CDW Corporation (CDW) Earnings Call Transcript & Summary

Welcome, everyone. I'm Katy Huberty, Morgan Stanley IT hardware analyst. And I'm really pleased to be joined by CDW's CEO, Chris Leahy; and CFO, Collin Kebo. CDW is one of the strongest companies we cover from an operational execution and quality of management perspective. And the company is exposed to so many of the growth drivers that have been discussed at this conference this week: digital transformation, projects that drive data insights and increased focus on security. So I'm really looking forward to this discussion. Before we begin, let me point you to the Morgan Stanley Research Disclosure website at www.morganstanley.com/researchdisclosures. If you have any questions, please don't hesitate to reach out to your Morgan Stanley representative. So Chris and Collin, thank you so much for joining us today.

Thank you, Katy. Happy to be here.

Chris, just to start, it's become clear that COVID will have a lasting impact on the way that we both work and learn going forward. How does a more permanent shift in those environments impact CDW's business longer term?

Yes, Katy. Great question. Before I dive in, I've been assigned the responsibility for the safe harbor comment, which is that our views are as of Q4 -- the Q4 call and we don't comment on our partners. So now I've done my duty there. Look, there's no doubt -- agreed, there's no doubt that the world changed in 2020 and COVID will absolutely have a lasting effect on the way that we work, on the way that we learn, on the way that we connect going forward. And I would say there are different flavors of what our customers are planning for, from return fully to work, learning to hybrid models to fully remote. And we are in the midst of those conversations with customers right now, helping to advise, help them design, help to build. And then ultimately, we'll orchestrate and manage the most appropriate solutions for their IT and operational needs. One thing that has become very clear is regardless of how our customers are working, how they're learning, what it actually looks like, number one, technology is more essential to our customers than ever before as a strategic driver. So digital capabilities are, certainly now, table stakes and will continue to be an essential part of all of our customers' ability to operate, compete, win and grow. I would also say complexity is greater than it ever has been. When you think about the choices, technologies, brands, consumption models, all the new legacy and modern approaches and architectures, it just created more complexity, and of course, that requires folks like CDW who can help with that complexity. We have, as you know, a really long history of evolving with technology and pivoting to areas of growth. I think 2020 was a great reflection on how our teams are able to do that and the strength that our broad portfolio and our diverse end markets bring to bear. So long term, we'll continue to do what we do best, which is leverage our vast competitive advantages to help our customers address their IT priorities and achieve their strategic objectives and, of course, out-execute the competition.

That's great. And speaking of pivoting to growth and maybe, Collin, you could chime in here, you guided to 2021 growth that's very consistent with your long-term model, growing 200 to 300 basis points above the U.S. IT market, which you think is 2.5% to 3% growth roughly this year. And that guidance is despite the fact that you have a more than 200 basis point headwind from the U.S. Census deal that benefited the business last year. Just given still an uncertain macro environment, what gives you confidence in that guide? And how might the sources of growth shift in 2021?

Yes. So Katy, I'll start. As you know, we hold ourselves accountable for growing fast or meaningfully faster than the IT market. In this continuing uncertain environment, it's certainly difficult to predict exactly how the year will play out, what the shape and the kind of slope of the recovery will look like. But we are certainly confident that the combination of our advantages will position us to outperform the market. And when I think about our value proposition, which 2020 really reconfirmed how strongly it resonates with our customers, but our value proposition resonates because they have to navigate the complex and really integrated IT experience, including in hybrid infrastructure and digital velocity. And what I would say is very, very few of our competitors have the depth of the full stack solution that we have, which would be cloud and services and software and hardware, along with the application workload and how that plays across cloud and on-prem. And that is exactly how our customers operate their businesses, their organizations. So they actually are now, more than ever, looking to a one-provider solution, an organization like CDW, that can provide against the full stack and full life cycle. So that gives us a great deal of confidence in our ability to continue to be both a vital partner at every step of the customer's journey to deliver the solutions they need and grow. In terms of sources of growth in 2021, again, there continues to be uncertainty, as you know, in the macro environment and success really revolves around this virus. That said, we are all feeling some optimism -- more optimism, I'd say, than a month ago in terms of customers generally and some new developments in the world of vaccine. So we do expect to see growth. We -- if I were to talk about specific channels, Corporate and Small Business channels tend to be quicker responders when the macroeconomic environment comes back. So we would think -- we would expect that coming out of the slope of the curve, they would be a leader in growth. Look, public, we're going to continue to expect to see success in Department of Defense and civilian agencies. But look, government's not really fully expected to make up the overlap of the Census project. And health care overlaps are tough in the first half of the year but the comparisons get easier. And I would tell you I would expect health care to be a leader in growth once their budgets are more firm, if you will. And then Education has just had a great end of the year last year, and we've got some backlog moving into this year. So we're going to see some deceleration in the back end of 2021, for sure. But that said, continue to expect K-12 and higher ed to be a growth driver.

That's great color. On the call, you mentioned your strategic planning process. Share a little bit more about CDW's strategy, the strategic planning process that was performed last year and where you plan to invest.

Yes, sure, Katy. So look, we have -- we do this every 3 years. It's a complete, detailed strategic review. And I think this discipline has been fundamental to our success because it does help us continue to evolve as technology evolves. One thing I would say, and I would expect a lot of companies are experiencing this, strategic planning is now a dynamic event. Even though we do this 3-year planning, we are going through strategic iterations on a quarterly basis. Our 3-part strategy, which has held for many, many years, remains the same. And that's, first, to acquire new customers and capture share; second, to enhance our solutions capabilities; and third, to expand our services capabilities. What you can expect to see going forward is reflected in what you've seen us doing. So for example, our recent acquisitions of Scalar in Canada and IGNW for cloud and DevOps capabilities and our 3 ServiceNow acquisitions, those highlight the opportunities we see from customers in high-growth areas and services that are highly relevant to their needs. It's really, I think about it, at the front -- at the tip of the spear of the advisory level so that we can help our customers in actually developing and designing their road maps going forward, which they are really stepping back and rethinking about accelerating digital capabilities, et cetera. We've also talked in the past about digitally enabling our sellers. AMANDA is a tool we've shared with you. That's our Account MANager Digital Assistant and propensity modeling, the things that make our sellers more effective and more productive. And we will continue to develop tools that allow the customer experience and the seller capabilities to be as seamless, as frictionless, as intelligent as possible. And then the last thing I would focus on is innovating our operating model. This is evergreen for us but it's really -- it's figuring out where we can streamline, where we can automate, how we can reinvent for digital core capabilities to drive speed and cost efficiencies. And you might remember, we implemented a partner portal about 1.5 years ago. That's a great example of reinventing our operating model for a digital space. So we're going to continue to focus on digital transformation and automation and being that full comprehensive provider for our customers as we move forward.

That's great context for how you're thinking about the business longer term. Just to dive into some of the segments that you briefly mentioned earlier, starting with Small Business. This was a segment that was hard hit last year but it's now recovering faster than the Corporate segment, which you certainly saw in the fourth quarter results. Talk a little bit about your conversations in order run rates in the Small Business category and how do you see the shape and pace of that recovery playing out this year.

Yes. Katy, you're absolutely right. Small Business customers do tend to be more nimble than even the larger Corporate customers reacting more quickly on each side of the macroeconomic environment. And we saw that last year. So in Q2, our Small Business customers pulled back on spend faster than Corporate customers and then accelerated spend faster than Corporate customers in Q4. And as we mentioned in the Q4 call, we were really encouraged by what we were seeing the activity in the Small Business space. Again, the timing and slope really going back to that Q4 call, it was encouraged when we felt customer confidence starting to build again. And as in many of our segments, we have subsegments. So for example, when you think about high growth, we have a group that focuses on high-growth venture capital-backed organizations. And they are very positive and very optimistic. And so we've also been focusing on the areas that seem to be coming back fast and first in the Small Business space. Look, in the long term, we do expect Small Business and then Corporate to be, again, a growth leader as we move into the second half of 2021 and beyond.

That makes sense. It's just so clear that technology is a driving force coming out of COVID, and it's really what differentiated so many companies during the pandemic and made executive teams and Boards realize how important that technology investment really is.

Katy, before you go to the next question, I'll tell you I had a question earlier today, and it was -- the question was, do we -- do I think that people will kind of go back to their old ways of doing things and was this -- is this just a shift or is it going to hold? And I think all of us can agree that this is going to stick. Whether you're fully remote or partially remote, the digital acceleration is here to stay and life has changed. And that's good for us. It's great for our customers because now technology has really become front and center of the strategy of the business.

And the government vertical, on the other side of the spectrum, was incredibly resilient over the last year, certainly helped by your Census project, but you also saw projects with the Department of Defense and other civilian agencies. Talk about what is driving government demand. And was this driven by COVID-related funding? Or is there maybe also a structural uplift in technology spend within the public sector?

Yes. Katy, I say it's some of both actually in the public sector. Our teams have done a great job helping customers follow stimulus funding. They are just extorting it, knowing where the money is and helping our customers do what they need to do to be able to capture the money. And therefore, the customers are able to take and prioritize IT investments despite some budget pressures. Within the government, key demand areas would have been remote enablement, automation, for sure, enhancing the citizen, the civilian experience. And we're starting to see solutions projects come back. So some of the larger projects that we have for the federal government, for example, where we couldn't get people -- our engineers on site, we're starting to see some of those come back. So look, we'd expect 2021 to continue to see good success supporting the Department of Defense and civilian agencies. It certainly won't make up for the overlap of the Census project, but we do think it will contribute meaningfully to our 2021 growth.

And within the public sector, health care was weaker during the pandemic. Clearly, that industry was focused on COVID and that hit budgets and prioritization. You made a comment earlier that you expect that segment to recover nicely as we go through the vaccine. How quickly could that snap back this year?

Yes. Well, I mean, that's a great question. And again, it really -- it comes back to, I think, trust and people going back to -- going back into the health care system for elective surgeries, et cetera. I mean I remember when there was uncertainty around HCA a couple of years ago, and you had hospital systems that didn't have certainty around their income streams. It's a similar situation. When you -- there's uncertainty around the income streams and therefore, budget clarity, there's just hesitation. But given where health care is going and if you think about virtual care solutions, for example, telehealth has been obviously very significant for health care systems. But other things like virtual rounding and remote monitoring and enhanced patient monitoring, there are so many areas of health care that are evolving as technology is changing and the patients and the consumers of health care are having -- creating new expectations, that I just have confidence that this -- the health care is going to, again, be a leader in our growth back. We have easier overlaps in the second half of the year than the first half of the year as well, so that's kind of a -- I guess I'd call that a little bit of a tailwind.

Okay. And the Education segment was sort of off the charts in the fourth quarter, up 140%. Certainly impressive but it also fuels this discussion around how quickly demand might normalize postpandemic. But any thoughts around how penetrated that market really is in terms of devices for remote learning? And you also talked about what -- Chromebooks drove a lot of the growth. You're seeing demand in PC accessories and NetComm projects. So is there an argument that there are new areas of spending that will emerge as schools transition back to in-person learning?

Yes. I think the answer to that second question is absolutely yes. And schools will certainly leverage stimulus funding to revamp the classroom, to support all the new devices, to upgrade wireless, network, audio-visual and create new types of spaces as we've seen educational institutions do that. In the past 15 years or so, they've really reengineered the spaces where kids learn. And I think we're going to see that again. As far as one-to-one and demand going forward, I think we still have a long way to go to get to a one student, one device. We've done a lot of work in the last 6 months and the first half of this year, we'll continue to see some of the backlog and demand. But over the next several years, I think, given the importance of digital equity and access and equity, there's just more to come, Katy. There are a lot of kids who don't even have access to the Internet. And as that starts to flow and that starts to change, the technology is going to be right behind it.

And if we step away from Education, just look at the broader PC market, which has been strong over the last couple of quarters, what are the arguments for a structurally larger client device market post-COVID? And how are you thinking about long-term PC growth?

Yes. I mean on a structural perspective, I'd say, it's the -- it's 1:1, so as you get remote and a dispersed workforce or learners, you definitely are going to see more devices there, new use cases, think about mobile form factors, think about things like curbside pickup and things like that, that are only growing. And once the consumer or the end user gets used to the digital experience, I really don't -- I think it's very difficult to pull back. So I'd say, certainly, more 1:1 and in some cases, possibly 2:1 is going to grow new use cases. The stimulus is really not structural so I wouldn't lean into that. And then refresh. The refresh of notebooks is more -- is a shorter period of time, as you know, than desktops, but it's also competitive. So when you think about these -- you think about technology companies and what their employees expect in terms of the technology, the richness of technology that they're using, we can start to see refresh cycles compress even more. So those are the ones that I would focus on.

Yes, we agree with all of those points. I want to spend the last 10 minutes or so on some of the growth drivers in the business, starting with security. You mentioned on the last call that CDW customer spend on security was $2 billion in 2020, and it's growing strong double digits in the fourth quarter that you just came out of. Is COVID catalyzing that security spend? Or should we expect this as a structurally larger and faster-growing business for CDW?

Well, Katy, I would say COVID did catalyze some growth, but I think it's kind of a durable demand, if I can say it that way. So a couple of things. I've had a number of people ask about SolarWinds' attack. And I guess what I would say about SolarWinds is it's just another example of the fact that security is a Board-level concern. And when anything is a Board-level concern when it comes to technology, it gets a lot of attention. And that, I think, just continues and heightens. The other thing is obviously, the threats are constantly emerging and evolving, and therefore, the technology and approaches are always changing. What COVID catalyzed is the distributed IT environment. And our customers now being very focused on securing all those endpoint devices and entryways into their infrastructure. So as we think forward and expect a continuation of a more dispersed workplace, maybe education space, et cetera, I think you're going to continue to see security be a real growth driver and expanding across -- it's ubiquitous. It's ubiquitous from the core infrastructure to the edge infrastructure to the endpoint devices up into the cloud. So we think there's a lot of opportunity there. And obviously, customers care quite a bit about it.

Another big growth driver last year was cloud, where you set double-digit growth across your end customer segments. And you've been investing heavily in cloud capabilities, including the recent acquisitions of IGNW and Aptris. How do you think about sort of the balance of CDW benefiting from advising your customers as they move to the cloud versus the other end of the spectrum of that shift to cloud cannibalizing some of CDW's traditional infrastructure hardware sales?

Yes, Katy, this question, I think about answering it from the customer back because certainly, there is a view around, could it cannibalize on-premise? But we think about what the customer needs and what the customer is looking to us for, and they're looking for outcomes. They're no longer buying storage and buying endpoint devices. They're buying an approach to a customer experience or a citizen experience or an employee experience. And they're thinking about their full stack. So they're thinking about their ecosystem, including their hardware and their software, the services needed to get everything together and cloud. And so we think about the benefit that we bring to bear as across that whole spectrum. And if ultimately, what a customer is doing is looking to optimize experience, optimize cost, optimize flexibility, optimize scalability, then the way we approach it is what's best for the customer. And what we are seeing is it's a combination. So cloud is certainly not an endpoint. A lot of people talk, it's not an endpoint. It's practice and pattern, it's microservices, it's modular. And so now you've got public cloud, you also have on-premise private cloud and multi-cloud approaches. The customer just wants to get the solution right. So we don't really see it as cannibalizing. We actually see the fact that we offer the full spectrum as an incredible advantage when we're talking to customers because they trust that we're going to bring to them the best solution, not just a solution like cloud-first.

It's a -- there's a timely question that came in over the webcast, which is whether cloud and security changed the way you do business and the types of expertise and skill sets of your people. Or is it just another product on the shelf of what your existing sales force can go out and deliver to the customer?

It's a little bit of both. So it's definitely bringing in new skill sets. So when you think about IGNW, for example, those -- that's bringing in advisory consultants and engineers who can have the conversations with customers to plan for modernizing applications as an example, so bringing in new skill sets, capability solutions engineers. But equally, it's continuing to train up and evolve our sales organization so that they're well prepared to sell to the customer in a more consultative manner.

Okay. And with leverage now below your long-term target, should we expect more M&A in some of these growth areas?

Yes. I think -- where are we now? About 1.7x and our stated net leverage ratio target is about 2.5 to 3x. Look, we feel we're in a good position of strength to use M&A to help execute on our 3-part strategy for growth. And we will continue to focus on what we've been focused on, things like cloud-native capabilities, security capabilities, fast growth, really services-oriented capabilities to bring to our customers. Now when you buy IGNW, and we've got a couple of hundred new folks in our organization and the traction in the sales organization is very strong and our customers are loving it, the next step is really to make sure we're scaling that up. So looking for organizations that can fortify capabilities that we've now started to build and grow is going to be really important. And of course, Katy, you know we're always disciplined. We've got our lenses, and we'll remain disciplined across the strategic, operational, cultural and financial lenses to ensure we're getting the right return.

And maybe a question for Collin. As we think about more of these cloud services as a service sales, oftentimes, that gets recognized as netted down. So your commission is recognized as revenue. That comes in at 100% gross margins. And we're often asked whether that is then offset by you paying higher commission rates to your sales force. And so is it neutral on the operating margin line? Or could we actually see operating margin expansion as your business mixes to these higher-growth areas that are typically sold as a service?

Yes. Sure, Katy. Just maybe definitionally, I think it's helpful for people to understand what's in that 100% gross margin items bucket. So there's Software as a Service and Infrastructure as a Service. Software assurance where a lot of our security practice sits. We have warranties and then other enterprise agreements where we act as agent. That part of our business has become a higher percentage of our gross profit. It was 28% last year and that's up from the low 20s in 2016. I think over the long term, we would expect that bucket to grow faster than the total portfolio. I think more near term, you should be mindful of the cycle and how strong hardware is and then hardware refreshes, that would have an impact on the gross margin and then there's ongoing product margin compression. I think if we were to go for a -- through a prolonged period where we mixed into those 100% gross margin items, we could see taking that up, but I'd want to see several quarters of that to occur. It can bounce around a little bit from quarter-to-quarter. But we did take our EBITDA target up back at our last Analyst Day as a result of mixing into netted-down items. But I think the big wildcard going forward is how strong of a hardware refresh there is.

Right. And as you said, over the last year, there have been a number of puts and takes on gross margin and more tailwinds from lower hardware mix but you've also had tighter supply. And I think a lot of companies at this conference are talking about better pricing for speed and execution. And so as you think about the variables coming into 2021, how do those net out? And how are you thinking about gross margins this year versus last year?

Yes. I think you hit some of the big drivers, Katy. Last year, our gross margin expanded 50 basis points, notwithstanding a heavy mix into public, and it's because of 100% gross margin items and then product margin, I'll call it, strength driven by supply and that premium around execution and trust. I think some tailwinds in 2021, we'd expect SaaS and security to continue to be strong. And I think certainly, through the first half of the year, there are going to be pockets of supply dislocation, client devices and Chromebooks, et cetera. I think the wildcards are, how long does this premium continue for speed and execution? And at some point, do we go back to more normal buying patterns? And as I mentioned earlier, I think the strength of a hardware refresh cycle and what impact that has on mix. I think those are the wildcards in gross margin. And then just back to your previous question, we do pay on a percentage of gross profit dollars. So the impact on gross margin is muted somewhat by the time you get to the operating margin line. And I guess the other thing I would say is we do intend to continue to invest in the business. We didn't burn the furniture last year. We think now is the time to press our advantages and we'll continue to do that this year, and that informs our mid-7% operating margin guide.

Right. Sure. I think we'd all take a really robust hardware refresh cycle even if it comes at lower margins. So it feels like there's an environment where you can win in multiple different scenarios.

Yes.

That's great. So it was really helpful to walk through some of the growth drivers. Really appreciate you both spending the time with us, and have a great day, everyone.

Thanks, Katy.

Thank you.

Thank you.