CDW Corporation (NASDAQ: CDW)

An interesting area to look for excess returns in the equity markets are public LBOs.  These are moderate to highly leveraged businesses (typically with debt amounts greater than 4x cash flow) which benefit from both growth in earnings and rapid debt repayment.  When thinking about debt repayment, the returns on cash deployed typically are not very high.  A 4x leveraged business in today’s credit environment carries a borrowing cost of 7.5%-8% all in, which after tax, costs shareholders ~5%.  This is clearly a much lower return amount than most corporations are able to earn on equity.  However, highly levered entities engaging in debt repayment offer some unique benefits to shareholders.

  • Equity holders have the benefit of owning the corporation with much fewer dollars deployed.  For example, CDW currently trades at a market capitalization of $5.8 billion with net borrowings of $3.1 billion.  This means prospective owners can buy into an $8.9 billion corporation for $5.8 billion.  When looking at prospective returns, if the company were debt free, book value would grow by a projected ~$500 million in 2014, or 5.6% on $8.9 billion (assuming P/BV multiple stays constant).  When considering current debt levels of $3.1 billion, book value would grow by a projected ~$360 million (taking into account after-tax cost of interest), or 6.2% on $5.8 billion.  The return figures are affected by a few variables, namely equity value in relation to enterprise value, return on equity capital, and the cost of borrowing.  But, generally, low cost leverage serves to increase equity returns and is a large factor driving private equity and real estate returns.
  • As debt is repaid and the balance sheet is “de-risked” valuation multiples tend to improve, providing an additional boost to returns.

A slew of private equity portfolio companies have come to the public markets over the past two years due to (i) a spate of behemoth LBOs from the 2005-2007 vintage which are now being monetized and (ii) very favorable valuations present in the public market.  I’ve been searching through some of these issues for investment candidates.

The Business

CDW is a company I’m familiar with from past experience.  It is the leading direct market reseller (DMR) of technology products in North America.  In simple terms, CDW partners with blue chip technology providers (e.g. HP, Cisco, Lenovo, VMware, Apple, EMC, Microsoft, and many more) to sell hardware and software products to 250,000+ customers including small and medium sized businesses, governments, healthcare institutions, and educational institutions.  CDW sells these products through a sales force of 4,400 coworkers, including 1,800 field sellers, skilled technology specialists, and advanced service delivery engineers.

CDW operates in a commodity business, cataloging and selling such products as PC laptops and desktops, servers, software licenses, and networking equipment.  It is trying to build up a value added solutions business (converged infrastructure, cloud solutions, virtualization, etc.), but solutions only accounts for 3% of total revenue.  The numbers tell a fascinating story.  Since 1993, the company has grown sales by 20%+ annually (8.5% since 2000), while slightly improving margins.  The company has outpaced the market and its primary DMR competitors and has increased market share every year.  I was very curious to know how a commodity reseller has been able to consistently improve market share while enjoying greater than twice the operating margin of its peer group.

We can silo the company’s operations to determine whether any competitive advantage exists.  At its core, CDW is engaged in three distinct operations: (i) procuring and managing commodity technology products, (ii) selling, marketing, and providing customer service to a large customer base, and (iii) investing in and managing working capital.  When you think about the nuclear units of the business, it becomes evident that the company has developed strong competitive advantages over time.

Scale is an important advantage in this industry and CDW’s size relative to its peers (larger than its four closest competitors combined) bestows it with important benefits in procurement.  Technology partners are primarily focused on moving greater volumes of product and provide substantial incentives to channel partners who can sell in vast amounts.  CDW benefits from significant vendor rebates, cooperative advertising arrangements, and favorable payment terms, which is reflected in its superior gross margin (16.5%) relative to peers (13.5%).

The company also runs the most productive and efficient sales force in the industry.  Revenue per sales employee of ~$2.5 million compares favorably to ~$1.5 million for peers.  The company has found the most effective way to organize and incentivize its sales team and has also been able to sell a larger variety of products through a narrower team of coworkers.  The net result of these efforts is an operating margin of ~7% vs. 3% for competitors.  CDW is also the industry standard bearer for managing the cash conversion cycle; it generates the highest returns on working capital in the industry.

The company’s margin advantage gives it a significant cost advantage over its peers, particularly tiny resellers.  It can offer the greatest breadth of product and service, match any price offered by competitors, and provide extremely well paid account managers to serve customers’ needs.  These factors explain CDW’s ability to outgrow the market and take share.

Key Long Term Risks

  • Technology: The consumption of technology changes rapidly and it’s therefore difficult to predict the impact of future development on the company’s revenue streams.  Most resellers have been quick to adapt to the latest trends in the market.  In the early 1990s, CDW made its living selling Apple Macintosh and IBM PCs, Windows software, and computer peripherals.  Today, it sells everything from routers to cloud software to converged infrastructure solutions.  If the world were to fully migrate to the cloud, where Chromebooks were omnipresent, it could have a meaningful impact on CDW’s business.  Thus far, the cloud has only served to benefit the company as it’s provided a boost to its Chromebook business, servers, storage, and cloud solutions.  As long as overall IT spend is growing with GDP, CDW will be well positioned to capture a share of the market.
  • Dell / HP:  The technology solutions market is still dominated by the direct channel, where customers purchase directly from vendors. For small and midsize businesses, however, channel providers such as CDW are valuable as they are a one stop shop for purchases, warranty, servicing, advice, and technology solutions.  It becomes very costly for a small IT department to manage multiple vendors, product defects, servicing, contracts, licenses, and warranties. Nevertheless, HP and Dell are in the process of reinventing themselves and are re-positioning their businesses to focus on business IT solutions.  They have been building out their account specialist teams and adding software solutions to their suite of offerings.  In the hardware channel, CDW is an important partner for HP, moving $2 billion of product annually, and is unlikely to face direct competition from its key vendor partner.  Dell, on the other hand, only sells direct and is focused on controlling the customer relationship.  As a private company, Dell is now able to make as much investment in this area as it deems necessary to compete.  Despite Dell’s push into this area, it will not be easy to displace CDW as there is a certain level of stickiness among customers who are accustomed to working with long tenured account managers.  Where Dell and HP are likely to win long term is in the value added solutions business, which is a growing, albeit tiny portion of CDW’s revenue base.

Valuation

By my estimate, current valuation in the market is fair for the company.  The stock is up nearly 80% since its IPO in July 2013, and the whole enterprise trades for 10.5x 2014 operating income.  It took the company 15 years to get to $5 billion of revenue and 9 more years to get to $10 billion.  It’s reasonable to think that CDW could get to $19 billion of revenue by 2025 (from $11 billion today).  Assuming slight margin improvement from today’s levels (there’s very little operating leverage in the business), the total equity IRR comes out to ~10%.  This doesn’t meet our hurdle of a minimum 15% return.

Conclusion

CDW is a franchise business, possessing a durable margin advantage and economies of experience with regards to its sales operation.  These advantages should snowball as further scale is achieved.  Management has historically been extremely prudent with capital, only making 2 small acquisitions in the company’s 25+ year history and operating successfully with a significant debt load.  Management has also focused on its core geographic strength in North America and not spent precious shareholder capital chasing potentially low return international opportunities, where CDW has no incoming advantage versus incumbents.  Further, the business only requires investments in working capital (and to a lesser extent IT systems) to grow, and the incremental returns on this capital are in the stratosphere (90%+).

The one constraint with this business is the lack of operating leverage.  The company must hire additional sales representatives to grow its business; there’s eventually a limit to the amount of business a single account manager can handle.  In addition, the more an account manager sells, the more commission he or she earns.  Operating margins have improved by a paltry 70 bps over the past 17 years.  As such, operating income will tend to grow with revenue, which in turn should grow a few points above GDP.  In my view, it’s unlikely this business can achieve an exponential outcome in earnings performance.

At current valuations, the opportunity is uninteresting.  Nevertheless, it’s a wonderful business and worthy of putting on the tracker.  At the right price, it would be a worthy name to add to the portfolio.

Feedback and conversation is most welcome.

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