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Edited Transcript of PCMI earnings conference call or presentation 24-Oct-18 8:30pm GMT

Q3 2018 PCM Inc Earnings Call

TORRANCE Oct 31, 2018 (Thomson StreetEvents) -- Edited Transcript of PCM Inc earnings conference call or presentation Wednesday, October 24, 2018 at 8:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Brandon H. LaVerne

PCM, Inc. - CFO, Treasurer, CAO & Assistant Secretary

* Frank F. Khulusi

PCM, Inc. - Co-Founder, Chairman & CEO

* Robert Jay Miley

PCM, Inc. - President

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Conference Call Participants

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* Kara Lyn Anderson

B. Riley FBR, Inc., Research Division - Senior Analyst of Discovery Group

* William Tennent Gibson

Roth Capital Partners, LLC, Research Division - MD & Senior Research Analyst

* Kimberly Rogers

Hayden IR, LLC - MD

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Presentation

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Operator [1]

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Good day, ladies and gentlemen, and welcome to the Third Quarter 2018 PCM, Inc. Earnings Conference Call. My name is Sarah, and I will be your coordinator for today. (Operator Instructions)

As a reminder, this conference is being recorded for replay purposes.

For opening remarks and introductions, I would like to turn the call over to Kim Rogers of Hayden IR. Please go ahead.

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Kimberly Rogers, Hayden IR, LLC - MD [2]

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Thank you, Sarah. Good afternoon, everyone. We appreciate you joining us today to discuss PCM's Third Quarter 2018 Financial Results.

Joining me on the call today are Frank Khulusi, PCM's Chairman and Chief Executive Officer; Jay Miley, President; and Brandon LaVerne, Chief Financial Officer.

Following the prepared comments, we will open the call to your questions.

At this time, I'd like to refer to the safe harbor statement under the Private Securities Litigation Reform Act of 1995. During this conference call, management may discuss financial projections, information or expectations about the company's products or markets or otherwise make statements about the future, which statements are forward-looking and subject to a number of risks and uncertainties that could cause actual results to differ materially from statements made. These risks and uncertainties are detailed in the company's filings with the Securities and Exchange Commission.

Now I'd like to turn the call over to Frank Khulusi. Please go ahead, Frank. Hello?

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Frank F. Khulusi, PCM, Inc. - Co-Founder, Chairman & CEO [3]

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Thank you, Kim. Good afternoon, everyone, and thank you for joining us today.

Q3 was another fantastic quarter for PCM. I'm very pleased with our continued success in executing in our strategic areas of focus and investment. Much like we saw in the second quarter, we increased our focus on higher-margin sales such as managed services, advanced technologies, cloud and security solutions and again walked away from some nonstrategic, low-margin volume business we identified as unprofitable. As a result, we achieved our highest ever gross margin of 16.7%, which was 170 basis points higher than the same quarter last year and 20 basis points higher than our previous record in Q2 of this year.

Our gross profit dollars, the primary volume growth metric we're focused on, increased 5%; while net sales, a GAAP measure, which in its calculation nets down certain hardware and software maintenance and subscription sales, was impacted by higher-than-anticipated additional $29 million in sales reported on a net basis.

Gross billings, a metric which neutralizes the effects of the net-downs, declined by only 1%, despite us walking away from the nonstrategic, low-margin volume business I mentioned earlier as well as integrated circuit supply shortages from a major chip manufacturer due to their high demand, which shortages affected the supply of certain PCs.

We also reduced our consolidated SG&A by 7%, which combined with the 5% increase in gross profit, fueled the 601% increase in GAAP operating profit and a 53% increase in adjusted EBITDA. These improvements resulted in GAAP diluted EPS of $0.47 and non-GAAP adjusted EPS of $0.61.

Along with our increased profitability, we continue to drive operating cash flow, bucking our normal seasonal trend by delivering an additional $15.5 million in cash from operations in the third quarter. This brought our total cash provided by operations for the year to $87.9 million, which helped reduce our net debt by $81.3 million since the end of 2017.

At this time, I'd like to turn the call over to our President, Jay Miley, for some more specific details on the quarter. Jay?

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Robert Jay Miley, PCM, Inc. - President [4]

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Thank you, Frank. In addition to the areas of focus Frank discussed and as further demonstrated in the financial results just released, we remain laser-focused on optimizing our cost structure. On a 5% increase in gross profit, our operating expenses, or SG&A, declined by $5.4 million or 7% and was down 11 basis points year-on-year as a percentage of net sales.

