Greetings, and welcome to the Insight Enterprises third quarter 2019 operating results conference call. At this time, all participants are in listen-only mode. A question and answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press star zero on your telephone keypad. It is now my pleasure to introduce your host, Glynis Bryan. Please go ahead.
Thank you. Welcome, everyone, and thank you for joining the Insight Enterprises earnings conference call. Today, we will be discussing the company's operating results for the quarter ended September 30th, 2019. I'm Glynis Bryan, chief financial officer of Insight, and joining me is Ken Lamneck, president and chief executive officer. If you do not have a copy of the earnings release that was posted this morning and filed with the Securities and Exchange Commission on Form 8-K, you will find it on our website at insight.com under our investor relations section. Today's call, including the question and answer period, is being webcast live and can be accessed via the investor relations page of our website at insight.com. An archived copy of the conference call will be available approximately two hours after completion of the call and will remain on our website for a limited time.
This conference call and the associated webcast contain time-sensitive information that is accurate only as of today, November 6th, 2019. This call is the property of Insight Enterprises. Any redistribution, retransmission, or rebroadcast of this call in any form without the express written consent of Insight Enterprises is strictly prohibited. In today's conference call, we will refer to certain non-GAAP financial measures as we discuss the third quarter 2019 financial results. When referring to these measures in today's call, we will refer to them as adjusted. These measures include adjusted earnings from operations, adjusted diluted earnings per share, adjusted free cash flow, and return on invested capital. These adjusted measures exclude intangibles, amortization expense, acquisition-related expenses, severance and restructuring expenses, and amortization of convertible debt discount and issuance costs.
You will find a reconciliation of these measures to our actual GAAP results included in the press release and the accompanying slide presentation issued earlier today. Please note that unless highlighted as constant currency, all amounts and growth rates are discussed in U.S. dollar terms. Any reference to our core business excludes PCM's results subsequent to the acquisition. Let me remind you about forward-looking statements that will be made on today's call. All forward-looking statements that are made during this conference call are subject to risks and uncertainties that could cause our actual results to differ materially. These risks are discussed in today's press release and in greater detail in our most recently filed annual report on Form 10-K and reports subsequently filed with the SEC.
With that, I will now turn the call over to Ken, and if you're following along with the slide presentation, we will begin on slide three. Ken?
Hello, everyone, and thank you for joining us today to discuss our third quarter 2019 operating results. In the third quarter, we continued to execute against our strategy to deliver IT solutions to our clients globally, leading with services and solutions that drive business outcomes for our clients. In addition, we closed the PCM acquisition on August 30th. Two months after the acquisition, we remain excited about the opportunity to drive growth in our expanded client base and footprint. Now turning to the third quarter results on slide four. Consolidated sales were $1.91 billion, up 9% year-over-year, including one month of PCM's results. Gross profit was $276 million in the third quarter, up twice the rate of sales at 18% year-over-year, including 6% growth in the core business and the addition of PCM.
Gross margins were 14.4%, up approximately 100 basis points year-over-year, driven by strong cloud and services growth in the core business and the addition of PCM. Consolidated selling and general administrative expenses were $223 million in the third quarter, up 21% year-over-year, including both organic growth of 8% and the addition of PCM. All this led to adjusted earnings from operations of $59 million, an increase of 7% compared to last year's third quarter. On a GAAP basis, earnings from operations decreased 11% to $44 million, driven by approximately $6 million of PCM acquisition-related expenses, $2 million of PCM intangibles amortization expense, and integration and restructuring expenses recorded in the quarter. Adjusted diluted earnings per share was $1.10, an increase of 10% year-over-year. On a GAAP basis, diluted earnings per share was $0.76.
Our third quarter results reflect our strategy to improve our gross margins by leveraging our four solution areas to optimize our business mix in higher margin categories, including cloud solutions and services. This led to 100 basis point improvement in gross margins in the quarter. The core business in North American and EMEA regions grew gross profit dollars mid-single digits year-over-year in constant currency, while the APAC region grew gross profit dollars 21% year-over-year in constant currency. These results were driven by a higher mix of gross profit from services sales, including cloud solutions. Gross profit earned from cloud offerings was 19% of our consolidated gross profits for the trailing 12 months, compared to 17% for the same period last year.
