CDW Corporation

Hello and welcome to CDW fourth quarter 2022 earnings call. My name is Drew and I'll be your operator today. If you would like to ask a question during today's call, please press star followed by one on your telephone keypad. If you change your mind, please press star followed by two. I would now like to turn the call over to Steve O'Brien, Investor Relations. Please go ahead.

Thank you, Drew. Good morning, everyone. Joining me today to review our fourth quarter and full year 2022 results are Chris Leahy, our President and Chief Executive Officer and Chair, and Al Morales, our Chief Financial Officer. Our fourth quarter and full year earnings release was distributed this morning and is available on our website, investor.cdw.com, along with supplemental slides that you can use to follow along during the calls. 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 these risks and uncertainties is contained in the earnings release in 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 operating income, non-GAAP operating income margin, non-GAAP net income, and 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'll find reconciliation charts in the slides for today's webcast and in our earnings release in Form 8K we furnished to the SEC today. Please note all references to growth rates or dollar amount changes in our remarks today are versus the comparable period in 2021 unless otherwise indicated. Replay of this webcast will be posted to our website later today. I 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. With that, let me turn the call over to Chris.

Thank you, Steve. Good morning, everyone. I'll begin our call with an overview of our fourth quarter and full year performance and share some thoughts on our strategic progress and expectations for 2023. Then I'll hand it over to Al, who will take you through a more detailed review of the financials, as well as our capital allocation strategy and outlook. We will move quickly through our prepared remarks to ensure we have plenty of time for questions. Our fourth quarter was an excellent example of the power of our business model when coupled with our broad and deep portfolio of technology solutions. In an extraordinary period of shifting customer priorities, we delivered record profitability. For the quarter, net sales were $5.4 billion, $100 million below 2021, and roughly flat on a constant currency basis. Non-GAAP operating income was $523 million, 23% above last year. And non-GAAP net income per share was $2.50, up 21% year over year, up 22% on a constant currency basis. These results were driven by the team's ability to pivot to meet customer priorities and capture high relevance, high growth opportunities. This led to excellent performance across services, cloud, security, and software. Performance that drove record profitability, an exceptional outcome given market dynamics, and an outcome that is a direct result of the investments we have made in solutions and services over the past several years. Simply put, our ability to deliver outcomes across the full stack and full lifecycle of technology drove strong profit growth, notwithstanding a meaningful decline in client devices. This quarter clearly demonstrates the power of our strategy when combined with the resiliency of our business model. So what happened to client devices this quarter? While we expected some level of contraction in client devices and accessories given the past two years of heavy investment, The magnitude of the decline in the fourth quarter was certainly steeper than anticipated. The primary driver was the K-12 market, which represented roughly half of the client device decline. We also saw a general moderation in client device demand across channels as economic uncertainty increased. As we always do, we stayed the course on our playbook and maintained our discipline with a focus on our customer and our value proposition. This discipline contributed to this quarter's excellent cash flows and strong economic returns. In Q4, the combination of lower transactional business and the team's success delivering on customer demand for solutions and services led to a meaningful shift in our sales mix. Let me put this in perspective for you. You've heard us speak over time about the impact of solutions mix and notably netted down revenue streams on our financial results. As we have grown our netted down revenue streams over time, total annual customer spend has consistently grown a few hundred basis points faster than net sales. In periods where we mix into more solutions business that nets down and mix out of client device business that fully shows up in net sales, that growth rate spread will be wider. In Q4, an extreme mix shift took place. The result was meaningful customer spend growth significantly dampened net sales growth, and very healthy gross margins that drove delivery of gross profit. Now let's turn briefly to the full year results. 2022 was a year of financial performance underpinned by progress on our three-part strategy for growth. The first pillar of our strategy is to capture, share, and acquire new customers. One way we do this is through strategic acquisitions. The addition of Sirius is a great example of this. Sirius elevated and expanded our services capabilities, providing an excellent cross-sell opportunity into our existing customer base. At the same time, Sirius customers represent excellent cross-sell opportunity given the broader CDW portfolio. The second pillar of our strategy is to enhance capabilities in high-growth solutions areas. Strategic coworker investments contributed to excellent solutions performance through 2022 with strong growth in cloud, security, and network upgrades. The third pillar of our strategy is to expand services capabilities. As a key enabler of our value proposition, services are fundamental to our full stack, full lifecycle, full outcomes go-to-market approach. Services engagement solve critical customer problems and drive enduring customer relationships. In 2022, the team delivered more than 20% services growth across the business. No doubt our acquisitions have accelerated our services breadth and depth, and have been foundational to our success. 2022 was indeed a year of strategic performance across all three of our priorities. It was also a year of exceptional financial performance. The team delivered record results with constant currency net sales growth of 15% and each profit category down the P&L statement up 20% or more. Results enabled by ongoing investment in our three-part growth strategy. Investments that have made us a vital technology partner, whether customers' priorities require transactional or highly complex solutions. You see the impact of these investments on our fourth quarter performance as the team pivoted to meet customer shifting priorities and advise, design, and orchestrate full outcomes. Outcomes that deliver five key organizational benefits. Innovation, lower costs, agility, risk mitigation, and enhanced experiences for customers and coworkers. Let's take a closer look at the fourth quarter. There were three main drivers of our fourth quarter results, our balanced portfolio of customer end markets, breadth of our product solutions and services portfolio, and relentless execution of our three-part strategy. First, the balanced portfolio of our diverse customer end markets. As you know, we have five U.S. sales channels, corporate, small business, healthcare, government, and education. Each channel is a meaningful business on its own, with annual sales ranging from $1.9 billion to over $10 billion over the last 12 months. Within each channel, teams are further segmented to focus on customer and market, including geographies and verticals. We also have our UK and Canadian operations, which together delivered sales of $2.9 billion. Our corporate team delivered another strong quarter with a 7% sales increase. The team helped customers accelerate implementation of priorities to automate tasks, detect fraud, and enhance customer and employee experiences. This drove excellent cloud software and security results. Our ability to address priorities focused on application and network modernization and consumption-based data center solutions led to excellent services and NetCon performance, each up double digits. Economic uncertainty led customers to deprioritize endpoint solutions, which resulted in a decline in client devices. Small business