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PC CONNECTION INC - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION

May 9, 2014

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, 2013 on file with the SEC.

OVERVIEW

We are a direct marketer of a wide range of information technology, or IT, solutions. We help our customers design, enable, manage, and service their IT environments. We provide IT 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 services involving design, configuration, and implementation of IT solutions. These services are performed by our personnel and by third-party providers. We operate through three sales segments, which serve primarily: (a) small- to medium-sized businesses, or SMBs, through our PC Connection Sales subsidiary, (b) large enterprise customers, in our Large Account segment, through our MoreDirect subsidiary, and (c) federal, state, and local government and educational institutions, in our Public Sector segment, through our GovConnection 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. However, 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 attempting to eliminate 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 comprehensive 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 individual manufacturers. Through the formation of our ProConnection services group we are able to provide customers with 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 improve gross margins in this competitive environment.

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 three 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 making major investments in our IT systems and solution selling personnel.

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To support future growth, we are expanding our IT solution business, which requires the addition of highly-skilled service engineers. Although we expect to realize the ultimate benefit of higher-margin service revenues under this multi-year initiative, we believe that our cost of services will increase significantly 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.

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 IT development to meet these new demands. This investment includes significant planned expenditures to update our websites, as buying trends change and electronic commerce continues to grow.

Our investments in IT infrastructure are designed to enable us to operate more efficiently. In the third quarter of 2013, we completed the first phase of a Customer Master Data Management, or MDM, software project, and placed into service $12.0 million of related software and integration costs. Accordingly, depreciation expense will include approximately $2.0 million (or approximately $0.5 million per quarter) related to this project. The Customer MDM software provides us with a more comprehensive view of our customers and serves as a foundation for future IT investments. While we have not yet finalized our decisions regarding to what extent additional software will be acquired, we expect to increase our capital investments in our IT infrastructure, which if fully implemented, would likely exceed $20 million over the next three to five years.

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:

Three Months Ended March 31, 2014 2013 Net sales (in millions) $ 559.8$ 505.4 Gross margin 13.0 % 13.2 % Selling, general and administrative expenses 10.9 11.2 Income from operations 2.1 2.0



Net sales in the first quarter of 2014 increased year over year by $54.3 million, or 10.8%, compared to the first quarter of 2013, due to increased sales in all three of our sales segments. The expiration of support for the Windows XP operating system in April 2014 led to increased sales of notebooks, desktops, and software. Gross margin (gross profit expressed as a percentage of net sales) decreased by 21 basis points compared to the prior year quarter due to this shift in product sales mix to lower margin product categories, such as desktops and notebooks. SG&A expenses increased in dollars, but decreased as a percentage of net sales. Personnel costs increased year over year in the first quarter of 2014 due to incremental variable compensation associated with higher gross profits and investments in solution sales and support personnel. Operating income in the first quarter of 2014 increased year over year by $1.6 million due to the increase in net sales.

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Net Sales Distribution

The following table sets forth our percentage of net sales by business segment and product mix: Three Months Ended March 31, 2014 2013 Business Segment SMB 45 % 47 % Large Account 36 37 Public Sector 19 16 Total 100 % 100 % Product Mix Notebook/Tablet 22 % 19 % Desktop/Server 16 15 Software 15 15 Net/Com Product 10 10 Video, Imaging & Sound 9 8 Printer & Printer Supplies 7 7 Storage 5 6 Memory & System Enhancement 3 3 Accessory/Services/Other 13 17 Total 100 % 100 % Gross margin The following table summarizes our gross margin, as a percentage of net sales, over the periods indicated: Three Months Ended March 31, 2014 2013 Business Segment SMB 14.9 % 15.1 % Large Account 12.0 11.5 Public Sector 10.5 11.9 Total 13.0 % 13.2 %



Cost of Sales and Certain Other Costs

Cost of sales includes the invoice cost of the product, direct employee and third party cost of services, 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, 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 were $3.7 million and $3.3 million for the three months ended March 31, 2014 and 2013, respectively. Distribution costs as a percentage of net sales for the periods reported are as follows:

