everybody, for joining here in the room and on the webcast as well. I'm Adam Tindle, and this is part of my supply chain coverage here at Raymond James. Very happy to have Mike Baur, Chairman and CEO of ScanSource. In terms of our format today, we'd love to keep it interactive. If you do have questions, please feel free to raise your hand. But we're just going to do a casual fireside chat. So hope to kind of cover a different array of topics for those less familiar with the company. We'll start at a high level and get into more specifics. So Mike, thanks again for being here.
Thanks, Adam. Where's the fire?
We're chilling here.
It would be a nice touch, actually.
It would be, yeah.
How about we need like a bourbon or something like that?
That'd be good, right?
So for those not familiar with ScanSource, if you want to maybe just take us through a little bit of the history and the evolution of the company.
Sure. Well, it's 32 years later, and we started as a kind of an IT distributor focused on these niche markets. And along the way, we did like most distribution companies, is we suffered through the technology changes and margin pressures and suppliers going direct and using the channel. And so we learned a lot over the years about the evolution of the channel. And one of the things that we were always envious of was ways to increase our profitability, meaning really for us, our gross margins. And we kept looking for new technologies, which did that, frankly. As we went from barcode printing and point of sale to selling telephony products, our margins went up. And then as the technologies changed, again, as traditionally happens, is that technologies get old, the margins go down. And so we were always looking for new things.
And in 2015, we decided to look for some adjacent market that would help improve our margins over time. And for us, that meant that we found this new channel called the master agent channel and the agency channel. And today it's called the advisory channel. And that was really started by our company with an acquisition of the largest master agent at the time called Intelisys. And this was a big deal because it was adjacent, yet we didn't sell to any of those existing customers. And those partners, as they're called, those agents, they really were selling alongside our traditional VAR channel, but we didn't know that. So it was a discrete channel that was underserved, and we came in and added some professionalism to the channel. And this was right when the UCaaS, CCaaS market started taking off in 2017, 2018, 2019.
And then, obviously, with COVID, boy, everybody wanted to talk about remote work and Zoom and Microsoft Teams and Webex and all the different ways to connect. And so we benefited from this massive move to remote work because we were selling all the hardware technologies and now all the cloud service technologies too. And along the way, we saw that the idea would be that an end customer is using all these technologies. And how cool would it be if we had a single partner, whether they're a VAR or an agent or an MSP, sell the entire solution set to the end customer? We're still waiting to see that happen. We've been talking about this hybrid distribution model, which means selling basically devices, hardware, and recurring revenue.
We believe if we can show the channel how to do that, that long term it opens our company up to a much bigger opportunity.
I know we're going to get into some of those subjects more specifically here in a little bit, like hybrid distribution. But you refer to ScanSource as a transformed company. Maybe we'll start there if you could provide an overview of this transformation and the value upside for your business.
This transformation was moving from where we have no backlog and we take orders today and ship today in the hardware traditional business to where we have this recurring revenue that is forecastable, and we have contracts that last three, four, five, six, seven years. For us as a company, it really transformed the financial model too from single-digit margins to very high margins. As a matter of fact, the gross margins in our recurring revenue business have been as high as 100% because of the way they're netted down. Our business went from this focus on the top line to really a focus on the gross margin line and then on the EBITDA line. We've talked about how that's transformed our company because we have this strong traditional hardware business that requires a lot of working capital, especially when you grow in double digits.
But when you don't grow in double digits, it generates a lot of free cash flow. And then we have this recurring revenue business that's very working capital light and is highly profitable for the distributor model. But we see that today transforming that has not been easy. But we started this in 2016 with the acquisition of Intelisys. And eight years later, we believe we now have the model that we wanted to have. It just took us a little while.
Yeah. Okay. Maybe we'll talk about the hybrid distributor concept. Just tell us more about what it means to be a hybrid distributor and how that journey is progressing.
I think it sets us apart. If we call ourselves a hybrid distributor, what we're trying to say is unlike any other IT distributor, we're selling a lot of hardware and we're selling recurring revenue. And there are other IT distributors who sell some recurring revenue, but really none that have the strategy we have where we're not so big on the hardware that the recurring revenue can't influence the profitability. So we believe that the more recurring revenue and the faster it grows, the transformation is really happening with our cash flow, with our profitability. And we think that the channel partners that we choose to sell to and through, really those companies are also transforming. So we're really creating this new channel of sellers who can sell hardware if they choose.
