CDW Corp.: Rating Downgrade On Uncertain Timing Of Growth Recovery

seekingalpha11-05

CDW's 3Q24 results were disappointing, with revenue declining and guidance lowered.The company's heavy exposure to hardware, which is facing weaker demand, is a headwind.As the market focuses on near-...

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(NASDAQ:CDW) in August this year, with my key thesis being that CDW will see growth acceleration as the macro environment turns for the better. The business also seemed to have lowered its cost structure as gross margin expanded despite revenue decline. I downgrade my rating from buy to hold as the timing of recovery has gotten a lot more uncertain, driven by poor end market demand and negative idiosyncratic factors. Earnings results update In the latest quarter (3Q24) reported on 30th October, CDW saw revenue decline by 2% y/y to $5.517 billion (2% q/q growth), driven by corporate revenue of $2.541 billion, public revenue of $2.336 billion, and other revenue of $640 million. Total revenue per selling day fell by $3 million from $89 million last year to $86 million this year. Splitting revenue by product type, cloud solutions demand remained strong while hardware sales remained challenged. Gross margins continue to sustain themselves at 21.8% (same as 2Q24 and 3Q23), but this did not translate to the same strength at the adj EBIT line, as the margin compressed by 20 bps y/y to 9.7%. As a result, adj EPS of $2.63 missed the consensus estimate of $2.86. The disappointing performance was accompanied by a lowered FY24 earnings guidance. FY24 gross profit is now expected to decline by a low-single-digit percentage, vs. the previous expectation for flat-to-low-single-digit growth. Accordingly, EPS guidance is also expected to decline by a mid-single-digit range in FY24, including a high-single-digit decline in 4Q24. Demand is weaker than I expected As much as I was confident that a recovery is near in my previous post, based on peers' comments and historical revenue performance, I realized that the stock price will not reflect this \"potential recovery\" until CDW actually reports solid evidence of this happening. Unfortunately, CDW failed to do so. On the contrary, multiple data points indicate a delay in recovery, making the near-term outlook even more uncertain. Specifically, it is evident that macro uncertainty continued to weigh on customer spend in 3Q24 as CDW continues to see elongated sales cycles, projects being pushed out, and project budget size decline. Notably, weakness was seen across all the segments. In the corporate segment, it was especially concerning to learn that corporate spending for large infrastructure investments such as netcomm, storage, and servers all declined by significant double-digits y/y. In the current environment where demand for data centers is on the rise, such a decline may imply that clients are really hurt by the poor macro environment, which is very negative for CDW demand outlook. As for SMB, there are no signs of recovery in spending as customers remain focused on preserving cash and prioritizing projects with a shorter-term return on investments. In the public segment, the outlook remains uncertain because of the US election. Depending on who wins the election and what policies the new president will implement, it heavily impacts government and education spending. Since these policymakings and implementation take time, uncertainty in this segment should continue for the near term, which weighs on 4Q24 and potentially 1H25 performance. Other aspects that make timing of earnings growth recovery more uncertain On top of the poorer-than-expected demand, there are three other areas (as highlighted by management) that further weigh on my confidence that CDW will see earnings growth recovery anytime soon:  Poor pricing strategy: It was noted that CDW irrational pricing has caused CDW to lose out on deal volumes. Viewed positively, it means that CDW simply needs to lower its prices to remain positive. However, this will impact margins directly, which means near-term earnings growth will see strong headwinds (remember that pricing adjustments have almost 100% incremental margin impact). Elevated exposure to large data center solutions, which saw an elongated sales cycle: In some ways, you could say that this is a poor strategic decision in that management should have further diversified its exposure. In my view, I don't think this is a bad long-term decision, but the fact that large deals are getting scrutinized with a tightened budget makes the timing of recovery increasingly murky. Unfavorable hardware/cloud mix: which weighs on the near-term performance because hardware investments are being pushed out by customers vs. cloud solutions seeing positive demand. As long as the macro environment remains uncertain (impacting demand), I think it will be hard for customers to ramp up hardware spending, especially in large deals (that CDW is heavily exposed to in the data center solution vertical). With little cloud solution exposure, any positive demand will not be enough to move the overall needle.  Valuation Combining all the points I mentioned above, my renewed view is that growth is unlikely to see a recovery anytime soon, and this screens badly when compared to TD Synnex Corp. (SNX), CDW's key peer in the industry. For comparison, SNX is expected to grow revenue by a high single-digit percentage one year forward, while CDW is expected to grow by only 2%. Although CDW has a higher margin profile, which warrants a higher multiple in a normalized environment, I believe market participants will shift their focus to growth in the near term, which puts pressure on CDW's valuation. Note that CDW is trading at a pretty steep premium to SNX (~19x forward PE vs. 9x), which means there is plenty of room for CDW to get derated. The lowest premium that CDW has ever traded vs. SNX was in mid-21, where the premium fell to 1.4x. Assuming that as the bear case multiple, it implies CDW to trade at ~13x forward PE, implying a potential 34% decline downside. Conclusion  My revised view on CDW is because of the poor demand environment and CDW company's specific challenges, which have made the near-term growth outlook significantly clouded. Given that the timing of a recovery is uncertain, and my expectation that market participants will focus on the timing of growth recovery, I see potential downside to the stock if the valuation gap between CDW and SNX closes. As such, I think it is better to simply stay on the sidelines (hold rating) and monitor the situation.","kind":"highlight","is_publish_news":true,"is_publish_highlight":false,"is_publish_live":false,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"0","news_tag":"analysis","news_rank":0,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.29.3","shortVersion":"4.29.3","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2481540054"}