declined 13%. The team pivoted to help customers address priorities to maximize prior IT investments and identify savings opportunities to fund new and ongoing projects. At the same time, the team helped customers address mission-critical priorities around security and take advantage of the benefits of cloud, both with heightened urgency. Strong growth from security and cloud were balanced against the decline in client devices as customers put upgrades on hold, awaiting greater clarity around the economy and employment plans. Strong results across healthcare and government could not offset the decline in education driven by K-12 client device dynamics, and public sales decreased 9% year over year. The healthcare team delivered another excellent quarter of robust growth, up 8%. Talent needs and data center projects remained key focus areas as customers increasingly sought technology solutions to address complex industry challenges. This drove excellent performance in netcom, servers, and services. Mission-critical investments to enhance patient care and experience continued, with telehealth and tele-sitting driving excellent collaboration performance. Government grew double digits, up 13.5%. Strong state and local sales growth continued, driven by customer adoption of IT strategies for hybrid cloud, as well as network modernization and zero trust security frameworks. Services increased more than 50% as the team helped state and local municipalities address talent gaps through enhanced training, as well as professional services engagement. CEDRAL also continued to grow in the fourth quarter. The team's ability to help agencies achieve their priorities around data management drove excellent server and storage performance. For education, higher ed's high single-digit sales growth was more than offset by declines in K-12, and overall sales decreased. Higher ed continued their success helping implement student success programs, which institutions use to promote enrollment. Our ability to help drive program elements that include improved security, campus connectivity, as well as enhanced dorm room experiences, drove double-digit growth across cloud, netcom, server storage, software, and security. For K-12, we expected a continuation of third quarter performance where sales were down low double digits, but instead experienced a more significant decline with client device units down more than 60%. As we shared last quarter, K-12 customers continued to focus on digesting the past several years' investments, and evaluating multi-year funding opportunities to ensure they are making the best decisions for the future. This quarter, as many schools achieved one-to-one student-client device ratios, there was a significantly heightened focus on reevaluating plans and demonstrating need for ECF awards. When the device per student ratio was below one-to-one, demonstrating need was straightforward. Today, with device per student at or above the one-to-one ratio, Demonstrating need is more complex. For example, articulating why new devices with higher processor capability are required to run more complex applications or provide greater security is just a more complicated discussion and takes more time and approvals. This heightened focus led some customers to defer or retract awarded funding commitments in order to assess, reevaluate, and potentially reapply under the third and final wave of ECF, which is scheduled to end December 31st of 2023. For CDW, this equated to several hundred million dollars of CDW awarded funding commitments being pulled back. I should note that even with these dynamic variables in the K-12 client devices arena, the team successfully executed on infrastructure opportunities across services, net common servers, leading to strong gross profit delivery. And just as we've been doing in past cycles with K-12, the team will be there for our customers to help them work through the challenges to achieve their mission-critical outcomes and efficiently utilize available funding mechanisms. Other, our combined UK and Canada results reflected broad-based and balanced performance in both regions in local currency. UK increased low double digits in local currency, and Canada increased high single digits in local currency. These results continue to demonstrate the grit and resilience of our teams and the power of our investments to drive growth in these markets. As you can see, our diverse end markets are both a key strategic advantage and a driver of our differentiated performance. The second driver of our performance was the broad and deep portfolio. Our ability to address priorities across the entire IT continuum delivered high single digit growth across our solutions portfolio. U.S. hardware sales declined mid-teens. Within hardware, network modernization upgrades drove double-digit increases in netcom. These excellent results were not enough to offset the decline in client devices and wraparound accessories. Supply conditions continued to improve across core transactional areas, while supply and solutions categories remained tight. Once again, we exited the quarter with an elevated backlog and extended lead times in solutions, and notably in netcom. We continue to expect this backlog to feather out over time. U.S. software sales increased 8%. Strength was broad-based as we continued to help customers manage data, enhance productivity, and secure their IT environments with strong double-digit increases in operating systems, application suites, and data management. Cloud remained an important driver of performance across the business and was a meaningful contributor to profitability. Once again, gross profit increased by double digits. Compute database, storage, mobility, and connectivity were key cloud workloads during the period. Security remains top of mind for our customers as cyber threats continue to emerge, evolve, and increase. Our teams delivered excellent results as they continue to conduct vulnerability assessments, implement identity and access management solutions, and provide training to our customers to help manage cloud deployments and enhance endpoint and application security. Services results were stellar again this quarter, up more than 20%, with balanced performance across professional and managed services. Services are integral to today's complex technology solutions. Customers continue to lean into CDW as an extension of their own team and leverage CDW services as part of their strategy. And that leads to the third driver of our performance this quarter, relentless execution of our three-part growth strategy. Clearly, investments in our customer-centric growth strategy contributed to our strong profitability this quarter. Investments in services and solutions have elevated our relevance to customers to the highest level it has ever been. Our rigorous strategic process that is designed to ensure we can serve customers across the full stack, full lifecycle, has made us a vital technology partner. whether customers' priorities require transactional or highly complex solutions. And that leads us to our 2023 outlook. Our baseline view of the US IT market in 2023 is for flattish growth, factoring in both expected mix and the level of overall economic uncertainty. Consistent with economic forecasts, this outlook assumes stronger growth in the second half relative to the first half. We continue to target CW market outperformance of between 200 and 300 basis points. Our current view of the market recognizes we are operating under greater uncertainty as it incorporates the potential impact of some of our recent wildcards and indeed, most notably, the economy. With thousands of sellers connecting with customers every day, we have a real-time pulse of the market. As we always do, we will provide an updated perspective on business conditions and refine our view of the market as we move through the year. In the meantime, we will continue to do what we do best, leverage our competitive advantages and out-execute the competition. Our fourth quarter results highlight that although we cannot definitively know where our customers will place their priorities, there are two things we know for sure. Technology will continue to be a critical driver of outcomes, and with our agility and broad and deep portfolio, we will be there to support our customers wherever their priorities lie. Now let me turn it over to Al, who will provide more detail on our financials and outlook.

