Black Box Corporation (NASDAQ:BBOX) Q3 2017 Earnings Conference Call January 31, 2017 5:00 PM ET
Ron Basso - EVP, Business Development and General Counsel
E.C. Sykes - President & CEO
Anthony Massetti - SVP & CFO
Tim Huffmyer - VP Finance
Greg Burns - Sidoti
Cobb Sadler - Catamount
Good day, ladies and gentlemen, and welcome to the Black Box Corporation Third Quarter Fiscal 2017 Financial Results Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. [Operator Instructions] As a reminder, this conference may be recorded.
I would like to introduce your host for today's conference, Mr. Ron Basso, Executive Vice President. You may begin.
Thank you. Good evening and welcome to Black Box Corporation’s third quarter of fiscal 2017 earnings conference call. With me today are E.C. Sykes, our President and CEO, Anthony Massetti, our Senior Vice President and CFO and Tim Huffmyer, our Vice President of Finance.
Earlier today, we announced our third quarter fiscal 2017 results by issuing a press release and furnishing it to the Securities and Exchange Commission on Form 8-K. We also posted this press release in the Investor Relations section of our website, blackbox.com. In addition to commentary from E.C, Anthony and Tim, we have a brief slide presentation supplementing the call. Those slides also are available in the Investor Relations section of our website. For those of you who are accessing the webcast, the slides will present on your screen.
Before we begin, and as a reminder, matters discussed in this call may contain certain forward-looking statements that involve risks and uncertainties concerning our expected financial performance. Actual results may differ materially from expected results, and reported results should not be considered as an indication of future performance. Potential factors that could affect our business and financial results include changes in the economic conditions in our end markets and the general market at large. Additional factors are included in our most recent Form 10-K and today's press release.
On this call, and as presented in today's press release, we will discuss some non-GAAP financial measures. Please refer to the schedules that accompany the press release for a reconciliation of these non-GAAP financial measurements to most directly comparable GAAP financial measurements and other supplemental information.
Now, I’d like to turn the call over to E.C.
Thanks, Ron. Good evening and thank you for joining us.
In the third quarter of fiscal 2017, Black Box continued to make progress on our journey to transform the company. Although our financial results were mixed, we continue to improve our management systems. This enabled progress in areas within our operational control such as working capital, cash generation, debt reduction, and operating expense management.
Our Q3 total revenue was expected to be impacted in the short term as a result of the adjustments we made to our commercial services and product sales organizations. These adjustments were designed to better position us in the market.
In addition, we continued to address the issues of the UCC market decline. The revenue results for Q3 were below our internal forecast and are disappointing. As we discussed in last quarter's call, it will take some time for improved revenue results to flow through the financials, given our typical 9 to 18 months’ sales cycle.
Our lower operating expenses in the quarter reflected our recent reutilization and continued access to leverage the benefits of our consolidated business structure. Although the structural decreases in our core OpEx were not enough to overcome the Q3 revenue shortfall, we continued to strengthen the balance sheet, resulting in solid positive cash flow, continuing improvement of our working capital, and decreasing long-term debt.
Overall, I'm pleased with the progress and the structural changes that we're making to reshape how we operate and deliver value to our clients. I'll share more after our financial update from Anthony and Tim. First, we'll hear from Tim.
Thank you, E.C. We posted revenue of $210 million, down from $219 million last quarter due to a decrease in both the product and service businesses. Products revenue was $36 million, down $6 million or 15% from $42 million last quarter, mostly due to a reduced number of large solution orders and a lower demand for certain legacy data networking products.
Services revenue was $174 million, down $2 million or 1% from $176 million last quarter, mostly due to a decrease in core commercial revenues in North America services as a result of lower demand for UCC-related projects and services, offset by an increase in federal revenues as a result of project timeline accelerations and higher volume of project awards.
Maintenance revenue, which is derived primarily from long-term agreements with our services clients was $38 million or 18% of our revenue for the third quarter. This is down 12% from $43 million or 19% of our revenues for the same period last year and slightly up from $37 million for last quarter.
This maintenance revenue trend is consistent with the market trends and is only one market we serve. The six-month order backlog is $171 million, down $13 million from $184 million last quarter and down $2 million from $173 million in the same period last year.
