Gerald Lyons - CFO Mike Baur - Founder, CEO & Executive Director Mary Gentry - VP of IR & Treasurer.

Adam Tindle - Raymond James & Associates, Inc Andrew Spinola - Wells Fargo Securities Chris McGinnis - Sidoti & Company.

Welcome to the ScanSource quarterly earnings conference call. [Operator Instructions] 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..

Thank you, and welcome to ScanSource's earnings conference call for our quarter ended March 31st, 2018. With me today are Mike Baur, our CEO; and Gerry Lyons, our CFO. We will review our operating results for the quarter and then take your questions.

A CFO commentary 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 sales, earnings, tax rates and interest expense for our fourth quarter 2018, 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 Form 10-K for the year ended June 30, 2017, 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 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 the CFO commentary and in our press release. These reconciliations can be found on our website and have been filed with our Form 8-K. I'd now like to turn the call over to Mike Baur..

Thanks, Mary, and thanks for joining us today. For our third quarter, we delivered strong results. The highlights include 10% net sales growth, 12% gross profit growth and non-GAAP operating income growth of 6%.

Net sales growth realized was strong across our business with year-over-year organic growth for both worldwide segments and for our geographic regions. Both net sales and non-GAAP diluted EPS, earnings per share, fell within our forecast range. Based on our sales results, we would have expected slightly better non-GAAP EPS.

However, it came in slightly lower due to a higher tax rate. This quarter's performance reflects progress in executing our strategic plan and the six key opportunities for growth for 2018.

First, strong demand for mobile computing solutions continued and was broad based from customers serving many vertical markets, including hospitals, warehouses, field service and retail. This business continues to benefit from the mobile -- mobility operating system refresh opportunity.

Our second opportunity for growth is video surveillance and reflected higher networkings spend driven by security concerns. Our customers are building out solutions around video surveillance and access control. These needs drove strong growth in networking products for the quarter.

Our third initiative, POS Portal, provides an excellent example of both solution selling and an expanded route to market. POS Portal sells bundled payment solutions that include hardware, software and support through independent software vendors.

POS Portal grew its payment business in SMB and midmarket and offered high-value contract deployment services, including replacement services, kitting and customized configuration. Fourth, a communications channel opportunity with our announcement in March of an expanded relationship with Mitel for premise-based products in the U.S.

ScanSource is also providing certification, training, post-sale technical support and channel field coverage for our Mitel customers. This expanded business opportunity aligns with our services and cloud strategies going forward. And we expect more opportunities to sell both premise-based and cloud products to both solution providers and agents.

The fifth growth opportunity is continuing to grow the success of Intelisys. We had another record quarter for Intelisys with 20% year-over-year growth. We are making additional accelerated investments in this business to expedite long-term growth in the agent channel. Cloud vendors are the fastest-growing part of this business.

And Intelisys has a tremendous line card of the leading UCaaS, which is unified communications as a service, and CCaS, which is contact center as a service, providers. In April, we announced the addition of Avaya cloud solutions under the Master Agent program.

By expanding our Avaya relationship, we can provide the Avaya communications solutions however customers choose, premises based, cloud or hybrid.

We are helping agents and VARs build their cloud and carrier services practices through programs and educational offerings, such as Intelisys Cloud University and Super9 Convergence, Advanced Commission Programs and opportunities for VARs to partner with our most successful and experienced agents.

Our sixth growth opportunity is our Network1 business in Brazil, where they had strong performance across the sales teams, enterprise, SMB, our Cisco team and our supply chain. Strong growth from cyber security vendors continued.

Network1 exceeded its goal of net new customers selling Cisco in its first year and is now selling the full Cisco line card of networking, collaboration, data center and security.

Our team in Brazil -- our teams in Brazil held our Innovation Forum 2018 in Sao Paulo and for the first time included both Network1 and ScanSource POS and barcode customers. We had over 1,100 attendees at this partner event, focused on growth and offering complete solutions for our customers.

Our results reflect the ability of our teams to take advantage of the growth opportunities in the markets that we serve. And with that, I'll turn the call over to Gerry to discuss our financial results in more detail and our outlook for next quarter..

Thanks Mike. For the quarter, our operating results tracked closely to our expectations for the quarter, with 5% organic sales growth and 11.6% gross margin and $81 million of operating cash flow. Both net sales of $896 million and non-GAAP EPS of $0.68 were within our forecast range, while GAAP EPS of $0.42, and fell below our forecast range.

