CDW Corporation (CDW) Earnings Call Transcript & Summary

So good afternoon, everyone. My name is Erik Woodring. I lead the hardware research coverage here at Morgan Stanley. Before I introduce our speaker, let me just read our disclosure. For important disclosures, please see the Morgan Stanley research disclosure website at www.morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley sales representative. So first time, I'll welcome CFO of CDW, Al Miralles, to the conference. Al joined in 2021. He was previously EVP and CFO at CNA Financial Corp. So awesome, thank you for being here. Thank you for joining us first time at the TMT conference.

Yes, thank you, Erik.

So I think the best place to start is maybe, what are you hearing from customers right? You guys are big. You have your fingers in a lot of different webs. You have hundreds of thousands of customers. And so what are you hearing from customers today? And what's kind of your outlook for IT spend? Maybe let's start there, and we can go forward and dig in.

Sounds good. Definitely a dynamic environment. Definitely, customers continue to favor tech, right, in this uncertain environment. It is an interesting environment right now. We scroll back to our outlook. Our outlook for 2023 is for a flattish IT market, and then we expect to outperform by 200 to 300 basis points. What we would have -- we've spoken to in last quarter was, in this environment, we definitely are seeing elongated sales cycles, more prioritization to spend, just customers being more thoughtful about what they're doing in an uncertain environment. That has lent itself as well to a bit more mix into software services, cloud security, really spend that will help customers to drive their initiatives, drive productivity and control costs. Some of that we've seen translate into lower spend on things like client devices where customers can mix out of that or defer some of those spends. So what we're calling for is first half of the year, something similar like that, and then expectation at the second half of pickup.

Okay. And maybe can you walk us through in the same kind of thought process by kind of end market vertical in terms of where you're seeing strength? Where are you seeing some weakness? Where are the kind of cross currents that are changing relative to, I don't know, 3 or 6 months ago?

Yes, sure. So we do have a balanced portfolio and balanced end markets and the benefit of that is that we see diversification in markets like this. So there's a countercyclical component with our public sector, right? And we're seeing strength there for sure. In the Corporate SMB space, you are seeing some of the behaviors we talked about, prioritization, elongation of sales cycles, being thoughtful. Definitely, still making tech a priority, just shows up in a different way.

Right. Okay. So something that was interesting that I want to double click on because it's more -- there's more to it than what you just said, but you talked about flat IT market growth, flattish, to be clear. Historically, you guys have talked about IT market spend outpacing GDP growth. Is flattish the way to think about market growth versus customer spend? Because you have this mix shift dynamic that takes place. So maybe just elaborate on how that mix shift is impacting your view on the term flattish for the year?

Yes. So first, look, we look at a lot of data points. So obviously, we have a vast customer base, and we work with thousands and thousands of partners. So our views are based on conversation with those customers day to day with our sellers, conversations with partners. We look at channel surveys. We look at Wall Street surveys, et cetera, and we triangulate on all of those things. So from that, we take a view of flattish. Now look, it's an uncertain environment, and so there is a level of prudence there that things will play out during the year, and we'll update things as we go. When we talk about our premium or outperformance, our typical is 200 to 300 basis points, and that's what we came out with. If you scroll back to last year, that premium we would have expected would be higher. And then in the fourth quarter, we had a pretty drastic shift where demand for client devices came in. There was more focus on netted down revenues, and with that, you do see some contraction of spend. So ultimately, customer spend may look broader or bigger than that, but that's how it is.

Right. And so you just -- you almost gave me the perfect lead into my next question, which was, if you look historically, CDW has gained, let's call it, 300 basis points plus across cycles. This year, you're guiding to 200 to 300 basis points, but you've talked about some of this mix shift in terms of weakness in client devices versus strength in this netted down revenue. And so is the right way to think about CDW and the share gains or outperformance being when it's a -- when it's software-oriented solutions outperforming hardware, perhaps you don't see as significant of those share gains and vice versa also being true, simply because of the exposure and how some of your software solutions are accounted for. Is that the right way?

Yes, you have it right, and I think fourth quarter is a good example. We went into the fourth quarter with an expectation. The IT market would be something like 4% for the year, and our outperformance would be 3.25 to 4.25 basis points. That contracted. And that was because there was a significant mix shift into those netted down revenues and out of client device. So in periods of higher client device mix in, you will see an expansion of that outperformance.

Okay. Something I want to touch, you mentioned it briefly in terms of talking about industry verticals, but something that we've been hearing from some of our companies, some of those companies that you work with is that there has been more weakness from the large enterprise than the SMB. In 4Q, we saw a bit of the opposite with that from you guys where SMB underperformed Corporate, MedLar, what it used to be called. And so are you seeing something opposite? Are you thinking about opposite of that dynamic in the market? Or was there something in 4Q that was just kind of unique in one-off or a Small Business that, again, was isolated to a specific quarter or specific trend, not bigger picture maybe?

Look, in the fourth quarter, both of those segments performed well. If I just click on Small, Small has been resilient and has held up well, and customer spend is still there. Small, like some of our other channels, but maybe even more so, did have a significant mix into netted down revenues. And that's driven by focus on cloud, software, security. During these times, they're trying to drive cost containment productivity and the like, if you will. So for small, their performance looked less significant on the topline, but the gross profit performance is really strong.

Got it. Cool. And then so let's get this out of the way. People like to ask about PCs when it comes to CDW. PC demand is notably challenged today. We just came from hosting Dell. And so are there any green shoots that you're seeing on the horizon in terms of your customer conversations? Any way that we should think about maybe the trajectory of commercial PC demand this year just based on what you're seeing? And then maybe if you could also touch on pricing. Pricing has been stronger than I think a lot of it us expected. So why has that there?

Sure. Yes. So first, in the near term, we're not seeing a lot of green shoots in that regard. What we experienced in Q4 in terms of that mix shift, we would expect much of the same for the first half of the year, that is mixing out of clients devices. And that's substantially across channels. Second half of the year, we would hope for a pickup, and you see some rebalancing out. There are reasons to believe that as you get further out, there are -- there is going to be a return to growth on the PC side, just not in the near term.

Right. Okay. And then maybe longer term, again, if the pre-COVID PC TAM was $260 million, the peak in 2021 was $340 million. We're kind of getting back to that pre-COVID level today, but longer term, what's the outlook from your guys' perspective in terms of when you're talking to clients? How do they think about the PC world? Is it being you served by some other technology -- some other compute device? Or can the TAM almost be larger post-COVID simply because whether it's more notebooks or larger installed base. What do you think? What are you hearing? How does CDW approach that question?

So I don't have a unit number for it. What I would tell you, there's good reason to believe that we'd expect to see a return to growth. Just a couple of things that I would note. And you noted it, through the pandemic, there was surging demand in that regard. PCs have become assets of innovation, right, work anywhere, learn anywhere. It's everywhere, if you will. A couple of data points that I think are interesting. One, if you look at the installed base out there, the installed base is aging, and many would say kind of the average installed base is 40 years or greater. That's number one. Number two, Device as a Service is growing and replacement cycles for Device as a Service is shorter than your typical refresh cycle. And then third, importantly, Windows 11. Windows 11 is coming along. The installed base is low penetration of Windows 11. So if you believe that, that's going to continue to grow, there are a lot of those units that are not upgradable, and therefore, you'd expect that upgrades will happen. So I think we're at this point where we may not see it immediately, but it simple. We're going to get back to you.

Okay. And the Windows 11 upgrade, is that -- we -- I feel like we used to talk about it as being somewhat PKO. Here comes the demand from that driver. Is it more elongated now and just maybe more of a consistent tailwind, would you say? Or is there a certain period where you'd say, okay, this is the time that we're going to see those types of refreshed come...

I think it's just -- it's inevitable. Ultimately, you're going to get there. You have to bring along the capabilities of those machines with software like Windows 11. So it's just a matter of time. And look, customers are figuring out how to extend a bit. There's a point though where you say, we're going to turn these over.

Right. Okay. So let's shift away from PCs, let's talk about kind of the enterprise infrastructure world. You've talked about demand in that part of the market being more resilient. What do you mean by that? What are you seeing? Can this business grow in 2023? Just help us understand, again, how enterprise infrastructure should look? Or have we looked at over the next 12 months?

So we've talked a lot about the mix shift in netted down, but just the non-netted down infrastructure is growing as well. So hybrid infrastructure, modernization of infrastructure, any technology that's really going to drive productivity, cost savings, allow the kind of digital transformation efforts to continue, there's demand there. There's growth there. That's where customers are still spending money. So we've seen it. That shows up in NetComm, in compute, in a lot of the infrastructure spend and good reason to believe that, that mix is going to continue.

Okay. So the term that's come up, I'd call it, in the last 3 months, maybe has been this term of optimization, optimizing spend, especially as it comes to cloud spending. So are you seeing any forms of rationalization in cloud spending from your customers? How does that impact spend with CDW, whether that's cloud or on-prem related, netted down related? Just -- is this a theme that is temporary, more structural? Help us break that down maybe.

Yes. First, I would say, cloud spend and focus on cloud continues to be significant and growth is significant. So that's a big driver for us for sure and broadly across the market. But some of the things that you just mentioned around optimization, to me, are part and parcel to behaviors of customers here, right? On all fronts, they're trying to be judicious about their spend. How do we optimize that? How do we stretch dollars? How do we get the most out of what we're doing? And I think that's showing up cloud spend now. But to be honest, a few years ago, the amount of cloud spend of these customers, it's increased significantly. And so now they're just looking at that and saying, how do we make the most of it. Candidly, that plays to our advantage. We're the trusted adviser to many of these customers. So when they think about how do they do that, they're coming to us and saying, help us to think about where should we spend it? How should we spend it? How do we kind of optimize it? So it's an important component of the market right now.

Okay. I'm going to ask you one question about this and one question only, which is supply chain. You're big. You're broad. Where are -- if any, are there still shortages? Where is their tightness? Where is their backlog? What's the outlook? When can we move kind of past that? I know we've passed a lot of it, but maybe not all of it. So just layout the land today.

I think you hit it. We're past a lot of it, not all of it. Solutions is where there's still friction, in particularly networking. So we still see extended lead times. The backlog is still there. We'll hold to the belief in 2023 and maybe a bit beyond that it will feather out, and we will get back to normal conditions, but we're not there yet.

Yes. Right. That would be great. Let's talk about public customers. I know we talked on Corporate and SMBs. There are still some large funding programs out there to support technology adoption. We talked last quarter about K-12 being a bit weak in the quarter. How do we think about the resilience of spend from public customers? How do we think a bit about the resilience of some of these funding programs? And we -- and I think we talked about them being paused in 4Q. Do they come back? Again, just help us distill the landscape from that perspective.

So let's start with K-12. I think what we experienced in fourth quarter was, they're still funding out there, and there's still phases left of the ECF funding, including through the end of this year. A lot of these school systems have been focused on digital equity and getting to optimal kind of student device ratio. I think that there was a realization during the period for some school systems that they're at or near that optimal level. So when they think about their need and ability to get to be eligible for funding, there was a re-rationalization. And so some of that spend got deferred, and in some cases, maybe that won't happen or it will happen on their school systems, if you will. So I think, for K-12, what we can expect is that, that funding that's still out there because it is still out there just will be dispersed more across the year as opposed to thinking that it would be a little bit more near term. Make no mistake though, we've seen these cycles before in K-12. If you go back to 2013 and '14, there were periods like this, and we do get back to demand. So that's our expectation there. More broadly, on government, there are plenty of programs that have been in place and will continue to move along funding programs that are out there. And so we feel good both in the Federal and the state and local area in terms of the different bills and funding mechanisms that should drive growth. There is an unevenness, right, in the Federal, we see a little bit of unevenness in spend and the timing, but there's healthy growth there.

Okay. Right. So something that I think has emerged that's really important, that's really exciting for you guys is, this netted down revenue grew 35% in 2022. Some of that inorganic from the Sirius acquisition, which we can get into. What are the underlying components in that netted down revenue that have been strongest? And how do we think about those same drivers from '22 continuing into 2023? Does that shift at all within the netted down revenue by year?

Sure. So let me just maybe remind folks on this topic. So the major categories of netted down include Software as a Service, software assurance, warranties and then agent commissions, if you will. And all of those are where we are not acting as the obligor in the transactions but acting as the agent. So essentially, there's customer spend, but basically, what we record as our net sales is the same thing as gross profit. Therefore, they come in 100% gross margin items as we like to call them. The underlying themes or drivers behind those categories are things like cloud, software and security. So as you can imagine, some of the growth there is driven by the fact that there's been this kind of structural growth in those areas. And so if you believe that those areas, cloud, security, software will continue to grow, we think that there's tailwinds behind it. And that's what we've experienced, and we have good reason to believe that will continue.

Right. And should we -- when you say a good reason to believe that, that should continue, as we think 3 to 5 years out, should we think about netter down revenue 100% gross margin revenue? Should we think about that continuing to increase as a percentage of mix from a gross profit dollar perspective? Is this is a long-term trend, even if hardware is strong? Or is this more temporary in this and that it might reach 33%, but then revert back if hardware is really strong? Is it a structural trend that we should think of? Or it kind of ebbs and flows?

Well, first, let me just say, it's not a strategy, it's an outcome, right? So our strategy is to continue to take share, drive our capabilities and solutions and in services. And so with that, we would expect that there would be growth in those particular areas. It is -- the dollar amount of our netted down revenues is growing. It's grown faster than net sales. And if we look at customer spend, it's growing something like 10 points in our customer spend over 5 years. But in periods where we have higher mix in the client devices, that's going to get -- it's going to get diluted, right? So we'll have periods where it's up or down, but we would expect that dollar customer spend and the dollar amount that shows up in a gross profit, hopefully will grow.

Okay. Perfect. So we touched a lot about demand. I want to get to kind of the margin and the cost side. You're the CFO, and so let's talk numbers. It's something that was really exciting in 2022, record company gross margins, 19.7% gross margin. Clearly, again, the mix shift helped you guys in terms of mix to netted down revenue. But you can kind of do the math and say, actually, this non-netted down part of your business, the more hardware-centric part of your business actually saw gross margin expansion as well in the year. What was that from? Why did you see such, let's call it, fairly significant gross margin expansion in that business in 2022?

Sure. A couple of things. So first, just non-netted down hardware, things driven by like hybrid infrastructure, right, where a customer wants to keep a component on-prem, if you will. That business has grown. And even in the fourth quarter, as we saw client device paid a bit, right, continue to see investments in modernizing infrastructure in that regard. That's number one. Number two is services. Obviously, we've put a lot -- invested a lot organically and inorganically in services, and that mix of our business and services has grown and comes with a higher margin. And then the third part, both in client device and in other non-in client device hardware, product margins have been firm, right? And some of this supply oriented, that is customers have been favoring speed versus price and so that's firm the margin. So when you add those 3 components up, they are big drivers of our margin overall. That third piece, and I think I've mentioned this, that could moderate a bit as time goes as supply starts to be more formally and more fully ease, you could see customers favoring that are pushing more on price and margin in lieu of speed.

Okay. All right. And so I promise you I'd come back to this topic. I want to come back, which is the Sirius acquisition. We're now more than a year beyond it. Can you do a bit of a postmortem, look back and say, how and why was that acquisition successful for CDW? And kind of how do you plan to leverage the insights that you've gleaned from that to guide your future M&A strategy?

Sure. Sirius was a big shift to us in terms of the size of the acquisition. Our typical filters on acquisitions, obviously, financial. Obviously, we look hard at culture -- I think hard about culture, operations and then making sure it's a strategic fit. Sirius check the boxes on all of those things and the cultural one really important. We knew this area folks well before the acquisition. So we knew what the folks would be doing business with, if you will. And that -- it's really been a great match in that regard. The strategic mix and the fact that Sirius really fit with our strategy, particularly on the solutions and services front, has really made the difference. And it's made the difference in terms of our go-to-market and how we show up. It obviously made the difference from a financial perspective. When we announced the deal and we said, here's what we would expect from a gross margin accretion and EPS accretion, right? It was significant, and that's really played out. And I'd say, even more so than we would have anticipated. So it's been a win for many angles and just feel like the organizations have meshed really nice. When we think forward, we are and we expect to be active on the M&A front, and we'll continue to look at various shapes and sizes of acquisitions. But I think the success of Sirius makes us think that the idea of doing something larger could make sense. Not now, per se, but in the future.

Okay. Perfect. Geographically, is there any appetite to expand further outside of the U.S.? Again, this is a kind of 90-10 U.S. international business. You've had success in Canada. You've had success with the U.K. business. How do we think about international expansion? Is that a priority? Is there a need for that? Maybe unpackage that.

Yes. I don't think we have to. That business is doing quite well. If you look at 2022, they did fantastic, and they grew significantly. So we don't have to. We have done acquisitions in that space. Remember, Kelway for the U.K. and as well as Scaler for Canada. And both of those businesses as they've combined have expanded and grown further, including that we operate in 150 countries. So they've shown that they can expand the footprint without acquisitions. That being said, when we think about M&A, look, we're looking at ability to expand our capabilities. We're looking at our verticals and our channels and how do we get deeper and broader there, and then we look at region. And so certainly, if an opportunity presents itself in each of those areas and the valuation is right, we do it.

Okay. Perfect. So it kind of expanding upon this capital allocation conversation. You touched on it a bit, but you've been able to work down your leverage post the Sirius acquisition. You just tweak your target leverage to 2 to 3x from 2.5 to 3x. To be fair, historically, you've been in that 2 to 2.5x range, sometimes even below that. But again, does that somewhat speak to the flexibility that you want to have in your capital structure in terms of looking forward and the potential optionality you have from a cash perspective to say, "Hey, maybe I do want to do something serious." Like is that symboling that or help us maybe unpackage?

You hit on the right theme, it's flexibility. So I view our whole capital allocation paradigm as flexibility within a framework, right? And so if you go down the line of all of those priorities, each of them give clarity with respect to our goal, but give us flexibility. On the net leverage, just recall when we finance the Sirius transaction, it was our inaugural investment-grade debt raise. And so one of our goals/commitments is to maintain our investment-grade ratings. So to that end, that net leverage range is commensurate with investment grade. So I think of that range as allowing us to stay within the investment-grade arena, but also give us flexibility from a liquidity perspective.

Right. Okay. And I guess the other side of that is capital returns. You've upped your capital return expectations to 50% to 75% of free cash flow. Obviously, great to hear, great to see. At the same time, I'd say, you've been fairly consistent in returning more than 75% of cash to shareholders. I know you wanted to have some flexibility and some, let's call it , be opportunistic. But should we think of 50% to 75% is maybe a starting point? Or are there any other areas, again, besides leverage that we've talked about and now this where you'd want to utilize cash in this environment?

50% to 75% is our target range. And we're going to pivot where we need to. We think that gives us enough opportunity to operate within that, and then again, in constant with our net leverage range in that regard. But look, ultimately, we're going to do what's going to be best for our shareholders. So -- but it's important that we just laid down a construct that we can articulate and give clarity to.

Okay. And I should have asked you that -- I should have followed up on the M&A side, but are there any product or technology or distribution gaps that you see where you could leverage M&A today?

I feel like we've filled in kind of the boxes of our capabilities broadly, and the question is kind of depth and breadth, continue to kind of move that along. And so again, I gave you kind of the vectors that we think about on M&A perspective. So there's always improve -- opportunities to improve and go deeper or broader in any of the capabilities we speak to. At the end of the day, the way I would say it is, we want to make acquisitions that are at the front of the IT value chain curve and that's our focus. It's really kind of bringing more to our customers.

Okay. So I think in this environment, when there's a lot of macro crosscurrents that investors might -- and I'm guilty of this too, kind of not to the forest through the trees and maybe not think about the long-term opportunities that you might have. And so when you think about the long-term opportunities in front of you for CDW, what are kind of like the key initiatives today that you're investing in so that you can say 3 to 5 years down the line, hey, we invested in that today so that we are stronger, again, at this point in the future?

Yes. So broadly, again, I'll just go back to our strategy. It takes share, get deeper, deeper, deeper with our customers solutions and services, right? We want to be the trusted adviser to our customers. We want to be the first call, full IT life cycle, full stack, right? And so whatever it takes to be able to do that. And because we're close with our customers and we act as a trusted adviser, but we also have deep alliances with our partners. We see the tech coming down the pike. We also hear what we hear from customers in terms of business problems we're trying to solve. So ultimately, that's the intersection that we try to drive for.

Cool. And then I'm going to ask one final question. But before I get to that, just in terms of people, any changes to go to market? Again, post Sirius, everything is kind of the same. Integration is at what stage now? Help us understand that.

Yes. So I wouldn't say everything is the same. Our go-to-market is now fully fleshed out, and we're operating or executing with Sirius. So a lot has changed in the last 6 to 12 months on that front, It's going really well, and we're really pleased with that. And again, very pleased from a people perspective, but also the recognition and validation we're getting from customers, right? Because Sirius definitely was a services-led organization, and we're learning from each other. So it's going really well. The stage we're at this point is continuing to execute on things like technology, full real estate infrastructure, and we're on that path now just execution. That's all mapped out and design. It's a matter of executing but going really well.

Cool. So we have a few seconds, but I just want to give you the opportunity to close. Maybe help us understand what should be most excited about CDW? What is potentially most underappreciated about CDW today?

Yes. I mean, look, I could rattle off, and I think I have already rattle off a lot.

You got 30 minutes to do it.

External things that I can point to. At the end of the day, it really comes down to our coworkers. We feel like we have the right strategy. Our strategy has been enhanced by capabilities we've built. We've got significant size, scale and capabilities, but all of that, you need the coworkers to do it. And at the end of the day, kind of our coworkers, their character resilience to bring, that's what allows us to print the kind of results we have.

Cool. Well, we are out of time. Al, thank you so much for joining us.

Excellent. Thanks, Erik. Appreciate it.

Thank you.