ScanSource, Inc. (SCSC) Q3 2012 Earnings Report, Transcript and Summary

Welcome to the ScanSource Third Quarter Earnings Announcement Call. [Operator Instructions] Today’s call is being recorded. If anyone has any objections, you may disconnect at this time. I would now like to turn the call over to Mary Gentry, Director of Investor Relations. Ma’am you may begin

Good afternoon. Thank you for joining us for the ScanSource earnings conference call to discuss financial results for the quarter ended March 31, 2012. My name is Mary Gentry, Director of Investor Relations, and with me are Rick Cleys, our CFO; Scott Benbenek, President of Worldwide Operations; and Mike Baur, our CEO. We will review operating results for the quarter, and then take your questions. This conference call contains certain comments, which are forward-looking statements that involve risk and uncertainties. These statements are subject to the Safe Harbor created by the Private Securities Litigation Reform Act of 1995. The statements made in this call are made as of today’s date. We may subsequently make these statements available on ScanSource’s website or otherwise. ScanSource does not assume any obligation to update the forward-looking statements provided to reflect events that occur, or circumstances that exist, after today’s date. Any number of important factors could cause actual results to differ materially from anticipated results. For more information concerning factors that could cause such a difference, please see the company’s Annual Report on Form 10-K for the year ended June 30, 2011, filed with the Securities and Exchange Commission. We will be discussing both GAAP and non-GAAP results during our call and have provided a reconciliation between these amounts in our press release. Mike Baur will now begin our discussion with an overview of quarterly results.

Thanks, Mary. Our financial results for the March quarter were good, but not great. Net sales for the March quarter were $708 million, up 15% year-over-year and down from the December quarter in line with our expectations. While we achieved the mid-point of our guidance, we were disappointed in the overall mix of business. Each of our North American business units grew year-over-year with double-digit growth rates. However, sales decreased in each of our international units compared to the last year, except for Brazil. In North America, we saw more big deals happen than forecasted. Internationally, we saw the opposite, with fewer big deals than forecasted. I’ll provide more sales detail in a few minutes about segment and business units. Our gross margin percentage for the March quarter was 9.8%, primarily due to the timing and lower attainment of vendor incentive programs in North America as we discussed last quarter. Vendor program goals are not realistic given overall market conditions for some of our larger vendors. Some program goals are too high for the available market, and in some cases, goal payout as a percent of revenue has decreased. Our inventory level decreased in December, but not enough, as we recorded 5.0 inventory turns in the March quarter. Our product management teams will be focused on improving our working capital metrics on a vendor-specific basis during the June quarter. With that, I’ll turn the call over to Rich to discuss our third quarter financial results in more detail.

Thanks, Mike. I will start my discussion with overall sales and operating results for the March 2012 quarter. As Mike pointed out, in our third quarter, the company generated worldwide sales of $708 million, which increased 15% over the prior year third quarter and decreased 10% from the second quarter of 2012. On a geographic basis, sales originating from our North American distribution segment increased 15% in comparison with the prior year quarter to $530 million. The International segment grew 18% from the prior year to $178 million. Excluding the impact of foreign exchange fluctuation, international segment sales grew 21%. The growth in the international segment was related to the addition of CDC Brazil, which was acquired in April -- on April 15, 2011. Within our product lines, we experienced a 16% in the worldwide POS Barcode and security products over the prior year quarter. These product categories represented 61% of our total sales for the quarter with the remaining 39% originating from communications platforms [ph]. Our communication sales unit experienced an increase of 14% in comparison to the prior year quarter. Our gross margin percentage decreased 94 basis points to 9.8% from the March 2011 quarter and 41 basis points sequentially. The decrease is largely the result of lower vendor incentive program achievement as a percent of sales, unfavorable product and geographic mix as well as pricing pressure in Europe and Latin America. SG&A expenses in the current quarter increased to $46.7 million compared to $40.3 million in the prior year. The increase is largely due to incremental SG&A expenses in Brazil and continued investment in Europe communications. We also completed the purchase accounting for the CDC Brazil acquisition this quarter. As part of completing our purchase accounting, we recorded an additional $3.7 million in intangible assets. We incurred a non-recurring pre-tax amortization charge of $400,000 due to true-up of this addition to intangible assets. As a reminder, the prior-year quarter included a one-time charge of $2.4 million for the funding of a supplemental executive retirement plan. As a percent of net sales, our SG&A expense ratio remained constant at 6.6%. From the sequential quarter, SG&A expenses decreased $1.8 million, but increased 41 basis point as a percent of net sales. The sequential increase in SG&A percentage is largely attributable to a decrease to our top line revenues and continued investment in our international business, somewhat offset by variable compensation expenses due to lower sales and profitability achievement. As a reminder, we have an earn out for CDC Brazil that is required to be re-measured to fair value every quarter. The quarterly re-measurement of this contingent consideration is presented separately from other SG&A expenses. In the current quarter, we recorded an expense of $1.2 million or $0.02 a share after taxes for the change in fair value. As mentioned on previous calls, factors impacting the fair value adjustment can cause volatility over time in this line item. Operating income was $21.5 million, down 15.7% from the prior year and 33% sequentially. Expressed as a percentage of sales, operating income was 3% in the current quarter compared to 4.2% in the prior year and 4.1% sequentially. This decrease is mainly due to lower gross margins. Additionally, we did not have a fair value adjustment for the earn-out in the prior year quarter. You may recall the fair value adjustment in December. The December quarter was a $722,000 gain. Interest expense was $254,000 for the quarter, down $429,000 and $749,000 the prior year and sequential quarters, respectively. The sequential decrease is due to the capitalization of interest to our ERP project, up $267,000. Interest income was $780,000 compared to $313,000 and $1 million in the prior year and sequential quarters, respectively. Interest income in the current year has been higher than previous years as we transferred $22 million to our Brazilian subsidiary in September 2011 to prefund future earn-outs payments. We would expect interest income to decrease as we complete our annual Brazilian earn-out payments for the purchase of CDC. We recorded a $206,000 loss in other income and expense this quarter compared to a $300,000 loss in the prior year, and a $370,000 gain in the second quarter. The effective tax rate this quarter was 32.3% and 34% for the quarters ended March 31, 2012, and March 31, 2011, respectively. This decrease reflects the benefit of changes in geographic mix to tax jurisdictions with lower corporate income tax rates and the recognition of a discrete tax benefit to our Brazilian acquisition in the amount of $430,000 for the current period. Our return on invested capital was 13.5% for the quarter compared to 18.2% for the prior year quarter and 19.3% for the December quarter. In summary, the March 2012 quarter had reported fully diluted earnings per share of $0.53 versus $0.60 in the prior year, the current year EPS includes the impact of the fair value adjustment. Turning to the balance sheet. Inventory turned 5x during the quarter, compared to 5.5x and 5.6x in the prior year and sequential quarters, respectively. We had 15 paid-for inventory days at March 31 down from 18 days at the same time last year and up from 11 days at the end of the second quarter. Inventory levels are down $14.7 million from the second quarter. However, levels are still up $100 million from the March 2011 quarter as the company has built inventory in anticipation of greater sales growth. There are $45.5 million in checks written but not cleared in the March accounts payable balance. At the end of June 2011, this amount was $73.6 million. Our days sales outstanding, DSO, was 57 days at March 31, 2012, compared to 56 and 57 days in the prior year and sequential quarters respectively, which are within our normal range of expectations. The company had cash and cash equivalents on hand of $34.3 million as of March 31, 2012, compared to $28.7 million at June 30, 2011. The company has spent $4.7 million and $10.2 million on capital expenditures during the quarter and year-to-date, respectively, primarily on our investment in a new ERP system. The company has initiated an assessment of the ERP project. Although the assessment is not complete, the company has determined that the go-live date will not occur in calendar 2012. And as a result, the projected total spent estimate can -- cannot be determined at this time. For the June quarter, we anticipate the spend on the project to be approximately $3.5 million. That spend estimate does include the cost of our internal labor. The company held $46.9 million of interest-bearing debt at March 31, 2012, down slightly from $60.1 million at the prior year-end. Funded debt borrowings are down $54.2 million from December. As sales declined in the third quarter, so did our investment in working capital. This ultimately resulted in decreased use of our revolving credit facility, and we were able to decrease our outstanding balances. Mike will now comment specifically on the quarterly result and outlook for each of our business units.

