PC CONNECTION INC - Quarter Report: 2011 March (Form 10-Q)

Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended March 31, 2011

OR

For the transition period from                      to                     

Commission file number 0-23827

PC CONNECTION, INC.

(Exact name of registrant as specified in its charter)

(603) 683-2000

(Registrant’s telephone number, including area code)

Former name, former address and former fiscal year, if changed since last report: N/A

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

YES  þ    NO  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

YES  ¨    NO  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

YES  ¨    NO  þ

The number of shares outstanding of the issuer’s common stock as of May 1, 2011 was 26,894,774.

Table of Contents

PC CONNECTION, INC. AND SUBSIDIARIES

FORM 10-Q

TABLE OF CONTENTS

Table of Contents

PC CONNECTION, INC. AND SUBSIDIARIES

PART I—FINANCIAL INFORMATION

Item 1—Financial Statements

CONDENSED CONSOLIDATED BALANCE SHEETS

(amounts in thousands)

See notes to unaudited condensed consolidated financial statements.

1

Table of Contents

PC CONNECTION, INC. AND SUBSIDIARIES

PART I—FINANCIAL INFORMATION

Item 1—Financial Statements

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(Unaudited)

(amounts in thousands, except per share data)

See notes to unaudited condensed consolidated financial statements.

2

Table of Contents

PC CONNECTION, INC. AND SUBSIDIARIES

PART I—FINANCIAL INFORMATION

Item 1—Financial Statements

CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY

Three Months Ended March 31, 2011

(Unaudited)

(amounts in thousands)

See notes to unaudited condensed consolidated financial statements.

3

Table of Contents

PC CONNECTION, INC. AND SUBSIDIARIES

PART I—FINANCIAL INFORMATION

Item 1—Financial Statements

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(amounts in thousands)

See notes to unaudited condensed consolidated financial statements.

4

Table of Contents

PC CONNECTION, INC. AND SUBSIDIARIES

PART I—FINANCIAL INFORMATION

Item 1—Financial Statements

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(amounts in thousands, except per share data)

Note 1—Basis of Presentation

The accompanying condensed consolidated financial statements of PC Connection, Inc. and its subsidiaries (the “Company,” “we,” “us,” or “our”) have been prepared in accordance with accounting principles generally accepted in the United States of America. Such principles were applied on a basis consistent with the accounting policies described in our Annual Report on Form 10-K for the year ended December 31, 2010 filed with the Securities and Exchange Commission (the “SEC”). The accompanying condensed consolidated financial statements should be read in conjunction with the financial statements contained in our Annual Report on Form 10-K.

In the opinion of management, the accompanying unaudited condensed consolidated financial statements contain all adjustments (consisting only of normal recurring adjustments) necessary for a fair presentation of the results of operations for the interim periods reported and of the Company’s financial condition as of the date of the interim balance sheet. The Company considers events or transactions that occur after the balance sheet date but before the financial statements are issued to provide additional evidence relative to certain estimates or to identify matters that require additional disclosure. Subsequent events have been evaluated through the date of issuance of these financial statements. The operating results for the three months ended March 31, 2011 may not be indicative of the results expected for any succeeding quarter or the entire year ending December 31, 2011.

Use of Estimates in the Preparation of Financial Statements

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions. These estimates and assumptions affect the amounts reported in the accompanying condensed consolidated financial statements. Actual results could differ from those estimates.

Note 2—Earnings Per Share

Basic earnings per common share is computed using the weighted average number of shares outstanding. Diluted earnings per share is computed using the weighted average number of shares outstanding adjusted for the incremental shares attributed to options outstanding to purchase common stock, if dilutive.