Three Months Ended March 31, 2014 2013 Purchasing/Distribution Center 0.65 % 0.65 % 13



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Operating Expenses

The following table breaks out our more significant SG&A expenses for the periods indicated (dollars in millions):

Three Months Ended March 31, 2014 2013 Personnel costs $ 45.8$ 41.9 Advertising 3.9 5.0 Facilities operations 3.2 2.6 Professional fees 1.8 1.7 Credit card fees 1.7 1.8 Depreciation and amortization 2.1 1.6 Other, net 2.6 2.1 Total $ 61.1$ 56.7 Percentage of net sales 10.9 % 11.2 %



Personnel costs increased year over year in the three months ended March 31, 2014, due to incremental variable compensation associated with higher gross profits and investments in technical solution sales and support personnel.

Year-Over-Year Comparisons

Three Months Ended March 31, 2014 Compared to Three Months Ended March 31, 2013

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

Three Months Ended March 31, 2014 2013 % of Net % of Net % Amount Sales Amount Sales Change Sales: SMB $ 253.5 45.3 % $ 235.7 46.6 % 7.5 % Large Account 200.9 35.9 186.4 36.9 7.8 Public Sector 105.4 18.8 83.3 16.5 26.4 Total $ 559.8 100.0 % $ 505.4 100.0 % 10.8 % Gross Profit: SMB $ 37.7 14.9 % $ 35.5 15.1 % 6.2 % Large Account 24.1 12.0 21.4 11.5 12.5 Public Sector 11.0 10.5 9.9 11.9 11.5 Total $ 72.8 13.0 % $ 66.8 13.2 % 9.0 %



Net sales increased in the first quarter of 2014 compared to the first quarter of 2013, as explained below:

Net sales for the SMB segment increased due to our focus on growing solution sales and the expiration in April 2014 of support for the Windows XP operating system, which generated increased demand for desktops, notebooks, and software products. Net sales for the Large Account segment increased due to our focus on growing solution sales and our acquisition of new customers, as well as the expiration in April 2014 of support for the Windows XP operating system. 14



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Net sales to government and education customers (Public Sector segment) increased due to increased sales to education customers and the federal government. Sales to state and local government and educational institutions increased by 28.8% year over year, and sales to the federal government increased by 20.2%. Sales of notebook/tablets increased to K-12 educational customer due to higher demand associated with the implementation of standardized digital testing education requirements. Federal government sales increased due to the expiration in April 2014 of support for the Windows XP operating system, as well as increased sales made under our federal government contracts.



Gross profit for the first quarter of 2014 increased year over year in dollars, but decreased as a percentage of net sales (gross margin), as explained below:

Gross profit for the SMB segment increased due to an increase in net sales. Gross margin decreased year over year due to lower invoice selling margins (46 basis points) on desktop and notebook products but was partially offset by increases in agency revenues (14 basis points) and vendor early payment discounts (10 basis points). Gross profit for the Large Account segment increased due to higher net sales and gross margin, which increased due to improved invoice selling margins (53 basis points). Gross profit for the Public Sector segment increased due to an increase in net sales. Invoice selling margins decreased by 139 basis points due to increased demand for lower margin products such as notebooks and desktops. Selling, general and administrative expenses increased in dollars, but decreased as a percentage of net sales in the first quarter of 2014 compared to the prior year quarter. SG&A expenses attributable to our three operating segments and the remaining unallocated Headquarters/Other group expenses are summarized below (dollars in millions): Three Months Ended March 31, 2014 2013 % of % of Segment Net Segment Net % Amount Sales Amount Sales Change SMB $ 29.9 11.8 % $ 28.3 12.0 % 5.7 % Large Account 16.4 8.1 15.3 8.2 7.2 Public Sector 12.9 12.3 11.4 13.7 13.2 Headquarters/Other 1.9 1.7 11.8 Total $ 61.1 10.9 % $ 56.7 11.2 % 7.7 % SG&A expenses for the SMB segment increased in dollars, but decreased as a percentage of net sales. The dollar increase was attributable to investments in solution sales and services and incremental variable compensation associated with higher gross profits, which was partially offset by lower advertising expense. The decrease in SG&A as a percentage of net sales was due to the leveraging of fixed costs over larger net sales. SG&A expenses for the Large Account segment increased in dollars, but decreased slightly as a percentage of net sales. The dollar increase was attributable to investments in solution sales and services and incremental variable compensation associated with higher gross profits. The decrease in SG&A as a percentage of net sales was due to the leveraging of fixed costs over larger net sales. SG&A expenses for the Public Sector segment increased in dollars, but decreased as a percentage of net sales. The dollar increase was due to higher advertising expense and incremental variable compensation related to higher gross profits. The decrease in SG&A as a percentage of net sales was due to the leveraging of fixed costs over larger net sales. 15



