CDW Corporation
Q3 2015 Earnings Call Transcript

Published: 4 Nov 2015

[Operator:]

Good day, ladies and gentlemen, and welcome to the CDW Third Quarter Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. As a reminder, this conference call is being recorded. I would now like to turn the conference over to Tom Richards, Chairman and Chief Executive Officer. Please begin.

[Thomas E. Richards:]

Thank you. Good morning, everyone. It's a pleasure to be with you to report CDW's third quarter 2015 results. Joining me in the room are Ann Ziegler, our Chief Financial Officer; Chris Leahy, our General Counsel; and Sari Macrie, our VP, Investor Relations. I'll begin with a high-level review of our performance and strategic progress. Ann will take you through a more detailed review of the financials, and then we'll go right to your questions. But before we begin, Sari will present the company's Safe Harbor disclosure statement.

[Sari L. Macrie:]

Thank you, Tom. Good morning, everyone. Our third quarter 2015 earnings release was distributed this morning and is available on our website, www.investor.cdw.com, along with supplemental slides that you can use to follow along with us during this 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 risks and uncertainties that could cause actual results to differ materially. Additional information concerning this risks and uncertainties is contained in the 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 earnings per share. All non-GAAP measures have been reconciled to the most directly comparable GAAP measures in accordance with SEC rules. You will find reconciliation chart in the slides for today's webcast, as well as in our press release and the Form 8-K we furnished to the SEC today. Please note that all references to growth rates or dollar amount increases in our remarks today are versus the comparable period in 2014 unless otherwise indicated. The number of selling days for the third quarter are the same in both 2015 and 2014, so there is no difference in growth rates for average daily sales and reported sales. A replay of this webcast will be posted to our website by this time tomorrow. 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. So with that, let me turn the call back to Tom.

[Thomas E. Richards:]

Thanks, Sari. I'm pleased to report that once again CDW delivered profitable growth. Net sales were up 7.2% with excellent profitability. Our adjusted EBITDA grew at more than twice our top line, up 16.3%, and non-GAAP earnings per share increased 30.8%. On a constant currency organic basis, which excludes Kelway results, net sales increased 3.6%. Our ability to deliver this profitable growth was the result of three key drivers

[Ann E. Ziegler:]

Thanks, Tom. Good morning, everyone. As Tom indicated, our third quarter financial results reflect the combined power of our balanced portfolio of channels, our breadth of product offerings, particularly our ability to bring innovative emerging technologies to our customers and our focus on profitable growth. Our results also reflect the progress we are making against our financial strategy to drive strong cash flow, deliver double digit earnings growth and return cash to our shareholders. Let me begin with our P&L. In case you have access to the slides posted online, it will be helpful to follow along. I am on slide 8. Consolidated top line growth was strong this quarter with net sales of $3.5 billion, 7.2% higher than last year on both a reported and average daily sales basis including two months of Kelway. Average daily sales were $54.7 million. While sales in Canadian dollars remain a relatively small portion of our total revenue, less than 5%, the strengthening U.S. dollar continued to depress organic net sales. Currency shaved approximately 60 basis points off of organic growth in the quarter, 40 basis points more than last year and 10 basis points higher than last quarter. On a constant currency basis, organic sales were 3.6% higher than last year. On an organic average daily sales basis, sequential sales were up 1.5% versus Q2 2015, which is below recent Q3 seasonality. As you remember, Q2 was well above recent normal seasonality, up 18.4% sequentially. Gross profit for the quarter increased 11.8% to $567.2 million. Gross margin was 16.2%, up 10 basis points versus Q2. On a year-over-year basis, gross margin was up 70 basis points. Given its higher mix of solution and services, Kelway added approximately 10 basis points to gross margin. More than half of the total gross margin improvement reflects the combined impact of a higher mix of revenues recorded at 100% gross margin such as our net service contract revenue and higher partner funding. Consolidated reported SG&A, including advertising expense was $362.6 million, up 12.4%. Consolidated adjusted SG&A including advertising was $287.4 million, an increase of 8.1%. This reflected the impact of consolidating two months of incremental Kelway expenses, increased sales payroll consistent with the growth in solution related sales and higher gross profits as well as increased advertising expense, which was 10.6% above last year as we continue to invest in the business. As a reminder, Kelway sales compensation as a percentage of sale runs higher than our North American operations given their higher mix of solutions and services revenue. We ended the quarter with approximately 7,300 North American coworkers, up roughly 75 coworkers since the end of 2014. Consolidated coworkers including Kelway were approximately 8,300, up over 1,000 since the third quarter of 2014. As you can see on the next slide, slide 9, adjusted SG&A for the quarter excludes $7.8 million of non-cash equity compensation, $7 million of acquisition and integration costs and $2 million of historical retention cost and other expenses. Our non-cash equity compensation increased year-over-year primarily due to ongoing annual long-term performance awards granted in Q1 and incremental Kelway awards. To make it easier to calculate our adjusted EBITDA, which is essentially our gross profit less adjusted SG&A expenses, we also adjust for depreciation and amortization. We retained a significant portion of this quarter's gross profit improvement and converted top line growth of just over 7% to adjusted EBITDA growth of 16.3% to $282.1 million. This translates to an adjusted EBITDA margin of 8.1%, up 70 basis points over last year. Let's look at the rest of the P&L. On slide 10, interest expense was 23.2% lower than last year at $38.5 million reflecting reductions driven by retainment and refinancing activities completed in 2014 and Q1 of this year. Our effective tax rate was 38.7% versus 37.9% in Q3 2014. On a GAAP basis, we earned $150.9 million of net income. Our non-GAAP net income which better reflects our operating performance was $143.2 million in the quarter, up 29.3% over last year. As you can see on slide 11, non-GAAP net income reflects after tax add backs in four general buckets

[Operator:]

Thank you. And the first question is from Sherri Scribner of Deutsche Bank. Your line is open.

[Sherri A. Scribner:]

Hi. Thank you. Tom, you mentioned some additional costs related to ramping the Dell business. Can you give us some sense of how much additional cost that will add to the operating expenses? And how do you expect that to ramp through 2016?

[Thomas E. Richards:]

Well, good morning, Sherri. First of all, thank you. Yeah, we're not going to be that specific truthfully because it would be hard to be precise and I don't want to lead you down a bad path. I would tell you that there's going to be a meaningful addition of coworkers and let me just give you the categories. So you got coworkers, you have marketing investment, you've got systems, all of those kind of things. But I will say that despite all of that, we obviously think the upside is pretty meaningful as I said. And we plan to deliver consistent with the targets we've said to people about adjusted EBITDA, so you should not expect to be what I'll call an aggregate negative relative to the targets we talked about for profitability.

[Sherri A. Scribner:]

Okay. That makes sense. And then thinking about the Education segment, you mentioned sort of a stall in eRates and not everyone has been approved yet. Would you expect that to resolve itself in 2016? I know it's a bit early, but trying to get a...

[Thomas E. Richards:]

Well, I hope so, Sherri, I hope so. When I think about the length of this process and all of the work that's gone into winning many of those awards, if you will, from a CDW perspective and the time invested, I think it's going to be a function of not only when they finally get what I'll call completed, but then when we have the window of opportunity to implement the solutions in the school districts, I think that will be probably the biggest gauge.

[Sherri A. Scribner:]

Thank you.

[Thomas E. Richards:]

All right. Thanks, Sherri.

[Operator:]

Thank you. And the next question is from Brian Alexander of Raymond James. Your line is open.

[Brian G. Alexander:]

Thanks and good morning. On the Dell contribution, Tom, it sounds like this might only impact 2016 revenue by about $200 million for some of the reasons you talked about. How big has Dell been for CDW in the past in terms of total revenue with federal and Wyse, et cetera? And is there any reason why CDW wouldn't represent a similar market share of Dell as it does for other large vendors like HP or Cisco? Because I think if that happens, this could be more than a $1 billion opportunity over time for CDW and I think Michael Dell actually stated publicly that CDW could be billions of dollars to Dell. So maybe just talk about the longer term opportunity. Thanks.

[Thomas E. Richards:]

Hey, Brian. First of all, good morning and second of all, I hope I answer all of those sub-questions that are in there. So I know you'll call me on it if I don't. So let me start down the path and say we do think – obviously, let me start with the big picture. I think it's reasonable to assume over some period of time and I don't know that I can tell you, Brian, exactly when that is when we'll be at full production and it's reasonable to assume that for a large partner that we could take a meaningful part of their channel revenue. So I think all of those are fair assumptions. Your math is the same as ours relative to what 150 basis points will probably mean to us next year. But I can tell you that the business we did have with Dell which really was a couple federal contracts and SKUs on SonicWALL and Wyse was in the $120 million, $130 million, $140 million, $150 million kind of range. So that'll give you one of the reasons why it's not a total incremental lift when you're thinking about next year, which is some of the early press, I think people didn't appreciate that and they were running to these numbers that didn't really understand that obviously you knew a little bit about that. I don't know, did I answer most of those questions? If I missed one, go ahead and ask it again.

