Earnings Call Transcript - SCSC Q2 2020

Operator, Operator

Welcome to the ScanSource quarterly earnings conference call. All lines have been placed in a listen only mode until the question and answer session. 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, Vice President, Treasurer and Investor Relations. Ma'am, you may begin.

Mary Gentry, Vice President, Treasurer and Investor Relations

Thank you and welcome to ScanSource's earnings conference call for the quarter ended December 31st, 2019. Our call will include prepared remarks from Mike Baur, our Chairman and CEO, and Gerry Lyons, our CFO. John Eldh, our Chief Revenue Officer, is also joining us. We will review our operating results for the quarter and then take your questions. We've posted a CFO commentary that accompanies our comments and webcasts in the Investor Relations section of our website. Certain statements made on this call, including our expectations for sales, operating performance, earnings, fair value of contingent consideration, operating cash flow, tax rates, interest expense, planned divestitures, and results for the third and fourth quarters of fiscal year 2020, are forward-looking statements. These statements are subject to risks and uncertainties that could cause actual results to differ materially from such statements. These risks and uncertainties include but are not limited to those factors identified in the earnings release that we put out today and in ScanSource's Form 10-K for the year ended June 30th, 2019, as filed with the SEC. Any forward-looking statements represent our views only as of today and should not be relied upon as representing our views as of any subsequent date. ScanSource disclaims any duty to update any forward-looking statements to reflect actual results or changes in expectations except as required by law. During our call, we will discuss both GAAP and non-GAAP results and have provided reconciliations between these amounts in the CFO commentary and in our press release. These reconciliations can also be found on our website and have been filed with our form 8-K. I'll now turn the call over to Mike.

Mike Baur, Chairman and CEO

Thanks Mary, and thank you for joining us today. For the quarter, we missed our sales forecast primarily from lost sales as we reorganized our North American VAR sales team. As we discussed on prior calls, we are executing our one ScanSource strategy. The goal of our one ScanSource strategy is to increase customer value by cross-selling and growing recurring revenue. We are setting up our VAR sales teams to sell solutions, connectivity, cloud, and Software as a Service (SaaS), including offerings from our Intelisys and intY acquisitions. The strategy behind one ScanSource is to become customer-centric, provide more value, and enable growth for our customers. Beginning in April, we combined our five North American VAR business units into one. We reorganized our teams by customer segments, changed customer assignments, introduced team selling, implemented Salesforce CRM, and adopted a new sales compensation plan. With these changes in the realignment of our sales teams, we created customer disruption and negatively impacted our service levels since April. As we encountered issues, we made adjustments, and now, following this quarter's sales results, we will make more changes. During this quarter, we had another record quarter with the Intelisys sales partners. This business grew 19% year over year, with the cloud suppliers growing even faster at 68%. One of our key objectives with Intelisys has been to recruit and sell through more VARs while still growing the agent channel. To date, out of approximately 4,000 Intelisys sales partners, approximately 15% are ScanSource VARs. Over a year ago, to accelerate the growth of the VAR sales channel, we started our Ignite program to identify and recruit VARs to join the Intelisys sales community. The Ignite team is focused on the ScanSource strategic sales partners and is working with the ScanSource account executives to introduce VARs to the financial benefits of recurring revenue. We learned that VARs require education and a financial investment to participate successfully. As an example of the success so far, a long-time barcode strategic VAR recently won a multiyear contract to supply thousands of mobility devices and recurring revenue in the form of connectivity services. These services will be worth minimally $300,000 in recurring commissions each year to the VAR. The Ignite team is currently working with over 600 key accounts in the ScanSource VAR base. This gives us confidence to accelerate our efforts to integrate more closely by aligning with the one ScanSource strategy and creating a teaming approach. Now Gerry will take you through the financial results and our outlook for next quarter.