The improved gross profit performance in the core business in the third quarter, together with the performance of PCM for one month, led to high single-digit growth in adjusted earnings from operations compared to last year. In addition, we improved our cash flow from operations performance by $90 million year-over-year in the third quarter, bringing the total for the first nine months of the year to $169 million in operating cash flow. We also reported return on invested capital of 14.9%, which includes the impact of acquiring PCM in the third quarter. Demand continues to be solid across key markets where we compete. Our third quarter results reflect lower hardware sales with a select few large enterprise clients in North America which is causing compression in our growth rate compared to the overall market trends.
While it may experience cyclical trends with large clients from period to period, our relationship with those clients remains strong, and we expect to return to growth in the hardware category in the fourth quarter. Our investments in our four solution areas, supply chain optimization, connected workforce, cloud and data center transformation, and digital innovation, have positioned us well to continue to compete in the marketplace. We're also very excited about the cross-sell opportunities we see in the mid-market space, and the potential to leverage our solution area strategy into the PCM client base to grow our position in this higher growth, higher margin end market. Next on to slide five.
We closed the PCM acquisition on August 30th, and are working diligently to integrate their business into ours to ensure we optimize execution in the market opportunity of the combined business, and deliver to our commitment to realize $70 million in run rate cost synergies by the end of 2021. To date, we have completed the organizational review of the combined senior leadership team, completed our planning efforts around brand, and finalized our timeline for e-commerce and core systems integration. We expect to be substantially complete the systems integration work by mid-2020. We're also on track to deliver more than half of the expected cost synergies by the end of 2020. Moving on to slide six. Next, I want to highlight an example of how we're leveraging our solution areas to help our clients achieve better business outcomes.
A financial services firm wanted to attract a new generation of customers and transform its customer experience by leveraging the power of artificial intelligence to create a multi-channel chatbot. As digital natives, Millennials generally prefer the use of social media platforms to connect with family and friends, and to transact banking and commerce. Our Digital Innovation team helped the client launch a multi-channel conversational agent or chatbot with rich capabilities for buying and selling stocks, locating nearby branches, getting quotes, and more. Users can ask questions around financial topics, and the chatbot is able to provide educational resources in the forms of articles and short videos. By providing seamless access to easily digestible information, the financial services organization has experienced a 72% increase in new accounts among the Millennial generation. With the chatbot, customers gain the experience of anytime, anywhere access and quick answers to questions.
On average, it takes a human customer service representative 15-20 minutes to answer an inquiry. The chatbot can do this in seconds. This is just one of many examples where our Digital Innovation team is delivering intelligent technology solutions to clients, which have broad application across a variety of client industries. Moving on to slide seven. Before I hand the call back over to Glynis, I want to take a moment to recap key highlights from Investor Day event in mid-October. First, I'd like to thank all of you who joined us live for the event, and if you weren't able to make it, please note that there is a replay currently available on our website. At the event, we outlined our long-term strategy and key measurements we intend to use to track our progress.
During the event, we noted that we believe our strategic assets give us competitive advantage in the marketplace. In addition, our strategic assets have been integral to our ability to deliver double-digit growth in adjusted EFO and EPS results and more than 700 basis points improvement in our ROIC metric over the last five years. They also position us well to continue to drive value in the future. Our strategic assets include our focus on culture, people, and leadership, our innovation-led approach and solutionary expertise, our global reach and scale, our diverse and loyal client and partner relationships, and lastly, our operational vigor and financial health.
We will leverage these strategic assets to achieve our key priorities, which include continuing to innovate in order to capture share in high growth areas like cloud and the intelligent edge, growing the business through solutions that drive better business outcomes for our clients, expanding the scale in our business and strategic clients and end markets, particularly in the mid-market, where the recent acquisition of PCM has added clients and capabilities to our portfolio, and lastly, continuing to optimize client experience and our execution through relentless focus on operational excellence. Next on to slide eight. To measure our progress against these priorities, we laid out four key metrics.