The following table sets forth the computation of basic and diluted earnings per share:

5

Table of Contents

For the three months ended March 31, 2011 and 2010, the following unexercised stock options were excluded from the computation of diluted earnings per share because the effect would have been anti-dilutive:

Note 3—Acquisition of ValCom Technology

On March 17, 2011, we completed the acquisition of ValCom Technology, a provider of infrastructure management and onsite managed services. Under the terms of the stock purchase agreement, we paid $8,495 at closing, subject to final validation of stockholders’ equity as of the closing date. In addition, we agreed to pay up to $3,000 upon the achievement of certain performance milestones over the next eighteen months. We incurred $500 of transaction costs related to the acquisition. The purchase of ValCom Technology will allow us to expand our services capabilities, and the excess of the purchase price over the net assets acquired represents potential revenue enhancements/synergies from our existing customer base and ValCom Technology’s assembled workforce of sales representatives and service technicians that we acquired in the transaction. We allocated the total purchase price to the tangible and identifiable intangible assets acquired and liabilities assumed based on their estimated fair values on the date of acquisition and recorded the excess of purchase price over the aggregate fair values as goodwill. The initial allocation of the purchase price was based upon a preliminary valuation, and accordingly, our estimates and assumptions are subject to change as we obtain additional information during the measurement period and completion of the valuation of intangible assets and contingent consideration. We have included the operating results of ValCom Technology in the Large Account segment in our Condensed Consolidated Financial Statements since the acquisition date. Pro forma results of operations have not been presented because the effects of the business combination were not material to our consolidated results of operations.

The following table reflects components of the purchase price at fair value as of March 17, 2011. The fair values of the intangibles were determined through a third party valuation using management estimates, which have not been finalized.

The fair value of the additional contingent consideration as of the date of acquisition is $2,880. Such valuation is based upon management’s initial estimates, including estimates of the probability of achievement of the performance milestones. Adjustments to the fair value of the contingent consideration will be reflected in our operating results, if necessary, during the earnout period. The goodwill balance of $3,092 is expected to be fully deductible for tax purposes.

6

Table of Contents

Note 4—Goodwill and Other Intangible Assets

Goodwill

Goodwill and intangible assets with indefinite lives are not amortized but are subject to an annual impairment test. These assets are tested more frequently if events or circumstances occur that would indicate a potential decline in fair value. The goodwill impairment test, performed at a reporting unit level, is a two-step test that requires, under the first test, that we determine the fair value of a reporting unit and compare it to the reporting unit’s carrying value, including goodwill. We use established income and market valuation approaches to determine the fair value of the reporting unit.

We completed our annual impairment test of an indefinite-lived trademark and goodwill on the first day of 2011 and determined that the fair values of the trademark and the reporting unit to which the goodwill relates substantially exceeded their respective carrying values. Accordingly, we did not identify any impairment. Our test of goodwill requires that we assess the fair value of the Large Account reporting unit. We determined its fair value as of January 1, 2010, by preparing a discounted cash flow analysis using forward-looking projections of the reporting unit’s future operating results, as well as consideration of market valuation approaches. When completing the step-one test on the first day of 2011, we elected to carry forward the previous determination of fair value for our Large Account unit rather than reassess its fair value.

We did not identify any events or circumstances that would indicate that it is more likely than not that the carrying value of this reporting unit was in excess of its fair value during the three months ended March 31, 2011. Accordingly, we did not perform an interim test for impairment.

As discussed in Note 3, we recorded an additional $3,092 of goodwill as a result of our acquisition of ValCom Technology in our Large Account segment in the first quarter of 2011. Goodwill was determined on the date of acquisition as the excess of the total purchase price over the net of the assets and liabilities acquired based on their estimated fair values. The initial allocation of the purchase price was based upon a preliminary valuation. Our estimates and assumptions are subject to change as we obtain additional information during the measurement period and complete the valuation of intangible assets and the contingent consideration.

Intangible Assets

The following table sets forth the amounts recorded for intangible assets for the periods ended March 31, 2011 and December 31, 2010.

