Datalink Corp. (NASDAQ:DTLK) Q2 2016 Earnings Conference Call July 28, 2016 5:00 AM ET
Paul Lidsky - President and Chief Executive Officer
Gregory Barnum - Vice President of Finance and Chief Financial Officer
Chad Bennett - Craig-Hallum Capital Group
Eric Martinuzzi - Lake Street Capital Markets
Kim Donovan - Needham
Hello and welcome to today's webcast. My name is Kate and I will be your event specialist today. All lines have been placed on mute to prevent any background noise. Please note that today's webcast is being recorded. During the presentation we’ll have a question-and-answer session. [Operator Instructions]
It is now my pleasure to turn today's program over to Paul Lidsky, President and CEO of Datalink. Mr. Lidsky, the floor is yours.
Thank you, operator, and good afternoon everyone. I’d like to welcome you to this afternoon’s conference call and thank you all for joining us. With me today is Greg Barnum, our Vice President of Finance and Chief Financial Officer. Greg will discuss our second quarter results in detail in just a few minutes, but first I would like to provide an overview.
I’m pleased to report that we had a solid second quarter after our challenging first quarter and as Greg will tell you both our revenues and our earnings increased substantially quarter-over-quarter as well year-over-year. One of the strongest and most encouraging trends we saw during the quarter is a change in [indiscernible] companies are approaching IT transformation. This is resulting an seven figure contracts for major data center upgrades that include high margin consulting, project planning and migration services as well as higher ticket product purchases and the implementation.
We continue to see that IT is retreating from the cloud first velocity that soon to be taking hold a few years ago, and instead recognizing that they need to blend the platforms that includes next generation technology on premise that is faster and most efficient and more scalable. Deciding what mix to use requires taking a hard look at all of the organizations workloads and making decisions based on business needs which requires high performance – what requires high performance, what’s mission critical, what’s affected by regulatory mandates and so on.
Companies are turning to our consulting team to do this analysis which is very complex and then to create and execute their plans. Later in this call I will tell you about two large client wins in the second quarter that illustrate this pattern and how it is impacting us.
The other big story of the quarter and the first six months is a trend we talked about in our last earnings call. And as the strong growth in continuing momentum in our flash storage sales, which sized directly back to data center modernization which I just discussed.
During the second quarter of 2016, flash represented 51% of our total storage revenues, up from 21% in the second quarter of 2015. This represents a year-over-year 132% increase in flash sales for the first six months, as organizations convert from legacy storage to all-flash or partial flash arise. The impact goes beyond storage. Flash is also playing a role in driving consulting and data migration services, new customer acquisition, converged data center, infrastructure sales and one call support revenues for converge architecture deployments.
There are other positive trends to report as well. In terms of margins our gross margin – our gross storage margins are holding steady after several years of decline. That applies both our legacy storage partners as well as newer pure play flash storage vendors. In the area of services, revenues are showing somewhat lower growth than on our past few reporting periods, 2% down year-over-year for the second quarter and 5% for the first six months. And part of that is due to advanced consulting projects in the pipeline that are still in the negotiation stage. As we’ve discussed before, these large engagements typically a very long sales cycles because of their complexity, we expect to see some of these contracts signed in the current quarter.
In addition, [indiscernible] to the expense reductions we’ve made over the last several quarters to align our expenses with changes in IT spinning habits as well as our own portfolio of products and services our Q2 earnings significantly beat treat expectations. Greg is going to elaborate on this point in just a moment.
And finally, we still have a strong balance sheet that will enable us to continue investing on new services that meet today’s’ challenging IT needs as well as take advantage of strategic acquisition opportunities that may arise.
I would like to turn the call now over to Greg to discuss our second quarter results in more detail, and then I will provide some additional perspectives on our performance and our further outlook. Greg?
Thanks, Paul. Before we begin with the quarter's results, let me first remind everyone that in today's conference call, we will be discussing our views regarding future events and financial performance. These forward-looking statements are subject to certain risks and uncertainties. Actual future results and trends may differ materially from historical results or those anticipated depending upon a variety of factors. We undertake no obligation to publicly update any forward-looking statement, whether written or oral, that may be made from time to time whether as a result of new information, future developments or otherwise. Please refer to our filings with the SEC for a full discussion of our risk factors.
My comments now on the income statement we'll be referring to non-GAAP amounts and percentages as reported in today's press release. A detailed reconciliation between GAAP and non-GAAP information is contained in the tables included in today's press release. And then to remind everyone that the primary adjustments we make to GAAP results relate to acquisition cost, stock-based compensation charges, and the amortization of intangibles and the net effective income tax on these adjustments.
