UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D. C. 20549

FORM 10-K

(Mark One)

☑ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2016

OR

◻TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from ___________ to ___________.

Commission File Number 000-23827

PC CONNECTION, INC.

(Exact name of registrant as specified in its charter)

Securities registered pursuant to Section 12(b) of the Act:

Securities registered pursuant to Section 12(g) of the Act:

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

YES  ☐    NO  ☑

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.

YES  ☐    NO  ☑

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 ☑ 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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  ☐

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.  (Check one):

Large accelerated filer ___     Accelerated filer       Non-accelerated filer ___  Smaller reporting company  ___

(Do not check if a smaller reporting company)

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

YES  ☐    NO  ☑

The aggregate market value of the registrant’s voting shares of common stock held by non-affiliates of the registrant on June 30, 2016, based on $23.80 per share, the last reported sale price on the Nasdaq Global Select Market on that date, was $265,826,436.

The number of shares outstanding of each of the registrant’s classes of common stock, as of February 27, 2017:

 The following documents are incorporated by reference into the Annual Report on Form 10-K: Portions of the registrant’s definitive Proxy Statement for its 2016 Annual Meeting of Stockholders are incorporated by reference into Part III of this Report.

TABLE OF CONTENTS

FORWARD-LOOKING STATEMENTS

Statements contained or incorporated by reference in this Annual Report on Form 10‑K that are not based on historical fact are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Exchange Act.  These forward-looking statements regarding future events and our future results are based on current expectations, estimates, forecasts, and projections and the beliefs and assumptions of management including, without limitation, our expectations with regard to the industry’s rapid technological change and exposure to inventory obsolescence, availability and allocations of goods, reliance on vendor support and relationships, competitive risks, pricing risks, and the overall level of economic activity and the level of business investment in information technology products. Forward-looking statements may be identified by the use of forward-looking terminology such as “may,” “could,” “expect,” “believe,” “estimate,” “anticipate,” “continue,” “seek,” “plan,” “intend,” or similar terms, variations of such terms, or the negative of those terms.

We cannot assure investors that our assumptions and expectations will prove to have been correct.  Because forward-looking statements relate to the future, they are subject to inherent uncertainties, risks, and changes in circumstances that are difficult to predict.  These statements involve known and unknown risks, uncertainties, and other factors that may cause our actual results, performance, or achievements to be materially different from any future results, performance, or achievements expressed or implied by the forward-looking statements.  We therefore caution you against undue reliance on any of these forward-looking statements.  Important factors that could cause our actual results to differ materially from those indicated or implied by forward-looking statements include those discussed in Item 1A., “Risk Factors” of this Annual Report on Form 10-K.  Any forward-looking statement made by us in this Annual Report on Form 10-K speaks only as of the date on which this Annual Report on Form 10-K was first filed.  We undertake no intention or obligation to update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise, except as may be required by law.

PART I

Item 1.  Business

GENERAL

We are a national solutions provider 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 have three operating segments, which serve primarily: (a) small- to medium-sized businesses, or SMBs, in our SMB segment, 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 through (i) outbound telemarketing and field sales contacts by sales representatives focused on the business, educational, healthcare, and government markets, (ii) our websites, and (iii) inbound calls from customers responding to our catalogs and other advertising media.  We offer a broad selection of over 300,000 products at competitive prices, including products from Apple, Cisco Systems, Dell, EMC, Hewlett-Packard, IBM, Lenovo, Microsoft, Symantec, and VMWare, and we partner with more than 1,600 suppliers.  Our most frequently ordered products are carried in inventory and are typically shipped to customers the same day the order is received.

Since our founding in 1982, we have consistently served our customers’ needs by providing innovative, reliable, and timely service and technical support, and by offering an extensive assortment of branded products through knowledgeable, well-trained sales and support teams.  Our strategy’s effectiveness is reflected in the recognition we have received, including being named to the Fortune 1000 and the CRN Solution Provider 500 for sixteen straight years.  Over the past few years, we have received numerous awards, including the Microsoft Operational Excellence Award for delivering market-leading operational excellence, as well as being recently named to the CRN Tech Elite 250.    We believe that our ability to understand our customers’ needs and provide comprehensive and effective IT solutions has resulted in strong brand name recognition and a broad and loyal customer base.  We also believe that through our strong vendor relationships we can provide an efficient supply chain and be an effective IT solution provider for our multiple customer segments.

We strive to identify the unique needs of our corporate, government, healthcare, educational, and small business customers, and have designed our business processes to enable our customers to effectively manage their IT systems.  We provide value by offering our customers efficient design, deployment, and support of their IT environments.  As of December 31, 2016, we employed 900 sales representatives, whose average tenure exceeded six years.  Sales representatives are responsible for managing enterprise, commercial, and public sector accounts, as specialization and a deep understanding of unique customer environments are more important than ever.  These sales representatives focus on current and prospective customers and are supported by an increasing number of engineering, technical, and administrative staff.  We believe that increasing our salesforce productivity is important to our future success, and we have increased our headcount and investments in this area accordingly.

In September 2016, we launched “Connection®,” uniting all of our subsidiaries into one cohesive brand, reflecting the promise of our trademark blue arc and our mission to connect people with technology that enhances growth, elevates productivity, and empowers innovation.  MoreDirect, our enterprise team, became Connection® Enterprise Solutions; PC Connection Sales Corp, our SMB-focused team, became Connection® Business Solutions; and GovConnection, our public sector team, became Connection® Public Sector Solutions.

We market our products and services through our websites: www.connection.com, www.connection.com/enterprise,  www.connection.com/publicsector, and www.macconnection.com.  Our websites provide extensive product information, customized pricing, rich content, and a digital platform for online orders. 

 Additional financial information regarding our business segments and geographic data about our customers and assets is contained in Management’s Discussion and Analysis of Financial Condition and Results of Operations in Item 7 of Part II, and in Note 13 to our Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K.

