Summary
- CDW missed revenue expectations by 11% in 4Q22 due to weak demand for PCs.
- I expect to see more long-lasting margin expansion in the future as a result of the shift toward solution sales.
- CDW plans to return 50-75% of free cash flow to shareholders.
Investment thesis
For 4Q22, I believe CDW Corp's (CDW) significant miss of estimates will be the biggest surprise. This, coupled with a downward guidance, was obviously not a welcome sight to investors. That being said, I don't think it's quite as dire as it seems. The distinction is the issue was not structural to CDW, rather it is an inevitable PC downcycle that CDW has to face - which you could blame it as macro. Looking back, 4Q22 was the first time CDW missed revenue expectations by 11%, which reflects the difficult macro backdrop that is leading to greater spending uncertainty among CDW's customer base. As I explain below, 4Q22's high gross margin is a "optical illusion" and is not sustainable, at least not today. However, I do believe CDW will reach such level as higher margin business becomes a larger part of revenue.
For FY23, CDW appears to have set a conservative bar by guiding for flat IT market growth, and I appreciate management plans to boost capital returns and have more balance sheet leeway for M&A to enhance growth.
Earnings results
Revenue for 4Q22 fell short of Consensus projections by 12%, with the shortfall being widespread across business segments but almost entirely attributable to the client device division. However, gross margin of 21.7% was an all-time high and beat Consensus estimates, thanks to the improved services margins and higher netted down revenue mix. Plus, thanks to careful management of expenses, operating income came in higher than anticipated. CDW guided FY23 revenue growth of 2-4% excluding FX impact, which was lower than the consensus estimate of 5%, and operating margins in the mid- to high-8% range, which was higher than the prior year's target of low 8% range.
Weakening demand
CDW observed a rise in the scrutiny of IT spend for project approval in 4Q22, which slowed down or delayed some projects like re-architecting more complex hybrid cloud workloads. This seems consistent with what I've heard about the IT and software industries as a whole, where deployments and rollouts are being delayed so that businesses can better manage their cash flow. While not everything is created equal, CDW's solution business did better than expected. A major reason for the revenue shortfall in the fourth quarter was weak demand for PCs. When you consider how much demand was pulled forward due to COVID, you can see why I think this PC demand downcycle was inevitable all along. Replacement cycle elongation, deal downsizing, and layoffs have all contributed to lower PC demand, especially in the SMB end market. Even in the elementary and secondary school sector, where the ratio of devices to students is at or above 1:1, CDW is seeing delayed spending on funding programs. On the other hand, the good news is that demand for traditional enterprise infrastructure held up better in the fourth quarter, but the bad news is that backlog is also decreasing on a sequential basis. My forecast for the IT market in FY23 is flat to slightly positive growth, continuing the pattern seen in 4Q22. This could be due to a weaker first half of the year followed by a stronger second half (to address today's postponed demands).
Gross margin
I believe CDW's fourth-quarter record gross margins of 21.7% were more of an optical thing than structural improvement. I believe this is due to the mix shift impact from higher product margins - PC demand plummeted and solution business with high GM grew into a bigger piece of the business. Gross margin should therefore normalize back to near high 19% and improve slightly as solution business improves in FY23, but it will not reach the levels seen in 4Q. As I mentioned before, however, the PC downcycle should limit revenue growth. Overall, I expect to see more long-lasting margin expansion as a result of this combination, which I think demonstrates CDW's robust model and ability to protect profitability despite challenges to broader demand trends.
Capital allocation
CDW has paused its share repurchase program for the past year so that the company's net leverage can fall back into its pre-acquisition range of 2x to 3x. A new $750 million buyback authorization has been announced, and management has stated their intent to return 50-75% of free cash flow to shareholders. Even though I think it's great that CDW is increasing its focus on shareholder returns, I think it's important to note that in the five years before its acquisition of Sirius, CDW returned roughly 100% of FCF to shareholders. I interpret this as management intent for other use of capital like M&A or further debt paydown.
Conclusion
CDW's investment shift toward solution sales and revenue shortfall offsetting helped the company maintain strong profits and earnings despite a decrease in spend in certain lower margin client device sales. As a whole, CDW's guidance confirmed my assumptions about a more subdued IT spending environment in the present macro, driven by increased customer scrutiny. Importantly, CDW's defensiveness as a large value-add reseller was also underscored by the company's earnings print and outlook.
For further details see:
CDW Corporation: Q4 Results Are Not As Dire As They Seem