ScanSource, Inc. (SCSC) Earnings Call Transcript & Summary

Thanks, everybody, for joining this morning. My name is Adam Tindle, and this is part of my technology supply chain coverage. Very happy to have the team from ScanSource here this morning. We’ve got Mike Baur, who is the CEO. We've got Steve Jones, CFO; and of course, Mary Gentry, the IR function. And in terms of our format here, we’re just going to keep it very open ended, just a full fireside chat. Anybody in the audience that has questions, please feel free to raise your hand and keep it as interactive as possible. So with that, Mike, thanks for being here, of course, Christmas time in New York, always a good time.

And why don't we start at a high level for those not as familiar with ScanSource that are either listening to the webcast or here in the room. Walk us through the background of the company and particularly the transformation to add digital distribution?

Great, Adam. Good morning. It's great to be back in person in New York. We used to do this every year for a long time, and it's been, I guess, 2 years now. So we're thrilled to be here. Glad we have some folks with us in the room too. ScanSource has been around 30 years this week, hard to believe for me, and all along, we've had the same strategy, which is identify technology markets that are in a stage of transition. And we're seeing that today, we'll talk about in a few minutes about the digital distribution. But when we started the company, we thought we were really in this barcode or automatic identification business, and it led to other adjacent businesses along the way, including the retail point-of-sale business that came out of barcode because they were the biggest user. As a matter of fact, saying barcode was not what we -- early on said, we called it automatic identification. If you think about it today, if you're here at the hotel, you're probably -- if you're in a room, you're scanning the menu for your room service with your phone, and that's automatic identification. So we're all using the technologies today, and we were early in '92 at helping the manufacturers of these cool technologies find a channel. So we've always been this company that helped manufacturers find channel partners. And there was always a logic to it because as the markets grew, manufacturers needed a variable cost sales force, and we could find thousands of independent technology resellers, we call them VARs back in the day, who wanted to sell new stuff. We came out of the computer industry. So selling automatic identification and barcode products was kind of easy for us, but it require a lot of specialization. We then found other similar markets -- the communication business started with PCs that became your phone system. And then later, it became selling proprietary PBXs as companies like Avaya and Mitel and others expanded their business. And then the third technology we got into in 2004 was the security business. It was not network security then and it was not even the old burglar alarm security because that was not as interesting for our business. We got into security when IP cameras came along. And that's when -- in 2004, it’s when the first time you could put cameras on your network. Hard to believe that it's only been that long ago. But those trends are things that we've always identified early at our company. So when we identify them early, we had higher margins as a distributor than normal. We also start with lower volumes. And then as the volumes go up, the margins decline. And so our business is always about identifying what's next. And what's next for us in digital happened in 2016 when we acquired a company called Intelisys, which again was an adjacency market for us that was not about devices. It was not about hardware. It was about connectivity and cloud. And so that business allowed us to really take a huge step forward into a new area of technology that now for our company is really helping grow the business.

And if you were to kind of talk about -- so you talked about kind of the qualitative aspect of the evolution towards digital distribution. Where would you say you are in this transformation at this point?

Well, for the markets we serve, it's interesting that everyone has been talking about cloud and digital for a long time. It's early for ScanSource. We're still early in this transition because some of the technologies that were, let's call them premise-based, especially in old phone systems, PBXs, those were slower to transition to the cloud. Data centers moved early. This is still one of those times where there's this transition period. So there's still a lot of people that still use devices that are anchored to the premise-based systems, but the future and the growth is absolutely in digital and cloud, especially in telecom and now also in our barcode and mobility business as well as security. Each one of those market is giving us growth opportunities with digital.

So I think that's -- and you told me I can go off script.

Yes. Yes.

So I think that's a little misunderstood and I'm mentioning this because RingCentral, I think, is right next door, presenting just as we speak. And I think there's a perception of ScanSource of Avaya kind of more on-premise exposure to that. But maybe talk about how you do serve both on-prem kind of the Avayas and more as a service to RingCentrals of the world. Do you have exposure to that in your business? Because I don't think that's that well understood.

