Stephen Sarno - Senior Vice President, Chief Financial Officer, and Treasurer Timothy McGrath - President and Chief Executive Officer.

Adam Tindle - Raymond James & Associates, Inc. William Gibson - ROTH Capital Partners Anthony Lebiedzinski - Sidoti & Company, LLC.

Good afternoon, ladies and gentlemen, and welcome to the Third Quarter 2018 Connection Earnings Conference Call. My name is Shannon, and I will be the coordinator for today. At this time, all participants are in listen-only mode. Following the prepared remarks, there will be a question and answer session.

As a reminder, this conference call is the property of Connection and may not be recorded or rebroadcasted without specific permission from the company. On the call today are Tim McGrath, President and Chief Executive Officer; and Steve Sarno, Chief Financial Officer. I’ll now turn the call over to Steve Sarno..

Thank you. I will now read our Safe Harbor statement for today’s call, which is also on Page 2 of the webcast slides being presented today as part of our call. Our slides for today’s call will also be made available in the Investor Relations section of our website after the call at www.connection.com.

Any statements or references made during the conference call that are not statements of historical fact may be deemed to be forward-looking statements.

Various remarks that management may make about the company’s future expectations, plans and prospects constitute forward-looking statements for purposes of the Safe Harbor provisions under the Private Securities Litigation Reform Act of 1995.

Actual results may differ materially from those indicated by these forward-looking statements as a result of various important factors, including those discussed in the Risk Factors section of the company’s Annual Report on Form 10-K for the year ended December 31, 2017, which is on file with the Securities and Exchange Commission as well as in other documents that the company files with the commission from time to time.

In addition, any forward-looking statements represent management’s view as of today and should not be relied upon as representing views as of any subsequent date. While the company may elect to update forward-looking statements at some point in the future, the company specifically disclaims any obligation to do so, even if estimates change.

And therefore, you should not rely on these forward-looking statements as representing views of any date subsequent to today. During this call, GAAP and non-GAAP financial measures will be discussed. A reconciliation between the two is available in today’s earnings release and on the company’s website at connection.com.

Please note that unless otherwise stated, all references to third quarter 2018 comparisons are being made against third quarter 2017. Today’s call is being webcast and will be available on Connection’s website. The earnings release along with the supplemental slides presented are also available on the website.

In addition, earlier today, we filed our Form 10-Q for the third quarter with the Securities and Exchange Commission. The Form 10-Q is available, both on the SEC website at www.sec.gov and in the Investor Relations section of our website at connection.com.

Before we begin today’s review of our Q3 operating results, I’d like to spend a few minutes to remind you of the company’s adoption of the new revenue recognition standard and how it impacts the reporting of our Q3 results.

As of January 1, 2018, we adopted the new revenue recognition standard using the modified retrospective approach as opposed to the full retrospective approach. In other words, our Q3 2018 results are stated under the new accounting standard for revenue recognition, while our prior years are stated under the prior revenue recognition standard.

In today’s earnings release, we have provided a comparison of our Q3 2018 results between the current and prior revenue recognition standards.

The main impact of adopting the new standard the Connection was that Q3 revenue, as reported under the new revenue recognition standard, was $107.8 million less than we would have reported under that prior revenue recognition standard.

$103.3 million of this impact related to treating certain software arrangements, such as security, cloud-based licenses and maintenance on a net revenue recognition basis. This is in addition to $4.5 million related to the timing of bill-and-hold transactions.

In reviewing our financial results today, we will be referencing the term, as presented, which reflects the implementation of the new revenue recognition standard, as well as amounts prior to the impact of the new standard to allow for comparability against historical results.

We plan to provide this comparative information for our earnings releases and conference calls in the next quarter as well. I’ll now turn the call over to Tim to provide some color on our Q3 operating results.

Tim?.

Thanks, Steve. July and August results were in line with our expectations and our forecast. However, towards the end of September, we experienced some customer delays along with some supplier constraints in the small to medium business space.

In addition, our healthcare vertical and our federal component of our public sector solutions segment performed at lower levels than expected. In the quarter, we saw a significant increase in cloud and security software. Consistent with this trend, we’re seeing a greater number of project-based roll outs across all three of our sales subsidiaries.

These project roll outs are a testament to our ability to help our customers improve their productivity, make them more secure and enhance their growth. These project roll outs ebb and flow for various reasons and in Q3 created some variability in our results.

However, we’re gaining market share, acquiring new customers and transforming our business, while we focus on improving operational efficiencies. Moving to Slide 3. Net sales, as presented, for the three months ended September 30, 2018 were $658.5 million.