Thanks, Rich. I’ll start my business unit comments with our North American segment, which includes the United States and Canada and represents 75% of overall sales. In North America, sales of $530 million represent an increase of 15% year-over-year, consistent with our historical experience of a declining sales in the December to March quarter North America declined 6% quarter-over-quarter. Our under achievement of vendor programs tied to aggressive growth targets led to lower gross margins. Higher inventory levels in certain product lines continued to be a challenge. Starting with North America POS and bar coding, we had good results, with sales ahead of plan. Higher big deals and strong results from Motorola, Honeywell, Zebra, Datalogic and Datamax drove the year-over-year growth. We also saw good point-of-sale sales with IBM, Pioneer and Verifone, as well as the best sales quarter since 2008 with Estam [ph] and MagTech. We saw favorable results in our scanner business and continue to have good traction in our key injection business. We had better alignment of our inventory levels in this unit and generally found inventory availability to be good with very few supply chain issues. Our security business unit had another quarter of excellent results with strong growth over last year and also sequential quarter growth. We had strong results from Axis, Ruckus, Cisco in March networks. We gained market share, particularly with our smaller vendors, and achieved record sales quarters, with Sony, Aircon, Samsung, ExacTech, Ddtel [ph] and Purewave. We also had great response from our new marketing efforts and increased the number of new customers. Consistent with seasonal trends in the security business, we had fewer big deals this quarter and the big deals that we had were smaller in size. Turning to our North America Communications unit, here we had double-digit year-over-year growth but were disappointed with the overall revenue achieved. We had fewer big deals than expected, particularly in our video [ph] and infrastructure areas, although we did have few big deals pushed into the June quarter. We had a record quarter with Polycom voice products and Plantronics as well as a strong services quarter. We successfully recruited new resellers for ShoreTel and continued to transition more ShoreTel resellers. Polycom named ScanSource Communications its global and North American distributor of the year for the second year in a row. Catalyst Telecom also had double-digit year-over-year growth but missed our internal plan. An increase in big deals, both the number of deals and the volume, and strong results from Juniper and Aruba drove the year-over-year growth. We had another strong services quarter with Avaya and ended the quarter on a strong note with higher sales in the month of March. While we brought ending inventory levels down somewhat, we still have some work to do here. We successfully recruited new Avaya resellers, including data networking customers that want to get into unified communications, and we are working to drive revenues from our new customers. Aruba Networks presented Catalyst Telecom with its Americas Distributor of the Year award. Now turning to our international segment, which is 25% of our overall sales. Net sales totaled $178 million for an 18% increase year-over-year. This increase includes the addition of CDC Brazil, which we acquired on April 15, 2011. Excluding CDC Brazil, our international segment sales actually declined year-over-year. Europe economic concerns had an impact on the competitive environment, including pricing pressures and delays in purchasing decisions. Both of our European sales units had weaker performance compared to our plan during the March quarter. For our Europe POS and barcoding units, sales were down year-over-year as big deals were lower than expected. It was the worst big deal quarter in the last few years, and many projects were either delayed or broken up into smaller pieces. As a result, our inventory levels are too high, since we anticipated shipment for these large deals which did not happen. While sales for the U.K. and Germany were down year-over-year, we had year-over-year growth in almost all of our other countries. We also had good year-over-year growth from Honeywell, LXE and ELO. ScanSource Europe was named Wireless Distributor of the Year by Motorola Solutions for the EMEA and voted Intermec’s Distributor of the Year for the EMEA region by Intermec’s reseller community for the second year in a row. Sales for our Europe Communications business were disappointing this quarter. They were down year-over-year. Again, a decline in large projects, primarily in Germany, made a big difference, results in inventory levels that were too high. We did have good vendor results with Avaya SMEC, Avaya data, Polycom and ShoreTel. The U.K. had an excellent quarter, beating plan, showing growth both year-over-year and sequentially. These better results in the U.K. are because we rely more on our run rate business there, not large projects. In February, Plantronics named ScanSource Communications Europe its Distributor of the Year for largest growth. Our Latin America businesses include Brazil, Mexico and Miami, which serves U.S. based exporters, the Caribbean and the rest of South America. Latin America sales were below our plan, though performance was better in Brazil. Beginning with Brazil, we had a favorable mix and better attainment under vendor programs. Our team delivered good results from Bematech, Honeywell, Zebra, HP and Datamax O’Neil. We sold to more customers this quarter, but we did have some large deals pushed into the June quarter. We have decided to move ahead with our plans to start a communications unit in Brazil. We see excellent opportunities for communications and we’ve signed 3 new vendors: Aruba, AudioCodes and Extreme, to get started. It was a challenging quarter in Miami, with sales for most barcode and POS vendors down, in part from postponement of projects to the June quarter. We did have good results from Zebra and ELO. Results were better in communications with Polycom and in security with our vendors across the board, including strong growth from Axis. New import regulations in Argentina have delayed sales of barcode [ph] products, since waiting for a license before shipping is now part of the process. Similarly, it was a slower sales quarter in Mexico and some sales decisions were postponed. We saw good year-over-year growth with Zebra, Intermec and NCR in our bar code POS units with Polycom, good growth in communications and with access and security. Now I will turn it over to Rich to communicate our June quarter end guidance.

Thanks, Mike. We believe total revenues for the June 2012 quarter could range from $780 million to $800 million and our earnings per share could range from $0.60 to $0.64 per diluted share. At this time, we’ll be glad to answer your questions.

[Operator Instructions] And our first question comes from Tony Kure with KeyBanc.

Couple of quick questions. Just on the vendor programs, Mike you mentioned that the expectation seems sort of unrealistic here. Those, first of all, just confirm, they reset annually, right? So now that you are in your fourth quarter, they should reset after the quarter. So, should we assume, are you expecting these to be reset on a more rational level as we move into 2013 -- or fiscal ‘013?

Well, Tony, not every vendor sets them the same way. And I would say in most cases today our larger vendors update the programs quarterly and so there are annual programs that we have, but many of them are actually on a quarterly basis. And what we have seen is the expectations for the March quarter were just overcooked and they -- the vendors look at their overall plan for the year and they generally look at it on a calendar year but they do have modifications for us based on what happened in the previous quarter. We don’t always get what we want, but we certainly are prepared to have this conversation with them about setting them more realistically, because we view the incentive programs as a key part of our compensation.

So I guess as we look at the guidance for the fourth quarter then does that assume -- does that assume that these vendor programs are going to be set at more realistic levels?

I would say, somewhat, but the other part of the story is that we saw a different mix of revenues. So we had vendor programs that are in there clearly that are impacting us in the March quarter, and we expect it to continue to impact us somewhat in the June quarter, yes, but we also see the result of the product mix and the geographic mix, meaning international business is generally higher margins, right? And certain products we sell are at higher margins, and the mix in the March quarter and the mix we plan in the June quarter will be similar.

Okay, so you are saying you are still expecting sort of a headwind from the unrealistically high expectations for the June quarter? I just want to make sure I’m hearing you right.

That’s right. You got it. Yes, sorry, yes.

Okay, and then from a top line -- from a sales perspective, for the fourth quarter guidance, is it safe to assume that North America would continue to outpace from a growth rate international on a organic basis if we exclude CDC.

Yes, I think that’s right. So again, the mix that we saw in March, we don’t see a reason why that would change on any significant basis going into June at this time.

Okay. And then as far as the one more thing on the guidance, you mentioned several times a lot of postponing deals into the June quarter across multiple regions, and it just sounds like a lot of uncertainty on the macro side, so that’s causing that, does your expectation for the bump sequentially in revenue, is that just a normal seasonal expectation or are you factoring in some of these deals coming through?

So we took into account all of the factors that we mentioned, including the fact that some deals that were pushed from March will happen in June, yes. And so we always have a forecast from our sales units going into the quarter that has big deals in there. So we’ve got their forecast, which assumes a certain number of those that were pushed to happen, and as we saw last quarter as you referenced, some of our units, are having fewer big deals than others, particularly international.

Okay, great. And then I actually -- just one more question, I think you mentioned March in one context was actually a strong month. Can you just talk about how, how the months progressed through the quarter?

Sure. I will be glad to. We -- a typical quarter for us, the last month of the quarter tends to be stronger than the first 2. And the reason I brought it up was because in particular case it was -- the January and February months were surprisingly weak compared to our historical experience. And so we were stronger in March, and we were hoping that, that continues through the June quarter. But it was a surprise; we got a lot of business late in the quarter. And we were more back-end loaded than normal.

