PC Connection (NASDAQ:CNXN) Q3 2020 Earnings Call

0:00 Good afternoon and welcome to the third quarter 2020 Connection earnings conference call. My name is Joelle 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 are Tim McGrath, President and Chief Executive Officer, and Tom Baker, Senior Vice President and Chief Financial Officer. I will now turn the call over to the company. Thanks. I will now read our Safe Harbor Statements. Any statements or references made during the conference call that are not statements of historical fact may be deemed to be forward-looking statements.

0:47 Various remarks that the 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, 2019, as updated in the Form 10-Q for the period ending September 30, 2020. each of which are 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.

1:33 In addition, any forward-looking statements represent management's view as of today should not be relied upon as representing views 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 as 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 earnings release and on the company's website at www.connection.com. Please note that unless otherwise stated, all references to third quarter 2020 comparisons are being made against the third quarter of 2019.

2:24 Today's call is being webcast and will be available on Connection's website. The earnings release will be available on the SEC website at www.sec.gov and in the investor relations section of our website at www.connection.com. I would like to now turn the call over to our host, Tim McGrath, President and CEO. Tim?

2:48 Thank you, Samantha. Good afternoon, everyone, and thank you for joining us today for Connection's third quarter 2020 conference call. As you see from our press release, our third quarter improved substantially over the second quarter. While clearly not back to pre-COVID levels, business activity is increasing. Momentum picked up in late June, as I mentioned on our second quarter call, and continued through July and August as our team stepped up to help customers further define their work-from-home and remote work strategies. Through September and October, we saw a continuation of this improvement with an acceleration of our public cloud adoption, growing demand for digital e-commerce platforms, digital health technology, software subscriptions, Managed Services, and Security.

3:40 The increased activity, which has continued through this fall, helped us deliver third quarter revenue of $652.8 million and gross profit of $107.8 million. These results were down 10.5% and 9.3% respectively compared to a record Q3 in 2019. Gross margins of 16.5% were up 22 basis points compared to Q3 of 2019. Operating income was $21.1 million, a decrease of 35.4% or 3.2% of net sales compared to $32.6 million or 4.5% of net sales in the prior year quarter. In Q3 of 2020, diluted earnings per share were 64 cents. A decrease of 28.3% from Q3 2019.

4:38 We ended Q3 with $108 million of cash and cash equivalents, representing an increase of $18 million from December 31, 2019. Before I provide a more detailed discussion of our performance by segment, I want to update you on our Enterprise Resource Planning or ERP implementation, which began in the second quarter as discussed on our call in August. I said the implementation was essentially complete in Q2, and it was. But it's been more costly than anticipated in Q3. Some adjustments and process improvements are continuing in Q4, but at lower levels than in Q3. To remind you, the new system will serve as the foundation for our path forward, supporting growth, greater collaboration, visibility, and efficiency across the entire organization.

5:31 Helping with pollution sales, cloud, CRM, common catalog, and financials. It will also enable better customer service and give us an improved foundation for evaluating and integrating future acquisitions. But as I said last quarter, the transition has not been without pain. During Q3, we determined that due to switchover processing errors, the company recorded certain out-of-period adjustments related primarily to the business solution segments. Second quarter net sales, gross profit, and net income were understated by $945,000, $4.2 million, and $3 million, respectively. Accordingly, these adjustments are reflected in our Q3 results.

6:16 In consultation with our professional advisors, we determined that these out-of-period adjustments were not material to our prior and current financial statements. ERP implementations are bare, as anyone who's lived through them will tell you, but I'm optimistic that we are at the point where the significant long-term benefits of having done it will be clear over the year ahead. Now let me go through our performance by segment. In our business solution segment, Q3 net sales were $231 million, a decrease of 15.6% compared to $273.8 million a year ago. Gross profit in the business solutions segment was $46.6 million, a decrease of 10.7% from a year ago. And gross margin for the segment increased by 112 basis points to 20.2% in the quarter, compared to 19% in the prior year.

7:13 The increase is partially due to an increase in sales in cloud-based security software, which are recognized on a net basis. and the impact of the out-of-period adjustment just discussed. We are experiencing improvement in our business solution segment. However, this continues to be the segment most affected by the COVID-19 pandemic as many of our customers have not yet returned to previous levels of business activities. In our public sector solution segment, Q3 net sales were $162 million, a decrease of 8.7%, compared to $177.4 million a year ago. Sales to state and local government and educational institutions was $130.5 million, Thank you for joining us.

8:22 Q3 of 2019 benefited from the timing of several large federal project rollouts that did not repeat in Q3 2020. Gross profit for the public sector segment was $22.8 million, a decrease of 7.4% compared to Q3 2019. However, gross margin grew by 20 basis points to 14.1% as software as a service became a larger component of our product mix. In our enterprise solution segment, Q3 net sales were $259.8 million, a 6.7% decrease compared to $278.3 million a year ago. Gross profit for the enterprise segment was $38.4 million, a decrease of 8.7% in the quarter. Gross margin for the enterprise segment decreased by 33 basis points to 14.8%.

9:17 The enterprise segment continued to see strong demand for endpoint devices and for software in continued support of a remote workforce. Having covered our sales and gross market performance, I'll now turn the call over to Tom to discuss additional financial highlights from our income statement, balance sheet, and cash flow statement. Tom?

9:37 Thanks, Tim. SG&A was $86.8 million this quarter, an increase of 0.6% from $86.2 million a year ago. The increase in SG&A was driven primarily due to an increase of $2.7 million in professional fees associated with the rollout of our new ERP, offset by a decrease in advertising spending and variable compensation due to the lower level of sales and gross profit achieved compared to the prior year quarter. SG&A has a percentage of net sales increased by 147 basis points year over year, largely as a result of lower revenue. However, sequentially, SG&A has a percentage of revenue declined by 79 basis points.

10:22 A large portion of our cost structure is variable and will scale with the business. As business conditions continue to improve, we do expect SDNA's percentage of revenue to moderate despite some continued investment in our ERP system. We remain committed to optimizing our cost structure to scale with the demands of our business as necessary. Our operating income was $21.1 million, a decrease of 35.4% this quarter from $32.6 million a year ago. Our effective tax rate was 19.6% down from 27.4% in the same period a year ago. Included in the current quarter's tax expense is a one-time discrete tax credit of $1.7 million related to recognizing R&D tax credits for the first time. That income for the quarter was $16.9 million, a decrease of 28.7% from $23.7 million a year ago.

11:20 Deluded earnings per share was $0.64, a decrease of 28% from the prior year period. Our trailing 12-month adjusted earnings before income taxes, depreciation, and amortization, or adjusted EBITDA, decreased 23% to $99.3 million from $129 million a year ago. We have $12.7 million remaining for stock repurchases under our existing stock repurchase program. Cash flow from operations for the first nine months of 2020 was $46.4 million versus $40 million for the same period a year ago. The change was driven primarily by an increase in accounts payable offset by an increase in accounts receivable and inventories. Our net cash used in investing activities of $9.6 million in the first nine months of 2020 was primarily the result of equipment purchases and IT initiatives.

12:18 The company used $18.8 million of cash for financing activities during the first nine months of 2020, consisting primarily of the Q1 payment of $8.4 million for our previously declared 2019 special dividend and $10.2 million of stock repurchases. Thank you, Tom.

12:40 As I said earlier, I am optimistic about continued improvement in our business. I am proud of how our team has helped our customers continue to adjust to the challenges brought about by the COVID-19 pandemic. We remain confident that we are very well positioned to meet their needs going forward. We continue to work closely with our customers as their technology needs evolve during the pandemic. Thank you very much. Virtual Care and Workflow Solutions for Home-Based Knowledge Workers. In fact, our healthcare revenue this quarter matched last year's levels.

13:37 We saw strong demand for software as a service, and we expect continued growth in this area for workplace transformation, cloud, security, and business resiliency solutions through our technology solutions group, TSG. TSG delivers comprehensive technology solutions to our customers through a combination of advanced consulting and industry-leading brands, among other things. Our industry expertise and industry-specific solutions have become strong differentiators in our core vertical markets. Healthcare, retail, and manufacturing, our largest vertical markets, showed continued sequential growth. We also saw double-digit year-over-year growth in the retail market.

14:23 Moving forward and for the balance of 2020, as our customers' needs grow and change, we will be here to help them enhance growth, elevate productivity, and empower innovation with technology. I want to thank our team for their continued passion and extraordinary effort through this unprecedented time. And I want to say to you, our shareholders, Thank you. To ask a question, you will need to press star 1 on your telephone. To withdraw your question, press the pound key. Please stand by while we compile the Q&A roster. Our first question comes from Adam Tindall with Raymond James.

15:19 Your line is now open.

15:21 Okay, thanks. Good afternoon. Tim, I just wanted to start on the notion of continuous improvement. And if it was possible to put a finer point on what you're seeing from a growth perspective in the months of October and November. Are you to a point now where your total company is seeing positive year-over-year growth? and also maybe secondly, how do you expect this to trend into the month of December based on the pipeline you're seeing? Just curious if there's, you know, customer budget left for a flush or, you know, has there been funds exhausted? So just, you know, finer point on months of October and November and early indications on December. Thanks.

16:01 Well, thanks. I appreciate the questions. So if we think about Q4, obviously there are a lot of macroeconomic factors, not the least of which is the vaccine and the pandemic. What we're really seeing is, as I mentioned, we saw continuous improvement throughout the quarter. In Q4, though, I think similar to what our competitors have been modeling, we're still thinking about being slightly down year over year. for the balance of Q4. I think sort of a square root, as you pointed out, might be a good graphical representation of what we've seen. So we are continually improving, but we want to be very cautious about that outlook as there still are a lot of unknowns.

16:51 Regarding a budget flush, there are some large projects rolling out in the quarter. We do see some strong companies investing. By the same token, we also see other companies that are holding back because of their challenges, and so we really do not see the traditional budget flush happening. Tom, any state add?

17:14 The only thing I can add is in Q4 last year, we saw a real... There wasn't a lot of software purchasing in the last two weeks of the quarter, and I think the jury's still out on whether that happens again.

17:33 Thank you so much for joining us. and then secondly on demand, obviously the stock market today thinks work from home is going to moderate and this is a category that typically is associated with that. But curious what you're seeing in terms of the cadence of demand for notebooks. Is it beginning to soften yet?

18:10 Yeah, so we haven't seen it begin to soften yet. So as you know, notebooks have been incredibly resilient. Right now we're seeing in the educational space Very high demand for Chromebooks, and as you know, supply there has been constrained. We're seeing spotty constraints really across our supplier base with several of the models being constrained. That said, overall, we don't see a big pullback in demand happening, although logically it's going to moderate sometime soon just based on what's happening in the economic environment.

18:52 Understood. Maybe just one last clarification on Tom on cash flow. I know it's been a healthy year to date, but use this quarter and AR was an issue in the quarter. I'm guessing that some of that's probably related to software sales, but maybe just an opportunity for you to talk about the health of the receivables portfolio.

19:13 So if you go back, Adam, two quarters and you assume that's normal, There are three things that are really affecting that receivable balance. Number one is we have granted some extended terms to customers as we go through the current economic environment. Number two is software sales. And if I look at the difference between computing a DSO based on billings versus based on revenue, that differential has nearly doubled in two quarters. So you're seeing a real lift, a real impact of software sales. And then the third, as we said, we've spent a little extra money on our ERP system.

20:01 One of the things we do is we're reasonably highly customized in how we deliver our invoices to our customers and what format we deliver them in. And one point in the quarter, Getting invoices to our customers in a format that they expect, we had to really muscle it through, and there were some delays. And each one of those three items accounts for about a third of the growth in that balance.

20:33 Very helpful. Thank you, guys. Thank you. Thank you. Our next question comes from Anthony Levodinsky with Sedodian Company. Your line is now open.

20:45 Thank you, and good afternoon, and thanks for taking the questions. First, just looking at the quarter, you highlighted retail vertical market strength. You also talked about TSG as well. First, I guess, what's driving specifically some of the retail strength, and can you give us a sense also as to what percent of your sales or maybe your gross profit dollars is coming from the tech solutions group?

21:14 Well, Anthony, thanks. Good to hear from you. So, yeah, we're very pleased with our retail market and that segment's growth. We think there are a couple of large drivers for that. One of them is our industry solutions group that's done a lot of work in helping our sales force deliver specific and really relevant expertise around retail solutions. The other is just those large retail project rollouts. and so that really is the combination of what's driving that growth. We've not specifically broken out the retail or the ISG, the vertical markets group.

21:54 Or the TFC group.

21:55 Or the TFC group, right. So we don't have that at this time.

22:00 Got it. Okay, that's fine. So, you know, as far as the ERP system, I mean, do you think that by the end of Q4 you guys will be behind some of the issues that you've called out?

22:14 Yeah, Anthony, you know, we called out specifically professional fees in our prepared remarks there. And, you know, there's probably, you know, $200,000, $300,000, $400,000 of other costs that were incurred. So let's call it $3 million total. Our expectations, we're going to cut that by at least a third this quarter. And then I think rolling into Q2, it should come down. Q1. Q1, it's going to come down even more than that. I think we're seeing the light at the end of the tunnel here.

22:50 Got it. Okay, perfect. As you pointed out, there's been some positive news about a vaccine today. How should we think about the impact on your business that you foresee given this, let's say, happens next year when What are you broadly thinking about the impact on the business?

23:15 Yes, so Anthony, again, we've seen kind of what the competitive landscape has modeled for those who have forecasted it, and I think we're in that range. If you think about our commercial business, our enterprise SMB business, our growth was certainly in the range of the competitive landscape and so when we think about Q4 we're thinking about that same range. We're really thinking that there's too many uncertainties to really dramatically pull that forecast up and so I think we're going to continue to forecast about the way we did in Q3 for Q4 in terms of revenue growth.

24:01 Okay, got it. But then next year I would assume that given the and many more. Thank you.

24:37 What you see in this quarter is the fact we just filed for the first time for the R&D tax credits, and that gave us that discrete item of about $1.7 million. So if you add that to our current tax expense, you get back to about the normalized rate.

24:54 Got it. All right. Well, thank you, and best of luck.

24:56 I just want to provide a little more color on our last statement. When we think about 2021, there are a lot of encouraging signals out there Thank you. Thank you. I'm not showing any further questions at this time. I would now like to turn the call back over to Tim McGrath for closing remarks.

25:40 Thank you. I'd like to thank all of our customers, vendor partners, and shareholders for their continued support and, once again, our dedicated coworkers for their efforts and extraordinary dedication through this time. I'd also like to thank those of you listening to the call this afternoon. Your time and interest and connection are appreciated. Have a great evening. Ladies and gentlemen this concludes today's conference call. Thank you for participating. You may now disconnect.