2023-06-08 11:55:08 ET
Summary
- I recommend a hold rating due to mixed performance, with concerns over the Enterprise division as corporate IT spending budgets are cut.
- Positive aspects include an expanded installed base for Client Devices, strong demand in networking, and growing need for cybersecurity.
- Investors should be cautious due to risks associated with meeting revised revenue growth expectations and ongoing macroeconomic uncertainty.
Investment thesis
I shift my recommendation to a hold rating for CDW Corporation ( CDW ) given the mixed performance so far, as the positive and negative aspects of the recent performance cancel each other out. CDW's continued struggles in the Enterprise vertical are probably not news to the market, as management has already acknowledged this headwind in a previous announcement . However, the 1Q23 results gave me cause for cautious optimism; things aren't quite as dire as they first appear. The networking, cybersecurity, and client device recovery markets all show signs of continued strength or resilience. Importantly, management seems confident that 1Q23 will be the low point for FY23, and that sequential growth will resume thereafter. Altogether, my belief is that CDW should be able to tide through this decline in IT spending with moderated damage, as some of its portfolio of solutions are rather defensive in nature. Overall, it's been a bit of a rocky ride, and I'd wait for more convincing signs of improvement before putting money into the name.
Enterprise segment is the drag but might be recovering
My primary near-term concern for the company and the stock is the Enterprise division. Corporate IT spending budgets are being cut as a result of increased scrutiny, and this has a knock-on effect for CDW in terms of closing deals. However, it’s the knock-on impacts that worry me in the near-term. As a direct consequence of the decrease or postponement of deal flow, there will be more significant declines in Client Devices, Servers, and Storage, which will consequently have a negative effect on the revenues generated from Services offerings associated with those Hardware products. It is akin to a domino effect, where the impact could snowball to be much bigger-than-expected. In addition, the company witnessed an unprecedented decline in client device demand in Canada and the UK. The bright side is that management reported large commercial clients deferred but didn't cancel. This is a very distinctive point, as it meant that deals are simply being pushed out to a later date as companies seek to cut costs. If we take management's words at face value, this means that CDW will see periods of strong growth acceleration as its comps compare against these “trough periods”. In fact, management noted at the JP TMC conference that customer discussions are improving, which I interpret as a sign that Enterprises are gradually opening their wallets in light of the inevitable need for IT and digitization advancements.
Spots of positivity in the business
Certain aspects of the business provide reasons for optimism, suggesting that CDW possesses a resilient portfolio. One notable area is the expanded installed base for Client Devices, surpassing pre-pandemic levels. Despite the current market challenges, CDW can leverage this customer pool to drive growth. This growth will be propelled by the presence of a substantial installed base that is approximately 4–5 years old, the upcoming end-of-life of Windows 11 prompting upgrades, and an increased adoption of Client Devices in markets such as K-12 education, where device life cycles are relatively shorter. Additionally, the demand for networking remains strong, and management has indicated that they are experiencing a positive impact. This is attributed to many customers being unable to update or modernize their networks in recent years, creating a favorable tailwind for CDW. In addition, management has signaled a positive tailwind in the networking sector, and demand has remained strong. This is due to the fact that many consumers in recent years have been unable to modernize or upgrade their network infrastructure. I also believe that CDW will see an increase in distributed end-points as people gradually return to work and school, albeit in a hybrid format. As a result, this should prompt more capital investments for network infrastructure. Finally, the demand for cybersecurity continues to be strong, and I anticipate this upward trend to continue, as customers' concerns about cybersecurity will only grow in the increasingly digital and interconnected future.
Financials
If we take a very long-term view, say 10 years, I believe the odds are higher that growth will continue to be positive as the growth driver for CDW enjoys a strong secular trend. Looking over the past decade (before covid), the business has consistently grown at high single digits with occasional low-teens growth, and I expect this to continue in a normalized environment. This is also a business that has always generate positive free cash flow for the past decade. The strong FCF generation capability has allowed CDW to flex its leverage ratio in times of need, and be able to revert back to the normalized 2x range.
Valuation
I believe the market is pricing this asset at fair value as well, which further reinforces my hold rating. Assuming consensus view reflects the general market, CDW is expected to generate $1.5 billion in earnings in FY25. Where I differ with the market is that I do not expect CDW to continue trading above its average multiple of 16x as I do not see any justification as growth is only expected to revert back to historical high single digits level. Assuming multiples revert back to 16x, then the stock has about 5% upside from here, which makes it fairly valued.
Valuation
Risks
While the revised guidance appears less risky in comparison to previous revenue growth expectations, I would point out that this would also mean higher risk/expectation for CDW to meet in the coming quarters, which investors should keep in mind. The guidance implies a significant increase in revenue and profitability in 2H23, which poses some risk if the current macroeconomic uncertainty persists or worsens.
Conclusion
In conclusion, I recommend a hold rating for CDW due to the mixed performance and the presence of both positive and negative factors. The Enterprise division remains a concern, as corporate IT spending budgets are being cut, impacting CDW's deal closures. However, there are positive signs, such as the expanded installed base for Client Devices, strong demand in networking, and the growing need for cybersecurity. CDW's defensive portfolio and potential for recovery in the Enterprise segment provide reasons for cautious optimism. Nonetheless, I would wait for more convincing signs of improvement before making any investment decisions, especially considering the risks associated with meeting revised revenue growth expectations and ongoing macroeconomic uncertainty.
For further details see:
CDW Corporation: Mixed Results Warrants A Hold Rating