The intangible assets of ValCom Technology were valued at the date of acquisition using third-party valuation specialists and will be amortized in proportion to the original estimates of the future cash flows underlying the valuation of the intangible assets. The weighted-average period of the intangible assets that we acquired in the first quarter of 2011 is 7.8 years. For the three-month periods ended March 31, 2011 and 2010, we recorded amortization expenses of $56 and $188, respectively.

7

Table of Contents

The estimated amortization expense for each of the five succeeding years and thereafter is as follows:

(*) Represents estimated amortization expense for the nine months ending December 31, 2011.

Note 5—Segment and Related Disclosures

We are required to report profits and losses and certain other information about our “reportable operating segments” in our annual and interim financial statements. The internal reporting structure used by our chief operating decision maker (“CODM”) to assess performance and allocate resources determines the basis for our reportable operating segments. Our CODM is our Chief Executive Officer, and she evaluates operations and allocates resources based on a measure of operating income.

Our operations are organized under four reporting segments—the SMB segment, which primarily serves small- and medium-sized businesses; the Large Account segment, which primarily serves medium-to-large corporations; the Public Sector segment, which serves federal, state, and local government and educational institutions, and the Consumer/SOHO segment, which serves the consumer and small office/home office (“SOHO”) markets. In addition, the Headquarters/Other group provides services in areas such as finance, human resources, information technology, product management, and marketing. Most of the operating costs associated with the Headquarters/Other group functions are charged to the operating segments based on their estimated usage of the underlying functions. We report these charges to the operating segments as “Allocations.” Certain of the headquarters costs relating to executive oversight and other fiduciary functions that are not allocated to the operating segments are included under the heading of Headquarters/Other in the tables below.

In March 2011, we acquired ValCom Technology, a provider of IT infrastructure and on-site managed services to medium-to-large corporations. We have included the operating results of ValCom Technology since the acquisition in our Large Account segment, which also includes the operating results of our MoreDirect subsidiary.

8

Table of Contents

Net sales represent net sales to external customers and exclude inter-segment product revenues. Segment information applicable to our reportable operating segments for the three months ended March 31, 2011 and 2010 is shown below:

The assets held by our operating segments are primarily accounts receivables, intercompany receivables, goodwill, and other intangibles. Assets for the Headquarters/Other group are managed by corporate headquarters, including cash, inventory, and property and equipment. Total assets for the Headquarters/Other group at March 31, 2011 are presented net of intercompany balance eliminations of $30,533. Our capital expenditures are largely comprised of IT hardware and software purchased to maintain or upgrade our management information systems. These systems serve all of our subsidiaries, to varying degrees, and as a result, our CODM does not evaluate capital expenditures on a segment basis.

Senior management also monitors consolidated revenue by product mix (Notebook and PDA; Desktop/Server; Software; Video, Imaging and Sound; Net/Com Product; Storage Device; Printer and Printer Supplies; Memory and System Enhancement; and Accessories/Other).

9

Table of Contents

Net sales by product mix is presented below:

Note 6—Commitments and Contingencies

We are subject to various legal proceedings and claims, including patent infringement claims, which have arisen during the ordinary course of business. In the opinion of management, the outcome of such matters is not expected to have a material effect on our financial position, results of operations, and cash flows.

We are subject to audits by states on sales and income taxes and unclaimed property, as well as employment and other matters. A comprehensive multi-state unclaimed property audit is currently in progress. While management believes that known and estimated liabilities have been adequately provided for, it is too early to determine the ultimate outcome of such audits. Additional liabilities could be assessed, and such outcome could have a material negative impact on our financial position, results of operations, and cash flows.

