Earnings Call Transcript - SCSC Q4 2023

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. I would now like to turn the call over to Mary Gentry, Senior Vice President, Treasurer, and Investor Relations. Ma'am, you may begin.

Mary Gentry, Senior Vice President, Treasurer, and Investor Relations

Good morning, and thank you for joining us. Joining me on the call today are Mike Baur, our Chairman and CEO, John Eldh, our President, and Steve Jones, our Chief Financial Officer. We will review our operating results for the quarter and for the fiscal year and then take your questions. We posted an earnings infographic that accompanies our comments and webcast in the Investor Relations section of our website. Let me remind you that certain statements in our press release, and the earnings infographic, and on this call 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 those factors identified in the earnings release we put out today and in ScanSource's Form 10-K for the year ended June 30, 2023, 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 earnings infographic and in our press release. These reconciliations can be found on our website and have been filed with our Form 8-K today. I'll now turn the call over to Mike.

Mike Baur, Chairman and CEO

Thanks, Mary, and thanks to everyone for joining us today. Our business is built on relationships, and we recently confirmed the value of the trust we have with our customers, suppliers, and employees developed over 30 years. As you know, on May 14th, we discovered that ScanSource was subject to a cyberattack that had a broad impact on the company. Thanks to the amazing work of our employees, working together with external cybersecurity experts, ScanSource's core systems were restored, and operations resumed on May 26. I am very proud of the exceptional teamwork and customer service our employees displayed throughout the cyberattack and system restoration. For fiscal year 2023, we delivered 7% annual net sales growth, exceeding our full year 2023 outlook. We had a record adjusted EBITDA of $180 million and a 4.75% adjusted EBITDA margin. Looking back on fiscal year 2023, we are very pleased with the progress we've made with our mid-term three to four-year goals that we introduced a year ago. Our mid-term goals, our net sales growth per year of 5% to 7.5%, adjusted EBITDA margin of 4.5% to 5%, mid-teens adjusted ROIC, and building recurring revenue as a percentage of gross profit to 30%. Despite recent weakness in some of our technology markets, our business remains healthy with revenues and profits growing. The ScanSource diversified portfolio of products and services is our strategy for long-term growth in the specialized technology markets we have chosen. These highly specialized markets reward the company, not only with revenue growth but also with higher profit margins because of our focus. ScanSource wins market share with deep knowledge from our sales teams, specific value-added tools and services, and a working capital strategy that flexes based on specific suppliers and customer requirements. As we enter fiscal year 2024, strong free cash flow and focus on Intelisys are keys for our success. Now that the supply chain challenges are behind us, we expect our normal business model that balances days on hand of inventory and days sales outstanding with gross margins to return. With the support of our key suppliers and customers, we are executing a multi-quarter working capital improvement plan focusing on reducing inventory levels. I will now turn the call over to John to discuss our business performance.

John Eldh, President

Thanks, Mike. Our Q4 results demonstrate the resilience of ScanSource's business amidst the significant disruption generated by a cyberattack. It was rewarding to see the execution and great work by our team in collaboration with our customers and suppliers. The Intelisys business continued to function as normal throughout Q4 as the cyberattack had no impact on our Intelisys customers and suppliers. Because of the cyberattack, we were unable to use our core systems to accept orders, receive inventory, or ship products for two weeks in May. Our customers and suppliers were appreciative of our consistent and continuous outreach and collaboration during this outage. Our teams worked hard to minimize the impact of our outage on our customers. While working capital results were disappointing for Q4, we're not achieving the appropriate inventory days on hand commensurate with expected slower growth. We are working with our suppliers and customers to reduce our inventory levels quickly and get back to normal, based on supplier-specific return on working capital metrics. Our goal is to better align profitability and inventory turn metrics. Our employees across the company are laser-focused on improving our return on working capital and ROIC metrics for fiscal '24. Now, turning to our segments. In our Specialty Technology Solutions segment, Q4 net sales decreased 3% year-over-year, and gross profit decreased 5%. Record sales in networking and physical security partially offset a slowdown in mobility, point-of-sale, and barcoding. Plus, this segment was the most impacted by the cyberattack. We are seeing slowing market demand and enterprise project delays in mobile computing and point-of-sale. We continue to see strong demand and growth in networking and video surveillance, fueled by more intelligent technologies. As we head into fiscal 2024, we expect sales growth to accelerate throughout the year, down slightly in the first half, and then return to growth in the second half. Moving onto our Modern Communications & Cloud segment. Q4 net sales and gross profit increased 1% year-over-year, strength in networking offset lower sales volumes in communication hardware as businesses shift to the cloud. We had double-digit growth in Cisco sales led by networking products, federal, and network security. Intelisys continues to be the leader in the agency space. Q4 end-user billings increased 8% year-over-year and now are $2.47 billion annualized. Q4 Intelisys net sales also increased 8% year-over-year. We're well-positioned for growth with our cloud offerings, including UCaaS and CCaaS. As part of our Intelisys business, UCaaS billings grew 13% year-over-year, and our CCaaS business billings grew 20% year-over-year. We are winning with customers in the mid-market and SMB space. We see this manifesting in awards from top suppliers, like RingCentral, 8x8, NICE, and Genesys for driving more new business than our competitors. We're also excited about driving new growth as the leader in customer experience. We help our customers close deals through investments we've made in a dedicated customer experience team. Our consistent execution as a trusted partner enabled us to navigate through the Q4 cyberattack. I want to extend a heartfelt thank you to our people, customers, and suppliers for their patience, understanding, and offers to help us during the challenges of the quarter. This collaborative spirit makes a tremendous difference for our shared success. Now, I'll turn the call over to Steve, who will take you through our financial results.

