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PC Connection, Inc. (NASDAQ:PCCC)

Q2 2014 Earnings Conference Call

July 31, 2014 04:30 p.m. ET

Executives

Tim McGrath – President and CEO

Joe Driscoll – CFO

Analysts

Brian Alexander – Raymond James & Associates

Prab Gowrisankaran – Canaccord Genuity

Operator

Good afternoon, ladies and gentlemen, and welcome to the Second Quarter 2014 PC Connection, Inc. Earnings Conference Call. My name is Brad, 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-answer 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 or historical fact 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 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 Factors 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 in other documents that the company files with the commission from time to time.

In addition, any forward-looking statements represents management's views as of today and should not be relied upon as representing views as 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 like to now turn the call over to Tim McGrath. Sir you may proceed.

Tim McGrath

Good afternoon everyone, and thank you for joining us today to review the company’s second quarter financial results. We’re pleased with our strong second quarter performance. Net sales grew by 13.6% with double-digit percentage growth in each of our sales segments. Due to the expiration of Windows XP, there was significant refresh activity in the quarter.

In addition, we expected some – excuse me, we experienced some pent-up demand for project roll-outs that were delayed from 2013. Sales also increased by double-digit percentages in a number of other categories, including software, networking and servers. We grow earnings faster than sales as net income and diluted earnings per share increased by 25% and 23% respectively.

Our Sales, net income and earnings per share in Q2 was the highest quarterly result in the company’s history. We continue to execute our core growth strategies to deliver a broad spectrum of IT solutions. Our goals are to increase market share, invest in higher margin technical solution capabilities, enhance operational efficiencies and maximize growth opportunities in targeted vertical markets.

As we review our results please note that unless otherwise stated all of our second quarter 2014 comparisons are being made against the second quarter of 2013. Consolidated net sales increased year-over-year by $76 million or 13.6% to $633 million. As noted earlier, Windows XP had a positive impact on our performance, but the impact in Q2 was less than the impact in Q1.

Gross profit dollars in the quarter increased by 13% to $84 million. Gross margin was largely unchanged at 13.23%. The product mix shift to lower margin notebooks and desktops was offset by strong performance in higher margin advanced technology solutions.

Net income for the quarter increased by 25% to $11.4 million, and diluted earnings per share increased from $0.35 to $0.43. Earnings grew faster than the rate of sales growth due to the leveraging of our fixed cost over higher net sales. Operating income as a percent of sales exceeded 3% in Q2.

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 10.7% to $268 million, with double-digit percentage increases in the notebook, desktop and software categories.

Gross profit dollars for SMB increased by 7%, however gross margin decreased by 48 basis points to 15.3%. 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 13.3% to $222 million. We experienced double-digit percentage sales growth in notebooks, software and storage. Total gross profit dollars grew by 24% and gross margin increased significantly from 11.2% to 12.3%.

Our overall commercial sales, which is the combination of our SMB and Large Account segments, grew by 12% over the prior year quarter. Quarterly sales in the Public Sector segment, which includes sales to government and education customers, increased by 20%. Sales to state and local governments and education customers increased by 19% whereas sales to the federal government were up 25%.

Gross profit dollars for the Public Sector segment increased by 13%, and gross margin decreased from 11.5% to 10.8% in Q2. The decrease in margin is attributable to the significant increase in sales of lower margin notebooks and desktops during the quarter.

We continue to invest in and focus on improving our operation and expanding our solution sales capabilities in the following key areas, data center, software, mobility, storage, Netcom, Security, Cloud and lifecycle services. These investments have led to increases in SG&A expense.

Our SG&A expense increased by $6 million, however, SG&A as a percentage of net sales was favorable by 30 basis points. Variable SG&A accounted for a significant part of the increase in dollars due to higher net sales. Fixed SG&A expense increased due to planned additions to our sales teams, and additions to our technical resources, including engineers, focused on data center and cloud solutions.

In addition, SG&A expense in the second quarter included approximately 500,000 of depreciation related to our Customer Master Data Management project.

Overall, our financial performance was solid. In addition to increasing EPS to $0.43 per share, we also increased our trailing 12 month adjusted EBITDA to $74 million. For the first six months of 2014, our results have been strong with revenues up 12% and earnings per share up 21%. Our balance sheet is also strong as our cash balance totaled $60 million as of June 30, 2014.