We are subject to the informational requirements of the Securities Exchange Act of 1934, as amended, or the Exchange Act, and accordingly, we file reports, proxy and information statements, and other information with the Securities and Exchange Commission, or the SEC.  Such reports and information can be read and copied at the public reference facilities maintained by the SEC at the Public Reference Room, 100 F Street, NE, Washington, D.C. 20549.  Information regarding the operation of the Public Reference Room may be obtained by calling the SEC at 1-800-SEC-0330.  The SEC maintains a website (http://www.sec.gov) that contains such reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC.  We maintain a corporate website with the address www.connection.com.  We are not including the information contained in our website as part of, or incorporating by reference into, this Annual Report on Form 10-K.  We make available free of charge through our website our Annual Reports on Form 10-K, quarterly reports on Form 10-Q, and current reports on Form 8-K, and amendments to these reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act, as soon as reasonably practical after we electronically file these materials with, or otherwise furnish them to, the SEC.

MARKET AND COMPETITION

In the fiscal year ended December 31, 2016, we generated approximately 40% of our sales from the SMB segment, 38% from medium-to-large corporate accounts (Fortune 1000), and 22% from government and educational institutions.  The overall IT market that we serve is estimated to be approximately $200 billion.

The largest segment of this market is served by local and regional “value added resellers,” or VARs, many of whom we believe are transitioning from the hardware and software products business to higher-margin IT services.  We have transitioned from an end-user or desktop-centric computing supplier to a network or enterprise-wide IT solutions supplier.  We have also partnered with third-party technology and telecommunications service providers.  We now offer our customers access to the same services and technical expertise as local and regional VARs, but with a more extensive product selection at generally lower prices.

Intense competition for customers has led manufacturers of our IT products to use all available channels, including direct marketers, to distribute their products.  Certain of these manufacturers who have traditionally used resellers to distribute their products have, from time to time, established their own direct marketing operations, including sales through the Internet.  Nonetheless, we believe that these manufacturers will continue to provide us and other third-party direct marketers favorable product allocations and marketing support.

We believe new entrants to the direct marketing channel must overcome a number of obstacles, including:

BUSINESS STRATEGIES

We believe we become our customers’ IT provider of choice by providing innovative IT solutions which meet their needs of increased productivity, mobility, virtualization, and security in a continually evolving IT environment.  We provide enhanced value by assisting them in cost-effectively maximizing business opportunities provided by new technologies and advanced service solutions.  The key elements of our business strategies include:

GROWTH STRATEGIES

Our growth strategies are designed to increase revenues by maximizing operational efficiencies while offering innovative products and value added service offerings, increasing penetration of our existing customers, and expanding our customer base.  Our six key elements of growth are:

SERVICE AND SUPPORT

Since our founding in 1982, our primary objective has been to provide products and services that meet the demands and needs of customers and to supplement those products with up-to-date product information and excellent customer service and support.  We believe that offering our customers superior value, through a combination of product knowledge, consistent and reliable service and support, and leading products at competitive prices, differentiates us from other direct marketers and provides the foundation for developing a broad and loyal customer base.

We invest in training programs for our service and support personnel, with an emphasis on putting customer needs and service first.  Product support technicians assist callers with questions concerning compatibility, installation, and more difficult questions relating to product use.  The product support technicians authorize customers to return defective or incompatible products to either the manufacturer or to us for warranty service.  In-house technicians perform both warranty and non-warranty repair on most major systems and hardware products.

Using our customized information system, we transmit our customer orders either to our distribution center or to our drop‑ship suppliers, depending on product availability, for processing immediately after a customer receives credit approval.  At our distribution center, we also perform custom configuration of computer systems and handheld devices as requested by our customers, which typically consists of the installation of memory, accessories, and/or software purchased.  Our customers may select the method of delivery that best meets their needs and is most cost effective, ranging from expedited overnight delivery for urgently needed items to ground freight, generally used for heavier, more bulky items.  Through our Everything Overnight™ service, orders accepted up to 7:00 p.m. Eastern Time can be shipped for overnight delivery from our distribution center.

 Our inventory stocking levels are based on three primary criteria.  First, we stock and maintain a large quantity of products that sell through quickly (such as notebook and desktop systems, printers, and monitors).  Second, we stock products obtained through opportunistic purchases (including first‑to‑market and end‑of‑life special promotions, and popular products with limited availability).  Third, we stock products in common demand, such as components we use to configure systems prior to shipping, for which we want to avoid shortages.  Inventory stocking decisions are made generally independent of the level of shipping service, as expedited shipping, including overnight delivery, is available through the majority of our drop‑ship suppliers as well as through our warehouse.

MARKETING AND SALES

We sell our products through our direct marketing channels to (i) SMBs including small office/home office customers, (ii) government and educational institutions, and (iii) medium-to-large corporate accounts.  We strive to be the primary supplier of IT products and solutions to our existing and prospective customers by providing exemplary customer service.  We use multiple marketing approaches to reach existing and prospective customers, including:

All of our marketing approaches emphasize our broad product offerings, fast delivery, customer support, competitive pricing, and our wide range of service solutions.

Sales Channels.    We believe that our ability to establish and maintain long-term customer relationships and to encourage repeat purchases is largely dependent on the strength of our sales personnel and programs.  Because our customers’ primary contact with us is through our sales representatives, we are committed to maintaining a qualified, knowledgeable, and motivated sales staff with its principal focus on customer service.

Outbound Telemarketing and Field Sales.  We seek to build loyal relationships with potential high-volume customers by assigning them to individual account managers.  We believe that customers respond favorably to one-on-one relationships with personalized, well-trained account managers.  Once established, these one-on-one relationships are maintained and enhanced through frequent telecommunications and targeted catalogs and e-mails, as well as other marketing materials designed to meet each customer’s specific IT needs.  We pay most of our account managers a base annual salary plus incentive compensation.  Incentive compensation is tied generally to gross profit dollars produced by the individual account manager.  Account managers historically have significantly increased productivity after approximately twelve months of training and experience. 

E-commerce Sales.  (www.connection.com, www.connection.com/enterprise, www.connection.com/publicsector, and www.macconnection.com)  We provide product descriptions and prices for generally all products online.  Our Connection website also provides updated information for more than 300,000 items.  We offer, and continuously update, selected product offerings and other special buys.  We believe our websites are important sales sources and communication tools for improving customer service.

Our MoreDirect subsidiary’s business process and operations are primarily Web-based.  Most of its corporate customers utilize a customized Web page to quickly search, source, and track IT products.  MoreDirect’s website (www.connection.com/enterprise) aggregates the current available inventories of its largest IT suppliers into a single online source for its corporate customers.  Its custom designed Internet-based system, TRAXX®, provides corporate buyers with comparative pricing from several suppliers as well as special pricing arranged through the manufacturer.