Gerry Lyons, CFO

Thanks Mike. Net sales for our second quarter declined 5% year over year, principally from lower sales volumes in North America and a higher than expected decline in our premise-based communications business. Because of the lower sales volumes, the GAAP diluted EPS and the non-GAAP diluted EPS fell below our forecasted range. In August, we announced plans to divest certain physical product businesses outside of the United States, Canada, and Brazil. These businesses had net sales of $156 million for our second quarter and, at December 31, 2019, had working capital of $167 million. A process is underway to sell these businesses, and based on the interest we have received, we anticipate having an agreement by the end of the third quarter of our fiscal year 2020. Consolidated net sales for our second quarter totaled $990 million, down 5% year over year and also down 5% on an organic basis. Foreign currency translation negatively impacted sales by approximately $7 million. Net sales for our worldwide bar coding, networking, and security segment declined 2% year over year or 0.4% on an organic basis. This reflected lower sales volumes in North America, partially offset by growth in mobile computing and our payments business. Net sales for our worldwide communications and services segment declined 12% year over year or 14% on an organic basis, primarily from significant headwinds in our premise-based communications business in North America. We also had a record quarter for Intelisys, where sales increased 19% year over year. We added $11 million of SaaS sales from the intY acquisition. Excluding the planned divestitures, non-GAAP gross profit dollars for the quarter decreased 5% year over year. Our second quarter fiscal year 2020 non-GAAP gross profit margin was 11.8%, down slightly from the year ago period of 11.9% and up from the prior period of 11.6%. SG&A expenses increased $2.2 million from the prior year quarter to $83 million for the second quarter fiscal year 2020. We made investments for our recurring revenue and services-based businesses. Our investments also include the digital capabilities we've added with the acquisitions of intY, RPM, and Canpango. Our second quarter fiscal year 2020 non-GAAP operating income was $26.6 million or 3.4% of net sales compared to $34.6 million or 4% in the prior year quarter. We have a $45 million contingent consideration liability on our December 31, 2019 balance sheet, reflecting the present value of expected future earn-out payments for the Intelisys acquisition. For second quarter fiscal year 2020, we recorded an expense for the increase in fair value of contingent consideration of $3.2 million for Intelisys. For the third quarter fiscal year 2020 forecast, we estimate the change in fair value of contingent consideration to be an expense of approximately $1.9 million. For fiscal year 2020, we estimate the effective tax rate excluding the planned divestitures to range from 25% to 26%, excluding discrete items. Now turning to the balance sheet and cash flow, we generated strong operating cash flow of $71 million for our second quarter and trailing 12-month operating cash flow of $143 million. We expect to generate positive operating cash flow during fiscal year 2020. Working capital investments declined 7% quarter over quarter and 8% year over year. The planned divestitures had approximately $167 million in working capital at December 31, 2019, down $37.5 million from the June 30, 2019 balance. With the completion of planned divestitures, we expect to use those proceeds to pay down debt. At December 31, 2019, we had cash and cash equivalents of $42 million and debt of $358 million. Our net leverage totaled approximately 2.3 times trailing 12 months of adjusted EBITDA. ROIC was 9.9 for the second quarter fiscal year 2020. Since August 2018, we have invested $81 million in our Canpango, RPM, and intY acquisitions that built strategic capabilities for recurring revenue but have not yet contributed to our EBITDA growth. Now turning to our forecast, we are providing our third quarter forecast excluding the planned divestitures. For the third quarter fiscal year 2020, we expect GAAP net sales to range from $865 million to $915 million and non-GAAP net sales excluding the planned divestitures to range from $725 million to $775 million. For the next two quarters, we are planning to see quarter-over-quarter net sales growth in line with our historical seasonal trends. Historically, sales drop 10% quarter over quarter for the March quarter and rise 10% quarter over quarter for the June quarter. For the full year fiscal year 2020, we expect annual sales growth of less than 1%. For our third quarter forecast, we expect GAAP diluted earnings per share to range from $0.16 to $0.26 per share and non-GAAP diluted earnings per share to range from $0.44 to $0.54 per share. The GAAP EPS does not include any non-cash charges from write-downs or losses associated with the planned divestitures, as those cannot be reasonably estimated at this time. For the March quarter, we expect gross profit close to 12% and a non-GAAP operating income margin below 3%. With the lower sales volume, we are not obtaining the SG&A leverage that we expected in our forecast for the year. For fiscal year 2020, we expect our non-GAAP operating margin to be a little over 3%, in line with our expected sales volumes. We are assuming approximately $3.3 million for interest expense in the third quarter, and we estimate the tax rate excluding planned divestitures to be in the range of 25% to 26% for fiscal year 2020, excluding discrete items. Now I'd like to turn the call back over to Mike for closing comments.

