CDW Corporation (NASDAQ:CDW) Q3 2023 Earnings Call Transcript

CDW Corporation (NASDAQ:CDW) Q3 2023 Earnings Call Transcript November 1, 2023

CDW Corporation beats earnings expectations. Reported EPS is $2.72, expectations were $2.59.

Operator: Hello, everybody, and welcome to CDW Third Quarter 2023 Earnings Call. My name is Sam, and I’ll be coordinating your call. [Operator Instructions] I’ll now hand you over to your host Steve O’Brien with CDW, Investor Relations to begin. So, Steve, over to you.

Steve O’Brien: Thank you, Sam. Good morning, everyone. Joining me today to review our third quarter 2023 results are Chris Leahy, our Chair and Chief Executive Officer; and Al Miralles, our Chief Financial Officer. Our third quarter earnings release was distributed this morning and is available on our website, investor.cdw.com, along with the supplemental slides that you can use to follow along during the call. I’d like to remind you that certain comments made in this presentation are considered forward-looking statements under the Private Securities Litigation Reform Act of 1995. Those statements are subject to a number of risks and uncertainties that could cause actual results to differ materially. Additional information concerning these risks and uncertainties is contained in the earnings release and Form 8-K we furnished to the SEC today and in the company’s other filings with the SEC.

CDW assumes no obligation to update the information presented during this webcast. Our presentation also includes certain non-GAAP financial measures, including non-GAAP operating income, non-GAAP operating income margin, non-GAAP net income and non-GAAP earnings per share. All non-GAAP measures have been reconciled to the most directly comparable GAAP measures in accordance with SEC rules. You’ll find reconciliation charts in the slides for today’s webcast and in our earnings release and Form 8-K. Please note, all references to growth rates or dollar amount changes in our remarks today are versus the comparable period in 2022 unless otherwise indicated. Replay of this webcast will be posted to our website later today. I also want to remind you that, this conference call is the property of CDW and may not be recorded or rebroadcast without specific written permission from the company.

With that, let me turn the call over to Chris.

Chris Leahy: Thank you, Steve. Good morning, everyone. I’ll begin today’s call with a brief overview of our performance, strategic progress and view for the balance of the year. Al will provide additional details on our results, our capital allocation priorities and our outlook. We’ll move quickly through our prepared remarks to ensure we have plenty of time for questions. The team continued to execute extremely well under persistently challenged conditions. Commercial markets remained cautious and conditions in international markets worsened, public markets held firm. For the quarter, the team delivered net sales of $5.6 billion, 8% lower than last year, record non-GAAP operating income of $556 million, up 1% year-over-year.

And record non-GAAP net income per share of $2.72, up 4% year-over-year. Record profitability that underscores the power of our strategy when underpinned by our resilient business model and financial rigor. Profitability driven by relentless execution and profitability that is a clear demonstration of the value we deliver to our customers. Customers maintain their laser focus on mission-critical priorities and optimizing costs and once again, our deep and broad portfolio enabled the team to pivot to solutions that address our customers’ priorities. Solutions that provide operating efficiency and expense elasticity like burstable performance in modern, hybrid and multi-cloud environments or solutions that are usage-based like SaaS and private cloud.

Solutions, we are well-positioned to deliver. In today’s environment, where customers are closely scrutinizing their IT spend. Our value as a trusted adviser is greater than ever before, an adviser who helps customers cut through complexity and evaluate options. An adviser, who designs, deploys, integrates and many times manages the solution. Capabilities made possible by the investments we have made in our three-part strategy for growth. Investments that enable us to serve customers across the full stack and full life cycle. Investments that have made us a vital technology partner. As we have executed our strategy, the amount that customers spend with us has consistently grown faster than net sales, a dynamic that reflects both the success of our strategic investments and increasing customer preferences for cloud and SaaS-based solutions.

Recall that these offerings drive significant customer spend that are netted down in our sales and thus dampen our top line growth while enhancing our gross margin. Let’s take a deeper look at quarterly results. There were three main drivers of performance, our balanced portfolio of customer end markets, our breadth of solutions and services portfolio and ongoing execution of our three-part strategy. First, our balanced portfolio of end markets. Each of our five build sales channels, corporate, small business, healthcare, government and education is a meaningful business on its own with 2022 annual sales ranging from $1.9 billion to over $10 billion. Within each channel, teams are further segmented to focus on customer end markets, including geography, verticals and customer size.