So turning to the quarter then, in the second quarter of 2016, we saw total revenues increase 9% over the second quarter of 2015, with product revenues increasing 14% and service revenues increasing 2%. As we discussed in the first quarter conference call, we had about $10 million of orders that flip from Q1 and to Q2 due to shipping delays. Adjusting for this the second quarter 2016 revenue growth would have been about 4% over the second quarter of 2015. Because of the timing of receipts of large orders between quarters and vendor shipping delays, I believe that the six months results when compared to the six months of last year represent a more comparable analysis of the business trend.
So looking at that, for the first half of 2016 our revenue mix was 22% storage, 28% networking and servers, 8% software, 1% tape, and 41% service. If you compare that to the six months a year ago we saw 23% storage, 28% networking, 7% software, 1% tape and 40% services. So we didn’t see much of a shift really between the six months this year compared to the six months last year. Although as we mentioned in our press release we did see a large increase in the percentage of the storage coming from all-flash storage.
As these percentages indicate then we saw our combined higher margin storage in software revenues hold steady in the first six months after seeing declines in 2015. As a result, our product gross margins for the first six months of 2016 were 19.3%, the same as in the first six months of 2015.
Our service gross margins for the first six months of 2016 declined 19.3% from 21.1% in the first six months of 2015. This decline is primarily due to the mix of our higher margin one call maintenance revenues continuing to decrease as a percentage of our overall maintenance revenues. One call revenues now comprised approximately 42% of our total maintenance revenues versus 46% in the first six months of last year. The change in the mix are due to the fact of flash storage is continuing to become a larger percentage of our revenues and we do not see much one call maintenance on flash products due to the design of the system [indiscernible].
As a result, our overall gross margin for the first half of 2016 was 19.3% compared to 20% in the first half of 2015. Our operating expenses as a percent of revenues decline to 17% in the first six months of this year from 17.6% in the first six months of last year, reflecting the cost actions that we took in 2015. Operating margins for the first six months was – for the first six months was 2.3% of revenue compared to 2.4% of revenues in the first half of 2015.
As we mentioned in our press release, we recently completed a study to see if our design activities qualified for the research and development tax credit. We concluded they did and as a result, our estimated income tax rate declined 38% from 42%. This contributed a little over a penny for share for the quarter in the six months. Going forward then, I would estimate that our tax rate including the tax credit for 2016 and beyond will be approximately 38% as reflected in the non-GAAP financial statement.
We ended the quarter with over $70 million in cash and investments, working capital of approximately $106 million and no debt.
Let me now turn the call back over to Paul.
Thanks, Greg. Now I’d like to spend a few minutes providing additional perspective.
First, let’s look at revenues beginning with the growth of our flash storage sales. As we mentioned earlier, flash in all accounts for 51% of our storage sales compared to 21% in 2015 and just 6% in 2014. That’s important because it’s helping offset shrinking legacy storage sales. Flash also is contributing to our services revenues because flash sales are frequently accompanied by consulting and data migration engagements.
Let me make three more quick points on the topic. First, newer storage partners like Pure and others are continuing to drive our flash growth, but now we’re also seeing all flash rays from legacy partners like NetApp contributing significantly to our sales in this sector. This not only means that we have different solutions for different client needs, but it also help protect us against the problems that may arise by relying on any one vendor.
Second, as I indicated earlier, we’re beginning to see flash adoption in our converged data center infrastructure sales and that’s significant because as you know, converged stacks are key building block for other initiatives like cloud projects that can build our advanced services revenues.
And third, as we approach a price point, where all-flash storage is becoming more cost effective than spinning desk, we expect to see ongoing growth in this category and related services. This will be a cornerstone of our business moving forward.
Also on the subject to product revenues I should mention that we also saw strong second quarter growth from some of our legacy storage and networking partners as well as [indiscernible] all recoding double digit sales increases during the quarter, showing that we are selling a good mix of products beyond just flash.
Turning to services, Greg and I’ve already reported that our revenues in this area increased 2% year-over-year for the second quarter and 5% for the first six months and the services comprised 41% of our second quarter revenues this year compared to 40% last year. This shows continued progress toward our goal of increasing services as a percentage of our business both to build our margins and to support our clients’ needs regarding design engineering and implementation of complex data center infrastructure projects.
Our consulting services did decline year-over-year, so that’s because we had exceptionally large projects for issue in the first six months of 2015. We believe that these services will grow overall for the 12 month period, as some of the larger deals currently in our pipeline reached the contract stage in the third and fourth quarters.