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. The overall IT market continues to undergo significant changes. Some of these market changes have resulted in reductions 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 I look out to the balance of the year, we believe sales growth will return to levels that are consistent with industry expectations. We experienced substantial growth in Q1 and Q2 from several areas that are not likely to continue to grow at the same rate for the rest of 2014, including the expiration of Windows XP. There could be additional Windows XP activity and additional project rollouts for the next couple of quarters but it is not expected to be at the levels we achieved in the first six months of this year.

Our SLED business grew at 19% in Q2. We expect to have a growth in SLED for the balance of the year but it is unlikely to continue at the Q2 rate of growth since the year-over-year comparisons will be much more difficult for the rest of 2014. Our federal business was up 23% for the first six months of 2014, but we expect the rest of 2014 to have Federal sales growth rates in the 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 to research new disruptive technologies for their data centers, and are also evaluating cloud alternatives, which has resulted in lengthening of purchasing decisions in some complex solution category. Industry experts have projected overall IT growth rates in the low mid-single digit range for 2014. Therefore we believe that the current consensus estimates for the company’s performance for the remainder of 2014 are reasonable.

Looking ahead to next year, our expectations for the first six months of 2015 are that our revenues will grow in the low single digit range. Industry experts are predicting overall growth of 3% to 4% and we will be comparing it to the 12% growth that we have achieved thus far in 2014. Again 2014 includes the increased activities from the Windows XP expiration, which is not expected to have any impact in 2015.

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

And now we will entertain your questions. Operator?

Question-and-Answer Session

Operator

(Operator instructions) Our first question comes from the line of Brian Alexander with Raymond James. Your line is now open.

Brian Alexander - Raymond James & Associates

Thanks and good results. Tim, I just wanted to ask you about the PC growth that you saw in the quarter. I think you said that the impact from Windows XP was not as robust in Q2 as it was in Q1, but if I look at your product mix breakout it looks like those categories grew roughly the same year-over-year in the second quarter as they did in the first quarter. So I just wanted to clarify the comments about PC growth slowing in Q2, and then also how much more you think it will slow in the back half of the year.

Tim McGrath

So, well thanks Brian for your comments, and thanks for your questions. We did have some large project rollouts in the quarter in Q2, and our notebook category was much larger in Q2 than our desktop category. So overall, we took a very measured approach and we spent some time really calculating what business we thought was actually from the XP expiration, and that is how we came to that determination. So it was close, but clearly Q1 had more XP refresh business in it than Q2.

Now for the second half of the year, for the rest of the year, we think that, there is likely to be some refresh activity. We think that is going to continue. Some XP refresh activity, but they just don’t see it happening at the rate that has happened for the first half of the year. So again, we are fairly confident that what our peer group is saying, what the industry analysts are saying, is pretty much on target.

Brian Alexander - Raymond James & Associates

So, if I think, just to recap what you said about the growth outlook for the rest of the year, and I think you were pretty explicit and detailed so I appreciate that -- so to make sure we are on the same page, with PC growth slowing and public sector growth slowing as well, it sounds like you are comfortable with overall growth for the company kind of in the mid-single digits in the second half of the year, and then I think you said low to mid-single digits in the first half of next year. I just want to make sure we're on the same page.

Tim McGrath

No, that is not entirely accurate. As you know, that is subject to change. There are a lot of points I have laid out there that and you have written about. Certainly the GDP, our capital investment, the job support, all help the overall economy. So, there is a lot of opportunity, but that is our best estimate.

Brian Alexander - Raymond James & Associates

And then as the PC growth slows, are there any categories that you would point to that you think might pick up the slack from customer spending in particular, are you seeing any more signs of life on the storage side? I think you had a nice pickup this quarter, so maybe talk a little bit about storage. And then also there's some chatter that we could see a server cycle with Windows 2003 expiring next year?

Tim McGrath

Yes. So, Brian, kind of all of the above. First off, regarding storage, so we are seeing good growth in storage. We know that is a little contra to the market. We know the market is fairly flat that, but we are focused there as this is an important solution category and as a result we have been seeing really nice growth.

We also are seeing nice growth in servers and that too is part of our strategy. In fact, we have got some programs that will be rolling out for the second half of the year focused on those server upgrades because indeed Windows server does expire early next year, and we believe our customer base is going to have to react well in front of that if they want to be ahead of it. So there is some opportunity there.

Brian Alexander - Raymond James & Associates

And then how should we think about margins, Joe, with the PC mix slowing and potentially some enterprise solutions growing, and so maybe remixing up on gross margin but potentially not seeing as much operating leverage as the overall revenue growth slows. So, a lift in gross margin but maybe offset by less Opex leverage, or how should be think about operating margins going forward?

