PC Connection, Inc. (NASDAQ:CNXN) Q2 2023 Earnings Conference Call August 2, 2023 5:00 PM ET
Samantha Smith – Investor Relations
Tim McGrath – President and Chief Executive Officer
Tom Baker – Chief Financial Officer
Conference Call Participants
Anthony Lebiedzinski – Sidoti
Good day and thank you for standing by. Welcome to the PC Connection Second Quarter 2023 Earnings Conference Call. [Operator Instructions] Please be advised that today’s conference is being recorded. I would now like to hand the conference over to management. Please go ahead.
Thank you, 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 provision 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, 2022, 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 as required by law even if estimates change. And therefore, you should not rely on these forward-looking statements as representing management’s views as of any date subsequent to today.
During this call, non-GAAP financial measures will be discussed. A reconciliation between any non-GAAP financial measures 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 second quarter 2023 comparisons are being made against the second quarter of 2022. 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 Connection’s Q2 2023 conference call. I’ll begin this afternoon with an overview of our second quarter results and highlights of our performance. Tom will then walk us through a more detailed look at our Q2 financials.
As we all know, the demand for IT products and services has been under pressure for the last 3 quarters. While our Public Sector delivered a record second quarter, our commercial customers continue to exercise greater caution and selectivity with their short-term IT investment plans as we saw year-over-year declines in our Business Solutions and Enterprise Solutions segments. However, as the quarter progressed, we did see some improvement in demand in the commercial space.
In addition, in Q2, we continued to make progress against our strategic plans to successfully transition our business, driving growth in integrated technology solutions and services across each of our segments. We also have taken actions to improve the depth of the executive management team, enable sales through additional training, increase technical sales resources and improve alignment of our incentives. We believe these changes drove a higher mix of advanced technology solutions, a record number of Enterprise Solution engagements and a record level of managed services performed at our technology integration center. In addition, we also continued to experience success in acquiring new accounts and expanded our solutions offerings within existing accounts during the quarter.
Now let’s discuss our Q2 performance. Consolidated net sales declined by 11.5% to $733.5 million compared to Q2 2022. As discussed, we saw good overall growth in our integrated solutions business, though it was not enough to offset the decreased demand for endpoint devices as our customers work through this economic backdrop that includes slower hiring and reduced headcount.
Gross profit declined 6.7% to $127.8 million. However, gross margins were up 90 basis points to 17.4% in Q2, compared to the prior year quarter. This increase in gross margin reflects our resilience in helping our customers solve their business challenges with technology in any economic environment, and it’s evident in the shift in product mix to advanced technologies.
Operating income in Q2 was $25.1 million, a decrease of 27.9% or 3.4% of net sales, compared to $34.8 million or 4.2% of net sales in the record prior year quarter. Net income in Q2 was $19.7 million, a decrease of 22.4%, compared to $25.4 million in the prior year quarter.
In Q2 2023, our diluted earnings per share was $0.75, a decrease of 22.3%, while diluted earnings per share adjusted for restructuring and other charges was $0.80, a decrease of 17.2% from $0.96 in Q2 of 2022.
We’ll now look a little deeper into our segment performance. In our Business Solutions segment, our Q2 net sales were $261 million, a decrease of 20.5%, compared to a record $328.4 million a year ago. Gross profit for the Business Solutions segment was $61.4 million, a decrease of 6.3% from a year ago. Gross margin increased 356 basis points to a record 23.5% in the quarter, compared to the prior year. This increase was the result of our business plans to shift product mix to the sales of data center products, including services, software and networking during the second quarter of 2023, in addition to a higher mix of netted down revenue, primarily software and services.
In our Public Sector Solutions business, Q2 net sales were a record $185.4 million, an increase of 22.6%, compared to $151.2 million a year ago. Sales to state and local government and educational institutions increased by 15.7% to a record $151.7 million, driven by strong demand in K-12. Sales to federal government increased by 67.8% to $33.6 million, compared to the prior year quarter. Our Public Sector capture pursuit teams won new contracts while expanding with an existing contract vehicles during the quarter.
Gross profit for the Public Sector segment was $23.5 million, an increase of 12.8% compared to Q2 ‘22. Gross margin decreased by 110 basis points to 12.7% in the quarter, compared to the prior year. The decrease in gross margin percentage was due to a higher mix of large rollouts of endpoint solutions in the second quarter of 2023.
In our Enterprise Solutions segment, Q2 net sales were $287.2 million, a decrease of 17.7%, compared to $349 million a year ago. Gross profit for the Enterprise segment was $43 million, a decrease of 15.1%, compared to the prior year quarter. Gross margin increased by 46 basis points to 15%, due to an increase in software and services. As the quarter progressed, we experienced increased momentum with respect to the number of customer engagements and quoting activity. We’re also beginning to see an uptick in RFPs for integrated technology solutions within the large account segment.
Taking a closer look at our industry verticals, we saw Healthcare revenue grow by 5% sequentially driven primarily by customers investing in workplace transformation solutions. In addition, demand for networking and collaboration solutions continue to be an integral component of patient care and the overall patient experience.
We are also pleased to share that our team’s commitment to exceptional customer service and our ability to enable digital transformation was recognized with two Partner of the Year Awards. Connection was named both the Microsoft U.S. Surface Solutions Partner of the Year and the Microsoft U.S. Modern Work, Surface Hub Reseller Partner of the Year for 2023. We will continue to build on that success as we help customers deploy the cloud and computing solutions that drive workplace transformation.
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 144 basis points to 13.8% of net sales in the quarter, compared to 12.3% in the prior year quarter, primarily driven by lower revenues. On a dollar basis, SG&A decreased $1.2 million, compared to the prior year quarter. The decrease in SG&A was primarily due to cost reduction initiatives, partially offset by ongoing investments in our services business. Looking forward, we anticipate a G&A rate similar to that of Q2.
In the second quarter of 2023, we continued our initiative to reduce our cost structure. As a result, we recorded a charge of $1.7 million for restructuring and other related costs associated with our internal cost reduction activities. Q2 operating income was $25.1 million, down 27.9% this quarter from $34.8 million a year ago. Our effective tax rate was 26.9%, down from 27% in the same period last year.
Net income for the quarter was $19.7 million, a decrease of 22.4% from $25.4 million a year ago. Our diluted earnings per share was $0.75, a decrease of 22.3% from the prior year period. Diluted earnings per share adjusted for restructuring and other charges was $0.80, a decrease of 17.2% from the prior year period. Our trailing 12-month adjusted earnings before income taxes, depreciation and amortization or adjusted EBITDA was $124.4 million, compared to $140.5 million a year ago, a decrease of 11%.
In terms of returning cash to shareholders, we paid an $0.08 per share quarterly dividend in June and repurchased 50,000 shares for an aggregate purchase price of $2 million at an average price of $39.75 per share. As of June 2023, we had $32.3 million remaining for stock repurchases under our existing stock repurchase plan. Today, we announced that our Board of Directors have declared a quarterly dividend of $0.08 per share payable to shareholders of record on August 15, 2023, and payable on September 1, 2023. We are committed to aggressively assessing M&A opportunities and other capital allocations such as dividends and stock buybacks.
Cash flow generated from operations for the first half of 2023 was $135.4 million, an improvement of $143.8 million from the same period a year ago. The increase in cash flow from operations reflects a decrease in accounts receivable inventory and an increase in accounts payable. Our accounts receivable balance decreased $16.4 million for the first half of 2023. Our DSO increased to 68 days from 66 days for the same period a year ago, primarily a function of netted product sales.
Our inventory balance decreased $48.9 million for the first half of 2023. The decrease in inventory was primarily due to a decrease in the amount of inventory we purchased combined with the delivery of inventory held associated with the continued fulfillment of orders and backlog. Our accounts payable balance increased $44.6 million for the first half of 2023 due to the timing of partner payments.
Our net cash used in investing activities of $4.9 million for the first half of 2023 was primarily the result of equipment purchases and IT initiatives that we believe will drive future efficiencies. The company used $9.5 million of cash for financing activities during the first 6 months of 2023, consisting primarily of payments of $4.2 million of dividends to shareholders and $5.4 million of stock repurchases. We ended Q2 with $244 million of cash and cash equivalents.
I’ll now turn the call back over to Tim to discuss current market trends.
Thanks, Tom. We remain focused on increasing our share of customer IT spend with our existing customers, and we are aggressively pursuing the acquisition of new customers. Our customers know that they can count on Connection to help them standardize, simplify and optimize their end-to-end IT environments and deliver their business outcomes through technology. Customers still need and want help improving their infrastructure, integrating their solutions and supporting their digital transformation. The technology solutions that we offer are designed to deliver productivity improvements and enable our customers to operate their businesses more effectively in this challenging economic environment.
