PC Connection, Inc.

Good afternoon and welcome to the third quarter 2022 connection earnings conference call. My name is Justin and I will be the coordinator for today. At this time, all participants are in a listen only mode. Following the prepared marks, 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'll now turn the call over to the company.

Thanks, Operator, and good afternoon, everyone.

I will now read our cautionary note regarding forward-looking 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. 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 31st, 2021, 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 other than required by law, even if estimates change. And therefore, you should not rely on these forward-looking statements as representing management's view as of any date subsequent to today. During this call, non-GAAP financial measures will be discussed. A reconciliation between any non-GAAP financial measure discussed and its most directly comparable GAAP measure 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 2022 comparison are being made against the third quarter of 2021. 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 2022 conference call. I'll begin this afternoon with an overview of our third quarter results, highlights of our performance, and share our updated thoughts on our business and the remainder of 2022. Tom will then walk us through a more detailed look at our financials. We delivered another strong quarter as we continue to execute well against our strategic objectives. During the quarter, our customer focus started to shift from rollouts of endpoint devices and related technology to digital transformation, data center modernization, cloud optimization, and security solutions. More than ever before, customers look to Connection to solve their complex technology needs and guide them through their technology initiatives with our broad-based capabilities. Gross profit grew 13.2% year-over-year as a result of these shifts in customer demand, while net sales grew 3.2% over a previous record revenue performance in the third quarter of 2021. Our gross margins grew 155 basis points to a record 17.6% in the quarter, compared to 16.1% in the prior year. These results demonstrate the continued execution of our business strategy to connect our customers with technology that enhances their growth elevates their productivity, and empowers their innovation. The technology and solutions that we provide are highly valued by our customers. As we look forward, we believe that these products and services will continue to be essential in helping our customers to achieve their business objectives with technology and automation. The business solution segment grew 12.2% while the enterprise and public sector segments declined 1.4% and 3.7% respectively. Our enterprise and public sector segments experienced an increased level of sales of software and services recognized as revenue on a net basis, which placed downward pressure on net sales. As we pointed out in the past, we believe gross profit is the best indicator of our true growth. Gross profit improves 13.2% on a consolidated basis compared to the prior year quarter. We achieved a record gross margin rate in the quarter of 17.6% compared to 16.1% in the prior year quarter. Our focus and ability to execute our plans to drive more advanced technology solutions contributed to this 155 basis point margin improvement. As customers complete their build out of endpoint solutions, budgets are now being allocated more heavily toward data center, software, and services. We continue to invest in our managed service capabilities, and we are experiencing strong growth for our solutions as customers are focused on the need to improve security, increase productivity, manage costs, and modernize their infrastructure. We also experienced strong growth in our vertical markets, and we delivered strong double-digit revenue growth in our finance and healthcare markets, and growth rates of 40% and 14% respectively. During the quarter, we saw improvements in our supply chain, which resulted in a decrease in our backlog compared to last year, as well as sequentially. However, our backlog remains elevated. We expect some challenges will remain through at least the balance of the year and into 2023. Now let's discuss our Q3 performance in a little greater detail. Operating income in Q3 was $31.7 million, an increase of 16.1%. or 4.1% of net sales compared to $27.3 million or 3.6% of net sales in the prior year quarter. In Q3 2022, our diluted earnings per share was $0.88, an increase of 15.4% from $0.76 in Q3 2021. We ended Q3 with $116.2 million in cash and cash equivalents. Now we'll look a little deeper into segment performance. In our business solution segment, our Q3 net sales of 315.8 million, an increase of 12.2%, compared to 281.4 million a year ago. Gross profit in the business solution segment was 63.3 million, an increase of 15.7% from a year ago. Cost margin increased 60 basis points to 20% in the quarter compared to the prior year, primarily due to an increase in demand for software and services recognized as revenue on a net basis. We saw an increase in demand for software, networking, and data center products. The increase in software and services demand is a result of more customers shifting their business to subscription services, cybersecurity, and off-premise cloud solutions, along with other cost-saving technologies. In our public sector solutions business, Q3 net sales were $154.4 million, a decrease of 3.7% compared to $160.2 million a year ago. Sales to state and local government and education institutions were $130.3 million, a decrease of 2.6% compared to the prior year. while sales to the federal government decreased 9.1% year over year. Gross profit for the public sector segment was $25.1 million, an increase of 23.3% compared to Q3 21. Gross margin increased by 356 basis points to 16.3% in the quarter. As our customers transitioned from on-premise solutions to off-premise and cloud solutions, The recognition of revenue on a net basis puts downward pressure on revenue while generating increased gross margins. In our enterprise solution segment, 2-3 net sales were $305.5 million, a decrease of 1.4%, compared to $309.7 million a year ago. Gross profits in the enterprise segment was $48.3 million, an increase of 5.7%, compared to the prior year quarter. Gross margin increased by 106 basis points to a record 15.8%, primarily driven by enterprise customers' business-driven need for cloud and data center solutions. 