Steve Jones, Chief Financial Officer

Thanks, John. Our Q4 financial results were negatively impacted by the mid-quarter cyberattack. However, Q4 net sales of $947 million exceeded our expectations, demonstrating the resilience of our business, the momentum we had in the quarter, and our position as a trusted partner. Last quarter, we communicated that we expected to generate positive operating cash flow for the quarter and the full year. Our Q4 timing was off, and we missed our working capital and cash flow goals. As you heard earlier, we are focused on inventory reduction and free cash flow for FY '24. Q4 adjusted EBITDA of $40.2 million increased 4% year-over-year. For the full year, sales increased 7% year-over-year, exceeding our guidance. Adjusted EBITDA of $180 million, up 8% year-over-year, was an all-time company record. Full year non-GAAP EPS of $3.85 is a decrease year-over-year of 3%. While our operating income grew 11% year-over-year, higher interest expense, driven by higher working capital levels and rising interest rates, offset the operating profit performance. We ended FY '23 with recurring revenues comprising 24% of the company's total consolidated gross profits. As we look to FY '24, we expect our business model to work as it has in the past, appropriately reducing the working capital to achieve our profitability and return on invested capital goals, while still meeting our customer demand. As John mentioned in his comments, our teams are working hard supplier by supplier to course correct our inventory positions. This focus by management on improving our working capital efficiency will allow us to generate significant free cash in FY '24. Now, turning to the balance sheet and cash flow. Q4 inventory turns improved quarter-over-quarter to 4.4 times, but are well below our normal operating levels and our targeted levels for the quarter. Days sales outstanding grew to 72 days and our accounts receivable balance grew quarter-over-quarter faster than revenues. As John stated earlier, employees across the company are very focused on improving these metrics over the next few quarters. Our balance sheet remains strong. From a net debt level perspective, we ended Q4 at approximately 1.6 times trailing 12 months adjusted EBITDA. During the June quarter, we had approximately $5 million in share repurchases and have an outstanding authorization with approximately $66 million remaining. Looking ahead to FY '24, the company expects modest revenue growth, reduced working capital, and significant positive free cash flow. Based on inputs from suppliers and customers, we are forecasting market headwinds in the first half of our fiscal year and expect first half revenues to be down slightly year-over-year. We're projecting better market conditions in the second half, supporting our full year growth outlook of at least 3%. We're projecting SG&A expenses to be flat to slightly up year-over-year as we prepare for growth to return in the second half. Adjusted EBITDA for FY '24 is forecasted to be at least $180 million and represents a 4.6% adjusted EBITDA margin. With our supply chain normalizing, we'll be focused on operating the business at more historic working capital levels. Operating cash will also benefit from the countercyclical nature of our business model and growth in our recurring revenue, which requires almost no working capital. Historically, when we grow in mid-single digits, we generate operating cash, and that, along with inventory efficiency improvements, will drive at least $150 million in free cash flow and lower our interest expense for the full fiscal year. For FY '24, our capital allocation priorities will focus on M&A opportunities to accelerate our strategic plan and also on share repurchases. We'll now open it up for questions.

Operator, Operator

Thank you. At this time, we'll conduct a question-and-answer session. One moment for our next question. Our first question comes from Greg Burns with Sidoti. Your line is open.

Greg Burns, Analyst

Good morning. Would you be able to quantify the impact of the cyberattack on revenue and earnings in the quarter?

