PC Connection's (CNXN) CEO Tim McGrath on Q4 2016 Results - Earnings Call Transcript

| About: PC Connection, (CNXN)
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PC Connection, Inc. (NASDAQ:CNXN) Q4 2016 Earnings Conference Call February 1, 2017 4:30 PM ET

Executives

Tim McGrath - President and Chief Executive Officer

Bill Schulze - Interim Chief Financial Officer and Corporate Controller

Analysts

Adam Tindle - Raymond James

Anthony Lebiedzinski - Sidoti

William Gibson - Roth Capital Partners

Operator

Good afternoon ladies and gentlemen, and welcome to the Fourth Quarter 2016 Connection Earnings Conference Call. My name is Chelsea, and I will be the coordinator for today. At this time, all participants are in listen-only mode. Following the prepared remarks, there will be a question and answer session. As a reminder, this conference call is the property of Connection and may not be recorded or rebroadcast without the specific permission from the Company.

On the call today is Tim McGrath, President and Chief Executive Officer; and Bill Schulze, Interim Chief Financial Officer and Corporate Controller.

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 management may make about the Company's future expectations, plans, and prospects, constitute forward-looking statements for purposes of the Safe Harbor provisions under the Private Securities Litigation Reform Act of 1995.

Actual results may differ materially from those indicated by these forward-looking statements as a result of various important factors, including those discussed in the Risk Factors Section of the Company's Annual Report on Form 10-K for the year ended December 31, 2015, which is on file with the Securities and Exchange Commission, as well as in other documents that the company files with the Commission from time-to-time.

In addition, any forward-looking statements represent management's view as of today and should not be relied upon as representing views as of any subsequent date. While the Company may elect to update forward-looking statements at some point in the future, the Company specifically disclaims any obligation to do so, even if estimates change. And therefore, you should not rely on these forward-looking statements as representing views of any date subsequent to today.

During this call, GAAP and non-GAAP financial measures will be discussed. A reconciliation between the two is available in today’s earning release and at the Company’s website. Today’s call is being webcast, and will be available on Connection’s website. The earnings release is also available on the website.

I would now like to turn the call over to Tim McGrath. Please proceed sir.

Tim McGrath

Thanks Chelsea. Good afternoon everyone and thank you for joining us today to review the Company's fourth quarter financial results. Q4 was an exciting time for the Company. We’ve purchased GlobalServe, largely completed the integration of Softmart and we continued our transformation as a global solutions provider. The Company achieved record net sales and gross profit in Q4 and on an adjusted basis, earnings per share.

Consistent with the overall trending in our industry, demand continued to be muted in Q4 with the exception of some targeted strength in the public sector. In addition, we saw a reduction in large deals in the quarter and more aggressive pricing on the deals that did shift.

We also experienced strong bookings in tour Federal business and we have a large backlog of projects that will shift in Q1. As we review our results, please note unless otherwise stated, all of our fourth quarter 2016 comparisons are being made against fourth quarter 2015. We also have a full quarter of Softmart results in Q4 of 2016 based on the acquisition date May 27.

In Q4, consolidated net sales increased year-over-year by $51.2 million or 7.5% to $735.5 million. Gross profit dollars in the quarter increased by 6.8% to $98.1 million. Consolidated gross margin decreased slightly to 13.3% from 13.4% in Q4 2015, due to the increased federal sales which generally have lower margins.

SG&A excluding special charges increased this quarter to $74.2 million from $68.7 million. This increase was due to higher variable compensation from increased gross profit, three months of Softmart SG&A expense and our investments over the last year on both sales and technical areas. We continue to manage cost in this mixed spending environment and look for ways for the business to be more efficient. This will enable us to continue to invest in the mission critical growth areas of the business.

Diluted earnings per share decreased from $0.51 to $0.49 however, adjusted earnings per share which excludes special charges for restructuring, acquisition and related amortization increased from $0.52 to $0.53 per share.

For the full-year of 2016, consolidated net sales grew by 4.6% to approximately $2.7 billion, and net income increased by 2.7% to $48.1 million.

As announced last quarter, the company acquired GlobalServe, Inc. on October 11, 2016. GlobalServe has developed a portal designed to meet its customers’ global IT needs with consistent delivery, reporting, pricing and logistics. We’re excited to be able to offer our customers this global capability, this industry leading tool, simplified our customers’ global IT procurement and reduces their cost.

And now with the latest release of the software, OneSource, we can offer this global capability to our SMB customers. We believe that this acquisition gives us true competitive advantage in the marketplace and we expect that this will be an important component of our overall future growth strategy.

The integration of Softmart is largely concluded. Softmart’s Microsoft business combined with the existing Connection business makes us one of the top Microsoft partners in the world. We’re optimistic that in 2017, we’ll see increased sales from Softmart’s existing customers as we go deeper and wider with those accounts.

