Insight Enterprises - Earnings Call - Q3 2019

Transcript

Speaker 0

Greetings, and welcome to the Insight Enterprises Third Quarter twenty nineteen Operating Results Conference Call. At this time, all participants are in a listen only mode. A question and answer session will follow the formal presentation. It's now my pleasure to introduce your host, Glynis Bryan. Please go ahead.

Speaker 1

Thank you. Welcome, everyone, and thank you for joining the Insight Enterprises earnings conference call. Today, we will be discussing the company's operating results for the quarter ended September 3039. I'm Glynis Bryan, Chief Financial Officer of Insight, and joining me is Ken Lamnick, President and Chief Executive Officer. If you do not have a copy of the earnings release that was posted this morning and filed with the Securities and Exchange Commission on Form eight ks, you will find it on our website at insight.com under our Investor Relations section.

Today's call, including the question and answer period, is being webcast live and can be accessed via the Investor Relations page of our website at insight.com. An archived copy of the conference call will be available approximately two hours after completion of the call and will remain on our website for a limited time. This conference call and the associated webcast contain time sensitive information that is accurate only as of today, 11/06/2019. This call is the property of Insight Enterprises. Any redistribution, retransmission or rebroadcast of this call in any form without the express written consent of Insight Enterprises is strictly prohibited.

In today's conference call, we will refer to certain non GAAP financial measures as we discuss the third quarter twenty nineteen financial results. When referring to these measures in today's call, we will refer to them as adjusted. These measures include adjusted earnings from operations, adjusted diluted earnings per share, adjusted free cash flow and return on invested capital. These adjusted measures exclude intangible amortization expense, acquisition related expenses, severance and restructuring expenses and amortization of convertible debt discount and issuance costs. You will find a reconciliation of these measures to our actual GAAP results included in the press release and the accompanying slide presentation issued earlier today.

Also, please note that unless highlighted as constant currency, all amounts and growth rates are discussed in U. S. Dollar terms. Additionally, any reference to our core business exclude PCM's results subsequent to the acquisition. Finally, let me remind you about forward looking statements that will be made on today's call.

All forward looking statements that are made during this conference call are subject to risks and uncertainties that could cause our actual results to differ materially. These risks are discussed in today's press release and in greater detail in our most recently filed annual report on Form 10 ks and reports subsequently filed with the SEC. With that, I will now turn the call over to Ken. And if you're following along with the slide presentation, we will begin on Slide three. Ken?

Speaker 2

Hello, everyone, and thank you for joining us today to discuss our third quarter twenty nineteen operating results. In the third quarter, we continue to execute against our strategy to deliver IT solutions to our clients globally, leading with services and solutions to drive business outcomes for our clients. In addition, we closed the PCM acquisition on August 30. And two months after the acquisition, we remain excited about the opportunity to drive growth in our expanded client base and footprint. Now turning to third quarter results on Slide four.

Consolidated sales were $1,910,000,000 up 9% year over year including one month of PCM results. Gross profit was $276,000,000 in third quarter, up twice the rate of sales at 18% year over year, including 6% growth in the core business and the addition of PCM. Gross margins were 14.4%, up approximately 100 basis points year over year, driven by strong cloud and services growth in the core business and the addition of PCM. Consolidated selling and general administrative expenses were $222,000,000 in the third quarter, up 21% year over year, including both organic growth of 8% in the addition of PCM. All this led to adjusted earnings from operations of 59,000,000 an increase of 7% compared to last year's third quarter.

On a GAAP basis, earnings from operations decreased 11% to $44,000,000 driven by approximately $6,000,000 of PCM acquisition related expenses, 2,000,000 of PCM intangibles amortization expense and integration and restructuring expenses recorded in the quarter. Adjusted diluted earnings per share was $1.1 an increase of 10% year over year. On a GAAP basis, diluted earnings per share was $0.76 Our third quarter results reflect our strategy to improve our gross margins by leveraging our four solution areas to optimize our business mix in higher margin categories, including cloud solutions and services. This led to 100 basis point improvement in gross margins in the quarter. The core business in North America and EMEA regions grew gross profit dollars mid single digits year over year in constant currency, while the APAC region grew gross profit dollars 21% year over year in constant currency.

