In 2017, I told The Motley Fool's chief investment officer, Andy Cross, that I thought Texas Instruments was one of the very best businesses not currently listed as a recommendation in a Motley Fool service. Since then, I have not found another business not already in the Foolish universe worthy of such an assertion. Until now!
For only the second time since that discussion in 2017, I've come across a stock -- this time, CDW (CDW -2.18%) -- that is one of the very best businesses not appearing as an active recommendation in a Motley Fool service.
Why do I have such a high opinion of the company?
To help explain, I pulled together a list of important questions I think investors should be asking about the company, and then went about answering them for readers on fool.com! In a way, I'm having a conversation with myself about CDW. Here's what I had to say.
Q. What is your investment thesis on CDW?
CDW was founded in 1984, and its stock went public the first time in 1993. It currently generates about $18 billion in revenue, has about 10,000 employees, and has a market valuation of about $18 billion as well. CDW originally stood for Computer Discount Warehouse, but today the official name is CDW Corporation. In the early 2000s, CDW mainly sold desktops, laptops, and printers.
Today, it still sells the latest computer and device hardware, but also sells products for data centers, networks, cybersecurity, mobility, virtualization, collaboration, automation, the public/private/hybrid cloud, and software as a service. CDW's cloud practice is large and growing. It offers services from over 70 public cloud vendors, and CDW generates about $3 billion in cloud revenue. When breaking down its sales, roughly 80% are from hardware and 20% from software and services.
CDW is a value-added reseller of a variety of technology products and a provider of business-to-business information technology solutions. Those products and services come from a wide range of companies, including Apple, Amazon, Alphabet, Microsoft, Adobe, NVIDIA, and ServiceNow. It also serves as a sales and solutions provider for companies like Zoom Video Communications, Okta, CrowdStrike, Splunk, Nutanix, Palo Alto Networks, and Zscaler.
Investing in CDW is a way to benefit from the growth of many of the most innovative companies in the world without paying elevated multiples of 10 or 20 times sales -- and sometimes higher. (I'm OK paying those multiples for small bets, but this is just another way to get exposure.)
CDW's success is not tied to any one technology product or tailwind. Instead, it offers a range of products and services from some of The Motley Fool's favorite companies. And unlike some of those early stage, rapid-growth companies, CDW is a highly profitable growing business. Also, unlike many tech darlings, CDW is not subject to disruption risk. Rather, CDW is technology agnostic, and technological disruption and innovation drive its business!
Information technology (IT) is getting more complex and more integral to businesses across industries as they adapt to the digital revolution, so I'm confident that CDW's service offering will remain in high demand for the foreseeable future. If you want to invest in the latest and greatest technologies but feel like they are outside your circle of competence and you are afraid of disruption risk -- but you still want exposure to technology -- then CDW may be right for you!
CDW operates in a large and growing market. It currently has a 5% share of a $360 billion total addressable market and is consistently growing its share. In the span of 2009-2019, CDW grew sales at 1.8 times the market rate (or by 4.4% compounded annually).
CDW's above-market growth is driven by three things:
- Competitive advantages, including its market-leading scale and key partnerships with leading digital companies (see more below).
- Solid execution.
- A trend in which a growing amount of IT spend is going through value-added resellers (like CDW) as opposed to going directly from the original equipment manufacturer (OEM) to the end user.
And here's where it gets exciting: Even though it only has 5% share, CDW is by far the largest player in this highly fragmented market with tens of thousands of smaller competitors, so there is a very long runway of attractive top-line growth from market share gains and occasional acquisitions. All in all, a pretty awesome elevator pitch, eh?
Q. How did you come across this CDW investment idea?
I've long been aware of CDW because I report on (and own stock in) two other leading digital IT service providers, Accenture (ACN -2.92%) and EPAM Systems (EPAM -3.44%). If you know me, then you know that Accenture and EPAM are two of my very highest-conviction investments. I was aware that CDW had a different business model, but that it was still a high-quality growing business. I followed the company from a 30,000-foot view but never got closer because I tend to prefer businesses with net cash and high free cash flow (FCF) margins, among other things (more on that later).
But then I read an excellent investment thesis on CDW by David Rolfe, chief investment officer at Wedgewood Partners, in his third-quarter 2019 letter to investors. Ever since, I've been analyzing CDW (equity research takes time, Fools), and I really like what I've learned! My investment thesis is very similar to Rolfe's because my research has led me to agree with everything he said.