The Internet supports three key business initiatives for us:

Business Segments.  We conduct our business operations through three business segments: SMB, Large Account, and Public Sector.

SMB Segment.  Our principal target markets in this segment are small-to-medium-sized business customers.  We use a combination of outbound telemarketing, including some on-site sales solicitation by business development managers, and Internet sales through customized Internet Business Accounts, to reach these customers.     

Large Account Segment.  Through our MoreDirect subsidiary’s custom designed Web-based system, we are able to offer our larger corporate customers an efficient and effective method of sourcing, evaluating, purchasing, and tracking a wide variety of IT products and services.  MoreDirect’s strategy is to be the primary single source procurement portal for its large corporate customers.  MoreDirect’s sales representatives typically have ten to twenty years of experience and are located strategically across the United States.  This allows them to work directly with customers, often on site.  MoreDirect generally places its product orders with manufacturers and/or distribution companies for drop shipment directly to its customers.

Public Sector Segment.  We use a combination of outbound telemarketing, including some on-site sales solicitation by business development managers, and Internet sales through customized Internet Business Accounts, to reach these customers.  Through our GovConnection subsidiary, we target each of the four distinct market sectors within this segment—federal government, higher educational institutions, school grades K-12, and state and local governments.

The following table sets forth the relative distribution of net sales by business segment:

Our brand, and each of Connection’s business segments, is supported by targeted marketing campaigns across a variety of media:

Digital.  We utilize a series of digital programs, in conjunction with advanced data analytics, to identify prospective customers and generate new leads within our existing customer base.  These programs include website, email, blog, social media, electronic catalogs, webinars, and video/multimedia promotions.

Print.  Connection produces a variety of print media, including direct mail pieces and Connected, a quarterly publication that provides informative articles on the latest technologies and industry trends.  We distribute specialty catalogs to education, healthcare, and government customers and prospective customers on a periodic basis.  The Company’s MacConnection®  brand publishes an eponymous catalog for the Apple market.  These publications showcase the depth of our in-house expertise in the marketplace and extend Connection’s brand to a wide audience of IT decision makers.

Specialty Marketing.  In addition to our digital and print marketing efforts, Connection maintains a strong presence at industry tradeshows and conventions across the country, including a number of healthcare and education IT conferences.  Connection also hosts a series of Technology Summits each year, with a focus on building stronger relationships with our customers and reinforcing our reputation as a trusted source of expertise.

Customers.  We maintain an extensive database of customers and prospects.  However, no single customer accounted for more than 2% of our consolidated revenue in 2016.  While no single agency of the federal government comprised more than 2% of total sales, aggregate sales to the federal government were 7.5%, 6.7%, and 6.5% in 2016, 2015, and 2014, respectively.  The loss of any single customer would not have a material adverse effect on any of our business segments.  In addition, we do not have individual orders in our backlog that are material to our business, as we typically ship products within hours of receipt of orders.

PRODUCTS AND MERCHANDISING

We continuously focus on expanding the breadth of our product offerings.  We currently offer our customers over 300,000 information technology products designed for business applications from more than 1,600 vendors, including hardware and peripherals, accessories, networking products, and software.  We select the products we sell based upon their technology and effectiveness, market demand, product features, quality, price, margins, and warranties.  The following table sets forth our percentage of net sales (in dollars) for major product categories:

We offer a 30-day right of return generally limited to defective merchandise.  Returns of non-defective products are subject to restocking fees.  Substantially all of the products marketed by us are warranted by the manufacturer.  We generally accept returns directly from the customer and then either credit the customer’s account or ship the customer a replacement or similar product from our inventory.

PURCHASING AND VENDOR RELATIONS

Product purchases from Ingram Micro, Inc., or Ingram, our largest supplier, accounted for approximately 21% of our total product purchases in 2016 and 2015, respectively, and 25% in 2014.  Purchases from Synnex Corporation, or Synnex, comprised 13%, 15%, and 13% of our total product purchases in 2016, 2015, and 2014, respectively.  No other vendor supplied more than 10% of our total product purchases in 2016, 2015, or 2014.  We believe that, while we may experience some short-term disruption if products from Ingram and/or Synnex become unavailable to us, alternative sources for products obtained directly from Ingram and Synnex are available to us.

Products manufactured by HP represented 20% of our net sales in 2016 and 22% in both 2015 and 2014.    We believe that in the event we experience either a short-term or permanent disruption of supply of HP products, such disruption would likely have a material adverse effect on our results of operations and cash flows.

Many product suppliers reimburse us for advertisements or other cooperative marketing programs in our catalogs and other marketing vehicles.  Reimbursements may be in the form of discounts, advertising allowances, and/or rebates.  We also receive allowances from certain vendors based upon the volume of our purchases or sales of the vendors’ products by us.  Some of our vendors offer limited price protection in the form of rebates or credits against future purchases.  We may also participate in end-of-life product and other special purchases which may not be eligible for price protection.

We believe that we have excellent relationships with our vendors.  We generally pay vendors within stated terms, or earlier when favorable cash discounts are offered.  We believe our high volume of purchases enables us to obtain product pricing and terms that are competitive with those available to other national IT solutions providers.  Although brand names and individual product offerings are important to our business, we believe that competitive products are available in substantially all of the merchandise categories offered by us.

DISTRIBUTION

We fulfill orders from customers both from products we hold in inventory and through drop shipping arrangements with manufacturers and distributors.  At our 283,000 square foot distribution and fulfillment complex in Wilmington, Ohio, we receive and ship inventory, configure computer systems, and process returned products.  Orders are transmitted electronically from our various sales facilities to our Wilmington distribution center after credit approval, where packaging documentation is printed automatically and order fulfillment takes place.  Our customers are given several shipping options, ranging from expedited overnight delivery through our Everything Overnight™ service to normal ground freight service.  Through our Everything Overnight™ service, orders accepted up until 7:00 p.m. Eastern Time, can be shipped from our distribution center for overnight delivery via United Parcel Service, or UPS, or FedEx Corporation.  Upon request, orders may also be shipped by other common carriers.

