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Good afternoon, and welcome to the Third Quarter 2020 Connection Earnings Conference Call. My name is Chiloe, and I'll be the coordinator for today. At this time, all participants are in a 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 rebroadcast without specific permission from the company.
On the call today are Tim McGrath, President and Chief Executive Officer; and Tom Baker, Senior Vice President and Chief Financial Officer.
I will now turn the call over to the company.
Thanks. I will now read our Safe Harbor statement.
Any statements or references made during the conference call that are not statements of historical facts 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, 2019, as updated in the Form 10-Q for the period ending September 30, 2020, each of which are 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 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 as of any date subsequent to today.
During this call, GAAP and non-GAAP financial measures will be discussed. The reconciliation between the two is available in today's earnings release and on the company's website at www.connection.com. Please note that unless otherwise stated, all references to third quarter 2020 comparisons are being made against the third quarter of 2019.
Today's call is being webcast and will be available on Connection's website. The earnings release will be available on the SEC website at www.sec.gov and in the Investor Relations section of our website at www.connection.com.
I would now like to turn the call over to our host, Tim McGrath, President and CEO. Tim?
Thank you, Samantha. Good afternoon, everyone, and thank you for joining us today for Connection's third quarter 2020 conference call. As you see from our press release, our third quarter improved substantially over the second quarter.
While clearly not back to pre-COVID levels, business activity is increasing. Momentum picked up in late June, as I mentioned on our second quarter call, and continued through July and August as our teams stepped up to help customers further define their work from home and remote work strategies.
Through September and October, we saw our continuation of this improvement with an acceleration of our public cloud adoption, growing demand for digital e-commerce platforms, digital health technology, software subscriptions, managed services and security.
The increased activity which has continued through this fall helped us deliver third quarter revenue of $652.8 million and gross profit of $107.8 million. These results were down 10.5% and 9.3% respectively compared to a record Q3 in 2019.
Gross margins of 16.5% were up 22 basis points compared to Q3 of 2019. Operating income was $21.1 million, a decrease of 35.4% or 3.2% of net sales, compared to $32.6 million or 4.5% of net sales in the prior year quarter. In Q3 2020, diluted earnings per share were $0.64, a decrease of 28.3% from Q3 2019. We ended Q3 with a $108 million of cash and cash equivalents representing an increase of $18 million from December 31, 2019.
Before I provide a more detailed discussion of our performance by segment, I want to update you on our Enterprise Resource Planning or ERP implementation, which began in the second quarter as discussed on our call in August. I said the implementation was essentially complete in Q2 and it was. But it’s been more costly than anticipated in Q3.
Some adjustments and process improvements are continuing in Q4, but at lower levels than in Q3. To remind you, the new system will serve as a foundation for our path forward supporting growth, greater collaboration, visibility and efficiency across the entire organization helping with solution sales, cloud, CRM, common catalogues, and financial.
It will also enable better customer service and give us an improved foundation for evaluating and integrating future acquisitions. But as I said last quarter, the transition has not been without pain. During Q3, we determined that due to switchover processing errors, the company recorded certain other period adjustments related primarily to the Business Solutions segment.
Second quarter net sales, gross profit and net income, were understated by $945,000, $4.2 million and $3 million respectively. Accordingly, these adjustments are reflected in our Q3 results. In consultation with our professional advisors, we determined that these out of period adjustments were not material to our prior and current financial statements.
ERP implementations are a bear as anyone who lives through them will tell you, but I am optimistic that we were at the point with significant long-term benefits of having done it will be clear over the year ahead.
Now let me go through our performance by segment. In our Business Solutions segment, Q3 net sales were $231 million, a decrease of 15.6%, compared to $273.8 million a year ago. Gross profit in the Business Solutions segment was $46.6 million, a decrease of 10.7% from a year ago and gross margin for this segment increased by 112 basis points to 20.2% in the quarter, compared to 90% in the prior year.
