TESSCO Technologies Incorporated

David Calusdian - IR Murray Wright - President and CEO Aric Spitulnik - CFO

Bill Dezellem - Tieton Capital

Good morning, everyone, and thank you for joining TESSCO's Q2 2018 conference call. Joining me today are Murray Wright, TESSCO's President and Chief Executive Officer; and Aric Spitulnik, the Company's CFO.

Please note that management's discussion today will contain forward-looking statements about anticipated results and future prospects. Forward-looking statements involve a number of risks and uncertainties and TESSCO's results may differ materially from those discussed today.

Information concerning factors that may cause such a difference can be found in TESSCO's public disclosures, including the company's most recent Form 10-K and other periodic reports filed with the Securities and Exchange Commission. With that introduction, I'd like to turn the call over to Murray Wright, TESSCO's President and CEO.

Murray?

Thank you, David, and good morning, everyone. Thank you for joining us on the call today.

We showed good progress this quarter as we continued our recent trend of year-over-year top and bottom-line growth. In fact, this was our fourth consecutive quarter of year-over-year revenue growth and our third straight quarter of EPS growth, of $0.21 EPS was the largest quarterly profit in seven quarters.

Revenue grew and all commercial markets including a 48% increase in revenue from the carrier market. As you know, we've been intent on improving our engagement in the carrier ecosystem during the past three quarters.

It's rewarding to see our efforts in that market continued to deliver results. The improved bottom-line performance was a direct result of the revenue growth we are seeing in the business combined with our effective expense management.

The initiatives we have put in place over the past year are targeted at generating higher revenue growth and managing our operating costs to improve profitability. Our financial results this quarter demonstrate that we are executing on our plan.

We are continuing to implement significant changes throughout the organization. And as we have previously said, this will likely cause fluctuations in our results through the remainder of the fiscal year.

We believe the execution of our strategy this year will provide a strong foundation for success in fiscal 2019. I'd like to give you an update on the progress we are making on our key priorities.

As we have discussed on previous calls, recalibrating our go-to-market strategy is a major undertaking for us this year. We made solid progress on the regionalization of our sales teams, bringing our sales professionals closer to our customers, driving efficiencies and forging stronger relationships.

We are beginning to win more business because of this stronger engagement in all markets. For example, we have increased our face-to-face meetings with customers and we are generating valuable market intelligence.

In the public carrier market, we have gained market share, in a large part because of strong ecosystem commitment and careful attention to our customer's needs. We are creating relevant solutions to maximize our customer supply chain demand.

Next, we are striving to improve how we engage with our vendor partners. We are developing deeper relationships and better collaboration with our value partners.

We are working better together to uncover new opportunities and develop new partnerships. To that end, in September.

TESSCO held its first ever vendor summit, gathering our key vendor partners to develop mutual objectives for the coming year. The feedback from our vendor partners was overwhelmingly positive, including the unveiling of TESSCO's vendor linked program which enables our key vendors to participate in a variety of go-to-market opportunities to better reach our customers.

And finally, we are working diligently to increase operating margins by balancing growth and costs. We are implementing cost efficiency initiatives throughout the organization, we are ensuring that we have the right talent and resources in critical areas throughout TESSCO, and at the same time we are concentrating our efforts on productivity and process improvements and capitalizing on key market opportunities.

We expect these, and other actions will increase our operating leverage and improve profitability as we accelerate our sales trajectory. And now, I'd like to provide a brief overview of our markets.

First, the public carrier market ecosystem. As I said earlier, we made significant gains in public carrier market sales from a year ago as the changes we are making in our go-to-market strategy continue to payoff.

The key point here is that our plan is working. Our sales, product, supply chain and program management teams are winning new opportunities while we work with our vendor partners to ensure our product offer and pricing are well-positioned for success.

While we are gaining market share, we have experienced a margin compression in the commercial markets. This is a result of a combination of several small factors, which in the aggregate had a more significant impact this quarter.

These factors included more aggressive pricing, product mix skewed toward higher dollar lower margin active equipment, a lower percentage of vendor sales this quarter and a change in our customer base with larger customer deals. We are taking several steps to improve gross margins including action plan, on pricing, product mix, Ventev and services.

The government market bounced back with a strong second quarter, with sales and gross profit up double-digits from a year ago. Many of the federal budgets and projects that were delayed from Q1 came through in Q2 driving the sales increase.

We are pleased with the growth in this market this quarter and we are seeking to generate additional opportunities in the quarter's ahead. In the value add reseller market revenue was up mid-single-digits from a year ago, while gross profit decreases slightly.

We are determined to increase our market share with a target group of the largest value add resellers. Historically, we have had minimal share with these customers, but we are working closely with these accounts to generate momentum towards stronger synergies with vendors and increased sharing of market intelligence.

We also have improved our relevance to these accounts by adding newer technologies to support Internet of things applications. There is still a significant opportunity to expand share in this market and we look forward to making additional progress in future quarters.

The private system operator market, revenues and gross profit grew almost 10% from a year ago. Our enhanced go-to-market strategy is enabling us to be more aligned with our manufacturing partners and customers and our value proposition to customers in this market is working well.

Turning to the retail market, sales decreased by high-single digits year-over-year as a result of further consolidation in our customer base. Some of our customers are also seeing a reduction in store traffic as consumers hold on to their phones for longer periods of time.

Meanwhile, we have one business in some new sectors including big box retailers and tier 1 customers. Gross margin in retail improved this quarter in parts due to customer mix but also due to investments from our vendor partners to win additional business.

We continue to expand our service offering including systemic integration with drop ship and Endless Aisle programs to give our retail - new ways to capitalize on new consumer spending habits. In the coming quarters, I am confident in our ability to execute in this market.

Before I hand the call over Aric, I want to leave you with a few key points. First, we are executing well on our strategic plan and are balancing the implementation of our go-to-market strategy with improved operating efficiency.

Second, we are delivering improved results. For the past four quarters, we've delivered high-single digit revenue growth while at the same time managing costs to improve profitability.

And third, while we still have work to do, we are focused on gross margin and managing through organizational and technology changes. The good news is that we are beginning to see the increased operating leverage we've been planning.

We expect this leverage will become more apparent in the next fiscal year. There is strong momentum in our business and all of the steps we've discussed and taken this year are a preparation for accelerated growth in fiscal 2019, which begins in April.

We are confident in our value proposition and we are encouraged by our ability to drive success in the quarters to come. And now, I'll turn the call over to Aric for a discussion of the financial results.

Aric.

Thank you, Murray, and good morning, everyone. In the second quarter, revenues increased 8% versus one year ago.

As Murray mentioned earlier, this is our fourth consecutive quarter of year-over-year top-line growth. The higher revenues resulted largely from a significant increase in sales to the public carrier ecosystem as well as some strong sales in all of the other commercial markets.

Gross margin declined 0.8%, largely due to changes in the customer and product mix including the increase in lower margin sales to the public carrier market. A gross margin improvement is a major attack area for us in the second half of the year.

SG&A expenses were essentially flat from a year ago despite normal increases in variable costs associated with the 8% revenue growth. This is in part due to the lower portion of retail sales this quarter, but more importantly due to the strong attention we have been given to expense reductions.

As a percentage of sales, SG&A was 18.4% compared with 19.8% of sales in the second quarter a year ago, largely as a result of the increase in revenue and gross profit operating income rose to $3.2 million from $2 million a year ago. Net income for the second quarter increased to $1.8 million or $0.21 per share compared with $1 million or $0.12 per share in the second quarter of last year.

Moving on to the balance sheet, we are investing in working capital to support our growth in the public carrier market. During the second quarter, sales increased 48% from a year ago and year-to-date sales in this market have increased 54%.

Accordingly, during this fiscal year, we experienced increases in inventory and accounts receivable and a corresponding decrease in cash including increased borrowings on our line of credit. The company is anticipating further growth, and much of this growth is expected to come from larger customer relationships in the carrier market.

To better prepare for this growth on October 19th, we amended our line of credit facility in an effort to ensure our ability to continue to make investments as needed. The new credit facility has a borrowing limit of up to $75 million with similar terms to the previous facility.

We believe the long-term benefits from serving our public carrier, another large strategic customer more than offset the investments and cash required to support this business. Finally, we remained committed to our dividend program and a dividend $0.20 per share with the record date of November 8th and a payment date of November 22nd.

We've made excellent progress midway through the fiscal year. We are executing on our plan to grow the top-line into approved profitability.

And we are in track to accomplish both of these goals in fiscal 2018. We continue to expect some fluctuation in our financial result this year as a result of significant changes across the company.

At the same time, we're encouraged by her progress and we look forward to sharing more of our success with you on future calls. And with that operator, we'll open the call for questions.

Good morning. Thank you.

Murray, would you please go into more detail of how you anticipate improving growth margin and what the magnitude of the increases that you are targeting?

Well, Bill as we mentioned on the call, there is a number of little items that we're addressing right now. So, I think there is action plan associated with each one of them for instance if you take pricing for example.

We've got new systems upgrades that are in place on pricing that will allow us to tailor customers or tailor pricing to specific markets. And we're just approaching pricing for instance with more rigor and more focus on how to be more strategic from a pricing perspective and so that's just a small example in the case of Ventev for instance.

We think that there is some really good opportunities to engage differently with specific markets on the commercial business and in order to do that we needed to have some technology improvements on the e-commerce side. We expect that to be completed sort of this quarter.

So those are all opportunities for us to address margin compression and as you know we're managing a portfolio of customers in the portfolio of products with different margins. So, we also are paying close attention to the mix of products and like I said there is action plans against all of those initiatives.

And would you care to identify the magnitude of their growth margin improvement that you are targeting?

I think we would just want to get back to the run rate in the short term that we experienced last year. I think I have said many times that what we really want to do is focus on the accelerating the growth on the top-line and holding our gross margins until some of the initiatives that we have in place where we materialize.

So that's what I'd be anticipating in the short-term.

And you may object to address my next question, but as you look to improve profitability, are you looking for more from growth margin improvement or sales growth? And if I guess I heard you right, really sales growth is what you see that coming from this?

Is that correct?

That's correct. Yeah, I think that - we think that we can continue to grow that topline, but make the improvement necessary to get us back to our previous rate from our growth margin perspective.

And then from that point forward, is the growth margin movement really a section of customer mix and product mix or is it that in addition to some additional initiatives that you think you can employ to enhance margin further?

You are right on it. Bill, it's yes and yes.

So, yes, we think that there is some improvements that we can make, but also as we - we've talked a lot about getting ourselves building the foundation in 2018 And the mix of products including service, recurring revenue, services, those are opportunities for us to change the mix of the business and we're paying close attention to some of that obviously and then product mix and our pricing will be an important driver as well.

Thank you. Since it sounds like there were any other callers, I'm going to ask a couple more questions please.

The first one is relative to your when in the big box market would you discuss what you can about that win and in terms of products brands and feature opportunity for additional wins?

Yeah, right now it's a couple SKUs I don't know that we can really talk about the - which vendors, and which customers it is right now, but it's our really our first step into a big box retailer, so it's exciting. Right now, it's not a material transaction, but there's always the possibility once you get the couple of SKUs into and continue to expand.

Obviously Ventev would be the ideal situation, but there are also other manufacturers that we feel like we can get into to those big box stores, so it's the beginning of a journey. And it's the first time we've been into this one particular big box store ever so it's exciting.

It's not material yet, but stay tuned hopefully down the road it may be coming.

Big box gives us a lot of new doors, Bill. Right so even though there's not a lot of SKUs there's a lot of doors.

And when did you begin shipping into that retailer?

Right at the end of the quarters when we finalized the agreement to do that.

And so, do you anticipate the fourth quarter to be at a full run rate, sorry the December quarter to be at a full run rate or would you still simply be working on the initial spell land to fill the shelves?

Yeah, I think we're going to be still working through the initial run end but again it's only a few SKUs right now so even if it is full it's not going to be a huge lift in Q3 or Q4, yeah.

Thank you. And then service that's an area that you have not had a great presence in the past talk about your strategy there and how if you're successful with that strategy cash flow may look different with that implementation?

On the services side, Bill, I think it's certainly just determining what's complementary. We have a lot of intellectual capital in the company and we want to make sure that we're supporting our customers and vendors in the right way and how we go to market and the services that we provide; we've started to package some of those so that we can offer those services to our current customers today.

And I think we're once again we've got several irons in the fire that we're trying, and some will be very successful I think, and others will perhaps not be as successful, but I'll give you an example where we've got in our retail business, we've got some capabilities around merchandising services and Endless Aisle capabilities and those I would say kind of roll up into our services opportunity. I mentioned on the call about IOT and all the degree of difficulty to start in a new business in new markets is pretty high, so we want to have a crow walk-run approach participating in the IOT market and we've signed some really important vendor relationships, some we can't release yet because it's all in the process of putting the final touches on that.

But that will allow us to move into the IOT world and then there's many services opportunities raft around selling IOT solutions.

Thank you. And then Murray I suppose the Q&A wouldn't be complete without a question about the public carriers, particularly given the high growth again this quarter.

Would you dive into some more detail in terms of how you are achieving this level of growth and the interest to the degree to which you think you can continue in the future?

Okay, thank you, Bill for - it wouldn't be complete if you didn't ask a question around the public carriers, but here's what's happening. I mentioned this on previous calls, we can only control the activity level, that TESSCO brings to the marketplace and the value proposition that we bring to our customers and to our vendor partners and we can certainly control the intensity of how we show up in those markets.

And I would say that's the biggest driver right now, as our team is more aggressive, we're showing up in more places. I think that there is evidence to say that the value proposition is working, and so that is a one side of it.

The other side is that, there's some big opportunities that exist in the carrier ecosystem with FirstNet for instance and 5G is on the Verizon, and I think it's a mark of TESSCO to position ourselves in the carrier ecosystem, which is what I've been describing it as. Now that we with the carriers, but with all the contractors, making sure that we've got value proposition that will be able to help us deliver in those markets should the carriers really start to accelerate their capital expenditures.

So, right now we're winning more share because I think we're showing up with the very, very solid value proposition and in the case on the previous quarter, we talked about a win at Verizon, and we haven't seen really any material changes there because we're working with them very closely on all of the foundational work that needs to be done, so the business can be conducted seamlessly. When you go from hundreds of suppliers down to six, you can imagine all the SKU counts and different SKU numbers for similar kinds of products, we have to purge through all of that and get it into a consolidated format, so that it's easy to transact into business together and we're working on those things right now.

So, that's one of the reasons that I think that to the second part of your question, do I expect to continue, I'm not sure it's always going to be at the current growth rates, but I'm sure that we're going to be able to participate in this market, at a much bigger level than we are today.

And I think you answered part of - in the next question, which is that Verizon when that you did announced last quarter, a degree to which it contributed to your success this quarter and it sounds like it was rather small as you're still in the early stages of that.

Yeah, I think that we're definitely scoring some points, there is no question Bill, but all the work there is a lot of work that has to be done for this business to be transacted in a seamless way and that's really what our teams are working on, the Verizon team and the TESSCO team are working closely together on this. So, I'm encouraged by the progress and our target dates.

I think, we'll start to see more material impact from that as we turn the corner into the fourth quarter and the first quarter of next year, we'll start to see more activity levels.

And is it correct that in the public carrier market, you have not seen a large increase in the overall level of activity, so the growth that we are seeing is really a function of TESSCO, simply giving a better job and increasing market share.

I think that's largely true, but I would say that the carriers are probably increasing their capital expenditures, like I said a lot of things that are, big opportunities that are existing in the marketplace today, so I think there is some of that that's happening for sure, upgrading systems and that sort of thing.

Thank you. And then I actually do have one more question and then I will step out.

Relative to the government business, it wasn't that many quarters ago that business appears as now it has - and now it appears just the opposite. So, with the appearance just simply incorrect or it have there been some changes that you all have instituted that are leading to that higher rate of growth?

No, I think that I can understand the impression but here is the answer, Bill really the transaction in the business that we've conducted with the government needs to have a little more predictability. That's an opportunity for us on a go forward basis, right now we're very opportunistic in that market and we've been winning larger transactions, which is great when you are winning them and when those transactions are available and if they are not available or you miss the quarter, that impacts the results.

So, that looks the little spiky. And what the teams working on right now is continuing to focus on winning those larger transactions trying to smooth it out with more run rate business.

Once again that's more as a coverage opportunity for us. I feel like the government value proposition, there is a value prop we have to the government is very solid, we need more assets we need more opportunities in front of the government business and I think that that's what we are focused on right now.

Great. Thank you all and nice quarter.

Thanks, Bill.

Thanks, Bill.

Okay. Well, thank you, operator, and thank you to everyone for joining us.

We're encouraged by our continued progress, and our ability to execute on our plan this year and we appreciate your interest in TESSCO. We look forward to speaking to you again on our next earnings call in January.

Have a great day.