CDW Corporation: 2 Major Growth Catalysts Ahead (NASDAQ:CDW)

Investment summary

I give CDW Corp. (NASDAQ:CDW) a Buy rating despite near-term weakness because I see two strong catalysts ahead that should drive growth acceleration as CDW moves beyond FY24. Specifically, I think the near-term catalyst is The PC refresh cycle will take place in H2 24 and in the medium term, growth will be supported by demand for AI PCs and AI-related deployments.

business overview

CDW sells IT products and services to businesses of all sizes. According to your fact sheet, CDW offers more than 100,000 products from more than 1,000 brands, including hardware and software products. Segment-wise, revenue is divided into three main segments. The total corporate sector, where CDW sells to companies, is the largest contributor to revenue (52% of revenue); the public, which includes government and healthcare customers, is the second largest contributor to revenue (35% of revenue); and others represent 13%.

A very complicated macroeconomic environment in the short term

I expect the difficult macroeconomic environment to continue to put pressure on CDW performance in the near term. This dynamic can be seen well in the 1Q24 performance, where revenue saw a decline across all segments with total revenue falling 4.5%, representing the sixth consecutive quarter of decline. This was also the third consecutive quarter in which CDW missed consensus expectations, suggesting that underlying conditions remain much worse than the market expected. My guess is that the current macroeconomic glut will persist, leading to longer sales cycles and project abandonments as clients prioritize cost-cutting initiatives and those with a rapid return on investment (ROI). Management's guidance also clearly reflects this macroeconomic headwind, as they reduced FY24 EPS growth to low single digits compared to previous guidance for mid-single digit growth.

The positive side, however, is that CDW is not seeing project cancellations, just increased budget scrutiny and project cancellations. In my opinion, this will lead to pent-up demand, which is good news for CDW because it could mean a strong growth acceleration for the company once it overcomes this down cycle. The question is when the cycle will change and I believe there are two main catalysts that will drive this recovery.

2 strong catalysts ahead

The first catalyst is the PC upgrade cycle, which is expected to will happen sometime in 2H24. The impact on CDW is that each additional PC (enterprise workstation) creates multiple sales opportunities for CDW, as the user would likely need certain computer peripherals (mouse, cables, keyboard, etc.) and software (business applications, cybersecurity , etc.) to continue with it. In fact, there are already early signs that this is happening, as CDW experienced stronger-than-expected PC demand in the first quarter across all end markets, driven by older device upgrades and Win 11 upgrades.

Additionally, there is one more underlying catalyst within this refresh cycle that could further drive growth in this cycle, and that is the increasing availability of AI-enabled PCs. My opinion is that it is only a matter of time before AI PCs make up the majority (IDC estimated 60% of PC shipments worldwide by 2027) of the market, particularly for enterprise use cases, as companies look to leverage AI in all aspects of their business to improve productivity and efficiency. The limitation today is availability. Microsoft just announced the first batch of Copilot Plus AI PCs a few days back. As availability increases, this could unlock demand for AI-enabled PCs, which are priced higher than conventional PCs (pricing advantages for CDW).

Looking ahead, I expect PC upgrade momentum to continue through 2Q24 and beyond, with demand for AI-enabled PCs supporting medium-term growth prospects.

The second catalyst also relates to AI. I think the world is still in the early stages of the generative AI opportunity. What this means is that customers are still in the experimentation stage, testing whether Gen AI can really satisfy their use case. The risk of dealing with Gen AI will also be a hurdle for companies to invest in this emerging technology, especially with data security risks (80% of companies They say that data security is the main issue). To make matters worse, there is macroeconomic uncertainty, meaning this potential demand is unlikely to translate into revenue any time soon.

