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Executives

Stephen Baldridge – VP Finance and Corporate Controller

Patricia Gallup – Chairman, CEO

Jack Ferguson – Executive VP, CFO

Tim McGratch – Executive VP Enterprise Group

Analysts

Brian Alexander – Raymond James

PC Connection, Inc. (PCCC) 4Q07 Earnings Call Transcript January 31, 2008 11:00 AM ET

Operator

Good day everyone and welcome to the PC Connection fourth quarter 2007 financial results conference call. Today’s call is being recorded. At this time for opening remarks and introductions I would like to turn the call over to the Vice President of Finance and Corporate Controller Mr. Stephen Baldridge, please go ahead sir.

Stephen Baldridge

Thank you and good morning everyone. This is Steve Baldridge, senior VP of Finance and Corporate Controller. Patricia Gallup, Chairman and CEO, Jack Ferguson, Executive Vice President and CFO and Tim McGrath, Executive Vice President Enterprise Group are also here with us today. We are pleased to have you join us today for PC Connection’s 2007 fourth quarter conference call. If you haven’t already seen our press release, you can contact Janice Rush at 603-683-2322 and she will fax or email a copy to you immediately. You can also view it at on our website.

Today’s call is also being webcast and will be available from PC Connection’s website. I’d like to inform our participants that any statements or references made during the conference call that are not statements of historical fact may be deemed to be forward looking statements. Various remarks that we may make about the company’s future expectations, plans and prospects constitutes forward looking statements for purposes of the Safe Harbor provision 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 risk factors in the company’s quarterly report on form 10Q for the quarter ended September 30, 2007, which is on file with the Securities and Exchange Commission.

In addition, any forward looking statements represent our views only as of today and should not be relied upon as representing our views as of any subsequent date. While we may elect to update forward looking statements at some point in the future, we specifically disclaim any obligation to do so, even if our estimates change and therefore you should not rely on these forward looking statements as representing our views as of any date subsequent to today. I’m now going to turn the call over to our CEO, Patricia Gallup, for her remarks on our quarterly and annual results. Pat.

Patricia Gallup

Good morning and again thank you for joining us. Today we announced record net sales of $490 million for the fourth quarter 2007 which represents an increase of $58 million or 13% from $432 million for the fourth quarter 2006. All three of our sales segments achieved year over year sales growth with our SMB and public sector segments increasing sales by 14 and 25% respectively. Net income for the fourth quarter of 2007 was $6.2 million or $0.23 per share compared to $4.6 million or $0.17 per share for the prior year quarter.

As stated in our press release, the quarter ended December 31, 2007 included special charges. Had those charges not been incurred, pro forma net income for the fourth quarter would have been $6.5 million or $0.25 per share. We did not incur special charges in the fourth quarter of 2006. Our press release includes a reconciliation of the pro forma amounts.

I’ll begin by commenting on our SMB segment, our original core business. Net sales increased by $32.3 million or 14% from the fourth quarter 2006 to a record $263.8 million. Corporate outbound sales for the quarter grew 25% year over year. Higher video products sales contributed to our fourth quarter revenue growth. In Q4 we recorded several large sales of video product to three commercial customers. These sales accounted for the majority of corporate outbound group’s sales growth. Consumer sales decreased reflecting our continued focus on commercial account growth.

Sales to large corporate account customers reported as our large account segment, increased by $8.4 million or 6% to $140.8 million from the corresponding prior year quarter. Through our more direct subsidiaries consultative sales and solutions process and their seasoned sales representatives, this segment continues to acquire new customers as well as win a greater share of existing customer’s business. Sales to government and education customers reported as our public sector segment, increased by 25% from the fourth quarter of 2006 to $85 million.

Through our gov connections subsidiary, public sector revenues increased primarily due to sales made under recently reported federal government contracts, including [80MC2, Soup 4] and First Source. Consolidated gross profit dollars increased in the fourth quarter of 2007 over the fourth quarter 2006 by 11% or $5.5 million to $57.5 million. Gross margins representing gross profit as a percentage of net sales was 11.7% in the fourth quarter 2007.

Excluding the effect of the low margin video sales, gross margin in the fourth quarter would have been 12.5% compared to 12% in the fourth quarter of 2006. Larger software agency fees, additional vendor considerations and lower customer rebates in the fourth quarter of 2007, however, partially offset the effect of the video products sale. SG&A expenses totaled $46.9 million for the fourth quarter of 2007 compared to $44.1 million for the fourth quarter 2006. Total SG&A expenses increased $2.8 million or 6.3% year over year in the fourth quarter 2007.