Teams are similarly segmented in our UK and Canadian operations, which together delivered US$2.9 billion in 2022 sales. These unique customer end markets often act counter-cyclically, given the different macroeconomic and external factors that impact each, you see the benefit of our balanced portfolio again this quarter with public performance partially mitigating declines in commercial. Commercial market conditions continue to weigh on customer confidence and drive cautious purchasing behavior. Instead of the modest improvement in hardware we expected, we continue to experience pressure, particularly in client devices. Corporate net sales decreased 12%. Momentum continued around projects focused on increasing productivity, as well as projects focused on enhanced customer and go over experiences.

With a shorter-term ROI lens, customers favored solutions enabled by cloud, which contributed to double-digit increases in corporate customer spend on cloud. AI and security were also major customer focus areas with CIOs increasingly being asked two questions, what are you doing with AI and how are you projecting our data? While AI remains in early stages of commercialization and development, and not yet translating into meaningful customer spend, our full portfolio of security offerings contributed to double-digit increase in security spend. Ongoing network modernization also led to excellent net comp performance, once again up double digits. Corporate top line performance continued to reflect meaningful year-over-year client device declines with ongoing postponement of upgrades and utilization of existing products.

Small business net sales declined 22%. Market conditions were consistent with the second quarter, and customers continue to see clarity around the economy and more conducive conditions for hiring and new business formation. Focus remains on cost management and the prioritization of product – projects that need to get done. Projects that were more want rather than needs remain hot. Consistent with the second quarter, solutions increased up low single digits, while transactions declined by double-digits. Focus on shorter-term ROI for mission-critical priorities drove double-digit spend in cloud and software. Client devices continue to drive small business top line performance as refresh remained on the back burner and declines were on par with the second quarter.

Public sales increased 1% year-over-year. Healthcare and education each posted a 2% increase, while performance was flat in government compared to last year’s exceptional near 40% growth. Government performed relatively in line with historical seasonality, with Federal’s mid-single-digit growth, offset by a mid-single-digit decline in state and local. The federal team continued its success helping agencies implement more efficient solutions to manage and protect data. This delivered excellent server performance up strong double-digits. The team also continued its work with agencies to optimize existing cloud investments and deliver new cloud solutions, which require rigorous proof of concept. The state and local team delivered solid sequential growth well above the historical averages, up 4%, but net sales declined mid-single digits compared to last year’s double-digit growth.

Solid Solutions growth was more than offset by a decline in transactions. Cloud-enabled solution adoption with strong, delivering double-digit increases in customer spend. Healthcare net sales increased 2% augmenting talent needs, modernizing data centers and driving cost savings and efficiency projects remain focused areas for customers. With complex industry challenges and tight operating budgets, healthcare systems continue to turn to cloud solutions. Armed with our full portfolio, which includes proprietary cloud-based health care solutions, the team drove a significant increase in cloud spend. Our broad portfolio of solutions also contributed to a double-digit increase in security spend growth as they help customers address heightened cybersecurity needs.

Needs driven by the disproportionate percentage of all ransomware attacks that target healthcare organization. For education, net sales increased low single-digits, the first positive growth quarter for education in over eight quarters. K-12 low single digits increase more than offset a low single-digit decline in higher ed. Higher ed high single-digits increase in Solutions was offset by a double-digit decline in transactions, a decline largely driven by ongoing declines in client devices. Institutions continue to invest to improve security, campus connectivity and student experiences. The teams continue to focus on delivering these impactful solutions led to double-digit growth across netcomm, services and software. It also delivered low-teens growth in cloud spend.

For K-12, the team continued their success helping schools and their efforts to achieve digital equity and improve learning outcomes, which delivered excellent growth in services and netcomm. Solutions grew meaningfully, while transactions declined low-teens, reflecting ongoing moderation of client device spend, security remained a key focus area with double-digit growth in customer spend. Other, our combined UK and Canada business came in below our expectations, down mid-teens. While the teams continue to execute well, the deterioration in market conditions in the UK and Canada were deeper than we anticipated, both the UK and Canada decreased by double-digits in local currency. Our diverse end markets are both a key strategic advantage and enable consistent performance amid an uncertain and uneven macro environment.