And now I’ll turn the call over to Bill Schulze to discuss the results of our business segments and financial highlights. Bill?

Bill Schulze

Thanks Tim. Sales for our SMB segment which serves small to medium size businesses increased by 5% to $276 million, strong sales in both mobility and software drove the top-line growth.

SMB gross margin in the quarter decreased by 20 basis points to 15.7%, due in part to the increased sales of lower margin mobility products mentioned above. For the full-year, gross margin increased by 30 basis points to 15.8%, which we attribute to our growth in sales of advanced technology solutions.

Sales by our Large Account segment increased by 4% to $289 million, our Large Account business had to compare against a very strong Q4 2015 which saw a 23% growth.

Gross profit dollars increased by almost 9%, due to our focus on driving margin improvements. Gross margin in Q4 was 12.2%, a significant increase from 11.7% last year. For the full-year, gross margin grew by 84 basis points to 12.8%.

Sales in the public sector segment which includes sales to government and education increased 18% to a $170 million. Sales to state and local governments and education customers decreased by 4% whereas sales to the federal government increased by 46%. Gross profit dollars for the public sector were up 10% over last year.

Our healthcare vertical, which includes customers in all three business segments, increased revenues by 23% and grew gross profit by 16%. We continue to invest in this vertical which connects healthcare customers with customized solutions and is projected to be a growth area for the foreseeable future.

In Q4, we incurred $1.5 million of acquisition and restructuring costs. This charge includes costs associated with the acquisition of GlobalServe, and severance related to internal restructuring. In addition, we incurred $470,000 of amortization of acquired intangible assets from the Softmart and GlobalServe purchases.

Overall, our financial performance was solid. Earnings per share, excluding one-time charges and amortization of acquired intangibles increased to $0.53 per share, up from $0.52 last year. In addition, trailing 12-month adjusted EBITDA increased by 7% to $95.5 million.

Our balance sheet is healthy. Our year-end cash balance of $49 million is lower than Q3s balance of $67 million due to the $11 million we paid for GlobalServe as well as higher seasonal working capital requirements.

On a year-to-date basis, we generated positive cash flow of $23 million, which is prior to the $43 million spent on acquisitions and a special dividend of $10.6 million paid in January last year.

In Q4, we declared a special dividend of $0.34 which was paid recently. This return $9 million to shareholders is a sixth year in a row that we have declared special dividend which now total more than $60 million. Our goal is to maximize shareholder value while maintaining financial flexibility.

We continue to assess M&A opportunities and other capital allocations such as dividends and stock buybacks. As a reminder, we still have approximately $18 million in previously authorized share repurchases.

I will now turn the call back over to Tim to discuss current market trends.

Tim McGrath

Thanks Bill. Our fourth quarter and full-year results reinforce the importance of product mix and advance technologies on gross profit margin. We believe our plan is on track and that our strategy is working. Despite the softness in overall IT spending, we are able to increase gross profits and thereby grow our adjusted earnings per share.

Looking ahead, current industry growth projections for 2017 are mixed but in the low-single-digit range. Our goal is to grow faster than the market by taking share. Noted in Q1, we’re projecting strong revenue performance from our public sector business due to some significant orders in our backlog.

We're also focused on advanced technologies and we’re investing in complex areas of the business in order to help our customers achieve their business outcomes. Our software business continues to grow including Cloud, virtualization, security and security assessments.

In addition, our net network operating center in Schaumburg, Illinois is now fully operational. We’ve made investments in our hybrid IT capabilities and we’re also seeing an increase in data center assessments.

Demand has been strong for converged infrastructure products and we’re experiencing strong growth in our services business.

We also continue to target vertical markets such as healthcare, retail, financial services and manufacturing. We believe our business model is more relevant than ever as we help customers navigate through technology that’s more complex and more disruptive. Our acquisition of Softmart and GlobalServe have expanded our capabilities and increased our customer count as well as our sales headcount, and enhanced our automated sales tools.

Our balance portfolio of customers, suppliers, products and solutions has helped us to deliver solid results. Our goal is to continue to deliver sustained and consistent performance.

We'll now entertain your questions.

Question-and-Answer Session

Operator

[Operator Instructions] And our first question comes from the line of Adam Tindle with Raymond James. Your line is now open.

Adam Tindle

Okay, thank you, and good evening. Tim I just wanted to start by asking about the cadence of the quarter overall. Did you see any increase in spending post election? And then, looking into 2017, you mentioned that low single-digit growth number. I think we’re hearing that others are more optimistic for accelerated IT spending into 2017, but your growth target wouldn’t suggest that that’s occurring. So, maybe talk about that dynamic in 2017 and your view on customer budgets?

