CDW - Q2 2023

Transcript

Operator (participant)

Good morning. Thank you for attending today's CDW Q2 2023 Earnings Call. My name is Megan. I'll be your moderator for today's call. All lines will be muted during the presentation portion of the call, with an opportunity for questions and answers at the end. I would now like to pass the conference over to Steve O'Brien with CDW. Steve, please go ahead.

Steven O'Brien (VP of Investor Relations)

Thank you, Megan. Good morning, everyone. Joining me today to review our Q2 2023 results are Chris Leahy, our Chair and Chief Executive Officer, and Al Miralles, our Chief Financial Officer. Our Q2 earnings release was distributed this morning and is available on our website, investor.cdw.com, along with supplemental slides that you can use to follow along during the call. I'd like to remind you that certain comments made in this presentation are considered forward-looking statements under the Private Securities Litigation Reform Act of 1995. Those statements are subject to a number of risks and uncertainties that could cause actual results to differ materially. Additional information concerning these risks and uncertainties is contained in the earnings release and Form 8-K we furnished to the SEC this today, and in the company's other filings with the SEC.

CDW assumes no obligation to update the information presented during this webcast. Our presentation also includes certain non-GAAP financial measures, including non-GAAP operating income, non-GAAP operating income margin, non-GAAP net income, and non-GAAP earnings per share. All non-GAAP measures have been reconciled to the most directly comparable GAAP measures in accordance with SEC rules. You'll find reconciliation charts in the slides for today's webcast and in our earnings release and Form 8-K. Please note, all references to growth rates or dollar amount changes in our remarks today are versus the comparable period in 2022, unless otherwise indicated. Replay of this webcast will be posted to our website later today. I also want to remind you that this conference call is the property of CDW and may not be recorded or rebroadcast without specific written permission from the company. With that, let me turn the call over to Chris.

Christine Leahy (Chairman and CEO)

Thank you, Steve. Good morning, everyone. I'll begin today's call as usual, with a brief overview of our performance, strategic progress, and our views on the second half of the year. Al will provide additional detail on our results, our capital allocation priorities, and our outlook. We'll move quickly through our prepared remarks to ensure we have plenty of time for questions. Our team executed extremely well in a market facing persistent challenges. As expected, commercial top line remained under pressure, and public returned to more normal seasonality. For the quarter, the team delivered net sales of $5.6 billion, down 9% in U.S. dollars, down 8% in constant currency. Non-GAAP operating income of $530 million was up 3%, and Non-GAAP earnings per share of $2.56 was up 3%.

These results demonstrate the power of our resilient business model when coupled with our broad and deep portfolio of technology solutions. In an ongoing period of economic uncertainty, our ability to drive outcomes and address customer priorities across the entire IT continuum, enabled the team to pivot to where our customers need us most. An ability that reflects the impact of strategic investments we have made to enhance our high relevance and high growth solutions and services. While transactional business remained under pressure, increases in solutions contributed to meaningful margin expansion. Margin expansion that, together with ongoing expense discipline, delivered strong profitability. Let's take a look at this quarter's key performance drivers. First, our balanced portfolio of end markets.

Each of our five sales channels, corporate, small business, healthcare, government, and education, is a meaningful business on its own, with 2022 annual sales ranging from $1.9 to over 10 billion. Within each channel, teams are further segmented to focus on customer end markets, including geography, verticals, and customer size. Teams are similarly segmented in our U.K. and Canadian operations, which together delivered $2.9 billion in 2022 sales. These unique customer end markets often act countercyclically, given the different macroeconomic and external factors that impact each. Our Q2 results provide an excellent example of this. Economic uncertainty continued to weigh on the commercial market, and both our corporate and small business results reflected ongoing cautious customer behavior. Caution that once again drove elongated sales cycles, smaller deal sizes, and greater focus on mission-critical projects.

Caution that also drove customer focus on short-term ROI, with both corporate and small business posting double-digit increases in cloud spend. For corporate, overall sales declined 16%. Mission-critical projects continued to move forward and slowly ticked up throughout the quarter. Large commercial customer spending sequentially improved. Continued postponement of upgrades and utilization of existing product resulted in a double-digit decline in client devices. While we remain cautious on the outlook for client devices, corporate delivered its first sequential volume increase in the past four quarters, providing some indication of demand stability. Notably, client device ASPs held, buoyed by mix into higher value, higher functionality units. Momentum around projects focused on increased productivity and enhanced customer and coworker experiences, and that drove excellent growth in cloud spend. Implementation of network modernization projects delivered double-digit Netcomm growth.

Small business declined 21%, reflecting the impact of ongoing caution by economically sensitive customers. Client devices continued to decline, with upgrades on hold, pending greater clarity around the economy and employment. Focus on mission-critical priorities around security and efficiency drove double-digit customer spend increases in both cloud and software. Public performance partially mitigated commercial market pressure and was seasonally higher than Q1. Sales increased 2% year-over-year with strong performance in government, another quarter of stable performance in healthcare, and an upturn in education. Government increased 12% and continued to benefit from strategic efforts to target complex services-enabled hybrid infrastructure and cloud opportunities. Federal delivered double-digit growth in the quarter, largely driven by the team's ability to help agencies implement more efficient solutions to manage and protect data. This delivered excellent Netcomm storage performance. Legacy Sirius relationships contributed to significant growth in services.

The state and local team also delivered double-digit growth. Excellent services performance reflected the team's success, helping state and local municipalities address talent gaps through enhanced training, as well as professional services engagement. Cloud adoption drove strong software and security performance. Healthcare performance was relatively flat. Talent needs and data center projects remained focus areas as customers increasingly leverage technology to address complex industry challenges. Customer hesitancy around cloud continued to dissipate and adoption increased meaningfully in the quarter. Client devices remained under pressure, given ongoing customer focus on mission-critical projects that deliver short-term ROI. In education, the double-digit increase in higher ed was offset by significantly improved but still lower year-over-year performance in K-12, and overall sales decreased 1%. Higher education institutions' ongoing emphasis on student enrollment drove investments in enhanced security, as well as campus connectivity and dorm room experiences.

