CDW's Growing Pains

CDW (Nasdaq: CDWC  ) traded down almost 9% after reporting earnings Friday morning. The computer wholesaler's lower-than-expected fourth-quarter earnings were clearly not what investors wanted to hear. But honestly, was the news really that bad?

Revenues for the quarter were $1.8 billion, a 13.5% jump from last year's Q4. Organic growth was 6.7%, and the recent Berbee acquisition contributed the remainder. Gross margins ticked up 10 basis points; while CDW operates in a deflationary industry beset by constant price erosion, the new products sold through Berbee contain a higher service content, therefore buoying gross margins.

But things started to fall apart with the unexpected $25 million settlement related to the company's 2003 purchase of Micro Warehouse. While CEO John Edwardson felt CDW had a legitimate defense, he argued that the extra time and money wasn't warranted and would ultimately be a distraction. Still, when stripping out this one-time cost of settling, earnings per diluted share came in flat at $0.86.

Making things worse were the laundry lists of "reasons" why operating margin fell from 6.7% to 5.9% from last year's Q4. Most of the extras were associated with incorporating Berbee's operating expenses, but they added up to more than investors expected.

As consolation, management offered a glimpse of what it believes is a sea of opportunity. Using data from the research firm IDC, CDW believes it's selling into a $204 billion-$216 billion information technology (IT) market. With $6.8 billion in annual revenues, CDW captures about 3.1%-3.3% of that pie. IDC also estimates that the market will generate compounded growth of 5.1% through the year 2010. In short, management believes it can continue to capture a larger share of the overall market at a faster average rate of growth.

However, because the firm operates in a niche, focusing on small- to medium-size businesses, any significant growth in market share will position it outside its area of competitive advantage. The company will compete more and more with the same players who make the products it sells, namely Hewlett-Packard (NYSE: HPQ  ) , Cisco (Nasdaq: CSCO  ) , and Microsoft (Nasdaq: MSFT  ) . CDW must keep costs under control if it wants its earnings to follow revenue growth. However, as the company showed in its earnings presentation, its returns on invested capital, while still well above cost of capital, have fallen over the past five quarters.

Investors will just have to wait and see whether CDW can gain leverage on its growing infrastructure, or whether lower profitability is here to stay. True, earnings weren't that bad -- but they weren't that good, either.

A fire sale on further Foolishness:

CDW is a Motley Fool Stock Advisor recommendation, while Microsoft is a Motley Fool Inside Value pick. Whatever your investing style, the Motley Fool has a newsletter for you!

Fool contributor Matthew Crews welcomes your feedback -- really! He has a financial position in CDW but has never bought any of its products. He holds no financial position in any of the other companies mentioned. The Motley Fool has a disclosure policy.

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