And we're trying to encourage them that there's still a lot of hardware being sold, being consumed, and recurring revenue services. We think that transformation makes us different, ScanSource, than any other IT distributor out there.
Got it. Last quarter, you resegmented the business. Maybe just talk to us about the different segments of the business and the decision to change reporting segments. Were you just trying to torture us on earnings night so we had to redo the model?
Well, yes, it was torture and on us. We were actually talking about it for several years because as we brought the Intelisys business to scale and as it was driving additional profitability, some of it intentionally at first, we didn't want to show our competitors everything we were doing. And we had some investors that said, "Don't ever tell them what you're doing." But we feel sorry for you guys, Adam. So we thought that we would figure out a way to better describe our business based on how the fundamental financials look. And when you're buying and reselling, that's one model versus just receiving commissions, which we do on the agency side, and then we pay commissions. So one side we have accounts receivable, we have inventory and payables, and the other side we have none of that, very little of that, I should say.
So the businesses operate totally different. And then for us, we had the segments with almost a technology segmentation, which now we've learned that's really not as important as putting all of the hardware products, if you will, communication, security, networking, barcoding, all of those in one segment that we're calling Specialty. And that includes North America, by the way, and Brazil. So all of that's in there. We were confusing people for the last couple of years because we talk about communications was not doing well, but then we talk about Cisco, and it did great. And so we had a lot of it. It was mixed signals on really is the segment really important or is it the technology? And really we think right now it's the business model is important. And then we got some more work to do.
We'd surely like to give more information about that Specialty segment because there are pieces in it that are going to grow at different rates. We haven't yet decided how we can best describe it, but stay tuned.
Okay. And then how about recurring revenue in both segments? I imagine that's tied into some of the margin expansion goals.
It sure is. And we always wanted to say we're going to sell recurring revenue to VARs when they buy and sell hardware. But we had a hard time finding the right fit. We bought this company this summer, Advantix, which I know we'll talk about. And that's a great example of how we're able to add recurring revenue directly to mobile devices. And we think by adding the recurring revenue, a reseller, a VAR, they're going to be more profitable, which is better for the end user as well because now the end user is getting a total solution and not buying the hardware from one source and the services from another source. We think long term, if we look at how the end user wants to buy, we think this model is better.
Okay. I'm going to get into macro and spending trends here. I think it was a helpful overview to start with, and then we'll pause for some audience questions. So just on the macro, remind us of what ScanSource has been experiencing from an overall demand perspective over the past few quarters. And then if you can dovetail, how might this calendar year end, which is typically a seasonal uplift, but how could it be similar or different than prior years?
Yeah, going back, you know the last year, actually, we've seen this decline in demand. So we called it soft demand for the last three quarters. And we were not getting a lot of indications of improvement until recently. We grew sequentially quarter to quarter last quarter, which was great news. The year over year, we think is still yet to come, growth. We think that's still yet to come. As we gave guidance back in August, September, we said for our fiscal year ending June 30, we think in the back half, which might even be as late as the fourth quarter, we'll see growth year over year. Demand is still soft. And we've looked at our competitors, at our partners, at our channel partners, our suppliers. Everyone is starting to see opportunities for growth to return. But boy, it's just not pervasive.
I mean, it's in very small areas, and you bring up a good point. It used to be we would sit here this time of year trying to talk about budget flush, and was there some seasonality coming, and we haven't heard that. We have not heard any of our customers, our partners say, "Hey, there's some budget flush opportunities." I mean, if that happens, boy, it's going to surprise us.
Yeah, and you're certainly not alone in that. I wondered if maybe the election was holding people back, and I wonder if there was maybe some improvement after the election. Have you seen any evidence of that? Was there something that was holding people back where it's starting to improve post-election?
We haven't seen. We haven't heard anything. We had actually an event just a couple of weeks ago, a lot of our partners together, and we didn't hear that theme other than there was certainly, I think, some excitement about potentially this might kickstart the business in 2025. I think everybody's still. All of our partners are still pointing to, let's see what happens in January. The challenge for our business is for us, seasonality. Our March quarter is always our most challenge to grow. We'll see.
