CDW Corporation Q4: Growth Outlook And Valuation Not Attractive (NASDAQ:CDW)

Overview

My recommendation for CDW Corporation (NASDAQ:CDW) is a hold rating, as I believe the near-term growth outlook remains unattractive, especially with CDW’s exposure to business hardware spending, which is undergoing a shift towards software spending. Also, CDW is currently trading at 22.5x forward PE, which is above its 5-year historical trading range, implying that the market is expecting a strong recovery in the near term, making the margin of safety (valuation-wise) thin here. Note that I previously gave a hold rating for CDW, as the previous results were mixed. On the positive end, networking, cybersecurity, and client device end markets did well, but on the negative end, CDW continued to struggle in the enterprise end market.

Recent results & updates

CDW ended FY23 poorly relative to my estimates. Revenue fell 10% vs. my 7% expectation to $21.37 billion, with 4Q23 revenue coming in at $5 billion vs. the consensus of $5.3 billion. The 4Q23 decline was dragged down by both the Client Devices and NetComm business units. That said, 4Q23 operating margin beat consensus estimates, coming in at 12.7% vs. consensus of 9.7%, hence driving 4Q23 earnings margin to 7%, ending the year with a net margin of 6%. Again, CDW results were mixed: the topline fared really poorly, but the FY23 exit margin did better than expected.

Given the ongoing uncertainty surrounding the macroeconomic outlook and the persistence of high interest rates, which put pressure on businesses’ cost of capital and their willingness to take risks, CDW continues to face challenges in the commercial hardware end market. These macro factors continued to impact business hardware spending in 4Q23, which continued to drive client device and NetComm revenue declines, with the latter decline accelerating to double-digit declines. I do not see any visible pathway for CDW to see a recovery in the hardware segment, as I expect businesses to continue shifting budget dollars to software solutions that can help them improve operational efficiency and productivity. This can be seen from CDW cloud and SaaS-based revenue growth outpacing overall net revenue growth. The same weakness seen in the larger enterprise end market echoed at a larger magnitude in the small and medium business [SMB] end market, where customers prioritized cloud projects with a shorter-term ROI – in other words, lower-budget projects that do not require a large capital outlay (less growth opportunities for CDW). Management outlook comments also painted a grim picture as they expect uneven market conditions to weigh on topline growth for a second consecutive year, with many of the trends seen in 2023 persisting into 2024. A concerning part of management’s assumption is that they are expecting a gradual recovery in hardware spending in 1H24, something that, I believe, might take longer than expected to recover given the macro uncertainty (inflation remains very sticky, so there are no reasons for the Fed to cut the rate in the near term). A 2H24 recovery might be more plausible due to the timing of PC upgrades.

An aspect that is worth highlighting and commending is CDW’s gross margin performance (which led to a better net margin in 4Q23), and management suggests this gross margin performance was a structural improvement. What was also noteworthy is the stability in product margins, which implies CDW is capturing more demand from higher up the value chain (this is a structural improvement in margins).

Based on our current view of mix and margin rates across our portfolio, our expectation for 2024 is for low to mid single digit first profit growth. This assumes a flat to modestly higher gross margin relative to full year 2023

And then finally on the product margin front but we studied this closely and really our assessment at this point, we’d be that product margins are holding firm, and I think that’s a reflection of both a competitive environment, but not any rational environment from a pricing and margin perspective. – 4Q2023 earnings call

A possible catalyst (this could be an upside risk to my hold rating) that could change the stock narrative in FY24 is probably the general AI opportunity. So far, management has mentioned that most customers are still in the evaluation phase, but what is encouraging is that CDW has already started gaining some traction in this area. They assisted a major IT client in developing a unique platform that accommodates AI workloads for training and inference (a multi-million dollar deal). This generational AI opportunity is new to almost everyone, and I say this is encouraging because CDW has to start somewhere to gain experience; the earlier, the better. Importantly, management does not perceive any indication that AI spending will eat into traditional hardware budgets. Rather, they anticipate incremental spending from departments like finance, marketing, and human resources, where Gen AI has the potential to drive productivity gains. As such, what this implies is that there could be a third revenue stream to further diversify the CDW revenue base (i.e., away from hardware revenue), and it is one with a strong secular tailwind. That said, this is still new, and I don’t think the market is going to price in this unless CDW really makes a huge breakthrough (e.g., signing a very large deal that can move the needle).

Valuation and risk

According to my model, CDW is valued at $214.92, representing a 10% decline. This target price is based on my lowered growth forecast of 1% for FY24 and 5% for FY25. My lowered growth expectation stems from the continuous weak macro environment that is weighing on CDW’s hardware business, which is the majority of its revenue base. That said, I have increased my net margin expectations because of the structural improvements in gross margin – a higher product margin and also a higher contribution from the growing software business that will become a larger part of the business. For valuation, I don’t think the current valuation of 22.5x forward PE is sustainable. Over the past 5 years, CDW has traded between a range of 17x to 21x and an average of 19.5x. At the current multiple, the market seems to be assuming a strong recovery over the near term, which, I think, is too risky to assume. In my model, I take a more safe approach by assuming CDW will see a mean reversion in FY24 back to 19.5x.

Summary

My recommendation for CDW remains as a hold rating. CDW continues to face ongoing challenges in the commercial hardware end market, as macroeconomic uncertainty and high interest rates continue to impact business hardware spending. Management outlook was also grim, as they anticipate the trends seen in 2023 to continue into 2024. Noteworthy is CDW’s gross margin performance and stability in product margins, indicating a structural improvement. While the general AI opportunity presents a potential catalyst for FY24, its impact remains uncertain.