Al? Thank you, Chris, and good morning, everyone. I'll start my prepared remarks with additional detail on the fourth quarter and full year, move to capital allocation priorities, and then finish up with our 2023 outlook. Turning to our fourth quarter P&L on slide eight, consolidated net sales were $5.4 billion, down 1.8% on a reported and an average daily sales basis. On a constant currency average daily sales basis, consolidated net sales declined 0.4%. Net sales were impacted by the significant change in client device demand during the quarter. With the decline in transactional products, there was a meaningful mix shift to solutions and services. Before moving down the rest of the P&L, I want to take a moment to talk about the impact of mixing into solutions and services on our results. Certain solutions, such as software as a service, software assurance, and warranty solutions, as well as agent commission fees, generate meaningful customer spend, but are recorded on a netted down basis. Since we are not the primary obligor on these solutions, we record gross profit as our revenue. That is why you sometimes hear us refer to these netted down revenues as 100% gross margin items. You certainly see the impact of this in both our net sales and our gross margin performance this quarter. As we continue to execute on our growth strategy and scale our solutions and services, we expect to continue to grow our netted down revenue streams. All else equal, this mixed dynamic will pressure net sales while remaining neutral to gross profit dollars and expanding gross margins. While much of what I've described is tied into the accounting treatment, It is also a reflection of our success in the execution of our three-part strategy to capture share, enhance capabilities in high-growth solutions, and expand services. The impact of this strategy was on full display this quarter as we experienced a significant mix shift out of client devices and into netted down revenues, reflective of our customers' priorities. Returning to the P&L, sequentially net sales decreased 12.5% versus the third quarter. Fourth quarter sales historically decreased versus the third quarter, but this quarter was exacerbated by the declined demand for client devices. To dimensionalize the shortfall in net sales relative to our expectations, two-thirds of lower net sales were related to the public sector and driven primarily by K-12. In aggregate, solution categories delivered results above our expectations. Notwithstanding the noted mixed shift of customer priorities, With respect to customer behavior, we did see increased scrutiny and deeper evaluation of projects and extra signatures increasingly required. In this environment, our sellers are staying close to their customers and working with their technical coworkers to help customers maximize return on investments. While we've not seen meaningful customer cancellations, we have seen some postponements, and re-architecting on more complex hybrid cloud solutions as customers balance cost and utility. On the supply side, we saw similar conditions as in the third quarter, with some improvement across categories, but pockets of pressure remain, especially in the solution space. Our solutions backlog remains elevated versus historic levels, and lead times are still extended. We expect our backlog to feather out over time as supply conditions ease, although not likely symmetrical across product categories. We continue to manage inventory strategically to support our customers so there's still uncertain supply environment. And just like our customers in this environment, our team is diligently managing working capital as we seek to enable profitable growth while ensuring strong economic returns. Our coworkers delivered excellent profitability in the quarter. Gross profit was $1.2 billion, a year-over-year increase of 21.1%, lapping for the first time a one-month serious contribution in the fourth quarter of 2021. Gross profit margin was a record 21.7%, up 410 basis points versus last year and 190 basis points above our prior year quarter record. The year-over-year expansion in gross profit margin was driven by several factors. First, product margins benefited from both mix into complex hybrid cloud solutions and lower mix of transactional products. When we mix back into transactional products, we would expect for this benefit to moderate. Second, as we expected for the fourth quarter, a greater mix in the netted down revenues. The category outpaced overall net sales, growing 26% in Q4 2022 compared to the prior year quarter, primarily driven by software as a service. And third, net sales contribution from high margin services, which increased 28% in Q4 2022 compared to the prior year quarter, with significant contribution from our recent acquisitions. Turning to SG&A on slide 9. Non-GAAP SG&A totaled $658 million for the quarter. The year-over-year increase in non-GAAP SG&A was primarily due to higher payroll, consistent with higher gross profit attainment, and higher coworker count. SG&A declined by $26 million compared to the third quarter, reflecting the variable component of our compensation structure, which is principally tied to gross profit attainment. In this uncertain economic environment, we are also being mindful of our discretionary spending and our pace of our hiring. Our fourth quarter expense levels reflect both the benefits of our variable cost model and our prudent expense management. Coworker count at the end of the fourth quarter was nearly 15,100, up approximately 1,100 in the last year, and essentially unchanged since the third quarter. Investments in our coworkers and in our strategy continue to be integral to our ability to outgrow the market profitably and sustainably. We are focused on discipline and balanced investments that drive value. This is evidenced by our record profitability in the period. GAAP operating income was $447 million, up 31.6% compared to the prior year. Non-GAAP operating income was $523 million, up 23.2%. Non-GAAP operating income margin was a record 9.6%, up 190 basis points from the prior year and 80 basis points compared to the third quarter. Similar to the third quarter, this improvement was driven by a confluence of favorable factors within gross margins. Moving to slide 10, interest expense was $59 million. Higher interest expense compared to the prior year was primarily driven by the senior notes issued last year to fund the acquisition of Sirius. This level of interest expense was in line with our expectation for the quarter. Our GAAP effective tax rate shown on slide 11 was 24.7%. This resulted in fourth quarter tax expense of $94 million. To get to our non-GAAP effective tax rate, we adjust taxes consistent with non-GAAP net income add-backs as shown on slide 12. For the quarter, our non-GAAP effective tax rate was 