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 increased 110 basis points to 13.5% of net sales in the quarter compared to 12.4% in the prior year quarter. Approximately 75% of the increase in this rate is solely due to the increase in sales of products which are recognized as revenue on a net basis. On a dollar basis, SG&A increased 11.5 million compared to the prior year quarter. In addition to the impact inflation continues to have on wages, there was also incremental increase in SG&A resulting from increased variable compensation due to higher levels of gross profit. We have also continued to make investments in incremental headcount focused on building our technical and sales organizations, as well as increased marketing spend. Q3 operating income was $31.7 million, up 16.1% this quarter from $27.3 million a year ago. Our effective tax rate was 27.6%, up from 26.6% in the same period a year ago. Net income for the quarter was $23.2 million, an increase of 15.8% from $20 million a year ago. Diluted earnings per share was $0.88, an increase of 15.4% from the prior year period. Our trailing 12-month adjusted earnings before income taxes, depreciation, and amortization or adjusted EBITDA was 145.5 million compared to 102.4 million a year ago, an increase of 42%. Cash flow generated from operations for the first nine months of 2022 was 15.7 million compared to 8.8 million in the same period a year ago. The increase in cash flow from operations reflect higher levels of earnings offset by increases in both accounts receivable and inventory, as well as a decrease in accounts payable. I'd like to take a moment to discuss a few components of our working capital trends in the past quarter. DSO increased to 69 days from 64 days at the end of 2021. The increase is a function of netted products recorded in accounts received on a gross basis, while the revenue is recorded on a net basis. Inventories increased by $3.1 million versus the end of 2021. This increase was driven by our enterprise segment, which has purchased inventory in advance of large project rollouts offset by our ongoing inventory reduction plans. Our accounts payable balance declined $23.3 million for the first nine months of 2022. Our net cash use and investing activities of $7 million for the first nine months of 2022 was primarily the result of equipment purchases and IT initiatives that will drive future efficiencies. I will now turn the 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. Our growth in Q3 is largely attributable to the customized IT solutions that we integrate and deliver on behalf of our customers as they continue to work through their digital transformation and efforts to gain competitive advantage with technology. Our customers look to Connection to integrate and deliver these innovative solutions. Toward that end, we continue to leverage our managed services capability as customers turn their attention toward data center, infrastructure, and digital transformation initiatives. Our years of experience with supply chain optimization and our ability to deliver custom integrated solutions continue to be important components of our growth and a competitive differentiator for us. Our growth was also attributed to our expertise in delivering customized solutions to our vertical markets. For example, in the finance vertical, we grew revenue 40% year-over-year and 12% sequentially as our customers were upgrading legacy hardware and focusing on securing their environments. Manufacturing revenue grew 3% year-over-year as clients focused on increasing automation and process integration, as well as long-term investment in new technologies to support cybersecurity risk reduction and growth opportunities. Revenue in healthcare grew 14% year-over-year, driven by post-pandemic technology refreshes and new investments in traditional and new patient care delivery models. Looking forward to the remainder of 2022, We believe customers will want to manage costs while leveraging technology for greater efficiency and as an enabler for competitive advantage. We expect our customers will continue to focus on data center security and cloud transformation. We anticipate this trend will continue in the near term and will put pressure on top line revenue growth as it did this quarter. Last quarter, we indicated that year over year growth rates would be moderating, which they did. We expect that trend to continue for the near term. These expectations are in part due to record results recorded in the prior year periods. Additionally, our customers are telling us that they're being more deliberate in spending and are being more restrictive on budgets in the face of increasing economic uncertainty. That being said, we believe we'll end the year with growth that's three to five percent above the IT industry growth rate, and we will continue to take market share. We remain focused on helping our customers achieve their productivity and efficiency goals while keeping them secure and connected in this uncertain economic environment. I'd like to take a moment to thank our valued employees for their continued effort and extraordinary dedication during this rapidly changing environment. We will now entertain your questions. Operator?