Was that different across regions at all or pretty much the same globally?

I’m sorry. I missed that, Tony, sorry.

That’s okay. Was that the same across both international and North America? Or was it...

No, this was specific to North America communications. On Catalyst specifically.

Our next question comes from Chris Quilty with Raymond James.

One item you may have gave in it and I might have missed it, the actual revenues from CDC in the quarter.

We did not give the revenues but what we did -- we gave you the growth numbers for international and then we indicated that we actually would have had a decrease in sales for all units except CDC when compared to prior year.

All right. I’ll back into something close to the number then.

All Right.

And just wanted to confirm, it looks like your gross margin expectations going into the June quarter are going to put the margins for this year well below the levels you’ve seen recently. Does the impact of trying to move the margin put further downward -- sorry trying to move the inventory put further pressure on the gross margins possibly?

Well, it certainly could, and so we are in a position where -- this is Mike, Chris, and we have inventory levels that are more than what we need, and we’re communicating with our vendors, there are certainly a couple of things that can happen: One, we can just reduce purchases and it will fix itself in the quarter with normal margins or, two, the vendor may give us incentives to move that product. And we may take some of that, we may help the vendor do that, so we may take a lower margin, so it’s vendor-by-vendor specific strategy for us. So implicit in the margins that we’re forecasting, it’s more of a -- not a worse margin environment than we saw in March, it’s just a continuation.

Okay. Also, just looking at the international market, can you give us a breakdown of where the margins performed internationally versus domestic?

Rich.

Hang on just a second.

Yes, we’ll get that for you, we will have that in the Q

Right.

And we’ve got a draft of that, here we’re going to...

Are you looking for gross margins, Chris?

Yes, please.

Okay. All right, coming right up.

And I don’t know if you can look and think at the same time, Rich. But when you talked about the ERP spending, finalizing the fourth quarter, should we look at that as incremental on top of your normalized SG&A. In other words, it’s sort of a couple of million above the run rate we saw in the most recent quarter?

The bulk of that ERP spend will end up getting capitalized on the balance sheet. So, it won’t be incremental on the SG&A spend, all right. So for the quarter, gross margins for the March quarter ended, on North America, we’ll be looking at about a 9.5%, with our international margins at about 10.7%.

Okay. Got you. And can you give me the CapEx number also? While you are doing that, we’ll bounce back to Mike, opening up a new communications effort in Brazil since you are not green fielding, should we look at this as more of a slow roll in terms of the cost structure in the same way that you initiated the security business, or does this turn out to be a hard start like your initial efforts in Europe?

Well, I think the -- it will be more like security, because they already have an infrastructure they’ll leverage, unlike when we made an acquisition in Europe with communications and they have a separate warehouse and separate IT system, we had to go through all of that. So here, they use the same -- same back office functions, same logistics, it’s just incremental head count, so the guy that’s running the business for us down there, Alex, he is going to devote most of his time to beginning this new unit, while the rest of this management team continues to work in our barcode and POS business. so we’re going to add some incremental head count, this is the answer, that are going to be business oriented people, not accounting people at this stage, they’ve got -- we got the bandwidth to the handle the start-up efforts with 3 vendors.

Okay. And the -- you have a couple of vendors lined up, but what does the competitive situation and the existing distribution of those products look like in Brazil?

So for our -- for the key vendors that we already do business with in North America and Europe, in the ones that we didn’t mention today, they already have some distribution. In most cases, it’s 2 or 3 existing distributors, some of them use some of the traditional names that we’ve seen in all of our other markets like the Ingram Micros and Westcons, but there are other small companies that are Brazilian-only companies that we’ll be competing with. And we believe that we will have a good value proposition because of our existing reach of customers, we’ve got thousands of customers in our existing database, barcode and POS resellers, who we believe are already buying some of these communications products and will buy more if they are combined with the [ph] CDC. So we believe we can bring with vendor an incremental reseller story, which would be the reason that they will sign up even if they already have several distributors in the region.

Chris, your capital expenditure for the March quarter was $4.7 million and year-to-date date $10.2 million.

Our next question comes from Andrew Abrams with Avian Securities.

Just some clarification, I might have missed a few things that you said. In the big deals -- you were talking about the big deals being pushed in Europe and kind of better big deals in North America, did you say that, you thought that was going to be the same in the June quarter or do you expect that to be different in the June quarter?