The sequential quarter decrease is primarily due to decreased orders in commercial services and North America services as a result of lower demands in UCC. Gross margin was 29.7%, up from 24.9% last quarter due to an increase in both products and services' gross margin.
Products gross margin was 44.2% up from 35.6% last quarter, primarily due to the inventory impairment loss recorded during 2Q'17. The positive results of cost reduction programs executed over the last year and a favorable mix of product sales related to a lower volume of large solution orders.
Services gross margin was 26.7% up from 22.3% last quarter, primarily due to the inventory impairment loss recorded during 2Q'17 and project mix within the quarter. SG&A was $57.4 million down $700,000 or 1% from $58.1 million last quarter.
To discuss the change in SG&A, we're presenting a slide to list and graphically represent the following items. During the third quarter, we had $1.8 million less restructuring expense and $200,000 less stock compensation expense compared to last quarter. In the third quarter, we realized the benefits from restructuring activity during the first quarter of '17 and the second quarter of '17 of $800,000 and $1.3 million respectively.
In the third quarter, we disposed of an underutilized facility resulting in a $300,000 loss and increased the accounts receivable reserve by $300,000 for a total of $600,000. The accounts receivable reserve is related to a single contract, which had subsequently been reserved for in the fourth quarter of fiscal 2016. We do not expect further loss related to this contract.
During the third quarter, compensation and benefits-related expenses increased by $2.2 million, mostly due to lower than normal claims activity in the second quarter of '17 and additional management positions added in third quarter of '17.
In the third quarter, we incurred restructuring charges of $1.1 million. $800,000 was related to management changes and progress on a reset business model with a focus on adjusting operating expenses to existing revenue, resulting in a projected annual SG&A savings of $1 million and additional $300,000 was related to facilities restructuring action within the quarter resulting in annual SG&A savings of $400,000.
We will continue to execute on our restructuring plans throughout the fiscal year and as certain phases of our initiatives are achieved, additional opportunity may exist to become more cost-efficient. We will also continue to make the appropriate investments to support sustainability and long-term growth of the company.
Adjusted operating income margin was 3.2% down from 3.8% last quarter. Operating earnings per share was $0.24 down 23% from $0.31 last quarter. The operational income tax rate was 35%. The GAAP effective income tax rate was 20% and is related to a geographic mix of business income and the write-off of deferred tax assets, specific to our equity award program.
I will now turn the call over to Anthony to complete the financial summary for the third quarter.
Thank you, Tim. Cash flow provided by operating activities was $9 million up from $4.8 million in the prior quarter and down from $28.8 million in the same period last year.
As discussed on previous calls, we remain focused on efficient use of the balance sheet. During the fiscal year, we've reduced the working capital as a percentage of revenues. Our goal will be to maintain this lower percentage as we seek future revenue growth.
DSOs were 53 days down from 56 days in the prior quarter and down from 62 days in the prior year. Aggregate DSOs inclusive of cost in excess of billings and billings in excess of cost, were 79 days down from 80 days in the prior quarter and from 80 days in the prior year.
Net debt was $80 million, down $6 million from $86 million in the prior quarter and down $31 million from $111 million from the same period last year. During the third quarter, we used all available free cash for debt reduction. Our leverage ratio is 2.7% down from 2.8% in the prior quarter and 2.8% in the same period last year. Our current incremental borrowing rate is 2.8%. We'll continue to prioritize the use of capital in the fourth quarter and expect to use our available free cash flow for debt reduction.
Now I'll turn the call back to E.C.
Thanks Anthony. In May, I presented our transformation roadmap, which contained the following phased approach. For stabilize, the company under one Black Box model and approved the predictability of our business with improved management systems, optimize our results by implementing our new business model with integrated systems and achieve above-market growth by investing in growth markets and reducing our investment in declining markets.
Expand our business by selectively serving adjacent markets and identifying tuck-in acquisitions that will accelerate our penetration into new markets, transform Black Box into our client's trusted digital partner by offering solutions that focus on business outcomes and empower their digital strategies.