Thank you. As a reminder to ask a question, you'll need to press star 11 on your telephone. One moment for our first question. And our first question comes from Adam Tindall from Raymond James. Your line is now open.

Okay, thanks. Good afternoon. Tim, I wanted to maybe start with the last comments that you were making there. That was very helpful. When you say 3% to 5% above the IT industry for 2022, could you help us with what you're thinking of as the IT industry growth rate and Maybe even simpler, I think it's going to imply that Q4 revenue might be down year over year. I just want to make sure that we're getting the model right based on the commentary you're making on Q4.

Well, thanks, Adam. Yeah, I think that's right. I think that – Obviously, if you look at our growth rate year to date, we've had a pretty good year. We do see that moderating a little bit in Q4, and we think we can take some market share. So I think exiting the year at 3% to 5% above market is still well within our reach.

Yeah, and if we baseline that, I think we're thinking 3% to 4% base growth rate. So you're kind of looking at, you know, 8%, 9% for the full year.

Got it. Okay. That's helpful. And, Tom, as we experience maybe some of this slowing here, I'm wondering how we think about margins moving forward, particularly as we try to model 2023. Sounds like we might have some continued challenges on top line. You're going to roll into some really difficult comparisons in Q1 and Q2. And I would imagine top line might even be flatter down in Q1 and Q2. If so, feel free to clarify if that's not the case. But if so, how we think about the margin trajectory moving forward as well.

There's a few moving pieces in there, right? You know, the growth in the services and cloud industry has certainly had a material effect on our margins this quarter, right? So question one is how does that continue going forward if you just look at the margin percentage? That's why we continue to try to stay focused on what's our gross profit growth rate because that's kind of the important thing. Now, that being said, if you take the mix out of it, I think we should be able to hold our historical margins on hardware. As you can see from the numbers, the endpoint spending was down a little this quarter compared to last year. And I think we kind of expect that to continue at least into Q4. And as we roll into next year, I'm thinking we can probably hold our historical margin rates. on the endpoint equipment and the data, the storage. But what's really going to be the wild card in terms of reported margins is how do those services and cloud and that 100% margin product roll through the P&L?

We're pretty optimistic on that. We're seeing incredibly strong growth rates in our cloud, our CSP, and our software business in general. As you know, that's... recorded on a net basis, which does drive that margin rate up.

Got it. Just one more for me. Tim, as you look at your pipeline and hear from your sales force as we're sitting here in November, we've got that month of December coming up. It typically tends to be the corporate budget flush month. And I'm just wondering what you're hearing qualitatively or anything that you could support with the metrics that you looked at on what the budget flush might ultimately look like in 2021. Thank you both.