The team's ability to deliver these solutions drove double-digit growth across cloud, Netcomm, storage, software, and security. Client devices were flat as a volume decline was offset by mix into higher value units, which drove strong ASP performance. For K-12, the team continued their success executing on infrastructure opportunities and delivered excellent growth in services, Netcomm, and storage. This quarter, the team also delivered a sequential improvement in client devices. As you know, the summer season represents the height of K-12 buying. With our June 30 quarter end, we occasionally see anticipated summer sales hit the end of Q2. We experienced this in the quarter with anticipated back half refresh driving a significant sequential improvement. Refresh, driven by aging devices and higher than historical breakage rates, given more students take their devices off-campus. Other, our combined U.K. and Canada business declined 7%.

Similar to the U.S., each team continued to execute well and sustained profitability improvements under challenging conditions. U.K. posted a low single-digit decline in local currency, while Canada declined by low double digits. We're seeing growing customer caution in both the U.K. and Canada, similar to what we heard from U.S. commercial customers a quarter ago. As you can see, the diversity of end market growth this quarter demonstrates the benefit of the first driver of our performance, our balanced portfolio of customer end markets. Category performance demonstrates the benefit of our second performance driver, our broad and deep portfolio of products and solutions, which enables the team to pivot and support customers wherever needed. Ongoing economic uncertainty in the commercial space continued to have an outsized impact on both transactions and solutions. While the rate of decline moderated, transactions were down double digits.

Solutions performance improved with mid-single-digit growth versus flat performance in Q1. Similar to Q1, all three of our portfolio categories, hardware, software, and services, were impacted by commercial pressure, with deferral of major hardware projects resulting in lower volumes in services and solutions. Hardware decreased 11% year-over-year. Client device performance in the commercial space significantly impacted hardware performance, and corporate continued to have the greatest category impact. Netcomm had an exceptional quarter, posting meaningful increases across all customer end markets. This strong performance was largely driven by improvements in supply and continued work on customers' network modernization projects. Services were relatively flat year-over-year. Growth varied widely with strength tied to channel-specific customer priorities, offset by services attached to transactional and solutions hardware.

Professional services were solid, and while managed services activity was solid, given extended sales cycles and ratable revenue streams, the impact on net sales was minimal. Software customer spend increased by mid-single digits, driven by mix into software as a service. Double-digit increases in network management software and database software were offset by continued declines in software categories tied to full stack projects and employment levels, and net sales decreased at a mid-single-digit rate. Security remained a key focus area for customers with spend up single digits. Top growth categories included endpoint security, email security, identity management, and physical security. Security associated with growth and business expansion remained challenged. Once again, cloud was an important driver of performance across the business, contributing meaningfully gross profit. Productivity, infrastructure as a service, and security were the top three workloads in the quarter.

Each of our customer end markets posted double-digit increases in cloud customer spend and gross profit. Profitable growth that was enabled by the strategic investments, both organic and acquired, that we've made in cloud capabilities over the past 10 years, capabilities that enable us to deliver for our customers and our stakeholders. This leads to the final driver of our performance in the quarter, our three-part strategy for growth, which is to, first, acquire new customers and capture share, second, enhance our solutions capabilities, and third, expand our services capabilities. Each pillar is crucial to our ability to profitably advise, design, orchestrate, and manage the integrated technology solutions our customers want and need today and in the future. Our investment in data analytics is a great example of this strategy in action. Like many of our strategic investments, data analytics delivers value across all three pillars.

Our data analytics capabilities are underpinned by the intimate knowledge we have about our customers, knowledge earned through deep and long-lasting relationships, which range on average over 12 years. They are also underpinned by our broad and comprehensive product portfolio, which provides extensive historical information about buying patterns across industries and verticals. This proprietary customer and product knowledge powers our data analytics and helps create robust and data-driven predictive models, models that identify customer needs and create personalized and targeted outreach to drive tailored services, products, and solutions, solutions that help our customers accelerate their strategies and achieve their missions. We continue to invest in the breadth and performance of these models utilizing machine learning and other advanced analytics techniques, and have produced tangible lift in sales conversion and market relevancy. Clearly, our investments in data analytics are delivering for CDW. They are also delivering for our customers.

Today, we have significant data analytics expertise across server, database, model construction, and training, expertise that delivers outcomes in our ICARE framework, particularly in the areas of innovation, agility, and experience. Expertise that bolsters our consultative professional services capabilities, including our AI consulting practice. For CDW, AI adoption feels very much like other transformative technologies of the past. Customers recognize the evolutionary benefits of AI, yet they face incredible complexity and choice, complexity and choice that plays to our strengths and our value proposition as a trusted partner and advisor. Just as we have in the past, we have made and will continue to make the investments necessary to ensure we are ready, ready to lead the market and ready to help our customers maximize the return on their AI investments. Another excellent example of how we strategically invest for today and the future.

That leads me to the expectations for the balance of the year. You'll recall on last quarter's conference call, we shared our expectations for the U.S. IT market to post a decline of high single digits in 2023. This assumed a moderate improvement in the commercial environment in the back half of the year and a return to normal seasonality in the public space. To date, the demand environment has been consistent with our expectations, and our view of the U.S. IT market remains unchanged. Within this environment, we continue to target outperforming the U.S. IT market by 200-300 basis points on an organic, constant currency basis. Wild cards remain the macro environment, further tightening of credit, and the potential for federal government budget disruptions. As we always do, we'll provide an updated perspective on business conditions as we move through the year.

In the meantime, we'll continue to do what we do best: leverage our competitive advantages and out-execute the competition. We will continue to judiciously invest to ensure we are there for our customers so they can achieve their mission-critical outcomes today and in the future. I hope you can tell from my comments that this quarter's performance reinforced our confidence that we have the right strategy in place, a strategy that serves us well when confronted with macro or end-market-specific challenges, a strategy designed to ensure we remain our customer's partner of choice, most importantly, a strategy that enables us to continue to deliver excellent cash flows and profitably outgrow the market. With that, let me turn it over to Al, who will share more details on our financial performance. Al?