The GAAP EPS included a higher-than-expected expense for the change in fair value of contingent consideration as a result of better-than-expected actual results for Network1 in Brazil. Consolidated net sales increased 10% to $896 million.

The dollar impact on sales due to foreign currency translation was positive $16 million, and the POS Portal acquisition added $22 million to net sales. We had continued to strengthen in our Worldwide Barcode, Networking and Security sales with 10% year-over-year growth that included a 4% year-over-year organic growth.

Net sales for our Worldwide Communication & Services segment increased 10% year-over-year as well, driven by Network1 in Brazil and our enterprise communications business in North America, and we had organic growth of 9% year-over-year in this segment.

Gross profit dollars increased 12% year-over-year from higher sales volumes and the addition of POS Portal. Our third quarter 2018 gross profit margin was 11.6%, up from 11.4% for the prior year period.

For the Worldwide Barcode, Networking and Security segment, the gross margin increased to 9.3% from the addition of our higher-margin POS Portal acquisition. For the Worldwide Communications & Services segment, the 16.3% gross margin was unchanged from the previous quarter and lower than the prior year.

Our prior year gross margin reflected unusually high vendor program recognition in our Worldwide Communications & Services segment. SG&A expenses increased $8.8 million from the prior year quarter to $73 million for the third quarter fiscal 2018.

This increase reflects the addition of POS Portal, and we are also making investments in our business related to our strategic plan to accelerate opportunities for growth. Our third quarter 2018 non-GAAP operating income was $27.8 million or 3.1% of net sales compared to $26.2 million or 3.2% in the prior year quarter.

We have $102 million contingent consideration liability on our balance sheet as of March 31, reflecting the present value of expected future payments for acquisitions. For the third quarter of 2018, we recorded an expense for the increase in fair value of contingent consideration of $4.8 million.

For our fourth quarter fiscal 2018 forecast, we estimate the change in fair value to be an expense of approximately $4.5 million, principally related to Intelisys. For the third quarter fiscal year 2018, the effective tax rate was 32.6%, and the non-GAAP effective tax rate was 31.9%.

Our effective rate was higher than our targeted rate of 30% from a discrete item in the quarter. For the fourth quarter fiscal year 2018 forecast, we are using a 30.4% effective rate. And for the fiscal year 2019, we currently estimate the effective tax rate to range from 26% to 27%. Now shifting to the balance sheet.

The third quarter of our fiscal year is typically a strong quarter for operating cash flow. And in this quarter, we generated $81 million of operating cash flow, which is significantly higher than the prior year period. Our inventory turns, typically slower in the March quarter, decreased to 5.5x compared to 5.6x for the year ago quarter.

And we believe that our inventory levels are appropriate giving -- given our sales forecast for the June quarter. DSO, or day sales outstanding, excluding Intelisys, came in at 64 days, higher than our most recent trends around 60 days.

The higher DSO reflects the aging of our receivables portfolio as of March 31, primarily in North America, as well as offering extended credit terms in certain international markets. We have not changed our underwriting standards, however.

Our balance sheet remains very strong and continues to provide us with the ability to execute our capital allocation plan, which includes, in order, organic growth, strategic acquisitions and share repurchases. At the quarter-end, we had cash and cash equivalents of $35 million and debt of $282 million.

Our net leverage totaled approximately 1.8x trailing 12-month adjusted EBITDA, and ROIC was 11.2% for the third quarter 2018.

While adjusted EBITDA for the third quarter increased 12% year-over-year, ROIC decreased due to the investments in our strategic plan, as I discussed earlier, and the increased borrowings on our revolving credit facility from the POS Portal acquisition.

We repurchased no shares for the quarter and have approximately $100 million remaining under our share repurchase authorization. Now turning to our forecast.

We expect net sales for the fourth quarter to range from $940 million to $1 billion, GAAP diluted earnings per share to range from $0.48 per share to $0.54 per share and non-GAAP diluted earnings per share to range from $0.74 per share to $0.80 per share.

The midpoint of our forecast range reflects organic sales growth in the low single digits for both segments and a gross profit margin that's a little over 11%. We expect interest expense over the next few quarters to be similar to the March quarter from the -- resulting from higher interest rate and lower average debt balances.

For the fourth quarter fiscal year 2018, we assume approximately $2.6 million for interest expense. And as I mentioned earlier, we're assuming a 30.4% effective tax rate for the fourth quarter of fiscal year 2018. And for fiscal 2019, when we'll have a full year impact of tax reform, we anticipate the tax rate to be in the range of 26% to 27%.

