Insight Enterprises CEO Discusses Q3 2010 - Earnings Call Transcript

Nov. 4.10 | About: Insight Enterprises, (NSIT)

Insight Enterprises, (NASDAQ:NSIT)

Q3 2010 Earnings Call

November 3, 2010 05:00 pm ET

Executives

Kenneth Lamneck – Chief Executive Officer, President, Director and Member of Executive Committee

Helen Johnson – Senior Vice President, Treasurer

Stuart Fenton – President, Insight EMEA and APAC

Analysts

Matt Sheerin – Stifel Nicolaus

John Lawrence – Morgan Keegan

Brian Alexander – Raymond James

Operator

Good day, ladies and gentlemen, and welcome to the Q3 2010 Insight Enterprises Incorporated earnings conference call. (Operator instructions.) I would now like to turn the conference over to your host for today, Ms. Helen Johnson, Senior Vice President and Treasurer. Please proceed.

Helen Johnson

Thank you. 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 ended September 30th, 2010. I’m Helen Johnson, Senior Vice President and Treasurer of Insight, and joining me is Ken Lamneck, President and Chief Executive Officer. I’m sitting in for Glynis today, who is home fighting the flu. She’ll be back in the office very soon.

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 8K, you will find it on our website at www.insight.com under our Investor Relations section. Today’s call including the question-and-answer period is being webcast live and can be accessed by the Investor Relations page of our website at www.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 webcasts contain time-sensitive information that is accurate only as of today, November 3, 2010. 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.

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 10K for the year ended December 31st, 2009.

With that, I will now turn the call over to Ken to walk you through an overview of our Q3 2010 operating results. Ken?

Kenneth Lamneck

Hello everyone. Thank you for joining us today to discuss our Q3 operating results. Today we report another quarter of healthy year to year growth driven by continued strong demand for IT products, improved execution, and operating leverage. Consolidated net sales increased 21% in Q3 to $1.2 billion, up from $969.9 million last year. On a constant currency basis, consolidate net sales grew 23%. Gross profit was $154.6 million, up 16% from last year, and gross margin was 13.2%, down from 13.8% in Q3 2009.

Earnings from operations increased 109% to $24.8 million, or 2.1% of net sales, compared to $11.9 million or 1.2% of net sales reported last year. Net earnings and diluted earnings per share were $14.4 million and $0.31 in Q3 2010 compared to net earnings and diluted earnings per share from continued operations reported Q3 2009 of $7.3 million and $0.16.

Within these results, our North American operating segment reported 34% growth in the hardware category and 25% growth in the software business. Hardware growth in North America continues to be driven by increased demand for notebooks, desktops, and accessories as well at networking and communicating products. Software growth was driven by increased volume across multiple publishers, including our largest software partner.

The shift in sales mix from higher hardware and software sales but lower services sales resulted in overall gross margin, this year compared to last year. We continue to be pleased with the leverage we are getting on a cost structure that resulted in a significant improvement in earnings from operations year to year, excluding the severance and unique items recorded in both periods.

In EMEA we saw double digit sales growth and constant currency, including positive growth across all product categories. Growth in Q3 was driven by higher volume of hardware sales, particularly notebooks and desktops, as well as software sales, primarily in the large enterprise and middle market client groups. Also in EMEA, we continue to make progress on the development of our new IT system for the region, but have concluded that we need some more time to get this system right for implementation.

Thus, we have decided to defer the first country launch until mid next year. The new system is important to our long term strategy to deliver hardware in key markets, and believe this delay is necessary for a smooth transition. In Asia/Pacific, sales declined 13% in constant currency, but our team there grew gross profit year to year to higher fees from enterprise agreements.

The overall market continues to improve and we believe we are making progress on our internal initiatives to improve our operational discipline and sales execution. In addition, we have been working to strategically add to management team here at Insight, and I am pleased to report that Mike Gugum(sp) has joined the company just this week as our new Chief Information Officer. Mike brings a wealth of IT and business transformation experience to Insight. Prior to joining our team, Mike held various IT leadership roles over a 15 year period at Motorola, including his most recent position, as Corporate Vice President, Information Technology. In his new role, Mike will oversee the development integration of our global IT infrastructure, including the current project ongoing in EMEA, and longer term plans to integrate our multiple systems here in North America.