It's a great point because, again, when I think -- when we talk about ScanSource as a hybrid distributor, that's one definition of selling devices and services. But most clients, most end customers are absolutely in the hybrid world, where they have on-premise and cloud. We were lucky and sometimes better be lucky than good. When we acquired Intelisys, they were still early in 2016 in this idea of cloud was going to really dominate telecom. RingCentral was one of the first suppliers we signed after we bought Intelisys. And RingCentral at that time wasn't sure they needed a channel. They thought they were going to really go direct. And so I think this was 2017, early 2018 is when we signed RingCentral and the history of our Intelisys business was on cable and connectivity with the carriers, the traditional carriers, whether it's Lumen, which was CenturyLink at the time, et cetera. And on the hardware side, it was the Avayas, the Mitels, the ShoreTels, RingCentral and then later Zoom, which we also carry. Obviously, Microsoft with their Teams product, we have a portfolio, 8x8. We have a portfolio of all of these cloud-based communication companies. And so we started talking about voice over IP back in the early 2000s, then it became UCaaS, Unified Communications as a Service as we bought Intelisys. So we got a foot squarely in the growing business. We’re RingCentral's largest distributor of products. We're also the largest for all the other companies I mentioned. So the end customers are still migrating from premise to cloud in the communications area, and we play in both and we think that's an opportunity because we don't have to say no to a customer, we say we can do both. And you, the VAR, you the agent or the end customer can decide how quickly they want to make this transition.

Right. Okay. So I may have taken some of your examples, but in case you have some more here, could you tell us more about what it means to be a hybrid distributor and offer a couple use cases to illustrate hybrid distribution?

Yes. We're trying to connect our channels together. So when I say channels, I'm talking about groups of customers who for us are reselling. So they go by different names, but we've got a distinct difference between a traditional VAR and what we call an agency or an agent. And the agency typically does not sell hardware at all. They don't want to sell hardware. A matter of fact, they're probably not even -- the margins are too low, and they're not interested. They don't understand why they would want to. What's happened is, and the VARs traditionally didn't sell services that were again, the CenturyLink -- Lumen, AT&T, Verizon, any of those connectivity services were complicated for the VAR and the VAR didn't understand how do I do recurring revenue? How do I pay my sales team if we're only going to get 136 of the sale ratably over 3 years. So it's not only a technology change for the VARs and the agents. It's also a different sales motion. And so what we've done is we've helped both groups -- partners find a way to work in each other's camp. And the reason is the end user wants if they can, one partner to do both because the end users buying both, they're buying devices and they're buying cloud services. And we believe as a hybrid distributor by staying in the hardware business, it allows us to sell more connectivity and more cloud. And we believe that's why we're still the #1 distributor in this technology services space where we have competitors to Intelisys, we're still by far the #1 player there. And we think it's because we have the device business.

Okay. Steve, maybe you can help us translate what we're talking about qualitatively into some more quantitative aspects of the model for investors. More specifically, how you're thinking about the margin opportunity for ScanSource, as Mike describes this model, the hybrid distributor of devices and digital?

Yes. Adam, when we think about our transformed company and where we're going, we see margin expansion opportunity as we go forward. I'm going to roll back to go forward a little bit. But if we think about pre-2016, the company was generating 10% gross profit margins, which was incredible for a distribution company. And that really talks to the fact that we had specialized technologies in our portfolio. Roll forward to 2016, we now introduce recurring revenue. And for us, recurring revenue is reported net. So it's virtually 100% gross profit margins. Throughout the next few years, we've added additional capabilities around our hybrid distribution strategy to where we are today. And our margins went from 10 to 11 to now we're knocking on the door at 12 consistently. And we think as the digital products grow faster, although hardware will grow, we think that the digital market is going to grow faster, that mix will just naturally increase our gross profit margins as well the fact that we're wrapping value-added services around that hardware and that digital sale for our sales partners.

Got it. So 12% gross margin now. And then presumably, that would go higher with more mix of digital. Can you -- now just so investors aren't confused. There is also an element of cost to serve for that digital. So if you were to kind of go down to the operating margin line, how would you translate that?

Yes. When we acquired Intelisys back in 2016, we were looking at 40% operating income business. And that's kind of where we think that business is going to play. The reason why it will fluctuate is because with the growth opportunity, we may want to invest there. We may want to accelerate investments in that portfolio.

Okay. So for total co, so obviously, the 40% is spectacular and a great business. But when you wrap it into total ScanSource altogether and look at the operating margin profile, how would you kind of describe that piece of the opportunity?

Yes. Our profitability metrics is adjusted EBITDA. And so when we look at our adjusted EBITDA, we think right now, we're right about 4.5%, 4.8%. We think as we go forward, and we've given some mid-range guidance in the next 3 to 4 years. We think that's going to continue to increase to closer to 5%.

Got it. Okay. And this will probably answer some of the questions or a piece of this question, but maybe discuss the broader financial profile of ScanSource and the key metrics that you're focused on?