So that is a great question, Adam. You know, we are a little concerned on that. We've talked to a number of customers who, in some cases, are still waiting for data center equipment and some of the advanced technology solutions. So, you know, to the extent that that is still a constraint, a lot of that could be pushed into 2023. And as you know, endpoints are slowing down. But generally speaking, many of the projects that we're involved in now are truly mission critical, and we feel pretty confident that we're going to meet our expectation and deliver our forecast.

Thank you.

Thank you.

And thank you. And one moment for our next question. And our next question comes from Anthony Libidzinski from Sudoti.

Your line is now open.

Good afternoon, and thank you for taking the questions. So first, in terms of the implied 4Q sales projections that you have, I mean, how much of that is because of the mix of business shifting more toward software and just horrible impact of netting versus just the from slower demand because of the macro environment.

Well, thanks, Anthony. Good to hear from you. So, Tom?

I would say, I mean, we're clearly seeing a little bit of a pullback in some of the hardware categories, Anthony, especially on the endpoint devices. So there is some of that, I think, baked in there. And we did have a really nice Q4 last year. But the vast majority of the pressure is coming from you know, all the software and services coming through on a net basis. So it's, I think it's more of the accounting and the net software, but there is some underlying demand softness coming.

Okay.

Gotcha.

Well, Anthony, what that looks like for us is, you know, our mid-market and commercial business has been very strong. With our enterprise business, you know, we are hearing As you're hearing out there in the industry, customers are in some cases asking for an additional signature. In some cases, they're delaying. But at the end of the day, we still feel very confident.

Got it. Okay. So overall, I think to your point, it sounds like your gross profit should certainly increase, I guess, in Q4, even though the reported revenue will be maybe not as good because of all this netting. So is that fair to say that you would expect your gross profit dollars to be up in the fourth quarter?

And then I'll start, and then I'll let Tom jump in. But clearly, we're seeing that mix shift into integrated solutions and We're seeing as part of that a lot of cloud, a lot of cybersecurity, and a lot of software. And as you know, all of that is – most of that is recorded on a net basis, and that, of course, does drive gross margins up.

Yeah, I think to answer your question directly, Anthony, I think the jury's still out on that. It's going to be nip and tuck, I think.

And thank you. Thank you.

Can you hear me, guys?

Yeah, we can hear you now.

Okay, sorry, yeah, that was a long pause there. Okay, and I guess my last question, I guess, is, you know, you made progress with your inventories versus your second quarter, so cash flow improved. So, you know, what would you say is your, you know, reasonable goal for your year-end inventories, and if you could just also touch on your cash flow priorities, that would be great.

So I think on the inventories, Anthony, a lot of it's just going to depend on how the supply chain frees up. We did see it improve a bit this quarter, and our goal is to continue to drive that number down. Now, that being said, We do have a couple of very large projects that are coming up, and I think a lot of it's going to depend on how that inventory comes in right at the end of the year. You know, if we can push it out to Q1, I think it's one thing if, you know, we're talking $30, $40 million here. So it's going to depend on the timing of the supply chain. But all else being equal, we should be able to drive down another $10-ish million, I think. Okay.

And also to put that in perspective, Anthony, our inventory levels are lower than last year, as we mentioned, but compared to ordinary levels, they're significantly elevated.

And then in terms of your cash flow priorities,

Yes, so we're kind of sticking to our guns there, Anthony. We have an approved share buyback in place, and we'll be looking at that. We also have made some upgrades to our system. We've made some upgrades to our senior staff, and as you know, our balance sheet is clean and our powder is dry, and we're also – continually looking at additional opportunities that could tuck in and enhance our capabilities in specific solution areas. Right now, as you know, debt markets are in pretty tough shape, and so it's probably nothing that's immediate, but we remain open to the idea of doing tuck-in acquisitions.

Thank you very much, and best of luck. Thank you.

Thanks, Anthony.

And thank you. and I am showing no further questions. I would now like to turn the call back over to Tim McGrath for closing remarks.

Thanks, Justin. 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 our call this afternoon. Your time and interest in connection

are appreciated have a great evening this concludes today's conference call thank you for participating you may now disconnect