We’re still recruiting for the lead sales position in North American and hope to conclude that search by the end of this year. Before I hand the call over to Helen, I want to take a moment to update you on a recent partner announcement. Specifically Welong with other similar resellers were recently informed that our largest software partner intends to make changes to certain elements of its channel and (inaudible) programs, effective in late 2011.

These revisions will pertain to both new and renewal business and will take effect over a multi-year period. Working closely with this partner to understand the components of the plan, and assess the opportunities and potential risks that the change may bring to our business. In the meantime, we’re working diligently to complete our long term strategic and operational plans, to make sure we grow market share and overall profitability.

In order to crystallize our plans, we’re deferring our investor and analyst day to mid-2011 rather than later this year. I will now hand the call over to Helen, who will discuss the Q3 operating results of our business segments.

Helen Johnson

Starting with North America, net sales were $871 million in Q3, up 27% from Q3 2009, and up 1% sequentially. Sales in our hardware category increased 34% year over year, and 8% sequentially, due to generally higher volume, particularly in the large enterprise and corporate client group.

Sales in our software category increased 25% compared to last year, due primarily to higher volume with multiple publishers, and we’re down sequentially due to typical seasonality. Sales of services declined 14%, due primarily to a large engagement in 2009 that did not recur this year.

Gross profit in North America increased 18% year over year, to $111 million, while gross margin decreased to 12.7% from 13.6% in the prior year. This change in margin reflects a 105 basis points decline in contribution from lower services sales, offset partially by a modest increase in product margins. Generally the growth in sales of lower margin hardware and software products, combined with the decline in sales of services, and a lower mix of fee based enterprise agreements has resulted in a decline in our gross margins in North America throughout 2010.

We expect gross margins in this segment will moderate somewhat further in Q4, due to a continuation of this trend and sales mix. Looking at administrative expenses for North America in Q3 were up $9.7 million to $89 million, from the $79 million reported in Q3 2009, but as a percentage of sales decreased to 10.2% compared to 11.6%. Within these results, compensation expense increased $4.1 million on higher sales and over attainment of our operating plan.

The balance of the change year to year relates primarily to higher employee benefit cost, which includes much higher medical claims experience in this year’s Q3, and to a lesser extent, higher salaries and wages. Sequentially, selling and administrative expenses for North America were up $2.6 million, as lower variable compensation on the seasonal decline in gross profit was offset by higher employee benefit expenses, and the effect of a reversal of a bad debt reserve recorded in Q2 of $2.9 million that did not recur this quarter.

We also recorded just under $200,000 in severance and restructuring expenses in this segment in Q3, compared to $4.5 million recorded in Q3 2009. As a result, earnings from operations in North America were $21.3 million, or 2.4% of net sales in Q3 2010, up from $9.5 million reported last year.

Moving on to EMEA, our EMEA operating segment recorded net sales of $268 million, up 8% in US dollars, in constant currency net sales increased 16%. Also in constant currency, sales of hardware grew 7%, software sales increased 22%, and sales of services increased 44% compared to last year, due primarily to higher volume with existing clients.

Gross profit in EMEA was up 8% in US dollars, and up 16% in constant currency terms, while gross margin remained relatively steady year to year, at 14.2%. Within these results, increases in product margin, and margin contributed on higher services sales offset a decline in margin from a lower mix of agency fees from software enterprise agreements.

Turning to administrative expenses in EMEA in Q3 were up 4% or $1.4 million in US dollars and in constant currency were up 13%. This increase year over year was primarily driven by higher variable compensation and sales incentives on increased sales. EMEA also recorded $99,000 in severance expense in Q3, compared to a $463,000 net benefit from the reduction of certain restructuring reserves recorded last year. As a result, earnings from operations in EMEA were $22 million in Q3 2010, up from $1.5 million recorded last year.

Our Asia/Pacific operating segment reported net sales of $33 million, down 6% from the prior year, in US dollars, and down 13% in constant currency. Despite lower sales, gross profit was $6 million, an increase of 25% year to year, in US dollars, and 18% in constant currency. Gross margin was 18%, up from the 13.4% recorded in the prior year quarter, due to increased fees from enterprise agreements.

Selling and administrative expenses in APAC increased 21% year over year in US dollars, or approximately $800,000 and 13% in constant currency terms. As a result of higher variable compensation on increased gross profit. As a result, our Asia/Pacific segment reported earnings from operations of $1.3 million, which was up 41% from the $900,000 recorded last year.

Moving on to our tax rate, our effective tax rate for Q3 was 36.2% which is in line with our normalized tax rate. This compares with 21.6% in the prior year quarter, in which the rate benefitted from the trueup of foreign tax credits resulting from the filing of our 2008 US Federal Tax Return and the recognition of certain tax benefits, resulting from the settlement of audit. We currently expect that our effective tax rate will be in line with our normalized expected rate of 36 to 39% in Q4 2010.

Moving on to working capital metrics and cash flow performance, due to expected seasonality in Q3, our operations used $92 million of cash, compared to $79 million for the same period in 2009, and we invested $4.3 million in capital expenditures this year, compared to $3.4 million last year. As a result, we ended the quarter with $94 million in cash, of which $86 million was resident in our foreign subsidiaries, and $164.5 million of debt outstanding under our revolving credit facility. This compares to $69 million of cash and $155.5 million of debt outstanding under our revolving facility at the end of Q3 2009.

Our cash conversion cycle was 25 days in Q3 2010, down one day from last year, as the benefits of tighter cash management practices in EMEA offset the effect of an increase in certain aged public sector receivables in North America. During Q4, we expect to return to positive cash flow, and we currently expect to end the year with a debt balance of approximately $100 to $110 million.

I will now turn the call back over to Ken for his closing comments.

Ken Lamneck

Thank you, Helen. For 2010 outlook for Q4, given continued strong demands for hardware and software products, partially offset by decline in services sales, we expect that diluted earnings per share will be between $0.38 and $0.43 in Q4. We are pleased with the momentum and demand for IT products so far in 2010, and the catalyst it has provided our business.

We executed better at maintaining our general cost disciplines while strategically in our sales force which has served us well as we close our 2010 and head in to 2011. That concludes my comments. We will now open the line up for your questions.

Question-and-Answer Session

Operator

(Operator Instructions.) Your first question comes from the line of Matt Sheerin with Stifel Nicolaus.

Matt Sheerin – Stifel Nicolaus

Yes, thanks, and good afternoon. So first question regarding your commentary about your largest software supplier changing the margin structure and rebates. I didn’t catch all that. Could you, as much as you can discuss it, give us a little bit more detail of what’s happening and the timeline, and what kind of impact as you know it now would it have on your business?

Ken Lamneck

Yeah, sure Matt. So basically our largest software partner has indicated that they will be making changes to their programs they have in place for similar retailers like ourselves, globally. What they’ve indicated to us, at this stage, was that it would not go into effect until last next year, that’s when we’ll start to see it phase in, and then it actually happens over a three year timetable. So different certainly from the last time this occurred, where there was a few months notice and then it went into effect immediately, all at once. So it’s certainly more phased in. They’ve given us some data, and there’s some modeling that we’re doing on our side, but they’re doing; but it has not been finalized so we cannot talk to the magnitude of the implications, yet. We hope to get as much of that work done as we get more data here from them, we’ll probably have a further update by our next analyst call. But we certainly just want to give a preview of what the notification was to us, and the good thing about it, again, is that we’ve got ample time to react to it, also the partner has indicated that they’re keeping the total fees and rebates in total the same, it’s just a matter of how they’re tweaking them in different areas. So it’s not like they’re extracting dollars; they’re keeping it the same, so we have to obviously maneuver ourselves to where those upsides are going to be and where they want us to focus our time and attention.

Matt Sheerin – Stifel Nicolaus

Okay, because in the last year you’ve been maneuvering so to speak in your business as you’re focusing more on the lower end of enterprise and smb, because the margins are more favorable there, right?

Ken Lamneck

That’s correct, and that’s also generally where this partner is encouraging people to continue to focus.

Matt Sheerin – Stifel Nicolaus

And then you pushed out the timing of your analyst day. Is that because of this? Because you want to get a better understanding of how this impacts the business?

Ken Lamneck

Certainly that was part of it, Matt. And the fact that that would be a question that would come up, and until we can get accurate modeling we think, to talk to it and sort of general terms really wouldn’t be sufficient, so we wanted to get a better understanding of that piece to it, as well as just a few other things internally that we’re working on as well. We thought it would be more prudent to push it out a few months.