The increase was partially due to an increase in sales and cloud-based security software, which are recognized on a net basis and the impact of the out of period adjustments just discussed. We were experiencing improvement in our Business Solutions segment. However this continues to be the segment most affected by the COVID-19 pandemic as many of our customers have not yet returned to previous levels of business activity.
In our Public Sector Solutions segment, Q3 net sales were $162 million, a decrease of 8.7%, compared to $177.4 million a year ago. Sales to state and local government and educational institutions was $130.5 million, an increase of 9.9%, compared to the prior year.
The increase in the SLED business was largely the result of increased sales to higher ed institutions that were purchasing devices for remote learning after experiencing record growth of 88% in 2019, sales to the Federal government were $31.5 million, 46.3% lower than the prior year.
Q3 of 2019 benefited from the timing of several large Federal project rollouts that did not repeat in Q3 2020. Gross profit for the Public Sector segment was $22.8 million, a decrease of 7.4%, compared to Q3 2019. However, gross margin grew by 20 basis points to 14.1%, as Software-as-a-Service became the largest component of our product mix.
In our Enterprise Solutions segment, Q3 net sales were $259.8 million, a 6.7% decrease, compared to $278.3 million a year ago. Gross profit for the Enterprise segment was $38.4 million, a decrease of 8.7% in the quarter. Gross margin for the Enterprise segment decreased by 33 basis points to 14.8%. The Enterprise segment continue to see strong demand for endpoint devices and for software in continued support of a remote workforce.
Having covered our sales and gross margin performance, I’ll now turn the call over to Tom to discuss additional financial highlights from our income statement, balance sheet and cash flow statement. Tom?
Thanks, Tim. SG&A was $86.8 million this quarter, an increase of 0.6% from $86.2 million a year ago. The increase in SG&A was driven primarily due to an increase of $2.7 million in professional fees, associated with the rollout of our new ERP, offset by a decrease in advertising spending and variable compensation due to the lower level of sales and gross profit achieved compared to the prior year quarter.
SG&A as a percentage of net sales increased by 147 basis points year-over-year, largely as a result of lower revenue. However, sequentially, SG&A as a percentage of revenue declined by 79 basis points.
A large portion of our cost structure is variable and will scale with the business as business conditions continue to improve, we do expect SG&A as a percentage of revenue to moderate despite some continued investment in our ERP system. We remain committed to optimizing our cost structure to scale with the demands of our business as necessary.
Our operating income was $21.1 million, a decrease of 35.4% this quarter from $32.6 million a year ago. Our effective tax rate was 19.6%, down from 27.4% in the same period a year ago. Included in the current quarter’s tax expense is a one-time discrete tax credit of $1.7 million related to recognizing R&D tax credits for the first time. Net income for the quarter was $16.9 million, a decrease of 28.7% from $23.7 million a year ago.
Diluted earnings per share was $0.64, a decrease of 28% from the prior year period. Our trailing 12-months adjusted earnings before income taxes, depreciation and amortization or adjusted EBITDA decreased 23% to $99.3 million from $129 million a year ago. We have $12.7 million remaining for stock repurchases under our existing stock repurchase program.
Cash flow from operations for the first nine months of 2020 was $46.4 million versus $40 million for the same period a year ago. The change was driven primarily by an increase in accounts payable offset by an increase in accounts receivable and inventories. Our net cash used in investing activities of $9.6 million in the first nine months of 2020 was primarily the result of equipment purchases and IT initiatives.
The company used $18.8 million of cash for financing activities during the first nine months of 2020, consisting primarily of the Q1 payment of $8.4 million for our previously declared 2019 special dividend and $10.2 million of stock repurchases.
I will now turn the call back over to Tim to discuss current market trends.
Thanks, Tom. As I said earlier, I am optimistic about continued improvement in our business. I am proud of how our team has helped our customers continue to adjust to the challenges brought about by the COVID-19 pandemic. We remain confident that we are very well positioned to meet their needs going forward. We continue to work closely with our customers as their technology needs evolved during the pandemic.