Joe Driscoll

Yes, our – when we create our plan for 2014, what we really focused on was a decent level of sales growth combined with improved gross margin percentage by, 10 or 15 basis points. We obviously had kind of an unusual first six months where the sales growth was well above our expectations. That does impact the gross margin percentage because a lot of it is in the lower margin category.

So I think if we revert back to a more normal level of sales growth, we should be able to get back to bumping up that gross margin percentage, at some rate for the balance of this year, once we get a more traditional product mix I guess is the way we are looking at it.

Brian Alexander - Raymond James & Associates

Great. Okay, thank you very much.

Tim McGrath

Thank you Brian.

Operator

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

Prab Gowrisankaran - Canaccord Genuity

Thanks for taking my question and congrats on the strong quarter. One question I had was you talked about the Windows XP expiry, which you talked about last quarter. But you had also talked about pent-up demand from rollout of large projects. How much of the benefit was the Windows XP expiry versus the rollout of large projects in the quarter?

Tim McGrath

So, our best calculation is, this is sort of our internal calculation, but we have studied it and we think, a little less than a third of the growth was about XP. And that is just our estimate, and of course that is subjective. Some of them are really hard to define. And as there is an ecosystem around an upgrade like that. So it is not just the PC or the notebook often there are accessories attached, memory, monitors that go along with that.

Prab Gowrisankaran - Canaccord Genuity

Okay. And in terms of large project rollouts is it mostly networking, Netcom and software, or do you see desktop server and notebook/tablet also part of the large project rollouts?

Tim McGrath

We said in our large account group we really saw good, terrific growth in software, some really nice movement that, but we also saw nice server rollouts – storage was very strong across-the-board. But we did see a number of desktop, or really notebook rollouts as well.

Prab Gowrisankaran - Canaccord Genuity

Okay, and another question I had was on the Public Sector segment, I know it's been depressed for a while, do you expect this federal bump up to stabilize at these levels or – if you can add some color on federal I know you -- SLED, you said, will moderate a little bit in the second half.

Tim McGrath

The Federal is up over 20% year-to-date. The first six months of the year though the number is actually. The dollars are actually pretty small. So, we are very pleased with the Federal growth. The dollars are still pretty small on a year-to-date basis. So, it is still early to say whether the Federal spending has recovered, but we are seeing a lot more sales activity, a lot more quotes, things like that. So I don’t think you will see 20% growth in Federal for the rest of the year, but we’re pretty confident that it is going to be a good year for Federal.

Joe Driscoll

That is right. It comes down to a lot of the contract vehicles and our ability to win. We are pretty confident of that, but it is still less than 5% of our overall business and these Federal sales rates are still below our 2012 levels. So we still got a lot of ground to make up.

Prab Gowrisankaran - Canaccord Genuity

Okay. And the last question I had was a clarification to the previous question you answered, so for the second half if I understood right, you expect in the mid-to-high single digit growth rates for ’14, and then the first half is low to mid-single-digit growth rates?

Tim McGrath

We are looking at mid single-digit for the balance of 2014. That would be our best guess right now, and that – probably a touch below that for the first six months of 2015 because we are going to be going up against big comps from the first six months of this year. So looking at mid-single digits for the balance of 2014, a little bit less than that in the first six months of 2015.

Prab Gowrisankaran - Canaccord Genuity

Great. Thanks a lot.

Operator

(Operator instructions) I’m showing no additional questions at this time. I like to turn the call back over to Tim McGrath for any closing remarks.

Tim McGrath

Thank you operator. We are encouraged with PC Connection’s strong performance this quarter. We had solid execution against all three of our sales segments, reinforcing the strength in our business model. Sales of notebooks and desktops continued to be strong in Q2 due to the expiration of Windows XP. In addition, our investments in technical solution sales led to strong growth in servers, networking and software.

As a national solution provider, our goal is to consistently invest in more complex solution capabilities, while delivering solid financial performance, and we were able to accomplish that in Q2 with double-digit sales increase, and 25% increase in earnings. We believe the team and the strategy that we have in place positions PC Connection well to gain market share and increase long-term shareholder value.

And I like to thank all of our customers, vendor partners, and shareholders for their continued support, and our dedicated coworkers for their efforts. I would also like to thank all of you listening to the call this afternoon. Your time and interest in PC Connection are appreciated. Have a great evening.

Operator

Ladies and gentlemen, thank you for participating in today’s conference. This concludes your program. You may now disconnect.

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Source: PC Connection's (PCCC) CEO Tim McGrath on Q2 2014 Results - Earnings Call Transcript

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