Yeah. Okay. How about key opportunities and challenges in the current technology distribution landscape? What technology trends support a growth outlook as we enter 2025?
Do I get extra points if I say AI?
Yes. Higher valuation multiple.
I mean, I would love to tell you, boy, AI is going to drive a huge amount of growth, but it's too early. Yeah, we want to, and we're hearing it. In one specific area of our Intelisys business, contact center and service, CCaaS, they are talking about that. And that makes sense. If you've got a large contact center and you can add more data that now gives you more information than you could before because of some language model that helps you, I think that could be an easy win. I don't think that's going to drive demand right away. I think it's going to create more long-term opportunity for the space because I think there were some areas like UCaaS and CCaaS for us in our communications that people were wondering where they're getting long in the tooth and as the growth slowed down.
So in that area, I do think AI will be an accelerator. And I think that'll help us. With the rest of our business, I think there is this idea, and we'll see, that there is a refresh cycle that's got to come soon. We've had a lot of products that have been sold many years ago, and we have heard that there are plenty of companies that are sweating the assets maybe a little longer than they were in the past. And so I do believe that across our business, when we've talked in the past about where the growth has been coming, even in these slow, say, four quarters, we have talked in the past quarters about our security business, physical security, just think video surveillance, still doing quite well.
One of the other areas that was the laggard to come back last year, when I think back on 2024 fiscal year for us, the area that started to, that was growing the fastest, the longest was networking, network products. They were the last to come back from a growth. I think that's going to happen in 2025. We're going to see the networking technology part of our business start to grow again in 2025. That's really going to help our partners and help our company.
Got it. And one last one, and I'll pause for audience questions. But we talked about the two different segments, specialty technology solutions and Intelisys and advisory. I know we talked about near-term growth, but what would be the key long-term growth drivers in each of the two segments?
Yeah, I think in Specialty, we believe that we still could add some new suppliers. There's still some areas that we would like to have new suppliers to add to our line card. And I think that'll happen as we start adding more of these services like this Advantix, where we can offer a multi-carrier SIM to a mobile device. There are some mobile devices, for an example, today that we don't resell. And an easy example would be a tablet that's more of a consumer tablet. We have rugged tablets, but we don't have, for example, Samsung tablets. And yet many of our partners in the channel sell them, resell them, but they don't buy them from ScanSource.
So if there was a way for us to create some additional value because we can now add this SIM, this multi-carrier SIM, which is unique, that allows us to activate on a cellular network that tablet for an industrial application, we think that'll drive growth for us even on the hardware side. On the Intelisys recurring revenue side, there's still plenty of opportunity for our carriers, traditional carriers, think Comcast, Verizon, Lumen, AT&T. These companies all still are predominantly direct sellers. There's still this move to the channel that hasn't happened like it has in the other part of our business. So a direct to indirect channel shift, I think, is going to start accelerating again as we look out. We think that's a big opportunity for us.
Yep. Great. We're going to talk financial metrics here in a second, but any questions so far on the high level? Quiet crowd.
Yes, indeed. It's after lunch.
It is after lunch. I know. I'm still digesting. We did give you guys coffee, though. So let's talk financial metrics and drivers. Just the key financial metrics that you've focused on and how those have evolved over the years as the business has evolved.
Yeah, maybe 10 years ago, 15 years ago, we were talking a lot about ROIC because we were this heavy working capital business. And Adam, you were one of those guys that pushed us early on to say, "Mike, are you sure you're getting the right return metrics for that investment?" And we talked about that a lot. And inside ScanSource, we spent a lot of time trying to evaluate what is our role, how much inventory should we carry, and how important is that to our profitability. So over time, I think we have figured out with our suppliers that, especially post-COVID, that maybe the need to have so much inventory on hand is not a big requirement like it used to be, as long as the supply chain is consistent.
As long as we can get lead times that are consistent, we believe we can continue to work our inventories to a more manageable level going forward. We think we're pretty close to it now, to be honest, though. That return metric really was important and still is today, but now we're looking at cash flow from that. We think that's what really proved the business model that had always been around at ScanSource. When you looked at our business, it was all we were always a grow top line, double digits, and we're going to consume cash because we need working capital. To be a mid-single digit, low single digit grower on the top line, we think will generate cash. That's a good thing.
And we think we've been very diligent in listening to shareholders tell us, "Hey, we don't need 15% growth top line if you guys can generate this kind of profitability." So we think we're at the right growth rate, growth model. And we think looking at the gross profit dollar growth is really a metric that we're focused on right now.
Since you did make that change, the stock basically doubled. So.
Congratulations, Adam. You were right. You called it.
Well done. You had to execute it, and you did. Last year, the focus was on working capital improvements and free cash flow generation. Talk about what drove that pivot and where the company sits in that journey to improve free cash flow generation.
Yeah, you know it was this working capital metric, but it was also this idea that we want to be positioned from a balance sheet perspective for smart acquisitions going forward because we made two small ones in the summertime. We believe that there will be some more strategic but small acquisitions to make, working capital-like type acquisitions, recurring revenue focus. And we think those will be important because we got our balance sheet now in a position where we can be opportunistic for the right deals. And yet our goals are still to have no more than one to two times leverage. We think that is appropriate for distribution. And we think that gives us the flexibility we need, but also it's going to continue to allow us to do two things. One is do selected acquisitions and continue to return cash to shareholders through share repurchases.
We think those are equally weighted in our metrics right now.
And I guess on the point of capital structure, the one to two times is a little bit below where a lot of your peers operate. And I think ebbs and flows on how investors perceive that obviously might create a little bit more sustainability when you're not up against the knife on debt. But how do you think about, I should say you and Steve and the Board, think about the right capital structure and why that 1x- 2x versus a, call it 2x, 3x, 4x like some of your peers have operated in?
Well, you know when I look back on it, when we really levered up our balance sheet, which still was fairly modest, we bought Intelisys back in 2016. The big change for us was that for these recurring revenue businesses, the multiples changed. We were buying distribution hardware companies for five to six times EBITDA, and then we bought Intelisys at 12 x. Like, whoa, okay. So it's a whole new world then. And so what used to be a small amount of EBITDA now is more expensive. And I think what we want to do is we want to be sensible about this idea that we can make small acquisitions. We can make strategic ones and pay potentially a multiple of something close to that.
But there are plenty of acquisitions, we believe, in the recurring revenue space where we can pay multiples, maybe even lower than we bought distribution companies for. But we want to be smart about it because right now there's a lot of money being invested in the channel we're competing in, in the Intelisys channel for private equity. So none of our competitors are public companies. So it's a lot of money that has come in to do consolidation, classic roll-up, and exit. And some of those exits are going to be way over what we're going to pay. But there's still some opportunities that have not been consolidated that we're looking at.
Maybe just on that topic, as you think about the competitive environment in Intelisys in particular, how does Intelisys differentiate? What are the main competitors that you run up against, and what's the main differentiation?
When we bought Intelisys, we actually had a list of like eight companies that were on our list to maybe acquire. And as we did our due diligence, Intelisys was clearly number one by a long shot. The gap has lessened because number two and number three bought number four and number five. And so that roll-up has happened. And so now there's four basic Intelisys companies competitors. And there used to be as many as really 15. But when we looked at making Intelisys the target, it wasn't just size. It was because they had scale. They had value-added offerings like education and service. They had a cloud university that no other distributor had created to teach partners how to use cloud. And so we think a big part of our value for the supplier is to keep the channel large and growing.
The suppliers, frankly, aren't serviced well if there's only a handful of large partners. They want to have hundreds or thousands because they want reach. There may only be a handful of distributors, but they need lots of agents. And so our job is to go and recruit. And I think this gets lost a lot in the what's our value prop. Part of our value prop is to go recruit new agents. Sometimes it's going to come from our VARs, turn them into agents. But that's still hard work. That takes a lot of effort before getting any revenue or any profitability. So our ability to do recruiting is something that differentiates us from all of our Intelisys competitors because they don't have this base of VARs to go look at.
We've got 30,000 VARs, and we think every year there's a few hundred that should make the pivot to sell recurring. And so we think that's where you're going to continue to see us spend money and effort.
Okay, perfect. On the M&A strategy, I guess more broadly speaking, what are the key characteristics that you're looking for, and what would be a good fit for the business?
I'll stay on the Intelisys side for just a minute more. There specifically, we did buy this company Resourcive who's an agency. We said we want to do two things. We want to buy an agency so we can create the channel agency model of the future with best practices and scale, and use that to teach the rest of the Intelisys channel. Here's how you build a scalable, a better model that also may sell hardware. This Resourcive company is going to be more of the hybrid model of the future. Having said that, our two stated goals was to acquire a management team. We bought an agency where the owner had already exited for all intents and purposes, just not financially, but had a young management team in place ready to grow. They're on board at Resourcive.
We also need to buy some technology to help these companies scale like Resourcive and like the Intelisys channel. So we're looking to buy some technology. It may come with an acquisition of another agent. It may come with the acquisition of a software company. But we still need that technology platform, this tool. That's what we need next. We also will look at helping some of the agents that kind of look like me, 60-something-year-old guys that want to take some chips off the table. And we want to, in some cases, acquire parts of their business. And they've offered it to us. Say, "Hey, ScanSource, Intelisys, will you buy 30% of my business?" And so we're looking at buying these contracts or books of business also. But our principal idea there is we want Resourcive to organically grow. That's the real strategy.
Okay. And we talked about the two different segments. As investors are thinking about M&A and inorganic investments, should they expect more in specialty technology, more inorganic investments in specialty technology, or Intelisys, an agency?
Yeah, I think Intelisys is an agency for sure. Even though Advantix, which we acquired, is in specialty, it's about a recurring revenue business that is primarily sold by VARs. So where we'll see specialty acquisitions is for more of that. More of these services-type companies, recurring services, not really professional services. I wouldn't rule it out, but that's not attractive. That doesn't have the valuation.
That's not viable.
Yeah. And so it needs to be something recurring, like this Advantix, where we can sell on a mobile device. You can now put in a SIM, and the user can transition from a Verizon coverage model to an AT&T to a T-Mobile on the fly with no new contracts. This is all done by the Advantix multi-SIM, multi-carrier tool. And this gives our partners a unique advantage in the market. So there are more ideas like that that we're looking at to help sell more hardware, but with more value. So our profitability for specialty, our gross margins should continue to go up.
Good. You talk about your midterm goals as a set and how they all fit together. Maybe you could elaborate on that point.
We've got this idea that revenue still needs to grow. So this 5.5%-6.5% midterm number, we want to get back to growth. We still think that is important. We don't need it to be 15%. We also believe that this EBITDA target that we've got of 4.5%-5% is the right number that we think that's aspirational but doable. As we continue to bring in more recurring, because the recurring part of our business is growing faster, the Intelisys and agency growing faster than the specialty hardware, that's going to happen. We're going to keep, we think, blending up the EBITDA if we do everything right. We've got to execute. We'll see it because the gross margin dollars are going to continue to grow faster than the revenue line.
And as we look at that, we used to, again, be focused almost exclusively on ROIC. And now that's also in there, but that's not critical to success. Free cash flow is. And we do have a free cash flow metric now that we guide to and that we target.
Yep. Yep. I think investors love that. I guess just as we wrap here, I know we covered a lot of different topics, and the business has certainly transformed. And congrats on all the success with that. What's the key message that you'd like to leave with investors as they think about ScanSource, both in the near term as well as the longer term?
Well, I think for us, the idea that we can grow the business significantly past here is the opportunity that we need to do maybe a better job going forward of explaining what our potential TAM is. Right now, it's hard to understand where the growth will come from because we get asked questions about how Zebra is doing, how Cisco is doing, how it used to be, how Avaya is doing, how SpotLink is doing. And they want to know about how Zoom is doing and Lumen and Comcast. And we need to do a better job. And it's challenging for us because we don't have a direct comparable, as you guys know, as a peer. But we need to do a better job of showing how our growth will happen over the next three to five years. And that's something we're focused on.
Is that going to be because of vertical markets, or is it technology, or is it end user type? But we're looking to look at who our end users are being served. Who are they? What markets are they in to give us some ideas about where our future growth could come from? Because we do believe we are tied to the overall IT growth. If the IT industry doesn't grow, we won't. We'll get marginal growth. But we need the overall IT industry to grow, and we need to sell more products that the IT market is serving to end users. If we do that, we're going to get more than our fair share.
Perfect. We'll leave it there, Mike. Thank you so much for the time.
Yeah, thanks, Adam. Great to see you.
You too. You bet.