Albert Miralles (SVP and CFO)

Thank you, Chris. Good morning, everyone. I'll start my prepared remarks with detail on the Q2, move to capital allocation priorities, and then finish up with our 2023 outlook. Turning to our Q2 P&L on Slide seven, consolidated net sales were $5.6 billion, down 8.5% on a reported and average daily sales basis. Q2 net sales were up 10.2% versus Q1 on a reported and average daily sales basis, ahead of our outlook, which had anticipated a mid-single-digit seasonal increase. Broadly speaking, our expectation held that Q1's uncertain macro environment would persist, with our commercial performance coming in as we expected, while public moderately exceeded our expectations.

Public results were driven by the strength in solutions performance across channels and the impact of some early shipping of anticipated client device refresh volume in K-12, leading to return up to year-over-year growth and the strongest sequential growth for this segment since Q2 2020. On the supply side, the dollar value of our backlog declined relative to Q1, which contributed to our stronger solutions performance. Backlogs and product lead times associated with transactional products ended the quarter essentially in line with more normal historical levels, while remaining supply chain challenges in Netcomm solutions continued to ease in the quarter. We continue to anticipate the remaining pockets of backlogs to feather out over time. As always, we judiciously managed our working capital to support our customers while ensuring strong economic returns. Our year-to-date free cash flow performance, which we will discuss shortly, reflects this discipline.

Our team delivered strong profitability in the quarter. Gross profit was $1.2 billion, a year-over-year increase of 1.1%. Record Q2 gross margin of 21% was up 200 basis points year-over-year. An increase in transactional product volume had a mild impact on margins compared to Q1. Overall margins remained strong, driving a year-over-year gross profit increase despite lower net sales. As a reminder, the record gross margin performance in recent quarters has principally been driven by two factors. First, product margins benefiting from both mix into complex solutions and a lower mix of transactional products. When we mix back into transactional products, we would expect for this benefit to moderate. Second, a greater mix into netted down revenues.

The category again outpaced overall net sales, growing 10% in Q2 2023 compared to Q2 2022, primarily driven by double-digit software as a service growth. Netted down sales represented 31% of our gross profit, compared to 28% in the prior year's Q2. This continues to be an important trend within our business. Turning to expenses on slide eight, non-GAAP SG&A totaled $652 million for the quarter. Relative to the prior quarter, prior year quarter, non-GAAP SGA was flat, as increased payroll expense associated with modestly higher coworker count was offset by the prudent management of discretionary expenses during the quarter.

Coworker count at the end of Q2 was approximately 14,900, down from Q1, principally due to our efforts to align our cost structure with the level of business demand, while continuing to prioritize the areas where we can provide the most value to our customers. Strategic investments in our solutions and services capabilities remain key to our three-part strategy for growth, an important catalyst for the achievement of our profitability and margin goals. GAAP operating income was $412 million. Non-GAAP operating income was $530 up 14 million or 2.6% versus the prior year.

The difference between our GAAP and non-GAAP operating income for the quarter was larger than usual, primarily the result of the workplace optimization charge in the quarter, which is detailed on slides eight and 11. Non-GAAP operating income margin reached a Q2 record of 9.4%, up 100 basis points from the prior year and up 90 basis points compared to Q1. We remain laser-focused on delivering leverage on our gross profit growth despite challenging market conditions. Moving to slide nine, interest expense was $58 million, approximately flat to the prior year and relatively in line with our expectations. Our GAAP effective tax rate, shown on slide 10, was 25.7%. This resulted in first quarter tax expense of $91 million.

To get to our non-GAAP effective tax rate, we adjust taxes consistent with non-GAAP net income add backs, as shown on Slide 11. For the quarter, our non-GAAP effective tax rate was 25.9%, within our expected range of 25.5%-26.5%. As you can see on Slide 12, with Q2 weighted average diluted shares of 136 million, GAAP net income per diluted share was $1.92. Our non-GAAP net income was $349 million in the quarter, up 2.8% on a year-over-year basis. Non-GAAP net income per diluted share was $2.56, up 3.2%. Moving ahead to Slide 13. At period end, cash and cash equivalents were $204 million, and net debt was 5.6 billion.

During the quarter, net debt was relatively flat, consistent with our plan to maintain our net leverage ratio within the range of 2-3x. Liquidity remains strong, with cash plus revolver availability of approximately $1.2 billion. Moving to Slide 14, the three-month average cash conversion cycle was 14 days, down four days from Q1, five days from the prior year's Q2, and below our targeted range of high teens to low twenties. Our cash conversion reflects our continued diligent management of working capital, particularly with respect to inventory. As we've mentioned in the past, timing and market dynamics can influence working capital favorably or unfavorably in any given quarter. We continue to believe our target range remains the best guidepost for modeling future working capital.

Our effective working capital management also drove excellent year-to-date free cash flow of $684 million, as shown on slide 15. For the quarter, we utilized cash consistent with our 2023 capital allocation objectives, including returning approximately $79 million to shareholders through dividends and $196 million in share repurchases. That brings me to our capital allocations on slide 16. Our execution remained consistent with the updated objectives we communicated at the start of the year. First, as always, increase the dividend in line with non-GAAP net income. Last November, we increased the dividend 18% to $2.36 annually. Going forward, we'll continue to target a 25% payout ratio. Second, ensure we have the right capital structure in place with a targeted net leverage ratio.

We ended the Q2 at 2.6x, flat to the end of Q1, and within our new range of 2x-3x. We continue to convert cash profits into cash flow and have rigorous process in place to proactively manage liquidity while maintaining our flexibility. Finally, our third and fourth capital allocation priorities of M&A and share repurchases remain important drivers of shareholder value. For 2023, we continue to target returning 50%-75% of free cash flow to investors through dividends and share repurchases. Moving to the outlook for 2023 on slide 17. We continue to see caution and prudence in the market and in the sentiment of our customers. Given this, there is no change to our previously shared expectation that the IT market will contract at the upper end of high single digits.