[Brian G. Alexander:]

Just longer term, can this be a business that you think is in excess of $1 billion? I know it's going to take time, but trying to think longer term.

[Thomas E. Richards:]

Yeah, it is. Well, it depends on how long long-term is for me on this question. But as you know, we have some other large partners that are $1 billion. I love the fact that Michael is so excited about CDW and the prospects. But I'd be really hesitant to say, yep, I see it being $1 billion by some timeframe, because there's just so many things. Let me just – suffice it to say, we did it with the expectation that it's going to help us meet a set of customers' needs that we've not been able to address in the past and we think it's going to have a meaningful impact on CDW.

[Brian G. Alexander:]

And then just as a follow-up on Kelway, if I look at their productivity, revenue per employee is about $900,000 per year. And I think CDW has been basically 2X that. So how is it that Kelway's operating margin profile is comparable to CDW, given that gap in revenue per employee? Is that just the richer mix of offerings that they have? Or what else would explain that?

[Thomas E. Richards:]

Bingo. It is they have a much higher – not much higher, they have a higher mix of solutions, which trickles itself all the way down through the business from a profitability perspective and that drives the bottom line number you alluded to. So you're right on target.

[Brian G. Alexander:]

Okay. All right, thanks.

[Thomas E. Richards:]

All right. Thanks, Brian.

[Operator:]

Thank you. And the next question is from Matt Sheerin of Stifel. Your line is open.

[Matt J. Sheerin:]

Yes. Thanks and good morning. A question just regarding your comment on the education market, I appreciate why, obviously, the revenue is down year-over-year for the reasons you stated. But on the issue of lower sales due to Chromebook and ASP declines there, can you quantify what the gap was there in terms of lost revenue or revenue opportunities that you walked away from? And as you go forward, is that the new normal where you're being more selective on lower margin, lower returns type of products?

[Thomas E. Richards:]

Well, Matt, I would say it's not the new normal. It is the normal for CDW to – if you think about, we've talked about how people are focused here and profitable growth has always been the guide, so to speak. So I think it's normal. If you think about what happens when you see a market and the ASPs drop in the meaningful way they did, and the margin comes out of it, that doesn't mean you're never going to go after that kind of business. There may be strategic reasons. But as a general course, it's just not worth it to chase those kind of deals for the sheer purpose of revenue and that's not the way we focus on CDW. Now, going forward, I think you are always going to be looking at ways to cut the cost so that you can find ways to make those kinds of sales and do it in a profitable way. And I think as we have always done in the past, we will continue to look for those. But we're just not going to be in it for the revenue chase, would be the way I would ask you to think about it.

[Matt J. Sheerin:]

Got it. Okay. And then just another question on Dell, if I can. It looks like Kelway has had a pretty good relationship with Dell there and if you could comment on that. And then also you looked at – you're talking about incremental revenue opportunities next year. But my question is, are you looking at any potential share shifts against your existing vendor base and how are those conversations playing out in terms of your relationship with your top vendors and top competitors for Dell?

[Thomas E. Richards:]

All right. So it's another one of those multiple question questions. So let me see. I can comment on your first question which I think was the relationship between Dell and Kelway. It's been a good relationship, very productive. And I think it's a great example of how when Dell is in the lineup with other ones, they have great relationships with the other partners. It's all about focusing on the customer. So I would say that one of the things that we did here when we thought about this was and the sales guys weren't necessarily in love with this, but we added incremental targets to people's book, so to speak, so that you wouldn't have people just doing share shift to make numbers, and I think we've shared that with everybody. I think the second thing we did, Matt, was we were very transparent with people, we talked to people, we explained the fact that this was driven by the number of times where a customer may have standardized on two different technologies, and we have to walk away from half the business. And that's not consistent with CDW. So I think on the whole and on the average, people were – appreciated our transparency. They appreciated the fact that we added the incremental goaling (43

[Matt J. Sheerin:]

Okay. Fair enough. Thanks a lot, Tom.

[Thomas E. Richards:]

All right. Thanks, Matt.

[Operator:]

Thank you. The next question is from Amit Daryanani of RBC Capital Markets. Your line is open.

[Amit Daryanani:]

Thanks a lot. Good morning, guys. I will start not with a Dell question. Could you talk about what happened with your ARs in the quarter? It was up about $150 million. It seems like a big uptick versus what we've seen seasonally in the past. So was it just a more back-end loaded quarter? Could you maybe walk through what happened there?