Q. How did CDW get to where it is today?
CDW has shifted from selling discrete technology products to selling integrated technology solutions to include technology road-map planning (advisory), design, installation, ongoing maintenance and support, and then eventual renewal. In other words, CDW provides support across the entire IT life cycle, and by doing so it creates long-term, sticky customer relationships. To support this business model shift, CDW has increased its hiring of technology engineers and specialists to provide these higher-margin services.
The business model shift, while ongoing, has been a huge success and has helped cement CDW as a leading IT solutions brand. In 2019, it was ranked the fifth-best solutions provider out of 500 by Computer Reseller News (CRN).
CDW was acquired by a private equity firm in 2007 and had a second initial public offering in June 2013. The company's fundamentals have improved dramatically since year-end 2012 (the year before it went public). Today, the company has lower debt ratios, higher interest-coverage ratios, and higher returns on invested capital (ROIC). The company's high-single-digit top-line growth (more on its growth below) is almost all organic since CDW has only made three acquisitions in the last 10 years. Its former chief legal counsel, Christine Leahy, became CEO on Jan. 1, 2019. Since then, she's made two of those three acquisitions, so it's possible that she will prioritize acquisitions more than her predecessor. But that remains to be seen.
Q. What is the CDW business model?
CDW acts as a middleman between technology vendors and customers. It does not manufacture products, so it spends very little on capital expenditures and nothing on research and development. A significant portion of its advertising expense is reimbursed by vendors through cooperative programs, so CDW only spends an average of about 1.2% of sales on advertising. Its two biggest areas of investment are working capital and people. Of its 10,000 employees, two-thirds are customer-facing.
It sells over 100,000 products from more than 1,000 vendor partners to over 250,000 regular customers. Vendor partners include OEMs, software publishers, cloud providers, and others. CDW adds between 50 and 75 new partners each year to ensure its product/service offerings remain relevant and innovative, to maintain long-term growth, and to future-proof the business. In addition to procuring products directly from its vendor partners, it also buys from third-party wholesale distributors. It primarily sells to customers with fewer than 5,000 employees.
Vendors want access to CDW's 250,000 customers (especially the smaller ones where the OEMs don't have a long-term relationship) as well as its sales force and distribution footprint, installation, service, and support staff. This is why CDW is typically the first- or second-largest channel partner for OEMs in North America (and often in the world).
Customers want the large product selection and availability, and the ease of buying hardware, software, and services from one reliable IT provider. They also appreciate that CDW is technology agnostic so they know it's providing them with unbiased advice. This is why the average customer has been working with CDW for 11 years.
It has diverse revenue streams selling its products to corporations, governments, and education and healthcare organizations. CDW primarily serves customers headquartered in the U.S., the U.K., and Canada, with roughly 88% of 2019 revenue generated in the U.S. But those customers have locations all over the world, so CDW is indirectly serving 150 countries across the globe.
Traditional competitors include Insight Enterprises (NSIT -3.45%), PC Connection (CNXN -2.11%), and ePlus (PLUS -2.02%). Relative to its peer group, CDW is multiples larger, growing faster, more profitable, and more attractively priced based on dividend yield and free cash flow yield.
|Sales (in billions)||Net Income (in millions)||FCF (in millions)||ROIC||Market Cap (in billions)||5-Year Revenue CAGR||Dividend Yield||FCF Yield|
Q. How is CDW's business different from Accenture and EPAM?
CDW is starting to offer more consulting services, so it does compete with Accenture and EPAM from time to time. But the big difference is that CDW is a value-added reseller that carries inventory on its balance sheet and has distribution centers to house that inventory and speed fulfillment. The other difference is that CDW mainly works with small and medium-size businesses so, for example, it would likely not be hired to do an enterprise resource planning implementation at a Fortune 500 company.
While we're on the topic, CDW does hold inventory, but it also has drop-shipment arrangements with vendors and distributors so that it doesn't have to hold that portion of inventory at its warehouses. Roughly 50% of CDW's sales come from these drop-shipment arrangements.