So I think what we were trying to say with that –- this is Mike. Forecast that we are putting out there, with our guidance and that’s a midpoint of 790, there is an assumption in the 790 of a certain number of big deals similar to March.

Got it. So from both regions, both general regions you are talking about something similar, no major change from where you were before?

Right.

Okay. And just on a general basis, I know we talked last quarter a little bit about the inventories and you are still pushing to work that down. I know there was a question about it already. Is -- how flexible are your vendors on this? I know you that make deals all the time in order to facilitate moving things, given the fact that the vendors had some unrealistic expectations to begin with, are they flexible on -- on your conversations with them to reduce inventories or as this kind of a battle to -- that keeps working out over the next couple of quarters.

Well, I think in general we try to be a really good partner with our vendors. I think that’s been our history with all of our vendors is that ScanSource is a key partner long-term. And clearly in this case, we are saying, hey, we need some relief. And either we need to have less inventory, or we need to have higher revenues at reasonable margin. And so that’s how we go at these conversations is, hey what’s the best way for us together as partners to improve our inventory turns or frankly improve or reduce the amount of paid-for inventory I have. So I have –- there are multiple ways that the vendor can help us get to the answer which is, I’ve got to have a better return on invested capital number than I had in March, and so either it’s dollars of inventory, dollars of paid-for inventory, gross margin, higher revenue. So we like the fact, that we can have a customized approach to each vendor. We don’t just go in and say, so everybody’s got to reduce inventory by X because there are some, some individual situations, and frankly, we have many vendors over the years who respond very well at this, so we believe we can get there. What typically happens is our goals and our expectations are generally faster than our vendors can respond and that’s why we are building into our forecast for June that we’re going to struggle with it, and we would like to think after we exit June that we’ll be in much better position on this product.

I got you. So it isn’t as much the negotiation as the length of time it takes to implement whatever it is, that you guys come up with, with each vendor?

Yes, that’s exactly right. Because at the end of the day, if we don’t get relief, if our margins are squeezed, and we have more working capital deployed -- what our strategy has always been is we then look to the SG&A, and we have to start reducing SG&A by vendor. And so again that’s where we want to go last, right. That’s the other tool we have in our tool chest is we got to reduce head count or people or program that are devoted to that particular product line or business unit.

Got you. So that is the last resort for you guys and I would assume for them, it’s just a matter of how fast you and they can implement whatever the changes are going to be?

That’s correct.

[Operator Instructions] And our next question comes from Keith Housum with Northcoast Research.

This is John Bard [ph] on the call for Keith. I guess, first off, a little clarification on -- you mentioned U.K. and Germany, was that worse than every other country in the area and was that just the POS bar code side, or did I mishear that.

Yes, I was talking in the Europe POS and barcode about the U.K. and Germany, that’s correct. So we said they were down year-over-year, but we had growth in almost all the other countries in Europe POS and barcoding, correct.

Okay, and was it from more hesitation with budgets or could be the –- then the user not get the pricing they were looking for?

Well, it’s interesting, because markets, especially the large ones like the U.K., it is where we have more big deals than the other countries and so the larger the deal, the more likely either it got postponed or canceled or broken up into smaller pieces. And so in the U.K. is for most of our vendors [indiscernible] it’s our largest market in Europe. So it’s the one that can definitely swing a quarter, depending on how well that market does, but -- and most of our largest customers are also in the U.K. in barcoding.

Okay. And then, from the last question with inventory, is it a little higher on the POS and UC side?

We called it out for several of the business units. The one, for example, that we didn’t discuss having higher inventory levels. We have levels that were more in line with North America POS barcode. And I would say also, that was the only one I didn’t say was a problem.

All right. And then last one, could you mention FX on a operating profit in the quarter.

Did we mention FX on operating profit?

Yes.

No, what we do is we will give you the difference in revenues in terms of growth on an FX adjusted basis. And I think we said 18% and 21%.

And at this time, we are showing no further questions on the phone line.

Okay. Well, thank you for joining us. Our next conference call will be to discuss the June 30 quarterly and annual earnings and is expected to be on August 16, 2012. Thank you for your participation.

Thank you. That does conclude today’s conference. Thank you all for participating. You may disconnect your lines at this time.