Our baseline review, baseline view incorporates a modest recovery in the second half of 2023. We have not seen indications that would suggest a major turnaround on our commercial channels otherwise. With this scenario as our baseline, we maintain our expectation to outgrow the market by 200-300 basis points and continue to anticipate that netted down revenues will grow faster than other products and solution categories. Keep in mind, in times of hardware softness, our overperformance tends to be on the lower end of this range, and vice versa. We also continue to expect a neutral currency impact for the full year. Modest tailwinds in the second half, after seeing modest headwinds in the first half. This assumes an exchange rate of $1.24 to the British pound and CAD 0.77 for the Canadian dollar.

Moving down the P&L, we expect our full-year non-GAAP operating income margin to continue to be in the range of 9%. This reflects our expectation of continued strong gross profit margin, with modest softening following three straight quarterly gross margin records. Operating margin is also supported by our actions to better align expenses. Finally, we expect our full-year non-GAAP earnings to be in the range of flat year-over-year in constant currency. This reflects an increase from our prior expectation, reflective of our better than expected Q2 results. Please remember that we hold ourselves accountable for delivering our financial outlook in a full-year constant currency basis. Additional modeling thoughts for annual depreciation and amortization, interest expense, and the non-GAAP effective tax rate can be found on slide 18. Moving to modeling thoughts to the Q3.

For average daily sales, we expect mid-single-digit sequential growth from Q2 to Q3. This equates to a mid-single-digit percent year-over-year reported net sales decline for the fourth quarter in terms of average daily sales. As noted, we anticipate gross profit and NGOI margins to be below Q2 levels, driven by both mix and rate elements. We expect Q3 non-GAAP earnings per diluted share to be flat to slightly down year-over-year. In 2023, we expect full year free cash flow to be approximately 5% of net sales, above our rule of thumb range of 4%-4.5%, and reflecting our strong cash generation in the first half of the year. While we continue to operate in a cautious and uncertain market, we remain confident in our ability to deliver profitability, margins, and cash flow to our stakeholders.

That concludes the financial summary. As always, we'll provide updated reviews, views on the macro environment and our business on our future earnings calls. With that, I'll ask the operator to open it up for questions. We would ask each of you to limit your questions to one with a brief follow-up. Thank you.

Operator (participant)

Thank you. If you would like to ask a question, please press star followed by one on your telephone keypad. If for any reason you would like to remove that question, please press star followed by two. Again, to ask a question, press star one. As a reminder, if you're using a speakerphone, please remember to pick up your handset before asking your question. We will pause you briefly as questions are registered. Our first question comes from the line of Asiya Merchant with Citigroup. Your line is now open.

Asiya Merchant (VP)

Great. Thank you very much for taking the questions, and congratulations on the results. If you could just talk a little bit about seasonality. You know, I know you guys are guided for the Q3, and as you look into the fourth quarter, there's a lot of debate on whether, you know, the pull-in in client devices for Q2 is going to result in below seasonal growth for the second half. That's on the client devices side. Just generally, a lot of caution on other hardware spend, whether it's on the compute or storage side, just given a cautious spending environment and shift towards AI. If you could provide me, you know, what you're seeing in the channels and in your end customers, that would be great.

Then I just have a follow-up on free cash flow as well. It's it's looking like it's pretty strong for this year. You know, how should we think about potential acquisition and a boost to the growth rates that you guys have outlined for this year? Thank you.

Christine Leahy (Chairman and CEO)

Well, good morning, Asiya. Good to have you on the line. Let me just say, with regard to expectations for the last half of the year and, and this concept of pull forward, you know, look, the, the quarter played out very, very much as we anticipated, with commercial still feeling some pressures, due to market sentiment and market caution, and public returning to seasonality with somewhat over-delivery by our government and education groups. Look, if I take a step back and I think about Q2 versus the second half, let me just say this, I'm encouraged by the tick-up that we saw at the end of Q2 with regard to commercial customers, in both activity and sentiment.

I'm encouraged by public returning to that seasonality that feels much more normalized as compared to pre-COVID, for example. I'm encouraged by the fact that our international team, notwithstanding sales decline, maintained their profitability progress that they're making. I'm encouraged, frankly, that small business feels like it is not getting any worse. It's kinda hovering around the bottom. It's not getting any better, but it's not getting worse. There are a lot of things that encourage me. I'm impressed with the execution of this team, frankly. They always, they always pull through in tough environments, and they did it again. All that said, we are still cautious. We're cautious, and, you know, we, we got a one month into the quarter where we saw some upticks, and we're cautious about the back end.

What I would say is, we still believe that we are starting to, and will continue to see a mild to moderate recovery in the back end, and we're holding firm to that. I mentioned K-12, and we had a little bit more in, in Q2 than we, we might have anticipated. That's just straddling quarters. That's just a phenomenon. We're not seeing anything that is causing us to believe that the second half is gonna be any different than we're suggesting in our outlook. You know, we're getting this from our customers. With 10,000+ sales folks and sales professionals and technologists in market, you know, we're getting a real-time pulse, and it feels like a pretty solid outlook to us.

Albert Miralles (SVP and CFO)

Asiya, maybe I would just. This is Al. Maybe I just add the, just kind of the, give you the technical component. With our Q2 delivery and kinda allocation across the channels, Q3 would essentially look seasonal. That is obviously, it's the seasonal peak for public, and we'd expect that would play out. What we experienced from the commercial channels for Q3 would look much like Q2. When we think about that pickup of activity, modest recovery, probably a little bit more weighted towards Q4 in those segments that have been softer in the last few quarters.

Christine Leahy (Chairman and CEO)

You had a follow-up, Asiya?

Asiya Merchant (VP)

Great, thanks. Just on the free cash flow-

Christine Leahy (Chairman and CEO)

On free cash flow.

Asiya Merchant (VP)

Yeah, yeah, just on the free cash flow.

Albert Miralles (SVP and CFO)

Yeah.

Asiya Merchant (VP)

Yeah, it's, it's obviously trending higher than what you guys, had previously anticipated or guided to. How should we think about the use of cash here?

