Mary Gentry - VP, Treasurer and IR Mike Baur - CEO Gerry Lyons - Interim-CFO.

Keith Housum - Northcoast Research Adam Tindle - Raymond James Chris McGinnis - Sidoti & Company Andrew Spinola - Wells Fargo.

Welcome to the ScanSource Quarterly Earnings Conference Call. [Operator Instructions] I would now like to turn the call over to Mary Gentry, Vice President, Treasurer and Investor Relations. Ma'am, you may begin..

Thank you, and welcome to ScanSource's earnings conference call for the quarter ended December 31, 2016. With me today are Mike Baur, our CEO and Gerry Lyons, our Interim-CFO. We will review our operating results for the quarter and then take your questions.

A slide presentation that accompanies our comments and webcast is posted in the Investor Relations section of our website. Certain statements made on this call, including our expectations for the third quarter and full year will be 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 10-K and 10-Q 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.

We will be discussing both GAAP and non-GAAP results during our call and have provided reconciliations between these amounts in our slide presentation and in our press release. These reconciliations also be found on our website and have been filed with our Form 8-K. Mike Baur will now begin our discussion with an overview of our results..

Thanks, Mary, and thank you for joining us today. We delivered stronger than expected bottom line results in the second quarter. GAAP diluted EPS of $0.91 and non-GAAP diluted EPS of $0.75 exceeded the upper end of our forecast. Higher gross margins in both segments contributed to our EPS upside.

Net sales of $905 million fell below our forecast range primarily in our worldwide barcode networking and security segment. We missed our sales forecast for two main reasons, first, a couple of anticipated big deal for ScanSource KBZ were delayed, and second, we had unusual supply constraints in multiple geographies.

However, our outlook midpoint for the third quarter reflects a return to year-over-year organic sales growth for both segments. We are under 10.9% gross margin in the second quarter which includes the first full quarter of Intelisys results. Excluding Intelisys, the gross margin blended to above 10% from an increased mix of higher margin sales.

Our Intelisys business unit is doing very well and it's an excellent example of our strategic plan to invest in high margin recurring revenue opportunities. Intelisys achieved record net sales for the quarter growing more than 20% over the prior-year.

Importantly, our team sees exciting channel growth opportunities ahead from our telecommunications cable and cloud services providers and we are continuing to invest in resources for this business. In January Avaya filed voluntary petitions under Chapter 11 of the U.S.

bankruptcy code restructures balance sheet to better position the company for the future. We are committed to supporting Avaya and our partners in this business as usual. We have seen no disruption in our support and resources from Avaya. Now let me talk about key opportunities for growth for 2017.

They include the following; first, we expect growth in our physical security business from market growth in video surveillance and the expansion of our online card, second, we plan for growth in our Cisco collaboration business and also our ZCare offering, and third, ScanSource Communications is executing a strategy to recruit and support bars currently buying from our vendors direct.

As we indicated last quarter, our strategic plan for the full-year fiscal 2017 shows strong growth and adjusted EBITDA compared to fiscal 2016 leading to an improved ROIC for full-year fiscal 2017. For the second quarter we delivered a 13.8% return on invested capital with improved margins and sequential EPS growth.

With that, I'll turn the call over to Gerry to discuss our financial results in more detail..

Thanks Mike. We are very pleased to deliver stronger than expected profitability and EPS performance for the second quarter. From a profitability side we exceeded our gross margin forecast and our operating income forecast. Our GAAP diluted EPS results $0.91 per share and non-GAAP EPS results of 75% per share are summarized on Slide 4.

Our GAAP results include $12.8 million pretax or $0.32 per share benefit from a confidential legal settlement which is recorded on the income statement and other income. We view this settlement as a onetime item and it is not expected to impact our business operations going forward.

As Mike indicated, the net sales for the second quarter decreased 9% to $905 million. Majority of this decrease was in the worldwide barcode networking and security segment and as a reminder our December 2015 quarter included an unusually large $38 million government deal.

Our second quarter 2017 gross profit margin was 10.9% higher than the sequential and prior-year quarter's. The margins reflects the addition of Intelisys results for full quarter and increased mix of higher margin sales. This included higher margins for international business.