The second strategic advantage and driver of our performance was our broad and deep portfolio, which enables us to pivot to address our customers’ evolving needs. Similar to the second quarter, solutions sales increased mid-single digits, while transactions remained under pressure, down high teens. Hardware declined by double digits. Similar to the second quarter, performance continued to reflect depressed client device demand, particularly in the commercial space. Overall, client performance was roughly in line with the second quarter’s double-digit decline. Net comp increased double digits with stable demand. Backlog continues to feather out and is now approximating historic levels. Cloud spend increased nearly 20% with increases across every end market, roughly half of our total third quarter cloud spend came from commercial customers and half from public.

Security spend increased by double digits with a significant portion being delivered via software and the cloud. Cloud and security success contributed to a mid-teens increase in software, increases across virtualization and network management and security were partially offset by declines in categories tied to full stack projects and employment levels. Solid managed and professional services growth was more than offset by the impact of continued drag from lower services attached to transactional and solutions hardware and overall services net sales declined. As you can see, performance varies significantly across the portfolio. That is the power of our deep and broad portfolio. It enables us to meet our customers where they are and it is power driven by the investments we have made in our growth strategy.

And that leads to the third driver of our performance this quarter, relentless execution of our growth strategy. A strategy guided by three pillars; first, capture share and acquire new customers; second, enhance capabilities in high-growth solutions area; and third, expand services capabilities. Over the past five years, we have broadened and deepened our capabilities. Our comprehensive life cycle management capabilities now deliver design, deployment, integration and management, capabilities that have deepened our relevance to customers and fortified our role as a trusted adviser to our customers. Capabilities that enable us to best serve customers across physical, digital or cloud based environment in the US and internationally and capabilities that drive favorable outcomes for our customers.

In today’s uncertain macro environment, with customers increasingly reluctant to make big upfront capital investment, our ability to deliver the cost savings outcome of our ICARE framework is a major competitive advantage. Armed with our consultative approach to problem solving, the teams both identify and implement consumption-based solutions with lower upfront costs, solutions that enable customers to move ahead with mission-critical projects, solutions that deliver value to our customers and deepen customer relationships. Many of these solutions are enabled by our Cloud Readiness Assessment, enablement and migration services, which are second to none in the industry. A great example of this in action is a solution we provided to an Illinois school district that had a legacy converged storage environment reaching end of life.

The customer had three priorities; first, student teacher and administrator experience. Second, agility to meet end of school year deadline; and third, deliver costs that they manage within the constraints of their fixed budget. After a comprehensive evaluation of the wide range of on-premise and hybrid cloud solutions we can provide, the team determined that a consumption-based approach would provide the best outcome for the customer ultimately developing a private cloud hyperconverged solution. A solution that supports deployment and management of modern applications and provides the ability to seamlessly scale for future growth, one that delivered needed flexibility and cost predictability and deepens our relationship as a trusted adviser, another great win-win.

Investments in our customer-centric growth strategy are foundational to our ability to consistently and profitably outgrow the US IT market, and that brings us to our expectations for the rest of the year. You will recall last quarter, we shared our expectations for the US IT market to post a decline of high single digits in 2023. This assumes three things. First, greater clarity in the market would lead to a modest improvement in the commercial IT hardware market in the back half of the year. Second, a moderate deterioration in the UK and Canada; and third, a return to normal seasonality in the public space. We did see a return to normal seasonality in public and while commercial spend has been stable there was a greater shift to solutions that net down in lieu of IT hardware spend.

We also saw a deeper-than-expected international market deterioration. Current conditions and order today customer interactions lead us to expect these trends to continue. Our estimate of US IT market growth in 2023 remains at a high single-digit decline, and we continue to expect to profitably outperform the US IT market by 200 to 300 basis points when adjusted for this year’s meaningful shift in customer spend to our complex solutions that net down. We are cognizant of the significant wild cards to our customers in the market space in this environment, a list that has grown more complex and now includes intensifying geopolitical instability and potential for federal government shutdown. We will continue to keep a watchful eye on these and other potential factors as we always do, and we will provide an update on business conditions on our next call.

In the meantime, we will continue to do what we do best leverage our competitive advantages and out-execute the competition. Now, let me turn it over to Al, who will provide more detail on our financials and outlook. Al?

Al Miralles: Thank you, Chris, and good morning, everyone. I’ll start my prepared remarks with detail on the third quarter performance, move to capital allocation priorities and then finish up with our 2023 outlook. This quarter, our continued execution and financial discipline delivered three notable records: record gross margin, record operating margin and record earnings per share on a diluted basis. We achieved these records on consolidated net sales of $5.6 billion, which were 9.4% in 2022 on a reported basis and down 8% on an average daily sales basis. Third quarter net sales performance reflected both the impact of uneven market conditions and our continued success providing cloud and SaaS-based solutions that drive meaningful customer spend.

On a sequential basis, third quarter net sales increased 1.6% on an average daily sales basis, slightly lower than our outlook, reflecting a higher-than-anticipated mix in the cloud and SaaS-based solutions that are netted down, in our top line results as well as economic conditions that adversely impacted our international business. Gross profit was $1.2 billion, essentially flat versus prior year as a record gross margin, which increased 200 basis points year-over-year, offset the impact of lower net sales. Our gross margin of 21.8% was driven by two factors. First, the impact of higher mix in the complex solutions, which have higher product margins; second, a higher mix into netted down revenues, which while dampening net sales growth also enhanced gross profit margin.

These cloud and SaaS-based revenue streams once again outpaced net sales growth. For this quarter, this category represented a record 32.6% and our gross profit compared 31% in a prior year third quarter. While we expect this mix shift to continue to be an important durable trend within our business, eventually, we anticipate a greater mix back in transactional products, which will balance out both the top line growth and corresponding gross margin impacts we’ve experienced in 2023. For the third quarter, non-GAAP SG&A totaled $671 million, down 1.9% year-over-year. Coworker count in the third quarter was approximately 15,000, up slightly from the second quarter. We continue to prioritize investments in our three-part strategy that are important catalysts for the achievement of our growth, profitability and margin goals.

As our customers optimize and rationalize their own IT investments, our disciplined approach to discretionary expenses helped drive non-GAAP operating income of $556 million, up $7 million or 1.3% versus prior year. Non-GAAP operating income margin reached a record 9.9%, up 110 basis points from the prior year. Moving down the P&L. Our interest expense tax rate remained in line with our expectations. As you can see on slide 8, our non-GAAP net income was $369 million in the quarter, up 3.5% on a year-over-year basis with third quarter weighted average diluted shares of 136 million. Non-GAAP net income per diluted share was also an all time record at $2.72, up 4.4% year-on-year. Moving to slide 9 at period end, net debt was $5.3 billion or 2.4 times net leverage.

During the quarter, net debt declined reflect our continued strong cash flow performance and modest debt repayment during the quarter, consistent with our targeted net leverage range of two to three times. Liquidity remains strong with cash plus revolver availability of approximately $1.4 billion. Moving to slide 10. The three-month average cash conversion cycle was 15 days, down three days from the prior year and below our targeted range of high teens to low 20s. Our cash conversion reflects our continued diligent management of working capital, particularly with respect to our inventory levels, and we expect to remain at the lower end of this targeted range this year. As we’ve mentioned in the past, timing and market dynamics can influence working capital in any given quarter.

And we continue to believe our target cash conversion range remains the best guidepost for modeling working capital longer term. Strong profits and effective working capital management drove our strong year-to-date adjusted free cash flow of $1.1 billion, as shown on slide 11, well-above our rule of thumb as a percentage of sales. For the quarter, we utilized cash consistent with our 2023 capital allocation priorities, including returning approximately $79 million to shareholders through dividends and $54 million in share repurchases. This brings us to our capital allocation priorities on slide 12. Our execution remained consistent with the objectives we communicated at the start of the year. First, as always, increased the dividend in line with non-GAAP net income.

This morning, we announced a 5% increase of our dividend to $2.48 annually. This is our 10th consecutive year increasing the dividend, we’ve grown the dividend at a compound annual rate of approximately 31% from the initial level. Going forward, we will continue to target a 25% payout ratio. Second, ensure we have the right capital structure in place with a targeted net leverage ratio. We ended the quarter at 2.4 times, down from 2.6 times at the end of last year and within our targeted range of two times to three times. We continue to convert profits into cash flow and have rigorous processes in place to proactively manage liquidity, while maintaining our flexibility. Finally, our third and fourth capital allocations of M&A and share repurchases remain important drivers of shareholder value.