These results were driven by a higher mix of gross profit from services sales including cloud solutions. Gross profit earned from cloud offerings was 19% of our consolidated gross profits for the trailing twelve months compared to 17% for the same period last year. The improved gross profit performance in the core business in the third quarter, together with the performance of PCM for one month led to high single digit growth in adjusted earnings from operations compared to last year. In addition, we improved our cash flow from operations performance by $90,000,000 year over year in the third quarter, bringing the total for the first nine months of the year to $169,000,000 in operating cash flow. We also reported return on invested capital of 14.9%, which includes the impact of acquiring PCM in the third quarter.

Demand continues to be solid across key markets where we compete. Our third quarter results reflect lower hardware sales with a select few large enterprise clients in North America, which is causing compression in our growth rate compared to the overall market trends. While we may experience cyclical trends with large clients from period to period, our relationship with those clients remains strong and we expect to return to growth in the hardware category in the fourth quarter. Our investments in our four solution areas, supply chain optimization, connected workforce, cloud and data center transformation and digital innovation have positioned us well to continue to compete in the marketplace. We're also very excited about the cross sell opportunities we see in the mid market space and the potential to leverage our solution area strategy into the PCM client base to grow our position in this higher growth, higher margin end market.

Next on to Slide five. We closed the PCM acquisition on August 30 and are working diligently to integrate their business into ours to ensure we optimize execution of the market opportunity of the combined business and deliver to our commitment to realize $70,000,000 in run rate cost synergies by the 2021. To date, have completed the organizational review of the combined senior leadership team, completed our planning efforts around brand and finalized our timeline for e commerce and core systems integration. We expect to be substantially complete the systems integration work by mid-twenty twenty. We're also on track to deliver more than half of the expected cost synergies by the 2020.

Moving on to Slide six. Next, I want to highlight an example of how we're leveraging our solution areas to help our clients achieve better business outcomes. A financial services firm wanted to attract a new generation of customers and transform its customer experience by leveraging the power of artificial intelligence to create a multichannel chatbot. As digital natives millennials generally prefer the use of social media platforms to connect with family and friends and to transact banking and commerce. Our digital innovation team helped the client launch a multi channel conversational agent or chatbot with rich capabilities for buying and selling stocks, locating nearby branches, getting quotes and more.

Users can ask questions around financial topics and the chatbot is able to provide educational resource in the forms of articles and short videos. By providing seamless access to easily digestible information, the financial services organization has experienced a 72% increase in new accounts among the millennial generation. With the chatbot, customers gain the experience of anytime, anywhere access and quick answers to questions. On average, it takes a human customer service representative fifteen to twenty minutes to answer an inquiry. The chatbot can do this in seconds.

This is just one of many examples where our digital innovation team is delivering intelligent technology solutions to clients, which have broad application across a variety of client industries. Moving on to Slide seven. Before I hand the call back over to Glynis, want to take a moment to recap key highlights from our Investor Day event in mid October. First, I'd like to thank all of you who joined us live for the event. And if you weren't able to make it, please note that there is a replay currently available on our website.

At the event, we outlined our long term strategy and key measurements we intend to use to track our progress. During the event, we noted that we believe our strategic assets give us competitive advantage in the marketplace. In addition, our strategic assets have been integral to our ability to deliver double digit growth in adjusted EFO and EPS results and more than 700 basis points improvement in our ROIC metric over the last five years. They also position us well to continue to drive value in the future. Our strategic assets include our focus on culture, people and leadership, our innovation led approach and solution area expertise, our global reach and scale, our diverse and loyal client and partner relationships, and lastly, our operational vigor and financial health.

We will leverage these strategic assets to achieve our key priorities, which include continuing to innovate in order to capture share in high growth areas like cloud and the intelligent edge, growing the business through solutions that drive better business outcomes for our clients expanding the scale in our business and strategic clients and end markets, particularly in the mid market, where the recent acquisition of PCM has added clients and capabilities to our portfolio And lastly, to optimize client experience and our execution through relentless focus and operational excellence. Next on to Slide eight, to measure our progress against these priorities, we laid out four key metrics. We will seek to grow faster than the market, CAGR over the next five years of between 810%, expand EBITDA margin to between 55.5%, optimize our return on invested capital to a range of between 1921%, and to continue to grow services gross profit as a percent of total gross profit to between 5052%. We will seek to make progress each year against these goals and we'll update you during our scheduled earnings calls. I will now hand the call back over to Glynis to provide more detail on our financial performance in Q3.

Speaker 1

Thank you, Ken. I'll start on Slide 10. I'd like to highlight changes we've made to our adjusted earnings from operations, adjusted net earnings and adjusted diluted earnings per share calculations reported today. We have historically excluded severance, restructuring, acquisition related and one time costs in our adjusted metrics. Starting in 2019, we're excluding the amortization of intangibles from our adjusted results.

In the third quarter, we excluded approximately $6,000,000 of amortization expense from our adjusted metrics. In addition, as is customary, our convertible notes were issued at a discount to par value to effectively prepay debt issuance costs of proceeds and to gross up the below market cash coupon on the notes. These amounts will amortize to interest expense and increase the reported convertible debt balance over the life of the note, and we will exclude this noncash interest expense from our adjusted operating results beginning in Q3 and going forward. We believe these changes in presentation will give investors a meaningful comparison of the cash based operating results period to period and will allow for meaningful comparisons to results of our competitors. To ensure comparability, we will make applicable adjustments to prior period results as well.

Moving on to Slide 11 in North America. In North America, net sales were $1,500,000,000 in the third quarter, up 10% year over year. The core business continued to see less spending for hardware products by select few existing clients, which drove the top line down 2% year over year. For the combined business, hardware sales increased 7% year over year, driven by PCM. Software sales increased 14% year over year and services sales increased 26% year over year in the third quarter, including higher sales of cloud solutions and insight delivered services primarily in the core business.

Gross profit in North America was up 22% year over year and gross margins improved 130 basis points to 14.4%, reflecting the increased mix of cloud and services sales on the business and a modest contribution from PCM for one month of the quarter. North America selling and administrative expenses increased 27% year over year, including a 10% increase in the core business, resulting from significantly higher healthcare expenses, investments in cloud subscriptions and internally used IT tools and increased headcount in our solution areas. In addition, we added PCM in the month of September. As a result, adjusted earnings from operations increased 10% year over year to $53,000,000 for the quarter. I'd like to provide some color around PCM and its impact in the quarter.

For the month of September, PCM contributed $172,000,000 in net sales, dollars 28,000,000 in gross profit and approximately $3,000,000 in earnings from operations, including just over $2,000,000 in intangible amortization expense. We also incurred estimated additional interest costs related to financing the acquisition of approximately $3,000,000 in the quarter. We will have PCM for the entire quarter in 2019 and expect seasonal top line performance consistent with prior year's PCM. Please note that historically PCM has experienced lower gross margins in Q4 compared to earlier quarters. In addition, also note that we currently expect amortization expense in Q4 in the fourth quarter to be approximately $6,000,000 which is up $2,000,000 from the outlook we provided in the second quarter call as we now have completed a preliminary assessment of the net assets acquired.

Lastly, we have line effect for the cost synergies we previously committed and are on track to deliver more than 50% by the 2020. Moving on to EMEA on Slide 12. Net sales in the third quarter increased 9% in constant currency to $356,000,000 An 11% increase in software sales and 8% increase in services sales year over year were partly offset by a decrease in hardware sales to larger clients. Gross profit grew seven percent in constant currency, while gross margin decreased 30 basis points due primarily to lower margin on services sales in the quarter. And operating expenses grew 8% in constant currency, and this drove adjusted earnings from operations to $3,400,000 down $1,700,000 year over year.

These results reflect performance in line with our expectations from the core business and a modest operating loss from the PCM business. Moving on to APAC on Slide 13. Net sales in the quarter increased 40% in constant currency to $42,000,000 The APAC region delivered year over year growth across all product categories in the third quarter. Gross profit grew 21% in constant currency and adjusted earnings from operations grew $700,000 year over year. On the tax side, our effective tax rate for the 2019 was 27.2%, up compared to last year and higher than our guided range due to the non deductibility of certain acquisition and restructuring related expenses.

Turning to our cash flow performance on Slide 14. Our cash conversion cycle was forty two days 19, up four days from the 2018, due primarily to the inclusion of PCM's full accounts receivable, payables and inventory balances with only one month of related sales. Year to date through the 2019, our operations generated $169,000,000 of cash compared to $247,000,000 of cash last year. Our prior year results reflect a higher than normal seasonality for cash flow performance as well as the benefits of our enhanced focus on reducing aged receivable balances. Our year to date results through the third quarter of this year are more in line with typical seasonality.

For the full year of 2019, we continue to expect cash flow from operations will be in our normalized annual range of between $160,000,000 and $200,000,000 In the first nine months of 2019, we invested $17,000,000 in capital expenditures with the same amount as invested in the same period last year. We also used $28,000,000 to buy back stock in the first nine months of this year as compared to $22,000,000 in the same period in 2018. All of this led to a cash balance of $141,000,000 at the end of the third quarter, of which $120,000,000 was resident in our foreign subsidiaries and $837,000,000 was outstanding under our financing arrangements. This compares to $111,000,000 of cash and $269,000,000 of debt outstanding at the end of the prior year quarter. In the third quarter, we refinanced our existing revolving credit facilities into a single $1,200,000,000 asset based loan maturing in 2024.

As of September 30, we had $553,000,000 outstanding under this facility, incurring interest at an average effective rate of about 4%. Also in the third quarter, we issued $350,000,000 in convertible notes maturing in five point five years, which bear a cash coupon of 0.75%. These notes have no called feature through year three and can be paid off thereafter under certain conditions. The initial conversion premium of the notes is $68.32 In connection with the issuance cost of the convertible notes, we entered into call spread transactions to effectively increase the initial conversion price of the notes to $103.12 We like the convertible notes because they represent a lower cost of borrowing than the ABL and allow us to put a fixed price tranche of debt into our capital structure for the intermediate term. One last item in cash flow of 2019, we purchased a new corporate headquarters building in Arizona for $48,000,000 We've outgrown our current facilities in Arizona and expect to sell those facilities.

We plan to relocate late in 2020. Moving on to Slide 15, I'd like to update you on our capital allocation priorities now that we have closed PCM transaction. First, we plan to continue to invest in organic growth, including growing our technical and sales talent and optimizing our scalable IT infrastructure, e commerce sites and service delivery platforms. Our second priority in the near term will be to pay down debt associated with the PCM acquisition. Our goal is to maintain a modest leverage of less than one times absent acquisitions.

Thirdly, we will continue to pursue strategic M and A opportunities. We've developed a robust framework to guide our M and A decisions and we have demonstrated the effectiveness of our integration process with past M and A transactions such as DataLink and Cardinal. In general, we look for M and A transactions that will be accretive within the first full fiscal year following the acquisition and we target an ROIC of 300 basis points above our weighted average cost of capital at the end of year three. Lastly, we will return excess cash to shareholders after meeting the other priorities I just outlined. With that, I will now turn the call back to Ken to review our 2019 outlook.

Ken?

Speaker 2

Thank you, Glenys. Moving on to Slide 17. With respect to our full year 2019 outlook, included the results of PCM for the last four months of the year, we expect net sales to increase between 911% compared to 2018. We expect diluted earnings per share for the full year of 2019 to be between $5.45 and $5.5 This outlook assumes an effective tax rate of 25% to 26% for Q4 twenty nineteen. Capital expenditures of 70,000,000 to $75,000,000 for the full year, including the purchase of real estate in the fourth quarter of approximately $48,000,000 and an average share count for the full year of approximately 36,000,000 shares.

This outlook excludes intangibles amortization expense, acquisition related expenses, severance and restructuring expenses and amortization of convertible debt discount and issuance costs during the first nine months of 2019 and those that may be incurred during the balance of 2019 and assumes no further purchase repurchases of our common stock over the balance of the year. This outlook is equivalent to an adjusted earnings per share between $4.9 and $4.95 under our previous guidance methodology used in the second quarter and now includes PCM operations, intangibles amortization expense and additional financing costs for the full quarter. Thank you again for joining us today and thank you for all the teammates across the globe for their performance in the third quarter. That concludes my comments and we'll now open your line up for questions.