Steve Jones, Chief Financial Officer

Hi, Greg. Thanks for the question, and thanks for joining us today. This is Steve. I'll be honest, Greg, we're still trying to sort through what the impact is for the quarter. We haven't completely quantified it yet, and we'll be able to do that in the future, as we're working through the details of the impact on our company.

Greg Burns, Analyst

Okay. Great. And then you mentioned, I guess with the working capital and free cash flow improvements, that's going to be coming down. Could you just give us your expectations for net interest expense for the year for fiscal '24?

Steve Jones, Chief Financial Officer

Greg, when we look at our net interest expense, we think that's going to be somewhere in the $5 million to $6 million range, as we look at it right now.

Greg Burns, Analyst

Okay. Last quarter, you mentioned some pricing pressure in the Intelisys division. It seems like billings and revenue grew in line this quarter, so it hasn't changed significantly. Could you provide an update on the market conditions for Intelisys?

John Eldh, President

Hey, Greg. This is John Eldh. Thanks for the question. As you heard, we had 8% growth in our billings, and also in Q4, 8% year-over-year growth in net sales. And while we did still see some continued downside pressure, it wasn't of any kind of significance for the quarter.

Greg Burns, Analyst

Okay. Thank you.

Operator, Operator

One moment for our next question. Our next question comes from Keith Housum with Northcoast Research. Your line is open.

Keith Housum, Analyst

Good morning, guys, and congratulations on working through the quarter. I think, better than a lot of us expected, you guys had a lot of things thrown at you during the quarter. Just trying to reconcile your guidance here, which is apparently obviously better than a lot of your largest vendors, and I'm guessing a lot of that has to do with the fact that you guys have a little more diversification, but also the focus on the SMBs. But can you perhaps elaborate a little bit more on what you're seeing for the first half of the year, which gives you, I guess, the guidance of perhaps slightly down for the first half?

John Eldh, President

Yeah, Keith. Good morning, and thanks for your question. Yeah, just to reiterate, as we discussed, we see that the first half is probably flat to down a little bit, and then we'll see growth coming back in the second half, and that's driven, in large part in the first half, due to a slowdown in the barcoding and POS and mobility segment, which we believe will also begin to rebound as we turn the corner into our second half. At the same time, we believe we will still see positive strength across our security, physical security, and networking segments.

Keith Housum, Analyst

Great. And John, coming from conversations that you're having with the end customers, your vendors, I guess, what's the source of, I guess, your confidence there?

John Eldh, President

Well, as you know, we're in kind of continuous contact with our partner community that's in touch with the end customer and also the supplier community. So we triangulate across the three of us.

Keith Housum, Analyst

Great. In physical security and networking, strong points for the quarter. I understand that you're probably working through a significant amount of backlog, at least some of your vendors were, in terms of the networking equipment, especially. Is that backlog continuing to be a tailwind for you guys going into next year?

John Eldh, President

Yeah. As we look to the supply chain overall, we see that we are back to pre-COVID and pre-supply chain lead times. There is some slight pressure still in networking, but for the most part, we are moving forward with the supply chain lead times back to normal.

Keith Housum, Analyst

Got you. Just one more question for me, and I'll turn it back over to the queue. In terms of M&A, it's an area that you guys haven't been that active in the market over the past several years. I guess, how would you guys rank the use of capital now in terms of your prioritization between M&A, investing back in the business, and share repurchases?

Mike Baur, Chairman and CEO

Hey, Keith. It's Mike. I'll respond to that. Our strategy involves ongoing investment in areas where we believe ScanSource can stand out. We think the markets we operate in are very specialized, and while we remain the leader, we also recognize the need to explore ways to enhance our growth potential. In the past, we pursued acquisitions primarily for geographic expansion and technology advancement. Moving forward, we've discussed, over the past three years, the possibility of smaller tuck-in acquisitions, partly because we were managing our balance sheet. However, during COVID, our balance sheet became impacted due to supply chain challenges and inventory issues. As our balance sheet improves, we now have the opportunity to consider more significant acquisitions that could help accelerate our growth and align with our strategic plan, and we would prefer to act on this sooner rather than later.

Keith Housum, Analyst

Great. Thanks, guys. Good luck.

Mike Baur, Chairman and CEO

Thank you.

Steve Jones, Chief Financial Officer

Thank you.

Operator, Operator

One moment for our next question. Our next question comes from Jake Norrison with Raymond James. Your line is open.

Jake Norrison, Analyst

Thanks for taking my question. A two-parter from me. Firstly, I'm hoping you guys could double-click on the guidance and what that embeds in terms of Intelisys performance. And then if you could double-click on the sort of pricing strategy around Intelisys, and if you could provide more color on if you are still pricing for market share gains and what should we expect there for fiscal '24?