For 2023, we now anticipate returning 60% to 75% of adjusted free cash flow to investors through dividends and share repurchases, up from our prior range of 50% to 75%. All in all, strong results given ongoing economic uncertainty and uneven market conditions. We continue to run our playbook and remain laser-focused on margins, cash flow and predictable profitability. And that leads us to our outlook on slide 13. The uncertain marketing conditions we’ve operated under throughout the year are persisting and continue to lead to customer caution and prudence. Given this, we expect that the IT market will contract at the upper end of high single digits. With this scenario as our baseline, we expect to deliver a 200 to 300 basis point growth premium to the market albeit not evident on a net sales basis as the outsized share of netted down revenue makes the impact of our premium.

Keep in mind that, our premium is most significant when hardware demand is strong, like in 2021 and 2022. We’re currently maintain a meaningful premium to the IT market on a customer spend basis. Moving down the P&L. We expect our full year non-GAAP operating income margin to be in the low to mid-9% range, up from our prior expectation of approximately 9%. This reflects our expectations of continued growth stronger profit margins along with expense efficiency as we manage through this uncertain economic environment. Finally, we expect our full year non-GAAP earnings per share to be flat to slightly up year-over-year in constant currency. This reflects an increase from our prior expectation of flat based on our strong third quarter profitability and relatively unchanged profitability expectations for the fourth quarter.

Please remember, we hold ourselves accountable for delivering our financial outlook on a full year constant currency basis. Additional modeling thoughts for annual depreciation and amortization, interest expense and the non-GAAP effective tax rate can be found on slide 14. Moving to modeling thoughts for the fourth quarter. For average daily sales, we now expect a largely seasonal mid-single-digit sequential decline from Q3 to Q4. This equates to a low- to mid-single-digit net sales decline on a year-over-year basis for the fourth quarter in terms of average daily sales. This is lower than we previously expected and reflective of both the current business conditions and top line mix components previously referenced. With this, we also anticipate gross profit and non-GAAP operating margins to be strong, similar to third quarter levels driven by both mix and rate elements.

And we expect fourth quarter non-GAAP earnings per diluted share to grow low single digits year-over-year. For full year 2023, we expect adjusted free cash flow to be approximately 6% of net sales, above our prior year expectation of 5% and well above our rule of thumb range of 4% to 4.5%, reflecting our strong cash generation in the first nine months of the year. While we continue to operate in a cautious and uncertain market, we remain confident in our ability to deliver profitability, margin and cash flow to our stakeholders while continuing to invest behind our strategy. That concludes the financial summary. As always, we will provide updated views on the macro environment and our business on our future earnings calls. And with that, I’ll ask the operator to open it up for questions.

We would ask each of you to limit your questions to one with a brief follow-up. Thank you.

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Q&A Session

Operator: Thank you. [Operator Instructions] Our first question today comes from Samik Chatterjee from JPMorgan. Samik, your line is now open. Please go ahead.

Samik Chatterjee: Hi, thank you and thanks for taking my question. I’ll just have two quick ones, and I’ll ask both together, if that’s okay. Chris, I think a broad investor concern here has been that most of the resilience we’ve seen in total spending from customers has been held by the public sector. And beyond that, when you look at the broader customers beyond the public sector, there hasn’t been as much momentum. And in fact, momentum in spending is probably deteriorating on the commercial side. Can you dive into what you’re seeing from a pipeline perspective going just beyond the public sector? And is there sustainability of demand from the commercial accounts. And for my second one, I mean, obviously, we’re getting close to the end of the year here and maybe any insights you have into how you’re thinking about next year spending.

We haven’t seen two consecutive years of significant declines in a while in enterprise spending. So any thoughts if we are at least looking at a year where you should be expecting higher spending from a lower level base, or are we looking for another year of declines from customers? Thank you.