I'd now like to turn the call back over to Mike for closing comments..

Thanks, Gerry. For the quarter, we achieved strong sales results across both segments and gross profit growth that outpaced our sales results. We are executing our strategic plan to focus on growth initiatives at value-added margins.

We see excellent opportunities ahead for profitable growth and are making the strategic investments to support these opportunities. We will now open it up for questions..

[Operator Instructions] Our first question comes from the line of Adam Tindle of Raymond James. Your line is now open..

Okay, thanks and good afternoon. First wanted to start with, Mike. At the beginning of this fiscal year, you set out a couple of goals for fiscal 2018, including a 3.5% operating margin and to improve ROIC. Looks like guidance here implies that you'll fall a little bit shorter on those goals.

And to be fair, maybe you didn't anticipate some of the solid growth in the business.

But first question, maybe talk about what changed to make you fall a little bit short of those 2 goals? And then second, talk about the puts and takes to achieving those goals in fiscal 2019?.

Sure, hey, Adam. I think as we look at where we are today versus where we are two or three quarters ago we're more excited than we were even then about the growth opportunities with our strategic plan.

As we looked at making some strategic investments to support that, we recognized that there is some short-term extra investment that puts pressure on delivering a quarterly result, but we believe that these are for the right long-term results for our shareholders and our investors.

And so I would say it's more -- we're even more excited about the areas that we're investing. So we have put more investment dollars into those areas, even if some of the expected results that we talked about a few quarters ago are not happening as quick as we said then. So I think you're right.

I think we would've thought back in August of last year that 3.5% by the end of fiscal 2018 should be very doable. But as we spent time over the last three and four months looking at some of these new opportunities to grow faster than market, we decided to make those investments in SG&A specifically to support these initiatives..

Okay.

And then puts and takes to achieving those 2 -- is the 3.5% operating margin and improving ROIC still kind of a core tenet of the company and a core goal? Or has that changed? If it's still a core goal, can you talk about puts and takes for fiscal 2019?.

Well, I think the -- if you look back at the last three or four quarters, we were improving the operating income through December. And then this quarter, dropping down from where we were was because of these investments. We see the 3.11% Operating income as a low watermark, and so we certainly expect it to grow from here.

So we expect as we look out the next few quarters that it would continue to grow in size. We also believe that as we get into a more historical business with POS Portal we'll have better insight into that business. We still have only owned that business since less than a year.

And it is, just like Intelisys was, more challenging in the first year of ownership to understand the impact it can make on our business. And in the case of Intelisys, an investment in Intelisys, as you guys have seen, is not necessarily reflected from a return for a while down the road. It can even be a year from now.

And so POS Portal doesn't have quite that life to the investment. What we do believe that some of the POS Portal investments we're making also are not realized in the quarter we make the investment. So your question of is 3.5% and higher still a core tenet, I would say, yes..

Okay. And one last clarification for Gerry. I think you had [held] on gross margin in the past. And I think guidance would imply typical seasonality to gross margin, which would be at sequential decline in kind of the 40 basis point range.

Is that the right way to think about gross margin for what you're implying for June?.

Yes, Adam. It is going to go down right because typically the March quarter is softer than the June quarter. And I think what we implied in our guidance was right at 11% or a little above 11%. It'll be somewhere in that 40 basis point range that you're quoting..

Our next question comes from the line of Chris McGinnis of Sidoti & Company. Your line is now open..

Good afternoon and thanks for taking my question and nice quarter. Quickly, I guess, just talking some of those growths -- some of the growth initiatives, especially around Intelisys.

Can you just talk maybe a little bit of what's happening behind the scenes in the acceptance by some of the customers you're working with and them adopting that? Thanks..

Yes, thanks, Chris.

When we think about Intelisys, what's -- what I think has changed from two years ago when we acquired the business is we were doing all of our planning around carrier -- the carrier business and how it was being shifted into the indirect channel, and that's a phenomenon that we are very familiar with is channel can become a much more viable route to market for a supplier, like the CenturyLinks of the world, for example, and Verizon.

And what's really changed in the last nine months to a year has been the recognition that these cloud vendors that Intelisys has brought to the ScanSource community focused on UCaas specifically, unified communications as a service, we're even more excited about that opportunity.

And so that's really where we're trying to figure out how do we best take those products to market. Is it through the agents and have them sell more cloud? Or is it also to sell it through VARs? And so the answers are we can't pick the route to market that's the winner. It's not obvious to us.