We will seek to grow faster than the market, a CAGR over the next five years of between 8% and 10%, expand EBITDA margin to between 5% and 5.5%, optimize our return on invested capital to a range of between 19% and 21%, and to continue to grow services gross profit as a percent of total gross profit to between 50% and 52%. We will seek to make progress each year against these goals and will update you during our scheduled earnings calls. I will now hand the call back over to Glynis to provide more detail on our financial performance in Q3.
Thank you, Ken. I'll start on slide 10. I'd like to highlight changes we've made to our adjusted earnings from operations, adjusted net earnings, and adjusted diluted earnings per share calculations reported today. We have historically excluded severance, restructuring, acquisition-related, and one-time costs in our adjusted metrics. Starting in Q3 of 2019, we're excluding the amortization of intangibles from our adjusted results. In the third quarter, we excluded approximately $6 million of amortization expense from our adjusted metrics. In addition, as is customary, our convertible notes were issued at a discount to par value to effectively prepaid debt issuance costs out of proceeds and to gross up the below-market cash coupon on the notes.
These amounts will amortize to interest expense and increase the reported convertible debt balance over the life of the note, and we will exclude this non-cash interest expense from our adjusted operating results beginning in Q3 and going forward. We believe these changes in presentation will give investors a meaningful comparison of the cash-based operating results period to period, and will allow for meaningful comparisons to results of our competitors. To ensure comparability, we will make applicable adjustments to prior period results as well. Moving on to slide 11 in North America. In North America, net sales were $1.5 billion in the third quarter, up 10% year-over-year. The core business continued to see less spending for hardware products by a select few existing clients, which drove the top line down 2% year-over-year. For the combined business, hardware sales increased 7% year-over-year, driven by PCM.
Software sales increased 14% year-over-year, and services sales increased 26% year-over-year in the third quarter, including higher sales of cloud solutions and Insight-delivered services primarily in the core business. Gross profit in North America was up 22% year-over-year, and gross margins improved 130 basis points to 14.4%, reflecting the increased mix of cloud and services sales in the business and a modest contribution from PCM for one month of the quarter. North America selling and administrative expenses increased 27% year-over-year, including a 10% increase in the core business, resulting from significantly higher healthcare expenses, investments in cloud subscriptions and internally used IT tools, and increased headcount in our solution areas. In addition, we added PCM in the month of September. As a result, adjusted earnings from operations increased 10% year-over-year to $53 million for the quarter. I'd like to provide some color around PCM and its impact on the quarter.
For the month of September, PCM contributed $172 million in net sales, $28 million in gross profits, and approximately $3 million in earnings from operations, including just over $2 million in intangible amortization expense. We also incurred estimated additional interest costs related to financing the acquisition of approximately $3 million in the quarter. We will have PCM for the entire quarter in Q4 of 2019 and expect seasonal top-line performance consistent with prior years' PCM. Please note that historically, PCM has experienced lower gross margins in Q4 compared to earlier quarters. In addition, also note that we currently expect amortization expense in Q4, in the fourth quarter, to be approximately $6 million, which is up $2 million from the outlook we provided in the second quarter call, as we now have completed a preliminary assessment of the net assets acquired.
Lastly, we have line of sight to the cost synergies we previously committed and are on track to deliver more than 50% by the end of 2020. Moving on to EMEA on slide 12, net sales in the third quarter increased 9% in constant currency to $356 million. An 11% increase in software sales, an 8% increase in services sales year-over-year were partly offset by a decrease in hardware sales to larger clients. Gross profit grew 7% in constant currency, while gross margin decreased 20 basis points, due primarily to lower margin on services sales in the quarter. Operating expenses grew 8% in constant currency, and this drove adjusted earnings from operations to $3.4 million, down $1.7 million year-over-year. These results reflect performance in line with our expectations from the core business and a modest operating loss from the PCM business.