[Ann E. Ziegler:]

Yeah, the thing you have to be careful about when you look at the components of our cash conversion cycle as opposed to the actual cash conversion cycle or working capital in total. One of the other things I mentioned was the impact of net service contract revenue on our gross margin. When we do things that are netted down, so to speak, and we go through this in our 10-Q, the revenues for AR are in many cases gross because we're collecting the gross amount for the customer, even though we're only recognizing the netted down amount in our GAAP revenues. So as you mix in to items that net down, it has a negative impact on your accounts receivable. It has a positive impact on your DPO. So those two things tend to offset. So if you look at the entire working capital or cash conversion cycle, it nets out. But if you look at individual components, it distorts the individual components.

[Amit Daryanani:]

Got it. That's helpful. And then if I just get back to the Dell question as well, basically the way you guys are describing this, should we think that maybe the near term for 2016 you could see some sort of margin headwind because you add a lot of expenses but the revenues don't show up, and then over time it normalizes? Is that the right way to think about it? And then sort of Brian's take on this could be a $1 billion business over time. If it becomes that, do you think it's going to be all organic? Or would there be some cannibalization away from your other larger vendors potentially?

[Thomas E. Richards:]

Let me answer the first question. Look, I kind of reinforce the notion is we don't anticipate not meeting the targets you guys have heard from us from an adjusted EBITDA perspective. So that would suggest that we think the growth that we'll get both in revenue and profitability will offset the investment as we move forward. And the second thing, look, I mean I said we're doing this because we think it's a growth catalyst for CDW that's driven around customers. I think it can be a meaningful part of the business. And we've tried to structure it so that there isn't cannibalization. Now, does this suggest that may never happen? Look, I'm not going to be that prescriptive and naïve. But I do believe that we've done this in a way that it should be focused on additional growth to CDW.

[Amit Daryanani:]

Perfect. Thank you, guys.

[Operator:]

Thank you. The next question is from Osten Bernardez of Cross Research. Your line is open.

[Osten H. Bernardez:]

Hi, yes. Good morning. Thanks for taking my questions. I just had a question with respect to the cadence of OpEx as we consider the addition of Dell. And I understand that you – the intention is to meet your stated goals for the year of looking into 2016, but I guess should we – how long do you think it would take for you to meet that goal? Will there be, I'm assuming there will be some startup costs associated with adding Dell on as a partner?

[Ann E. Ziegler:]

I did say in my comments that we do expect SG&A to grow more rapidly than revenues in Q4. So you'll see that in Q4. Remember, our medium term targets, as we start thinking about 2016, our medium term targets are annual targets, and we have from time to time a little bit of lumpiness in the quarter in terms of SG&A. Remember, in particular, Q1. Q1 declined on a revenue basis in general sequentially from Q4, right? And we carry the SG&A over. So you generally see SG&A being a higher percentage in Q1, and then that tends to normalize as you move sequentially through the year. And so again, there's no change to our medium term targets, and beyond Q4 of this year, I don't think we're pointing to any material change to the trends in the business in terms of how SG&A flows through.

[Osten H. Bernardez:]

Got it. And then secondly, when I look at the business and how you were able to grow your solution sales much rapidly than your transactional business for the quarter, how do we think about, or how are you thinking about the mix of that business as you look ahead? Are you in a place where you believe you can better predict where solution sales will end up on a relative basis looking into 2016?

[Thomas E. Richards:]

No, I think a lot of it starts with what's important to customers and what customers feel like they need to get addressed. Some of what you're seeing this year is a function of the focus they had on client devices and transactional products last year. I think we actually talked about the way to think about this. They have budgets and when they have priorities that drive a spend, like last year it was a lot of the client refresh, then solution projects get pushed out, and then when you get a new year, you have the ability to have, what I'll call, the balance. We love the balance we have in our business between transaction and solution products. It gives us the ability to constantly be in the mode of helping customers, and as you heard me say in my formal comments, we're in the 52% – 48% perfect balance. And as we think about going forward next year, we've continued to invest in our solutions business as you've heard me talk about, whether it's in the term of coworkers, in the term of the ECC that I mentioned. And so we would continue to expect to see our solutions business growing at a good clip going forward.

[Osten H. Bernardez:]

Thank you.

[Thomas E. Richards:]

Okay.

[Operator:]

Thank you. The next question is from Katy Huberty of Morgan Stanley. Your line is open.

[Kathryn Lynn Huberty:]

Yeah. Thanks. Good morning. If you achieved your target of growing 200 basis points to 300 basis points above market, it suggests the market was flattish in the third quarter, so I just wonder how that impacts your view of market growth going into the fourth quarter and next year?