25.2%, 30 basis points below our expected range of 25.5 to 26.5% due to lower state taxes as well as non-deductible items. As you can see on slide 13, With fourth quarter weighted average diluted shares of 137 million, GAAP net income per diluted share was $2.09. Our non-GAAP net income was $343 million in the quarter, up 20% on a year-over-year basis. Non-GAAP net income per diluted share was $2.50, up 21%. Turning to full-year results in slide 14 through 19, as Chris mentioned, 2022 performance reflected exceptional execution, relentless focus, and a strategy that is working. Net sales were $23.7 billion, an increase of 14% on a reported and an average daily sales basis. On a constant currency average daily sales basis, four-year consolidated net sales grew 15.2%. On a combined constant currency basis, we estimate full-year sales increased 5% below our prior expectation of 8.25% due to the moderation in IT market growth as well as a contraction in our premium in the fourth quarter. Gross profit was $4.7 billion, up 31.3%, and gross 19.7%, up approximately 260 basis points year-over-year. In 2022, software and services accounted for more than 40% of the total gross profit. Organic and inorganic investments in our services and solutions capabilities and a continued shift in the netted down revenues are driving growth. Operating income was $1.7 billion, and non-GAAP operating income was $2.1 billion, up 24.6%. Net income was $1.1 billion, and non-GAAP net income was $1.3 billion, up 19.9 percent. Non-GAAP net income per share was $9.79, up 22.9 percent. Moving ahead to slide 20, at period N, cash and cash equivalents were $315 million, and net debt was $5.6 billion. During the quarter, we reduced borrowings under our senior unsecured term loan by $200 million, consistent with our plan to reduce leverage. Liquidity remains strong, with cash plus revolver availability of approximately $1.4 billion. Moving to slide 21, the three-month average cash conversion cycle is 21 days, down three days from last year's fourth quarter, and within our range of high teens fellow 20s, reflecting our continued diligent management of working capital. Our effective working capital management, along with strong growth in the business, also drove excellent year-to-date free cash flow of $1.3 billion, as shown on slide 22. For the quarter, we utilized cash consistent with our 2022 capital allocation objectives, including returning $80 million to shareholders through dividends in addition to $200 million in debt repayment. Which brings me to our capital allocations on slide 23. Our execution remained consistent with objectives we communicated last quarter. For 2023, we're updating those objectives as follows. First, as always, increase the dividend in line with non-GAAP net income. Last November, we increased the dividend 18% to $2.36 annually. This increase demonstrates our confidence in the earnings power and cash flow generation of the business. Going forward, we'll continue to target a 25% payout ratio, growing the dividend in line with earnings. Second, ensure we have the right capital structure in place with a targeted net leverage ratio. We ended the fourth quarter at 2.6 times net leverage, down from 3.4 at the end of 2021, demonstrating strong growth in the business and excellent cash flow generation. As we expected and communicated during the third quarter call, 2.6 times had us near the lower end of our 2022 targeted net leverage of 2.5 to 3 times. For 2023 and beyond, our targeted net leverage ratio will be 2 to 3 times a range that is consistent with our commitment to an investment-grade capital structure and provides us with flexibility to proactively manage liquidity over time. Finally, we have successfully satisfied the commitments we made when we financed the acquisition of Sirius. As such, we are pleased to reestablish our third and fourth capital allocation priorities of M&A and share repurchases, respectively, in 2023. For 2023, we will target returning 50 to 75% of free cash flow to investors through dividends and share repurchases. This is supported by the Board's authorization for a $750 million increase in the company's share repurchase programs. Moving to the outlook for 2023 on slide 24. While we are cognizant of potential market variables as we look forward remain confident in our ability to execute, pivot to growth opportunities, and outperform the broader market. While the overall IT market growth rate sentiment has been mixed, in the near term, we continue to expect netted down revenues will grow faster than other product and solution categories. With this in mind, we expect the IT market to be approximately flattish, reflecting our expectation of mix and the level of economic uncertainty. we maintain our long-held expectation to outgrow the market by 200 to 300 basis points per year. Currency is expected to be neutral for the full year, with modest headwinds in the first half and modest tailwinds in the second half. This assumes an exchange rate of $1.24 to the British pound and 77 cents for the Canadian dollar in the first quarter. Moving down the P&L, we expect our full-year non-GAAP operating income margin to be in the mid to high 8% range. We expect full year non-GAAP earnings per diluted share growth to be at the upper end of a mid single digits range in constant currency. Please remember, we hold ourselves accountable for delivering our financial outlook on a full year constant currency basis. Additional modeling thoughts for annual depreciation and amortization, interest expense, and the non-GAAP effective tax rate can be found on slide 25. Moving to modeling thoughts for the first quarter. Related to average daily sales, we expect low single-digit sequential growth from Q4 to Q1. This equates to a mid-single-digit percent year-over-year reported net sales decline for the fourth quarter. We anticipate continued strong gross profit margin and NGOI margin in the first quarter, above the full year 2022 levels for both, but reflecting some moderation from what we experienced in Q4. And we expect first quarter non-GAAP earnings per diluted share to grow low single digits year over year. Finally, in line with the reevaluation of our capital priorities, we're adjusting our long-term rule of thumb for full year free cash flow. In 2023, we expect full-year free cash flow to be within a range of 4% to 4.5% of net sales, up from our prior range of 3.75% to 4.25%. As you know, timing has a meaningful impact on free cash flow, and it may ebb and flow by quarter and across years. That concludes the financial summary. As always, we will provide updated views on the macro environment and our business on our future earnings calls. With that, I'll ask the operator to open up for questions. We'd ask each of you to limit your questions to one with a brief follow-up. Thank you.