John Eldh, President

Yeah, Jake. Thanks for the question. When we look at Intelisys for FY '24, we are expecting a 7% growth rate on that business.

Jake Norrison, Analyst

Okay. Perfect. And then if you guys could just provide color on the sort of mix of larger and smaller deals in the quarter and if that had any impact on margin? Thank you.

John Eldh, President

Yeah, Jake. We saw a slowdown of our larger deals in the quarter, but we actually saw a positive bounce-back of our run-rate business in the quarter.

Operator, Operator

Thank you. One moment for our next question. And we have a follow-up from the line of Greg Burns with Sidoti. Your line is open.

Greg Burns, Analyst

I just wanted to ask about the Logitech relationship that you, I guess, entered into this quarter or recently. How does that typically work when you add a new vendor to your line card? Does it take a while for that to ramp up? Do you expect that to be meaningful to your 2024 revenues? Thanks.

John Eldh, President

Yeah, Greg. Thanks for the question. We are very excited about the addition of Logitech to our portfolio. It's going to be a great fit for us in the collaboration space and communications. And it'll ramp over time, but we're expecting a positive contribution throughout the year.

Steve Jones, Chief Financial Officer

Hey, Greg. This is Steve Jones. I wanted to clarify something. When you asked about net interest expense, were you referring to interest expense minus the interest income we would have when we reconcile, or were you asking about it in relation to our EBITDA?

Greg Burns, Analyst

Interest expense less income.

Steve Jones, Chief Financial Officer

Okay. Let me just clarify. So that'll be around $9 million to $10 million, not the $5 million to $6 million.

Greg Burns, Analyst

Okay. Yeah, that makes more sense. Thank you.

Operator, Operator

One moment for our next question. And we have a follow-up from the line of Keith Housum with Northcoast Research. Your line is open.

Keith Housum, Analyst

Just one more question for you guys. I mean, working capital, perhaps, Steve, you can walk us through, I guess, the challenges in working down your working capital. I got to believe that accounts receivable is easier to work down than inventory. But maybe you can walk us through some of the challenges in doing that over the next few months or quarters and how should we think about it going throughout the year?

Steve Jones, Chief Financial Officer

Yeah, Keith. This is Steve. Let me explain the difference between inventory and accounts receivable. It's more challenging to change accounts receivable under certain conditions with customers. When we examine our accounts receivable year-over-year and consider the business growth, we believe we're in a good position, and our accounts receivable is healthy. We plan to make some improvements in our days sales outstanding, but our primary focus is on inventory levels. If you look at our current inventory levels, especially with the anticipated slowdown in the first half of the year, our teams will be working with suppliers to reset and correct our inventory as we move from the previous disruptions in the supply chain to a more normalized flow of inventory to meet demand.

Keith Housum, Analyst

Great. Just one follow-up to that. Do you guys have the ability to send inventory back to your vendors or is it just a matter of slowing down your purchases, as you sell a lot more?

Steve Jones, Chief Financial Officer

We can adjust our inventory to keep it fresh, but the main focus will be aligning our orders with future demand and allowing that inventory to move out of our warehouse.

Keith Housum, Analyst

Okay. Thank you.

Mike Baur, Chairman and CEO

Hey, Keith. It's Mike. To add a bit more detail to the earlier discussion, we've maintained a close relationship with our suppliers regarding the ideal inventory levels needed to meet demand. We have typically been open to carrying a bit more inventory than the market needed, but our current levels are unprecedented due to the distorted lead times from the supply chain crisis, which is now over. We believe our suppliers will understand the need to align our lead times and inventory levels with actual demand. This shouldn't catch them off guard, and we can adjust this more quickly than we can with accounts receivable, as Steve mentioned. The current inventory levels are unsustainable for our suppliers, who prefer not to have excess inventory in the channel, as it can become outdated. If a product is deemed discontinued, we have the right to return those products, which suppliers want to avoid because unsold inventory can go bad, similar to bananas. Our goal is to collaborate with our suppliers to determine the optimal inventory levels.

Keith Housum, Analyst

Great. Thank you.

Mike Baur, Chairman and CEO

You bet.

Operator, Operator

Thank you. I'm showing no further questions at this time. I would like to turn it back to Steve Jones for closing remarks.

Steve Jones, Chief Financial Officer

Yeah. Thank you for joining us today. We expect to hold our next conference call to discuss September 30 quarterly results on Thursday, November 9th at approximately 10:30 AM.

Operator, Operator

Thank you for your participation in today's conference. This does conclude the program. You may now disconnect.