Mike Baur, Chairman and CEO

Thanks Gerry. We are confident that completing our one ScanSource go-to-market transformation to drive recurring revenue growth is the right strategy for our business. After we complete this transformation, we expect to be able to deliver fiscal year 2021 results that reflect our strategy, including moving ROIC above 10% and delivering double-digit non-GAAP earnings per share growth. We will now open it up for questions.

Operator, Operator

Thank you. Our first question comes from Adam Tindle with Raymond James. Your line is now open.

Madison Shaw, Analyst

Good afternoon. This is Madison on for Adam, and thanks for taking my questions. I wanted to start with some of the commentary around the North America sales reorganization and lost sales. Can you just talk about the timing, the timing of the impact for this? Are you expecting it to be a continued headwind throughout the rest of the fiscal year? And then are you seeing any customer attrition related to this, or is it just the case of missed sales to those customers?

Mike Baur, Chairman and CEO

Hey Madison, this is Mike. As we said in our prepared remarks, we started this process in April. As you heard on the call, we provided more color on all the different things we were doing since April, such as the new Salesforce CRM system, different compensation plans, and moving customers from one team to another. What we learned was that there were many moving pieces, and we didn't see the impact of that until this past quarter from a negative perspective. Now that we know what happened, and in certain cases, we have customers who said, ‘Hey, I'm not happy with the new salesperson or sales team. I want somebody different, or I'm going to go away.’ We had to make some adjustments, as we said, and in some cases, especially with customers who are not regularly buying from us, they decided to go somewhere else for now. We believe that in our forecasts for Q3, regarding what we indicated about Q4 seasonality, we should experience a normal seasonal change from December. This generally means we would decline 10% from the December quarter to the March quarter, which we are forecasting, and we expect to grow 10% from March to June. We are planning to get through this, and yes, we've lost some customers, but we believe we can regain many of them with quick changes.

Madison Shaw, Analyst

Okay. That's really helpful color. Just to follow up here on cash flow, obviously a bright spot here in the first half. I know you're sticking by the positive comments for the full year. But can you help us level set expectations for the second half on cash flow? Do you expect that the second half will be positive as well? I don't want to get ahead of ourselves from a modeling standpoint.

Gerry Lyons, CFO

Madison, this is Gerry. I think that's right. We should expect cash flow to be positive for the second half as well. We obviously have some working capital coming down, which is good. The volume coming down isn't ideal, but it drives cash flow for us. But to answer your question more directly, we do expect the second half to be positive.

Operator, Operator

Our next question comes from Keith Housum with Northcoast Research. Your line is now open.

Keith Housum, Analyst

Hey Mike, you're referring to these changes you made to the North American VARs, but you started that in April. What took so long for the ramifications to appear? Why is it three quarters to really see the impact of that?

Mike Baur, Chairman and CEO

Sure. Well, part of what we decided was to ensure we made some adjustments as we saw deficiencies or gaps in processes that weren't working well. So we made some changes along the way. We learned that in some cases those changes weren't sufficient, and customers gave us the benefit of the doubt in the June quarter. By the September quarter, they may have said, ‘Okay, you guys didn't fix this issue,’ and they were ready to go somewhere else. When we provided our forecast back in November for the December quarter, we based our views on the data we had, which was the sales results from October. That gave us confidence in November to still project the December numbers as we did. We recognize that from mid-November to the end of December is when it became obvious that there was a sales disconnect.