And on Slide 5 and 6, you can see our current quarter, sequential quarter, and prior-year quarter margins by segment. For both segment, second quarter 2017 gross margins came in stronger than our forecast.

SG&A expenses excluding the amortization of intangible assets and acquisition costs increased $4.6 million from the prior-year quarter to $69 million for the second quarter of 2017.

This increase reflects the addition of Intelisys which was not in the prior year quarter and additional investments including headcount to support key initiative in our strategic plan. These investments support the growth opportunities that Mike described earlier.

Our second quarter 2017 non-GAAP operating income was $29.6 million or 3.3% of net sales compared to $36 million or 3.7% in the prior-year quarter. Sequentially, non-GAAP operating income improved from $26.7 million or 2.9% of sales.

We have $111 million contingent consideration on our December 31, 2016 balance sheet reflecting the present value of expected future earn-out payments for acquisitions of Intelisys which occurred in September 2016 and Network1 which occurred in January 2015.

For the second quarter 2017 we recorded a loss for the increase in fair value of contingent consideration of $1.8 million. For our third quarter 2017 forecast we estimate the change in fair value of contingent consideration to be a loss of approximately $3.7 million.

Our effective tax rate was 35.6% for the second quarter 2017 and 34.7% for the prior year period. For the fiscal 2017 forecast, we're using 35.3% effective tax rate. The tax rate for the quarter is higher than the full-year rate due to a higher mix of income in the United States including the legal settlement.

Second quarter 2017 GAAP diluted EPS of 91% increased both year-over-year and sequentially while our non-GAAP diluted EPS of $0.75 decreased year-over-year and increased sequentially. Average diluted shares for second quarter 2017 totaled $25.3 million down 6% from the earlier period year as a result of share repurchases.

Now shifting to the balance sheet and the capital allocation plan. Our working capital balance sheet and cash flow measures are referenced on Slide 7 and 8 in our presentation. One of the highlights from Slide 8 is the $128 million of operating cash flow generated over the last 12 months.

Although some of this relates to timing, the business teams had increased working capital efficiency and we expect continued improvements for the remainder of fiscal year 2017. Inventory returns remained at six times and we decreased inventory levels by 10% over the prior quarter and 15% year-over-year.

DSO excluding Intelisys came in at 60 days still higher than our typical range and primarily reflects the aging of customer specific accounts in North America and Brazil.

Our balance sheet remains very strong and continues to provide us with the ability to execute our capital allocation plan which includes organic growth, strategic acquisitions and share repurchases. At December 31, 2016 we had cash and cash equivalents of $45 million and debt of $142 million for a net debt of $97 million.

Our leverage totaled approximately 0.88 times trailing 12 months adjusted EBITDA. And our ROIC was 13.8% for the second quarter 2017. During the quarter we repurchased $3.5 million of shares and at the end of the quarter we had approximately $100 million remaining on our share repurchase authorization. Now turning to our forecast on Slide 9.

We've missed our sales forecast range over the last few quarters primarily from the timing of big deal in ScanSource's KBZ. We expect net sales for the third quarter fiscal year 2017 to range from $800 million to $860 million.

And GAAP diluted earnings per share to range from $0.42 per share to $0.49 per share and non-GAAP diluted earnings per share to range from $0.62 per share to $0.69 per share.

The foreign exchange rates used in our forecast are summarized in our presentation slide and the midpoint of our sales forecast reflects year-over-year low single-digit organic growth. With that I'll turn the call back over to Mike..

Thanks Gerry. We have two reporting segments and I'll start with worldwide barcode networking and security which represented 66% of overall sales this quarter. Net sales of $595 million decreased 14% from the prior year. Overall we believe our POS market businesses maintained market share.

We saw good results with vendor maintenance service contracts and our custom configurations center offerings continue to see strong demand. ScanSource KBZ had significant competitive wins this quarter and continues to have success with ZCare Services.

Extreme Networks completed the acquisition of Zebra's Wireless LAN Business in October which led to ScanSource been authorized as an Extreme distributor. For the quarter, initial results were good.

Competition in our wireless and networking business continued as a result of consolidation by certain key vendors and this led to lower sales for the quarter. As we come out of this consolidation phase, we would expect to grow net sales and improve the profitability of our networking business.

Our physical security business including video surveillance cameras and video management software had a strong quarter with upper single digit year-over-year growth and as I said earlier we are planning for good growth due to the strength of the video surveillance market and the planned expansion of our line card.

Our second segment, worldwide communications and services which represents 34% of our overall sales. Net sales of $309 million increased 2% from a year ago and 3% from the sequential quarter. This is our first full quarter with Intelisys.

We had a great quarter with Intelisys and they continue to add new sales partners, our new employees to grow and support sales and build relationships to events such as Intelisys mindshare events held throughout the year across the country. Intelisys team is also developing new programs and marketing plans to recruit ScanSource bars.

We had good results with many of our unified communications vendors including our enterprise voice, video and services business. We had very good results for barcode in job where two vendors are helping us expand our video and voice solutions.

In North America we had a record big deal quarter and we see opportunities to compete in new customer segments to gain market share. In December, ShoreTel named ScanSource communications as it's value-added distributor of the year. In Europe we are working to gain scale as we build out our integration of Imago in our European communications business.

We expect to grow revenues as we compete for market share across the U.K. and Europe. We have strong support from our key vendors in this business unit. We had a solid quarter for Network1 in Brazil with good sequential growth from new vendors including Fortinet, VMware and Veritas and from our cyber security vendors.

In December, HP recognized Network1 as it is best value-added distributor of 2016 in Brazil. Cisco recently appointed Network1 as a distributor last quarter and we see tremendous opportunities as we begin to sell Cisco in Brazil in calendar year 2017. We will now open it up for questions..

[Operator Instructions] Our first question comes from Keith Housum with Northcoast Research. Your line is now open..

Good afternoon, everybody. Thanks for taking my question. Mike can you provide a little more color on the delay from the KBZ deals in the quarter and some of the supply constraints.

I guess do you see those issues contained in the second quarter or do you see fulfilling both of those issues occurring?.

Hi, Keith. Well factored into our forecast is resolution of both of those issues.

So in the case of KBZ deals this isn't the first time that we've had some of the big deals kind of move around on us and part of it is we're used to seeing frankly the energy behind big deals that are closing, happening generally on a same quarter and the ScanSource and in the KBZ case, our key vendor there has a quarter in that's a month different than ours as you recall from last quarter and year ago.

So that's part of what's causing this and that’s why our reference was to a delay and sitting here now we're building our forecast based on that business, as well as in the supply constraints which is very unusual, I can't recall the last time we had a supply constraint as ScanSource with any of our suppliers but those were some unusual situations and frankly was in each of our geographies and it led to deals that we had expected to happen that did not.

And so again built into the forecast is the resolution of that too. So it's not an ongoing supply issue..

Okay, great. And then in startup with Intelisys can you go down a little bit further in terms of what was the impact to the gross margin, the operating margin from the Intelisys addition for the quarter..

Sure Keith, this is Gerry. Without Intelisys the gross margin was not 10.9 but 10.1..

And how about the operating margin?.

I don't have that number right in front of me, so I'll have to get back to you on that..

Okay. No worries.

And then Mike I heard right from the WLAN sale from Zebra to Extreme, you sounds like you didn't miss the [deal] [ph] with the addition of Extreme?.

Yes, that's right. That's the reason I called it out as it was good news.

We certainly were somewhere worried about it because there was the change for an early Zebra, Extreme but also our partners and we weren't sure how easily would be for us to move that business over and work under the Zebra team but they both Zebra and Extreme did a great job making sure we got connected with the right people, got the right programs in place in and frankly yes, it was a real bright spot in that deal, I mean just rare to see a deal happen that smoothly..

Great, thanks. I'll jump back in queue..

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

Okay. Thank you and good evening. Just wanted to ask, you saw a strong recovery in the communications business, operating margin. Looks like there is some opportunity in the barcode networking and security business still which I think Mike you alluded to in the prepared comments.

If you could just maybe talk about what needs to happen to get back to the new 2% level that you've seen in the past and is that something that could happen quickly or will it take time..

Yes, thanks Adam.