Education continues to be a strong market as we support institutions managing a hybrid environment of classroom and online learning. In healthcare, we are working with our customers to optimize their infrastructure, following the first and second waves. These efforts support our customer’s ongoing investments in telemedicine, virtual care and workflow solutions for home-based knowledge workers.
In fact, our healthcare revenue this quarter match last years’ levels. We saw strong demand for Software-as-a-Service and we expect continued growth in this area for workplace transformation, cloud, security, and business resiliency solutions through our Technology Solutions Group, TSG. TSG delivers comprehensive technology solutions to our customers through a combination of advanced consulting and industry-leading brands among other things.
Our industry expertise and industry-specific solutions have become strong differentiators in our core vertical markets, healthcare, retail and manufacturing, our largest vertical markets showed continued sequential growth. We also saw double-digit year-over-year growth in the retail market.
Moving forward and for the balance of 2020, as our customers’ needs grow and change, we will be here to help them enhance growth, elevate productivity and empower innovation with technology.
I want to thank our team for their continued passion and extraordinary efforts through this unprecedented time. And I want to thank you, our shareholders that we are confident that our financial strength, dedicated workforce, relentless pursuit of innovation, and strong customer relationships will propel us forward for many years to come.
We’ll now entertain your questions. Operator?
[Operator Instructions] Our first question comes from Adam Tindle with Raymond James. Your line is now open.
Okay. Thanks good afternoon. Tim, I just wanted to start on the notion of continuous improvement and if it was possible to put a finer point on what you are seeing from a growth perspective in the months of October and November? Are you to a point now where your total company is seeing positive year-over-year growth?
And also, maybe secondly, how do you expect us to trend into the month of December based on the pipeline you are seeing? Just curious if there is customer budget left for a flush or has there been funds exhausted, so just – finer points on months of October and November and early indications on December. Thanks.
Well, thanks, Adam. I appreciate the questions. So, if we think about Q4, obviously, there are a lot of macroeconomic factors not the least which is the vaccine in the pandemic, what we are really seeing is, as I mentioned, we saw continuous improvement throughout the quarter in Q4 though, I think similar to what our competitors have been modeling, we are still thinking about being slightly down year-over-year for the balance of Q4.
I think, sort of a square root, as you pointed out, and I’d see a good graphical representation of what we’ve seen. So we are continuing improving, but we want to be very cautious about that outlook as there is still are a lot of unknowns. Regarding a budget flush, there are some large projects rolling out in the quarter.
We do see some strong companies investing, by the same token we also see other companies that are holding back because of their challenges. And so, we really do not see the traditional budget flush happening.
Tom, anything to add?
In Q4 of last year, we saw a real – there was a lot of software purchasing in the last two weeks through the quarter and I think the risk about whether that happens now.
Yes. That’s understandable. That’s helpful though. Thank you. I also wanted to ask, Tim, you talk about obviously notebook is your biggest category and just kind of a two-parter on both supply and demand. I guess, first on supply. So just talk to us about how constrained supply is right now? Are you missing opportunities in that category?
And then, secondly, on demand, obviously, the stock market today thinks work from home is going to moderate and this is a category that typically is associated with that. But curious what you are seeing in terms of the cadence of demand for notebooks. Is it beginning to soften yet?
Yes. So, we haven’t seen it begin to soften yet. So, as you know, notebooks have been incredibly resilient. Right now, we are seeing in the education space, very high demand for Chromebooks and as you know supply there has been constrained.
We are seeing spotty constraints really across our supplier base with several of the models being constrained. And that said, overall, we don’t see a big pullback in demand happening, although logically it’s going to moderate from times too just based on what’s happening in the economic environment.
Understood. Maybe just one last clarification on Tom, on cash flow. I know it’s been healthy year-to-date, but its use this quarter and AR was an issue in the quarter. I am guessing that some of that’s probably related to software sales, but maybe just an opportunity for you to talk about the health of the receivables portfolio?
So, if you go back, Adam, two quarters you see, there are three things that are really affecting that receivable balance. Number one is we have granted some extended terms to customers as we go through the current economic environment. Number two is software sales and if I look at the difference between computing, DSO based on billings versus based on revenue, that differential has nearly doubled in two quarters.
