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. First time, Al, welcome, CFO of CDW, Al Miralles, to the conference. Al joined in 2021. He was previously EVP and CFO at CNA Financial Corp. Awesome. Thank you for being here. Thank you for joining us first time at the TMT conference.
Yeah. Thank you, Erik. Thank you.
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. 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 favored tech, right? In this uncertain environment. It is an interesting environment right now. When scroll back to our outlook, our outlook for 2023 is for a flat-ish IT market. We expect to outperform by 200-300 basis points. What we've spoken to in last quarter was in this environment, we definitely are seeing elongated sales cycles, more prioritization of 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-
Mm-hmm
...drive productivity, and control costs. Some of that we've seen translate into lower spend on things like client devices.
Mm-hmm
where customers can mix out of that or defer some of those spends. What we're calling for is first half of the year, something similar like that, expectation that the second half would pick up.
Okay. Maybe, can you walk us through in the same kind of thought process, by kind of end market vertical in terms of where are you seeing strength? Where are you seeing some weakness? Where are there kind of crosscurrents that are changing relative to, I don't know, three or six months ago?
Yeah, sure. We do have a balanced portfolio and balanced end markets. The benefit of that is that we see diversification in markets like this. There's a counter cyclical component, with our public sector.
Right.
Right? 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.
Mm-hmm.
just shows up in a different way.
Righ, okay. You know, something that was interesting that I wanna double-click on because it's, there's more to it than what you just said. You, you talked about flat IT market growth, flat-ish, to be clear. You know, historically, you guys have talked about IT market spend outpacing GDP growth. You know, is flat-ish 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 flat-ish for the year.
Yeah. First, look, we look at a lot of data points. Obviously, we have a vast customer base, and we work with thousands and thousands of partners. Our views are based on conversation with those customers day-to-day with our sellers.
Mm-hmm.
Conversations with partners. We look at channel surveys, we look at Wall Street surveys, etc. We triangulate on all of those things. From that, we take a view of flattish. Look, it's an uncertain environment.
Mm-hmm.
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.
Yeah
Our typical is 200-300 basis points. That's what we came out with. If you scroll back to last year, that premium we would've expected would be higher. In the fourth quarter, we had a pretty drastic shift where demand for client devices came in. There was more of a focus on netted down revenues. With that, you do see some contraction of spend. Ultimately, customer spend may look broader or bigger than that.
Right.
That's how we see it.
Right. 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 200-300 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. Is the right way to think about CDW and the share gains or outperformance being, you know, 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 of thinking about it?
Yeah. You, 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 3.25-4.25 basis points. That contracted, and that was because there was a significant mix shift into those netted down revenues, and out of client device. In periods of higher client device mix in, you will see an expansion of that outperformance.
Okay. Something I wanna 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 the 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, you know, Medlar, what it used to be called. Are you seeing something opposite? Are you seeing a bit opposite of that dynamic in the market, or was there something in 4Q that was just kind of unique and one-off for a small business that again, was isolated to a specific order or specific trend, not bigger picture, maybe?
Look, in the fourth quarter, both of those, segments performed well.
Mm-hmm.
If I just click on small has been resilient and has held up well.
Yeah.
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.
Mm-hmm.
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. For small, their performance looked less significant on the top line.
Right.
Their gross profit performance is really strong.
Got it, cool. Let's get this out of the way. You know, people like to ask about PCs when it comes to CDW. PC demand is notably challenged today. You know, we just came from hosting Dell, 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? Maybe if you could also touch on pricing. Pricing has been stronger than I think a lot of us expected.
Sure. Sure.
Why has that been?
Sure. Yeah. 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.
Mm-hmm.
That is mixing out of client devices.
Got it.
That's substantially, across channels. Second half of the year, you know, we would hope for a pickup, and you'd see some rebalancing out. There are reasons to believe that as you get further out, there is gonna be return to growth.
Mm-hmm.
on the PC side, just not in the near term.
Right. Okay. You know, maybe longer term, again, if the pre-COVID PC TAM was 260, the peak in 2021 was 340, you know, we're kinda getting back to that pre-COVID level today. 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 usurped 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 install base? What do you think? What are you hearing?