As you know, we continue to invest incrementally in our U.K. business due to the start-up nature of that business. That said, when excluding the $2 million increase year-on-year associated with the U.K. business, the operating expenses in the remaining segments were down $7.4 million year-on-year or 9%. Of that $7.4 million decrease, variable SG&A, which includes commissions, credit card processing fees and warehouse fulfillment costs decreased by 4% year-on-year or 550k, largely driven by intentionally walking away from some of the business that had very high variable costs relative to the gross profit we were realizing on that business.

The remaining $6.8 million of the $7.4 million decrease came from improvement in our fixed cost structure, which was down 11% or a 25 basis point improvement as a percentage of net sales. In addition to the surgical focus on reducing our cost structure, we remain committed to the transformation of our business as we continue to invest in cloud, managed, endpoint and field services and advanced solutions in the hybrid data center and security arenas. In fact, we continue to make sizable investments in all of these areas, which in turn, are helping us to not only sell more of our sticky, higher-margin services as demonstrated by our 11% increase in service sales, but also allows us to garner higher gross margins on the hardware and software that we sell alongside these services, which is clearly demonstrated by our record-setting gross margin of 16.7% of net sales.

From a category perspective, as measured based on gross book revenues net of returns, software continues to be our largest category at 30% of our mix. We remain committed to evolving our partnerships with SaaS software providers and remain a leader in the cloud service provider model for a largest software publisher, where we are seeing significant year-on-year growth and are capturing meaningful market share.

This category is the category most affected by the push software publishers have away from the traditional licensing model toward the subscription and cloud-based annuity software model. This push today manifests itself in higher gross profits over the course of the year but negatively impacts the quarter of transition. Despite this trend, our software category performed well and grew 2% year-on-year.

Delivered services is now our third-largest category, representing 9% of our mix and grew 11% year-on-year and has been a consistent performer for us all year long. Networking is our fourth-largest category, representing 8% of our mix and grew 25% year-on-year. And sales of OEM hardware, maintenance contracts is our fifth-largest category, representing 8% of our mix and grew 8%.

Our second- and sixth-largest categories, the notebook and tablets category and the desktop category, which represents 16% and 7% of our mix, respectively, was down 12% and 10% year-on-year. The performance of these categories was impacted by 3 things. First, as we discussed previously, we continued to walk away from nonstrategic, low-margin volume business, which we have identified as unprofitable, which impacted revenue in this category. Second, integrated circuit supply shortages from a major player in the semiconductor industry hampered industry supply for finished goods in the quarter. And third, we were unable to repeat a large rollout to a large federal customer that occurred last Q3 that impacted comparisons by approximately $4 million. These 3 items together accounted for more than the entire decline in this category.

We are honored to have received the CRN Triple Crown Award for second consecutive year, which underscores the value of the investments in our core technology practices and our people as we evolve from an IT solution provider to a valuable and trusted partner in the IT decision-making process for our customers.

I'd like to end by saying that I've never felt better than I do right now with respect to PCM's future. I'm proud of the hard work and energy the team around the world is putting into transforming our business. We have many things in the pipeline that I believe shall allow us to continue to drive meaningful improvements in operating margins over the longer term, such as our continued journey to consolidate the number of ERP systems we utilize today. To that end, we have made significant progress in 2018, literally migrating thousands of customers to our new ERP platform with minimal, if any, business disruption. And we will continue to make progress throughout the remainder of the year.

We currently expect to have the vast majority of our business transition to the new platform by July of next year. Once completed, I believe the new platform should allow us to realize over time significant increases in sales rep productivity as well as several operating efficiencies with regards to how we serve our customers.

I'll now turn the call over to Brandon LaVerne, our Chief Financial Officer, who will discuss our third quarter results in more detail. Brandon?

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Brandon H. LaVerne, PCM, Inc. - CFO, Treasurer, CAO & Assistant Secretary [5]

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Thanks, Jay. Detailed information about non-GAAP financial measures and a reconsideration of those non-GAAP financial measures are provided in our current report on Form 8-K filed with the SEC earlier today and also available on our website.

As I review the results for the quarter, all comparisons will be relative to the third quarter of 2017, unless otherwise noted.