Net sales prior to the impact of the new revenue recognition standard increased by 5.1% to $766.3 million, compared to $729.2 million in Q3 a year ago. Moving to Slide 4. Gross profit, as presented, increased by 4.5% to $100.4 million, compared to $96.1 million a year ago.

Gross margin, as presented, was 15.3%, compared to 13.2% in the prior year quarter. Moving to Slide 5 for a more detailed discussion of our performance by segment. In our Business Solutions group, Q3 net sales, as presented, was $244.9 million.

Prior to the impact of the new revenue standard, net sales were $294.2 million, representing an increase of 1.3%, compared to $290.6 million a year ago. Gross margin, as presented, for this segment increased by 327 basis points to 18.2% in the quarter, which represents our highest margin on record for this segment.

Our Business Solutions segment had strong growth in cloud and security software, net/com hardware and services. We’re selling across the solution stack and seeing robust growth in advanced technologies. In addition, we had strong growth in the finance and manufacturing vertical markets.

In Public Sector solutions business, Q3 net sales, as presented, were $148.2 million. Prior to the new standard, sales were $168.5 million, representing a decrease of $2.1 million, compared to $170.6 million a year ago. Gross margin, as presented, for this segment increased by 118 basis points to 12.1%.

The decline in our federal business was partially offset by very strong growth in state, local and education. The growth in sled was fueled by growth in Net/com and mobility products. In our Enterprise Solutions segment, Q3 net sales, as presented, were $265.5 million.

Prior to the new standard, sales were $303.6 million, an increase of 13.3%, compared to $268 million a year ago. Gross margin, as presented, for this segment increased by 156 basis points to 14.3%. The Enterprise segment continue to benefit from large project refreshes, many of which have been in the retail space.

This combination drove strong growth in mobility, net/com products and server/storage products, which as presented grew during the quarter at 26%, 13% and 12%, respectively. In addition, we continue to benefit from Windows 10, cloud and security migrations. Customers in these markets realize that technology enables competitive advantage.

Having covered our sales and gross margin performance, I will now turn the call over to Steve to discuss additional financial highlights from our income statement, balance sheet and cash flow statement.

Steve?.

Thanks, Jim. For those following along on our webcast slides, we’re on Page 6 of the presentation. SG&A, as presented, increased this quarter to $81.5 million and 12.4% of net sales from $74.4 million and 10.2% of net sales a year ago. Under the prior revenue standard, our SG&A expense as a percentage of revenue would have been 10.6%.

This increase in our percentage of SG&A, as presented, was primarily due to the new revenue recognition standard, which added 174 basis points. In addition, over the last four quarters, we have been investing in our solutions sales capabilities with an emphasis on cloud and data center solutions.

In Q4, we will be focused on operational efficiencies and reducing investments in non-strategic areas. Our operating income, as presented, decreased this quarter to $19 million from $21.7 million a year ago. Under the prior revenue recognition standard, our operating income would have been $19.2 million.

Our effective tax rate was 27.8%, down from 39.6% in the same period a year ago as a result of the Tax Cut and Jobs Act, which became effective for Connection in Q1 of this year. The impact of the act was a decrease in our federal tax rate from approximately 35% to 21%.

This decrease in the federal tax rate was partially offset by an average state rate that rose from 5% to 6.5% due to changes in individual state income apportionment. We expect our rate for the year to be in the range of 27% to 29%. The lower tax rate contributed approximately $2.3 million, or $0.08 per share during Q3 of 2018.

Net income, as presented, for the quarter increased 5% to $13.8 million from $13.1 million a year ago. Prior to the impact of the new accounting standard, net income would have increased 6.2% to $13.9 million. Earnings per basic and diluted share, as presented, increased 6% and 4% to $0.52 and $0.51, respectably, compared to $0.49 a year ago.

Prior to the impact of the new accounting standard, earnings per basic and diluted share would have increased 6% to $0.52. Moving to Slide 7 of today’s presentation, earnings before income taxes, depreciation and amortization or EBITDA, as presented. Our trailing 12-month adjusted EBITDA increased 7% to $99.1 million from $92.4 million a year ago.

Prior to the impact of the new revenue standard, our trailing 12-month adjusted EBITDA would have increased 8% to $99.9 million. Turning to the balance sheet on Slide 8. We ended Q3 with $102.2 million of cash and cash equivalents, representing an increase of $52.3 million from December 31, 2017.

Cash flow from operations, shown on Slide 9, generated $81.3 million of cash versus $28.4 million for the same period a year ago, representing an increase of $52.9 million in cash generated.

Investing activities of $15.6 million for the nine months of 2018 were primarily the result of equipment purchases and capitalization of our system upgrade that’s currently in progress.

