ScanSource Investors Get the Skinny on New Agency Business

ScanSource is pointing to growth and new opportunity in its agency model in the face of lagging hardware demand.

Investors on Tuesday turned their attention to the hybrid distributor's plan to build a customer-facing agency business. The "NewCo," which will officially launch with an acquisition in the upcoming months, will complement ScanSource's initial foray into the agent/advisor space with tech services distributor Intelisys.

Intelisys, which ScanSource bought in 2016, has proven a reliable source of recurring revenue, free cash flow and sales growth in recent years. ScanSource CEO (and interim Intelisys CEO) Mike Baur has vowed to put more investment into the tech services distributor (TSD) as it navigates margin pressures and consolidation in the TSD marketplace.

ScanSource brought in $158 million in free cash flow last quarter, and those leftover funds will play an important role in investments in both the Intelisys and NewCo businesses. Baur said ScanSource's capital allocation plan includes share repurchases and M&A.

ScanSource's Mike Baur

"Our preferred use of free cash flow is to fund growth of high-margin recurring revenue businesses that are working capital-light," Baur told investors on Tuesday.

ScanSource Earnings

ScanSource net sales its fiscal third quarter (ended March 31) declined 15% year-over-year to $753 million. The distributor's specialty technology solutions business saw another decline in net sales (14%), while a slowdown in networking hardware sales contributed to a 16% net sales drop for the modern communications and cloud division.

Related:Moneyball 2.0: The Indirect Sales Channel

On-prem communications hardware has often been the culprit for sales declines in the modern communications business, but ScanSource identified its networking portfolio as a surprising area of decline. That could correlate with Cisco reporting last quarter that it saw declining product orders and a networking revenue drop of 12%. ScanSource has ridden a wave of Cisco growth in the last few years, earning its award for Americas Distributor of the Year.

Intelisys improved year-over-year, with revenue ticking up 4%. The TSD's net sales grew 7%, with contact center as a service (CCaaS) and unified communications as a service (UCaaS) being key growth areas, at 33% and 11%, respectively. That's despite a decrease in per-seat pricing that the UCaaS industry is facing, Baur said.

End user billings – meaning the total amount of monthly recurring charges from suppliers to end customers (in deals sold by Intelisys agents) – sits at $2.68 billion annualized.

Related:Answering 10 Burning Questions About ScanSource 'NewCo'

Baur estimates the total addressable market for the agent model to be between $200 billion and $400 billion in end-user billing. That includes tech sales that are currently happening through direct teams that could one day go through TSDs and agents.

Baur noted that partners in the agent model are navigating macroeconomic headwinds of their own.

"Our sales partners tell us that they are seeing a more cautious IT spending environment from end customers, accompanied by longer sales cycles for third quarter," he said.

Analysts Inquire about the Agent Model

Baur increasingly has drawn attention to the Intelisys business in recent earnings calls, and his new mention of ScanSource's pending agency business elicited several questions from investors about how the TSD model differs from that of value-added resellers.

In the TSD model, Intelisys holds contracts with different carrier and software providers on behalf of independently owned agencies. These agencies, referred to by Intelisys as "sales partners" and other TSDs as "technology advisors" or "trusted advisors," sell a supplier's tech solution to the end-user business customer. The vendors operate in an as-a-service model with monthly billing. The vendor manages the technology solution for the customer and bills the customer monthly. The agents collect a monthly commission (passed onto them by the contract-holding TSD) from the vendor.

Related:ScanSource Launching Agent Subsidiary, Eying M&A Targets

The agent/advisor can use the deep TSD portfolio of suppliers to give their clients a vendor-neutral evaluation of the best fit products. They also can use their purchasing power to negotiate favorable pricing. In recent years, some agents have leaned away from calling themselves brokers of transactional telecom services and into consultants for multisite IT solutions.

Baur said on the earnings call that Intelisys works with about 4,000 agencies, many of which are fewer than 10 people. And these partners tend to focus on selling, Baur said.

"They do have technical resources, but they have virtually no back office. Most of these agencies run off of QuickBooks, just to be honest — even the larger ones. We process all the commissions and the end users are billed by the suppliers. So they don't really have to have a back office of any significance," Baur said.

ScanSource NewCo

Baur said ScanSource plans to launch its own agency in part because agents struggle with customer renewals. Being lightly staffed has meant that some partners focus more on new customer acquisition rather than ongoing account management.

Baur has said that ScanSource hopes to acquire a digital tool that it can use in ScanSource NewCo to renew, cross-sell and upsell more effectively.

"If we can build this contract management tool set that goes along with people, we believe we can show the rest of the Intelisys partners how to scale and how to use, frankly, some of our resources to work their installed base so that they have less churn," Baur said.

In a similar vein, Baur has said NewCo would address challenges that agent consolidation has presented for client retention and cross-sell. Many agencies have sold their books of business to private-equity backed players, but Baur said no innovation has emerged from these deals.

Intelisys historically has not participated in partner M&A, but Baur said he has come to believe that in "the channel model of the future," partners will have the option to sell their base to a TSD that will farm it for new revenue. That being said, "NewCo" will exist as a subsidary of ScanSource rather than Intelisys. It will function as an exclusive agent of Intelisys, but Baur said a firewall will exist between Intelisys and NewCo to protect the customer information of Intelisys agents.

Baur said ScanSource is getting closer to announcing an acquisition that will form the foundation of NewCo.

"Our primary goal here is to get a management team, learn how an agency can work in the future and do some things, frankly, that we don't see being done today in the channel."

Asked by investors how NewCo will impact Intelisys' margins, Jones said the new venture will provide relief to Intelisys.

The TSD landscape has in recent years seen different distributors offer higher commission splits to agents at the expense of margin.

ScanSource's Steve Jones

"Margins have really started to get compressed on the Intelisys side as the agent is taking more of the margin share," Jones said. "So we think for ScanSource, this will help expand our margin opportunity in this agency channel. That's the way we're looking at it; that's the way we're modeling it."

For a detailed FAQ of what the new entity will and won't entail, read Channel Futures' 10 Burning Questions About ScanSource NewCo.

Above: Channel Futures' Coffee with Craig and James podcast features a discussion of ScanSource "NewCo."

Intelisys Investments

Baur noted how the field of TSDs has dwindled from 16 to five national brands. In the last 20 years, younger companies like Telarus, Avant and Sandler Partners have come onto the scene, rapidly gained market share and even hired key Intelisys executives. But Baur pointed to Intelisys' established scale.

"Even with the consolidation, Intelisys remains the largest technology services distributor in the business," he said.

In the meantime, Intelisys appears to be filling several positions on its channel sales teams. Notably, Eddie Acosta has accepted the role of vice president of Central region sales.

"We are swamped with the number of people wanting to come to Intelisys. We're excited about that," Baur said. "It's actually taken us quite a bit of time to sort through the talent that we have applying for all the positions we have open."