Keith Housum, Analyst

Okay. And that disconnect continued into the first quarter. Is that why your guidance for next quarter is five below expectations?

Mike Baur, Chairman and CEO

Well, it's probably this, Keith. It's likely we took what occurred in December, noting that any other December quarter is going to be lower in the March quarter. Thus, we are looking at December as our guide, not last year's performance. We have to forecast based on the December values, and we anticipate it's going to be less because that aligns with historical trends. We would like to perform better, and if we manage to bring customers back, it will improve our forecast.

Keith Housum, Analyst

Okay. You mentioned you have more changes to make. What gives you confidence that these changes will win back these customers?

Mike Baur, Chairman and CEO

Well, we've spoken with many of them and consulted our sales teams, and we believe these challenges were self-inflicted. We had some customers who were unhappy because their sales rep was promoted to another team for greater value creation. The disconnect with their rep is something that cannot easily be replaced. It might take an executive visit to express our value and introduce a new team. We can't bring their previous rep back, but we can introduce them to a new team member and explain how they can provide even better support. This approach will involve more traditional methods of customer relationship management. We have also structured our account teams differently, creating a larger group of account executives. This new structure gives us a better chance to re-engage these customers.

Keith Housum, Analyst

I need to squeeze one more in here, and I'm changing gears. I know we're very early into the coronavirus situation, but we're hearing concerns about supply chains and potential disruption. What are you hearing from vendors and perhaps customers in regard to supply chain impacts if things worsen?

Mike Baur, Chairman and CEO

We've sent communications to our teams to provide updates, and based on what we've heard so far, there may be minimal disruptions. Some vendors have communicated they do not have workers returning to the factory following the New Year yet, indicating there might be one or two weeks of disruption. In terms of the supply chain, we are hearing that it may be limited to one or two weeks.

Operator, Operator

Our next question comes from Chris McGinnis with Sidoti Company. Your line is now open.

Chris McGinnis, Analyst

Good afternoon. Thanks for taking my questions. I wanted to ask a little about the cloud services you're offering. You talked about one of the headwinds being an investment by VARs. Can you elaborate on what that investment is and how you're helping them overcome that hurdle?

Mike Baur, Chairman and CEO

Yeah, sure. Chris, thanks for the question. We created this Ignite team and implemented a strategy with a blueprint and playbook intended for our team to engage with the VARs' leadership, including their CFO and owner. We explain that for traditional hardware VARs to add recurring revenue, they must invest in sales personnel and processes that won't yield a return for three years. Generally, it takes about three years to see the financial benefit. Once they reach that point, they start seeing significant profits. Our team guides them to minimize their investment risk. That is what we mean by a financial investment. This isn't an easy transition, and it often takes longer than expected. However, once it starts generating revenue, it transforms their hardware business into a more highly-valued recurring revenue model, providing owners with a better exit strategy in the future. That is our message. If they want a more valuable business, this is essential, and we can support them in achieving that.

Chris McGinnis, Analyst

Thanks for that. Lastly, regarding the guidance you provided for Q2 compared to where you ended up, a lot of it was due to the Salesforce changes. Can you talk about market demand, specifically within communications? Was there an escalation in the trends you were seeing from Q1 to Q2?

Mike Baur, Chairman and CEO

Sure. We attribute about two-thirds of the miss last quarter to our Salesforce reorganization, while the remaining third reflects accelerated shifts from premise to cloud. This transition occurred faster than we had forecasted. Yes, the demand for cloud solutions continues to grow, supporting our adjustments in focus toward cloud-based services. We are actively reallocating resources from premise to cloud strategies.

Operator, Operator

Thank you. I am not showing any further questions at this time. I would now like to turn the call back over to Mike Baur for any closing remarks.

Mike Baur, Chairman and CEO

Thank you for joining us today. We expect to hold our next conference call to discuss March 31st quarterly results on Monday, May 11th, 2020.

Operator, Operator

Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect.