Scansource, Inc. (SCSC) Q1 2024 Earnings Call Transcript

Welcome to the ScanSource quarterly earnings conference call. I would now like to turn the call over to Mary Gentry, Senior Vice President, Treasurer and Investor Relations. You may begin.

Good morning, and thank you for joining us. Joining me on the call today are Mike Baur, our Chairman and CEO; and Steve Jones, our Chief Financial Officer. We will review our operating results for the quarter and then take your questions. We posted an earnings infographic that accompanies our comments and webcast in the Investor Relations section of our website. As you know, certain statements in our press release, infographic, and on this call are forward-looking statements and subject to risks and uncertainties that could cause actual results to differ materially from expectations. These risks and uncertainties include the factors identified in our earnings release and in our Form 10-K for the year ended June 30, 2023. Forward-looking statements represent our views only as of today, and ScanSource disclaims any duty to update these statements except as required by law. During our call, we will discuss both GAAP and non-GAAP results and have provided reconciliations on our website and in our Form 8-K. I'll now turn the call over to Mike.

Thanks, Mary, and thanks, everyone, for joining us today. Our team executed well in a softer revenue environment and our business fundamentals remained strong. It’s our purpose to be a trusted partner for our customers and our suppliers, exceeding their expectations in all demand environments. First quarter net sales were softer than expected. Net sales declined 7% and reflect mixed demand. As in the past, we have benefited from a diverse ecosystem of partners who sell into different areas of technology and end markets. This allows our sales and marketing teams to find growth opportunities as demand changes during challenging market conditions. As an example, during the supply chain crisis, we utilized our strong balance sheet to minimize inventory shortages while enabling our customers to meet stronger than normal demand. During Q1, technology growth areas included networking and physical security, which have been strong throughout this calendar year. And as we have discussed in previous quarters, our strong growth continued from our Cisco portfolio of products and services, especially in the areas of network security, software, and Meraki endpoints. For our barcode, mobility, and point of sale business, demand was lower than expected with fewer large enterprise deals. Based on our survey of customers and suppliers and our recent Channel Connect event, we believe the slowing demand for barcode, mobility, and point of sale was widespread. Our Intelisys Technology Services business continues to grow as demand remains solid, with sales growth of 9% in the quarter. This includes growth in contact center, which is CCaaS, up 27%, and growth of UCaaS of 10%. Our gross profit margin for the quarter remained consistently strong, benefiting from sales mix, especially as our recurring revenue from Intelisys grows faster than our device business. As the highest growth opportunity for our company, Intelisys remains an area of investment for the company. As a reminder, we also benefit from the fact that our Intelisys business has very low working capital requirements. In a quarter like this one with declining net sales, we expect our business to generate strong free cash flow, and it did. Our first quarter free cash flow topped $91 million. Our strong free cash flow demonstrates that our business model is working as expected. As we indicated last quarter, we expected a slower first half of fiscal year '24 with improvement in the second half of FY '24. However, we are now expecting a slower demand outlook for the remainder of our FY '24. With the softening demand expectations, we expect free cash flow to be a bright spot throughout our fiscal year. Changes in the technology distribution market and our belief in the growth opportunities ahead make this an ideal time to use our balance sheet to be disruptive in the market, both organically and through acquisitions. As in the past, we will make acquisitions where we expect higher growth and higher margins for the company. We have confidence in our business and are well positioned to take advantage of our opportunities for profitable growth. I'll now turn the call over to Steve to take you through our financial results for the quarter and outlook for fiscal year 2024.

Thanks, Mike. Our Q1 financial results reflect our transformed business model that derives more than 25% of our gross profit from our recurring revenues, including strong growth from our Intelisys business, successful execution of our working capital normalization plan, and a mixed demand across technologies in our device business. Q1 net sales of $876 million were lower than expected, while gross profit margins of 12.2% were slightly ahead of our expectations with a more favorable mix of revenue. While we expected a year-over-year revenue decline, we saw slower demand in our barcode, mobility, and point of sale technologies, with fewer large deals in the quarter. These technologies are reported in our Specialty Technology Solutions segment, which saw a revenue decline of 12% year-over-year and a 16% year-over-year decline in gross profits. In our Modern Communication & Cloud segment, revenue was equal to the strong results we posted last year, with strong networking and security sales from Cisco and 9% year-over-year growth in our Intelisys business, offsetting lower sales of communication devices. Gross profits in our MC&C segment grew 4% year-over-year and benefited from a favorable mix of Intelisys revenue. For the quarter, we delivered $91 million in free cash flow with solid progress on our multi-quarter working capital improvement plan. Inventory levels are normalizing to reflect both a return to normal supply chain lead times and our expectations of demand. Accounts receivable balances are moving with revenue as we would expect. Our Q1 free cash flow got off to a fast start as our business model is working as expected. Now going a bit deeper into the balance sheet and cash flow. We are pleased with the improvement of our working capital. Our goal is to increase our inventory turns while maintaining appropriate inventory levels to meet customer demand. You may recall, we talked about lead times during the supply chain crisis exceeding 12 months. Those days are behind us, and our suppliers have done an outstanding job returning lead times to normal, allowing us to return to more efficient inventory levels. Q1 inventory turns were 4.4x, well below the normal operating levels for our business. We expect to see improved inventory turns in Q2 given the progress we made on our ending inventory level this quarter. DSO declined slightly to 71 days, and Q1 was a strong quarter for cash collections. Our balance sheet remains strong. From a net debt leverage perspective, we ended Q1 at approximately 1.2x trailing 12-month adjusted EBITDA with ample liquidity within our existing credit facility. For the remainder of FY '24, our primary capital allocation priority is to focus on M&A opportunities to accelerate our strategic plan. Looking ahead to Q2 and the rest of our fiscal year, the company expects continued first half revenue headwinds and a slower recovery in the second half than we believed last quarter. We continue to execute on our working capital plan and expect to generate significant free cash flow in the year. We expect to manage our SG&A spend to match our revenue growth expectations for FY '24 and beyond, focusing our investments on faster-growing business areas. We are updating our annual guidance to reflect our latest expectations. For FY '24, we now believe that our revenue will be at least $3.8 billion and adjusted EBITDA to be at least $170 million. We are increasing our free cash flow estimates to at least $200 million. To help with analyst models, we expect a net expense range for interest expense, interest income, and other expenses from $11 million to $12 million for fiscal '24. Our estimated effective tax rate, excluding discrete items, is expected to range from 26.6% to 27.6% for the fiscal year. Our updated guidance reflects our expectations for near-term demand environment. We remain confident in the resilience of our business model and our ability to be well positioned for a return to growth. I'll now turn the call back over to Mike for some closing comments.

Thanks, Steve. We recently held our annual customer and supplier event for the U.S. and Canada for over 1,700 attendees in Orlando, Florida. Our theme was opportunities for growth, and we had many conversations with our customers about where they see growth in the next 12 months. We also held our customer and supplier event in Brazil, where the theme was. Our customers and suppliers from both events shared feedback on areas where ScanSource can improve and where we achieve high marks. I'm very proud of our amazing group of employees that constantly achieve excellent results with our customers. We are reminded of our success when we receive industry recognition from our suppliers. Just this week, we received the Americas Distributor of the Year Award from Cisco, which is a first for ScanSource. Our team was recognized at the Cisco Global Partner Summit for our success at recruiting and enabling sales partners and producing double-digit growth with Cisco security, networking, and software. Recent awards from additional suppliers demonstrate our leadership in the industry. We are really pleased to be recognized by customers and suppliers with Distributor of the Year Awards from Aruba, Extreme, and Zoom. We will now open it up for questions.

Our first question comes from Greg Burns with Sidoti.

Can you explain how you are guiding for roughly flat revenue, yet anticipating a 7% decline in the first quarter along with expected weakness in the second quarter? Does this suggest you are forecasting growth in the second half of the year? How do you arrive at a flat outlook for the year when starting off with a slight deficit in the first quarter?

Yes, Greg, thanks for the question. Thanks for joining us today. This is Steve. You're right. As we look at the first quarter and the first half, we still see headwinds similar to what we saw in the first quarter to go through the half. And then as we get into the second half of the year, we would see a year-over-year increase or a growth to get to our $3.8 billion. So you're thinking about it the right way.

What are you considering to drive that growth? What factors are you looking at?

We benefit from a diverse portfolio of products and technologies, which will lead to varying growth rates among our technologies in the second half, helping us to accelerate. Additionally, we experienced a setback in the fourth quarter last year due to a cyber event, making comparisons in the fourth quarter easier for us.

And then in terms of M&A priorities, like are you looking to expand on Intelisys' capabilities? Or is there a new technology segment you might be wanting to get into? Like what are your priorities or goals in terms of M&A?

Greg, it's Mike. I'll take that one. What we've talked about for the last 2 quarters is that we really see continued opportunity in our Intelisys business. We're very bullish on it. It continues to be an area that we are in investment mode. We love the recurring revenue. We love the high margins. We really believe that, that business is still in growth mode for our company, and frankly, for the industry, as suppliers look to technology services distributors like ScanSource, Intelisys to really lead the way. But we also think for us, we have an opportunity to do some disruptive things this year.

That's organically?

Both, actually. What we're trying to do is to take a look at the total supply chain from manufacturing to end user, and we've talked about this with a few of our suppliers. How do we work with our key suppliers and our customers to facilitate a more efficient channel as we look out in the future? And we really think there's a lot of friction still in the business model as it exists today, so we're being very thoughtful about where strategic acquisition opportunities are and how we can change our existing business organically. So we're in a great position to do it. We believe now is the time to take advantage of our balance sheet and the fact that we have a team of people that are anxious to do this.

Your next question comes from Adam Tindle with Raymond James.

I just want to start on margins, noticing that gross margin fairly healthy here and understand the mix dynamic. The operating or EBITDA margin was down healthily year-over-year. It sounds like, Mike, you're doing some things to address that when you talked about full year operating expenses in line with revenue. But maybe just double click on this dynamic in the quarter of gross margin versus EBITDA margin. Why that was such a delta? What drove that? And what's happening moving forward to rightsize that?

Adam, this is Steve. Let me take that one. So if you look at our SG&A for the quarter, it's really unusually high from what we were running fourth quarter and what we would expect. That's really because of about $4 million worth of unusual expenses that we saw in the quarter. So we would anticipate that, that EBITDA margin would have been closer to our kind of 4.5% excluding those items, and we don't see those going forward.

Can you expand on it? Is that like inventory write down now or something that would be one-time in nature?

Sure. Yes. We had some specific customer bad debt reserves that we took in the quarter as well as some one-time people costs.

Got it. That's helpful. I want to revisit the revenue and EBITDA guidance for the year. We're starting Q1 with a 7% decrease in revenue and over a 20% decrease in EBITDA. For the full year, we expect flat to modest growth depending on the metric analyzed. It's a challenging climb. Steve, could you provide some insights on the outlook for the year? It appears that Q2 may present similar or even tougher comparisons. Let’s ensure we have a clear understanding of the Q2 dynamics. Mike, could you discuss the growth opportunities as the year progresses? As Steve mentioned, it's a mix across segments, and any qualitative insights into the growth opportunities you foresee would be valuable in shaping our revenue expectations for the year.

Yes, thank you, Adam. Looking at the first half, we anticipate Q2 to be similar to Q1 regarding the challenges we're facing, based on feedback from our suppliers and industry contacts. As we consider the second half, it's worth noting that we've only been providing annual guidance for a few years, so we're still adapting and striving to offer accurate projections. Various technologies are growing at different paces, but we remain optimistic about strong growth for Intelisys, which we believe will be a highlight for us in the second half. Additionally, when examining growth trends for the latter half of the year, the fourth quarter presents an easier comparison and should exhibit quicker growth due to the impact of the cyber incident we experienced last year, which affected our business at that time.

Okay. Just to clarify, when you say Q2 will look like Q1, is that in dollar terms or will the year-over-year decline appear similar?

Similar in year-over-year decline. We're still seeing those same headwinds as we're going through this quarter.

And Adam, it's Mike. Regarding your other question, what we're facing right now is somewhat complex. To provide annual guidance without a significant backlog or bookings is inherently uncertain. What we aim to do is share insights from our recent customer event in Orlando, where we engaged in numerous one-on-one discussions. I was also in Miami this week with our Cisco customers discussing their growth expectations. Consistently, they mentioned that their pipelines have pretty much emptied, although the supply chain has returned to normal. We're now trying to understand what a typical technology year will look like next year, not just in the calendar sense. In alignment with the traditional ScanSource model, we experience seasonality in our Q3, which is the March quarter. We are uncertain if that seasonality will persist because Q2 is unpredictable. We're trying to assess what customers are saying and what some suppliers have publicly shared about Q1 and Q2. We've noticed that some of our barcoding and point of sale suppliers are reporting declines of around 30%, which we certainly feel within our customer base. However, we remain hopeful for a rebound in the second half of our year. We mentioned this back in August, but we now believe that growth will likely be softer than initially anticipated based on conversations with customers and the situation with supply chains. Some suppliers are indicating that their bookings are not at previous levels. We want to be clear that we are preparing for a reasonable second half, while also keeping an eye on future opportunities. We aim to ensure that our investments are positioned for the rest of calendar 2024, which corresponds to our fiscal year 2025, without sacrificing potential growth due to soft conditions in the next two quarters.

And your next question comes from the line of Michael Latimore with Northland Capital Markets.

Your comments on Intelisys seem fairly positive. Should we assume that the kind of growth rates you're seeing in CCaaS and UCaaS are sustainable for the foreseeable future?

Mike, it's Mike. Yes, we do. That business for us has continued to grow. The dollars have gotten much larger. So even as in some cases, the UCaaS growth rate is maybe less than it was a year ago, the dollars are still substantial and CCaaS has gone up dramatically. So yes, we're still seeing that happen. We still see the quarter-over-quarter growth happening and the year-over-year happening. Certain suppliers are doing better than others, and that was expected as well. There would be some leveling out last year with the winners, and we think we're in the right place. We have the right suppliers to win in this market.

Do you think Intelisys is gaining market share in those categories?

We believe we are experiencing more success than the industry's growth rates would imply. As the largest technology services distributor, we face competition from our rivals, which means we are also vying for market share. This competition can influence our growth rate, as we sometimes need to accept lower margins, a common occurrence in distribution. In some ways, our end-user billings are performing quite well, which we consider a good indicator of our overall success.

Have the lead vendors in each category changed much over the last year?

I would say they've taken more share, yes. I think there's been a shift to the lead vendors, yes. And again, what we're seeing is some of the suppliers and vendors are more willing to embrace the channel, embrace the agent community than others. And those that really go all out to make sure that the agents are profitable and have a long-term return on investment are the ones that are winning.

Yes. Can you highlight which vendors are kind of in the top group business point?

Not today, but in previous quarters in CCaaS, we've mentioned companies like Five9, Genesys, and NICE. However, we chose not to mention any specific ones this quarter. That refers to comments from earlier quarters.

Right, right. In the CCaaS world, generative AI has gotten a lot of attention. Does that flow through? Is that visible to your channel and your business? Or is that not really a driver yet?

It is likely still in the early stages, but we believe it will be a significant factor and our channel will benefit. Typically, partners prefer not to sell products that are not fully developed, but they do want to be involved in the initial stages as well. We will observe how this develops.

Can you highlight which use cases and verticals in physical security are performing well?

Yes. Over the years, we've talked about our physical securities led by our video surveillance technologies. And if you think about it, gosh, you just look around the world. Every time there's some events, there's more interest in do we have video to capture that. And so the video technologies continue to improve. You’ve got 4K cameras, you got even better cameras now, color, thermal. And then, well, for example, here in Greenville this week, we had one of our key suppliers, Axis Communications. Axis was here with their mobile experience centers. Basically, a big RV with $1 million worth of equipment demonstrating all of the capabilities of video surveillance, and Axis continues to be one of our leading suppliers. And of course, they're also talking about AI and how you can use software and identity capabilities to enhance that. And so probably the biggest vertical for us historically, Mike, is education. And kind of, again, no surprise there. You have funding from the federal government for school systems, and we have a lot of partners that are very strong in education and in physical security.

Your next question comes from Keith Housum with Northcoast Research.

Hello, Keith? We don't hear Keith. You want to go to the next caller?

Okay. One moment. I see no further questions at this time. I'll now turn the call back over to Steve Jones.

Yes. Thank you, and thank you for joining us today. We expect to hold our next conference call to discuss December 31 quarterly results on Tuesday, February 6, at approximately 10:30 Eastern Time.

This concludes today's conference call. Thank you for your participation. You may now disconnect.