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SG&A expenses for the Headquarters/Other group increased slightly due to an increase in unallocated personnel and related costs. The Headquarters/Other group provides services to the three segments in areas such as finance, human resources, IT, marketing, and product management. Most of the operating costs associated with such corporate headquarters services are charged to the operating segments based on their estimated usage of the underlying services. The amounts shown above represent the remaining unallocated costs.



Income from operations for the first quarter of 2014 increased to $11.7 million, compared to $10.1 million for the first quarter of 2013. Income from operations as a percentage of net sales was 2.1% for the first quarter of 2014, compared to 2.0% of net sales for the prior year quarter.

Our effective tax rate was 39.2% for the first quarter of 2014, compared to 39.5% for the first quarter of 2013. Our tax rate will vary based on variations in state tax levels for certain subsidiaries, valuation reserves, and accounting for uncertain tax positions. We do not expect these variations to be significant in 2014.

Net income for the first quarter of 2014 increased to $7.1 million, compared to $6.1 million for the first quarter of 2013, principally due to the increase in operating income.

Liquidity and Capital Resources

Our primary sources of liquidity have historically been internally generated funds from operations and borrowings under our bank line of credit. We have used those funds to meet our capital requirements, which consist primarily of working capital for operational needs, capital expenditures for computer equipment and software used in our business, repurchases of common stock for treasury, and as opportunities arise, acquisitions of new businesses.

We believe that funds generated from operations, together with available credit under our bank line of credit, will be sufficient to finance our working capital, capital expenditure, and other requirements for at least the next twelve calendar months. We expect our capital needs for the next twelve months to consist primarily of capital expenditures of $8.0 to $10.0 million and payments on leases and other contractual obligations of approximately $3.7 million. We have undertaken a comprehensive review and assessment of our entire business software needs, including commercially available software that meets, or can be configured to meet, those needs better than our existing software. In the third quarter of 2013, we completed the first phase of our Customer MDM software project, and placed into service $12.0 million of related software and integration costs. While we have not finalized our decisions, regarding to what extent new software will be acquired and implemented beyond the Customer MDM software, the incremental capital costs of such a project, if fully implemented, would likely exceed $20.0 million over the next three to five years.

We expect to meet our cash requirements for the next twelve months through a combination of cash on hand, cash generated from operations, and borrowings on our bank line of credit, as follows:

Cash on Hand. At March 31, 2014, we had approximately $64.9 million in cash. Cash Generated from Operations. We expect to generate cash flows from operations in excess of operating cash needs by generating earnings and managing net changes in inventories and receivables with changes in payables to generate a positive cash flow. Credit Facilities. As of March 31, 2014, no borrowings were outstanding against our $50.0 million bank line of credit, which is available until February 24, 2017. Accordingly, our entire line of credit was available for borrowing at March 31, 2014. This line of credit can be increased, at our option, to $80.0 million for approved acquisitions or other uses authorized by the bank. Borrowings are, however, limited by certain minimum collateral and earnings requirements, as described more fully below. 16



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Our ability to continue funding our planned growth, both internally and externally, is dependent upon our ability to generate sufficient cash flow from operations or to obtain additional funds through equity or debt financing, or from other sources of financing, as may be required. While we do not anticipate needing any additional sources of financing to fund our operations at this time, if demand for IT products declines, our cash flows from operations may be substantially affected. See also related risks listed below under "Item 1A. Risk Factors."

Summary of Sources and Uses of Cash

The following table summarizes our sources and uses of cash over the periods indicated (in millions): Three Months Ended March 31, 2014 2013 Net cash provided by operating activities $ 23.8$ 19.0 Net cash used for investing activities (1.5 ) (1.7 ) Net cash provided by financing activities - 1.3 Increase in cash and cash equivalents $ 22.3$ 18.6



Cash provided by operating activities in the first quarter of 2014 largely reflects the seasonal decrease in working capital requirements, similar to the prior year quarter, such as lower account receivable and inventory. Operating cash flow in the first quarter of 2014 resulted primarily from net income before depreciation and amortization, and a decrease in accounts receivables and inventory, partially offset by a decrease in accounts payable. Accounts receivable decreased by $22.1 million from the prior year-end balance due to improved collection efforts as evidenced by our lower days sales outstanding, which decreased to 39 days at March 31, 2014, compared to 40 days at March 31, 2013, and 42 days at December 31, 2013. Inventory decreased by $7.7 million in the first quarter of 2014 due to efforts to reduce stocking levels. Inventory turns increased to 27 turns for the first quarter of 2014 compared to 26 turns for the prior year quarter.

At March 31, 2014, we had $109.6 million in outstanding accounts payable. Such accounts are generally paid within 30 days of incurrence, or earlier when favorable cash discounts are offered. This balance will be financed by cash flows from operations or short-term borrowings under the line of credit. This amount includes $16.1 million payable to two financial institutions under inventory trade credit agreements we use to finance our purchase of certain inventory, secured by the inventory which is financed. We believe we will be able to meet our obligations under our accounts payable with cash flows from operations and our existing line of credit.

Cash used for investing activities decreased by $0.2 million in the first quarter of 2014 compared to the prior year quarter due to lower purchases of property and equipment. These expenditures were primarily for computer equipment and capitalized internally-developed software in connection with the IT initiative referred to above.

Cash provided by financing activities decreased by $1.3 million due to lower proceeds from the exercise of equity awards.

Debt Instruments, Contractual Agreements, and Related Covenants

Below is a summary of certain provisions of our credit facilities and other contractual obligations. For more information about the restrictive covenants in our debt instruments and inventory financing agreements, see "Factors Affecting Sources of Liquidity" below. For more information about our obligations, commitments, and contingencies, see our consolidated financial statements and the accompanying notes included in this Quarterly Report.

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Bank Line of Credit. Our bank line of credit extends until February 2017 and is collateralized by our receivables. Our borrowing capacity is up to $50.0 million at the one-month London Interbank Offered Rate, or LIBOR, plus a spread based on our funded debt ratio, or in the absence of LIBOR, the prime rate (3.25% at March 31, 2014). The one-month LIBOR rate at March 31, 2014 was 0.15%. In addition, we have the option to increase the facility by an additional $30.0 million to meet additional borrowing requirements. Our credit facility is subject to certain covenant requirements which are described below under "Factors Affecting Sources of Liquidity." We did not have any borrowings under the credit facility during the quarter ended March 31, 2014.

Cash receipts are automatically applied against any outstanding borrowings. Any excess cash on account may either remain on account to generate earned credits to offset up to 100% of cash management fees, or may be invested in short-term qualified investments. Borrowings under the line of credit are classified as current. At March 31, 2014, the entire $50.0 million facility was available for borrowing.

Inventory Trade Credit Agreements. We have additional security agreements with two financial institutions to facilitate the purchase of inventory from various suppliers under certain terms and conditions. These agreements allow a collateralized first position in certain branded products in our inventory that were financed by these two institutions. Although the agreements provide for up to 100% financing on the purchase price of these products, up to an aggregate of $47.0 million, any outstanding financing must be fully secured by available inventory. We do not pay any interest or discount fees on such inventory. The related costs are borne by the suppliers as an incentive for us to purchase their products. Amounts outstanding under such facilities, which equaled $16.1 million in the aggregate as of March 31, 2014, are recorded in accounts payable. The inventory financed is classified as inventory on the consolidated balance sheet.