We also place product orders directly with manufacturers and/or distribution companies for drop shipment directly to our customers.  Our MoreDirect subsidiary generally utilizes drop shipping for substantially all product orders.  Order status with distributors is tracked online, and in all circumstances, a confirmation of shipment from manufacturers and/or distribution companies is received prior to initial recording of the transaction.  At the end of each financial reporting period, revenue is adjusted to reflect the anticipated receipt of products by the customers in the period.  Products drop shipped by suppliers were 75%, 74%, and 73% of net sales in 2016, 2015, and 2014, respectively.  In future years, we expect that products drop shipped from suppliers may increase, both in dollars and as a percentage of net sales, as we seek to lower our overall inventory and distribution costs while maintaining excellent customer service.

Certain of our larger customers occasionally request special staged delivery arrangements under which either we or our distribution partners set aside and temporarily hold inventory on our customer’s behalf.  Such orders are firm delivery orders, and customers generally pay under normal credit terms, regardless of delivery.  Revenue on such transactions is not recorded until shipment to their final destination as requested by the customer.  Inventory held for such staged delivery requests aggregated $23.2 million and $27.7 million at December 31, 2016 and 2015, respectively.

We maintain inventories of fast moving products that account for a high percentage of our ongoing product sales transactions and sales dollars.  We may also, from time to time, make large inventory purchases of certain first‑to‑market products or end‑of‑life products to obtain favorable purchasing discounts.  We also maintain sufficient inventory levels of high volume components and accessories used for configuration services.

MANAGEMENT INFORMATION SYSTEMS

Our subsidiaries utilize management information systems which have been significantly customized for our use.  These systems permit centralized management of key functions, including order taking and processing, inventory and

accounts receivable management, purchasing, sales, and distribution, and the preparation of daily operating control reports on key aspects of the business.  We also operate advanced telecommunications equipment to support our sales and customer service operations.  Key elements of the telecommunications systems are integrated with our computer systems to provide timely customer information to sales and service representatives, and to facilitate the preparation of operating and performance data.

MoreDirect has developed a custom designed Internet-based system, TRAXX®.  This system is an integrated application of sales order processing, integrated supply chain visibility, and has full Electronic Data Interchange (EDI) links with major manufacturers’ distribution partners for product information, availability, pricing, ordering, delivery, and tracking, including related accounting functions.

Our success is dependent in large part on the accuracy and proper use of our information systems, including our telephone systems, to manage our inventory and accounts receivable collections, to purchase, sell, and ship our products efficiently and on a timely basis, and to maintain cost-efficient operations.  We expect to continue upgrading our information systems in the future to more effectively manage our operations and customer database.

Our investments in IT infrastructure are designed to enable us to operate more efficiently. While we have not yet finalized our decisions regarding the areas of future investment in our IT infrastructure, we expect to increase our capital investments in our IT infrastructure, which if fully implemented, would likely exceed $20 million over the next one to three years.  For further discussion see “Liquidity and Capital Resources” of Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of this Annual Report on Form 10-K.

COMPETITION

The direct marketing and sale of IT related products is highly competitive.  We compete with other national solutions providers of IT products, including CDW Corporation and Insight Enterprises, Inc., who are much larger than we are.  We also compete with:

Additional competition may arise if other new methods of distribution emerge in the future.  We compete not only for customers, but also for favorable product allocations and cooperative advertising support from product manufacturers.  Several of our competitors are larger than we are and have substantially greater financial resources.  These and other factors related to our competitive position are discussed more fully in the “Overview” of Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of this Annual Report on Form 10-K.

We believe that price, product selection and availability, and service and support are the most important competitive factors in our industry.

INTELLECTUAL PROPERTY RIGHTS

Our trademarks include among others Connection®, PC Connection®, GovConnection®, MacConnection®, The Connection™, HealthConnectionTM, Mobile Connection®, Cloud Connection®, Service Connection®, ProConnection™, Education Connection®, MoreDirect®, TRAXX®, WebSPOC®, Softmart®, GlobalServeTM, Raccoon CharacterTM,  and their related logos and all iterations.  We intend to use and protect these and our other marks, as we deem necessary.  We believe our trademarks have significant value and are an important factor in the marketing of our products.  We do not maintain a traditional research and development group, but we work closely with computer product manufacturers and other technology developers to stay abreast of the latest developments in computer technology, with respect to the products we both sell and use.

WORK FORCE

As of December 31, 2016, we employed 2,501 persons (full-time equivalent), of whom 1,268 (including 368 management and support personnel) were engaged in sales-related activities, 475 were engaged in providing IT services and customer service and support, 464 were engaged in purchasing, marketing, and distribution-related activities, 102 were engaged in the operation and development of management information systems, and 192 were engaged in administrative and finance functions.  We consider our employee relations to be good.  Our employees are not represented by a labor union, and we have never experienced a labor related work stoppage.

Item 1A.  Risk Factors

We cannot assure investors that our assumptions and expectations will prove to have been correct.  Important factors could cause our actual results to differ materially from those indicated or implied by forward-looking statements.  Such factors that could cause or contribute to such differences include those factors discussed below.  We undertake no intention or obligation to update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise.  If any of the following risks actually occur, our business, financial condition, or results of operations would likely suffer.

Instability in economic conditions in the financial markets may adversely affect our business and reduce our operating results.

Our business has been affected by changes in economic conditions that are outside of our control, including reductions in business investment, loss of consumer confidence, and fiscal uncertainty at both federal and state government levels.  Reductions in federal government spending may result in significant reductions in program funding.   Considerable uncertainty also exists regarding expected economic conditions both globally and in the United States, and future delays or reductions in IT spending could have a material adverse effect on demand for our products and consequently on our financial results.

Despite the recent increase in general economic optimism, there is always a risk that heightened economic expectations may not be realized.  Economic instability may arise, and it is difficult to predict to what extent our business may be adversely affected.  However, if IT spending should again decline, we are likely to experience an adverse impact, which may be material on our business and our results of operations.

We have experienced variability in sales and may not be able to maintain profitable operations.

Several factors have caused our results of operations to fluctuate and we expect some of these fluctuations to continue.  Causes of these fluctuations include:

Our results also may vary based on our ability to manage personnel levels in response to fluctuations in revenue.  We base personnel levels and other operating expenditures on sales forecasts.  If our revenues do not meet anticipated levels in the future, we may not be able to reduce our staffing levels and operating expenses in a timely manner to avoid significant losses from operations.

Substantial competition could reduce our market share and may negatively affect our business.

The direct marketing industry and the computer products retail business, in particular, are highly competitive.  We compete with other national solutions providers of hardware and software and computer related products, including CDW Corporation and Insight Enterprises, Inc., each of which is much larger than we are.  Certain hardware and software vendors, such as Apple, Dell, Lenovo, and HP, who provide products to us, also sell their products directly to end users through their own catalogs, stores, and via the Internet.  We also compete with computer retail stores and websites, who are increasingly selling to business customers and may become a significant competitor.  We compete not only for customers, but also for advertising support from IT product manufacturers.  Some of our competitors have larger customer bases and greater financial, marketing, and other resources than we do.  In addition, some of our competitors offer a wider range of products and services than we do and may be able to respond more quickly to new or changing opportunities, technologies, and customer requirements.  Many current and potential competitors also have greater name recognition, engage in more extensive promotional activities, and adopt pricing policies that are more aggressive than ours.  We expect competition to increase as retailers and direct marketers who have not traditionally sold computers and related products enter the industry.

In addition, product resellers and national solutions providers are combining operations or acquiring or merging with other resellers and national solutions providers to increase efficiency.  Moreover, current and potential competitors have established or may establish cooperative relationships among themselves or with third parties to enhance their products and services.  Accordingly, it is possible that new competitors or alliances among competitors may emerge and acquire significant market share.    We may not be able to continue to compete effectively against our current or future competitors.  If we encounter new competition or fail to compete effectively against our competitors, our business may be harmed.

We face and will continue to face significant price competition.

Generally, pricing is very aggressive in our industry, and we expect pricing pressures to escalate should economic conditions deteriorate.  An increase in price competition could result in a reduction of our profit margins.  We may not be able to offset the effects of price reductions with an increase in the number of customers, higher sales, cost reductions, or otherwise.  Also, our sales of IT hardware products generally result in lower profit margins than those associated with software products.  Such pricing pressures could result in an erosion of our market share, reduced sales, and reduced operating margins, any of which could have a material adverse effect on our business.

Virtualization of IT resources and applications, including networks, servers, applications, and data storage may disrupt or alter our traditional distribution models.

Our customers can access, through a cloud-based platform, business-critical solutions without the significant initial capital investment required for dedicated infrastructure.  Growing demand for the development of cloud-based solutions may reduce demand for some of our existing hardware products.  If the transition to an environment characterized by cloud-based computing and software being delivered as a service progresses, we will likely increase investments in this area before knowing whether our sales forecasts will accurately reflect customer demand for these products, services, and solutions.  We may not be able to effectively compete using these virtual distribution models.  Our inability to compete effectively with current or future virtual distribution model competitors, or adapt to a cloud-based environment, could have a material adverse effect on our business.

We may experience a reduction in the incentive programs offered to us by our vendors.

Some product manufacturers and distributors provide us with incentives such as supplier reimbursements, payment discounts, price protection, rebates, and other similar arrangements.  The increasingly competitive computer hardware market has already resulted in the following:

Many product suppliers provide us with advertising allowances, and in exchange, we feature their products on our website, and in our catalogs and other marketing vehicles.  These vendor allowances, to the extent that they represent specific reimbursements of incremental and identifiable costs, are offset against SG&A expenses.  Advertising allowances that cannot be associated with a specific program funded by an individual vendor or that exceed the fair value of advertising expense associated with that program are classified as offsets to cost of sales or inventory.  In the past, we have experienced a decrease in the level of vendor consideration available to us from certain manufacturers.  The level of such consideration we receive from some manufacturers may decline in the future.  Such a decline could decrease our gross profit and have a material adverse effect on our earnings and cash flows.

Our business could be materially adversely affected by system failures, interruption, integration issues, or security lapses of our information technology systems or those of our third-party providers.

Our ability to effectively manage our business depends significantly on our information systems and infrastructure as well as, in certain instances those of our third-party providers. The failure of our current systems to operate effectively or to integrate with other systems, including integration of upgrades to better meet the changing needs of our customers, could result in transaction errors, processing inefficiencies, and the loss of sales and customers.  In addition, cybersecurity threats are evolving and include, but are not limited to, malicious software, attempts to gain unauthorized access to company or customer data, denial of service attacks, the processing of fraudulent transactions, and other electronic security breaches that could lead to disruptions in critical systems, unauthorized release of confidential or otherwise protected information, and corruption of data. Although we have in place various processes, procedures, and controls to monitor and mitigate these threats, these measures may not be sufficient to prevent a material security threat or mitigate these risks for our customers. If any of these events were to materialize, they could lead to disruption of our operations or loss of sensitive information as well as subject us to regulatory actions, litigation, or damage to our reputation, and could have a material adverse effect on our financial position, results of operations, and cash flows.

We could experience Internet and other system failures which would interfere with our ability to process orders.

We depend on the accuracy and proper use of our management information systems, including our telephone system.  Many of our key functions depend on the quality and effective utilization of the information generated by our management information systems, including:

Our management information systems require continual upgrades to most effectively manage our operations and customer database.  Although we maintain some redundant systems, with full data backup, our primary computer and telecommunications hardware is located in a single facility in New Hampshire, and a substantial interruption in our management information systems or in our telephone communication systems, including those resulting from extreme weather and natural disasters, as well as power loss, telecommunications failure, or similar events, would substantially hinder our ability to process customer orders and thus could have a material adverse effect on our business.

Should our financial performance not meet expectations, we may be required to record a significant charge to earnings for impairment of goodwill and other intangibles.

We test goodwill for impairment each year and more frequently if potential impairment indicators arise.  Although the fair value of our SMB and Large Account reporting units substantially exceeded their carrying value at our annual impairment test, should the financial performance of a reporting unit not meet expectations due to the economy or otherwise, we would likely adjust downward expected future operating results and cash flows.  Such adjustment may result in a determination that the carrying value of goodwill and other intangibles for a reporting unit exceeds its fair value.  This determination may in turn require that we record a significant non-cash charge to earnings to reduce the $73.6 million aggregate carrying amount of goodwill held by our SMB and Large Account reporting units, resulting in a negative effect on our results of operations.