Chris Leahy: Okay. Good morning, Mr. Samik. Let me get to the first question first on the commercial side. Look, I’ll just say again that the environment this year, all year, frankly, has been cautious. It’s been uneven — has been challenging. All that said, I would say one thing that has held true is investments in technology continue to be a priority for all of our customers. What that’s looked like in terms of their spending has been pretty consistent throughout the year as well. Commercial customers have remained focused on cost optimization throughout the year on operating efficiency, on experience, both employee and customer experience. And they have been more focused on consumption based and ratable solutions like cloud, much more hesitant to make significant upfront capital investments and very much focused on managing their costs throughout the year, given the fact that we continue to not have the clarity, I’d say, in the business environment that would give them the confidence to invest more heavily.

Now remember, what we’re seeing from where our customers are investing and how they’re investing across cloud, security in some of these areas that I call mission-critical has been very strong. Clouds up double digits, securities up double digits, software is up significantly. And this is the customer reflecting the need for technology to drive their missions forward. In terms of the real impact to commercial, I would look at hardware and in particular clients. We saw some budgets loosening up a little bit in the second quarter, and we anticipated that, that would lead to a modest recovery, I’d say, in the back half of the year in hardware, in particular, in the client device. That’s not proved to be true. Our customers in — across corporate and small business are not seeing the clarity of the business climate and therefore not willing to increase their spend in that area.

But net-net, what I would say about commercial is still investing behind technology in a different bucket, a bucket that is more cloud-based right now, more ratable, more prudent and measured around the immediate spend, but still very much seeing technology as critical to their mission, as I said. As we think about next year, look, we’ll give you our views as we get through the year. One thing I’d say again about client devices is we’re not seeing the pickup or signs of a pickup that we were hoping to see in the last half of the year. So when that happens, we’ll see. But once there’s clarity in the market, we might get to see that, but we have not seen those signs just yet. And that’s where I’d leave it. I think we’ve got to get through the last couple of months.

Here’s what I just close with. The good news, which is the investment behind our strategy as physicians CDW to be able to offer our customers the broad portfolio, and we are seeing when they need help with their technology no matter where it sits across the full stack or the life cycle. Our sales and technical teams are there. And the good news is I’m really pleased with what I’ll say is the engagement, the activity, the discussion and the depth with which we’re ingraining our relationships with those customers. So feeling very good about when we kind of come out of the curve, we’ll accelerate out with our customers. You’ve seen that in the past, and I wouldn’t expect it to be any different at this time.

Operator: Thank you. Our next question comes from Erik Woodring from Morgan Stanley. Erik, your line is now open. Please go ahead.

Erik Woodring: Awesome. Thank you very much for taking my questions. I have two as well. Chris, maybe can we just start out. Can you just give us a bit more detail on linearity in the quarter? And specifically how the trends progressed from July through September and into October and how that has influenced your updated expectations for the full year? And then I have a follow-up. Thank you.

Chris Leahy: Yes, sure, Erik. Here’s — I’d just say, it was pretty stable throughout the whole quarter. You’ll remember, in Q2, we talked about an uptick as we went through the quarter, and that gave us some level of confidence that there might be some more clarity in the business climate. In Q3, we just kind of saw the same level of activity across the three months.

Erik Woodring: Okay. Super. Thank you very much for that, Chris. And then, Al, I just wanted to dig into your gross margin comments a bit. We’ve heard for several quarters now about a mix shift to these more complex solutions that are obviously higher margin, when we eventually see a mix shift towards more transactional sales, as you’ve kind of cautioned us as we look forward. Do you expect that this will drive a mix away from these complex solutions? Or can kind of both of these trends coexist together because I think it does have an important influence on what — how we think about gross margins in the future. So if you could just kind of help us understand if this is a zero-sum game or if you can see strong transactional alongside strength in complex solutions and what that would do for gross margins, that would be helpful. Thank you

Al Miralles: Yeah. Thanks, and good morning, Erik. I think they definitely can coexist. I think what we’ve seen in the environment Erik, it’s essentially, I’ll say, commercial customers kind of fixing on their spend and choosing to weight that towards more of these netted down revenue streams, if you will and holding back on some of these other spend items in IT hardware and particularly in clients. But our expectation and our expectation was that with less uncertainty in the economic environment, we would see an incremental pickup on the hardware side, in particular clients. And so the expectation would be that the durable trend of our netted down revenues would persist and likely outpace net sales, but we also would see pickup in some other categories. So I do believe that, that would co-exist, we’re not seeing in the current environment in a more cautious environment, but that’s what hopefully the future will hold.