We continue our journey on this roadmap, primarily in the first two phases; stabilizing and optimizing the business and I'm encouraged by their progress that we've made developing the required management system. As we're moving forward to the next phase of transformation, it is essential that we get the management system platform right in order to prepare the company for long-term success.
The scope to stabilize the company is larger than anticipated and is taking longer than I like. However, it is prudent to firmly establish our footing before taking the next steps. There has also been significant progress improving the balance sheet, driven by the maturing management system.
A few of our complements on strengthening the balance sheet include, a year-to-date net debt reduction of $30 million or 27%. We have delivered reductions for five consecutive quarters. A year-to-date free cash flow increase of $14 million or 186%. A year-to-date net inventory decrease of $23 million or 47%. A year-to-date improvement of working capital of $28 million or 22%.
And regarding revenue, as mentioned in the last earnings call, the recent actions taken to strengthen the sales team were expected to have short-term impacts from revenue. The consolidated results were lower than expected and disappointing. The structural improvements to the operating expenses and the improved management system will not become evident in approved earnings until revenue comes in line with expectations.
Before sharing our plans for revenue growth, I'll share the Q3 revenue overview from the business units. The federal group continued their strong performance and again exceeded plan. For those of you who have been following the federal group for a while, they struggled for several years as they repositioned themselves in the market by focusing on client's desired business outcomes.
In many ways, their transformation is the model for the transformation of the commercial services and products group. I would also like to note that our federal business grew 19% in Q3 year-over-year. The products group revenue was below expectations. North American group is selling products direct to end users and through distribution resulting in occasional channel conflict issues.
In Q3 the process to consolidate U.S. sales into the distribution channel was started, including replacing certain roles in the sales organization. These changes as well as unexpected turnover in the sales organization reduced the North American product sales capacity. We anticipate these impacts to sales capacity being resolved in Q4.
We recognize that business model shifts can be disruptive and we will closely monitor them and continue to adjust as needed. The international products group revenue overachieved in Q1 and Q2 and the underachieved in Q3 and remain on plan for the year.
As mentioned in Tim's remarks and in prior calls, certain commercial service markets we serve are declining. Our shift of investments in the growing markets has shown results, but they're not strong enough yet to offset the decline in the UCC market. In addition, in Q3, commercial services revenue were below expectations as the adjustments to enhance sales structure were not yet realized.
As mentioned, it's expected these improvements to our sales structure will require 9 to 18 months to be fully realized. We're beginning to see early indications of success in this area. That is required to build the foundation for sustainable revenue and earnings growth, had more areas to be addressed and are first estimated, the steps we haven't addressed the major elements of the platform that we can build upon.
However, the work is not complete. For example, our multiple ERP systems in over 60 supporting applications are being further simplified. In January, we launched an 18-month ERP consolidation project that will reduce the number of commercial services and federal business units to one system and modernize and integrate the applications.
This will create a flexible and dynamic next-generation platform which will increase our ability to serve our clients, provide a real-time unified view to better manage the business and further reduce our operating cost. In the future, I'll provide updates on the progress of this project.
The products group will continue to consolidate and find efficiencies on the current system. Our activity to create the business management system and foundation for growth continue. Significant progress has been made to shift more of the attention to activities to grow revenue. I'm pleased to share a few of these activities.
We've identified an excellent new commercial service sales leader who we will announce and welcome to the organization shortly. Although the search to find the right person took longer than I desired, I'm pleased we're able to identify a proven sales leader with the right background to lead the commercial services during this transformation.
Also, we're engaging with the premier global strategy consulting company to assist us in creating a strategy and identity that will accelerate our near-term growth and transform the company into a leading digital service provider and as we continue to identify and pursue market-driven strategies to grow our business, I invite you to watch a video on our website that will show you our approach to the immersive retail opportunity. You can find the video at blackbox.com\retail.
Based on our current view, using our developing management systems, we expect Q4 consolidated revenue to be slightly lower than Q3, as a result of the improvements to the commercial services sales process put in place. These will continue to impact short-term revenue results.
We expect our products group revenue to return to near plan levels and our federal group is expected to overachieve. The strategy, consultant and the ERP implementation mentioned earlier will add $3.5 million to $4 million to our operating expenses in the fourth quarter.
