Business Context and Reporting Period
ScanSource, Inc. is a global technology distributor and services provider serving approximately 38,000 customers and more than 500 suppliers across the United States, Canada, Latin America and Europe. Its two segments are Worldwide Barcode, Networking & Security and Worldwide Communications & Services.
This unaudited Form 10-Q covers the quarter and nine months ended March 31, 2019, ScanSource’s fiscal third quarter of 2019. The request labels the period “2018 Q3,” but the filing reports fiscal 2019 results.
Financial Performance and Position
| Metric | Quarter ended March 31, 2019 | Prior-year quarter | Nine months ended March 31, 2019 | Prior-year nine months |
|---|---|---|---|---|
| Net sales | $893.4 million | $895.6 million | $2.912 billion | $2.852 billion |
| Gross profit | $110.0 million | $103.9 million | $342.7 million | $322.8 million |
| Gross margin | 12.3% | 11.6% | 11.8% | 11.3% |
| Operating income | $18.8 million | $17.9 million | $69.9 million | $47.9 million |
| Net income | $11.7 million | $10.6 million | $46.0 million | $22.8 million |
| Diluted EPS | $0.45 | $0.42 | $1.79 | $0.89 |
- Quarterly sales declined 0.3% as reported, but increased 2.0% on a constant-currency, acquisition-adjusted basis. Nine-month sales increased 2.1% as reported and 3.9% on that adjusted basis.
- Quarterly operating margin was 2.1%, versus 2.0% in the prior-year quarter. Nine-month operating margin was 2.4%, versus 1.7%.
- Quarterly non-GAAP diluted EPS was $0.77, versus $0.68; nine-month non-GAAP operating income was $99.1 million, versus $93.2 million.
- Quarterly and nine-month effective tax rates were 25.8% and 25.4%, respectively, compared with 32.6% and 46.9% in the prior-year periods. Management expects a fiscal 2019 effective tax rate of approximately 25% to 26%, excluding discrete items.
Segment Results
- Worldwide Barcode, Networking & Security sales were $596.9 million for the quarter, down 1.2%, while operating income increased 45.8% to $16.9 million. Results benefited from higher vendor programs and improved gross profit; reported sales were pressured by foreign exchange and lower big-deal volume.
- Worldwide Communications & Services sales were $296.4 million, up 1.8%, while operating income declined 66.1% to $2.2 million. Higher employee-related costs and weaker international operating performance offset sales growth.
- For the nine months, Communications & Services sales increased 5.6% and operating income increased to $22.0 million, primarily because contingent-consideration expense was substantially lower than in the prior year. Excluding that item, adjusted operating income declined to $33.4 million from $35.4 million.
Cash Flow, Liquidity and Debt
- Cash used in operating activities was $24.5 million for the nine months, compared with $6.2 million used in the prior-year period. The primary use was a $169.0 million increase in inventories.
- Cash used in investing activities was $43.1 million, including $32.2 million for acquisitions and $11.0 million of capital expenditures.
- Cash provided by financing activities was $62.3 million, principally from net revolving-credit borrowings, partially offset by contingent-consideration payments.
- Cash and cash equivalents were $20.4 million at March 31, 2019, versus $25.5 million at June 30, 2018. Net working capital investment increased to $752.7 million from $651.9 million.
- Total debt was $347.7 million, including $342.6 million drawn under the revolving facility, compared with $249.4 million at June 30, 2018. Revolver availability declined to $57.4 million from $156.0 million. The company was in compliance with all debt covenants.
- Inventory turns fell to 4.3 times in the quarter from 5.5 times in the prior-year quarter, reflecting strategic inventory purchases and lower-than-planned sales. Management expects fiscal 2019 capital expenditures of $10 million to $12 million.
Material Changes Versus the Prior Comparable Period
- Profitability improved despite essentially flat reported quarterly sales, driven by higher gross profit margins, lower year-to-date contingent-consideration expense and lower tax rates.
- Year-to-date change-in-fair-value expense for contingent consideration fell to $11.5 million from $28.6 million. The remaining liability was $74.3 million at March 31, 2019, primarily related to Intelisys.
- ScanSource acquired Canpango, Intelisys Global and RPM during fiscal 2019 for combined net cash consideration of approximately $32.2 million. The acquisitions were not material individually or in aggregate to consolidated results, although RPM purchase-price allocation remained incomplete.
- Goodwill increased to $319.0 million from $298.2 million, primarily from current-year acquisitions. Inventory increased to $760.7 million from $595.9 million.
- Interest expense rose to $9.4 million from $6.7 million for the nine months because of higher average revolving-credit borrowings.
- The company adopted ASC 606 using the full retrospective method on July 1, 2018; management reported no material impact on the consolidated financial statements.
Guidance, Outlook, Risks and Unusual Items
- Management expects a fiscal 2019 effective tax rate of approximately 25% to 26% and capital expenditures of $10 million to $12 million.
- On April 30, 2019, after quarter-end, ScanSource entered into a new credit agreement with a $350 million revolving facility and a $150 million term loan, maturing April 30, 2024. The agreement includes an accordion feature permitting total commitments of up to $750 million, subject to lender commitments.
- Future Intelisys earnout payments are expected to reach up to approximately $85.0 million on an undiscounted basis and are expected to be funded through operating cash flow and the revolving facility.
- Key risks include foreign-exchange and interest-rate volatility, dependence on major suppliers, customer credit risk, demand and pricing pressure, acquisition execution, working-capital requirements, and the ability to achieve expected results from acquisitions.
- Foreign-currency contracts had a net notional amount of $104.9 million. A hypothetical 100-basis-point interest-rate change was estimated to affect annual pre-tax income by approximately $3.1 million; a hypothetical 10% foreign-exchange movement was estimated to affect pre-tax income by approximately $0.9 million.
- Unusual items included $1.9 million of restructuring costs during the nine months, $1.0 million of acquisition costs, contingent-consideration fair-value expense, and a $0.2 million discrete tax benefit related to finalizing Tax Cuts and Jobs Act accounting.
- Management stated that litigation is not expected to have a material adverse effect, that no material off-balance-sheet arrangements exist, and that existing liquidity should satisfy requirements for at least the next twelve months.
Important Facts for Investors to Verify
- Reconcile the request’s “2018 Q3” label to the filing’s March 31, 2019 fiscal third-quarter reporting period.
- Assess whether the $165 million inventory increase, lower inventory turns and negative operating cash flow indicate temporary strategic stocking or emerging demand and working-capital pressure.
- Review available borrowing capacity after the April 30, 2019 refinancing and the effect of the new term loan on leverage, interest expense and covenant headroom.
- Validate the assumptions and timing underlying the remaining Intelisys earnout liability and the reported potential payments of up to $85.0 million.
- Separate recurring operating performance from amortization, contingent-consideration remeasurement, restructuring and acquisition costs when evaluating non-GAAP results.
- Monitor segment trends, particularly the decline in quarterly Communications & Services operating income and the weaker international performance.
- Review acquisition integration, the incomplete RPM purchase-price allocation and the carrying values of goodwill and intangible assets.