Now let me combine products and services for you to tell you about two large engagements that I mentioned at the beginning of the call. Both of these are examples of major data center modernization contracts that we won specifically because of our ability to deliver a complete package from consulting and workload analysis to design implementation and data migration.
The first involves a $7 million engagement with one of the largest banks in the United States. They wanted to modernize their data center to achieve better performance, scalability and efficiency. We did all the preliminary analysis and recommended two of our major storage partners fewer for Tier 1 applications and HDS for Tier 2 and 3, for both their production and [indiscernible] recovery environments. We are delivering the new technology and also engaged to execute the planning and migration of the data to these new platforms.
The second project is one of the nation’s largest property in casualty insurance companies, they needed to refresh their legacy storage environment to improve reliability as well as performance in scalability. Today we’ve sold them over $10 million of Pure storage and NetApp and over $500,000 of services and the project is only half way complete. Data link is providing data migration, implementation, project planning and management and automation services as well.
That brings me to margins and here again we have already covered the high points. Storage gross margins have stabilized to 21.5% for the first six months of 2016 as they also were in the first six months of 2015. Overall product gross margins have steady at 19.3% year-over-year for the same reporting periods. Service gross margins declined to 19.3% from 21.9%, as Greg said primarily because of the one call mixed with vendor related maintenance and overall gross margin for the first half of 2016 was 19.3% compared to 20.0% in the first half of 2015.
We expect our service margins to improve as we continue to build our consulting business with the services like data migration, data center relocation, disaster recovery, cloud management and our newest practice security. Meanwhile we still continue to build our wallet share, customer base and converged data center infrastructure sales. The number of customers spinning over $1 million with us in Q2 client from 30 last year to 40 this year. We had 70 new clients during the second quarter of this year and we logged a 32% increase in our converged sales, Q2 over Q1 of this year.
Now let me turn to the outlook for the rest of the fiscal year. As you know, we discontinued near term quarterly guidance in February because of the volatility of current IT spinning patterns, revenue fluctuations from quarter-to-quarter related to variable delivery timetables for complex consulting services and associated products and the fact that other IT companies have adopted annual guidance for the same reasons.
You will also remember that we have been forecasting 4% to 6% annual revenue growth since February of this year. Since that time, the market has accepted flash storage at a faster rate than we anticipated. Flash storage has a deflationary impact on our top line growth due to the greater efficiencies that it provides which translates in the less infrastructure when applied to many workloads. We think flash sales will continue to accelerate over the course of the next several quarters and so we are adjusting our annual growth guidance to be more in line with industry averages which we have packed to 2% to 3%.
We recognized that the market is undergoing a major shift as the technology landscape changes and companies moved from regular technology refresh to business driven IT investments, but we remain very confident we’ve positioned Datalink to perform well in this new environment.
We now have a diverse portfolio of products and services that can meet a broad range of customer needs. We have defects [indiscernible] that is secured complex seven figure engagements with Fortune 500 companies. We have a focus on helping our clients utilize next generation technologies to meet C level business objectives. We have an exceptionally strong balance sheet which allows us to invest in new services as the need arises as well as take advantage of new strategic acquisition opportunities. And we also continue to constantly rebalance our expenses to match the evolution of our business, all without impacting our ability to pursue business or execute against our strategy.
And now Greg and I will be happy to answer your questions. Operator, I’ll turn it back over to you.
[Operator Instructions] Your first question comes from the line of Chad Bennett. Your line is open.
Hey guys, good afternoon, nice job on the quarter.
So, Paul maybe – is there any way to think about the penetration of flash in your installed base at this time, and then maybe a follow up on that, based on the percentages you gave storage and even drilling down more into how much of that storage revenue is flash, I mean your disk business is pretty modest I guess I’d say at this point. Do you really think there is meaningful degradation in that business going forward or do you think that disk business has stabilized?
Well, we certainly can say for certain but I don’t think that the disk business is going away any time soon. There are many workloads that are appropriately placed on spinning disks. There are many workloads which don’t gain from the efficiencies of flash and there are other workloads which are not constructed to gain from those efficiencies and have to be rewritten. And so spinning is going to be a part of our world for a long time.
What we see is just a continued evolution in client thinking about how to apply flash to workloads, and as the price of flash and the efficiency as the flash combined to create a lower total cost of ownership for our clients you’ll see them begin to go as far as to create all flash data centers. And so this evolution is just going to continue over the next several years, I don’t think that there is going to be – there is no indication that there’ll be a stair step function in terms of spinning just moving to flash, I think it’s just a continual migration.
Okay. And then in terms of penetration of flash, do you have any idea there under your base?
I don’t – we don’t have that number, but I would tell you that we have – we certainly have not penetrated the majority of our clients storage environment today.
So there is quite a bit of runaway ahead of us most of it actually.
Okay. And then on the service side of the business, maybe for Greg or Paul for that matter. So little bit of a slow start in the first half of the year but it certainly sounds like you have some nice projects that you’re negotiating right now for the second half. I guess have our thoughts changed at all in terms of – I know we’ve moderated the growth rate for the overall business but if we look into next year have our thoughts changed on the growth rate of the services business overly, intermediate term next several years?
I think over the next several years, no I don’t think our thoughts have changed. Our consulting practice is still a very small business when compared to the rest of what we do. And so the fact that we have been fortunate enough based on the talent that we have brought on board to win these very large deals has created some bumpiness in the way that the revenue flows, but we don’t see any end in sight to the opportunity and our services portfolio continues to evolve as our client needs evolve which is very easy to do on the consulting side of the business. So I think that as the business grows the volatility of large deals becomes less of a factor and I think that based on what we’re seeing more and more of our clients are appreciating the fact that we have this consulting and managed service capabilities to apply to our Next Gen technology practice. So I think overtime our growth expectations for it are accurate.
Okay. Thanks for taking my questions guys.
Sure Chad, thank you.
Your next question comes from the line of Eric Martinuzzi. Your line is open.
Thanks. Just stepping back on the full year outlook now on that 2% to 3% range, your first half of the year has been about a 2% if we look at it all in first half 2016 versus first half 2015, that was a mix of about a minus one on the products side and a plus five on the services side. Does that – do you think that’s sustains the rest of the year, in other words products relatively flat with service providing the counter to get you to that 2% to 3% for the full year?
Yeah I would deal with that later right now, I know we had a stronger storage first quarter than we thought we would – first six months than we thought we would have had. Networking was probably a little weaker in the first six months that we thought it would have been, but I think by the time we get to the end of the year product will be up low single digit, yes.
But remember now the guidance we gave was to take $764 million and deduct $22 million of fulfillment from that and then apply growth rate if you recall.
Yeah I understand. You’ve trained me well on that, Greg.
And starting from that $743 million and doing that plus or minus – not plus or minus but the range of 2% to 3% that puts me in a range for the year of $758 million to $765 million, so I’ve done the math there. The – as I look out to – and I know you’re not trying to give quarterly guidance here but the seasonality of Q3 now versus year’s past, the wrinkle here is obviously the overall growth rates come in a little bit and then you’ve got this shift in favor of flash versus legacy storage systems but I’m just wondering historically there is – Q3 has been flat to down a little bit at least in general maybe not each and every year but flat to down a little bit in Q3 versus Q2, does that sustain this year you think?
I don’t see the reason why it wouldn’t be that way. We do see the slowdown in the summer months, yes.
Okay. And then the workforce, it’s been a year you guys went through the difficult process of restructuring the workforce a year ago. The market continues to be very dynamic, certainly that shift of flash front and center. Your workforce, do you have the right number of heads, does heads needs to go up or down within – if total headcount doesn’t change does that worry you, will you point the high rank engine change at all?
This is Paul, Eric. I think we have the right size workforce for the business. We – our Next Gen technology practice whether its flash for new entrance like Pure and Nimble and [indiscernible] and others or whether it’s flash from our traditional partners, our Nep App all flash business is very strong. We need a strong architectural organization to help us design these systems, we need strong installation capabilities. So I think in that area we are structured properly. I think the areas that where we would hire based on need is in our consulting and managed services practices which is really a hiring is based on projects and sustain utilization. So I think that’s where we point our hiring but we are constantly evaluating all parts of the business, not necessarily with an eye towards but also with an towards where do we need additional talent.
Okay. And then lastly you did – you talked about the balance sheet strength $71 million of cash and then about $27 million out on the line of credit. So on that cash balance of about $44 million, you’ve talked in quarters passed about how that has changed, how your M&A efforts have changed a little bit. I know for shareholders that don’t Datalink, M&A is part of the strategy of the company, where are you focusing the M&A efforts as far as geographically or product wise?
I think geographically I think we continue to look in Texas, Ohio, Florida those were probably our three big ones right now. But of course, we’re looking in almost any of our studies were up and down the eastern seabird for instance where we don’t have market dominance. We’re looking at some of the cities in the Midwest, we have a strong growing business in [indiscernible], we would invest there to grow that bigger, that’s been very good for us. So we continued to start to reevaluate but the three cornerstone stage have remained at Texas, Florida and Ohio.
I think that as we look at the type of companies we’re looking for, we have evolved our sort of filter for those. We are very interested in companies that have strong fiscal practices especially around their next generation technology, their security and services that go with that and we’re very interested in Next Gen technology in the storage base. Probably less interest Eric in traditional storage manufacturers as an acquisition target in terms of resellers. So a little bit different, we’re pointing on a little bit different direction and as we always have always looking for 20% to 30% of targets revenues coming from professional services that they deliver.
Understand. Okay, thanks for taking the questions.
Sure Eric. Thank you.
Your next question comes from the line of Matt [indiscernible]. Your line is open.
Thank you very much. Good afternoon, gentlemen. I guess a couple of questions from me. The first one, Paul you had mentioned adding 70 new clients in the quarter, maybe you could give us a little bit of a description of those, I mean you mentioned a couple of mark key engagements in your prepared remarks but maybe a characterization of the new clients, how does that number 70 translate relative to recent periods and I guess the drivers of the additional clients in the business you think?
Well, okay Matt, I think that characterization – I mean we’re still mid to large enterprise operation, so those 70 clients fall into the adjustable market that has always been our market. I think they run the gamed of the different verticals. Many of them were a competitive take outs. We have been using especially flash – all flash arise regardless of manufacture both – and we have used both our traditional partners like NetApp and our newer partners like Pure to actually go in and redo data centers that are in the hands of competitive infrastructure OEMs or other competitors in the market.
So that’s become a kind of a stable now, I mean we don’t often use spinning disk as a redefining technology for unseating our competitor but we used flash quite often, regardless of the manufacture. So I think that’s been the dynamic change there.
Got it, got it. And then one of the metrics that I often ask you guys about is – and you’ve highlighted in the past that sort of retraining or I guess refocusing the sales heads that you guys have in the company towards selling services as part of their daily lives, right. Maybe you could update me on some of the metrics I know that you guys track about percentage of sales pipeline and have services in them etcetera and what the trends are there because I think that to me is one of the more important metrics as the business trends sort of evolves over time. Thanks.
Okay. Well you know the metrics that we really been tracking because we think it’s key is that the level of participation of our traditional sales force to sell services and I’m pleased to report that after having said a fairly high bar for participation were to about 35%. Our high bar says that your prospects or your sales have to be at or greater than $200,000 or you have to have a strategic sale – we have a cloud management workshop that just comes in under $200,000 that is considered strategic. So we have a high bar set for participation in the business and 35% is a great number. Obviously the target is a 100, you never reach it but we are continuing to see that number increase as we move through the last few years. So I think that that’s our number one metric, it’s the one that we all look at the executive team on a regular basis and is the one that we sort of use to determine what’s next in the business.
I would tell you that if you were to walk among the sales folks in the company regardless of location, you’ll hear many more than that 35% talking about opportunities that they are wanting to get into their pipeline. So I think that we’ve crossed that threshold of where consulting and managed services are an unknown and an uncomfortable new concept to something that I believe most everyone in the sales organization endorses and is working to include in their customer base. So overtime we’re going to see that number, that participation rate increase and then – and I’m very pleased with that.
I mean that’s great to hear, thanks, and that’s helpful color. Just as a tiny follow up and then I’ll jump back in the queue, where was that metric on a year-over-year basis just so I can live with it?
Probably - I don’t have the exact numbers but I would tell that we were probably closer to 10% a year ago at this time.
All right, thanks very much. All the best.
Your next question comes from the line of Rich Kugele. Your line is open.
Hi guys, this is Kim Donovan on for Rich Kugele.
How are you? I believe you previously said you signed about 60 – sorry, 30% of your customers with Cisco, what do you think of that number can grow to overtime?
We’ve signed Cisco of about 30%, there is no reason why we can’t sell all our customers to Cisco [indiscernible]. Most people would be [indiscernible] Cisco owns – what, almost 95% of the clients that we go after. I would say again much like consulting Cisco is something that we’re evolving overtime. I would like to see that number get to 50% - and this is just the target, our numbers are not depending upon it but I would like to see us get to a 50% mark. We’re in 30% now, that’d be a nice climb and then I think when we get towards 50% then we can look at the landscape, look at what we’re selling, look at what’s evolved in the industry and then reset from there.
Great. Thank you.
There are no further audio questions at this time.
All right operator, well Greg and I just wanted to thank all of you for participating. We thank you for your questions and we will look forward to giving you a new update at the end of next quarter. Have a good day.
Thanks to all of our participants for joining us today. We hope that you found this webcast presentation informative. This concludes our webcast and you may now disconnect. Have a good day.
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