Sure.
How does CDW approach that question?
I don't have a unit number for you.
Yeah.
Um-
It's fine.
What I would tell you, there's good reason to believe that we'd expect to see a return to growth. Just a couple things that I would note, and you noted it, through the pandemic, there was surging demand in that regard.
Mm-hmm.
PCs have become assets of innovation.
Mm-hmm.
Right? Work anywhere, learn anywhere. It's, it's everywhere, if you will. A couple 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 install base is four years or greater.
Mm-hmm.
That's number one. number two, Device as a Service is growing.
Mm-hmm.
Replacement cycles for Device as a Service is shorter than your typical refresh cycles.
Okay.
Third importantly, Windows 11, Windows 11 is coming along. The installed base is low penetration of Windows 11. 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. I think we're at this point where we may not see it immediately, but at some point, we're gonna get back to growth.
Okay. Win 11, the Win 11 upgrades, is that, you know, I feel like we used to talk about it as being somewhat peaky. Oh, you know, 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 gonna see those types of refresh from?
I think it's just. It's inevitable.
Right. Okay.
Ultimately, you're gonna get there. You have to bring along, bring along the capabilities of those machines, with software like Windows 11, so it's just a matter of time. Look, customers are figuring out how to extend a bit. There's a point, though, where you say, "We're gonna have to turn these over.
Got it. Okay. Let's shift away from PCs. Let's talk about kinda 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 be looked at over the next 12 months.
We've talked a lot about the mix shift-
Yeah.
-in netted down, but just the non-netted down, infrastructure's growing as well. Hybrid infrastructure, modernization of infrastructure, any technology that's really gonna drive productivity, cost savings.
Mm-hmm.
allow the kinda digital transformation efforts to continue, there's demand there's growth there. That's where customers are still spending money. We've seen it. That shows up in NetComm.
Mm-hmm.
in compute
Mm-hmm.
in a lot of the infrastructure spend, and good reason to believe that that mix is gonna continue.
Okay. A term that's come up, I'd call it in the last three months maybe, has been this term of optimization, optimizing spend, especially as it comes to cloud spending. 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? Is this a theme that is temporary, more structural? Help us break that down maybe.
First, I would say cloud spend and focus on cloud continues to be significant and growth is significant.
Mm-hmm.
That's a big driver for us for sure, and broadly across the market. Some of the things that you just mentioned around optimization to me are part and parcel to behaviors of customers here.
Mm-hmm.
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? I think that's showing up in cloud spend now. Let's be honest, for a few years ago, the amount of cloud spend of these customers, it's increased significantly. 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 advisor 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 this?
Right.
It's an important component of the market right now.
Okay. I'm gonna ask you one question about this and one question only, which is supply chain. Well, you know, you're big, you're broad. Where are, if any, are there still shortages? Where is there tightness? Where are there backlogs? What's the outlook? When can we move kind of past that? I know we're past a lot of it, but maybe not all of it. Just lay of 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.
Mm-hmm.
... networking. 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-
Mm-hmm
... and we will get back to normal conditions, but we're not there yet.
Yeah. Right. That would be great. Let's talk about public customers. I know we talked on corporate and SMBs. You know, there are still some large funding programs out there to support technology adoption. We talked last quarter about K12 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? I think we talked about them being paused in 4Q. Do they come back? Again, just help us distill the landscape from that perspective.
let's start with K12.
Sure.
I think what we experienced in fourth quarter was there's 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. When they think about their need and ability to be eligible for funding, there was a re-rationalization.
Okay.
Some of that spend got deferred, and in some cases, maybe that won't happen, or it will happen in other school systems, if you will. I think for K12, what we can expect is that funding that's still out there, 'cause 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.
Mm-hmm
... in K12. If you go back to 2013, 2014, there were periods like this. We do get back to demand. That's our expectation there.
Okay.
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. 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?
Mm-hmm.
In Federal, we see a little bit of unevenness in spend and the timing, but there's healthy growth there.
Okay. Thanks. Something that I think has emerged that's really important, that's really exciting from 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 2022 continuing into 2023? Does that shift at all within the netted down revenue bucket?