As we discussed earlier, we've expended significant efforts to decrease our operating costs to generate capital for future investments. I view these investments as critical for our transformation. In the meantime, we will continue with our expense controls and working capital focus to the business.
Now, I would like to provide you with a few examples of how the progress we're making on our transformation is resounding with our clients. In our products business, we closed a multiyear product rollout with a major European retailer. We won this deal by leveraging our software team in Ireland to customize the KVM solution for their specific needs.
The final solution is comprised of products that are completely developed in [Elmo] Black Box. By demonstrating our differentiation, we improved our margins and maintained control of the final solution. Our ability to succeed on a project like this is a result of our teams seeing a market opportunity and assembling the right resources, in this case our acquired software development capability to serve the client. I expect more of these solutions, to be delivered from our products group.
The federal team continues to win large competitive bid opportunities that will support our military and diplomatic personnel at home and abroad. In addition to the Marines, Camp Lejeune Project announced in November we were awarded three large contracts in Q3. We'll provide additional details on these contracts in the coming weeks.
Our commercial service team has extended the contract with a large financial institution managed service client for another full year. In my conversation with the client, they again confirmed the excellent level of service that our team is proving and we're actively collaborating on additional areas where Black Box can add value to our relationship.
Moving forward, our vision for Black Box is clear. We intend to be the trusted digital partner. Our goals are to provide best-in-class products and services, enable digital convergence of disparate platforms and to create innovative solutions through expanded strategic relationships.
Because of our unique position with our clients, we see many emerging trends in their businesses. As a trusted digital partner, we will support them as our multiple systems converge. To give you visibility into the short-term objectives to execute on this vision and transmission roadmap, on last quarter's call and in addition to the four parties that I've communicated to the Black Box team.
We will execute on our transformation, improve working capital and generate cash, simplify our business operating model and position the company for growth. In Q3, we met or exceeded all these objectives as noted in my prior remarks. In Q4 our objectives are the same.
I'm confident that our new focus organization is developing a competitive set of services and products for the convergent digital market. We're building the foundation for a stronger Black Box.
With that, I will open up the line for questions.
Thank you. [Operator instructions] And our first question comes from the line of Greg Burns from Sidoti. Your line is open.
Good afternoon. Can you just talk a little bit more about the disruptions you had in the products group and it sounded like you said they were going to get back to plan in the fourth quarter. So, I guess you expect those disruptions to be addressed or maybe they have already been addressed, but could just give a little bit more color on that?
Yes. Greg, we would be glad to. So, those disruptions, well, there's two activities going on. One is, we are resetting that business model as mentioned so that we have a single go-to-market strategy, which is through distribution as opposed to dual strategy at present.
We are aligning our headcount to that strategy. In addition to that, we had a little more turnover than it was expected which reduced our total capacity. We've already closed on some of that capacity gap, and we expect we'll close on the balance of it in this quarter.
Okay. Thanks. And you mentioned you're seeing some early -- I guess the changes to the sales organization or still causing a little disruption in the business, and it's going to take a little while to see results, but you did mention, you're seeing some early signs of success. Could you give us a little bit more color on what you're seeing?
Yeah certainly. Greg, we did take some major steps to align our sales team to a market-driven structure approach. One is this workforce in the past and are confident about our workforce in the future. That team is working through that go-to-market strategy. We've already seen some improved activity from some customers.
While we're seeing that improved activity, I have reservations into that space off of our developing management system, and I would like to get a few cycles of validation before we make any strong proclamations of exactly where that's headed. So, I am encouragement of what I see, but I also just want to be thoughtful and careful and conservative before we give any future guidance on that area.
Okay. And then in terms of OpEx, I guess last quarter was about $6.5 million of variable comp and bonuses that were not in SG&A. How much of that came, if any -- was in the number that came back in the third quarter?
Hey Greg, Tim here. Actually, very little of that bounced back into the third quarter based on our performances there. You'll see a OpEx walk from the second quarter to the third quarter, and the primary change related to moving from the second to the third quarter was more in the claims-related expenses rather than on the comp side. So very little of that came in Greg.