Our financing activities during the first nine months of 2018 used $13.4 million of cash, which was due to the Q1 payment of $9.1 million for our previously declared special dividend and $4.4 million of cash used to buy back 169,000 shares of our common stock at an average price of $25.87 per share under our previously authorized stock repurchase plans.

Please note on Slide 10 that as of September 30, 2018, we have $13.4 million remaining for stock repurchases under our existing stock repurchase programs. Moving to accounts receivable. Our days sales outstanding, or DSO, increased from 43 days a year ago to 50 days at the end of Q3.

The entire 7-day increase is due to the impact of the new revenue standard, which resulted in the use of a lower net sales denominator in our DSO calculation. Moving to capitalized expenditures. During Q3, we capitalized $4.1 million, which was mainly due to our ERP system upgrade that is currently in progress.

We expect our spend, both capitalizable and expensable remaining for this project to be in the range of $8 million to $9 million over the next nine to 12 months. I will now turn the call back over to Tim to discuss current market trends..

Thanks, Steve. Demand for IT products and solutions continue to evolve as customers are using technology to transform and secure their businesses. It’s good to see continued growth and execution in the retail, manufacturing and financial vertical markets. I’m also pleased with the growth and execution in our enterprise and SLED businesses.

We remain focused on helping our customers drive their success with improved technology solutions. Our goal is to go faster than the market by taking market share in this evolving IT environment. Customer success is measured in many ways and enabled by advanced technologies.

We’ll continue to invest in complex areas of our business in order to help our customers improve productivity, enhancing growth and empower innovation. Our software business continues to grow, including cloud, virtualization and security. In addition, we’re seeing strong growth in mobility, servers, storage and net/com.

We were also pleased with our strong operating cash flows. Our goal is to maximize shareholder value, while maintaining financial flexibility, which allows us to continue to assess M&A opportunities and other capital allocations such as dividends and stock buybacks.

We remain focused on gross margin improvements, operating expense management and our strategic plan to help our customers solve their business challenges with technology solutions. We’ll now entertain your questions.

Operator?.

Thank you. [Operator Instructions] Our first question comes from Adam Tindle with Raymond James. Your line is open..

Okay. Thanks and good afternoon. Tim, I just wanted to start just kind of from the ground up listening to your sales reps and vendor commentary.

Could you just maybe talk about what you’re hearing on the overall demand environment moving forward? Are you seeing any indications of moderation in growth, where the customer budgets and IT growth look like in 2019, is what you’re hearing from sales reps and vendor commentary would be helpful?.

Oh, thanks, Adam. I think slightly different for each subsidiary. But overall, as we mentioned on the call, we are seeing a transformation happen in the business. We are seeing the business sort of gravitate toward project roll out or solution-based roll out. And as I mentioned, those can ebb and flow.

With that said, we’re seeing really good growth in cloud and security. And as you know, when you’re involved in those type of upgrades, you’re also looking at several other components to enable that transformation. So I think, that’s a trend that continues to happen. We are seeing more customers look towards project roll outs.

And with those upgrades, they’re looking more than ever before to drive their return on investment or their improvements in productivity. So we don’t see demand slowing down.

But we do note in the macroeconomic environment, there are still some challenges and some questions out there like the – sort of like everybody else in our environment, we’re not really sure what effect the tariffs may have on us. They haven’t – they’ve had a minimal effect to date and nothing significant in Q4 either.

The – some of the jitters that have happened with Wall Street may have a slight effect, but again, nothing significant. So enterprise – to sum it up, enterprise will be very strong, has a full funnel and we’re very confident in Q4 and beyond.

We did see SMB, the Business Solutions moderating a little bit, but we’re still pretty confident there that this will continue to perform. And then with Public Sector, we see good growth in sled, but we are cautious on Fed.

As you know, the federal government is cutting their budgets under the Trump administration, so we’ll see a slight pullback there. So, we’re on to Q4. We’re confident in where we’re headed and we don’t see anything major out in front of us..

Okay, that’s helpful.

And as the business shifts more towards the solutions and stuff like that, you – would we expect to see gross margin change, or would we kind of maintain at this mid-15% level, or should it move up as we move more towards the solutions area?.

So it’s a great question. I think that likely, we’ll maintain. These large projects tend to be planned months in advance and they tend to be fairly competitive. We do kind of beat them out. But I’m going to ask Steve to give us kind of a quick review on our gross margin by segment..

Adam, on this, it also depends – we’re seeing a good growth in enterprise, which has a slightly lower gross margins than what we have in the Business Solutions group. And then I think, we’ve seen a little bit more challenge in the public sector space.