Sure. So when we're executing this hybrid strategy, one of the big things that we talked about and introduced last year was a new metric for us, which was the percent of gross profit coming from recurring revenues. That was a big deal for us because that was kind of the proof point that this transformation is working and translating into financial gain for the company and for our investors. That percent of gross profit coming from recurring revenue, naturally increases our gross profit margins overall as a company. And so that's the next step. So when we look at that, we see these expanding margins. Then you look at our ROIC, and we're consistently hitting mid-teen ROIC as a financial metric. And that, we believe, is our value creation metric for us. If I expand on this just a little bit, when we look at the metrics overall as we go forward in our new hybrid distribution strategy, it's really 4 things. Those 3 plus we believe that we have to have sustainable top line growth. Remember, when we talk about our revenue streams, a big portion of that is hardware. That's got to continue to grow. And so we've given a 3- to 4-year guidance where our revenues are going to grow sustainably at 5% to 7.5%, which is faster than the markets that we serve. If we think about our profitability that adjusted EBITDA margin will go from 4.5 to 4.8 moving towards 5. And there's 2 real drivers underneath that. One is that mix that we talked about in our gross margin and then the other one is we're going to continue to gain leverage on our SG&A. And those 2 things help us to expand that profitability margin. We believe those 2 things will then lead to a mid-teen ROIC consistent performance. And then last but not least, over the next 3 to 4 years, we believe that we're going to be hitting 30% plus of our gross profits coming from recurring revenue streams. And that, we believe, has a different value creation for investors than where we were 6 years ago, which was 0 and where we are now.

Where -- what's the mix right now?

Right now, it's 24%. So we started tracking that and talking about that on our earnings calls mid last year, I think.

Okay. So Mike, again, going off script here. If about 1/3 of your business is going to be this 40% operating margin, faster growing, really attractive digital distribution business. And I know that there are stand-alone businesses primarily in the private markets that just do that digital distribution piece. I guess how do you think about the value of keeping these 2 businesses together? Because I could imagine an outside investor might kind of look at these as kind of 2 disparate assets and say, hey, why don't we take this one and make it a separate entity, split it up, some sort of value creation opportunity between the 2. So we tend to look at these things on paper as if that's really easy to do and not in practice. But yes, if you could split -- create the Intelisys -- the old Intelisys piece and have a much different valuation multiple and there could be a lot of things you could do. So maybe kind of speak to your vision of either potentially pursuing that at some point or why they need to be together?

Well, we certainly believe that our hardware distribution business is frankly undervalued. And I think one of the things we learned as we went down this hybrid path and really pushed it hard with our customers last year is we're now getting into hardware opportunities because we can do the connectivity and cloud and digital that we would not have been able to do before. So that business, the hardware business is growing frankly, faster than we thought it could. It's because we're now getting -- one example, we had recently where we had a big customer who needed to deploy mobile devices and each mobile device, which was a hard and rugged device, not an iPhone needed a SIM card. And so our typical sale would not include the SIM card. Our partner would not sell the SIM card. As a matter of fact, this particular deal was not going to go through us or our partner. But because we could provide a eSIM, they call it, which would allow our customer, and this was for I think about 5,000 mobile devices. So it’s a big order. Our customer want that because we could work with them to program and put the SIM cards in the devices at our distribution center and ship them to the end user. So we got a 5,000-unit order because we can do both. So in my mind, the vision is we need to do more of that. If that proves not to be the future, then obviously we would think differently. But we believe right now that, that's going to help us continue to grow both the hardware and the digital business. And yes, we think the probable -- one of the reasons that people still probably discount the hardware business is because of that earlier comment we talked about relative to our on-prem communication business. It has gone down dramatically from where it was, but we've had a headwind for at least 6 years where that business has been declining, say, 20% a year. And we've been trying to be careful not to draw too much attention to it so that we don't embarrass one of our suppliers. But the point is -- we now -- that business is now -- and I think on our earnings call, we said it was less than 10%, just communication on-premise business that is no longer the headwind it was. We believe there will still be some sold. I think that's going to allow us to see improvements in our business.

Okay. That's helpful. And you report on -- 2 segments, Specialty Technology Solutions and Modern Communications & Cloud, which you thankfully redefined marry.

Yes.

Back to the old segments.

Yes. Yes.

If you want to maybe just kind of give a quick for investors not familiar of those 2 segments and the key growth drivers in each segment?