But what is obvious is every vendor that ScanSource has in that communication space has a hybrid offer or they have a cloud or premises, and we want to do all of it. So we're having to really provide a platform so we can sell premise-based equipment through an -- to an agent but also have a VAR by services through the agency model.

So we want to have VARs sell agency products and agents sell VAR products, if that make sense. And so it's that we don't know which channel the end user prefers. We want to make sure we're in position with our key vendors to provide the route to market that the end customer prefers.

We think that's what's turned out to be a bigger opportunity than we realized two years ago we bought Intelisys..

Great. That helps.

And I guess just to be following up in this area, but maybe just a little bit about maybe the outlook in terms of M&A for opportunities like this? And how to expand, I guess, in higher-margin business and service-based business?.

Well, we certainly think that we've now got multiple routes to market, think agents as a route to market, VARs, ISVs, which is a route to market we acquired through POS Portal.

We've got some other relationships with MSP that we don't talk about a lot that we've had for years but probably not as many MSPs as we have VARs and agents, but we also have ISOs that we picked up through POS Portal. So all of these routes to market were interestingly part of the acquisition.

And what we're finding is future acquisitions would be -- don't necessarily have to be to acquire a new customer base. We just have to acquire new offers. And so you're right, we might find some new services that we need for this existing customer base.

And in doing that, we're looking to our customers to tell us what we can provide at scale that they currently don't offer. And the example we talked about last year was managed services as a general theme.

And most of our key successful partners, VARs, customers, agents, all have some form of a managed service offering, either as a service or it's something they wholesale. And so I would suggest that we're going to continue to add more services like that, but it may not require an acquisition.

It may just require a signing of a new vendor, or also it might be we do something jointly with an existing provider, maybe more of a joint investment. So multiple ways to do it.

But as we've said, we got these -- this necklace of service offerings we're trying to develop, and we believe our customers are giving us the guidance as to where they want us to go next..

Okay, great. And then, I guess, just maybe following up on that just because some of the prior acquisitions more recent were more about geographic expansion.

How do you feel about your footprint now?.

Yes, the geographic expansion has certainly led us to Latin America and Europe with our product business. We do think that the same services we're offering today from Intelisys and POS Portal and others many of them will translate to the other geographies. So we would expect to over time move those same services geographically, yes..

Okay. And then, lastly one of the highlights, obviously, Mitel.

You just -- how long do you expect that bump? I mean, is that a 12-month bump from them coming onboard? And maybe just a little bit more about that relationship?.

Relationship with who, I'm sorry, Chris?.

Mitel..

to take this business that's transitioning and grows it. So over the next two to three quarters, we'll be able to see the results of this for sure..

Our next question comes from the line of Andrew Spinola of Wells Fargo. Your line is now open..

Mike, just to take those questions one step further, when you're thinking about Intelisys over the medium term, I think you reported here that it grew 20% year-on-year. I think it's been growing at that rate for the -- each of the quarters this fiscal year.

I mean when you think about looking forward, is it growing 20% because it's coming off of a small base right now? Or when you're describing this addressable market and new geographies potentially, how do you think this business can perform over the longer term? What sort of growth you think it can do?.

Well, we have been the beneficiary of two dynamics that are going on with Intelisys. One is this shift to the indirect channel by traditional carriers. And that has been driving the growth in the past, and I think that has contributed for sure to this 20% number.

I think the other thing that's going on is these -- this expanded line card, if you will, of vendors, supplies.

So whether it -- if you look at the Intelisys list -- and I don't want to list everybody because then it'll take me a few minutes because we now have about 50 or 60 key suppliers there, but just as a placeholder -- these are the RingCentrals of the world, the UCaaS vendors.

And using them as the placeholder, those vendors are all showing growth in their markets dramatically. And Intelisys is taking market share from their competitors; meaning the other master agents that are working with these suppliers, we're growing faster than the market.

So we think the market study that suggests the UCaaS is growing at a CAGR of about 10% and about 13% -- it's growing about 13% in the cloud space. And if we're growing at the rates we are, we're going faster than that is my point. So we're getting market share in an already growing marketplace, and that's what's exciting.

And that's why we believe there is an opportunity to gain unusual share within this UCaaS space, and that leads us to have the confidence to make these what we're calling internally some accelerated investments in Intelisys..

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

Great. Thanks for joining us today. We expect to hold our next conference call to discuss June 30th quarterly and full year results on Tuesday, August 28, 2018..

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