Tim McGrath

So, for Q4, really it was an interesting time Adam. It was across the industry, I think it was a fairly muted IT standard as I think you noted. And that’s consistent with really what we saw here. We didn’t see the large number of large projects. And we did see customers continue to evaluate their data-center alternatives. And going forward into 2017, there is a bit more optimism in the air.

Clearly, there is, a couple of drivers, we’re seeing more reports will indicate that software is going to be a significant growth driver for us. We think, our mobility will continue to be strong. And we also think the investments that we’re making in the hybrid IT space are going to pay good dividends for us.

But that said, if you look at IDC and others, there are still in the low single-digit range. We are more optimistic than that, in particular because we’ve done some acquisitions. And so, we do expect to outperform the industry norms. But we want to be very conservative, I’d say there is some cautious optimism starting to come into 2017 but we’ve got a long way to go.

Adam Tindle

Okay. And I don’t know if Bill has this, but you guys mentioned in the past that you were expecting about $100 million from Softmart in the second half of the year. I think you implied about $60 million in Q4 for Softmart. Was that the Softmart number in Q4 $60 million?

Bill Schulze

So, Adam, in Q4, both our SMB and our Large Account teams spent a considerable time integrating and training the Softmart account managers. Basically that integration I’m happy to share concluded as of January 31.

And so, the last time they Softmart operated and dependent it was really Q3, and accordingly we’re not giving out, we’re not separating the results for Softmart in Q4.

Adam Tindle

Okay. Well, if I make maybe some assumptions on my own on what Softmart might have been, I think either way your SMB revenue would have been down pretty meaningfully year-over-year in Q4 on an organic basis. So, I just wanted to understand maybe what happened in the quarter? Was there perhaps some share loss or is this reflective of market trends? And I think others are attacking -- other competitors are attacking the SMB market with more digital strategies and kind of shifting resources. But I’d just be interested to get your take on connections, SMB strategy and how that might change?

Tim McGrath

So, we weren’t Adam, we’re certainly not down in the meaningful way. You’re probably over-estimating the effect of Softmart on SMB. That said we’re making a number of changes to our strategy but we’re pretty bullish overall on the sales center and the model. The team has done a really good job with margins, they’ve done a great job selling across the solution stack and bringing in advanced technologies. And we’ve done a reasonable job adding customers.

So, I would say that the overall IT spend, was a little wider than we had hoped but certainly not a significant decline. And we’re pretty optimistic going forward for SMB or connection commercial business for 2017.

Adam Tindle

Okay. And maybe one last one on Margins, you guys had a nice increase in gross margin in 2016. I know Softmart probably contributed some to that but also some advanced technologies. But the operating margin line was largely flattish. So, just wanted to hear you talk a little bit more about this dynamic and your view on where operating margins can go into 2017?

Bill Schulze

So, thanks Adam. So, correct and general, the gross margin was significant improvement for us last year. And more than anything else, it’s even more than the effect of Softmart it’s our selling what we call advance technology solutions. And, these solutions are at a higher margin, there is software, there are data centers, there are securities.

So, on the downside to those is, to be able to be that resource to your customers, you have to be able to provide a level of skill and knowledge and that requires investments into our, what we call our technical services group. So, those investments, we’ll continue to make those the next year and they will result in a higher SG&A in dollars but not as a percentage of sales for next year. So, I hope that helps you.

Adam Tindle

Okay, yes, thank you.

Tim McGrath

Adam, let me just comment, we did see some large projects in Q4 in the public sector, and those large projects, federal projects, do tend to pull on the margin a little bit. We also saw as I mentioned a slowdown in big deals in Q4 for enterprise and that of course has the opposite effect if you’re not doing those large deals, you don’t have that tug-on margin. Enterprise team did a terrific job raising margins and selling those advanced technology solutions.

Bill Schulze

Yes. And for the full-year SMB margin, I thought you heard probably in the call that SMB margin was up 30 basis points for the full-year that’s the only downside we really had to margin was in the Federal area, we had some large deals but they were at a lower margin though, those large federal deals. But overall, we’re very pleased with our margin growth particularly in the SMB and Large Account area.

Operator

Thank you. And our next question comes from the line of Anthony Lebiedzinski with Sidoti. Your line is now open.

Anthony Lebiedzinski

Yes, good afternoon. Thank you for taking the question. So, I think Tim, you mentioned that you expect to receive some benefits from your new Schaumburg, Illinois facility. I was wondering if you could just perhaps expand on that and give us some additional insight as to what you’re thinking about, how that will help 2017 and beyond.

Tim McGrath

Well, thanks. So, in Schaumburg, we’ve got -- we’re kind of running three different businesses there if you will. We have an SMB business, which is Tele-web, a call-center business, that’s new for us in the area, we’re seeing nice growth there and able to attract talent. So we’re pretty pleased with that.

