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PC Connection, Inc. (NASDAQ:PCCC)

Q1 2008 Earnings Call Transcript

May 1, 2008 11:00 am ET

Executives

Stephen Baldridge – SVP, Finance and Corporate Controller

Patricia Gallup – Chairman and CEO

Jack Ferguson – EVP, Treasurer and CFO

Tim McGrath – EVP, Enterprise Group

Analysts

Brian Alexander – Raymond James

Operator

Good day, everyone, and welcome to the PC Connection first quarter 2008 financial results conference call. Today's call is being recorded. At this time, I would like to turn the call over to the Vice President of Finance and Corporate Controller, Mr. Stephen Baldridge. Mr. 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, PC Connection Enterprises, are also here with us today. We are pleased to have you join us today for PC Connection's 2008 first 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 on our website. Today's call is also being webcast and will be available from PC Connection’s website.

I would 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 constitute forward-looking statements for purposes of the Safe Harbor provisions of 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 Annual Report on Form 10-K for the year ended December 31, 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 results. Pat?

Patricia Gallup

Good morning, everyone. And again, thank you for joining us. Today, we announced net sales of $424 million for the first quarter of 2008, which represents an increase of $26 million, or 6%, from $398 million for the first quarter 2007. This is a record level for our first quarter sales and represents the 12th consecutive quarter of year-over-year revenue growth. I am pleased to report that all three of our segments achieved year-over-year sales growth, with our Public Sector segment increasing sales by 23%. Net income for the first quarter of 2008 increased by $1.4 million to $4.8 million, or $0.18 per share, compared to $3.4 million, or $0.13 per share, for the prior-year quarter.

I'll begin by commenting on our SMB segment, our original core business. Net sales increased by $6.2 million, or 3%, from the first quarter of 2007 to $240 million. Of that, corporate outbound sales for the quarter grew 9% year-over-year, while consumer sales decreased, reflecting our continued focus on commercial account growth. We achieved a 12% increase in business-to-business web sales this past quarter. Recent enhancements to our business websites provide our customers greater purchasing flexibility and strengthen long-term relationships.

Sales to large corporate account customers, reported as our Large Account segment, increased by $6.9 million, or 6%, to $117 million from the corresponding prior-year quarter. MoreDirect continues to obtain new customers and a greater share of existing customers' business. Sales to government and education customers, reported as our Public Sector segment, increased by 23% from the first quarter of 2007 to $66 million. Revenues for our GovConnection subsidiary increased primarily due to sales made under federal government contracts, including ADMC2, SEWP IV, and First Source.

Consolidated gross profit dollars increased year-over-year in the first quarter of 2008 by 6% or $2.8 million, to $52.7 million. Gross margin, representing gross profit as a percentage of net sales, was 12.4% in the first quarter of 2008, compared to 12.5% in the first quarter of 2007. Agency fee revenues, which are reported on a net basis, declined in the first quarter of 2008, compared to the prior-year quarter.

SG&A expenses totaled $45.4 million for the first quarter of 2008, compared to 444.2 million for the first quarter of 2007, representing a 3% increase. The dollar increase was primarily attributable to an incremental variable compensation related to increased revenue and gross profits in 2008. SG&A expense as a percentage of sales improved to 10.7% for the quarter, compared to 11.1% for the prior year period. Better leverage of our cost structure accounted for the 40 basis point improvement.

Income from operations for the quarter increased 28% to $7.4 million, or 1.7% of net sales, compared to $5.7 million, or 1.4%, for the first quarter of 2007. Net income for the quarter increased by 1.4 million to $4.8 million when compared to the first quarter of 2007, up 41% year-over-year. Average annualized consolidated sales productivity for the first quarter increased by 5% year-over-year. Average sales productivity for our Public Sector segment increased by 17% due to gains achieved under a number of new federal contract vehicles noted earlier.

In the Large Account segment, sales productivity increased 16% from the first quarter of 2007. We attribute this increase to enhancements in sales support activities and growth in our service revenues. Overall productivity in our SMB segment was unchanged year-over-year due to new hires of sales representatives.

Now, on to Q1 product sales trends. Our largest product category was notebooks and PDAs, which accounted for 15% of total sales. Video, imaging, and sound was the second largest selling category, accounting for just under 15% of our overall sales. Desktop and server sales accounted for 14% and software sales for 13%. While the highest year-over-year growth category was video, imaging, and sound, we also experienced strong growth in storage devices and net/com products. Both categories increased over 20% year-over-year, reflecting industry demand for total solution sales.

Average selling prices, or ASPs, for computer systems decreased year-over-year by 9% in Q1 2008, and decreased by 5% compared to the fourth quarter of 2007. Q1 notebook and PDA revenues declined by 13% compared to the prior year as both units sold and ASPs decreased by mid-single digits year-over-year. Desktop and server revenues increased by 2% year-over-year, as a 12% increase in unit sales offset a 10% decrease in ASPs.