You know one of the things that we realized of course is that we built the business that has capacity and it's always been our plan to do that because we want to be prepared whenever our vendors see growth coming and we've always had a strategy of having either sometimes little more inventory than we maybe should and a little more headcount and maybe we should and then what we said on a long as if the vendors don't provide us the margins we need to support that infrastructure we would be investing you've heard us talk about that in the past.

And so what I was indicating that they was, we believe that the growth opportunities are there in this business unit and that we have infrastructure and capacity to serve and so we believe right now if we improve the volume on the top line with the SG&A we have Adam that we can then improve the operating margins to level similar to what you're describing.

You think that's a reasonable place to be yes. Mid 2.5 that range would be appropriate..

Got it. Makes sense. And then you mentioned expecting solid year-over-year growth in adjusted EBITDA for fiscal 2017 which I know you mentioned on previous calls. Based on results in March guidance it doesn't imply a very strong June quarter.

So just hoping you can maybe expand on what's driving the upswing there and your level of visibility into the implied June quarter. Thanks..

Adam, this is Gerry. I think as we said the last time it's really the addition of Intelisys the primary factor that gives us our confidence..

Okay. I guess - I was just looking at it from a sequential standpoint and Intelisys being in a business for both the March and June quarters, but it looks like you would need to have a pretty significant sequential uplift in the June quarter.

So I didn't know if maybe there was any programs or backlog or anything that you would point to based on how the June quarter looks like it's lined up..

No, I don't think so Adam, it's Mike again. You know if you go back and look at our historical the March to June is always an increase and I didn't do that math because we're not forecasting June today course.

But it would be normal for us to see an uptick in the business and the overall indicators that our teams brought us as we review the quarters was that the business overall looks good and so whether that's in communications or in our barcode segment.

We felt good about the initiatives we got in place and I mentioned a couple of things in particular, the physical security business we think that that does have some renewed growth and we have been talking about that for a while and as part of that to take advantage of what the end markets are telling us, we need some vendors that are kind of new to that space, that will come out with more competitive offerings, we’re going to expand our vendor line card in that physical security space and don't forget we also said for a couple of quarters that our Network1 business has new vendors and we just announced Cisco that we've also had several vendors that have been online now about two or three quarters and we expect those vendors and those business units to start contributing from that.

So that's kind of why June would not be surprising to have a reasonable uptick..

Okay, got it. Thank you and best of luck..

Thank you. [Operator Instructions] Our next question will come from Chris McGinnis with Sidoti & Company. Your line is now open..

Good afternoon. Thanks for taking my questions. So I guess just to start up on the gross margin maybe the - obviously I know Intelisys growth, the improvement to that.

I just looking forward - is that contribution, Gerry I think that you mentioned 10.1 versus 10.9, as we kind of think about that going forward is that higher margin than traditional 10% of your target?.

That's right, Chris. That's what we're forecasting for the third quarter is something very similar to what you saw our results for the second quarter..

Okay, thank you. And then maybe Mike if you just touch on, you talked about penetrating….

What's that Chris, we lost it, sorry..

The VARs that you're looking to go after and instead of them going direct.

Can you just talk maybe a little bit about your strategy?.

Yes, sure. So you know typically in our business we've had some of our vendors that have always had a reasonable amount of direct VAR business and they call on various things whether they are one tier or just a direct or certain medallions.

But we've got a few vendors that have recently started working with us on a plan for different reasons - for their own different reasons to encourage those direct VARs to choose a distributor and/or to move into distribution as a choice but one with a kind of a recommendation or push from the vendor.

So, we've got a program in several of these cases where we're having to build some initiatives to make sure that that VAR wants to buy from a distributor versus direct.

We don't think it's going to be a difficult conversation, but sometimes those are things we want to do very carefully and in the history of the company we've always had these opportunities come along, but this is the first time in a probably year or so that we've seen some growth coming from some of these one-tier channels choosing distribution.

So that was worth noting this quarter. We see that already starting and we expect more that to happen..

Okay.

And then last question maybe just on the appetite for acquisitions, obviously Intelisys still going to seemingly pretty good here, just the going forward strategy and appetite?.

Well, as we said about our capital allocation plan, number 1 organic growth, number 2 acquisitions and I would say that as we've talked over the last few months with you guys and our investors is we really love this idea that there are more services type recurring revenue, high margin businesses that are similar to Intelisys that would be complementary to our existing hardware business.