[Thomas E. Richards:]

Yeah. Well, first, Katy, first of all good morning. Second, that's in the annual number that we try to benchmark on, the 200 basis points to 300 basis points, it does jump around, obviously. As you know, there are all kind of mixed signals going on right now about the economy and on one hand you read the facts about GDP was readjusted to what, like 1% or something in the quarter, and then I saw a survey by CIOs that said they had back end funding available. So we're just going on the operating assumption that it's going to be the kind of same kind of growth into the last part of the year that we've seen to this part. Would I love it to be more? No one would be more happy than me. But I think from an assumption standpoint, the 2% to 3% – the 3% growth is about what we expect.

[Kathryn Lynn Huberty:]

Okay, got it. And then over the last month a number of companies, Rackspace, Teradata, HP, Oracle capitulated and partnered with AWS. Any updated thoughts as to whether that could be a sales channel, Amazon, Microsoft Azure over time? Or is the opportunity still around consulting and helping companies transition to cloud with more of a direct relationship with the customer?

[Thomas E. Richards:]

No. We've got a really meaningful Azure practice today, and growing at a really exciting clip. So I think that is part of our strategy long-term. And while we don't have a formal relationship with AWS today, we have ways with other partners if that's something that's important to a customer, we can help them there. But I think your instincts are correct, as I alluded to the kind of growth numbers we're seeing in our cloud business, Katy, is very much driven by infrastructure-as-a-service and that is right along the lines of the Azure question that you asked.

[Kathryn Lynn Huberty:]

Great. Thank you.

[Thomas E. Richards:]

All right. Thanks, Katy.

[Operator:]

Thank you. And the next question is from Jayson Noland of Robert Baird. Your line is open.

[Jayson A. Noland:]

Okay, great. Thank you. Good morning. I wanted to ask on the hiring pause in North America, your Corporate numbers look good but you must have seen something in the quarter. Was it slippage or smaller deal sizes? What made you rein in hiring?

[Thomas E. Richards:]

No, it was a lumpy – my favorite economic term here, it was a lumpy quarter from a growth perspective and we saw in August it felt like a pause. And I don't know if it was just CDW or a bigger economic issue, and that's really, Jayson, what caused us to say, you know what? We've got existing capacity. This is not talking about Dell and Kelway and that. This is on a pure organic basis. So we're going to just hold where we are. But then we did see a nice comeback in September and dripping into October, so felt pretty good about turning on the faucet again, so to speak. And that's why I'm pretty optimistic we're going to be able to get close to that 100-plus customer-facing coworkers that I've challenged the sales executives to deliver.

[Jayson A. Noland:]

Okay. That sounds good and makes sense. And I wanted to follow up on the solutions business, so strong and more than offsetting some softness in transactions. But specifically the drivers there, it sounds like security and emerging storage were strong. Could you detail a little more what's going well in solutions and why it's expected to continue?

[Thomas E. Richards:]

Yeah. So if you think about – I'll talk about the high-level categories. So NetComm which was – had a really strong quarter and I think that is in part driven by security as people upgrade, what I'll call, the physical part of their security infrastructure. I think that had a lot to do with the NetComm growth. We continue to have good growth in servers and storage in the mid- to high-single digits. I think some of the server growth is by people as we had a program focused on the expiration of 2003 last year. I think when you're engaged in those kind of discussions, whether the customer makes a decision right then or you plant the seed for some future upgrade. We are seeing interestingly enough in the server space, a lot of people taking advantage of upgrading with options, whether it's adding hardware or memory. That helps drive some of that growth, which means that some of the software investment people made in virtualizing and creating an incremental capacity is now being consumed. So that's all kind of goodness. And in the storage space, the, what I'll call, emerging technology people whether it's flash or if you consider CI part of that, those have been great growth engines for us and I think suggest that customers are always on this track to look for more efficient ways to manage the exponential growth in data that just is the nature of the world we live in would be the areas I would say. I also don't want to miss the constant, double-digit growth in our services business, which is an important part of the solutions story. And that's been pretty a Steady Eddie double-digit growth business for us and that's an important part of why solutions has continued to grow.

[Jayson A. Noland:]

Thanks a lot, Tom.

[Thomas E. Richards:]

All right. Thanks, Jayson.

[Operator:]

Thank you. There are no further questions in the queue at this time. I'll turn the call back over for closing remarks.

[Thomas E. Richards:]

Okay. Thank you again to everybody for taking the time to be with us today, and for your interest in CDW. And I'll leave you with this thought. It's Thanksgiving time, so go hug a turkey, they need it. All right, thanks, everybody. See you.

[Operator:]

Thank you. Ladies and gentlemen, this concludes today's conference. You may now disconnect. Good day.