Note 7—Bank Borrowing and Trade Credit Arrangements

We have a $50,000 credit facility collateralized by substantially all of our assets. This facility can be increased, at our option, to $80,000 for approved acquisitions or other uses authorized by the lender at substantially the same terms. Amounts outstanding under this facility bear interest at the prime rate (3.25% at March 31, 2011). The facility also gives us the option of obtaining Eurodollar Rate Loans in multiples of $1,000 for various short-term durations. The credit facility includes various customary financial ratios and operating covenants, including minimum net worth and maximum funded debt ratio requirements, and restrictions on the payment of dividends to shareholders, repurchase of our common stock, and default acceleration provisions, none of which we believe significantly restricts our operations. Funded debt ratio is the ratio of average outstanding advances under the credit facility to EBITDA (Earnings Before Interest Expense, Taxes, Depreciation, and Amortization). The maximum allowable funded debt ratio under the agreement is 2.0 to 1.0; this ratio did not limit potential borrowings at March 31, 2011. Decreases in our consolidated EBITDA, however, could limit our potential borrowings under the credit facility.

No borrowings were outstanding under this credit facility at March 31, 2011 and December 31, 2010, and accordingly, the entire $50,000 facility was available for borrowing at both dates. The credit facility matures on October 15, 2012, at which time amounts outstanding become due.

At March 31, 2011, we had security agreements with two financial institutions to facilitate the purchase of inventory from various suppliers under certain terms and conditions. The agreements allow a collateralized first position in certain branded products in our inventory that were financed by these two institutions up to an aggregated amount of $47,000. The cost of such financing under these agreements is borne by the suppliers by

10

Table of Contents

discounting their invoices to the financial institutions as an incentive for us to purchase their products. We do not pay any interest or discount fees on such inventory financing. At March 31, 2011 and December 31, 2010, accounts payable included $18,288 and $14,603, respectively, owed to these financial institutions.

Note 8—Fair Value

Our financial instruments consist primarily of cash and cash equivalents, accounts receivable, and accounts payable. The carrying values of cash, accounts receivable, and accounts payable approximate their fair values due to their short-term nature. We are required to measure fair value under a fair value hierarchy that maximizes the use of observable inputs and minimizes the use of unobservable inputs. Observable inputs are obtained from independent sources and can be validated by a third party, whereas unobservable inputs reflect assumptions regarding what a third party would use in pricing an asset or liability. A financial instrument’s categorization within the fair value hierarchy is based upon the lowest level of input that is significant to the fair value measurement. Three levels of inputs may be used to measure fair value:

Level 1—Quoted prices in active markets for identical assets or liabilities.

Level 2—Include other inputs that are directly or indirectly observable in the marketplace.

Level 3—Unobservable inputs which are supported by little or no market activity.

We measure our cash equivalents at fair value and classify such assets within Level 1 of the fair value hierarchy. The classification has been determined based on the manner in which we value our cash equivalents, primarily using quoted market prices for identical assets. Assets and liabilities measured at fair value on a recurring basis consisted of the following types of instruments at March 31, 2011 and December 31, 2010:

The Level 3 liability consists of contingent consideration related to the acquisition of ValCom Technology. The fair value of the contingent consideration was estimated by applying the income approach. The measure is based on significant inputs that are unobservable in the market. Key assumptions include a discount rate of 4.1% and a 100% probability of achievement.

11

Table of Contents

PC CONNECTION, INC. AND SUBSIDIARIES

PART I—FINANCIAL INFORMATION

Item 2—MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION

AND RESULTS OF OPERATIONS

Our management’s discussion and analysis of our financial condition and results of operations include the identification of certain trends and other statements that may predict or anticipate future business or financial results that are subject to important factors that could cause our actual results to differ materially from those indicated. See Item 1A. “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2010 on file with the SEC.