We also have our legacy Valcom [ph] or managed services business there. And that’s been a very strong business, double-digit services growth in the quarter. And that’s mission-critical to our overall strategy as managed services enabled so much of our growth.

And then finally, as you mentioned, we did open a network operating center, a knock and we’re seeing nice growth there, nice trajectory upward of customers who want our help managing and securing their networks. That’s our Schaumburg business.

Anthony Lebiedzinski

Got it, got it, okay. And then, I assume that the GlobalServe acquisition really wasn’t meaningful as far as contribution to your results for the fourth quarter, that’s more of a 2017 benefit, is that fair to say?

Tim McGrath

That’s absolutely right. We are excited about it though, we’re seeing really good funnel growth, we’re seeing large enterprise customers who want global capabilities engage us in new and meaningful ways. So that’s exciting. So the funnel is starting to fill up there.

And as I mentioned the OneSource software has been ported now so that SMB customers can take advantage of it. And that’s a great promise for the future.

Anthony Lebiedzinski

Got it, okay. And then, lastly, I mean, given that two acquisitions in 2016, what is your appetite for additional acquisitions in 2017 or do you -- would it be fair to say that you would likely take a step back and perhaps be looking at more acquisitions in 2018?

Tim McGrath

Well, that’s interesting. First-off, we really want to assure that we’ve digested the acquisitions and that all systems are go, so that’s our priority one as we go into ’17, just to make sure we make both acquisitions a real success. So that said, we think we have a solid strategy, we think we have a good team in place. And we think we have strong balance sheet.

So, we do remain open to the idea of tuck-in acquisition, if it could strengthen our solutions’ capabilities or if it were accretive. So we remain open on the point but right now we’ve got a lot to do early in 2017, you may recall we also rebranded the company in September of last year and so there will be some exciting things to do there as well.

Anthony Lebiedzinski

Got it. Okay. Thank you very much.

Tim McGrath

Thank you.

Operator

[Operator Instructions]. And our next question comes from the line of William Gibson with Roth Capital Partners. Your line is now open.

William Gibson

Hi, you talked about a backlog in the public sector market and pushing into the first quarter. Is that weighted heavy towards the federal as well?

Tim McGrath

It is Bill, yes. Thank you.

William Gibson

Okay. And one thing I noticed is on your acquisitions cost, it looks like, was there a reversal in Softmart or was that related to the integration or just fine-tuning the numbers. What was behind that?

Bill Schulze

Are you talking about the adjustments Bill?

William Gibson

Yes.

Bill Schulze

So, there was not a reversal of expenses Bill for Softmart.

William Gibson

You showed $34 million roughly in the second and $32 million now. And so, was that all just the charges we’d been having in the integration cost or what was the difference?

Bill Schulze

You’re talking about the actual purchase price Bill?

William Gibson

Yes.

Bill Schulze

Let me get back to you on that okay, I’ll research that.

William Gibson

Okay. And then, you mentioned the four verticals seemed to be real easy rolling on the growth and healthcare. Can you give us just sort of a rough estimate of how large that is, I know you’re not breaking out that number, I don’t know if you’d want to disclose that to other competitors or what’s behind that?

Tim McGrath

Let me speak in general terms Bill. So as I mentioned we had really strong healthcare growth, we’re up 23% and that’s exciting. And there is a lot of promise there for the future when you look at the trends happening with electronic health records with virtual consults and perhaps security is a very promising market.

But we’re seeing a promise in our other verticals as well, to look at our financial services vertical, there is a potential there with some deregulations to really drive some IT upgrades, we’re excited about that. We’re engaging our financial customers. And as you know, really the manufacturing world from end-to-end is changing as a result of technology and the Internet-of-Things.

And then finally, retail world as well. So, we’re engaging on all fronts. And we do expect our pure vertical market growth to be significantly larger than the overall IT industry growth. We see that as a real growth engine for us. And we don’t break that out but when you combine those four verticals, it’s significant.

William Gibson

Okay. Thank you.

Bill Schulze

So, Bill, follow-up on the reversal, you are correct. The Softmart acquisition was subject to a working capital adjustment which we settled in Q4 and settled favorably. And it netted down to us to be a $31.9 million purchase.

William Gibson

Okay, good. Thanks.

Tim McGrath

Thank you.

Operator

Thank you. And I’m now showing any further questions at this time. I would now like to turn the call back to Tim McGrath for any closing remarks.

Tim McGrath

Well, thanks. I’d like to thank all of our customers, vendors, partners and shareholders for their continued support and our dedicated co-workers for their efforts. I’d also like to thank all of you listening to the call this afternoon. Your time and interest in Connection are appreciated. Have a great evening.

Operator

Ladies and gentlemen, thank you for participating in today’s conference. This does conclude the program. And you may all disconnect. Everyone have a great day.

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