Description

Business description

CDW is a value added reseller (“VAR”) of IT products to small and medium sized businesses in the US and Canada. Founded in 1984, CDW first went public in 1993 with $270mm in revenue and 247 employees. In 2007, CDW was taken private by Madison Dearborn and Providence. CDW went public for the second time in June 2013.

CDW generally does not sell to “enterprise-level” customers who have well-developed internal IT departments and direct relationships with OEMs. Instead, CDW focuses on medium / large businesses (defined as 100-5,000 employees, 46% of LTM revenue), and small businesses (defined as 10-100 employees, 8% of LTM revenue). Beyond corporates, CDW’s government, education, and healthcare channels each generate over a billion dollars in revenue.

CDW offers a compelling value proposition to both customers and vendor partners. For customers, CDW provides access to a wide range of products and brand-agnostic advice on technology spending decisions to businesses that might have limited or nonexistent internal IT departments. Of CDW’s 4,400 customer-facing employees, 1,800 are technology specialists or engineers. For vendors, CDW’s customer relationships provide access to hard-to-reach small and medium sized organizations. In effect, CDW is an outsourced IT department for its customers and an outsourced sales function for its vendors.

CDW identifies an addressable market of ~$200bn out of ~$650bn of total US IT spending. The percentage of sales sourced through resellers has increased 200bps to 59% since 2007, evidence of OEMs’ growing reliance on the indirect channel.

Thesis Summary

CDW is a dominant industry leader with a long track record of achieving above market growth while maintaining substantially higher margins and returns than the competition. CDW has built an enormous scale advantage over the rest of the industry. This has been the key to its strong performance and will continue to provide a sustainable and widening competitive moat.

Investors seem to be questioning CDW’s business quality and longer term growth prospects, as shown by its ~11x multiple on 2015 consensus EPS. As CDW continues to deliver impressive ROIC (~31% vs. ~10% for other public VARs and wholesale distributors) and steady market share gains, the durability of its competitive advantages will become even more evident and the low valuation multiple will become increasingly difficult to justify. Valuation will also benefit as CDW reduces leverage and returns cash to shareholders, and as the private equity ownership overhang diminishes.

Competitive advantages drive consistent outperformance

CDW is clearly the “800-pound gorilla” of the industry with revenue more than 3x that of NSIT, the number two player in North America. CDW’s commanding lead in the highly fragmented industry, and the lackluster outcomes of past M&A transactions in the space, suggest that CDW has advantages that are not replicable within any reasonable time horizon. Meanwhile, with CDW representing only 5% of the $200bn TAM, its consolidation opportunity is largely untapped.

CDW’s scale benefits are demonstrated in consistent outperformance in terms of revenue growth, margin, and ROIC. Organic revenue growth outpaced IT spending growth by 215bps from 2003-2013, and the outperformance has been more dramatic in recent periods. CDW’s revenue CAGR was 520bps over the IT market from 2009-2013, and CDW expects to outpace 2014 IT market growth by 400-500bps. By comparison, other publicly traded VARs have struggled with organic revenue growth in line or below overall IT spending over the past decade.

CDW has maintained stable EBITDA margins that are 2.5x those of its publicly traded VAR competitors. CDW’s business model is capital-light and management is intently focused on operational efficiencies. As such, CDW has generated impressive returns over the years: average ROIC was 31% from 2004-2013, and EBITDA grew at an 8% CAGR over that same time period. CDW employees generate 2x to 4x the gross profit of their counterparts at other publicly traded VARs.

CDW has been able to achieve these results because of its unrivaled national scale, the widest vendor relationships and product selection, and superior customer service. This has allowed CDW to grow above the market and take share from the thousands of small regional VARs who lack purchasing power (less competitive pricing) and offer narrow selections (not brand agnostic, beholden to specific vendors, few choices for customers).

At first glance, supplier concentration might give an investor pause. However, CDW’s scale and vast array of products actually give it flexibility and leverage over vendors. CDW has firm control over the end customer relationship, and it can easily replace a vendor’s product with a comparable offering (e.g. Lenovo instead of HP). On the other hand, a large supplier like HP has no alternative channel to replace the significant revenue sourced through CDW (i.e. $2bn+, more than 5% of HP’s total US revenue). Vendors have direct relationships with Fortune 500 companies, but they lack the sales force required to reach the long tail of smaller customers. CDW provides a critical outsourced sales function – no other VAR comes close in terms of breadth and volume.

Cloud threat may be overstated (and could be an opportunity)

There seem to be general worries that CDW and other tech distributors/re-sellers will be dis-intermediated by cloud-based technology. After extensive work on this topic, we think that these fears are overblown. If the largest cloud vendors and cloud-based services of legacy IT vendors can maintain their torrid pace of growth through the end of the decade (nearly 30% CAGR for cloud revenue vs. less than 4% growth for overall US corporate IT spending), their revenue will amount to ~20% of total US corporate IT spending. In this scenario, VARs like CDW are likely to capture a significant portion of that 20% by serving cloud vendors in the same way they have served more traditional IT vendors in the past. As cloud service vendors face more difficulty increasing customer penetration, they will lean on resellers to reach new customers in order to live up to lofty top line growth expectations. Nearly all large cloud vendors are using the indirect channel to some extent, and CDW’s cloud portfolio includes 200 SaaS, PaaS, and IaaS providers across 36 categories. According to NetSuite’s CEO: “SaaS companies started direct because it was a completely unproven model. We’ve always believed in channels. We think the opportunities are with the Fortune 5 million, not just the Fortune 500.”