Speaker 0

Thank you. We'll now be conducting a question and answer session. Our first question today is coming from Matt Sheerin from Stifel. Your line is now live.

Speaker 3

Yes, thank you and good morning. Just a couple of questions. Just first, regarding the contribution from PCM. I know you talked about growth rates. Could you just give that apples to apples number?

What was the contribution in the quarter?

Speaker 1

So it was only we only had PCM in the quarter for one month. It was $172,000,000 of revenue, 28,000,000 of GP and essentially when you net and that had a small contribution at the EFO line, but when you net it out, it was less than $01 in terms of total EPS in the quarter because of the interest below the line. Got it. I didn't look at number or not, but as you go through the P and L, you end up with less than a penny of EPS.

Speaker 3

Okay, that's helpful. And then you talked, I think, Ken, about the expectation for I know you did, Glynis, about gross margin being down in the fourth quarter due to seasonality in North America. PCM, as you've pointed out, has higher gross margin. So is that a function of the seasonality in that business, too?

Speaker 1

Yes. So the question that we the comment that I made regarding fourth quarter was specifically related to PCM. So if you look historically at the PCM business, their fourth quarter has always been 100 plus basis points lower than prior quarters. And my comment was related specifically to looking at expectations for PCM. Remember that their gross margin in the fourth quarter has historically been lower than other quarters.

I was not making a comment about the base Insight business.

Speaker 3

Got it. Okay. And then Ken, you talked about relative strength in IT spending, still pretty good demand in North America. Could you give us some further insight into the hardware segments, particularly on the storage side where we're starting to hear from some peers and distributors of a bit of a pickup after kind of

Speaker 2

a lull or weakness for a couple of quarters? Yes. I think and you've seen a lot of the data, of course, from some of the major suppliers out there in that regard. So I would say that the business continues to, I think, to gain momentum there. It certainly had gone through a lull as you saw, but I think there's certainly that is coming back, and we're seeing some good strength across some pretty important vendors for us.

So overall, it's not across the board. It's in pockets, but I'd say overall net net, we are definitely seeing some pickup in the storage area.

Speaker 3

Okay. That's it for me. Thank you.

Speaker 2

Thanks, Matt.

Speaker 0

Thank you. Our next question today is coming from Mark Wiesenberger from B. Riley. Your line is now live.

Speaker 4

Hi, good morning. It's actually Kara Anderson on for Mark. Just the first question that I had is around the property purchase for the new headquarters in Arizona. Just wondering if there are any other plans for real estate for the real estate acquired through the acquisition of PCM?

Speaker 1

So, yes, welcome back, Kara. We have planned PCM owned five buildings across the country, we're going to be retaining one and we will be selling five over the next within the next year four over the next year. They will have to be replaced with other facilities, but we will leverage the fact that they're significantly underutilized, get the cash out of those buildings and use that to pay down debt. Three of them are in So it actually means that we should actually be able to recoup some significant dollars to pay down debt with those parts of sales.

Speaker 4

Got it. And then just looking at the sales mix in the quarter, now with one month of PCM, is that kind of a reflective of the mix going forward or how should we think about that with PCM?

Speaker 1

The sales mix you mean in hardware, software and services, is that what you're talking about? Yes. Thank you. Okay. Well, it was one month of PCM in that quarter.

I think that their business is a little bit less in terms of revenue associated with services, but the hardware, software split is probably a little bit more weighted towards hardware than our businesses. So in third quarter in the fourth quarter, you should see a little bit more hardware associated coming from PCM and not that much impact on our services number going forward because they were smaller services as a percentage of total revenue.

Speaker 4

Got it. And then can you just go back through the guidance, the EPS guidance? I think you pointed out the underlying assumption for the core EPS guidance embedded in the $5.45 to $5.5 EPS guide. Is that unchanged from previous guidance or did the core shift No,

Speaker 1

that is unchanged from previous guidance in Q4. So I'll walk you through it. In Q2, we said $4.85 to $4.95 and we said that excluded PCM. What we're seeing today is for the fourth quarter, we're at $4.9 to $4.95 that does include PCM, but the contribution from PCM is nominal in that guidance. So it's still within as we view the guidance range that we had previously expressed.