Albert Miralles (SVP and CFO)

Yeah, great, great question. Look, we've had a good run of 4+ quarters on the free cash flow generation side. Look, driven by strong cash profits, let's say, but also by pretty diligent management of working capital in an environment that's been challenging. I'd say, look, on an evergreen basis, you'd expect that we will continue to be judicious about working capital, but certainly there's a countercyclical component to this. As the environment's been a bit softer, we've been tighter in that regard. As we look to the second half and we look to pick up, and particularly in the transactional side, it's reasonable to believe that there'd be a bit of a more pull on our working capital in the second half.

Notably, you'll see from our cash conversion that much of that favorability has come on the inventory side. We're trying to make a little space for an expectation of pulling a bit more on working capital in the second half. That being said, for the full year, we gave you a refresh rule of thumb of 4-4.5, and we expect it will come out for the full year at five. Just to your latter point on M&A and otherwise, look, we're going to utilize our capital where we see best, both supporting our strategic objectives, but also where the best relative value is.

Asiya Merchant (VP)

Great. Thank you.

Operator (participant)

Thank you. Our next question comes from the line of Adam Tindle with Raymond James. Your line is now open.

Adam Tindle (Managing Director)

Okay, thanks. Good morning. I just wanted to start, it looks like kind of the old CDW that we've come to know and expect in terms of over-delivering relative to expectation is, is back this quarter. At a high level, Chris, prior to this quarter, we had two quarters that were very different, from plan in Q4 and Q1. I just would be curious, for investors that are, wondering what, changed in Q2, from a, either a guidance process or what enabled the over-deliverance, that we can, kinda get confidence that this, the old CDW is back moving forward?

Christine Leahy (Chairman and CEO)

Well, good morning, Adam. Appreciate that. You know, look, I'd say a couple things. The macro environment really had a significant impact on Q1 and Q2, well, Q1 and in the front end of Q2. When you think about the challenges to our larger commercial customers, in particular, which have an oversized impact on the whole of the business, I would say that, number one, was the first driver. The second is, we were anticipating a return to seasonality for the education space and the government space, but as you know, those are really the summertime and the third and fourth quarter, as Al mentioned. As we sat in Q1, we had a tough economic environment impacting our large commercial customers, and our public sector just couldn't quite make it up.

What you're seeing now is the benefit of the countercyclicality and the difference in diversity of our end markets really coming into full play. It was a-- I would call it timing to some extent, and the macro environment. I'd also say, Adam, that we are seeing this, this, somewhat of a stability. I'll use the question, a little bit of stability. You know, I mentioned client devices are still down, but first, first quarter of sequential increase in commercial, K-12's still down, but, you know, delivered very nicely in the quarter. We're starting to see on the commercial side, in particular, a little bit of uptick in sentiment. That's giving us some, some optimism.

Then you add the execution of this team, as you know very well, this team executes like nobody else. Given the change, the change in the market that we're seeing happening in back to seasonality, we're just going after it and leveraging our competitive advantages. You know, customers have been holding off on spending for a long time, so as they start to loosen the reins a little bit, we have been there and will be there for them.

Adam Tindle (Managing Director)

Got it. Maybe just a follow-up for Al on guidance, just a little bit more in the weeds question here. Your Q3 guidance, I think you said mid-single digits sequentially per day, which, if I look back historically, that's kind of seasonal, like you said. As I think about Q3, that's typically a big public sector, particularly government, quarter, but you've also had a very strong public sector result during Q2. I guess the question would be: What gives you confidence that there wasn't pull-in during Q2 in public sector, and why guide mid-single digits in Q3 or that seasonal based on that strong Q2 result? Thanks.

Albert Miralles (SVP and CFO)

Yeah, sure. Thanks, Adam, for the question. You're right, Q2 is really strong. Particularly in public segment. All of the data that, you know, we see in the pipeline that we evaluate ongoing, which suggests there's continued strength there. I'd say notably, in the government side and as well, higher ed, that really had strong performance on the quarter. We mentioned, Adam, that K-12 had some, you know, I'll call it kind of summer seasonal pickup in activity, which some of which we might typically see kind of straddle over to Q3. There's probably a little bit of that that showed up in Q2, modest enough that we feel comfortable holding to the expectation of seasonal uptick in public overall.

Adam Tindle (Managing Director)

That's helpful. Thanks, and congrats on the results.

Christine Leahy (Chairman and CEO)

Thanks, Adam.

Operator (participant)

Thank you. Our next question comes from the line of Matthew Sheerin with Stifel. Your line is now open.

Matthew Sheerin (Managing Director and Senior Equity Research Analyst)

Yeah. Yes, thank you. In terms of, Chris, your, your commentary about seeing at least a modest recovery in the commercial markets in, in Q4, based on what you're hearing from customers, do you see any sort of PC refresh, or is that more on the infrastructure and solution side, where projects getting pushed out, will get done?

Christine Leahy (Chairman and CEO)

Yeah, you know, Matt, it's a great question. We've been all asking ourselves this for a long time, when are PCs gonna start to come back? That, as we all know, is really tied to the market and projects that are re-related to growth initiatives within organizations and employment. You know, look, I think that the fog has not yet been cleared, and I don't think our customers yet are on the kind of solid footing of they're ready to open the claw, so to speak. They're still being incredibly judicious in their spending. They're scrutinizing relentlessly, frankly. What we're hearing is more focus around mission-critical, and I'll call that more solutions-oriented endeavors right now. It's hard to gauge on the PC refresh and when we'll start to see it come back.

That said, look, we all, we all know that the, the PCs are the productivity tool, right? They're what connect people to the applications. I think we all agree on that. We also know that we've got devices that are sitting old in the system. We talked about K-12 as an example, two to three years old, breakage 5x higher than it was pre-pandemic, frankly, Windows 11 is right around the corner. Now, you heard us talk about ASPs and customers buying, devices that are kind of higher functionality, higher productivity. Those would, those would be Windows 11 devices. We do see customers starting to, explore the benefits-

Matthew Sheerin (Managing Director and Senior Equity Research Analyst)

Mm-hmm

Christine Leahy (Chairman and CEO)

... of Windows 11, and that's gonna set in at some point, and that's gonna be a nice tailwind. Whether it will be Q3, Q4, 2024, it feels a little longer term than this year.