Throughout its history, CDW has navigated shifts in tech industry spending all while gaining market share. CDW’s business model is not dependent on any particular product or brand. CDW thrives on changes in the IT landscape: as complexity increases, CDW’s value proposition rises.

Deleveraging and capital deployment opportunity adds to earnings growth

Continued deleveraging and potential share buybacks will be powerful accelerants to earnings growth in the coming years. CDW’s leverage stands at 3.4x ND/EBITDA. As CDW continues to pay down and refinance expensive LBO-era bonds when they become callable, its average interest rate should decline to ~4.7% by 2015, down from over 7% in 2013. Management has stated their comfort with 3x ND/EBITDA, and their intention to return cash through a combination of buybacks and dividends. CDW’s strong FCF generation should allow it to reach this leverage target by early 2015. If CDW holds leverage constant and deploys most of its FCF to buybacks, share count could shrink over 10% by 2016. Management’s longer-term compensation policies emphasize cash earnings per share, which should create preference for the buyback option.  

Inefficiencies

CDW is difficult to categorize. It is often lumped in with the wholesale tech distributors out of convenience: they are well covered by the Street and share superficial similarities (i.e. both distribute IT products). However, CDW’s advantages clearly distinguish it from this group. Wholesale tech distributors have an inferior business model because they lack CDW’s direct end-user relationship, limiting what they can contribute to the IT supply chain. As middlemen between OEMs and the VARs, they occupy the weakest, least valuable position versus both their customers and their suppliers. Not surprisingly, they have produced far weaker ROIC than CDW over the past decade: ~10.8%, vs. ~31% for CDW.

In terms of actual operating and returns metrics, distributors considered by many to be best-in-class like Fastenal, Grainger, and Henry Schein, are more comparable. Indeed, management uses this group to help benchmark their performance. Despite similar characteristics, CDW trades at a 25% discount to these names on an EV / consensus forward EBITDA basis.

Liquidity is another source of inefficiency: ~40% of the stock is still held by private equity firms Madison Dearborn and Providence, so trading volume is light. Liquidity will improve over time as the private equity owners continue to sell, which should eventually lead to a more efficiently priced security.

Concerns (or lack thereof) over recent drivers of performance: PC refresh and education

More recently, there has been some concern that CDW’s strong performance in the first half of 2014 will be followed by a period of subpar growth as the benefit from the PC refresh cycle dissipates. We believe that this worry is overblown. CDW provided more detailed revenue disclosure prior to its LBO, and in 2006, revenue from computer products and servers accounted for ~25% of revenue. These categories probably account for less of CDW’s business today, considering that CDW has grown faster than the overall IT market while the US commercial PC market has shrunk ~30% since 2007 (based on IDC data). Assuming that 15% and 7.5% of 2013 CDW revenue came from PCs and servers respectively, and applying IDC’s figures for US commercial PC revenue and Windows server revenue growth in 1H2014, refresh-related activity may have contributed 20-25% of the y/y growth seen in the first two quarters (total growth of 10% in 1Q14, 12% in 2Q14). The impact of the PC refresh that flows through CDW’s gross profit line is even smaller given that PCs are the lowest margin business. Extending this analysis through the end of 2015, an expected decline in the PC market and a slight uptick in servers (2015 server refresh) will likely have a neutral effect on top line growth in 2015 and could actually be a benefit to gross profit.

Strength in education has also resulted in some concerns about an impending growth slowdown. CDW has been delivering double digit y/y growth in the segment since Q2 2013, driven by increased sales of Chromebooks to support new digital testing requirements for the Common Core program. However, we seem to be in the early stages of an extended education spending cycle. A public policy think tank estimated that the technology costs associated with the implementation of the Common Core will amount to nearly $7 billion over seven years. CDW should be a beneficiary of this increased spending.

Operating and valuation assumptions

We use IDC forecasts as the base for our corporate, education, healthcare, and government IT spending growth projections, and then assume that CDW can grow 250bps faster. Given that CDW’s revenue growth outpaced IT spending by over 500bps between 2009 and 2013, and management guidance points to a 400-500bps positive growth differential in 2014, this assumption feels conservative. EBITDA margins have been stable for over a decade and we believe CDW will continue to achieve management’s medium-term target of mid-7% adjusted EBITDA margin without difficulty. This results in expected adjusted EBITDA growth in the high single digit range. We assume that CDW continues to pay down the more expensive notes as they become callable, and that after reaching the target leverage ratio of 3.0x, excess cash is used for share repurchases. EBITDA growth, decreasing interest expense, and share count shrink will result in an EPS CAGR of ~20% for the next several years. We think that CDW will generate over $3.00 per share in adjusted earnings in 2016. At a multiple of 15x, CDW is worth more than $45 per share.

Disclaimer:  We and our affiliates are long CDW. We may buy or sell shares without notification. This is not a recommendation to buy or sell shares.

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