Well, what's interesting in the Specialty Technology segment, that's one that, frankly, again, reflects where we've come from. It's still this old automatic identification business called barcode, call it POS, whatever you want to call it. But now I would say the big push is mobility, identification, communication with the SIM cards, where we used to -- not provide that anymore. So we're seeing a fantastic growth in mobility. These again are rugged devices that require batteries, that require the batteries to last throughout a day. And so there's always these, I would say, hype segments of our barcode business. Some of you guys remember the RFID high back in early 2000s. Well, guess what you use as your key in this hotel, an RFID key. I mean the oldest forever new, sometimes these things come around too early. But I think our business is benefiting from all of these technologies that are now starting to become mainstream. Again, using your camera to take a picture of a QR codes, so you can get information. That all has allowed the market opportunity for our oldest business, barcode, to continue to grow. So it's growing. We've got our video surveillance business continue to do amazingly well. And of course, no surprise, people want cameras everywhere. And we're focused on B2B, not B2C, but cameras everywhere and being on the network allowed us to grow our network business. So we have -- we didn't start out saying we want to be a network product distributor, but we now are a very large network product distributor because you need wide -- local area networks and access points and routers and switches. And so our Cisco business took off dramatically over the last few years because of the need for network services. So that segment has continued to do very well. And then overall on modern comms, the growth of the Intelisys business is, again, fueling the growth of the RingCentrals, the Zooms, the 8x8s, all of the UCaaS and now CCaaS, whether it's Five9 or others, CCaaS and we work with Genesys. Genesys was a huge competitor to our Avaya channel for many years in contact center. Now they're a partner with us. So we've added contact center as a service capability, and we see that growing dramatically over the next few years.

Perfect. You mentioned Cisco and they've been kind of the poster child for supply chain constraints -- so not speaking specifically about them, but it just reminded me to ask the question on update broadly on supply chain constraints. Is it stabilizing? Is it getting better? We're sitting here and with the end of the calendar year coming up, we typically get some level of commercial budget flush, I'm just kind of curious, your view of supply chain at this point?

Well, the supply chain hasn't changed a lot in the last year, meaning lead times for us. So -- but what's happened is we've gotten used to lead times that are longer than ever. The reality has always been we have consistency from the suppliers, even if it's a 4-month lead time versus 60 days, we can win because we can then plan what we need for our channel partners. I think it's -- we've taken on more inventory as a result. We have to constantly look at our ROIC and make sure either that metric is appropriate or we go back to the suppliers and say we need more margin. And so in some cases, we've asked for more margin to offset the additional inventory. Now some people would argue, including some analysts that maybe we're not getting paid enough, and we would agree with that. And we want to share that with our suppliers who are listing. But we love the idea that we're winning market share because we have inventory. But we don't think it's going to get much better any time soon now.

Okay. So not seeing much improvement in supply chain at this point?

Yes. And again, it's the lead times that would change. Right now, we're good with the lead times, we are. We don't need it to improve to make our business better. Our business is very healthy with the way it is today.

Okay. Yes. And Steve, let's stay on that topic. You called out higher working capital investment in the September quarter. What are the drivers for higher inventory and accounts receivable as well? Because I know Mike touched on inventory, but not the AR piece. How temporary are these higher levels? And should we see higher ROIC when working capital metrics improved?

Yes, to Mike's point, the inventory increase is really an offset to the supply chain challenges. And so those longer lead times, you would carry more inventory to adjust for that. The other thing that we're having to adjust for is the lead times are inconsistent. And so that predictability makes it challenging. But where we're sitting today is we've got a market that has very strong demand. And so we want to make sure that we're in a position to take advantage of that. And this is what ScanSource has done historically, has been able to leverage our strong balance sheet to be able to take advantage of market trends and market demand that's out there. So that's really raising our inventory level. The good thing is, is in this constrained environment, we're the #1 or #2 customer for many of our suppliers. So Mike introduced me to a new term, getting more than our fair share of allocation. And so we feel like we're getting more than our fair share of allocation and we're happy to do that because we still see the demand being strong in the future. We haven't seen any kind of drop-off there. When we look at the AR, it's a little bit different. So this is now shifting over to our sales partner and trying to address some of the problems that they're seeing with this supply chain interruption. So we've got a sales partner who has a solution. They can get 90% of the SKUs to go deliver that solution, but they can't get the last 10%. Well, we're allowing them with some collared AR terms, some extended terms to take that inventory and go deploy it, but they're not going to get paid from their customer until that solution is complete. And so maybe it's, hey, I can't get cradles for my barcode scanners or whatever it may be, they have to complete that order to get paid.

The Golden Screw.

Exactly. The Golden Screw, perfect. So what we're trying to do is for our good payers, we're trying to work with them and help them be successful and kind of offset some of that supply chain slack that's in there on those last components. For us, it's getting the order off the street. So we get the majority of the order upfront, and we know that they're committed for the last 10% and we're happy with that. Now as supply chain disruptions kind of normalize and eventually they will, I would love to know when, but eventually, they will. Our working capital will come down. And as it does, our ROIC will rise as we're in that transition period, for sure.