Thank you. We will now start today's Q&A session. If you would like to ask your question, please press star followed by one on your telephone keypad now. If you change your mind, please press star followed by two. When preparing to ask your question, please ensure your phone is unmuted locally. Our first question today comes from Matt Sheeran from Stifle. Your line is now open.

Yes, thank you and good morning, everyone. I was hoping to ask just questions regarding your take on the client device environment. Not a big surprise that it was down significantly, particularly in K through 12. But could you talk about the commercial side of the business? Sounds like some customers are being more cautious on upgrades. What's your thought on the PC cycle on the commercial side of the business and how you see that playing out this year?

Good morning, Matt. Yeah, it's a good question. We have seen customers elongate the replacement cycle given the uncertain times. I mean, you're seeing what we're seeing with hiring freezes and layoffs and things like that. So right now there's just more pause than we had seen earlier in the year. You know, eventually the benefit of enhanced productivity and security from the newer replacements will certainly drive a replacement cycle, but it's not happening right now with the level of uncertainty.

Okay. And that's not contemplated in your forecast for the year?

A rebound?

In terms of, yeah, yeah.

Yeah, you know, our forecast contemplates the environment to feel pretty much like it feels now. That's what we've reflected in the forecast. I mean, we do expect the PC market to remain larger than it was pre-pandemic, but right now our forecast reflects the current environment and the current temperature.

Okay. And then in line with that, are you also seeing pricing pressure or ASP declines as memory and other component prices come down? And is that also going to be reflected in your business?

Good morning, Matt. This is Al. We are not seeing, I would say ASPs in the fourth quarter and ongoing continue to be really firm. And so that is not contemplated in our outlook.

Okay, thank you very much.

Our next question today comes from Rupu Bhattacharya from Bank of America, Merrill Lynch. Your line is now open.

Hi, thank you for taking my questions. Chris, from the prepared remarks, I mean, it's clear that client devices are weak and likely will remain weak in the near term. But, you know, if we think about it, if SMB is really a bellwether for the macro economy, are you concerned that demand for advanced solutions or data center devices like servers and storage, that demand can also moderate? So what have you assumed for sustainability of that demand through 2023? And I think in the prepared remarks you guided for kind of the seasonality in this year to be skewed more to the second half versus the first half. So what are you expecting to be stronger in the second half of 23?

Morning, Rupu. Let me break that out. There are a couple questions in there. Let me just start with a small business. And, you know, what I say on small business is the team is really executing well in a fairly cautious environment. And as I did mention, we are helping customers grow. with priorities around infrastructure, networking, et cetera, primarily led by software and cloud. And of course, security is still top of mind. So what we're not seeing is a dampening in the small business of the need to modernize their infrastructure and maximize their prior investments. So we're seeing what I would say is continued steady demand from our small business customers, for sure, with an emphasis, again, on cloud and security. In terms of the split, first half to second half of the year, I'm going to let Al address that in terms of the seasonality there. And then I think there was another question in there that you had. Was there another question that you had?

Well, just the sustainability of demand for servers and storage and solutions. throughout the year? I mean, do you think that that, you know, can be better in the second half, or do you think it's the same at this level throughout the year?

Yeah, here's what I'd say. I think, as we've said for a while now, you know, technology has become more vital to every walk of life and to competitive advantage and to success, et cetera, and we believe it's going to probably be more resilient to a challenging economic environment. Equally, you know, given our business model and the strength of our portfolio, our ability to capture opportunity in a more difficult environment is pretty strong. But our expectation is for a level of resiliency in the technology space.

And good morning, Rupal. Okay. On your question on seasonality, so first, just look, our outlook is based on the premise we continue to see strength in software and services. and lower growth in terms of hardware overall. With respect to the timing of that first half, our typical seasonality would be first half 48, 49. We'd expect to maybe be slightly below that in the first half, and that's reflective of that continued tilt towards more netted down revenues and cloud security, et cetera, with the expectation that in the second half, you may see a pickup there more on the client device. And so second half a bit stronger in terms of top line impact, if you will.

Reflutes, Chris, again, I would just add, let me just add that as we think about the customer behavior more recently, and a lot of folks have been talking about extra signatures, a little more scrutiny, et cetera. Yes, we have been seeing that. What we haven't been seeing is a pullback, wholesale pullback, in projects in fact those infrastructure projects that we had talked about being delayed a little bit are actually coming to the forefront again back to the technology being essential to to all of our customer base so we are seeing that resiliency as well got it thanks for the details there can i ask a follow-up um al i i may have missed this but on the call did you mention what was

netted down items as a percent of gross profit in the fiscal 4Q and sounded like that percent was unusually high in the quarter and you expect that to moderate. But your guide for next year for operating margin, I mean, you're guiding it to be higher at mid to high 8% versus your original guide for this year was low 8%. So I guess my question to you would be, what are you assuming for netted down items as a percent of gross profit in 2023 And in general, can you help us parse out that year-on-year operating margin improvement? What are some of the factors that are driving the increase, and what are some of the headwinds year-on-year?