Moving on to APAC on slide 13, net sales in the quarter increased 40% in constant currency to $42 million. The APAC region delivered year-over-year growth across all product categories in the third quarter. Gross profit grew 21% in constant currency, and adjusted earnings from operations grew $700,000 year-over-year. On the tax side, our effective tax rate for the third quarter of 2019 was 27.2%, up compared to last year and higher than our guided range due to the non-deductibility of certain acquisition and restructuring-related expenses. Turning to our cash flow performance on slide 14, our cash conversion cycle was 42 days in the third quarter of 2019, up four days from the third quarter of 2018, due primarily to the inclusion of PCM's full accounts receivable, payables, and inventory balances with only one month of related sales.
Year-to-date through the third quarter of 2019, our operations generated $169 million of cash compared to $247 million of cash last year. Our prior year results reflect a higher-than-normal seasonality for cash flow performance, as well as the benefits of our enhanced focus on reducing aged receivable balances. Our year-to-date results through the third quarter of this year are more in line with typical seasonality. For the full year of 2019, we continue to expect cash flow from operations will be in our normalized annual range of between $160 million and $200 million. In the first nine months of 2019, we invested $17 million in capital expenditures, with the same amount as invested in the same period last year. We also used $28 million to buy back stock in the first nine months of this year, as compared to $22 million in the same period in 2018.
All of this led to a cash balance of $141 million at the end of the third quarter, of which $120 million was resident in our foreign subsidiaries and $837 million was outstanding under our financing arrangements. This compares to $111 million of cash and $269 million of debt outstanding at the end of the prior year quarter. In the third quarter, we refinanced our existing revolving credit facilities into a single $1.2 billion asset-based loan maturing in 2024. As of September 30th, we had $553 million outstanding under this facility, incurring interest at an average effective rate of about 4%. In the third quarter, we issued $350 million in convertible notes maturing in five and a half years, which bear a cash coupon of 0.75%. These notes have no call feature through year three and can be paid off thereafter under certain conditions.
The initial conversion premium of the notes is $68.32. In connection with the issuance cost of the convertible notes, we entered into call spread transactions to effectively increase the initial conversion price of the notes to $103.12. We like the convertible notes because they represent a lower cost of borrowing than the ABL and allow us to put a fixed price tranche of debt into our capital structure for the intermediate term. One last item in cash flow of 2019, we purchased a new corporate headquarters building in Arizona for $48 million. We've outgrown our current facilities in Arizona and expect to sell those facilities. We plan to relocate late in 2020. Moving on to slide 15, I'd like to update you on our capital allocation priorities now that we have closed PCM transaction.
First, we plan to continue to invest in organic growth, including growing our technical and sales talent and optimizing our scalable IT infrastructure, e-commerce sites, and service delivery platforms. Our second priority in the near term will be to pay down debt associated with the PCM acquisition. Our goal is to maintain a modest leverage of less than one times absent acquisitions. Thirdly, we will continue to pursue strategic M&A opportunities. We've developed a robust framework to guide our M&A decisions, and we have demonstrated the effectiveness of our integration process with past M&A transactions, such as Datalink and Cardinal. In general, we look for M&A transactions that will be accretive within the first full fiscal year following the acquisition, and we target an ROIC at 300 basis points above our weighted average cost of capital at the end of year three.
Lastly, we will return excess cash to shareholders after meeting the other priorities I just outlined. With that, I will now turn the call back to Ken to review our 2019 outlook. Ken?
Thank you, Glynis. Moving on to slide 17. With respect to our full year 2019 outlook, including the results of PCM for the last four months of the year, we expect net sales to increase between 9% and 11% compared to 2018. We expect diluted earnings per share for the full year of 2019 to be between $5.45 and $5.50. This outlook assumes an effective tax rate of 25%-26% for Q4 2019, capital expenditures of $70 million-$75 million for the full year, including the purchase of real estate in the fourth quarter of approximately $48 million, and an average share count for the full year of approximately 36 million shares.