The dollar increase was primarily attributable to increased personnel and advertising expense. SG&A expense as a percentage of sales improved to 9.5% for the quarter compared to 10.2% for the fourth quarter of 2006. Improved personnel expense leverage and cost reductions in other areas accounted for the decrease in SG&A as a percentage of sales. Income from operations for the quarter increased 29% to $10.1 million or 2.1% of net sales, compared to $7.8 million or 1.8% for the fourth quarter of 2006. Net income for the quarter was $6.2 million compared to $4.6 million for the fourth quarter of 2006. On an annual basis, sales increased over 2006 by $150 million or 9.2% with sales growth in all three segments.

Our gross profit dollars for 2007 increased 9.4%, slightly higher than our revenue growth, reflecting a slight improvement in our gross margin rate. We experienced gross profit growth in all three segments. SG&A expense increased in 2007 by only $7.7 million or 4.4%. SG&A expense as a percentage of sales improved 46 basis points over the prior year. Our annual operating income improved by $12.9 million or 54% to $36.8 million in 2007. Operating income as a percentage of net sales was 2.1% in 2007, compared to 1.5% in 2006, reflecting primarily our improved expense leverage in cost reductions in 2007.

Net income increased to $25 million or $0.85 per share compared to $13.8 million or $0.54 per share in 2006. Annualized average sales productivity for the fourth quarter increased on a consolidated basis by 19% year over year. In the large accounts segment, sales productivity increased 21% from the fourth quarter 2006. This significant increase resulted from enhancements to sales support activity. Average sale productivity for our public sector segment increased by 19% due to improvement in this segment’s average sales representative tenure as well as to the additional contract vehicles I mentioned earlier.

Overall productivity in our SMB segment improved by 20%, also due to improved sales representative tenure. Now, onto product trends, sales trends. Our largest selling product category in Q4 was video, imaging and sound, accounting for 18% of our overall sales. The large video products sales noted earlier drove most of the product category’s growth. Notebooks and PDAs was the second largest product category in Q4 2007, accounting for 15% of total sales.

Both software and desktop and server sales each accounted for 13% of total sales. While the highest year over year growth category in the quarter was video imaging and sound, we also experienced strong growth in storage devices and software. In Q4, each of these categories increased over 20% year over year, reflecting industry demand for total solutions sales. Average selling prices for ASPs for computer systems decreased year over year by 2% in Q4 2007. However, ASPs were level compared to the third quarter of 2007.

Q4 notebook revenues were level compared to 2006, as a 6% decrease in ASPs was offset by a 6% increase in unit sales. Desktop revenues increased 6% year over year, primarily due to an 8% increase in unit sales. Fourth quarter server sales increased 23% over 2006, as both ASPs and unit sales increased by double digit percentages. For the third straight quarter, server sales have increased by 20% or more. We continued to invest in our services initiatives with sales of services increasing 22% year over year.

This growth reflects the continued development of managed or skewable service offerings in our SMB segment, through our service connection brand, continued growth in custom service sales from our professional services subsidiary, pro connection and through partner referrals, increased product certifications such as our recent Cisco gold certification, which enable us to promote higher margin solutions selling and provide access to additional vendor funding and increased levels of sales training and promotion of services to our customer base. We believe these continuing investments strategically position PC Connection to capture a larger portion of the services market. While we improved the leverage of our expense structure, both for the quarter and for the year, we will continue to monitor our operating costs and review our spending plans and programs to enable the best possible allocation of our resources.

Furthermore, we plan to continue to make investments in systems, brands, sales representatives and new customer acquisition programs to support the growth of our sales organization and customer base. Accordingly, we are evaluating opportunities in a consolidating market and will consider acquiring additional businesses with complimentary corporate cultures to add new customers and talent. And now Jack Ferguson will discuss our balance sheet and cash flow in more detail. Jack.

Jack Ferguson

Thank you Pat. First the cash flow. Cash flow generated from operations for the year ended December 31, 2007 was $400,000 compared to $26.4 million for the prior year. The effect of our increased earnings in 2007 was offset by increases in accounts receivable and inventory. These increases were due primarily to our $58 million increase in Q4 revenues which drove the increase in receivables. Inventories also increased by $6.7 million year over year in the quarter. Capital expenditures this year were slightly lower than in the prior year, amounting to $7.1 million in 2007, compared to $8 million in 2006. Cash flows from financing activities improved this year, due to our continued ability to minimize borrowings from our bank line of credit.