Sure. So let me just start with the operating margin. So operating margin, I would most notably point to expectation that we would continue to be somewhat higher on gross margin in 2023 versus 2022. I certainly would not expect that those gross margins would match what we saw in Q4, which was really extraordinary. But I would just start from that square that somewhat higher gross margins in 2023 will certainly drive our NGOI margin, coupled with expectation we'd have some operating leverage there. To your original question on netted down revenues for the quarter, you're right. My prepared remarks noted that Netting down revenues grew 26% year-over-year. On a percentage of GP basis, Rupaloo, that was 31% in the fourth quarter, so continue to be really strong.

Our next question comes from Sameek Chatterjee from JPMorgan. Please go ahead.

Hi. Thanks for taking my questions. I guess for the first one, sort of the capital allocation priorities that you referenced in your prepared remarks. Maybe we can sort of get a bit more colored about how you're thinking about the M&A pipeline here and sort of what are the focus areas, particularly as you look at sort of the changing mix of where customers are looking to spend. How are you thinking about the M&A pipeline and what are the focus areas for the company? And I have a follow-up, please.

Let me just start and then Chris can add on from an M&A perspective. So, uh as you know our capital priorities reopens both m a and sherry purchase uh and the way that i would think about that as i spoke to that range of our free cash flow 50 to 75 we would expect return to shareholders so if you take the dividend you can get a sense for what that range would look like there is a range there because we view that is um really optionality for us to toggle between what's going to drive the longest strategic value, including M&A, as well as what's going to maximize shareholder return in the more near term. And so both of those options, an array of options, are available to us. We're certainly back on the path of share repurchases, but M&A is also on the horizon as well.

Yeah, and I would just add, you know, we're never out of the market. We did have a pretty heavy year integrating Sirius, which has been incredibly successful and, you know, having an impact in the market. But we're always looking for organizations that can add capabilities in – broaden capabilities, I should say, in high growth, high relevance areas, and also add scale to those practice areas that we've built. if we can add scale at a faster pace, and we think about geography and our global presence. So we're always looking, and it's good to have a solid year of the serious integration behind us.

And for my follow-up, I know we're all talking about client devices being softer than expected, but I think you also mentioned on the flip side, solutions track much better than expected. which, again, sort of is counter to the mixed impressions we get about enterprise spending. So maybe if you can sort of give us a bit more color on, is that really solutions doing better than expected, more of a supply dynamic where supply is easing up faster, or are you seeing sort of upsized deals from your customers, or is it really a strong run rate of orders that you continue to see on that front, continued interest from customers? Just trying to sort of parse that out in terms of the backdrop of the macro backdrop that we have.

Yeah, no, it's a very fair question. And I would characterize it this way. We are seeing strong demand in the solution space. And while we've had some supply feather out, I mean, where it's really moderated is on the client device space, some pockets in solutions, but we're still carrying heavy backlog, particularly in netcom. So the demand that you're seeing reflected in our performance is just that. It's demand. It's not a flow through of backlog.

Our next question today comes from Armit Daryani from Evercore. Your line is now open.

Thanks for taking my question. I have two as well. Chris, maybe to start with, you folks are talking about IT spend being flat in 23. When I listen to IDC Gartner, even some of your peers, they're all talking about IT spend being up about 3%, 4%. Amit Singer- From your perspective, you know where is the biggest delta here, which is what you're talking about versus what maybe IDC got me appears to saying. Amit Singer- And then, how much of the delta, do you think is you know, perhaps conservatism and you can call it where you're seeing that versus the net down revenue impact that you have.

Amit Singer- Good morning on it well look I wish I could say that it felt stronger out there, I really do but that's not what the temperature is that we're feeling so. You know, we build our expectations by listening to our customers. We've got thousands of sellers and technical advisors out there. And it's just the pulse that's coming back to us and looking at industry and partner data. We're feeling that it's going to be flattish. And then the two to three to 100 basis points of premium that we always commit to would be on top of that. In terms of mix, I guess what I would say is we don't calculate in our customer spend versus net sales as an example. But of course, In this kind of environment, as we've explained, when you've got hardware that's more muted and you've got, in our case, netted down solutions more heavily in the mix, you can expect more meaningful customer spend than the net sales line reflects. But that said, we are right now feeling flattish. Of course, we'll update you as we move through the year, but that's kind of where we feel right now.

Got it. You know, it almost seems like you folks should start to guide gross profit dollars growing at a premium to IT spend versus revenues, given the way the mix is going out. But that may be a discussion for a different day. I do want to ask you a follow up on the netcom market. You talked about December quarter, I think, was up in that business. I'd love to get a sense, you know, as you see supply starting to improve, especially in the netcom side. Are you seeing cancellations or deferrals happening over there? And then how do you deal with netcom into 23 in this flat IT spend environment?

Good morning, Amit. We are not seeing any level of cancellation or postponements there. The demand on netcom, and you can see from our reported results, really, really strong. We're not getting a lot of help from a supply perspective, honestly. Extended lead time still there. Our backlog has not moved substantially. Our backlog has moved more in client, as Chris suggested. Supply is still, there's still friction there on the NetCon side, but that's notwithstanding really strong written demand.

Perfect. Thank you.

Our next question today comes from Eric Woodring from Morgan Stanley. Your line is now open.

Great. Thank you. Good morning guys. Um, you know, Chris, maybe a high level question for you and that's now that you have a year of serious under your belt, you know, and that being one of the larger acquisitions CDW has done, um, in the last handful of years, you know, how do you think about doing more transformational deals going forward rather than tuck in deals? And then does kind of the lower leverage targets that you guys communicated today, Is that because you want greater flexibility to do larger deals? I just want to kind of get the sense of how you're thinking about transformational deals, because it does seem like Sirius has been a pretty significant success for you and what your appetite would be for those types of deals going forward. And then I will follow.