The failure to comply with our public sector contracts could result in, among other things, fines or liabilities.

Revenues from the Public Sector segment are derived from sales to federal, state, and local government departments and agencies, as well as to educational institutions, through various contracts and open market sales.  Government contracting is a highly regulated area.  Noncompliance with government procurement regulations or contract provisions could result in civil, criminal, and administrative liability, including substantial monetary fines or damages, termination of government contracts, and suspension, debarment, or ineligibility from doing business with the government.  Our current arrangements with these government agencies allow them to cancel orders with little or no notice and do not require them to purchase products from us in the future.  The effect of any of these possible actions by any government department or agency could adversely affect our financial position, results of operations, and cash flows.

We acquire a majority of our products for resale from a limited number of vendors.  The loss of any one of these vendors could have a material adverse effect on our business.

We acquire products for resale both directly from manufacturers and increasingly indirectly through distributors and other sources.  The five vendors supplying the greatest amount of goods to us constituted 59% of our total product purchases in the years ended December 31, 2016 and 61% in both 2015, and 2014.  Among these five suppliers, product purchases from Ingram, our largest supplier, accounted for approximately 21% of our total product purchases in 2016 and 2015, respectively, and 25% in 2014.  Purchases from Synnex comprised 13%, 15%, and 13% of our total product purchases in 2016, 2015, and 2014, respectively.   No other vendor supplied more than 10% of our total product purchases in 2016, 2015, or 2014.  If we were unable to acquire products from Ingram or Synnex, we could experience a short-term disruption in the availability of products, and such disruption could have a material adverse effect on our results of operations and cash flows.

Products manufactured by HP represented 20% of our net sales in 2016 and 22% in both 2015 and 2014.    We believe that in the event we experience either a short-term or permanent disruption of supply of HP products, such disruption would likely have a material adverse effect on our results of operations and cash flows.

Substantially all of our contracts and arrangements with our vendors that supply significant quantities of products are terminable by such vendors or us without notice or upon short notice.  Most of our product vendors provide us with trade credit, of which the net amount outstanding at December 31, 2016 was $177.9 million.  Termination, interruption, or contraction of relationships with our vendors, including a reduction in the level of trade credit provided to us, could have a material adverse effect on our financial position.

Some product manufacturers either do not permit us to sell the full line of their products or limit the number of product units available to national solutions providers such as us.  An element of our business strategy is to continue increasing our participation in first-to-market purchase opportunities.  The availability of certain desired products, especially in the direct marketing channel, has been constrained in the past.  We could experience a material adverse effect to our business if we are unable to source first-to-market purchases or similar opportunities, or if significant availability constraints reoccur.

We are exposed to inventory obsolescence due to the rapid technological changes occurring in the IT industry.

The market for IT products is characterized by rapid technological change and the frequent introduction of new products and product enhancements.  Our success depends in large part on our ability to identify and market products that meet the needs of customers in that marketplace.  In order to satisfy customer demand and to obtain favorable purchasing discounts, we have and may continue to carry increased inventory levels of certain products.  By so doing, we are subject to the increased risk of inventory obsolescence.  Also, in order to implement our business strategy, we intend to continue, among other things, placing larger than typical inventory stocking orders of selected products and increasing our participation in first-to-market purchase opportunities.  We may also, from time to time, make large inventory purchases of certain end‑of‑life products, which would increase the risk of inventory obsolescence.  In addition, we sometimes acquire special purchase products without return privileges.  For these and other reasons, we may not be able to avoid losses related to obsolete inventory.  Manufacturers have limited return rights and have taken steps to reduce their inventory exposure by supporting “configure‑to-order” programs authorizing distributors and resellers to assemble computer hardware under the manufacturers’ brands.  These actions reduce the costs to manufacturers and shift the burden of inventory risk to resellers like us, which could negatively impact our business.

We are dependent on key personnel.

Our future performance will depend to a significant extent upon the efforts and abilities of our senior executives and other key management personnel.  The competition for qualified management personnel in the computer products industry is very intense, and the loss of service of one or more of these persons could have an adverse effect on our business.  Our success and plans for future growth will also depend on our ability to hire, train, and retain skilled personnel in all areas of our business, especially sales representatives and technical support personnel.  We may not be able to attract, train, and retain sufficient qualified personnel to achieve our business objectives.

The methods of distributing IT products are changing, and such changes may negatively impact us and our business.

The manner in which IT hardware and software is distributed and sold is changing, and new methods of distribution and sale have emerged, including distribution through cloud-based and SaaS solutions.  In addition, hardware and software manufacturers have sold, and may intensify their efforts to sell, their products directly to end users.  From time to time, certain manufacturers have instituted programs for the direct sales of large order quantities of hardware and software to certain major corporate accounts.  These types of programs may continue to be developed and used by various manufacturers.  Some of our vendors, including Apple, Dell, HP, and Lenovo, currently sell some of their products directly to end users and have stated their intentions to increase the level of such direct sales.  In addition, manufacturers may attempt to increase the volume of software products distributed electronically to end users.  An

increase in the volume of products sold through or used by consumers of any of these competitive programs, or our inability to effectively adapt our business to increased electronic distribution of products and services to end users could have a material adverse effect on our results of operations. 

We depend heavily on third-party shippers to deliver our products to customers.

Many of our customers elect to have their purchases shipped by an interstate common carrier, such as UPS or FedEx Corporation.  A strike or other interruption in service by these shippers could adversely affect our ability to market or deliver products to customers on a timely basis.

Natural disasters, terrorism, and other circumstances could materially adversely affect our business.

Natural disasters, terrorism, and other business interruptions have caused and could cause damage or disruption to international commerce and the global economy, and thus could have a negative effect on the Company, its suppliers, logistics providers, manufacturing vendors, and customers. Our business operations are subject to interruption by natural disasters, fire, power shortages, nuclear power plant accidents, terrorist attacks, and other hostile acts, and other events beyond our control. Such events could decrease demand for our products, make it difficult or impossible for us to deliver services or products to our customers, or to receive products from our suppliers, and create delays and inefficiencies in our supply chain.  In the event of a natural disaster or other business interruption, significant recovery time and substantial expenditures could be required to resume operations and our financial condition, results of operations, and cash flows could be materially adversely affected.