And so what you described creates 2 risks to touch on, I'm sure you thought about this, but elevated inventory or taking on more inventory, broadly speaking, across the tech conference, we're hearing of second derivative of demand decelerating. And so if we go into a scenario where demand really softens more significantly and you have excess inventory, have you thought about the possibility of inventory write-downs? And then secondly, lending more on the AR piece like you just described the potential for bad debt.

Yes. As you know, Adam, for a distributor working capital is king. That's what you have to focus on. On our inventory, we've got a few things that we rely on in terms of the systemic ability to either push some inventory back and do some rebalancing with our suppliers. We're always looking at -- people may be surprised, we have probably close to 200 people looking at our inventory daily. And so they're in there managing and monitoring at a SKU level what we own. So we believe our inventory is fresh from a bigger macro kind of risk. We've got price protection. So if the prices drop, we're protected in that situation. And we're constantly looking out to make sure that our inventory is the right inventory. And then the last piece of that is a lot of our deals, a big portion of our deals are specific and priced into the system. And so we know that end user. That's a deal that's kind of called or named out in the future. So that gives us more confidence that those deals will go through.

Any questions? We've got about 4, 5 minutes hit capital allocation here in a second, but if you think of anything, just raise your hand. Actually, before I do capital allocation, you talked about -- in the answer to the inventory, you talked about a very strong demand. And I think Mike and Steve, you both talked about very strong demand. That's probably surprising for investors to hear. So maybe if you could double click on that comment. Where is demand strong? Where are you seeing very strong demand? Is it particular pockets or by technology or just any color?

Sure. I think mobility, so this mobility business. And again, that leads to automation and productivity for companies as they've got distributed employees. There's a big one in self-checkout. We talked about that on a few calls with investors is I was in the airport recently and going to one of the Hudson's little stores where you buy stuff. Every one of them has self-checkout at the end, right? And we didn't have those 3 years ago. So self-checkout has just taken off like gangbusters, and that was not a product we could sell 3 years ago. So the -- excuse me, those are 2. And then the last one is, again, our video camera, video surveillance business continues to just boom, with all the issues around crime and policing and a big customer for our channel is education to schools. They're a huge customer for video surveillance. So those are the 3 areas that are really still just booming.

Makes more sense when you put it in that context.

And then, Adam, we also talked about our UCaaS and CCaaS business on the last call. And I think we said CCaaS was growing at 20%, UCaaS growing at 60%. So we still see strong demand in those digital businesses that people have tended to say, hey, where are we in this refresh cycle. We still see strong demand there.

Perfect. So let's touch on capital allocation, how you think about that? And when you think ScanSource will start generating cash? How will you use those proceeds?

Yes. Our capital allocation strategy is really twofold. First is to have a good capital deployment strategy. And the second one is to make sure we have a very strong balance sheet. On that capital allocation strategy, it's still really three-pronged. First one is to fuel our growth. And growth has 2 forms for us. One is organic growth which you've seen us invest in our working capital to take advantage of that. The second one, we've been acquisitive as a company, and we still believe there's some M&A opportunity to help accelerate our hybrid distribution strategy. Now they won't be transformative. There'll be more tuck-ins and specific things that can help us either grow our recurring revenue or expand our margins. So that would be another growth opportunity for that. Again, we want to make sure we've got a strong balance sheet. So as we think about that capital allocation, we still target between 1 and 2x adjusted EBITDA for our leverage ratio. Some may say that's conservative, but we believe that keeps us flexible and agile to take advantage of those opportunities as they come up. And then lastly, it would be to return capital to shareholders in the form of a share repurchase. When we think about cash, we've called it out on our last 2 calls, I believe, that we think we're going to use cash in the first half as we've had higher growth and we've invested in our working capital. We believe in the second half of our FY '23, which starts in January that that will -- we'll be in a free cash flow generation period.

And then what -- how does that shake out for the whole year, positively?

We believe it's going to be positive for the whole year.

Got it. Well, 1 minute -- actually, we're out of time, but Mike, the key message that you'd like to leave with investors as they think about ScanSource both near and long term?

Well, we're in growth businesses, in technology, and we're a lower-cost partner for all these manufacturers that are trying to figure out how do they lower their cost. We help them reach the market at a variable cost basis. And so we're seeing more interest from suppliers to use distribution now than ever.

Perfect. Mike, Steve, thank you so much.

Thanks.

Thanks, Adam. Appreciate it.