of action in terms of Chromebooks.

Jeff Koche - Raymond James & Associates

Okay. And you said that that Netcom was strong -- or it obviously was, it was up high-single digits. It sounded like it was stronger more in the public. Can you talk -- give us some color on what drove that?

Tim McGrath

Yeah. I think, the higher ad was the driver of that, we had really good growth in our select phase and there are number of factors there, we are seeing good adoption all the way around with security which is really been a hotspot. And overall software is strong I think it will continue to be strong.

Jeff Koche - Raymond James & Associates

Outside of public, was Netcom up?

Tim McGrath

Yes. We were up in all segments.

Jeff Koche - Raymond James & Associates

And you were kind of talking about -- I know storage was down; I'm not sure if you broke out servers, but I take it that that segment was helped more on the desktop side. And so I'm just kind of curious, there seems to be like a little bit of a disconnect between how you're doing it Netcom and storage and servers. Just wondering what you see there?

Tim McGrath

Just in several level up, we had reasonable server performance and I think are very good our Netcom software performance and we are going to be recovering and very focused on the storage side. Again lots of new, I mean, you’ve written about it or Raymond James has lots of new and disruptive storage players in the market. It combines with of course cloud offerings. And so for that segment of the business, I think there’s a lot of moving pieces.

Jeff Koche - Raymond James & Associates

Yes. So are you seeing a lot more demand for flash? And if you could, as a side note, kind of talk about your cloud strategy. I know you guys are investing pretty significantly. And I'm sure it's growing of a very small base, but how are you -- how do you -- what's your strategy to kind of counteract some of the disruption for tiered traditional businesses?

Tim McGrath

So we get, first of question we are seeing growth in flash and then we are excited about what we’re doing with our cloud business, so in our cloud business, we have a strategy that really helps our customers kind of define what their needs are. And if that need is to go to public and will them, if that need is for a private or a hybrid cloud, then we will help them or build that out for them. And in addition we resell several clouds offering from our mainstream suppliers like VMware and HP.

Jeff Koche - Raymond James & Associates

I know some of the distributors are kind of trying to become more cloud aggregators. Do you see -- I mean, is that kind of one of the capabilities that you are working on right now, and something that you are differentiating with? And are you looking kind of to maybe go with the distributor offerings? Like Ingram has announced several initiatives and partnering with Parallels. Just wondering what you guys are thinking there?

Tim McGrath

So that’s good question Jeff, you know we’re cautiously optimistic and we are evaluating that, we were closed with our distribution partner, but before we put our stamp of approval on an offering, we’re going to invest that our and make sure that we’re getting our customer base instruct, involved in a very strong solution. So obviously the strong offerings from IBM, HP, Microsoft, VMware those are easy for us. Those are solid offerings and we are getting great attraction there. With the -- more of the public offerings and more of the one-off, we’re going to major twice and cut once, because there’s an awful lot of space, as you know for a monthly annuity to move a workload off-premise, we've got to ensure that that’s the right premise for our customer.

Operator

Thank you. (Operator Instructions) And I am saying no further questions in the queue at this time. I’d like to turn the call back to the speakers for closing remarks.

Tim McGrath

Well, thank you operator. I’d like to thank all of our customer’s, vendor, partners in shareholders for the continuous support and our dedicated core workers for their reference. I’d also like to thanks those of you who finish to our call this afternoon, your interest in PC Connection and your time are appreciated. Have a great evening.

Operator

Ladies and gentlemen, thank you for participation in today's conference. This now concludes the program, and you may now disconnect. Everyone, have a good day.

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