Consolidated net sales were $510.6 million, a decline of 6% or $32.7 million from last year, almost all of which or $29 million relates to an increase in sales reported on a net basis over last year. Our commercial net sales declined by $41.9 million, driven by $17.1 million of increases in sales reported on a net basis and the impact of the other items Frank and Jay discussed previously.

Our Public Sector segment sales declined $10.8 million, which was impacted by $11.5 million of increase in sales reported on a net basis. Gross billings net of returns for the segment actually increased despite the headwind of the large, low-margin federal contract that we did not rebid on for a loss back in Q3 last year that continues to affect our year-over-year compares and the large rollout to a different federal agency in the prior year that did not recur, as Jay mentioned.

Our international business has performed well, collectively growing $20 million or 49%. Overall, our consolidated sales of services grew 11% in the quarter and grew to 9% of sales compared to 7% of sales last year. Our top partners by billed revenues in the third quarter 2018 were Microsoft, HP Inc., Dell, Cisco, Apple, Lenovo and Hewlett Packard Enterprise. Collectively, these top 7 partners represented approximately 55% of gross billed revenues.

We have said many times in the past that given the revenue recognition and corresponding net-downs issues that impact our top line, that the best mechanism to measure our growth is looking at gross profit dollars, which are unaffected by such revenue recognition adjustments. I'm happy to say that despite the 6% decline in net sales, consolidated gross profit grew 5% to $85.1 million, with gross margin also improving to a record 16.7%, up 170 basis points.

The increase in gross profit was primarily due to the shift in mix for its higher-margin solutions and service sales, partially offset by the decline in vendor consideration. The increase in gross profit margin was primarily due to the increase in sales recorded on a net basis and the increase in gross profit margin associated with the shift in mix towards higher-margin solutions and services and partially offset by the decrease in vendor consideration as a percentage of net sales.

While gross profit increased 5%, consolidated SG&A expenses decreased by 7% or $5.4 million, driving significantly enhanced profitability. The decrease was primarily due to a decrease in personnel costs of $2.4 million, which includes a $1 million decrease in severance cost, a decrease in restructuring charges of $2 million, which includes $900,000 of duplicative expenses associated with our terminated back office support services provided by a former service provider in Pakistan, a $700,000 decrease in M&A and related litigation costs and a $600,000 decrease in outside service costs.

Interest expense increased by $300,000 to $2.3 million due to higher variable interest rates over the prior period as well as a little higher average borrowings outstanding during the third quarter of 2018 versus the third quarter of 2017.

Income tax expense was $2.4 million or 28.5%. Income taxes in Q3 reflects excess tax benefits associated with stock-based compensation, offset by $300,000 associated with adjustments to 2017 tax year provisional estimates previously recorded related to the Tax Cuts and Jobs Act of 2017. Our annual effective tax rate is approximately 28.5%, and we believe this is a reasonable number for the full year 2018.

As a result of the increased gross profit and reduced SG&A, we're able to deliver operating profit of $10.6 million, up from $1.5 million in the prior year. On a non-GAAP basis, adjusted EBITDA increased $5.5 million or 53% over the prior year. This drove our diluted earnings per share to $0.47 per share compared to a loss of $0.06 per share last year. And adjusted earnings per share increased to $0.61 from $0.27 last year.

Looking at the balance sheet and cash flow. We stated at the beginning of the year that we expected an improvement in our cash flow in 2018 resulting not only from our net profits but also from the normalization of our working capital metrics. I'm happy to report that, again, in the third quarter, we continued this trend, and we generated an incremental $15.5 million of operating cash flow, totaling $87.9 million for the 9-month period of 2018.

In addition to the cash flow from our profits, working capital improvements for the year-to-date period were driven primarily by a $23 million increase in accounts payable and a $39 million reduction in inventory, but offset by only a $12 million increase in accounts receivable. We also indicated previously that we'll see a reduction in capital expenditures, which were only $3.8 million in the 2018 year-to-date period compared to $14.1 million in the 2017 year-to-date period.

As a result, our net debt declined by $81.3 million since the beginning of the year.

At this point, I'll turn the call back over to Frank to discuss our outlook. Frank?

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Frank F. Khulusi, PCM, Inc. - Co-Founder, Chairman & CEO [6]

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Thank you, Brandon. Given our continued strong performance and solid outlook for the fourth quarter, we're increasing our 2018 guidance for non-GAAP earnings per share to a range of $2.22 to $2.32 and increasing our gross margin guidance for the year to a range of 16.15% to 16.35%, assuming Q4 net revenue roughly in line with Q3.

This reflects our expected focus on gross profit dollars growth, while continuing to shed certain nonstrategic, low-margin volume business during the fourth quarter. As we cycle out of nonstrategic, lower-margin volume business, while we continue to deliver growth in our areas of strategic focus, we should in the long term be able to also drive meaningful consolidated top line growth. We strongly feel that the future for PCM is very bright, and we’re better positioned than ever.

I'm extremely grateful to our PCM team who through their hard work, dedication and unwavering commitment to our vision are making our success possible.

Sarah, we can now open the call for Q&A.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from the line of Kara Anderson with B. Riley FBR.

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Kara Lyn Anderson, B. Riley FBR, Inc., Research Division - Senior Analyst of Discovery Group [2]

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Can you guys talk a little bit about the U.K. business, how the ramp is going? Do you feel like you're getting traction? And are you where you want to be at this point?

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Frank F. Khulusi, PCM, Inc. - Co-Founder, Chairman & CEO [3]

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We are never satisfied with where we are at any point anywhere in the business. We're always striving for bigger, better. We are however on balance pleased, considering the seasonality of the business and considering the items I talked about before. Obviously, this business is new for us and we're still learning. So what we said last quarter is that, that business tends to have a lot of public sector in it. And we anticipate that we're going to play more and more in that starting next year because it takes a while to get on the frameworks, and we anticipate to be able to start doing that next year. Also from a seasonal perspective, it seems to have more of a Q1 strong seasonality profile similar to our Canada business. So with that in mind, at this point, we still have very high expectations for that business. We're continuing to hire very opportunistically in the market. And at some point next year, we will be pleased with the results. I hope it's that -- that's what we're planning for.

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Kara Lyn Anderson, B. Riley FBR, Inc., Research Division - Senior Analyst of Discovery Group [4]

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Okay, great. And then on -- just talking about sort of the quarter's performance on the gross margin level relative to your internal expectations and certainly, you must have outperformed, can you call out the specific items that surprised you, I guess, on that line? And was it really just the higher netting?

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Frank F. Khulusi, PCM, Inc. - Co-Founder, Chairman & CEO [5]

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In terms of positive surprises, right? Because here we're talking about we came in...

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Kara Lyn Anderson, B. Riley FBR, Inc., Research Division - Senior Analyst of Discovery Group [6]

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Yes.

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Frank F. Khulusi, PCM, Inc. - Co-Founder, Chairman & CEO [7]

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Specifically, had a higher expectations in -- that we put out on our second quarter conference call. And the answer is both. We were very pleased with our results in terms of driving the high-value stuff, which had a positive impact on our gross margin, as well as the higher net-downs that we experienced in the quarter. So both items kicked in. And we were very happy and very pleased with our very strong record gross margin as a result of it. Does it answer your question, or you'd like more color?

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Kara Lyn Anderson, B. Riley FBR, Inc., Research Division - Senior Analyst of Discovery Group [8]

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Yes. No, that's helpful.

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Frank F. Khulusi, PCM, Inc. - Co-Founder, Chairman & CEO [9]

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Okay. Yes?

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Kara Lyn Anderson, B. Riley FBR, Inc., Research Division - Senior Analyst of Discovery Group [10]

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And then on the decrease in SG&A from personnel costs, was that really just a variable component or are you reducing headcount at all?

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Robert Jay Miley, PCM, Inc. - President [11]

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No, it was -- it was a combination of -- on a GAAP basis, a reduction in headcount, as we optimized our workforce. Also, we had a pickup in severance year-on-year. And I think you'd find those 2 things are the vast majority of what personnel drop.

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Frank F. Khulusi, PCM, Inc. - Co-Founder, Chairman & CEO [12]

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So the severance is only -- has an effect on a GAAP basis since it's backed out on a non-GAAP basis. From a non-GAAP perspective, it's all in personnel as well as the variable that you identified. But keep in mind that those personnel actions actually took place earlier, and we just continue to receive significant benefits of these things. We are also continuing to invest heavily in the areas of focus. So it's not like we're not investing in the areas that we should be investing. It's the exact opposite. And we will continue to make adjustments to the business by taking cost out of the areas that we consider to be nonstrategic and deploying that funding, if not more than that, in the areas that we think are the future for PCM.

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Kara Lyn Anderson, B. Riley FBR, Inc., Research Division - Senior Analyst of Discovery Group [13]

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Understood. And then so when we think about with the reduction in fixed costs and then balancing that with the investments in the build-up in the U.K. business, I'm not sure what's left there. How should we think about the structure going forward as it compares to sort of the third quarter level?

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Brandon H. LaVerne, PCM, Inc. - CFO, Treasurer, CAO & Assistant Secretary [14]

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So as far as the overall SG&A profile, overall for the company, we're clearly trying to optimize. And so while we are ramping in the U.K as we had indicated, we are still optimizing within North America. And we believe that there might be some incremental, slight incremental increases, if any, over the course of next year of SG&A. We're still looking for that reduction as a percentage of sales.

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Frank F. Khulusi, PCM, Inc. - Co-Founder, Chairman & CEO [15]

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So I mean if your question is more specific to the fourth quarter, we do expect and built into our forecast, there's a slight uptick in SG&A expenses from Q3 to Q4.

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Operator [16]

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Our next question comes from the line of William Gibson with Roth Capital Partners.

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William Tennent Gibson, Roth Capital Partners, LLC, Research Division - MD & Senior Research Analyst [17]

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Say with regards to the IC shortages, do those continue? And secondly, related to that, were those delayed sales? Or did it result in lost sales?

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Frank F. Khulusi, PCM, Inc. - Co-Founder, Chairman & CEO [18]

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Well, first of all, with respect to the sales delays versus the lost sales, let me just say that in Q3 overall, something that we failed to mention earlier, we were very pleased with our October demand. As a matter of fact, our October demand, which is normally a hockey stick at the end of the quarter. But the hockey stick was more pronounced than the same period last year or the period before -- I mean I'm talking about September, sorry, not October. Our demand in September for Q3 was a stronger hockey stick as compared to the same period at Q3 of 2017 or as compared to Q3 of 2016. So that in my opinion bodes well for what we're doing and potentially the demand environment overall. And the reason I mention that is I don't want to overemphasize this issue with respect to the IC shortage. We just -- it is something that we were planning on with respect to certain orders that we have. And obviously, it did affect our demand, Otherwise, we wouldn't have brought it up. But we're not worried about it in the long term.

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William Tennent Gibson, Roth Capital Partners, LLC, Research Division - MD & Senior Research Analyst [19]

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Okay. And in regard to September demand, how was that in the public sector? And what's sort of the breakdown between state and local government and federal in terms of demand?

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Frank F. Khulusi, PCM, Inc. - Co-Founder, Chairman & CEO [20]

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Jay, do you have that? Do you want to take that?

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Robert Jay Miley, PCM, Inc. - President [21]

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Yes. So look, I mean -- and Brandon mentioned it in his comments, on a gross billings basis, year-on-year, we actually grew in our Public Sector business year-on-year though. So I think that's good for you to know. In terms of the breakdown between our federal business and our state, local education business, Q3 is a heavy -- it's the fiscal year-end for the federal government. So it's a seasonally high year for us in Fed relative to SLED. But we are seeing improvements in terms of the overall health of that business in our public sector arena generally.

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Frank F. Khulusi, PCM, Inc. - Co-Founder, Chairman & CEO [22]

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So as Jay said, Q3 is strong in Fed year, but in a 3-month quarter, from a seasonal perspective, with respect to Fed, Q2 is a strong SLED quarter. So 2018 was somewhat the same with respect to our overall health of the business. Gross billings is a great indicator and that grew for us in Q3. And we have actually pretty high expectations for that business being able to contribute nicely in 2019, both from a top line as well as bottom line improvement perspective.

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Operator [23]

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(Operator Instructions) We have no further questions at this time. I would now like to turn the call back to Frank Khulusi for closing remarks.

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Frank F. Khulusi, PCM, Inc. - Co-Founder, Chairman & CEO [24]

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Thank you, Sarah, for your help on this call, and thank you all for joining us this afternoon. We look forward to updating you on our progress in the coming quarters. Until then, goodbye.

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Operator [25]

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Ladies and gentlemen, thank you for participating in today's conference. This does conclude today's program. You may all disconnect. Everyone, have a great day.