Matt Sheerin – Stifel Nicolaus

Okay, great. And then a question on the gross margin in Europe and you may have mentioned this Helen, but I missed it. Why the gross margin was up so much sequentially. Was that because of higher percentage of services business?

Helen Johnson

It was really driven by a mix of business, a little bit less public sector and enterprise percent of the total and that’s more in the middle market, drove up the margins in the quarter. As we head into Q4 we expect this is seasonally strong software quarter for us in EMEA and they have much more large enterprise clients in that quarter, so we do expect this to normalize back to the rate we’ve discussed in prior quarters, in the 13ish range for Q4.

Matt Sheerin – Stifel Nicolaus

Okay, got it. Thank you.

Operator

Your next question comes from the line of John Lawrence from Morgan Keegan .

John Lawrence – Morgan Keegan

Good afternoon. Ken could you comment just a little bit, obviously the trends that we’ve seen just continue to – I guess your expectation is you go through the quarter from where you give us guidance and continue to sort of exceed expectation. Can you give us some sort of idea of where the upsides are coming from and the exceeding expectation, obviously volumes are good, or maybe quantify it in some sort of sales productivity or something. Some of the metrics that we can look at, please?

Helen Johnson

I’ll take that one, John. So in Q3, margins came out pretty much like we had expected, particularly in North America. The upside for us in Q3 really came on the volume side, both in hardware and software products, and we expect that trend to continue as we head into Q4 as well. Combine that with a little bit lower mix of services sales, we do expect further moderation of the gross margin rate in North America in Q4, and that’s contemplated in the guidance that we gave today.

John Lawrence – Morgan Keegan

Okay, and secondly, any metrics of just – or comment a little bit about the integration of the sales force and that process, and how that’s helping you in the quarter and what we could look at to see that productivity curve, I guess.

Ken Lamneck

Yeah, thanks John for the questions. As you know, we actually fully implemented that execution in July, so we’re four months into that, and I’d say we’re certainly pleased with the metrics we’ve established in and around that at this stage of the game. We certainly have lots more to do, but the initial execution has gone off very well, and we’re certainly starting to see signs where it we are getting better coverage, we’re able to penetrate clients further than we had in the past, so it’s going to be a long process but I’d say initially we’re pleased with how that has gone, and there’s been no sort of hiccups at this stage of the game at all. We’ll continue to drive that and it’s certainly what we expected to occur, as we’d indicated, and we certainly are contemplating the benefits of that here, so we’ll continue to go on quarter by quarter to build on that success.

John Lawrence – Morgan Keegan

And not to belabor the point, but just the idea of better regional coverage, deeper penetration within the account, and the order possibly has more line items. Would those be some of the success factors we’re seeing?

Ken Lamneck

Yes, that’s exactly what it is. You know, we’ve really sort of eliminated any of the silos we may have had, how we approach clients, and have come together to get a lot more synergy, and with that of course, as you indicated, we get better coverage, we get deeper penetration, and we get a breadth of coverage and of course part of that as we indicated to you is the continuation of hiring 30 new sales reps per quarter, and that continues to be on track and we’re in our third phase of that, of hiring, and will continue that through next year as well, which will give us better coverage on the opportunity that is available in the marketplace.

John Lawrence – Morgan Keegan

And last question from me, to follow Matt’s question, just to dive in a little bit more on the software side. The last time, just remind us, the last time this adjustment was made, it was more of a soft dollar arrangement where we went to look at things like training and those times for rebates. Is that not correct?

Ken Lamneck

No, it was pretty – it was very much the fee structure you get from these enterprise agreements as well as rebates, were both impacted, last go around.

John Lawrence – Morgan Keegan

And would you assume that just – I know it’s hard to say, but at the end of the day, Ken, is it roughly the same type of thing, or is it just a totally different structure to the fee structure?

Ken Lamneck

I would say that it’s similar in type, John. We don’t, again, have the magnitude of the numbers, just because we’re certainly modeling that, but to reiterate, the difference this time is that it’s not a couple of months notice, it doesn’t occur for almost a year, it will go into effect. And additionally, it’s phased in over three years, from that vantage point, so those would certainly be marked differences. And again, to reiterate, the total fees and rebates that they’re going to avail to the channel aren’t changing at all, it’s just going to be redirected, really encouraging us to go more that sort of mid market space, small client space.

John Lawrence – Morgan Keegan

And I guess it’s too granular to ask what percentage of business of total revenues roughly for 2010 would be affected by this change?

Ken Lamneck

For 2010 there’s no impact, of course, it’s not going to take effect until that latter part of 2011. So there’d be no impact in 2010.

John Lawrence – Morgan Keegan

I’m sorry, the amount of volume going through this, how much of your business would be affected if you used the 2010 numbers?

Helen Johnson

It’s approximately 40% of our consolidates sales, and of that this partner constitutes a majority.

John Lawrence – Morgan Keegan

All right. Thanks, good luck.

Operator

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

Brian Alexander – Raymond James

It’s Brian Peterson stepping in for Brian Alexander. Just a follow up on the channel changes with your large software partner. Are you guys calling that out specifically because there’s such a large driver of your revenue, or is this change or this anticipated change actually greater in magnitude than other changes with other partners? Because if they’re actually showing the same dollar amounts, into the channel, it sounds like it will be fairly similar. So I’m just trying to get a sense of that magnitude of the actual change relative to the entire channel.

Ken Lamneck

Yeah, Brian, this is Ken. You actually sound like Brain as well. But no, I would say that we’re just being prudent. It was an announcement that was made to us, so we wanted to make sure you were aware of that. We don’t have, again, the specifics to give you the commentary on the magnitude. It’s just being worked through at this stage of the game. I think it’s another three or four, maybe five months before we have those specifics, so we’re just really being prudent on what specifics are out there. As indicated, it’s our largest software partner so we just wanted to make sure that we’re making that information that we have available.

Brian Peterson – Raymond James

Okay, that’s fair. Just on your hardware growth for North America, it was definitely better than what we were expecting. I know you alluded to some strength and large enterprise, a lot of hardware categories, and even software. Could you say maybe what grew a little bit better than average, particularly on the hardware side? And as you look into Q4, what kind of expectations do you have regarding the budget flush, and what’s really reflected into your guidance?

Ken Lamneck

Yeah, Brian, I’d say that we certainly saw the notebook desktop arena do very well this past quarter, and our geographies of course in North America as well as in the UK, so that continues to go strong. That was certainly a leader for us, the networking product category we saw a continued growth there as well in those geographies. On the software side we certainly saw the enterprise agreements, continue to accelerate as well as areas around virtualization were very strong as well. So as far as the last question had a budget flush, hard to day. Last year, of course, it was pretty significant in you recall. Hard to say what that would be this year, we think there certainly will be some, but it’s hard for us to put a magnitude of what that will be, but we certainly are preparing for it, and positioning ourselves to take advantage of that, but like always, we don’t always see that toward the latter part of the quarter.

Brian Peterson – Raymond James

Okay, and your inventory was up about 29% sequentially. I know that actually a small number in dollars, but can you explain what drove the increase there?

Helen Johnson

Inventory is up sequentially due to generally higher volume in the hardware category, but also due to specific client engagements where we acquire inventory on their behalf in contemplation of kind of a roll out of a project. We don’t have any outlook on this for Q4.

Ken Lamneck

We feel really good about the quality of that inventory, and the client that it’s geared toward.

Brian Peterson – Raymond James

Okay, good. And just kind of last, and I know this has been asked before, but the gross margins, you expected some sequential erosion heading into Q4. You talked about some lower margins, I know there’s some mix and some lower services. I’m just trying to see if actual pricing or product margins are getting incrementally worse, heading into Q4. Is that an impact at all?

Helen Johnson

No, over the last few quarters – that was a North America statement by the way, and in North America over the last few quarters product margins have remained relatively steady, and it grew just a little bit, year to year, in Q3, so it isn’t a pricing issue so much as a mix issue.

Brian Peterson – Raymond James

Okay, that’s it for me. Thanks guys.

Operator

At this time I’m showing we have no further questions. I’d like to hand the call back over to management for closing remarks.

Ken Lamneck

Thanks everybody for joining our call, and that’s it for us. Thank you very much.

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