So, you are seeing a real lift – real impact of software sales. And then the third, we’ve spent a little extra money on our ERP system. One of the things we do is, we are reasonably highly customized in how we deliver our invoices to our customers and what format we deliver them.
And one point in the quarter, getting invoices to our customers in a format that they expect was we hadn’t really muscled it through and then there were some delays. In each one of those three items accounts for both a third of the growth in that balance.
Very helpful. Thank you guys.
Yes. Thank you.
Thank you. Our next question comes from Anthony Lebiedzinski with Sidoti & Company. Your line is now open.
Thank you and good afternoon. And thanks for taking the questions. So, first, just looking at the quarter, you highlighted retail vertical market strength. You also talked about TSG as well. So, first, I guess, what’s driving specifically some of the retail strengths? And can you give us a sense also as to what percent of your sales of your – or maybe your gross profit dollars is coming from the Tech Solutions group?
Anthony, thanks. Good to hear from you. So, yes, we are very pleased with our retail market and that segment’s growth. We think there are couple of large drivers for that. One of them is our Industry Solutions group that’s done a lot of work in helping our sales force deliver specific and really relevant expertise around retail solutions. The other is just as large retail project roll outs. And so, that really is the combination of what’s driving that growth. We have not specifically broken out the retail or the ISG, the virtual markets group.
Or the TSG group.
Or the TSG group. So, we don’t have that at this time.
Got it. Okay. That’s fine. So, as far as the ERP system, I mean, do you think that by the end of Q4, you guys will be behind some of the issues that you’ve called out?
Yes, Anthony, we called out specifically professional fees in our prepared remarks there. And there is probably $200,000, $300,000, $400,000 of other costs that were incurred. We saw $3 million in total. Our expectation is we are going to cut that by at least a third this quarter. And rolling into Q2, it should come down, I mean Q1 it’s going to come down even more than that. So, we are going to – I think we are seeing the light at the end of the tunnel here.
Got it. Okay. Perfect. Okay. And then, so, as you pointed out, I mean, there has been some positive news about a vaccine today. So, how should we think about the impact on your business that you foresee given this, let’s say happens next year? Or what are you broadly thinking about the impact on the business?
Yes, Anthony. Again, we’ve seen it kind of what the competitive landscape has modeled for those who have forecasted it. And I think we are in that range, where if you think about our commercial business, enterprise, SMB business, our growth we are certainly in the range of the competitive landscape. And so when we think about Q4, we are thinking about that same range. We are really thinking that there is too many uncertainties to really dramatically pull that forecast up. And so, I think we are going to continue to forecast about the way we did in Q3 for Q4 in terms of revenue growth.
Okay. Got it. Okay. But then, next year, I would assume that given the comparisons that you are going to be facing that, that should help that also. Okay, I guess – okay, and then – and last question, I guess, for Tom, do you expect the tax rates to go back down to that 27%, 28% range in the fourth quarter?
Yes. So, our normalized tax rate is still in that 27.5-ish percent range. What you are seeing in this quarter in fact, we just filed for the first time with the R&D tax credits and that gave us that discrete item of about $1.7 million. So, if you add that to our current tax expense, you get back to about the normalized rate.
Got it. Alright. Well, thank you and best of luck.
Anthony, we want to provide a little more color on our last thing, we think about 2021, there are lot of encouraging signals out there around growth and specifically as we think about our customer base and the efficiencies around our new ERP system, there is a lot to look forward to. So, when it comes to 2021, in addition to a relatively easier compares, we are thinking there will be legitimate market growth.
Got it. Alright. Thank you and best of luck.
Thank you.
Thank you. I am not showing any further questions at this time. I would now like to turn the call back over to Tim McGrath for closing remarks.
Thank you. I'd like to thank all of our customers, vendor partners and shareholders for their continued support, and once again, our dedicated co-workers for their efforts and extraordinary dedication through this time. I'd also like to thank those of you 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 call. Thank you for participating. You may now disconnect.