OVERVIEW

We are a leading direct marketer of a wide range of information technology, or IT, solutions. We help companies design, enable, manage, and service their IT environments. We provide products, including computer systems, software and peripheral equipment, networking communications, and other products and accessories that we purchase from manufacturers, distributors, and other suppliers. We also offer an extensive range of design, configuration, and implementation of IT solutions. These services are performed by our personnel and third-party providers. We operate through four sales segments, which primarily serve: (a) small- to medium-sized businesses, or SMBs, through our PC Connection Sales subsidiary, (b) large enterprise customers, in Large Account, through our MoreDirect and ValCom Technology subsidiaries, (c) federal, state, and local government and educational institutions, in Public Sector, through our GovConnection subsidiary, and (d) consumers and small office/home office (“SOHO”) customers, in Consumer/SOHO, through our PC Connection Express subsidiary.

We generate sales primarily through outbound telemarketing and field sales contacts by account managers focused on the business, education, and government markets, our websites, and inbound calls from customers responding to our catalogs and other advertising media. We seek to recruit, retain, and increase the productivity of our sales personnel through training, mentoring, financial incentives based on performance, and updating and streamlining our information systems to make our operations more efficient.

As a value added reseller in the IT supply chain, we do not manufacture IT hardware or software. We are dependent on our suppliers—manufacturers and distributors that historically have sold only to resellers rather than directly to end users. Certain manufacturers have on multiple occasions attempted to sell directly to our customers, and in some cases, have restricted our ability to sell their products directly to certain customers, thereby eliminating our role. We believe that the success of these direct sales efforts by suppliers will depend on their ability to meet our customers’ ongoing demands and provide objective, unbiased solutions to meet their needs. We believe more of our customers are seeking total IT solutions, rather than simply the acquisition of specific IT products. Our advantage is our ability to be product-neutral and provide a broader combination of products, services, and advice tailored to customer needs. By providing customers with customized solutions from a variety of manufacturers, we believe we can mitigate the negative impact of continued direct sales initiatives from any individual manufacturer. Through the formation of our services group, ProConnection, we are able to provide customers complete IT solutions, from identifying their needs, to designing, developing, and managing the integration of products and services to implement their IT projects. Such service offerings carry higher margins than traditional product sales. Additionally, the technical certifications of our service engineers permit us to offer higher-end, more complex products that generally carry higher gross margins. We expect these service offerings and technical certifications to continue to play a role in sales generation and improved gross margins in this competitive environment.

Market conditions and technology advances significantly affect the demand for our products and services. Virtual delivery of software products and advanced Internet technology providing customers enhanced functionality have substantially increased customer expectations, requiring us to invest more heavily in our own

12

Table of Contents

IT development to meet these new demands. As buying trends change and electronic commerce continues to grow, customers have become more sophisticated due to the amount and quality of information available and the increased number of readily available choices. Customers are also better able to make price comparisons through the Internet, thereby necessitating more aggressive pricing strategies to remain competitive. The changing landscape of the consumer and business markets in which we operate could have a negative effect on our financial condition, results of operations, and cash flows. While it is not possible for us to estimate with any degree of accuracy the level of sales we may have lost or may lose in the future as a result of such increased buyer sophistication, our consolidated Internet sales have consistently represented approximately 30% of total sales over the last three years.

We have undertaken significant actions with respect to our websites in order to keep up with the improvements made by our competitors. We have historically increased the level of internet marketing expenditures on third-party “click fees” and affiliate charges, particularly with respect to consumer marketing, in order to increase visibility on third-party search engines. We have also launched various promotions, including selected free freight offers, in efforts to generate higher internet sales and increase brand awareness. All of these activities are costly, aggregating $5.8 million in the year ended December 31, 2010, and decrease our operating results accordingly. These costs are expected to increase in future periods as we continue to expand our internet visibility and functionality, and if we do not generate increased internet sales, our operating margins may be further impacted.

The primary challenges we continue to face in effectively managing our business are (1) increasing our revenues while at the same time improving our gross margin in all four segments, (2) recruiting, retaining, and improving the productivity of our sales personnel, and (3) effectively controlling our selling, general and administrative, or SG&A, expenses while increasing investments in our IT systems and solution selling personnel.

