PC Connection's (CNXN) CEO Tim McGrath on Q1 2017 Results - Earnings Call Transcript

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PC Connection, Inc. (NASDAQ:CNXN) Q1 2017 Earnings Conference Call April 20, 2017 4:30 PM ET

Executives

Tim McGrath - President and CEO

Bill Schulze - Vice President, Interim Treasurer & CFO

Analysts

Adam Tindle - Raymond James

William Gibson - Roth Capital Partners

Anthony Lebiedzinski - Sidoti

Operator

Good afternoon ladies and gentlemen, and welcome to the First Quarter 2017 Connection Earnings Conference Call. My name is Aila, and I will be the coordinator for today. At this time, all participants are in a 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 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, 2016, 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 web site. Today’s call is being webcast, and will be available on Connection’s web site. The earnings release is also available on the web site.

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

Tim McGrath

Well thank you. Good afternoon everyone and thank you for joining us today to review the company's first quarter financial results. Net sales grew by 17% in Q1, led by sales growth of 26% in large account and 30% public sector. There were a number of large project rollouts in the quarter that we completed, in an effort to expand our customer base and grow our market share.

We saw this as a unique opportunity to win new customers, drive services revenue and enter into long term relationships. These deployments were one time project rollouts that will not be repeated.

The company achieved record first quarter net sales and gross profit. We think the overall trending for the IT environment has returned to a more normalized seasonality. We saw strong growth in both the public sector and large account segments. A significant portion of public sector sales, however, was attributed to a large customer in the federal space. Excluding these project rollouts, public sector revenues grew by mid-single digits.

We are seeing an increase in demand in the large account space and we are winning new customers. The segment's revenues grew by 26% year-over-year and gross profits grew by 20%. Sales of software and networking communications products grew by 61% and 87% respectively in this segment. Sales for SMB segment grew 5% in the current quarter. Sales of services grew 25%, software grew 21% and mobility grew 10% in the segment. In addition, we are pleased with the contingent transformation into advanced technology solutions.

As we review our results, please note unless otherwise stated, all of our first quarter 2017 comparisons are being made against first quarter 2016. We also have a full quarter of Softmart's results in Q1 of 2017.

In Q1, consolidated net sales increased year-over-year by $98.2 million or 17.2% to $670.6 million. Gross profit dollars in the quarter increased by 5.5% to $86.7 million, consolidated gross margin decreased to 12.9% from 14% in Q1 2016. This is due to increased large account and public sector sales, which generally have lower margins. As we will discuss later, gross margin was also adversely affected in Q1 by product mix.

SG&A increased in the quarter to $75.3 million from $67 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 in both sales and technical areas. We have introduced additional operating expense disciplines and we continue to monitor costs in this mixed IT spending environment. This will enable us to continue to invest in the mission critical growth areas of the business.

Net income for the quarter decreased to $7.4 million, down 18% and diluted earnings per share decreased from $0.34 to $0.28.

And now I'd like to provide an update on the two recent acquisitions. During Q1, we completed the integration of Softmart's sales force and split them up between the large account and SMB groups. We fully converted them on to our IT systems, completed their training programs, assimilated them into our culture and aligned their sales strategy with ours. This integration impacted their Q1 sales. Q1 sales for legacy Softmart customers totaled $28 million, split evenly between the two segments.

Following the conclusion of the Softmart integration, we are pleased with the March results and we are optimistic, as we enter Softmart's historically strongest quarter. We now have world class licensing optimization capabilities for our customers.

With GlobalServe, we have a portal that enables consistent delivery, reporting, pricing, and logistics for our customers. We are excited to be able to offer our customers this global capability. This industry leading tool simplifies our customer's IT procurement, and reduces their costs. This acquisition has exceeded our expectations for stimulating demand in the large account space.

We believe that GlobalServe gives us competitive advantage, and we expect this to be an important component of our future growth strategy.

And now I will 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 sized businesses increased by 5% to $274 million. Strong sales in both mobility and software contributed to the top line growth.

SMB gross margin in the quarter decreased by 67 basis points, due in part to the change in sales mix and related lower vendor funding. Sales by our large account segment increased by 26% to $253 million. We won several new large customers in Q1, and we are confident that they will remain long term value to clients. Gross profit dollars increased by almost 20% and gross margin was 12.5% in Q1. The decrease in margin from last year was attributed to both customer and product mix changes.

Sales in the public sector segment, which includes sales to government and education customers, increased 30% to $144 million. Sales to state and local governments and education customers increased by 15%, whereas sales to the federal government increased by 62%. Gross profit dollars for the public sector were down 6% from last year, due to lower margin. Earnings per share decreased to $0.28 down from $0.34. However, trailing 12 month adjusted EBITDA increased to $92 million.

Our balance sheet is healthy, the Q1 2017 cash balance of $66 million is well above the year end amount of $49 million. In Q1, you may recall, we paid a special dividend of $9 million. So the quarterly cash flow [indiscernible] is over $25 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. We are pleased with our top line acceleration in the first quarter, and we expect that our margin will return to seasonal rates. During the quarter, we are able to take market share in a relatively growth environment. We believe our plan is back on track, and that our strategy is working, despite the softness in the overall IT spending, we were able to increase net sales and gross profits. Our goal is to grow faster than the market by taking share and to return to normal seasonal gross profit and net income.

We are also focused on advanced technologies and we are investing in complex areas of the business, in order to help our customers drive their business outcomes. Our software business continues to grow, including cloud, virtualization, security and security assessments. In addition, as mentioned last quarter, our network operating center in Schaumburg, Illinois is now fully operational. 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 our 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 counts, sales headcounts and enhanced our automated tools. Our balanced portfolio of customer, suppliers, products and solutions will help us to deliver solid results. Our goal will be to continue to deliver sustained and consistent performance.

We will now entertain your questions. Operator?

Question-and-Answer Session

Operator

[Operator Instructions]. Our first question is from Adam Tindle with Raymond James. Your line is now open.

Adam Tindle

Okay. Thank you and good afternoon. Tim, in terms of looking at the full year here, even if I take out the acquisition in Q1, revenue still grew double digits organically. So how are you thinking about IT market growth in 2017 and what connection is targeting in terms of achievable growth rate for the year?

Tim McGrath

Well, thanks Adam. You know, all of the analyst estimates and you know yourself, really have been fairly consistent, as they look out at the balance of 2017. We have seen points of [indiscernible] in little areas that we think are going to drive growth. We are seeing good growth in vertical markets. Some of the vertical markets, we are seeing exceptional growth in, and we are seeing new energy in the large accounts space, and that's very encouraging.

Also as you know, we have seen some growth in the federal space, but that really has been project dependent and is, what I would term, hyper-competitive. So overall for the market, we've maintained that the low single digit is still the market rate of growth, and for us, we want to model about twice that rate of growth.

Adam Tindle

Okay. And maybe in terms of the leverage here, operating expenses grew at nearly double the pace of gross profit dollars on a year-over-year basis, and sequentially gross profit dollars were down, yet OpEx was up. I know you are investing in technical and engineering resources. Can you just give us a sense of when you expect these to pay-off and when we might see some leverage in the model?

Tim McGrath

Well, you should see leverage starting in Q2. I am going to let Bill comment on that. But clearly, Adam, as a result of our Q1 and our plans to complete the integration, we are very focused on expense disciplines and really, making sure that we are efficient. So we are looking hard at those areas that we think there is an opportunity in, and clearly, we will be bringing that out in Q2.

Bill Schulze

Hi Adam, Bill. So we are only 13 days into the quarter, but at this point, we are liking what we see. Our gross margin has normalized, and given what the 13 days of history is, our expectation at this point that our gross profit will ripe [ph] and will exceed SG&A in Q2.

Tim McGrath

So we think the model that you have are pretty good. Now we think your estimates are reasonable, and we are driving toward that end. But we will also be working on the expense discipline and taking out costs where we can.

Adam Tindle

Okay. And just lastly Tim, on the broader market. You cited in the release, delays in customer purchases of data center solutions, how much do you think this is a widespread industry trend, versus perhaps some company-specific execution?

Tim McGrath

Yeah, it's a great question Adam. For us, as you know, since we are announcing, we are sort of the first ones out of the gate for our competitive landscape. I don't think we have a great visibility, and I think it does tend to be customer project dependent. But that said, for us, it was a mix issue, and I'd like to share an example if I could; one of the large accounts that we took on, that was a new account for us, we did a project that was fairly low margin, about a little less than $8 million in revenue, but they have an annual spend of about $100 million. And there is a lot of advanced technology and value to come. So those are examples of where, we may bid a project competitively, in an effort to kind of land and expand. And so for some of those value products, and for some of the software products, we do expect to be right back on track for Q2.

Adam Tindle

Okay. Thank you.

Tim McGrath

Thank you.

Operator

Our next question is from William Gibson with Roth Capital Partners. Your line is now open.

William Gibson

Thank you. I'd like to follow-up a little bit on Adam's questions, on operating expenses. Is there -- does G&A come in a little in the second quarter or is that -- is that a good run rate for the year now?

Tim McGrath

So SG&A will increase as our gross profits increase, but we are not expecting any other upside to it.

William Gibson

Okay. And it sounds like on the advanced technology products, you expect growth in large accounts? Is that safe to say?

Tim McGrath

[Indiscernible], thanks. So we expect growth across the board in advanced technology. Really pleased with a lot of the actions that we are seeing internally, in our SMB division, Connection Business Solutions. We are seeing good growth across the advanced technology stack, and we are seeing growth in all of the key areas, and growth as a percentage of total revenue. We are seeing growth really come back in the enterprise space, and that is customer dependent. But they're started to move with [ph] advanced technologies, and the same is true for public sector. So across the board, our goals remain intact, and we do believe that we will see continued increases in advanced technologies, which will be a driver of margin.

William Gibson

Thank you. And well a follow-up on the large account where you got the new customers. Did GlobalServe and Softmart play a role in that or did that come through your existing force?

Tim McGrath

I think it's a little bit of both. For GlobalServe, we are pretty excited of what we are seeing. The funnel is filling up. There is a large number of new customers in the funnel, a very large number. But that said, getting them through the process, we have got three significant large account wins that came in through GlobalServe in March, that's exciting. But as you know, in GlobalServe, the model is much about serving our U.S. based customers. So the opportunity to win new customers is there, and using GlobalServe's one source portal is an opportunity.

But our win is to get that U.S. business. So we are pretty excited about that, and we think it is going to be significant. We also think there is a great opportunity with Softmart, an opportunity to perhaps leverage hardware, where perhaps they have only bought software from us in the past. And as I mentioned, in the call script, that process is a little slower than we thought in Q1, as we ramped up their sales force and fully integrated them. And as I mentioned, we did about $28 million in Q1, which is a little lower than our expectation, and that $28 million was split 50-50 between large account and SMB. We do expect that will be larger in Q2, as it’s a larger period for Microsoft, it's the end of their year, as you know, in June. So we are optimistic about that, and now that the integration is behind us, you know, we are optimistic about our future growth.

William Gibson

Thank you. And then just one follow-up, is the federal government project still playing out in future quarters, or is that behind us?

Tim McGrath

That is done Bill, that's behind us.

William Gibson

Okay. Thank you.

Operator

[Operator Instructions]. Our next question is from Anthony Lebiedzinski with Sidoti and Company. Your line is now open.

Anthony Lebiedzinski

Thank you and good afternoon. So I just wanted to go back to, I think Tim, what you said that -- talk about new customers that you were able to get some of your sales growth coming from new customers. Can you perhaps quantify what percentage of your sales growth came from these new customers, and also as a follow-up, I would be curious to know what was the product mix for those new customers?

Tim McGrath

Anthony, thanks. I really can't quantify the exact numbers. I can tell you that we have seen multiple new customers come into the large accounts base, and -- really across the board. But I also want to clarify, it was a little abnormal in terms of product mix, and that was largely driven by a large federal customer that was more of a desktop notebook rollout, and that does skew the public sector business, as we properly identified earlier. So that I think is an anomaly, and I think it will come back to more sort of seasonal product rates, and I think the spread across our product lines will get right back on track. So when we look at product mix, I think you can expect us in Q2 to return to our normal product mix. I don't have an exact number for new customers.

Anthony Lebiedzinski

Got it. Okay. Thanks for that additional color. And as far as the other question I had was about lower vendor funding, that was one of the reasons for the lower margins for the SMB segment. So how should we think about vendor funding on a go forward basis?

Tim McGrath

So the lower vendor funding is somewhat related to the product that you sell. Vendors are generally put more dollars behind advanced technology solutions as opposed to velocity products. So in the quarter, our sales were skewed more toward the velocity. But going forward, on a rate basis, our vendor funding, we expect it to be normalized and consistent with prior periods.

Anthony Lebiedzinski

Okay, thank you. And lastly, tax rate came in lower than what we had expected, roughly 35%. How should we think about the tax rate for the rest of the year?

Tim McGrath

Well thanks, that's a good question. So there is a new -- some new gap in play in Q1, regarding income tax benefits. So there is going to be more variability going forward to tax rates. But I would expect the rates to be closer to our historical 40% rate. But again, there will be variability going forward. But at the current time, I am modeling 40%.

Anthony Lebiedzinski

Right. So are you referring to ASU 2609 of your share based compensation?

Tim McGrath

Sounds like you have a little [indiscernible] background to you?

Anthony Lebiedzinski

All right. Thank you very much.

Tim McGrath

Thank you.

Operator

And I am showing no further questions. I would now like to turn the call back to Tim McGrath for any further remarks.

Tim McGrath

Well thank you. I'd like to thank all of our customers, vendor partners and shareholders for their continued support and our dedicated coworkers for their efforts. I'd also like to thank those of you listening to our call this afternoon. Your time and interest and connection are appreciated. Have a great evening.

Operator

Ladies and gentlemen, thank you for participating in today's conference. You may all disconnect. Everyone, have a great day.

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