Sure. Let me just maybe remind folks, on this topic. The major categories of netted down include software as a service, software assurance, warranties, and then, agent commissions, if you will. All of those are where we are not acting as the obligor in the transactions, but acting as the agent.
Mm-hmm.
Essentially, there's customer spend, but basically what we record as our net sales is the same thing as gross profit. Therefore, they come at 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. As you can imagine, some of the growth there is driven by the fact that there's been this kinda structural growth in those areas.
Yep.
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. When you say good reason to believe that that should continue, you know, as we think three to five years out, you know, should we think about netted 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 a long-term trend, even if hardware is strong? Is this more temporary in the sense 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 kinda ebbs and flows?
Well, first let me just say it's not a strategy, it's an outcome.
True.
Right? Our strategy is to continue to take share, drive our capabilities and solutions and in services. With that, we would expect that there'd be growth in those particular areas. It is the dollar amount of our netted down revenues is growing. It's growing faster than net sales.
Mm-hmm.
If we look at customer spend, it's grown something like 10 points in our customer spend over five years. In periods where we have higher mix in the client devices, it's gonna get diluted.
Okay.
Right? 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 our gross profits hopefully will grow.
Okay, perfect. We touched a lot about demand. I wanna get to kind of the margin and the cost side. You're the CFO, and, so, let's talk numbers. You know, something that was really exciting in 2022, record company gross margins, 19.7% gross margins. Clearly, again, the mix shift helped you guys in terms of mix to netted down revenue. 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 things. First, just non-netted down hardware, things driven by like hybrid infrastructure.
Mm-hmm
Right ? Where a customer wants to keep a component on-prem, if you will. That business has grown. Even in the fourth quarter, as we saw client device fade a bit, right? Continue to see investments in modernizing infrastructure in that regard. That's number one. Number two is services. Obviously, we've invested a lot organically and inorganically in services, and that mix of our business and services has grown and comes with a higher margin.
Mm-hmm.
The third part, both in client device, and in other non-client device, hardware, product margins have been firm, right?
Mm-hmm.
Some of this supply-oriented, that is, customers, have been favoring speed versus price, and so that's from the margin. When you add those three components up, they're big drivers of our margin overall.
Okay.
That third piece, and I think I've mentioned this, you know, that could moderate a bit.
Okay
As time goes, as supply starts to more formally and more fully ease, you could see customers, favoring that or pushing more on price and margin in lieu of speed.
Okay. All right. I promised you I'd come back to this topic. I wanna come back, which is the Sirius acquisition. We're now more than a year beyond it. Can you do a bit of a post-mortem look back and say, you know, how and why was that acquisition successful for CDW? Kinda, 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 for us in terms of the size of the acquisition.
Mm-hmm.
Our typical filters on acquisitions, obviously financial, obviously we look hard at culture, think hard about culture, operations, making sure it's a strategic fit. Sirius checked the boxes on all of those things, the cultural one, really important. We knew the Sirius folks well before the acquisition, we knew what the folks we'd be doing business with, if you will, 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. It's made the difference in terms of our go-to-market and how we show up, 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, an EPS accretion," right, it was significant, and that's really played out, and I'd say even more so than we would have anticipated. It's been a win from many angles, and just feel like the organizations have meshed really nicely.
Good. Good.
When we think forward, you know, we are and can expect to be active on the M&A front.
Mm-hmm.
We'll continue to look at various shapes and sizes of acquisitions. I think the success of Sirius makes us think that the idea of doing something larger could make sense.
Mm-hmm.
Not now, per se.
Yep
... but in the future.
Right. Okay, perfect. Geographically, is there any appetite to expand further outside of the U.S.? Again, this is a kinda 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.
Yeah. I don't think we have to.
Mm-hmm.
That business is doing quite well. If you look at 2022, they did fantastic, and they grew significantly. We don't have to. We have done acquisitions in that space, remember Kelway?
Mm-hmm
... For the U.K., and, as well as Scalar for Canada. Both of those business as they've combined, have expanded and grown further, including that we operate in 150 countries.
Mm-hmm.
They've shown that they can expand the footprint without acquisition. 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, we look at regions. you know, certainly if an opportunity presents itself in each of those areas.
Mm-hmm
... and the valuation's right, we do it.
Okay, perfect. 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 tweaked your target leverage to 2-3 x from 2.5-3 x. To be fair, historically, you've been in that 2-2.5 x range, sometimes even below that. Again, does that somewhat speak to the flexibility that you wanna 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 symbolizing that or, help us maybe unpackage?
You hit on the right theme, it's flexibility.
Yeah.
I view our whole capital allocation, paradigm is flexibility within a framework.
Mm-hmm.
Right? If you go down the line of all of those priorities, each of them, give clarity with respect to our goal.
Mm-hmm
but give us flexibility.
Yeah.
On, on the net leverage, just recall when we financed the Sirius transaction, it was our inaugural investment grade debt raise.
Mm-hmm.
You know, one of our goals, commitments is to maintain our investment grade rating. To that end, that net leverage range is commensurate with investment grade. I think of that range as allowing us to stay within the investment grade arena.
Mm-hmm
...but also give us flexibility from a liquidity perspective.
Right. Okay. I guess the other side of that is capital returns. You've upped your capital return expectations to 50%-75% of free cash flow. Obviously, great to hear, great to see. You know, at the same time, I'd say you've been fairly consistent in returning more than 75% of cash to shareholders. I know you wanna have some flexibility and some, what's called, be opportunistic, should we think of 50%-75% as maybe a starting point, or are there any other areas, again, besides leverage that we've talked about, and now this, where you'd wanna utilize cash in this environment?
50%-75% is our target range.
Okay.
We're gonna pivot where we need to. We think that gives us enough opportunity to operate within that, and then again in concert with our net leverage range in that regard. Look, ultimately, we're gonna do what's gonna be best for our shareholders.
Mm-hmm.
But it's important that we just lay down a construct that we, can articulate and give clarity to.
Okay. I should have asked you this. I should have followed up on the M&A side, 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, the question is kinda depth and breadth, continue to.
Mm-hmm
...move that along.
Okay.
Again, I gave you kind of the vectors that we think about on M&A perspective. There's always 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 wanna make acquisitions that are at the front of the IT value chain for us.
Okay.
That's our focus. It's really kind of bringing more to our customers.
I think in this environment when there's a lot of macro crosscurrents that investors might, you know, and I'm guilty of this too, kind of not see the forest through the trees and maybe not think about the long-term opportunities that you might have. When you think about the long-term opportunities in front of you for CDW, what are kinda like the key initiatives today that you're investing in so that you can say three to five years down the line, "Hey, we invested in that today so that we are stronger," you know, again, at this point in the future?
Yeah. Broadly, again, I just go back to our strategy. It's take share, get deeper with our customers, solutions and services, right? We wanna be the trusted advisor to our customers. We wanna be the first call. Full IT life cycle, full stack.
Mm-hmm.
Right? Whatever it takes to be able to do that. Because we're close with our customers and we act as a trusted advisor, 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. Ultimately, that's the intersection that we try to strive for.
Cool. I wanna 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.
Yeah. I wouldn't say everything's the same. Our go-to-market is now fully, you know, fully fleshed out and we're operating, we're executing.
Mm-hmm
...with Sirius. A lot has changed in the last six-12 months.
Mm-hmm
...on that front. It's going really well, and we're really pleased with that. Again, very pleased from a people perspective, but also the recognition and validation we're getting from customers, right?
Good.
Because Sirius definitely was a services-led organization.
Mm-hmm.
We're learning from each other.
Right.
It's going really well. The stage we're at this point is continuing to execute on things like technology, you know, full real estate infrastructure, we're on that path now of just execution. It's all mapped out. In design, it's a matter of executing, going really well.
Cool. We have a few seconds, I just wanna 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?
Yeah. I mean, look, I could rattle off, and I think I have already rattled off a lot.
You've 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.
Mm-hmm.
We feel like we have the right strategy. Our strategy's been enhanced by all the capabilities we've built. We've got significant size, scale and capabilities. All of that, you need the coworkers to do it.
Right.
At the end of the day, kind of our coworkers, their character, resilience they bring, that's what allows us to print the kind of result.