This outlook excludes intangibles amortization expense, acquisition-related expenses, severance and restructuring expenses, and amortization of convertible debt discount and issuance costs during the first nine months of 2019, and those that may be incurred during the balance of 2019, and assumes no further repurchases of our common stock over the balance of the year. This outlook is equivalent to an adjusted earnings per share between $4.90 and $4.95 under our previous guidance methodology used in the second quarter, and now includes PCM's operations, intangibles amortization expense, and additional financing costs for the full quarter. Thank you again for joining us today, and thank you for all the teammates across the globe for their performance in the third quarter. That concludes my comments, and we'll now open your line up for questions.
Thank you. We'll now be conducting a question and answer session. If you'd like to be placed into question queue, please press star one on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star two if you'd like to remove a question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. Once again, that is star one to be placed into question queue. One moment, please, while we poll for questions. Our first question today is coming from Matt Sheerin from Stifel. Your line is now live.
Yes. Thank you, and good morning. Just a couple of questions. Just first, regarding the contribution from PCM, I know you talked about growth rates. Could you just give that apples to apples number? What was the contribution in the quarter?
We only had PCM in the quarter for one month. It was $172 million of revenue, $28 million of GP. Essentially, that had a small contribution at the EFO line. When you net it out, it was less than $0.01 in terms of total EPS in the quarter because of the interest below the line.
Got it. Okay.
I don't know if that's a relevant number or not, but as you go through the P&L, you end up with less than $0.01 of EPS.
Okay. That's helpful. You talked, I think, Ken, or no, you did, Glynis, about gross margin being down in the fourth quarter due to seasonality in North America. PCM, as you've pointed out, has higher gross margin. Is that a function of the seasonality in that business, too?
Yes. The comment that I made regarding fourth quarter was specifically related to PCM. If you look historically at the PCM business, their fourth quarter has always been 100-plus basis points lower than prior quarters. My comment was related specifically to looking at expectations for PCM. Remember that their gross margin in the fourth quarter has historically been lower than other quarters.
Okay.
I was not making a comment about the base Insight business.
Got it. Okay. Ken, you talked about relative strength in IT spending, still pretty good demand in North America. Could you give us some further insight into the hardware segments, particularly on the storage side, where we're starting to hear from some peers and distributors of a bit of a pickup after a kind of a lull or weakness for a couple of quarters?
Yeah. I think, and you've seen a lot of the data, of course, from some of the major suppliers out there in that regard. I would say that the business continues, I think, to gain momentum there. It certainly had gone through a lull, as you saw, but I think that is coming back, and we're seeing some good strength across some pretty important vendors for us. Overall, it's not across the board. It's in pockets, but I'd say overall, net we are definitely seeing some pickup in the storage area.
Okay. That's it for me. Thank you.
Thanks, Matt.
Thank you. Our next question today is coming from Marc Wiesenberger from B. Riley. Your line is now live.
Hi. Good morning. It's actually Kara Anderson on for Marc. Just the first question that I had is around the property purchase for the new headquarters in Arizona. Just wondering if there are any other plans for the real estate acquired through the acquisition of PCM.
Yes. Welcome back, Kara. What we have planned, PCM owned five buildings across the country. We're going to be retaining one, and we will be selling four over the next year. They will have to be replaced with other facilities, we will leverage the fact that they're significantly underutilized, get the cash out of those buildings, and use that to pay down debt. Three of them are in California, it actually means that we should actually be able to recoup some significant dollars to pay down debt with those first sales.
Got it. Then just looking at the sales mix in the quarter, now with one month of PCM, is that kind of reflective of the mix going forward, or how should we think about that with PCM?
The sales mix, you mean in hardware, software, services? Is that what you're talking about?
Yes. Thank you.
Okay. Well, it was one month of PCM in that quarter. I think that their business is a little bit less in terms of revenue associated with services, but the hardware software split is probably a little bit more weighted towards hardware than our business is. In the fourth quarter, you should see a little bit more hardware associated coming from PCM and not that much impact on our services number going forward because they were smaller services as a percentage of total revenue.
Got it. Can you just go back through the guidance, the EPS guidance? I think you pointed out the underlying assumption for the core EPS guidance embedded in the $5.45-$5.50 EPS guide. Is that unchanged from previous guidance, or did the core shift around?
No, that is unchanged from previous guidance in Q4. I'll walk you through it. In Q2, we said $4.85-$4.95, we said that excluded PCM. What we're saying today is for the fourth quarter, we're at $4.90-$4.95. That does include PCM, the contribution from PCM is nominal in that guidance. It's still within, as we view it, the guidance range that we had previously expressed. We do have $2 million more of intangible amortization. Last time, we would've given you $4 million for intangible amortization in the guidance range that we provided. We now have $6 million based on our preliminary assessment of the net asset value. That's a change, I guess, in the overall guidance as you get to that $4.90-$4.95 number.
Got it. Thank you.
Thank you. As a reminder, that's star one to be placed into question queue. Our next question today is coming from Paul Coster from JP Morgan. Your line is now live.
Hi, guys. Thanks. This is Paul Chung on for Coster. Thanks for taking our question. Just to follow up on the kind of guidance range, probably the bulk is from some amortization of add backs, but just want to get a sense. I'm calculating maybe, I don't know, anywhere between $0.15 and below is kind of from the core business. Is that the right way to think about it?
I'm sorry, are you talking about the impact of amortization expense in the $5.45-$5.50 number? Is that your question?
Yeah, that's correct. I think it's maybe around, I don't know, $0.40 kind of benefit from the add back. Is that correct? Just wanted to get a sense for putting a number around the kind of the core business benefit.
Sorry. Just give me a second. In Q3, on a year-to-date basis, the add back for intangible assets, we're looking at the schedule in the back, so I will tell you the add back for intangible assets for the nine-month period.
Around $0.28. Is that correct?
Yes.
All right. If I take-
We're going to have an incremental $6 million in Q4 related to PCM.
Okay.
I'm sorry. In 2019, there's a slide in the deck, in the appendix, slide 19. If you look at slide 19, the EPS associated with intangible amortization nine months of 2019 is $0.38. I think you said $0.28. It's $0.38 before tax. We're going to add $6 million, which is roughly $0.12 to that number for PCM, plus whatever the normal quarterly amortization was before that.
Okay. Thanks for that clarification. As we think about kind of the normalized run rate for some key operating items, was the 3Q contribution in OpEx, was that just one month or was it a full quarter impact? I just want to get your thoughts on how to think about the combined business OpEx kind of run rate on a quarterly basis or even an annual basis for the combined business.
The impact that you saw for PCM in September was just the impact of one month of their OpEx or revenue and gross profit included in our numbers. We will have three months of PCM, in the fourth quarter. We will start realizing some synergies, not many, but we'll start realizing some synergies around mostly the corporate costs that start going away effective with the acquisition. I can't give you a percentage number in terms of what that would translate to in terms of a run rate for OpEx, which I think is what you're asking me for.
Right. Okay.
If you look at what we told you between EFO and gross margin for PCM, that's a one-month impact. I would assume that if you get that impact for the quarter and then maybe a slight discount for some synergies, that would get you to a run rate for PCM in terms of OpEx.
Got you. Okay.
Most of it start coming in in 2020.
Okay. Then kind of on a high level, last question, sorry. From purchasing decisions, are you seeing more interest in this trend of Hardware as a Service, which is kind of being offered by certain large OEM partners? How does this kind of impact your business, and do you see that accelerating from what your customers are saying? Thank you.
Thanks for the question, Paul. This is Ken. We definitely are seeing, as the world starts to move more and more towards subscription as a service, certainly in the software front, we're starting to see it also apply itself towards hardware. There's some innovative programs in place. I'd still say it's pretty early innings, in that regard, from some of the partners that we deal with. As far as the traction, we're seeing a good amount of it, of course, in the storage front, which Matt had sort of alluded to. There's certainly some of that happening in a pretty strong way there, where they're all sort of looking at opportunities to provide choices for clients in order to provide it sort of as a service or on premise.
That's definitely a trend, but again, it's still early to give you any kind of real data points yet.
Thank you.
Thank you. We've reached the end of our question and answer session. Ladies and gentlemen, that does conclude today's teleconference. You may disconnect your line at this time, and have a wonderful day. We thank you for your participation today.