In addition, we believe the hybrid work environment continues to drive demand for better remote collaboration capabilities and tools. Finally, security and other cloud solutions remain mission-critical across all of the markets that we serve. In response to these technology trends, we’ve continued to invest in our technical resources and tools designed to enable our customers to better make these transformations.
Last quarter, we disclosed that some of these investments and their results will be brought to the forefront in the coming months and quarters. As you know, the adoption of artificial intelligence has accelerated, promising advancements and valuable benefits to AI adopters. We recognize AI as a powerful tool with significant potential to unlock greater automation, efficiency and productivity, both internally and for our customers to realize that potential.
Connection has a team dedicated to working with our partners, focused on driving infrastructure, software, services and solutions anchored around automation and artificial intelligence. We believe our focus and our business strategy remains well aligned with the shifting dynamics of how customers deploy, utilize and consume technology. We continue to connect our customers with technology that enhances growth, elevates productivity and empowers innovation. We help our customers expertly navigate through a complex set of choices within the technology landscape. We help calm the confusion of IT for our customers.
As we move forward to the balance of 2023, you could be confident that our focus is where it’s always been: on our customers. We see value with every engagement no matter the organization size or industry. We believe that diversity and our ability to demonstrate value in any situation is what enables us to continue to grow and expand our client base. Based on our interactions with our customers, we believe the demand for endpoint devices will continue to be challenged as they were in Q2. However, we are seeing an increase in new project engagements. While the timing of these projects remains uncertain, we are encouraged by the uptick in activity.
While growth rates for the U.S. IT market continue to be challenging in the near-term, we believe we can outperform the market and take market share. As we navigate through the remainder of 2023, we’ll remain focused on improving our operational efficiencies, managing our costs and scaling our expenses appropriately. Great companies can take market share in any economic environment, and challenging conditions often present the best opportunities to showcase how valuable the right guidance and expertise can be.
On that note, I’d like to take a moment to thank our valued employees for their continued efforts and extraordinary dedication during this rapidly changing environment.
We will now entertain your questions. Operator?
[Operator Instructions] Our first question comes from the line of Anthony Lebiedzinski of Sidoti. Your line is now open.
Thank you and good afternoon and thanks for taking the questions. So Tim, you talked about seeing an increase in project engagements, talked about seeing better performance as the quarter went on. So, what can you share with us as far as what you are seeing in terms of your business trends so far into the third quarter?
Well, thanks, Anthony. Good to hear from you. When you think about Q2, it started off pretty rough. April was a lower month for us, and then the quarter did get progressively better. And I think that trend is continuing into Q3. And so from a booking perspective, we are seeing a real positive trend across all three segments. We think about our engagement with our engineers and our enterprise engagements around solution architects and how busy they are looking at their funnels, they are up about 16% year-over-year. So overall, we are optimistic that the mission-critical projects will continue. We don’t have a firm date for when we think endpoint devices will really start to uptick. We are hopeful that we will see a little more momentum in Q3 and then again in Q4. But we are still – when it comes to endpoint device, I think we are still bumping around the bottom. When it comes to advanced technologies, we are seeing solid demand, seeing solid demand in the Net/Com area. So Tom, did I leave anything out there?
Yes. Anthony, the thing that continues to happen is we have seen a lot of activity on the quoting and kind of the inquiry side of the business. People are still being very cautious of what they invest. So, sitting here today, if I had to tell you, Q3 is probably going to be a little better than Q2, but that’s kind of the trajectory we are on. We are hoping to see things firm up a little bit more in Q4.
Understood. Thank you, guys for that. And then in terms of the gross margin, certainly came in ahead of our expectations, so nice to see that. How should we think about the sustainability of your gross margin here going forward?
So, there are really two components in there, Anthony. One, if you look at our press release, you can see we had a pretty significant increase in Net/Com products and the services. And those things tend to be a little bit higher margin. And you also saw a market change in the mix of notebooks and desktops, right. So, which tend to be lower margins. So, those things drove – just that mix shift drove a chunk of that change. And then obviously, the software netting is another component that’s in there. I think that we are very happy with where we are. When the endpoint devices start to come back, and we had quarters where those were around 50% of our revenue. When we get back to that level, I think margins will drift back down a little bit.
I will add that we are very pleased with what we saw in our Business Solutions team. As you heard, a 350 basis point increase in margin, again, based on the shift in mix was great work by the team. And certainly, we will do all that we can to sustain that momentum.
Understood. And then just switching gears to your balance sheet. It’s obviously very strong balance sheet, plenty of cash. Your inventory was down nicely. Do you think you can make further progress with your inventory, or how should we think about that?
I think maybe we can – there is a little bit more to squeeze out of that. During the quarter, what we saw is some order fulfillment that enabled us to release a lot of inventory that we had on hand. Why do our backlog really hasn’t changed much since Q4, so it wasn’t like we liquidated a whole bunch of backlog. It’s just we got products coming that allowed us to ship inventory we had on hand. There is probably a little bit more we can squeeze out of that if business levels remain like this. But we are kind of getting down closer to where we have historically been before all the supply chain challenges.
Alright. Thanks very much. I will pass it on to the next caller and best of luck going forward.
Thank you, Anthony.
Thank you, Anthony.
Thank you. Please standby for our next question. Our next question comes from the line of Jake Norrison of Raymond James. Your line is now open.
Hi. Can you hear me?
Yes. Good afternoon Jake.
Okay. This is actually Adam [indiscernible] Jake’s been. No, it’s okay. Tim, how are you doing? I wanted to maybe just start rewinding back to Q2 results. And obviously, it was a little bit below our expectations from a revenue perspective. But I am wondering versus your own internal expectations, whether it’s by customer vertical segment or product category, what you would call out as the largest variance based on what you were expecting in Q2?
Yes. I would say a couple of things in there, Adam. Overall business activity was a little bit less than I think we had anticipated, like Tim said in his remarks earlier that April was a pretty tough month. The other component that’s really pushing on revenue is just all the software and services netting that we are experiencing. So, the gross – while the revenue was below expectations, the gross margin – the gross profit was less of an issue for us, which is why our earnings were actually okay despite the level of revenues.
Yes. And then when you look at the specific segments, obviously, a really nice growth in our Public Sector business. And we do think that is sustainable moving through Q3 in their busy season. But clearly, our Enterprise and our Business Solutions team were below expectations just based on the nature of the economic backdrop and what our customers are going through right now.
Got it. Okay. And you mentioned some green shoots at the end of the quarter kind of finishing strong, and it sounds like the month of July is off to a good start. I guess anything either by customer vertical or category to call out as to what’s really driving the turn here?
Again, Public Sector leading the way with large contracts in both the Federal and SLED areas. So, we are seeing really good momentum there. And we are optimistic that just given the mission-critical nature of our solutions that the enterprise customers, when we are looking at the funnels and the projects out there that they will start to pick up a little more in Q3 and optimistic, the same for our Business Solutions, our small and medium team. So, I think Public Sector is there. And we would like to see and are confident, we will get some momentum with both enterprise and SMB.
Got it. And then maybe one for Tom, I guess you obviously had some optimization occur in the quarter. How are you thinking about the trajectory of OpEx moving forward in the back half of the year, whether that’s on a dollar basis or as a percent of revenue? Just how we should be thinking about OpEx trajectory? It would be helpful.
Yes. So, if I think about it as a percentage of revenue, Adam, I think you are going to see a Q3 that looks a fair amount like Q2. A couple of things going on there, we did take a charge in the quarter to take some costs out, and the run rate of that was probably a little – let’s call it, $5.5 million or $6 million a year on a run rate basis. But we are continuing to invest primarily in our services business and our technical selling organization as we try to demonstrate more strength in those areas. I think the level of spending in absolute dollar terms might be up a little bit quarter-over-quarter next quarter. And then obviously, as revenue – hopefully, as revenues come back in Q4, we will see a little bit of an uptick. But hopefully, that rate has gotten as high as it’s going to be for the foreseeable future.
Got it. Thank you very much.
Thank you, Adam.
Thank you. At this time, that concludes the question-and-answer session. I would now like to hand the call back to Tim. Please go ahead.
Thank you, Jules. I would like to thank all of our customers, vendor partners and shareholders for their continued support and once again, our coworkers for their efforts and extraordinary dedication. I would also like to thank those of you listening to the call this afternoon. Your time and interest in Connection are appreciated. Have a great evening.
Thank you for your participation in today’s conference. This does conclude the program. You may now disconnect.