Author: prakashgopinath

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.

Book Review – The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success

I recently read The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success by William Thorndike.  This is a must read book for investors and executives alike.  It dispels many notions about what makes a successful CEO and also brings to light how uncommon common sense is in corporate America.  Despite running fundamentally different businesses and having unique backgrounds, the similarities among the eight CEOs profiled were striking.

Key approaches / characteristics shared by the CEOs profiled include:

  • Capital allocation was the most important role of the outsider CEO; the outsider CEOs quickly exited low return businesses, invested heavily in high return businesses, and made acquisitions/repurchased shares only when the price was right and prospective returns met specified hurdles
  • Leverage was universally employed to make acquisitions or repurchase shares; when the price was right, the outsider CEOs bet big and weren’t afraid to borrow substantial funds to do so
  • A fanatical approach to cost controls; the CEOs always had a strong COO at their side to prudently monitor cost and right size operations; shareholder funds were rarely, if at all, spent on lavish offices or costly travel policies; the ships were right sized to the max which is why you rarely saw these CEOs undertake “cost cutting” or “restructuring” initiatives – there simply was no need or room to improve
  • Extreme decentralization; the CEOs believed in allocating authority to the business units almost to the point of ignorance; this had the effect of motivating and retaining highly talented individuals; the CEOs realized very early on that talented people want autonomy and authority more than money; Charlie Munger always talks of Berkshire’s “seamless web of deserved trust”
  • The CEOs were not focused on the key metrics Wall Street is focused on: growth in revenue and growth in earnings per share; they were focused on cash flow, market share, returns on capital, and increasing value per share over time; they had a deep understanding that value per share could be increased at above market rates through adroit deployment of retained earnings and prudent use of leverage
  • They prided themselves on inactivity, but prepared constantly; most of the CEOs (with the exception of John Malone and Henry Singleton) made very few acquisitions, but when they did, the acquisitions were large in relation to enterprise value; in some cases, ten years went by before a CEO would make a meaningful acquisition; similarly, share repurchases were only made during severe bear markets or sharp corrections in the company’s share price; these CEOs did not engage in automated share repurchase programs nor did they pay dividends
  • The CEOs did not have an investor relations department, refused to talk to Wall Street analysts, provided no forward guidance, and spent zero time on the road speaking to investors; they focused all their time looking for high return opportunities to deploy shareholder capital

Buffett says that he’s a better investor because he’s a businessperson and a better businessperson because he’s an investor.  In fact, the CEOs profiled approached their business like a shrewd investor would approach his or her portfolio.  They made infrequent, but large bets, cut their losers quickly, let their winners ride, and studied all the time, waiting patiently for the right opportunity to surface.  A great majority of companies today don’t have a rational policy for capital allocation.  Many cash rich companies have automated share repurchase programs or make a barrage of acquisitions, irrespective of price.  These managements destroy a lot of shareholder value in the process.

A great recent example of how management can add substantial shareholder value is the Daily Journal Corporation, chaired by Charlie Munger. Profits at DJCO have been flat to declining over the past five years, yet the stock is up 260% (compared to 80% for the S&P 500).  How is this possible?  Munger had all the company’s cash (no dividends paid, all earnings retained) in treasuries for many years leading up to the financial crisis.  Then, in late 2008 / early 2009, he deployed substantially all the company’s cash into Wells Fargo and U.S. Bancorp stock.  A massive, infrequent bet resulting from patience and prudence in the past created a bonanza for the shareholders of DJCO.

Be a Business Analyst

“Be a business analyst, not a market, macroeconomic, or security analyst.” -Charlie Munger

This concept, although a very simple one, has taken me a long time to internalize.  For many years, I approached investments from a market or macroeconomic perspective.  As I result, I suffered from psychological misjudgements which prevented insights from surfacing.  What does it mean to be a business analyst?