Okay. So, the $3.5 million to $4 million of incremental OpEx in the fourth quarter that's -- is that like permanent expenses or is that like restructuring, once you get the ERP together, that rolls off? How should we think about that and then that $6.5 million or so of bonus or variable comp, do we see that coming back into the P&L at some point?
So, our third quarter OpEx run rate is a good starting point. We do have additional expenses that we expect to come in as E.C. mentioned in his comments and you can carry forward some of these restructuring charges that we've specifically called out in offsetting benefits basically into the fourth quarter.
As we get into, we'll be working and setting the FY'18 plan here in the next couple of the weeks and guiding on that in May, but I would expect, we would be targeting -- we will be targeting bonus to be in our numbers in FY'18 to continue to incent the hard-working team we have.
Okay. Thanks for that and then the Avaya bankruptcy, are you seeing any fallout from that? How do you see that impacting your business and I think they also instituted new channel program? Does that affect you guys in any way?
Yes. So, Greg, actually we're in close conversation with Avaya. They're a key partner with ours and we enjoy that conversation with them. There's been rumor, street talk on that for a long time. So, I don't know that caught anybody by surprise and didn't catch up by surprise and we've already taken some steps to understand our clients, where they're at, and who maybe need which types of assistance.
We're not seeing any particular impacts now. We are having conversations with different ones that are thinking about how to address the issue, but right now it's not having any material impacts to the company.
Greg, this is Anthony. There's no balance sheet risk either AP or AR. We're current with Avaya.
Okay. What percent of your UCC business is Avaya?
We've never produced those metrics Greg. So, I'm not at liberty to say right now.
Okay. All right and I guess it sounded like you would give some additional color on the federal contract wins at some point, but in terms of size of the comparable to the Marine in total or each individually, is there anything additional you could give us by way of that federal, the federal contract wins.
It's difficult to do with the information that we can share right now. I think they have a solid market position there and I think I've reflected some numbers that they're going to overachieve some in Q4, but I'll be looking for some additional press releases we have as we get authorization to release that information.
Okay. How much, I guess how big is the federal business right now, I guess on an annualized basis and do you I guess with the pipeline that you see out there and the recent wins, do you still expect that to grow in fiscal '18?
So, I think we've talked before, this business is north of $100 million and the growth rate on it, we've alluded to, but we do expect low double-digit growth rate here as we have visibility into next year Greg.
Okay. And I guess any pickup in activity on that side of the business since the election?
No not really. While we continue to stay close to stay close to that market, they really are to reposition themselves in the marketplace and we're not seeing any change in activity as a result of the change in administration.
Okay. All right. Thank you.
Thank you. And our next question comes from the line of Cobb Sadler from Catamount. Your line is open.
Thanks a lot guys for taking the questions. Just had a question if you could maybe run through by vertical maybe rank the different sectors how they performed select maybe traditional data networking versus storage? It sounds like UCC was obviously the worst, but could you just -- could you run through that for us real quick?
Sure. Good afternoon. So, the UCC market, which we've alluded to here over the last several quarters, has not performed well, so we've seen that be down maybe low single or low double digits here. What we are seeing success in and getting some traction on is really related to our infrastructure business as we refer to it.
That infrastructure business includes data infrastructure, some IOT type links and we are seeing a stabilized market there with low single digit growth there and all that's in our services segment, outside of the federal of business that we just referred to.
Okay. Got it. Okay and then just the -- I know you don't want to give how big the Avaya business as a portion of UCC, but would you say that maybe Avaya lagged the other UCC vendors or is it stabilized and performing in line with the UCC vendors. I am just trying to get a feel for, was one vendor a big drag on your UCC business or was it pretty systematic across the UCC sector?
Cobb, really, we're seeing more macro market forces than we are with one particular vendor that's there and so we haven’t seen any particular problem with one or any particular one.
Okay. All right. Thank you very much. Appreciate it.
Thank you. [Operator instructions] At this time, I am showing no further questions. I would like to turn the call back over to Ron Basso for closing remarks.
Thank you and we thank you all for your time today. As a reminder, our press release has been filed on Form 8K and is available on blackbox.com. Thank you and this concludes today's conference call.
Ladies and gentlemen, thank you for your participating in today's conference. This does conclude the program. You may now disconnect. Everyone have a great day.
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