We may experience increases in shipping and postage costs, which may adversely affect our business if we are not able to pass such increases on to our customers.

Shipping costs are a significant expense in the operation of our business.  Increases in postal or shipping rates could significantly impact the cost of shipping customer orders and mailing our catalogs.  Postage prices and shipping rates increase periodically, and we have no control over future increases.  We have a long-term contract with UPS, and believe that we have negotiated favorable shipping rates with our carriers.  While we generally invoice customers for shipping and handling charges, we may not be able to pass on to our customers the full cost, including any future increases in the cost, of commercial delivery services, which would adversely affect our business.

We rely on the continued development of electronic commerce and Internet infrastructure development.

We continue to have increasing levels of sales made through our e-commerce sites. The on-line experience for our clients continues to improve, but the competitive nature of the e-commerce channel also continues to increase.  Growth of our overall sales is dependent on customers continuing to expand their on-line purchases in addition to traditional channels to purchase products and services. We cannot accurately predict the rate at which on-line purchases will expand.

      Our success in growing our Internet business will depend in large part upon our development of an increasingly sophisticated e-commerce experience and infrastructure. Increasing customer sophistication requires that we provide additional website features and functionality in order to be competitive in the marketplace and maintain market share. We will continue to iterate our website features, but we cannot predict future trends and required functionality or our adoption rate for customer preferences. As the number of on-line users continues to grow, such growth may impact the performance of our existing Internet infrastructure.

We face uncertainties relating to unclaimed property and the collection of state sales and use tax.

We collect and remit sales and use taxes in states in which we have either voluntarily registered or have a physical presence.  Various states have sought to impose on direct marketers the burden of collecting state sales and use taxes on the sales of products shipped to their residents.  Many states have adopted rules that require companies and their affiliates to register in those states as a condition of doing business with those state agencies.  Our three sales companies

are registered in substantially all states, however, if a state were to determine that our earlier contacts with that state exceeded the constitutionally permitted contacts, the state could assess a tax liability relating to our prior year sales.  A multi-state unclaimed property audit continues to be in process, and total accruals for unclaimed property aggregated $0.8 million at December 31, 2016.

Privacy concerns with respect to list development and maintenance may materially adversely affect our business.

We mail catalogs and other promotional materials to names in our customer database and to potential customers whose names we obtain from rented or exchanged mailing lists.  Public concern regarding the protection of personal information has subjected the rental and use of customer mailing lists and other customer information to increased scrutiny.  Legislation enacted limiting or prohibiting the use of rented or exchanged mailing lists could negatively affect our business.

We are controlled by two principal stockholders.

Patricia Gallup and David Hall, our two principal stockholders, beneficially own or control, in the aggregate, approximately 56% of the outstanding shares of our common stock as of December 31, 2016.  Because of their beneficial stock ownership, these stockholders can continue to elect the members of the Board of Directors and decide all matters requiring stockholder approval at a meeting or by a written consent in lieu of a meeting.  Similarly, such stockholders can control decisions to adopt, amend, or repeal our charter and our bylaws, or take other actions requiring the vote or consent of our stockholders and prevent a takeover of us by one or more third parties, or sell or otherwise transfer their stock to a third party, which could deprive our stockholders of a control premium that might otherwise be realized by them in connection with an acquisition of our Company.  Such control may result in decisions that are not in the best interest of our public stockholders.  In connection with our initial public offering, the principal stockholders placed substantially all shares of common stock beneficially owned by them into a voting trust, pursuant to which they are required to agree as to the manner of voting such shares in order for the shares to be voted.  Such provisions could discourage bids for our common stock at a premium as well as have a negative impact on the market price of our common stock.

Item 1B.  Unresolved Staff Comments

None.

Item 2.  Properties

We lease our corporate headquarters located at 730 Milford Road, Merrimack, New Hampshire 03054-4631, from an affiliated company, G&H Post, which is related to us through common ownership.  The initial term of the fifteen-year lease ended in November 2013, and we amended the lease in May 2014 to extend the term for an additional five years.  In addition to the rent payable under the facility lease, we are required to pay real estate taxes, insurance, and common area maintenance charges.   The amended lease has been recorded as an operating lease in the financial statements.

In August 2008, we entered into a lease agreement with G&H Post, which is related to us through common ownership, for an office facility adjacent to our corporate headquarters.  The lease has a term of ten years and provides us with an option to renew the lease for two additional two-year terms, at the then comparable market rate.  The lease requires us to pay our proportionate share of real estate taxes and common area maintenance charges as either additional rent or directly to third parties and also to pay insurance premiums for the leased property.  The lease has been recorded as an operating lease in the financial statements.

In August 2014, we entered into a ten-year lease for a facility in Wilmington, Ohio, which houses our distribution and order fulfillment operations.  We also operate sales and support offices throughout the United States and lease facilities at these locations.  Leasehold improvements associated with these properties are amortized over the terms of the leases or their useful lives, whichever is shorter.  We believe that our physical properties will be sufficient to support our anticipated needs through the next twelve months and beyond.

Item 3.  Legal Proceedings

We are subject to audits by states on sales and income taxes, unclaimed property, employment matters, and other assessments.    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, as formal assessments have not been finalized.  Additional liabilities for this and other audits could be assessed, and such outcomes could have a material, negative impact on our financial position, results of operations, and cash flows.

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 business, financial position, results of operations, or cash flows.

Executive Officers of PC Connection

Our executive officers and their ages as of March 3, 2017 are as follows:

Patricia Gallup is a co-founder of PC Connection and has served as Chair of the Board since September 1994, and as Chief Administrative Officer since August 2011.  Ms. Gallup has served as a member of our executive management team since 1982.

Timothy McGrath has served as Chief Executive Officer since August 2011, and as President since May 2010.  Mr. McGrath has served as a member of our executive management team since he joined the Company in 2005.

William Schulze has served as Interim Treasurer and Chief Financial Officer since October 2016, and as Vice President and Corporate Controller since October 2011.  From December 1998 to October 2011, Mr. Schulze served in various finance management roles at the Company.

Item 4.  Mine Safety Disclosures

Not applicable.