  • When studying a new investment, security analysts first look at stock charts and trading history.  Business analysts read the annual report.
  • Security and market analysts spend mornings looking at the futures market and price action in certain stocks.  Business analysts read financial reports and relevant company/industry news, and speak with experts they can trust.  When no new information is available, which is usually the case, business analysts sit still and spend time researching other opportunities.
  • Security analysts spend a lot of time calculating financial ratios such as price/earnings, free cash flow yield, compound annual growth rates, valuation vs. peers, etc.  Business analysts determine whether they can understand the business and whether the business has a sustainable competitive advantage.
  • After earnings releases, security analysts pay close attention to the price action in the stock and the company’s results vs. street expectations.  Business analysts focus on whether the long term thesis is still in tact, whether the company is extending its advantage in its core market, management’s ability and credibility, and whether other key metrics (e.g. market share, unit cost, investment in r&d, brand awareness) are improving.
  • Security analysts use historical and one year forward valuation metrics when evaluating the suitability of an investment.  Business analysts carefully study the long term record of the company, then try to see 5-10 years into the future.  Business analysts view a company as an unfolding movie, not a still photograph.
  • Security analysts let price action dictate their views and moods.  Business analysts understand that the market is there to serve them and instead focus on business fundamentals.
  • Macroeconomic analysts worry incessantly about inflation, interest rates, China, Europe, the debt bubble, etc.  Business analysts purchase fractional ownership in businesses which provide a large margin of safety, can survive (and even benefit from) market cycles, and will outperform over a long time horizon.
  • Security analysts run screens for low price/earnings ratio, 52-week lows, high free cash flow yield, high returns on investment capital, etc.  Business analysts read Value Line and annual reports, building a database of targets in their mind.

Business analysts approach investments as if there were no daily trading in the market.  They have an almost myopic focus on business fundamentals and do not let Mr. Market dictate their mood.  In the past, I suffered from first conclusion bias by approaching investments as a security, market, and macroeconomic analyst.  I committed errors of commission by buying stocks which traded at low multiples and high free cash flow yields, or by buying businesses which I thought would benefit from a loose theory of where the macroeconomic environment was heading.  Similarly, I committed errors of omission by avoiding high multiple stocks, stocks which had run up 50-100% in the prior 12 months, and businesses which would be harmed by high interest rates or a slowdown in Europe.  Often times, heuristics lead to the wrong conclusion.  I could have avoided many of these misjudgements had I taken the approach of a business analyst.

As Howard Marks says, the job of the analyst is to know the knowable: securities, businesses, and industries.  If a wonderful business is acquired at a reasonable price, the investment should perform commendably given a sufficient time horizon.  Be a business analyst.

Introduction

“Live as if you were to die tomorrow.  Learn as if you were to live forever.” -Mohandas Karamchand Gandhi

The word “jeeva” means “life” in Kannada, the language of the southern state of Karnataka, India.  This blog will mostly serve as a personal notebook as I explore topics which are of interest to me: better living, better thinking, continuous learning, and business analysis.  Over the years, I’ve found that I learn best through writing and teaching and hence will document on this blog my ongoing areas of study.  The primary area of focus will be on business and investment analysis.  This will include specific company and industry analysis, investment recommendations (to the extent attractive opportunities can be found), a target wish list, a portfolio tracker, discussions of behavioural finance, and some limited thoughts on the macro-economy and money management industry.  I will also spend some time writing about better living, models for better thinking and decision making, books I am reading, and topics from other academic disciplines to the extent they connect with the aforementioned topics.

Warren Buffett says that it’s important to find the right heroes in life and to mimic their best characteristics.  Two of my biggest heroes, Mr. Buffett and Charlie Munger, have meaningfully influenced my thinking.  This blog will often touch on themes which they’ve discussed over the years.  However, as independent thinking is a virtue they both espouse, I will focus most of the writing here on my independent thoughts and not simply repeat ideas which they’ve already discussed.  There are more than a handful of high quality blogs on the web which are similarly themed.  This property has a reason to exist as it aims to (i) help me clarify my thinking through writing and feedback from the community, (ii) provide more in-depth company analysis, (iii) apply some of the approaches and techniques of the great investors, and (iv) provide curated ideas on how to live better and improve happiness.

My hope is that this blog will, over time, extend to a broader audience, starting with close friends and family, and eventually to a larger community of engaged readers.  I have so much to learn from the wisdom of other human beings and welcome your feedback.  I hope this will also serve as an educational resource for those people interested in the topics I plan to write about.

Thank you for joining me on this journey.