Q. Does CDW have a healthy balance sheet?
CDW was previously owned by private equity firms (through a leveraged buyout) so it has significantly more debt than I am typically comfortable with. By the company's own account, it has "substantial indebtedness." It has $3.2 billion in net debt and $951 million in trailing FCF, according to the website New Constructs, so its net debt to FCF is about 3.4 times.
I typically don't want to see the net debt/FCF ratio higher than 2, meaning that the company could pay off all its net debt with two years' worth of FCF. In CDW's case, it would take almost four years of FCF to pay off all its net debt. But since CDW's 2013 IPO, it has reduced its leverage ratios significantly, and according to S&P Global, CDW has improved its interest coverage ratio (EBIT/interest expense) from 2 times in 2013 to 7 times at the end of 2019. The average maturity on its debt is over six years, and its weighted average cost of debt is only 4.3%.
I'm also comfortable with CDW's financial leverage because it does not also have a fixed-cost business model with a lot of operating leverage. (It's when companies have both debt leverage and operating leverage that they are more likely to get into trouble.) Instead, CDW has a variable cost structure. That means if sales slow, the company can immediately respond by reducing compensation expense and working capital (working capital is the company's biggest capital investment, and if business slows it can easily cut investments in inventory). This ensures that there is enough operating income or cash flow to service the debt. Importantly, CDW is capable of generating even more cash flow than normal during a recession because it could dramatically reduce working capital.
CDW has a target net-debt-to-EBITDA ratio of 2.5 to 3. It's currently slightly below its target. I think the debt is used to support its capital allocation plan (see below) and to boost return on equity (ROE) to fantastically high levels. According to S&P Global, CDW's five-year average ROE is 55%, and its trailing ROE is 76%.
Q. What are CDW's historical growth rates and how do they relate to recent performance?
CDW is operating with lots of business momentum because of solid execution, its business model shift, and the digital revolution. From 2014-2019, this was CDW's five-year compound annual growth rate (CAGR) in various metrics:
- 8.4% for revenue (nearly all of it organic).
- 24.6% for net income.
- 28.6% for GAAP-diluted EPS.
- 20.8 % for adjusted diluted EPS.
- 15.8% for FCF (calculated as operating cash flow less capital expenditures).
FCF grew slower than net income during this time period because in 2014, the starting year for these calculations, FCF was so much higher than net income. Regardless, FCF still grew at almost double the rate of revenue.
In 2019, CDW's sales grew 11%, GAAP-diluted EPS increased by 19%, and adjusted diluted EPS increased by 18%. Of the 11% top-line growth in 2019, roughly 1% came from acquisitions and a little less than 1% came from the devices-as-a-service solution for the U.S. Census Bureau. CDW is leasing smartphones and tablets to enable 500,000 field workers to take the census. This will also add about 1 percentage of incremental revenue growth in 2020, but the census project will end this year (so this is a significant but nonrecurring revenue stream).
At the same time that CDW is generating stable and strong organic revenue growth, its ROIC is consistently rising. The combination of strong or rising organic revenue growth with strong or rising ROIC is investors' nirvana because it indicates that CDW is creating lots of business value.
It's a growing business with a growth mindset. In fact, the company recently created a new role of chief growth and innovation officer to address that fact.
Long-term growth should come from a conversion-to-digital tailwind and continued market share gains. Additional growth could come from acquisitions and continued international expansion. CDW has a growing presence in Canada and the U.K. and recently set up legal entities in the Netherlands and India. That's the first small step to setting up larger fulfillment operations in those countries over time. This is an exciting growth story, Fools.
Q. CDW's revenue is growing at roughly 8% CAGR, but its net income is growing at 25%. How?
Its revenue growth is somewhat tied to customer headcount growth, but CDW has been able to generate slight operating margin improvements as it shifts to higher-margin services and from leveraging technology and automation internally. Below the operating margin line, CDW's net income also benefited largely from deleveraging (paying down debt reduces interest expense) and from corporate tax cuts. Almost 90% of its sales are generated in the U.S., so it benefited greatly from corporate tax reform.
Q. Discuss CDW's margins and returns profile. Why is its ROIC is increasing?
As a reseller, CDW is a low-margin business. Its gross margins are stable in the 16.5% to 17% range, and its net operating profit after tax (NOPAT) margins are less than 5%. It has a long-term goal to generate free cash flow margins of about 4%.