To support future growth, we are expanding our IT solution business, which requires the addition of highly-skilled service engineers. We are only in the preliminary stages of this initiative and although we expect to realize the ultimate benefit of higher-margin service revenues, we believe that our SG&A expenses will increase as we add service engineers. If our service revenues do not grow enough to offset the cost of these headcount additions, our operating results may decline. In addition, we are continuing our comprehensive review and assessment of our entire business software needs. That review and assessment includes the review of commercially available software that meets, or can be configured to meet, those needs better than our existing software. As of March 31, 2011, we have capitalized $4.5 million of software and integration costs for the initial phase of this software project. While we have not yet finalized any decisions regarding to what extent additional software will be acquired, we expect to increase investments in our IT infrastructure in the next three-to-five years, which will likely increase SG&A expenses.

RECENT EVENTS

On March 17, 2011, we announced the acquisition of ValCom Technology, a provider of IT infrastructure and onsite managed services to medium-to-large corporations. ValCom Technology had approximately 200 employees as of the acquisition date and is headquartered in the greater Chicago area. For the year ended December 31, 2010, its revenues and operating income were $39.6 million and $3.0 million, respectively. We have included the operating results for ValCom Technology in our Large Account segment since the closing date, which had an immaterial impact on our operations during the period. Please see Notes 3 and 4 of the Notes to the Condensed Consolidated Financial Statements of this report for further discussion of this acquisition.

13

Table of Contents

RESULTS OF OPERATIONS

The following table sets forth information derived from our statements of income expressed as a percentage of net sales for the periods indicated:

Net sales in the first quarter of 2011 increased by $53.7 million, or 13.1%, compared to the first quarter of 2010. Net sales for our SMB, Large Account, and Public Sector segments increased in the first quarter of 2011 by 11.7%, 16.5%, and 14.0%, respectively, compared to the prior year quarter. Gross margin increased year over year due to additional vendor consideration as a percentage of net sales and improved invoice selling margins in each of our operating segments. Operating income in the first quarter of 2011 increased to $7.5 million, compared to $4.2 million in the prior year quarter, due to the increase in net sales and gross margin.

Net Sales Distribution

The following table sets forth our percentage of net sales by reporting segment and product mix:

14

Table of Contents

Gross Profit Margins

The following table summarizes our gross profit margins, as a percentage of net sales, over the periods indicated:

Consolidated gross profit dollars for the first quarter of 2011 increased by $10.2 million compared to first quarter of 2010 due to an increase in revenue and gross margin. Gross profit margin, as a percentage of net sales, increased by 80 basis points to 12.7% in the first quarter of 2011 compared to the prior year quarter. Improved invoice selling margins and additional vendor consideration as a percentage of net sales in the first quarter of 2011 increased overall gross margin compared to the prior year quarter.

Cost of Sales and Certain Other Costs

Cost of sales includes the invoice cost of the product, direct costs of packaging, inbound and outbound freight, and provisions for inventory obsolescence, adjusted for discounts, rebates, and other vendor allowances. Direct operating expenses relating to our purchasing function and receiving, inspection, internal transfer, warehousing, packing and shipping, and other expenses of our distribution center are included in our SG&A expenses. Accordingly, our gross margin may not be comparable to those of other entities who include all of the costs related to their distribution network in cost of goods sold. Such distribution costs included in our SG&A expenses, as a percentage of net sales for the periods reported, are as follows:

Operating Expenses

The following table breaks out our more significant operating expenses for the periods indicated (in millions of dollars):

15

Table of Contents

Personnel costs increased year over year in 2011 due primarily to increased variable compensation associated with higher gross profits and investments in sales and sales support areas. Professional fees in the first quarter of 2011 increased year over year due to $0.5 million of costs related to our acquisition of ValCom Technology.

Year-Over-Year Comparisons

Three Months Ended March 31, 2011 Compared to Three Months Ended March 31, 2010

Changes in net sales and gross profit by business segment are shown in the following table (dollars in millions):