We do have $2,000,000 more of intangible amortization. Last time, we would have given you $4,000,000 for intangible amortization in the guidance range that we provided. We now have $6,000,000 based on our preliminary assessment of the net asset value. So that's a change, I guess, in the overall guidance as you get to that $490,000,000 to $495,000,000 number.

Speaker 4

Got it. Thank you.

Speaker 5

Thank you.

Speaker 0

Our next question today is coming from Paul Coster from JPMorgan. Your line is now live.

Speaker 5

Hi, guys. Thanks. This is Paul Chung on for Coster. Thanks for taking our questions. So on the just a follow-up on the kind of guidance range.

Probably the bulk is from some amortization of add backs, but just want to get a sense, calculating maybe, I don't know, anywhere between $0.15 and below is kind of for the core business. Is that the right way to think about it?

Speaker 1

I'm sorry, are you talking about the impact of amortization expense in the 40 the $545,000,000 to $550,000,000 number? Is that your question?

Speaker 5

Yes, that's correct. I think it's maybe around, I don't know, $0.04 0 kind of benefit from the add back. Is that correct? And then just want to get a sense for putting a number around kind of the core business benefit.

Speaker 1

Sorry, just give me a second. In Q3, on a year to date basis, the add back for intangible assets So I'm really looking at the schedule in the back. So I will tell you the add back for intangible assets for the nine month period was

Speaker 5

Around $0.28 Is that correct?

Speaker 1

Yes.

Speaker 5

Right. So if

Speaker 1

And I take we're going to have an incremental $6,000,000 in Q4 related to PCM. Sorry. In 2019, if you there's a slide in the deck in the appendix, Slide 19. And if you look at Slide 19, intangible the stock sorry, the EPS associated with intangible amortization nine months of 2019 is 38. I think you said 28, it's 38 before tax, before tax.

And we're going to add $6,000,000 which is roughly $0.12 to that number for PCM plus whatever the normal quarterly amortization was before that.

Speaker 5

Okay, thanks for that clarification. And as we think about kind of the normalized run rate for some key operating items, it 3Q contribution in OpEx? Was that just one month? Or was it a full quarter impact? Or just want to get your thoughts on how to think about the combined business OpEx kind of run rate on a quarterly basis or even an annual basis for the combined business?

Speaker 1

So the impact that you saw for PCM in September was just the impact of one month of their OpEx or revenue and gross profit included in our numbers. We will have three months of PCM in the fourth quarter. And we will start realizing some synergies, not many, but we'll start realizing some synergies around the mostly the corporate costs that start going away effective with the acquisition. So I can't give you a percentage number in terms of what that would translate to in terms of a run rate for OpEx, which I think is what you're asking me for.

Speaker 5

Right. Okay.

Speaker 1

And then If you look at what we told you between EFO and gross margin for PCM, that's a one month impact. I would assume that if you get that impact for the quarter and then maybe a slight discount for some synergies that would get you to a run rate for PCM in terms

Speaker 5

of Got it. Okay. And then Okay. And then kind of on a high level last question, sorry. From purchasing decisions, you seeing kind of more interest in this trend of hardware as a service, which is kind of being offered by certain large OEM partners.

Does this how does this kind of impact your business? And do you see that accelerating from what your customers are saying? Thank you.

Speaker 2

Yes. Thanks for the question, Paul. This is Ken. Yes, we definitely are seeing as the world starts to move more and more towards subscription as a service, certainly in the software front, we're starting to see it also apply itself towards hardware. So there's some innovative programs in place.

I'd still say it's pretty early innings in that regard from some of the partners that we deal with. As far as the traction, we're seeing a good amount of it, of course, in the storage front, which Matt had sort of alluded to. There's certainly some of that happening in a pretty strong way there, where they're all sort of looking at opportunities to provide choices for clients in order to provide it sort of as a service or on premise. So that's definitely a trend, but it's going to still early to give you any kind of real data points yet.

Speaker 5

Thank you.

Speaker 0

Thank you. We reached end of our question and answer session. And ladies and gentlemen, that does conclude today's teleconference. You may disconnect your lines at this time and have a wonderful day. We thank you for your participation today.