In 2006 cash flows from financing activities were impacted by net repayments of $20 million on our credit line. While cash did decrease slightly year over year in 2007, our cash balance remained strong with no yearend borrowing from our credit facility. Now to the balance sheet. With our $58 million increase in quarterly sales, accounts receivable as of December 31, 2007 increased by $32 million to $202 million compared to the balance at December 31, 2006. Days sales outstanding or DSOs, however, improved to 43 days as of December 31, 2007 compared to 45 days at December 31, 2006 and 45 days at September 30, 2007.

Inventory balances increased year over year approximately 10% to $76.1 million at December 31, 2007. This increase was attributable to inventory staged for planned customer rollouts in Q1 of 2008. Inventory turns were 21 this quarter compared to 20 turns for the fourth quarter of 2006 and 22 turns for the third quarter of 2007. We believe inventories are in excellent condition both in quantity and in quality. Net sales of products drop shipped by distributors and other vendors directly to customers accounted for 51% of total net sales in the fourth quarter this year compared to 52% in the fourth quarter last year. On an annual basis, drop shipments increased from 50% of sales in 2006 to 51% in 2007.

We continue to focus on increasing drop shipments where appropriate and cost effective which allow us to maintain lower inventory levels. In summary, we believe the balance sheet remains very healthy. We will now entertain your questions. Operator.

Question-and-Answer Session

Operator

Thank you sir, today’s question and answer session will be conducted electronically. At this time if you do have a question you may signal by pressing star one on your touchtone phone. If you are using a speakerphone today please make sure your mute function is turned off to allow your signal to reach our equipment. And once again if you do have a question at this time, please press star one on your touchtone phone. Star one for questions and we’ll pause for just a moment to allow everyone a chance to signal. We’ll take our first question from Brian Alexander with Raymond James.

Brian Alexander – Raymond James

Good morning, could you guys just talk a little bit about what you’re seeing from a demand perspective through the month of January. Obviously there’s a lot of concern out there and you’ve got your entire business in North America where there seems to be more concern, so if you can go through the different customer segments and talk about what you’re seeing, normal seasonality or if there’s any difference in patterns versus your expectations.

Tim McGratch

Hi Brian, this is Tim McGrath, I’ll take that question. So the question was how do we see demand by segment for January 08? And customer demand as you know was solid for us in Q4 and at this point is in line with our expectation for the quarter Q1. For January, we are right on our expectation, so we really aren’t seeing very much fluctuation. And that is across all three segments.

Brian Alexander – Raymond James

Okay great and then on the large deals that you had in the quarter, it sounds like that was about $30 million of incremental revenue, if I back into what the implied profitability was on the incremental revenue, it doesn’t seem like it generated much in the way of incremental margin, could you just kind of walk us through the margin profile of those deals. Were those two new customers or existing customers and how should we think about those types of deals going forward? Was this more of a one off or might you entertain large deals at very little profit if that assumption is correct in the future?

Tim McGratch

Okay Brian, again this is Tim McGrath and I’ll cover that. I think the question really is given the large opportunistic deals that we generated in Q4, how did that effect our business, what was the reason, the strategy for that. And I think we’ll kind of break that up a little bit, I’ll kind of cover the sales aspect and I’ll ask Steve for a little help on some of the go forward margin aspects. Overall as you know our sales increased 14% in Q4 and a big part of that increase was from the video products sales to three separate commercial customers.

These sales were generated as part of the new customer acquisition strategy to drive account growth. The strategy worked really well for us as since that time we have received higher margin orders in other product categories from those customers. But if you exclude those video products sales, the corporate outbound team in our SMB organization where the sales were generated, still increased over 8% year over year in the quarter. So overall I think it was the right move for us, we did increase market share and we’ll continue to grow that business in 2008. Steve, did you want to comment further?

Stephen Baldridge

Hi Brian, on gross margin as a percent of net sales, our rate was 11.7% in the fourth quarter of 2007. Excluding the effect of the low margin video sales, gross margin rates for the quarter would have been 12.5% compared to 12% in the fourth quarter of 2006. Partially offsetting the effect of the lower video product sales margins were larger software agencies, additional vendor consideration and lower customer rebate costs in the fourth quarter of 2007 versus the fourth quarter of 2006. On an annual basis, despite the low margin video sales, the gross margin rate improved slightly from 12.2% in 2006 to 12.3% in 2007.