Matthew Sheerin (Managing Director and Senior Equity Research Analyst)

Okay, thank you. On, on the infrastructure and advanced solutions side, I guess there's some concern that, you know, we're seeing backlog across, you know, many companies come down because a component availability, product availability is much better now. Also, as, as customers maybe refresh servers, they, they move to a, a cloud model, I guess that would benefit you. Are you seeing any signs of, of any of those things playing out?

Christine Leahy (Chairman and CEO)

... On the networking side, we certainly saw a healthy flush this quarter, and I would say that, you know, we had double-digit growth across all of our customer segments, and that was largely due to a backlog flush and a continuation of network modernization projects. In terms of the movement to cloud and AI, look, I would just say that this is a topic of conversation. I've used the word frenzy before, but it's a topic of conversation, and as I said in my prepared remarks, there's a lot of complexity. There are a lot of questions out there. What will it drive?

What I would just say, Matt, is, look, the, the benefit of our broad portfolio and the investments we've made across high-growth, high-solutions areas, as well as the services, capabilities in particular, position us well to support customers wherever they are on the IT spectrum and whatever they're buying. In any case, you know, I do really see the customer decisions benefiting CDW because we'll benefit them with the portfolio and our capabilities.

Erik Woodring (Managing Director and Head of US Technology Hardware Equity Research)

Okay, thank you very much.

Operator (participant)

Thank you. Our next question comes from the line of Amit Daryanani with Evercore ISI. Your line is now open.

Amit Daryanani (Senior Managing Director)

Yep, thanks, and congrats on a nice print here. You know, I guess, Chris, I want to kind of go back to this question around the June quarter upside that you folks are seeing, but you're still not you know, you're not really raising the full year guide, I guess. I would love to maybe just go back to this and understand, you know, what are you seeing in the back half that refrains you from perhaps taking up the full year guide, at least reflect the upside you saw in June? Was it a bit of a pull-in? Is it conservatism? Just I'd love to understand, given the big beat in June, what refrains you from raising the full year guide?

Christine Leahy (Chairman and CEO)

Yeah, you know, Amit, is that thanks for the question. Here's what I'd say: I'd say too early to call. You know, we're taking it quarter by quarter right now. On the commercial side, there's still caution, there's still prudence. There's no doubt that's still sitting in the market, notwithstanding, as I said, a slight uptick as we get to the end of the quarter. You know, a couple of weeks, a month of a quarter does not, does not, I was going to say trend make, but it really doesn't create solid ground yet. We have to give it a little more time. We see some good indicators, but they're just not enough to make the call. Moderate feels better to us than, you know, major turnaround.

On the public side, look, the way that, both education and government work is we track very early in the year. In Q1, we're tracking the projects that are coming in. we have very good visibility to seasonality, and generally what's going to happen during the strength, the strong seasonality. K-12 has been strong, and it's delivering. You know, having some of that come in in June in our Q2 first versus Q3, we're not worried because we actually are seeing a real uptick in refresh needs. We talked to you, you know, a couple of years ago about the breakage rates and how that was going to drive refresh. Well, well it is. On the public side, it's looking very, very normal to us.

We don't want to get ahead of our skis on either commercial or public. We're just kind of calling it as we see it as we rounded out the quarter. That's, that's what I'd say. I don't know if, Al, you want to add anything?

Albert Miralles (SVP and CFO)

Yeah, I, I would just echo, you know, Chris's, Chris's comments there and just say, Amit, that look, we had called for in, in the last quarter, a modest recovery based on the information we had at the time. Q2 did come in a bit stronger. We're now effectively saying Q3 looks seasonal and Q4 ultimately look above seasonal on that expectation of a pickup. There are still plenty of puts and takes that could call that into question, but we're comfortable overall, with what we're seeing and the kind of all of the data that we, we, evaluate that, that pickup is appropriate, but certainly wouldn't expect at this point that it's going to be much more of a term than that.

Amit Daryanani (Senior Managing Director)

Perfect. Thank you. Then, you know, I guess, Al, maybe if we could ask you this question. You know, gross margins are up fairly nicely, I think 140 basis points in the first half of this year versus last year. You touched on a couple of things that are helping you there, but, you know, maybe you can talk about how much of an uplift you think is cyclical in nature, the fact that, you know, PCs are down a lot, versus things that might be a bit more structural in nature. I'd love to just understand, how do you think about gross margin run rate as we go forward from here? Thank you.

Albert Miralles (SVP and CFO)

Yeah, sure, Amit. You're right. Look, 2022, we ended 2022 with gross margins of just shy of 20%, which were new record levels, and we're up from there. If I had to parse it kind of year-over-year, Amit, I think it's both a combination of I'll call it kind of somatic components of netted down revenue and that continued growth there, right? Particularly focused in cloud, SaaS, security, if you will. We do think there are durable themes there, but there also have been factors driven by both mix and rate. On the mix side, obviously, the tougher environment has shifted more customer spend into solutions which come at, and services, which come at higher margin.

Good reason to believe that that could, would balance out over time, and when that does, and particularly with client on it, you could see some moderation, there. Then on the rate side, look, I've talked a couple of quarters now about product margins being firm, and they've held up, and even in this quarter, continue to hold up. Some of that is, I'd say, a more durable theme from all indications of customers going a bit upmarket in terms of kind of products but also it's just been a really firm environment, I think, substantially driven by supply chain. There are some of the puts and takes. Look, we, we feel good overall. We're holding to our NUI margin of 9% for the full year, but it's reasonable to expect that you could soften a bit here on gross margin.

Operator (participant)

Thank you. Our next question comes from the line of Erik Woodring with Morgan Stanley. Your line is now open.