We continue to invest in our services initiative through increased levels of sales training and promotion of services to our customer base. Sales and services increased significantly year-over-year, reflecting continued growth in customer service sales from our professional services subsidiary, ProConnection, and through partner referrals, as well as increased sales of managed or SKU-able service offerings through our ServiceConnection brand, and increased product certifications, such as our recent Cisco Gold certification, which enable us to promote higher margin solution selling and provide access to additional vendor funding. We believe these continuing investments strategically position PC Connection to capture a larger portion of the services market. While we improve the leverage of our expense structure this quarter, 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 continually evaluating opportunities in a consolidating market and will consider acquiring additional businesses with complementary corporate cultures that add new customers and talent.

And now, Jack Ferguson will discuss our balance sheet and cash flow in more detail. Jack?

Jack Ferguson

Thanks, Pat. First, the cash flow. Cash flow provided by operations for the quarter ended March 31, 2008 was $10.7 million, compared to $5.9 million for the prior-year period. The majority of this increase was due to a reduction in inventories in 2008, which ultimately improved cash flow. Capital expenditures in the first quarter of 2008 were higher than in the prior-year period, amounting to $2.9 million in 2008, compared to 1.5 million in 2007. We recently completed an extensive desktop upgrade, which accounted for much of this increase. Financing activity in the first quarter of 2008 represented a $1 million use of funds, compared to a $2.6 million source of funds for the prior-year period. We purchased over $900,000 in treasury shares in the first quarter of 2008, whereas in 2007 the exercise of stock options provided $2.5 million in cash. Cash balances increased by approximately $7 million in the first quarter of 2008. Our cash flows remained strong with no outstanding quarter-end borrowings from our credit facility.

Now, to the balance sheet. Accounts receivable as of March 31, 2008 decreased by $24 million to $178 million, compared to the balance at December 31, 2007. Days sales outstanding were 44 days as of March 31, 2008, compared to 42 days as of March 31, 2007. Inventory balances decreased by $10 million, compared to the balance at December 31, 2007. Inventory turns were 21 this quarter, which was unchanged on both a year-over-year and a sequential basis. We believe inventories are in excellent condition, both in quality and in quantity. Net sales of products drop shipped by distributors and other vendors directly to customers accounted for 53% of total net sales in the first quarter of 2008, compared to 50% in the first quarter last year. We continue to focus on increasing drop shipments where appropriate and cost effective, which allow us to maintain lower inventory levels.

In summary, the balance sheet remains very healthy. We will now entertain your questions. Operator?

Question-and-Answer Session

Operator

Thank you, sir. (Operator instructions) And for our first question, we go to Brian Alexander with Raymond James.

Brian Alexander – Raymond James

Thanks. Good morning.

Jack Ferguson

Good morning.

Patricia Gallup

Good morning.

Brian Alexander – Raymond James

Could you guys talk a little bit more about the linearity you saw in the SMB and the large enterprise segment? I know there is a lot of mixed signals out there, but overall suggesting that demand has slowed in both of those segments in North America. And if I kind of look at your SMB growth, excluding the consumer weakness it looks like you had stability there, and in large corporate, no signs of a slowdown through the March quarter. So maybe help us understand if those did deteriorate as the quarter progressed and what you've seen so far in April.

Tim McGrath

Hi, Brian. This is Tim. I'll take that. So why don't we start with our customer segment demand for the MoreDirect, our Large Account sector. I think overall, Brian, as you know, and certainly as reported by the industry demand surveys, we did see drops in demand in Q1, and we do kind of expect that trend to continue in Q2. As you know, out there in the competitive landscape we've been focused on acquiring new customers and keeping our current customer base very happy. And to that end, what we are seeing in the Large Account sector is that some projects are being pushed into later quarters as our customer base kind of shares the same concern. They are as worried as everyone else is about the economy. So, overall, we are seeing a little softness, but we see no reason that we shouldn't grow organically at the same rate as the market.

Brian Alexander – Raymond James

What about SMB?

Tim McGrath

For SMB, our SMB segment also has seen in according with the industry a little softness. But again, with SMB, we are focused on the business fundamentals. We are focused on our plan. And again, I think we see no reason that we shouldn't grow organically at the same rate as the market.

Brian Alexander – Raymond James

Okay. Any sense for where you think the market is growing?

Tim McGrath

A lot of it – we get from the reports we hear [ph] from you folks, Brian. But right now, I'd say our information is consistent with the demand surveys that are out there.

Brian Alexander – Raymond James

Okay. And if I look at the gross margin in the SMB sector, it was up year-over-year (inaudible) basis points. It was up a lot sequentially. Should we interpret that to be a function of the weakness that you saw in consumer sales, combined with some of the product mix effects that you alluded to, or you are having more success with solutions sales, if you will, that are higher margin? Or maybe help us understand what's driving the gross margin strength in SMB.