Brian Alexander – Raymond James

So I guess just to follow up and get more specific, what would the revenue have been and what would the gross margin have been in the SMB segment specifically, excluding these deals? It sounds like it’s about what, $30 million revenue and gross margins would have been closer to 14%?

Stephen Baldridge

Hi Brian, this is Steve Baldridge, the sales growth in SMB as we noted would have been approximately 1% excluding those video sales. And that’s a result that would end up with about an 8% increase in our outbound corporate sales group in SMB and that increase was offset by the declining consumer sales. The impact of the low margin video sales had an approximately 150 basis point impact on the SMB margin rates during the quarter.

Brian Alexander – Raymond James

So it doesn’t sound like there was much gross profit generated on those sales at all.

Stephen Baldridge

Correct, I think as Tim indicated this was a new customer acquisition strategy and the strategy seems to be working as we have since received orders for other products from these customers this quarter.

Brian Alexander – Raymond James

And those are carrying margins that are more comparable to the corporate average or are they still depressed?

Tim McGratch

Yes Brian, this is Tim, those are very healthy margins and they are in line with the corporate average.

Brian Alexander – Raymond James

Okay and let’s see, the public sector for you guys has historically has not been profitable given some of the issues you had a few years ago where you had to downsize that business, or at least your run rate was less than it used to be, so now that that business seems to be on track again and you’ve got double digit revenue for the last three quarters in terms of growth, are we looking at a scenario where, I know in the third quarter it was profitable, I assume in the fourth quarter that segment was profitable, should we think that the public sector will be profitable in 2008?

Jack Ferguson

Yes, this is Jack Ferguson, we believe that the public sector will show a slight profit for the year as a result of those two quarters and we believe going forward that should be continued upward.

Brian Alexander – Raymond James

So, how should we think about operating margins by segment? For 2007 I believe you were under 2% in SMB, in the corporate segment I think you continued to show pretty healthy mid single digit operating margins, I’m not sure if there’s room for expansion there, but how could you frame for us the operating margin outlook roughly by segment as we move forward?

Jack Ferguson

I’m not sure I have those numbers handy by segment, because keep in mind there is an element of corporate cost that obviously has not been completely absorbed within the operating segment. So from an overall company point of view you have to take that into account as well. Clearly as you’ve seen from our past reports, our large accounts segment has probably the highest operating income with SMB in second place and the public sector being in third place. We expect growth potential in the public sector and some in SMB but I think most of the change will be in the public sector as we increase our sales.

Brian Alexander – Raymond James

Okay and the final one is, Dell seems to have formalized a channel strategy in North American and I’m just wondering if PC Connection is a part of that?

Tim McGratch

Brian this is Tim, I’ll take that one. The question really is, our go forward plan with Dell and Dell’s channel strategy is that right?

Brian Alexander – Raymond James

Yes.

Tim McGratch

So, obviously Dell is a formidable competitor, if we look at what Dell did in Q4, it shipped as you know 40 million PCs. If you look at what HP did in Q4, they shipped 50 million PCs. So clearly I think the channel has momentum. HP, our partner for example is seeing a lot of momentum there so we are going into the year with our eyes wide open. We have not made any specific commitments in either direction but we continue to watch that very closely.

Tim McGratch

Great, that’s it for me.

Operator

And just a reminder, if you do have a question at this time please press star one on your touchtone phone, star one for a question. And it appears there are no further questions at this time, I’d like to turn the call back to Patricia Gallup for any additional or closing comments.

Patricia Gallup

Great, thank you operator. In closing, we’re pleased with our record quarterly and annual sales and our growth in earnings per share. We’re also very pleased with the growth in our service revenues year over year which were actually at 58%. 2007 was another consecutive record year for us and we believe going forward that we have the right people and strategies in place to continue to take market share and grow our business. I’d like to thank all of our customers and vendor partners for their business and support and our dedicated co workers for all of their efforts. I’d also like to thank those of you on the call this morning for your time and your interest in PC Connection. Have a great day everyone.

Operator

Again that concludes today’s conference call, we do thank you for your participation, you may disconnect at this time.

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Source: PC Connection, Inc. Q4 2007 Earnings Call Transcript
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