Erik Woodring (Managing Director and Head of US Technology Hardware Equity Research)

Awesome. Thank you. Good morning, guys. Chris, I was wondering if you could just maybe elaborate on some of the pricing dynamics you are seeing in the market today. Meaning are, are discounts accelerating, and if so, where? Conversely, are you pulling back on any discounting? You know, how are customers responding to, to any pricing changes? How do you expect that to trend into the second half? Just, just broadly, any incremental color you could share on pricing would be helpful. Thank you.

Christine Leahy (Chairman and CEO)

Yeah, let me, I'll start, Erik, with you, you, you know that we're price plus model, right? You're familiar with that model. If the prices, the OEM prices go up, we're usually passing that on to the customer, but let me set that aside for a second. I would characterize it as follows: I would say that pricing is holding fairly firm in an intensely competitive market. I say that and give credit to the team that is reflecting to the customer the value that the CDW is delivering. I, I, I will acknowledge that we're in a very intensely competitive environment, and when you think about the levels of scrutiny and all the things we've talked about in terms of purchasing, processes right now, there's a lot of gritting it out.

That said, ASPs are holding pretty firm for CDW. You know, what happens in the second half? I would expect the market to remain competitive, but I would expect also that the value that we, for example, wrap around client devices when they come back more robustly, that really resonates with customers, and I would expect us to hold ASPs pretty darn firm.

Erik Woodring (Managing Director and Head of US Technology Hardware Equity Research)

Awesome. That is, that is super helpful. Then I, I'd love to follow up again with you. You know, just on, on some of the nuances, or comparing and contrasting a bit what you're hearing from, you know, the existing mid-market, the, the corporate clients versus the smaller SMBs, just any differences or similarities, that, that you're hearing from them? Maybe slightly nuanced, but, anything that you could call out would be super helpful. Thank you.

Christine Leahy (Chairman and CEO)

Yeah, no problem, Erik. Here's what I would say. Small businesses are acting like small business. They're the most highly sensitive to the economy, and in particular, hiring, right? So right now, again, the fog hasn't cleared. Without more clarity around the economy and potential for growth and hiring, you know, they're kind of in a bit of a hold position, except for those mission critical projects that are productivity related, that are security related, that are, frankly, even a little lower cost because we're talking about cloud versus large hardware purchases. You know, interest rates have really impacted that group of customers in terms of access to capital, and we're seeing that. I do think we've stabilized there, kind of at the bottom, as I said.

The difference when we look at the larger commercial customers, first quarter to now, we talked about first quarter, that large commercial customer being what was the real drag, if you will, on the overall results. Those are the customers we've started to actually see the uptick in. Think about the last month of the quarter, starting to see movement back to mission critical projects, the things that were on delay. That's where we're actually seeing some stability and sequential, sequential increase in client devices. You know, the difference is the small businesses, they're gonna be a little longer to get, kind of get back on the, major buying page. Those larger entities are starting to inch back in, and that's what's giving us, you know, that's one input to the confidence we have in the back end of the year.

Does that help?

Erik Woodring (Managing Director and Head of US Technology Hardware Equity Research)

Yeah, that's super helpful. Thank you so much, and congrats again. Thanks, guys.

Christine Leahy (Chairman and CEO)

Yeah. Thanks, Erik.

Operator (participant)

Thank you. Our next question comes from the line of Samik Chatterjee with J.P. Morgan. Your line is now open.

Samik Chatterjee (Managing Director and Senior Equity Research Analyst)

Hi. Thanks for taking my questions. I guess, Chris, maybe to some extent, following up here on Erik's question about what you're hearing from customers, with supply generally improving, is the visibility that customers are providing you or even the heads-up in terms of, like, the heads-up around projects that they're planning, is that starting to come in and to sort of, get compressed a bit more? What are you seeing on that front? I have a follow-up. Thank you.

Christine Leahy (Chairman and CEO)

Yeah, I mean, Samik, that would be some of it. You know, we think about activity, right? We think about quoting, we think about the activity we track in our CRM system, we think about, obviously, invoicing and writings. All of those activities with the customer is what drives our kind of pipeline analysis to inform what is coming and what we think is coming down the pike. Back to those kind of mission critical, we are starting to see some of those loosen up, which means writings around those are ticking up slightly across the whole, the full stack related to solutions, for example. The answer is yes. It's, it's about the activity that we triangulate with the customers and the conversations we're having.

Samik Chatterjee (Managing Director and Senior Equity Research Analyst)

Okay, good. If I can just ask more specifically to Netcomm, that has continued to be an area of growth, but you did mention that you're continuing to work down backlog. I think one of the questions we get often is, how sustainable can that growth be once the backlog gets drawn down and normalized? Any thoughts around that? I mean, are you expecting a similar pickup in Netcomm, sort of in the pipeline once spending recovers to a more normalized level? Or is backlog going to be a headwind in relation to growth?

Christine Leahy (Chairman and CEO)

Yeah, it's a fair question. Here's how I think about network modernization. There is a lot that is driving a continuous need for network modernization. Take any of the segments or customer end markets, higher ed, it's all about wooing students, which means it's all about experience, which means their network has to be improved. When you think about kind of leveling into a hybrid work or back to work, that has major network requirements. It's basically, as you tickle AI, frankly, as you're thinking about consulting and advising customers around AI use cases, that has network upgrade, if you will, modernization requirements. As we think about a refresh coming down the pike, that's gonna have upgrade requirements. Our classrooms definitely are focused on modernization.

While the backlog was, was quite helpful to results this quarter, I don't expect that we're gonna see, network modernization, dramatically slow down in the near term, given the needs.

Albert Miralles (SVP and CFO)

Samik, this is Al. Just maybe add one thing. What we experienced with the backlog with Netcomm in the quarter was what we would call pretty orderly. We have been saying we expected that backlog would work its way down, and it did. While it contributed to the performance for Netcomm, certainly underneath there, there's still continued written demand, as Chris suggested.

Samik Chatterjee (Managing Director and Senior Equity Research Analyst)

Got it. Got it. Great. Thank you.

Operator (participant)

Thank you. Our next question comes from the line of Shannon Cross with Credit Suisse. Your line is now open.