Stephen Baldridge

Hi, Brian. This is Steve Baldridge. I'll take that one. On a consolidated basis, as we indicated, our gross margin rates were 12.4% in Q1 this year versus 12.5% last year. And just to talk briefly about each of the segments, and I'll hit the SMB question, our Large Account sector margin rates were basically unchanged year-over-year in Q1, while, as you noted, our SMB rates were up. They were up 40 basis points, despite the challenging environment. And in the SMB space, I think there were a number of contributing factors to their margin performance. Number one, just execution by the sales organization. Secondly, the level and increase in services sales. Third, as you mentioned, product mix. And finally, just strong inventory management. Our Public Sector margin rate was down 160 basis points year-over-year in the first quarter of this year versus last year, but that was due to a reduction in agency revenues, which we report on a net basis.

Brian Alexander – Raymond James

Okay. What about just overall software licensing trends, particularly as it relates to Microsoft? There are some rumors [ph] out there that this could be a tougher year for that business. I don't know if you have any details on where you think that business is tracking and where it's heading for the year relative to last year.

Tim McGrath

Brian, this is Tim. I'll take that. And I think we are seeing good growth in software overall. Our software grew by 16% in Q1 and that really resulted in double-digit increases in all three of our sales segments. Much of that was driven by new product upgrades and of course the continued growth of VMware. So our Microsoft EA business specifically quarter-over-quarter was flat.

Brian Alexander – Raymond James

Quarter-over-quarter or--?

Tim McGrath

I'm sorry, year-over-year was flat for the quarter.

Brian Alexander – Raymond James

Was that below your expectations?

Tim McGrath

No, I think that was in line with our expectations.

Brian Alexander – Raymond James

Do you expect it to grow this year?

Tim McGrath

We do expect it to grow. And as some of the sales segments ramp up throughout the year, EA sales will ramp up with them.

Brian Alexander – Raymond James

And then, maybe just finally and I could get back in the queue, just talk a little bit about the weakness in the notebook category. You've been running for the last four quarters – prior to this quarter actually closer to flat and this quarter down quite a bit. You had a little bit of a tough comp last year. But is there something fundamental going on in the notebook category where it's becoming more difficult for direct marketers like PC Connection to make adequate profits and therefore you are shifting your attention elsewhere, or is this just an anomaly?

Tim McGrath

Hi, Brian. This is Tim. I'll take that one as well. Our notebook revenue declined compared to the prior year, and both units and ASPs were down by the single-mid-digits. But the reduction in units sold was really due to a large order that we had in the previous year. So there's also been a shift as we increase our focus on selling storage and net/com products. And I really don't think there is anything fundamental to that.

Brian Alexander – Raymond James

Okay. And actually, one final one. Sounds like your number one priority for deploying excess cash is M&A. Have you seen any change in the M&A landscape in terms of sellers' willingness in this environment? Any change in valuations that you could point to on the M&A front? And then, maybe talk a little bit about what's holding you back from a stock buyback.

Jack Ferguson

Okay. This is Jack. I'll take that one. First, from an M&A point of view, we continue to get overtures from different companies and different organizations having certain organizations for sale. We are very particular about what kind of organization we need. They have to have the right culture, complementary products, the right management, customer base, to really fit in. I think you see our last few acquisitions from MoreDirect to Amherst, they fit very well into our organization. They sometimes are few and far between, but we continue to look for them and are – we are continuing now. I am not sure that the pricing has really been affected that much. Obviously, people trying to sell are trying to get the top dollar for their companies and we are trying to make an economical purchase. It has to fit into our overall return on investment for us to really take it seriously.

So, as far as the stock buyback, I think we continue to look at the best uses of our available cash funds and obviously monitor the stock prices. Where it's opportunistic to buy back shares we will do so. And we are continuing to look at that. As you know, we bought back nearly $1 million this last quarter and we will continue. We haven't announced any particular program, but I think we will continue to look at that as the market and as our cash flows come out and as we review our other options for those cash flows.

Brian Alexander – Raymond James

Thank you.

Operator

(Operator instructions) And with that, ladies and gentlemen, we have no further questions on our roster. Therefore, Ms. Gallup, I'll turn the conference back over to you for any closing remarks.

Patricia Gallup

Thank you, operator. Again, we are pleased with PC Connection’s continued profitable growth in the first quarter of 2008. We believe that the investments we are making to increase sales and improve efficiencies will allow us to continue to improve operating performance and thereby build long-term shareholder value. PC Connection continues to be a recognized leader in our industry. In the past year we were named as one of the VARBusiness Top 100 Federal Integrators, entered inclusion in both the InformationWeek 500 and Internet Retailer Top 500. In addition, we appeared on the Fortune 1000 for the seventh consecutive year, and recently were named in Forbes Magazine as America's Most Trustworthy Company.

In closing, I would like to thank all of our customers and vendor partners for their business and support and all of our dedicated co-workers for their efforts. I would also like to thank those listening on the call this morning for your time and for your interest in PC Connection. Have a great day, everyone.

Operator

And ladies and gentlemen, this does conclude the PC Connection first quarter 2008 financial results conference call. We do appreciate your participation and you may disconnect at this time.

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