Yeah, no, look, it's a great question, Eric. And it's all a matter of supply and demand, right? You know, we're pretty particular in looking at organizations that really complement our suite of capabilities and or scale them. along with the, obviously, the financial return, but the fit in terms of culture. And I'll tell you, we've done eight over eight quarters and check, check, check. They've all been really outstanding. Now, that said, there are companies out there that we think of and always reflecting on, and some other larger transformational deal would certainly be something we'd consider. But it's a matter of finding them and making sure they're going to fit and provide the financial return. And you asked a question on the debt ratio, though. Al, did you want to tackle that? Sure.

So, Eric, obviously we're within our stated range, and I noted that our new leverage range is two to three times. So certainly we have room in that regard, and I would say as we think about M&A, certainly smaller bolts on, as we've certainly done plenty of, we can do that with free cash flow and with our existing net leverage capacity. As we think about things bigger, obviously, we're going to look at what's the best use of our capital, which could include taking on more debt and could include other avenues. I will just note that while our goal is to stay within that investment grade capital structure, certainly from the rating agencies, we get some room there that if you do larger M&A and you go beyond that, you have a grace period, if you will, and you have time that you then get back into that range. So all of that would be contemplated in our calculus as we think about deals.

Okay, totally understand. And then, Chris, I'm not sure who wants to take this one, but generally I think we've been hearing in the market kind of more weakness at the large enterprise level versus SMBs. your results would somewhat suggest the opposite with small business down versus the corporate business up. And so can you maybe just talk about some of the high-level trends you discussed in terms of extra signatures or deal downsizing, how that differs between the corporate business versus SMB business, if you are seeing any differences there? And again, same thing. I know we asked about pricing earlier on this call, but any difference in pricing between corporate versus SMB? And that's it for me. Thanks.

Okay, Eric, yeah, so differences between enterprise and SMB in terms of the process. You know, I would say that the, look, larger enterprises have a muscle for this, and we're dealing with that muscle, and we know how to deal with the muscle. The smaller business, frankly, turn to us for cost evaluation as a trusted partner, and so in some ways we actually play this added role with them, which is how do you figure out where you make adjustments in your technology roadmap to achieve the cost effectiveness. So in terms of the behavior itself, I'd say small and medium-sized businesses are being cautious. Enterprises have kind of kicked in their muscle, and they're doing the analysis that they do. But all of that said, we do continue to feel strong demand across all of our segments. You know, even K through 12 that we've talked about, that was a real dynamic in the quarter. We're still very successful with them with, you know, network modernization and all the things that have to support the client devices. The demand's okay right now.

Super. Thanks for the color.

Our next question comes from Shannon Cross from Credit Suisse. Your line is now open. Thank you very much.

I was wondering, can you talk a bit about working capital requirements as your model turns more and more to net it down? I noticed inventory levels came down quarter over quarter, you know, even with the shortfall in PCs, and you've raised your target for free cash flow. So just how do you see your cash flow and balance sheet morphing over time? And then I have a follow-up. Thank you.

Good morning, Shannon. So a few things. One, our, we talked about our rule of thumb for free cash flow, and we raised that. And I would say that's a reflection of our continued improvement and progress on really effectively, uh, managing working capital and also, uh, uh, somewhat of a factor or supported by the, uh, counter cyclical nature of the business. So obviously as, uh, as this environment, this economic environment kind of moderates a bit. It actually helps from a cash flow perspective. So both of those things kind of in play. Your comment about netted down or question about netted down is a good one. It is a bit of a mathematical exercise, but just recall with our netted down revenues that while they show up in our net sales net, we're actually collecting gross dollars. So what that does from a cash conversion cycle perspective, it actually has the tendency to increase the DSO, increase DPO, given the denominators and the numerators. So the way we think about that is really on a net basis. And, you know, can we continue to make progress within that band of high teens, low 20s on cash conversion? So all of those factors we consider as we're managing the business, including the puts and takes relative to our investments and inventory. as well as how we manage AR and AP. So that's all part of really a dynamic operating model around working capital, and we're making really good progress on that front.

Great. Thank you. And then can you talk a bit about demand you're seeing for devices of service, infrastructure as a service? You know, it seems like in a challenged end market, maybe the ability to pay more erratably would be, you know, gaining some traction. But I'm just curious as to what's the... What you're hearing may be both from, you know, an enterprise standpoint as well as SMB. Thank you. Yes, Shannon, I'll take that.

On the infrastructure as a service, that is picking up. You know, our OEMs have been building that capability over time, and I'd say we've hit an inflection point where customers are eager to learn more and invest. Primarily enterprise, I would say, is a little stronger than the demand that we've seen in small business. On device as a service, that's a little more complicated because on the one hand, while it's an obvious of interest type solution, it's more complicated if it's either a lease or it's more complicated than that. And so it hasn't taken off to the extent that one would think, but may in the future.

Great. Thank you.

Our next question comes from Jim Suva from Citigroup. Your line is now open.

Thank you so much. I have a question on there's been a lot of government stimulus programs. I was wondering how you've been seeing those roll out, develop, embrace any potential red tape or slowdowns in them or accelerations of them. Thank you so much.

Jim, thanks for the question. Can I say they're rolling out as they typically do and sometimes that includes red tape and not all the things that that you expect with government. I mean seriously there's when we think about the federal budget that was passed, you know we're used to dealing with that, and you know where we can go find the funds, and I think that's been pretty. kind of standard operating procedure, if you will. The Infrastructure Act is a little more to figure out where funds that can benefit our customers vis-a-vis technology that's taking a little bit more time is what I'd say. But it's, you know, nothing that is daunting us or nothing that concerns us, frankly.

Okay. And have you also been finding a lot of those new programs and systems have been kind of more on the higher end? service product offerings that you've had, say, today versus five or 10 years ago, meaning more like cloud and security and software solutions as opposed to more kind of plug and play hardware solutions?

Yeah, that's a great point. The ability to access that funding for more advanced solutions is absolutely there. you know, there's more demand for that versus, you know, merely, you know, client devices, for example. That's a good point. Security, another one that tends to thread through all of the funding mechanisms at this point. So, yeah, that's a good point, and the answer is yes.

Our next question is from Keith Husam from North Coast Research.

Your line is now open.

Good morning, appreciate the opportunity. Chris, just looking at the hiring that you guys did over the year, you know, 1,100 people through the first three quarters, and then obviously you guys were flat in the fourth quarter. I guess two things. One, is that kind of testament to your thoughts on the overall market perhaps weakening here as you guys went through the fourth quarter? And then what kind of people were you hiring during the year in order to meet your needs?

Yeah, Keith, good morning. As we've been doing over the last few years, we've really been targeting our hiring in a couple of areas. It was the high demand, high capability. So think about the sales organization, think about the practice areas like technical specialists in security and cloud, software, the spaces that we've talked about, and really targeting those areas, along with what I would say is technologists and digital specialists for our own evolution of our business. So that's really where we've been focusing. In terms of as we come into the back half of the year, You know, just consider that discipline management of the business. You know, as we look out at the economy, as we see what's happening, we're just being very disciplined in the way that we're approaching our own cost management. And you'll see that in some tempering in our hiring in the back half of the year.

Great. I appreciate it. And then looking at your guide a little bit more, try to unpack it. As you think about like the macro environment, are you expecting roughly a flat GDP? And what kind of assumptions are you making for interest rates as you guys think about your guide?

Yeah, good morning, Keith. I would say just in terms of broad macro GDP, yes, I'd say flat, maybe slightly down, if you will, and you get your translation from an IT market perspective with all of the components that we talked about, both our mix and uncertainty as well. Interest rates, look, I don't know if we have a formal market view on that, Certainly we make sure that the posture of our capital structure is protected against that. We do have largely a fixed rate capital structure, but we do have a component of our debt that's term loan, that's adjustable rate. And so the way we think about that is the most effective way to manage our interest rate risk is where we see there's risk there that we might pay down that debt a bit faster. You saw that in the fourth quarter and we'll continue to operate in that regard. And obviously we think about that in the construct of overall capital priorities.

Our next question is from Adam Tindall from Raymond James. Your line is now open.

Okay. Thanks for squeezing me in. I wanted to ask on 2023 revenue growth guidance at 2% to 3%. I think it's a lower overall starting point than I can recall in many years. I know your split says the assumption is no market growth, but the largest global distributor just guided to double the growth rate that you're describing. For investors that take this to mean that your share gain premium is effectively lowering inherently in this guidance, which is notable as we're shifting away from PCs, maybe you could, Chris, opine on that market share premium piece as we move into a different environment from a mixed perspective away from transactional and towards solutions and tie into your observations that you saw during Q4. Thanks. Thanks.

Thanks, Adam. Let me just start with our guide, when our guide is coming versus when some of the other observations about the outlook for the market came out a month or month and a half ago. And the pivot that we've talked about in Q4, we started to see more dramatically end of November and into December. So that might be having an impact on the discrepancies that you're hearing. In terms of the 200 to 300 basis points and the validity of the 200 to 300 basis points, I think that question was the one you were asking. You know, we still view that as our target go-get. As we mentioned, Adam, and this might be what you're getting underneath, but as we mentioned, as we think about 2023 and the dynamics that we've seen in the fourth quarter of 2022 continuing into 2023, namely for us stronger growth in cloud and software as a service and security and and more muted hardware sales, that does mean that our customer spend will be more meaningfully greater than the number. I think you gave a 2.5% figure. It will be meaningfully greater than that number. So we would look at that outperformance as 200 to 300 basis points plus, if I could put it that way. Okay.

And maybe just a quick follow-up, Al, on the Q1 guidance. In years past, CDW would talk about seasonal being down high single-digit sequentially, 7%, 8% down. Today, you're guiding flat to low single-digit growth sequentially. And as I think about the mix of the business, with Sirius being in there, I would think it would be even more seasonal to Q1, given the enterprise focus. So maybe just help me understand the change now to seasonality versus historically. Thank you.

Sure. Thanks, Adam. Look, the most notable thing I would just say is the Q4 was a very extreme period. And so as we look at Q1, you're right. Seasonally, we would typically say there would be a contraction to Q1. And I guess what you should take from that is while thematically we'd still expect this mix-in to net it down and lower transactional, maybe not as extreme as what we saw in Q4. And therefore, with some of that balancing out, we'd expect that we'd have modest growth on the top line in the first quarter. And then again, a little more modest in terms of the gross margin. So just really kind of a bit of a dampening effect of the extremity that we saw in Q4. Got it.

Thank you.

There are no further questions at this time. I will now hand you back over to CEDW for closing remarks.

Thank you, Drew. And let me close by recognizing the incredible dedication and hard work of our 15,100 coworkers around the globe. Your ongoing commitment to serving our customers is what makes us successful. And thank you to our customers for the privilege and opportunity to help you achieve your goals. And thank you to those listening for your time and continued interest in CDW. Al and I look forward to talking to you next quarter.

Thank you for joining CDW fourth quarter 2022 earnings call. You may now disconnect your line.