So, depending on what mix we see not only amongst product, but also amongst the segments can influence it slightly..

Understood. Okay, thank you very much..

Thank you..

Thank you. Our next question comes from William Gibson with ROTH Capital Partners. Your line is open..

Thank you. Tim. you mentioned you’re still taking share in these complex areas.

Is that mainly from the small regional competitors, or are you getting anything from the big guys as well?.

I think mainly, it is the small competitors. You do have to look by segment. Our enterprise team grew it over 13% in the quarter. And that segment, I think, we are more head-to-head with the larger players in our industry. But across the Board, clearly, we’re taking share growing faster than the IT market and a lot of that is from the smaller bars..

Okay, thank you. And I know you mentioned you remain positive on the SMB segment.

But is there a little more color there as to – do you think there are something just due to the environment that could be changing for smaller companies?.

No, I really don’t, because as you know, technology does help to drive competitive advantage and many companies are looking to us for help with that. And in particular, what we saw happening in our Business Solutions, or SMB group during the quarter, as we mentioned, strong July and August.

And then towards the end of September, we saw some orders push. But if we look into a detailed analysis on those orders, the majority of them will be recaptured in Q4. And based on the environment and the complexity of project roll outs, we don’t know what will happen in the end of Q4. But we do not see a real pullback happening.

We think that business will maintain..

Thank you..

Thank you..

Thank you. Our next question comes from Anthony Lebiedzinski with Sidoti & Company. Your line is open..

Yes. Good afternoon, and thank you for taking the questions. So in your October 18th press release, you guys talked about supply shortages, as well as the timing of shipments affecting your third quarter performance.

Can you guys perhaps quantify the impact of those two and whether the – and what’s the situation now as far as the supply shortages and as far – and also as far as the timing of shipments? Has that already transferred over to Q4?.

Well, thanks. This is Tim. I’ll start that and Steve, you can help out. But in Q3 specifically, we did see some product constraint. It was really limited to just a couple of million dollars. It was in the net/com space, and it caused us to hold up some projects.

We do think that has resolved itself and we do not think that that will be an issue going forward. So it really was networking that held up a large project, but that has resolved itself. And we’re not hearing too much more about supply shortages.

Steve, did I miss anything?.

No, I would just add that – two pieces to the – a couple of pieces to that. One is, yes, it was a couple million worth of networking product, and I can confirm that, that did ship within Q4 and we have not seen any significant shortages to date in Q4.

I think this was something that just happened to happen and hit us right at the end of the quarter, of course. And then, in regards to, I think, the other part of your question was, in regards to the delays that we experienced, we have seen a portion of that already shipped within Q4 and then there was a small piece that moved to Q1.

Everything else is expected to go in Q4 and none of it has gone away..

Got it. Okay, well, thanks for that.

And also, I know it’s still early in the fourth quarter, but could you guys perhaps give some guidance, or how we should think about the impact of 606 on Q4 sales?.

Sure. So, predicting the impact of 606 is very much due to whatever the mix is, particularly on software, that’s cloud-based and security-based, as well as maintenance. So, obviously, we had some difficulty predicting that within Q3.

And I think like others we – we’re actually – we saw a lot of movement more than we expected to the cloud and to security products. We actually think that that’s good news. But I think, we’ve kind of started to look at this from more of a gross profit perspective, which is not as susceptible to 606, no material difference is there.

And we do see growth in gross profit for the fourth quarter..

Got it. Okay.

Well, you only have one more quarter to go through the 606 noise?.

[indiscernible] than we are..

Right. Okay. And then kind of wrapping up. So, you ended the quarter with over $100 million of cash.

You didn’t buy back any stock in the quarter, kind of like when you’re looking at capital allocation, are you guys thinking about that going forward?.

Thanks, Anthony. So, as you know, we’re a powder dry. So we are always looking at possible opportunities out in the marketplace. But we have – we are clearly looking at – and we’ll evaluate share buybacks, as well as dividends. So I’d say, all options are in play. But at the end of the day, assessing dividends and buybacks are clearly on our agenda..

All right. Thank you..

Thank you..

Thank you. And I’m currently showing no further questions at this time. I’d like to turn the call back over to Tim McGrath for closing remarks..

Well, thank you, operator. I’d like to thank all of our customers, vendor partners and shareholders for their continued support and our dedicated coworkers for their efforts. I’d like – also like to thank all of those – excuse me, I’d like to thank those of you who are listening to our call this afternoon.

Your time and interest in Connection are appreciated. Have a great evening..

Ladies and gentlemen, this concludes today’s conference. Thanks for your participation. Have a wonderful day..