Shannon Cross (Managing Director)

Thank you very much. Chris, can you talk a bit about what the discussions you're having with customers on AI? What I'm curious about is, you know, within your various customer segments, you know, is there any that are sort of ahead? I, I don't know, I kind of doubt state and local would be, but you know, where, where people are in their AI discussions, where maybe they're thinking about first deploying some of these, you know, generative AI solutions, you know, and, and, and how you, how you see it developing, because you have such a unique position in that you speak with, with so many various customer groups? Thank you.

Christine Leahy (Chairman and CEO)

Yeah, sure. Good morning, Shannon. Yeah, I guess when we think about AI, we think of it very simply, two, two parts, two sides. First, it's a catalyst for CDW to accelerate and expand our own internal use cases, obviously. Then it's an opportunity to evolve our, our, help our customers evolve using our services, capabilities, and transaction capabilities. You know, it might sound very simplistic, but I'll tell you the way that we think about it, is putting tools in the hands of coworkers and customers, and taking the work out of the hands of coworkers and customers. I mean, it really does fall into those two, two buckets. CDW's full stack approach allows us to help customers across the entire value chain, from what I'll call the base to the tip.

Think advisory services, right? And think applications, think modeling and tools, think computing and data structure that's required to run on all of that. We are having conversations, I would say, on the advisory level, it's essentially is assessments, AI maturity, how do you use AI instances? How do you use data models? Do I wanna use, you know, private or LLMs? It's basically some of the basics. Application level, it's around the embedded AI tools that are there or coming, and ensuring customers understand the benefits that they can accrue, and then helping them consume and use those, those benefits. And then modeling and tools, and obviously, infrastructure required, and the tools to create the use cases. You asked about particular industries.

Look, I'd say contact center is, is, is a huge use case, and it was a fast pickup in a number of industries, including for financial services, retail, et cetera. We've seen a lot of activity there. You think about things like marketing transformation, you think about things like knowledge assistance and customer assistance. Those are the types of use cases that we're talking actively with customers about right now, and that's really across industry. You know, so think customer assistance, think retail, think food, think knowledge assistance, think financial services, et cetera. Those are the buckets that we're really starting to have conversations about, in addition to what I would say, more proprietary conversations with customers about specific ways that they can monetize, specific to their industry or to their organization. That's what we're seeing right now.

There's a lot of discussion, a lot of.

Shannon Cross (Managing Director)

And-

Christine Leahy (Chairman and CEO)

Go ahead. Go ahead. Go ahead, Shannon.

Shannon Cross (Managing Director)

I was just gonna say, Are you hearing for customers that, like, next year's budgets might expand because they're finding so much benefit from AI, and it's so early in the investment cycle that, you know, they see their IT expenditures maybe, you know, growing above trend? I know the trend right now is down, but in theory.

Christine Leahy (Chairman and CEO)

Yeah. Here's, here's, here's what I'd say about that: I, I would continue to think that our customers are at the front end of this discussion, we certainly have some, as I said, a number with contact centers where we've already implemented solutions, and they're, they're reaping the benefits. I think in the middle of the year right now, given the environment we're in, customers are, are not prepared to increase budgets as a result of AI for 2024 yet, because we're in the, we're in the midst of helping them plan what their 2024 looks like. Do I think over the last, over the next, six to 18 months, customers are really gonna understand the tremendous benefit? You know, I called it evolutionary, evolutionary. It's, it's transformative.

It really is one of those technologies that is gonna massively change, how companies operate and, and the benefits they accrue. I think we're gonna have to wait and see a little bit longer to understand what that opportunity looks like and when it's gonna come to fruition. It will be there, in, in our view. It will absolutely be there.

Shannon Cross (Managing Director)

Great. Thank you so much.

Operator (participant)

Thank you. Our last question will go to the line of Keith Housum with Northcoast Research. Your line is now open.

Keith Housum (Managing Director and Equity Research Analyst)

Good morning, guys. Just a little bit broader question in terms of the M&A strategy. You guys made two acquisitions this year, at least that we know of, Locus Recruiting and Enquizit. Perhaps can you just touch real quick on what both of those acquisitions add to you guys and how it makes CDW better going forward?

Christine Leahy (Chairman and CEO)

Oh, yeah, sure. Both of the acquisitions were, you know, relatively, you know, relatively small, didn't have a material impact on the financials, but I would say strategically right down the fairway and on our sweet spot. The first one that I think, that you're thinking of is Locus, which is a consulting company, and they're in what we call our talent orchestration space. They help us to basically provide professional and managed services engineers, so they expand our technical talent base, in the end. It's a way to have, I'll call it, kind of a flexible, burstable model across across our technology resources. Locus actually doubled the size of that business in one fell swoop, and we're really delighted.

We're actually, we've seen a very significant success almost right out of the bat with Locus because we've been able to fill talent needs and talent orchestration needs with customers, even more quickly around all of the important areas, like networking, cloud, and security. Enquizit is the other one that the acquisition we made recently, also very exciting. They're a AWS premier cloud service provider in the government and education, and not-for-profit space. They complement our existing digital velocity team. Think of what Enquizit does as professional services around application modernization and cloud migration, and they also have a proprietary tool that combines professional services with IP, which helps automate the migration process. It's, it's very unique to Enquizit, so far, that's gained a lot of traction in our federal space.

Two great acquisitions that we were delighted to bring into the family and already paying dividends.

Keith Housum (Managing Director and Equity Research Analyst)

Great. Thank you.

Operator (participant)

Thank you. That will conclude the question and answer session. I'll now pass the conference back over to CDW for closing remarks.

Christine Leahy (Chairman and CEO)

Thank you. I want to recognize before we close, the incredible dedication of our coworkers around the globe and their extraordinary commitment to serving our customers, our partners, and all CDW stakeholders. You show the power of execution excellence every day and in every way. Thank you to our customers for the privilege and opportunity to serve you. To our investors and analysts participating in this call, we appreciate you and your continued interest in and support of CDW. Al and I look forward to talking with you again next year. Signing off from Navy Pier.

Operator (participant)

That concludes the CDW Q2 2023 Earnings Call. Thank you for your participation. I hope you have a wonderful rest of your day.