PC Connection, Inc.

Good afternoon and welcome to the third quarter 2021 connection earnings conference call. My name is Lori 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.

Operator, and good afternoon, everyone. I will now read our Safe Harbor Statement. 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 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, 2020. 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 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.connections.com. Please note that unless otherwise stated, all references to third quarter 2021 comparisons are being made against the third quarter of 2020. 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 now like to turn the call over to our host, Tim McGrath, President and CEO. Tim?

Thank you, Samantha. Good afternoon, everyone, and thank you for joining us today for Connections Q3 2021 Conference Call. I'll begin this afternoon with an overview of our third quarter results, highlights of our performance, and then share our updated thoughts on the balance of the year. Tom will walk us through a more detailed look at our financials and our capital allocation strategy. We are excited to announce record Q3 revenue and growth profit for both our enterprise and our business solution segment. These results demonstrate the continued execution of our business strategy to connect our customers with technology that enhances growth, elevates productivity, and empowers innovation. A number of factors combine to improve our results, including strong performance at our manufacturing and healthcare vertical markets, along with growth in mobility, desktops, displays, storage, and services. These results were driven by the continued trends of work from anywhere and the need for services and security. On a consolidated basis, Q3 organic revenue grew by 15.1% compared to last year's third quarter. Looking at our segments, business solutions grew 21.8%. The enterprise segment grew 19.2%. while the public sector segment declined 1.1%. In Q3, demand was again greater than supply, and lead times extended in several areas. Our team continued to leverage our capabilities and scale to navigate the ongoing supply constraints on behalf of our customers. However, the supply chain has yet to recover to the point that it can consistently fulfill demand on a timely basis. In fact, our backlog has increased once again to record levels. We anticipate some of these challenges will persist for the balance of the year and into 2022. We're continuing to work with our partners and customers on a daily basis to manage these issues. In addition, a number of our customers are asking us to secure and store product in an effort to support planned rollouts, which is driving higher inventory levels than usual. Our loyal customers know that we have the expertise, scale, and capacity, so they rely on us for these services. Looking forward, our customers will continue to need help with their digital transformations, remote work, hybrid cloud, and security. And this has driven our backlog to even higher levels at the end of October. Looking at our vertical markets during the quarter, manufacturing grew 24% year over year. Our manufacturing customers want solutions that include industrial infrastructure, IoT, security, cloud, and workplace productivity. In addition, our healthcare vertical experienced double-digit growth year over year. We did see recovery in large projects and security as a top concern for our healthcare clients. Demand was also a function of our customers' need to improve operational efficiencies and the patient experience, and long-term care. We're also seeing continued growth in telehealth and non-contact patient monitoring. Now let's discuss our Q3 performance in a little greater detail. Third quarter revenue was up 15.1% to $751.4 million from 2020, while gross profit was up 11.9% to $120.7 million. Gross margins were 16.1%, down 46 basis points from Q3 2020. The decrease in margin is primarily due to a shift in our product mix to more client-based devices. It is notable that our gross margin on client-based devices was actually up meaningfully year over year. However, the sheer volume of this mix shift reduced overall margins. We view this shift as temporary. As the supply chain constraints and data center products ease, we expect our margins will normalize. Operating income in Q3 was 27.3 million, an increase of 29.7% or 3.6% of net sales compared to 21.1 million or 3.2% of net sales in the prior year quarter. In Q3 2021, diluted earnings per share was $0.76, an increase of 18.1% from $0.64 in Q3 2020. We ended Q3 with $89.7 million of cash and cash equivalents. We'll now look a little deeper into segment performance. In our business solution segment, our Q3 net sales were $281.4 million, an increase of 21.8%, compared to $231 million a year ago. Gross profit in the business solutions segment was $54.7 million, an increase of 17.5 percent from a year ago. Gross margin decreased by 73 basis points to 19.4 percent in the quarter, compared with 20.2 percent in the prior year. Customer spending in this segment was comprised of a larger than normal mix of mobility solutions that tend to have slightly lower margins. In our public sector solutions business, Q3 net sales were 160.2 million, a decrease of 1.1 percent compared to 162 million a year ago. Sales to state and local government and educational institutions were 133.7 million, an increase of 2.5 percent compared to the prior year. Sales to the federal government were 26.5 million, a decrease of 15.8 percent compared to the prior year, primarily due to a reduction in large software projects that did not repeat this quarter. The federal sector is experiencing delays with several large contract vehicles, as much of the stimulus funding remains unallocated at the contract level. Gross profit for the public sector segment was 20.3 million, a decrease of 10.8% compared to Q320. Gross margin decreased by 138 basis points to 12.7%, primarily due to a reduction in software sales and a product mix that was more heavily weighted toward lower margin client devices, such as Chromebooks. In our enterprise solution segment, Q3 net sales were 309.7 million, an increase of 19.2%, compared to $259.8 million a year ago. Gross profit for the enterprise segment was $45.6 million, an increase of 18.7% in the quarter. Gross margin for the quarter decreased by six basis points to 14.7%. Gross margins were favorably affected by increased sales of software sold on a net basis, offset by a greater mix of mobility products. We've continued to see strong demand in the enterprise solution segment, especially in the manufacturing and healthcare verticals, both of which achieved double-digit growth. 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?

Thanks, Tim. SG&A was $93.4 million this quarter, an increase of 7.6%, from 86.8 million a year ago. As a percentage of net sales, this represented a decrease of 86 basis points year-over-year. The year-over-year Q3 increase in SG&A was primarily driven by an increase in variable compensation and increases in marketing costs. Q3 operating income was 27.3 million, up 29.7 percent this quarter from 21.1 million a year ago. Our Q3 effective tax rate was 26.7 percent, up from 19.6 percent in the same period a year ago. As you may recall, in the prior year quarter, we recorded some one-time tax credits that favorably affected our tax rate. Net income for the quarter was 20 million, an increase of 18.4 percent from 16.9 million a year ago. Diluted earnings per share was 76 cents, an increase of 18.1% from the prior year period. Our trailing 12-month adjusted earnings before income taxes, depreciation, and amortization, or adjusted EBITDA, was 102.4 million compared to 99.3 million a year ago. Cash flow from operations for the first nine months of 2021 was 8.8 million versus 46.3 million for the same period a year ago. In the year-ago quarter, we generated significant cash as business activity dropped off and partners extended terms. Cash flow from operations for the first nine months was driven by a decrease in accounts receivable as DSL improved by nine days since December. As we stated earlier, customers are placing orders in advance to mitigate the risk of product shortages, which has resulted in higher than normal inventory levels negatively affecting our cash flow. A decrease in payables also negatively impacted cash flow from operations for the first nine months of 2021. Our net cash used in investing activities of $5.6 million in the first nine months of 2021 was primarily the result of equipment purchases and IT initiatives offset by proceeds from life insurance. The company used $9.2 million of cash for financing activities during the first nine months consisting primarily of the Q1 payment of our 2020 special dividend. We expect to exit 2021 with approximately 10 percent growth. Based on our confidence in the business and our desire to return cash to our shareholders, we are announcing that our board of directors has approved a special dividend of $1 per share payable on December 3rd to shareholders of record on November 18th. Our strong balance sheet allows us to pay this dividend while maintaining the ability to continue to grow the business. Let me remind you, we also have $12.7 million remaining for stock repurchases under our existing stock repurchase program. I will now turn this call back over to Tim to discuss current market trends.

Thanks, Tom. I want to take a few moments to review some of the highlights in our business. In Q3, Connexion continued to experience significant demand in products and solutions that enable our customers to be productive from anywhere. We expect this trend will continue into the first half of 2022. In addition, continued growth across our vertical markets. Manufacturing saw revenue growth of 24% year-over-year and 7% sequentially compared to Q2 2021 as manufacturers looked to augment the available workforce, automate and invest in new technologies to address both short-term and long-term workforce challenges stemming from the COVID-19 and workforce skills shortages. Healthcare experience revenue growth of 10 percent year-over-year as a result of organizations expanding and securing infrastructure to support a surge in employee remote access and telemedicine activity, as well as improving the patient and provider experience. Our technology solutions group saw strong demand and growth for managed services cybersecurity, and network transformation services. Our services business grew more than 23% year over year. In addition, we achieved Microsoft Azure Expert Managed Service Provider certification. As an Azure Expert MSP, we offer customers access to in-demand hyperscale cloud solutions and resources. Connection has demonstrated industry-leading technical capabilities and offers end-to-end support across Azure cloud environments through our Microsoft Center of Excellence. Looking at the balance of 2021 and assuming that supply chain constraints don't further deteriorate, we believe we can deliver long-term growth rates that are 300 basis points above the IT industry. We're focused on helping our customers enable their post-COVID hybrid workforce accelerate their digital transformation, and empower their innovation. We'll now entertain your questions. Operator?

Thank you. And as a reminder, to ask a question, you will need to press star 1 on your telephone. We have a question from Adam Tendall of Raymond James. Your line is open.

Hi, this is Catherine on for Adam, and let me add my congratulations to your results. Tim, you talked about backlog and lean times continuing to grow. Could you dive into the composition of this backlog, and is it more concentration in a product category or consumer vertical? And taking that a step further, even though manufacturing and health were up strong double digits year over year, was demand limited by supply in these areas?

Well, thanks, Catherine. So there's a lot to cover there. When we think about our backlog, clearly in the quarters you're hearing, we had significant growth in mobility. And so the backlog for devices is strong, but there's also additional backlog for NetCom products, backlog for storage. and some of the data center products. So the backlog, while we expect some of that will be reduced in Q4, we really need to see that end-to-end supply chain improve to help our overall margins. We're pretty confident that will happen, and so we think that we'll see a good margin recovery here in Q4 and continue to see good growth. When it comes to the manufacturing healthcare vertical, yeah, I'd say overall, not just our business, certainly throughout the competitive landscape, backlog and supply constraint has been a challenge. And we did see constraints pretty much across the board. Tom, what would you add to that?

No, I would just say, you know, the product mix probably had the biggest impact on our gross margins. So I think we said, you know, we were down 46 basis points today. That is exclusively due to shifts in product mix. And, in fact, as I mentioned in the call, if you look at the client-based device, the client devices, we were actually able to improve margins there pretty reasonably well. So it's a little bit of softness in software. Client devices were better, but the totality of the mix is really what affected the margins.

Okay, that was very helpful. And, Tom... On the margins on a go-forward basis, you said that they would moderate a little bit in client devices over time, and we can expect operational improvement in the second half of 2022?

Yeah, so I think what you should see is probably a little bit more of a shift back towards a richer software mix and a richer data center mix and, you know, You know, notebooks and mobility comprised 40% of our revenue this quarter. I think it was an eight- or nine-point increase. So that should moderate, you know, maybe not completely next quarter, but certainly over the next couple of quarters. And then in terms of, you know, the operational improvement, you know, I think our G&A was 12.4% of revenues this quarter. That should also moderate a little as the revenues go up.

Perfect. Thank you. Thank you, Catherine.

And there are no further questions at this time. I will turn the call over back to the company for closing remarks.

Well, thank you, Lori. I want 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 throughout this time. I also want to thank those of you listening to our call this afternoon. Your time and interest and connection are appreciated. Have a great evening.

And this concludes today's conference call. Thank you for participating.