Operating Leases. We had a fifteen-year lease for our corporate headquarters with an affiliated company related through common ownership. The initial term of the lease ended November 30, 2013, and we had the option under the original lease agreement to renew the lease for two additional terms of five years each. In addition to the rent payable under the facility lease, we are required to pay real estate taxes, insurance, and common area maintenance charges. For the quarter ended March 31, 2014, we rented the space on a month-to-month basis for approximately $0.1 million per month. Following the end of the quarter, as noted in Item 5, we amended the lease for our corporate headquarters on May 8, 2014 to extend the term for an additional five years. The amendment requires a monthly payment of $104,434. We also lease facilities from our principal stockholders and facilities and equipment from third parties under non-cancelable operating leases which have been reported in the "Contractual Obligations" section of our Annual Report on Form 10-K for the year ended December 31, 2013.

Off-Balance Sheet Arrangements. We do not have any other off-balance sheet arrangements that have or are reasonably likely to have, a current or future material effect on our financial condition, changes in financial condition, results of operations, liquidity, capital expenditures, or capital resources.

Contractual Obligations. The disclosures relating to our contractual obligations in our Annual Report on Form 10-K for the year ended December 31, 2013 have not materially changed since the report was filed, other than with respect to the renewal of our lease for our corporate headquarters as described above and in Item 5 below.

Factors Affecting Sources of Liquidity

Internally Generated Funds. The key factors affecting our internally generated funds are our ability to minimize costs and fully achieve our operating efficiencies, timely collection of our customer receivables, and management of our inventory levels.

Bank Line of Credit. Our bank line of credit extends until February 2017 and is collateralized by our receivables. As of March 31, 2014, the entire $50.0 million facility was available for borrowing. Our credit

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facility contains certain financial ratios and operational covenants and other restrictions (including restrictions on additional debt, guarantees, and other distributions, investments, and liens) with which we and all of our subsidiaries must comply. Any failure to comply with these covenants would constitute a default and could prevent us from borrowing additional funds under this line of credit. This credit facility contains two financial tests:

The funded debt ratio (defined as the average outstanding advances under the line for the quarter, divided by the consolidated Adjusted EBITDA for the trailing four quarters) must not be more than 2.0 to 1.0. We did not have any outstanding borrowings under the credit facility during the first quarter of 2014, and accordingly, the funded debt ratio did not limit potential borrowings as of March 31, 2014. Future decreases in our consolidated Adjusted EBITDA, however, could limit our potential borrowings under the credit facility. Minimum Consolidated Net Worth must be at least $250.0 million, plus 50% of consolidated net income for each quarter, beginning with the quarter ended March 31, 2012 (loss quarters not counted). Such amount was calculated as $287.9 million at March 31, 2014, whereas our actual consolidated stockholders' equity at this date was $327.1 million.



Trade Credit Agreements. These agreements contain similar financial ratios and operational covenants and restrictions as those contained in our bank line of credit described above. These trade credit agreements also contain cross-default provisions whereby a default under the bank agreement would also constitute a default under these agreements. Financing under these agreements is limited to the purchase of specific branded products from authorized suppliers, and amounts outstanding must be fully collateralized by inventories of those products on hand.

Capital Markets. Our ability to raise additional funds in the capital market depends upon, among other things, general economic conditions, the condition of the information technology industry, our financial performance and stock price, and the state of the capital markets.

SUMMARY OF CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Our critical accounting policies have not materially changed from those discussed in our Annual Report on Form 10-K for the year ended December 31, 2013. These policies include revenue recognition, accounts receivable, vendor allowances, inventory, and the value of goodwill and long-lived assets, including intangibles.

INFLATION

We have historically offset any inflation in operating costs by a combination of increased productivity and price increases, where appropriate. We do not expect inflation to have a significant impact on our business in the foreseeable future.

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PC CONNECTION, INC. AND SUBSIDIARIES PART I-FINANCIAL INFORMATION


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