However, I believe these issues will eventually be resolved, similar to what happened with previous emerging technologies. eventually being adopted (a good example is the Internet) and at a fast pace. The fact is that mainstream AI can significantly improve a company's productivity, and I believe every business owner will find a way to take advantage of this. in a Recent CIO Technology Survey conducted by Foundry, it was observed that, while budgets are still tight, the main focus is on AI. Therefore, given CDW's extensive portfolio of products and solutions (a search for “AI” on CDW's website shows more than 500 results related to services, software, services, storage, etc.), I expect that AI generative will eventually become a tailwind for growth as customers move from evaluation to implementation.

The difficulty is determining the moment of inflection. I'm pretty sure this won't help drive CDW growth in the coming quarters, but in the medium term I see it becoming a major growth driver.

Valuation

In the short term, I think the difficult macroeconomic environment will continue to put pressure on CDW growth, meaning FY24 is likely to be a negative year as well. However, the start of the PC refresh cycle in the second half of 2024, together with the availability of more AI-enabled PCs, should drive growth to positive numbers in FY25/26, supported by a recovery in conditions. macro (inflation rates are currently moving in the right direction). After FY25/26, companies preparing their deployment of AI-related hardware and solutions should continue to support growth. If we look at CDW's revenue growth historically, it has never seen more than two consecutive years of declining growth, and I think this is in line with my expected timeline for growth to recover in FY25.

My future expectations for CDW are -5% growth in FY24, positive 5% YoY growth in FY25, and 10% YoY growth in FY26. The basis for this outlook is that In FY24, the macroeconomic situation is clearly bad, but the H2 2024 PC upgrade schedule should cushion some of this headwind. As such, FY24 growth should be of lower magnitude than that of FY23. FY25 growth is expected to recover gradually as some of the macroeconomic headwinds may propagate. FY26 should see growth fully recover to the historical range of ~10%.

In terms of earnings expectation, I used adjusted earnings because that's what management guides, and the market is valuing CDW based on adjusted earnings (CDW's current stock price as of this writing is $231 .57 and the forward adjusted EPS estimate (normalized) is $10.12, which is ~23x). For conservative reasons, I assumed flat margins for FY24 as I expect revenue growth to be negative (although FY23 saw net margin improvement despite -10% growth). In FY25 and FY26, I expect net margins to grow at the same pace as over the last decade, at 40 basis points per year.

Currently, the market values ​​CDW at 21x Forward PE (+1 stdev of CDW beyond the 5-year trading range), which I believe is due to the expected recovery in FY25. In my model, My guess is that CDW trades at 20 times forward PE, the average of the last five years, because I don't expect growth to accelerate beyond 10%. Attaching this multiple translates to an implied market cap of ~$33.3 billion.

I've also included return on equity in my total return calculation because in recent years, CDW has been returning capital to shareholders through share buybacks and dividends. Using the same share repurchase rate (2%/year) and the consensus expected DPS return, I expect a total return of ~19% (share price up 17.6% and ~1.7% dividends).

Risk

A big risk is the timing of growth recovery, as current macroeconomic headwinds could last much longer, putting further pressure on companies' willingness to increase their technology spending budget. The most important implication is that this will likely delay the PC refresh cycle schedule as companies look to further deplete current assets.

Another thing I fear is the amount of debt on CDW's balance sheet. As of 1Q24, the company has a net debt position of ~$4.8 billion. In the worst case scenario, if a decline similar to what CDW experienced in FY 2009 (EBITDA fell 22%) repeats (which could be due to many reasons, such as a major global recession if a conflict occurs in full rule in the Middle East) East), CDW could be forced to cut buybacks and dividends as the leverage ratio increases.

Conclusion

Overall, despite the near-term headwinds coming from the macroeconomic environment, I am giving CDW a Buy due to two key catalysts. The first is the PC refresh cycle expected in the second half of 24, and the second is the demand for generative AI. While the exact timing of this inflection point is uncertain, I believe CDW's broad product portfolio positions them well to capitalize on these two catalysts. Key risks to this thesis are the possibility of a prolonged economic downturn delaying the PC upgrade cycle and CDW debt levels.