PART II

Item 5.  Market for the Registrant’s Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities

Market Information

Our common stock commenced trading on March 3, 1998, on the Nasdaq Global Select Market and trades today under the symbol “CNXN.”  As of February 27, 2017, there were 26,719,185 shares of our common stock outstanding, held by approximately 61 stockholders of record.  This figure does not include an estimate of the number of beneficial holders whose shares are held of record by brokerage firms.

The following table sets forth for the fiscal periods indicated the range of high and low sales prices for our common stock on the Nasdaq Global Select Market.

In 2016, we declared a special cash dividend of $0.34 per share.  The total cash payment of $9.0 million was made on January 12, 2017 to stockholders of record at the close of business on December 30, 2016.  In 2015, we declared a special cash dividend of $0.40 per share.  The total cash payment of $10.6 million was made on January 12, 2016 to stockholders of record at the close of business on December 29, 2015.  We have no current plans to pay additional cash dividends on our common stock in the foreseeable future, and declaration of any future cash dividends will depend upon our financial position, strategic plans, and general business conditions.

Share Repurchase Authorization

On March 28, 2001, our Board of Directors authorized the spending of up to $15.0 million to repurchase our common stock.  We consider block repurchases directly from larger stockholders, as well as open market purchases, in carrying out our ongoing stock repurchase program.  

We did not repurchase any shares in 2015 or 2016.  As of December 31, 2016, we have repurchased an aggregate of 1,682,119 shares for $12.2 million under our Board approved 2001 repurchase program.  The maximum approximate dollar value of shares that may yet be purchased under this Board authorized program is $2.8 million.

On February 11, 2014, our Board approved a new share repurchase program authorizing up to $15.0 million in share repurchases.  There is no fixed termination date for this repurchase program.  Purchases may be made in open-market transactions, block transactions on or off an exchange, or in privately negotiated transactions.  We intend to complete the 2001 repurchase program before repurchasing shares under the new program.  The timing and amount of any share repurchases will be based on market conditions and other factors.

Stock Performance Graph

The following performance graph and related information shall not be deemed “soliciting material” or to be “filed” with the SEC, nor shall such information be incorporated by reference into any future filing under the Securities Act of 1933 or the Exchange Act, each as amended, except to the extent that we specifically incorporate it by reference into such filing.

The following stock performance graph compares cumulative total stockholder return on our common stock for the period from January 1, 2011 through December 31, 2016 with the cumulative total return for (i) the Nasdaq Stock Market Composite and (ii) the Nasdaq Retail Trade Stocks (Peer Group) for the period starting January 1, 2011 and ending December 31, 2016.  This graph assumes the investment of $100 on January 1, 2011 in our common stock and in each of the two Nasdaq indices, and that dividends are reinvested.

Item 6.  Selected Financial Data

The following selected financial data should be read in conjunction with our Consolidated Financial Statements and the Notes thereto, and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and other financial information included elsewhere in this Annual Report on Form 10-K.

Item 7.  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.”

OVERVIEW

We are a national solutions provider 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 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 and technical support 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, especially in relation to changing revenue levels.

To support future growth, we are expanding our IT solutions 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 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 and provide our customers enhanced functionality.  While we have not yet finalized our decisions regarding the areas of future investment in our IT infrastructure, we expect to increase our capital investments in our IT infrastructure in the next one to three years, which will also likely increase SG&A expenses as assets are placed into service and depreciated. 

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 increased in 2016 by $118.6 million, or 4.6%, compared to 2015, due to increased sales in all three of our sales segments.  Our investments in advanced solution sales including our acquisition of Softmart in May 2016 led to increased sales of software.  In addition, net sales of notebooks/mobility increased as mobility continued to be a strategic focus for customers in all three segments. Gross margin (gross profit expressed as a percentage of net sales) increased significantly due to our focus on increasing sales of higher-margin advanced solution products.  SG&A expenses increased in dollars and as a percentage of net sales due to incremental variable compensation associated with higher gross profits, investments in solution sales and support personnel, and the acquisitions in 2016 of Softmart and GlobalServe.  Operating income in 2016 increased year over year in dollars, but remained unchanged as a percentage of net sales.

Sales Distribution

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

Gross Profit Margins

The following table summarizes our overall gross profit margins, as a percentage of net sales, for the last three years:  

Cost of Sales

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.

Operating Expenses

The following table reflects our more significant operating expenses for the last three years (in millions of dollars):

Personnel costs increased in 2016 compared to 2015 due to investments in our sales force and solution sales support, increased variable compensation associated with higher gross profits, and the inclusion of the personnel costs of Softmart and GlobalServe since their respective 2016 acquisition dates.  Facilities operations increased year over year in 2016 due to the relocation of our Chicago-area facility, as lease expense for the previous facility overlapped the new lease.  We will not incur any lease expense in 2017 for the previous facility.

YEAR-OVER-YEAR COMPARISONS

Year Ended December 31, 2016 Compared to Year Ended December 31, 2015

Net sales increased by 4.6% to $2,692.6 million in 2016 from $2,574.0 million in 2015.  Changes in net sales and gross profit by operating segment are shown in the following table (dollars in millions):

Gross profit for 2016 increased year over year in dollars and as a percentage of net sales (gross margin), as explained below:

Selling, general and administrative expenses in 2016 increased in dollars and as a percentage of net sales compared to the prior year.  SG&A expenses attributable to our three operating segments and the remaining unallocated Headquarters/Other group expenses are summarized below (dollars in millions):  

Income from operations increased by $2.0 million to $80.5 million in 2016, compared to 2015.  Income from operations as a percentage of net sales remained unchanged at 3.0% for 2016 and 2015.  The increase in operating income resulted primarily from an increase in gross profits.

Income taxes.  Our effective tax rate was 40.2% for the year ended December 31, 2016, compared to 40.3% for the year ended December 31, 2015.  Our tax rate will vary based on income apportionment to certain jurisdictions, valuation reserves, and accounting for uncertain tax positions.  However, we do not expect these variations to be significant in 2017.

Net income increased by $1.3 million to $48.1 million in 2016, from $46.8 million in 2015, principally due to the increase in operating income.

Year Ended December 31, 2015 Compared to Year Ended December 31, 2014

Net sales increased by 4.5% to $2,574.0 million in 2015 from $2,463.3 million in 2014.  Changes in net sales and gross profit by operating segment are shown in the following table (dollars in millions):