And that has - we've identified several we're not going to talk about today, but we believe there are other places and other opportunities for the company that will be complimentary to what we're doing and we will see those generally happen from acquisition.

I think from our standpoint again we made I think 25 acquisitions over the years, we've always been a believer in acquiring either a core, highly successful, maybe a smaller franchise that has gotten to a point where they can no longer either fund the growth or they would benefit from the scale of ScanSource can bring and/or gives us a way to get into some new geographies.

So, we've always used acquisitions to give us a jumpstart and frankly reduce the time it takes to get relevant in the market. And I believe right now there is some windows of opportunity in these services spaces similar to Intelisys where ScanSource execute on..

Thanks for taking my questions and good luck in Q3..

Our next question comes from Tony Spinola with Wells Fargo. Your line is now open..

Hi, it's Andrew Spinola.

Mike, could you just walk me through again the part of the segment that had the supply constraints in the quarter was the wireless and networking part of the segment, is that correct?.

Yes, that's right..

And just so I understand that that would be it's one vendor that is having the issues is that correct..

No..

It's multiple so it's not - so is it a function of something that's going on ScanSource or why would it be multiple vendors that we're having shortages at the same time, is it components or….

You could keep guessing and I’ll probably not confirm but let me try.

It was very unusual as I’m seeing, we were surprised that, gosh in one quarter you could have literally three different reasons why you would have problems in three different geographies but they are, they are not connected and it makes no sense but as you know, ScanSource never lacks for cooperation with vendors on inventory issues, or things - so these are things that have happened in the marketplace that were unexpected obviously because we normally have enough supply with six inventory returns, my gosh we got generally plenty of inventory.

So it's unusual, we don't believe there is any - matter of fact we have good visibility that they are not going to continue to happen and that's why we feel good about our forecast for March..

Got it. Yes, that actually makes quite a bit of sense, thanks Mike. The growth rates bounced around quite a bit in Q1, Q2 and you did mention a return to our organic growth in fiscal Q3 not to – we're just thinking about all of the things it sounds like you're being pushed out of fiscal Q2 into fiscal Q3.

In general is this segment seeing organic growth when you sort of adjust for the push-outs or is it is really just that you got a bunch more revenue pushing it to Q3..

Well, just where I can put up try and pull a bit of sensibility to it too, when I think about Andrew's, we're still - the quarters to be down sequentially on revenue. So if you think about it that respect it's not that unusual being that the number we got set up there is not a crazy number.

And so for things that are - get pushed for us to know they're moving or not you think about what we said in our prepared remarks when there's specific to that KBZ unit and there is a timing issue, I can tell we've got enough visibility today to know that those will happen. So those are not difficult to guess.

In other years and other quarters where there's been these push-out delay stuff, we rarely would ever commit to a number that would be in a forecast not knowing if we then would, if we got delayed or deferred or loss so that isn't what these are about, these are very specific deals large enough that visibility and large enough for us today to say we have accomplished, they will be in our forecast.

So we feel about - these are kind of unusual again and we want to call them out..

Definitely, I understood. And just one last question, I think you mentioned security is going to high single digits on networking you just commented on, is barcode still growing at this point or how is that business performing for you..

Well the barcode and POS business for us for the last few quarters we've had – quarters we had a lot of big deal and its going to come of a big deal lumpy story and this quarter we didn't talk about that and I think it's one of those where today there are some opportunities for growth in this past quarter but wasn't anything significant that happened in the quarter.

And I would hope it would happen but it didn’t but our view for the - if you look at the forecast, the midpoint of the forecast it suggests that there would be at least reasonable sales in the barcode POS in that segment but we're saying we’re going to have organic growth, it's going to be small but we are going to have organic growth.

So all of the businesses are helping to do that..

Perfect, thanks so much..

Thank you. And I'm showing no further questions. I would now like to turn the call back over to Mike Baur for any further remarks..

Thanks. And thank you for joining us today. We expect to hold our next conference call to discuss March 31 quarterly earnings results on Tuesday, May 9, 2017..

Ladies and gentlemen, thank you for participating in today's conference. You may all disconnect. Everyone, have a great day..