But, according to New Constructs, it was still able to generate a trailing 12-month ROIC of 17% and a return on tangible invested capital of 53%. CDW's return on tangible capital is so much higher than its ROIC (which is also high) because lots of goodwill was added to the balance sheet during the leveraged buyout. That return-on-tangible-capital figure shows the truly awesome profitability of the underlying operating business.
Impressively, its ROIC has increased for the past five consecutive years, and we can use a DuPont Analysis to see that the increase was driven by higher NOPAT margins and higher invested capital turns. Basically, the company is becoming more efficient at managing its working capital and other assets on its balance sheet. This means CDW is able to generate healthy ROIC despite low margins because of its high and improving capital efficiency, or invested capital turns, and its improving margins are boosting returns as well. In my experience, it is somewhat rare to find a business whose ROIC is getting a boost from both higher turns and higher margins, and I think this is an indicator that the company has been firing on all cylinders.
Q. CDW's improving returns on working capital data are impressive. How does it do it?
One of the benefits of operating under private equity ownership is you get very focused on aggressively managing working capital and cash conversion very quickly because those cash flows are needed to service the large debt load. Today, CDW's balance sheet is much healthier, but it is still operating under its tougher efficiency guidelines, especially with regards to monitoring the cash in and out of the business. It's just built into this company's corporate DNA now.
Q. Does CDW generate strong FCF and is its FCF growing?
We've talked about revenue growth and ROIC, which are important because they ultimately drive free cash flow. CDW is a low-margin business, but its FCF is pretty strong because its average capital-expenditures-to-sales ratio is only 0.5% (that's really low) and because the company is very efficient at managing working capital and its cash conversion cycle. As I said earlier, CDW's FCF grew at a 5-year CAGR of 16%. CDW generated more FCF than net income in each of the past four years (2016-2019), and it has a long-term goal to generate an annual FCF margin in the 3.75% to 4.25% range.
From 2018 to 2019, CDW's capital expenditures increased a whopping 174% (from $86 million to $236 million) as it dramatically ramped up spending for the contract with the Census Bureau. But this is a one-time project that will end in 2020. This means that CDW's capex will return to its normal level of about 0.5% of sales, and that the 2019 boost in capex will turn into depreciation (which is a non-cash expense that is added back on the cash flow statement). Expect that the company's FCF will remain strong and continue to grow at least in line with its organic revenue.
Q. What are CDW's competitive advantages?
CDW's moats include its long-term relationships with both vendors and customers, the scale and scope of products and services offered and distribution capabilities, and unique insights gained from being a key partner to both customers and IT vendors. The company sits in the middle of the tech supply chain offering attractive value propositions to both customers and vendor partners (OEMs, software companies, and the like). CDW says that it acts as both "an extension of its customers' IT staffs" and "an extension of its partners' sales and marketing resources."
What truly makes CDW unique is its multiple sources of interlocking competitive advantages. Of those, I'm most impressed by its scale and scope relative to its peers. Its size allows it to invest heavily in its sales force and engineering teams, own three distribution centers, and make sure that it gets its fair share of inventory from vendors when there are supply shortages. This means that CDW will have the inventory that its customers require.
Q. What makes CDW's business unique and hard to replicate?
This is similar to the competitive advantage question, but it goes a step further. I won't recommend a company that isn't truly differentiated and doesn't have differentiation that shows up through superior corporate financial performance.
CDW is unique because it has multiple sources to reinforce its moat. I especially like that it is the single largest player in an attractive industry and has a scale and scope that is multiples larger than its peers. This provides the company with negotiating leverage, innovative product offerings, multiple levers of profitable growth, and an attractive workplace for top tech talent.
I also think it's unique because it provides an equal amount of value to both its vendor partners and its customers and is run by a CEO who is committed to taking a stakeholder approach to drive sustainable profitable growth. This second point is of grave importance and will contribute as much (or more) to long-term business value growth than anything else.
It is CDW's non-zero sum and stakeholder approach to growing the business sustainably over time that provides the company with its most enduring moat, while providing investors with a different type of margin of safety.
Q. What are CDW's capital allocation priorities? What does it do with its strong FCF?
CDW's capital allocation priorities are (in order):
- Increase the dividend annually.
- Maintain the net debt-to-EBITDA ratio at 2.5 to 3 (basically, it pays down debt whenever the company moves above that range).
- Use free cash flow for acquisitions and share repurchases.
CDW paid a $0.17 per share annual dividend in 2013, and the current annual dividend is $1.52 ($0.38 quarterly). That means it has increased the dividend nearly ninefold (or 794%) since its June 2013 IPO. It most recently increased the quarterly dividend by 29%. Its goal is to maintain a payout ratio of about 25% and to grow the dividend in line with earnings. If you like dividend growth stories, this company has one!
Although its first priority is to increase the dividend, CDW actually spends more on annual share repurchases than it does on dividends. It has historically reduced the diluted share count by about 3% per year. Given that CDW is currently operating below its target leverage ratio, it intends to return more than 100% of FCF to investors in 2020 (as it did in 2019).
Regarding acquisitions, CDW looks for product relevance and innovation, strategic and cultural fit, international expansion, and attractive financial returns. I like that CDW is not overly aggressive with acquisitions (it's only bought three companies in the last 10 years) and that this is not a roll-up story. Its ROIC has actually improved despite the acquisitions, which is a key indicator of success.
Q. Does CDW have pricing power and/or recurring revenue?
I'm going to say no, for now, because it doesn't increase prices annually and doesn't have recurring revenue that we'd see from companies with long-term contracts or that sell use-once-and-dispose consumables, or that sell subscription services.
CDW's contracts are not long term (with customers or vendors), but only 12 months in length. Its managed-services contracts are longer (and therefore recurring), but managed services are a small part of its business. Managed services provide basic infrastructure hosting for things such as database management, break/fix support and patching, and performance and capacity monitoring and reporting.
Pricing at CDW is actually set by the account managers (sellers) because they have the closest relationship with the customer. The sales force is given a price minimum and a price range, and then picks the best price based on its knowledge of the customer and the competitive environment. Sellers are compensated based on a percentage of gross profit, and this model clearly works because of CDW's (already referenced) very stable gross margin profile. More than 50% of CDW's sales are generated from account managers who have been working at CDW for at least seven years. This long-tenured sales force helps to build those long-term, sticky customer relationships.
It's also important to note that a great business generates high ROIC and has opportunities to reinvest at high returns to drive organic revenue growth and strong FCF over a long time. Pricing power and recurring revenue are two paths to high ROIC and consistent growth, but not the only paths. CDW generates high and increasing ROIC and has demonstrated a long record of above-market organic revenue growth.
The lack of pricing power is more than made up for by its unique business model of providing a real value proposition to both its vendor partners and its customers. It also helps that CDW has a CEO with a stakeholder approach to sustainable profitable growth.
Q. What can you tell me about CDW's management team and its corporate governance?
Christine Leahy has been CEO since Jan. 1, 2019, and has worked at CDW since 2002. According to S&P Global, she owns $11 million worth of its stock, which is not bad for only holding the CEO position for about 15 months. In her first letter to shareholders, Leahy stressed CDW's commitment to taking a stakeholder approach to drive long-term profitable growth:
We will never take for granted our reputation with our customers, co-workers, partners, shareholders and communities where we employ, live and have impact -- a reputation that has been built over 35 years through relentless commitment, dedication, hard work, philanthropic contributions and complete integrity. I assure you that every single day during my time as the leader of your Company and as your fellow stakeholder, CDW will continue to never allow for complacency regarding our business performance or anything less than the full commitment to serving our customers and enhancing the value of our shareholders' investments and the lives of our stakeholders. The means will be as important and non-negotiable as the ends. This is my commitment to you.
I admire several of the company's corporate governance policies, including having a clawback policy, a separate CEO and chairman, majority voting, no executive perquisites, diversity on the executive committee (six of 13 execs are women) and board (four of 11 board members are women), and strict stock-ownership guidelines. Board members are required to own five times their annual cash retainer in stock, and the CEO is required to own six times her annual base salary in stock.
I also love that the company's executive compensation plan is partly based on both market share gains (which drive organic revenue growth) and free cash flow (which is the driver of intrinsic value growth and what we are ultimately after as investors). Would I like to see CDW add an ROIC metric to its incentive compensation plan? Yes, of course, because ROIC is a primary driver of stock prices! But this is a management team that clearly understands the drivers of business value and the importance of return-based metrics, so I'm agreeable with this comp plan.
I also applaud that the company is transitioning to an annual election of directors starting in 2021.
Q. Is management committed to investing in long-term profitable growth?
This is an important question, so we need to spend some quality time discussing it. One thing I really love about this management team is its commitment to reinvesting back into the business to maintain long-term profitable growth. In her first annual report to investors, Leahy mentioned the phrase "profitable growth" at least four times.
Later in that same report, it becomes clear that Leahy and her management team understand the vital link between reinvestment, proper incentive compensation, and profitable growth, when she says: "We have built a strong sales organization and deep services and solutions capabilities over time and expect to continue to invest to enhance these capabilities, which we believe when combined with our competitive advantages of scale and a performance driven culture, will help drive sustainable, profitable growth for us today and in the future. ... Our strong, execution-oriented culture is underpinned by our compensation system."
Then on the fourth-quarter 2019 earnings call, an analyst asked CDW management if the company is "underearning a little bit because of the investments?" CFO Collin Kebo's response (which I absolutely love) was:
... in your question, are we underearning? I guess, the flip of that is, are we overinvesting? And I would say, no. We feel like we have the right balance between investment back into the business that allows us to continue to create differentiation in the marketplace that enables the sustainable outperformance versus the market. So could we pull back on investment in the short term? Yes. Absolutely. Would the margin float up? Yes. But I think that 200- to 300-basis-point premium that we've consistently been able to deliver [referring to the 2% to 3% in annual market share gains], over time, you would see that get chipped away. So we think we have the right balance between investing in the business and growth in margin.
Earlier on the same call, Kebo said: "... our fourth-quarter and full-year results reflect the combined power of our balanced portfolio of channels, broad product offerings and ongoing execution of our three-part strategy. They also reflect successful investments in our business that build on our long-term financial strategy to drive strong cash flow, deliver sustained profitable growth, and return cash to shareholders."
On the earnings call, Leahy explained why the company created the new role of chief growth and innovation officer:
We're really focused on scaling sustainable growth. So this is about focus for growth. And in particular, when we think about our customers, our partners and products and the channels and platforms that we use [and] sell, and the technology and digital capabilities that underpin those, the connective tissue between them is becoming more and more important. So this role is really intended to help align and focus our efforts and investments around driving the connectivity there. When you take a step back, CDW has historically delivered meaningful profitable growth. And we've done that through continual innovation and continual investment, disciplined investment, and focus on investing where the growth is. So when I think about growth and innovation and bringing that team together, it's just another natural step in the way that we think about growth in the future.
As a long-term, business-minded, quality-growth investor, this is exactly the language I love to hear from a corporate management team that I'm thinking of partnering with.
Q. Can you briefly discuss the workplace culture?
Competition for tech talent these days is intense. CDW has a workplace culture that's performance-driven (I already discussed the incentive programs for sellers and executives) and highly engaged. It runs an engagement survey of employees every two years and pulse surveys in off years. CDW has a 96% participation rate in the surveys, and actions to come out of them include expanding paternity leave, improving automation, and offering ongoing career training.
Leahy has a 93% CEO approval rating on Glassdoor.com, and CDW is on Glassdoor's 2020 list of Best Places to Work. CDW scores a perfect 100 on the Human Rights Campaign Corporate Equality Index, is ranked in the top 100 Best Places to Work in IT, according to Computerworld, and is ranked as a "best place to work" for military veterans and for women. CDW is also ranked as one of the top 100 "most just companies" in the U.S., according to JUST Capital.
The company is also on Forbes' 2020 list of America's Best Employers for Diversity, and CDW has several groups to promote diversity and inclusion in the workplace and has a "be Green" environmental initiative. The company would be well served to set stricter environmental goals and to share the progress against those goals by publishing annual sustainability reports.
Q. What are the risks to the CDW story?
Possible near-term risks are that CDW is unable to get enough inventory because of supply constraints brought on by the novel coronavirus outbreak or that customers cut back on spending due to uncertainty in a U.S. presidential election year. These are wild cards to be aware of.
Another risk is vendor concentration. Products from Cisco and HP account for 25% of CDW's overall sales. And products from its seven largest vendors account for 60% of sales.
But a potentially larger long-term risk to the stock is if we experience a broader economic downturn in which customers may temporarily cut their IT spending. CDW's diversified revenue clientele may help mitigate what could be significant cuts (for example, government or education spending may remain healthy even though corporate spending is cut). It also helps that, as the world has digitized, technology has become more integral to organizations than it was during the Great Recession.
On the other hand, a recession scenario could actually present an opportunity for CDW. A neat thing about its business model is that cash flow actually has the potential to be stronger during a recession because the company would significantly reduce working capital, which is its single largest capital expense. This strong FCF would allow the company to continue to increase the dividend, buy back discounted stock, and (hopefully) make acquisitions that allow it to come out of the recession even stronger.
Q. How did CDW fare during the 2008-09 financial crisis, and how might it fare during the next recession?
CDW held up fairly well during the global financial crisis with sales decreases of only 1% in 2008 and 11% in 2009. Then sales quickly rebounded 23% in 2010. An awesome showing, considering it was the worst financial crisis since the Great Depression. But earnings did not hold up so well. The company reported losses in 2008 and 2009, largely because of impairment charges to write down some of the goodwill from going private. But those were noncash charges in 2008 and 2009, so cash flow from operations was still positive.
CDW is a people business and thus has a variable-cost structure. This means if sales slow, the company can immediately respond by reducing compensation expense and working capital to make sure there is enough cash flow to service the debt, increase the dividend, and invest aggressively during the downturn. Today CDW is in a much more favorable financial position than it was during the last recession. It entered the last recession leveraged at 10 times EBITDA. In fact, CDW's management says that whenever the next recession occurs, it will be ready to make acquisitions on the cheap.
Q. What are your thoughts on CDW's valuation?
The market downturn in late February has brought the stock price down more than 20% from its 52-week high of $146 a share. When evaluating whether a stock is a bargain, a lot of investors focus on the price-to-earnings ratio, so let's start there. CDW's forward P/E is currently hovering around 17, compared with a past average of about 15 since its 2013 IPO. The stock has clearly re-rated higher because:
- The business model has shifted from selling discrete tech products to selling fully integrated tech solutions.
- Fundamentals have improved.
- Interest rates fell to all-time lows.
What precise P/E does it deserve? I don't know. But I'm very confident that an appropriate P/E is closer to 18, 19, or 20 (or even higher) than it is to 15. CDW has developed into a high-quality growing business with excellent management and exposure to long-duration tailwinds.
According to market research firm IDC, global IT spending is projected to grow at a roughly 4% CAGR through 2023. But U.S. IT spending (CDW's largest market) has historically grown at an average of 5% per year, and CDW's core markets are projected to grow at 5% annually over the next four years. Let's assume long-term market growth of 5% and that CDW outgrows the market (i.e., takes market share) by 2% to 3% per year which is its goal. Based on that, long-term organic revenue growth would average around 7% to 8%.
CDW outgrew the market by 2.9% annually from 2006 to 2019 and by a whopping 4.4% from 2009 to 2019. And from 2009 to 2019, CDW's revenue grew at a 9.7% CAGR. To be fair, 2009 was in the depth of the financial crisis, so that calculation is starting from a low base. But from 2009 to 2010, CDW's sales rebounded 23%. If I start the CAGR calculation in 2010, its sales still grew at an annualized rate of 8.3% from 2010 to 2019.
In addition to the projected 7% to 8% top-line growth, it would be fair to factor in slight margin expansion as the company shifts to selling higher-margin software, services, and solutions and continues to reduce the diluted share count by about 3% per year. That suggests that EPS and/or FCF per share could grow about 10% to 11% per year. Add in the dividend yield of 1%, and investors can expect total annualized shareholder returns of about 11% to 12%, assuming that the P/E ratio does not change (to be conservative).
Here's another way to think about it. According to New Constructs, CDW trades at a 4.7% FCF yield. That by itself is relatively attractive because it is more than four times higher than the 10-year U.S. Treasury note (a proxy for the risk-free rate), which yields an all-time record low of nearly 1% as of this writing.
Add CDW's almost 5% FCF yield plus an expectation that the company can grow FCF per share by about 10%, and I calculate that CDW can provide investors with an expected annualized return of roughly 15%.
When you combine these two methods, you can estimate that CDW will provide investors with expected annualized returns in the 11% to 15% range. Those should be market-crushing returns, Fools.
Q. Why don't you own any CDW stock yet?
I plan to buy a starter position as soon as The Motley Fool's trading restrictions allow.
For other stocks in my "Everything You Want to Know" series, click below: