CDW Corp Q3 FY2021 Earnings Call

Hello, everyone, and welcome to the CDW Third Quarter 2021 Earnings Call. My name is Bethany, and I'll be coordinating this call for you today. If you would like to register a question at the Q&A, you can do so by pressing the appropriate keys on your telephone keypad. If you change your mind, you can cancel the request by pressing the appropriate keys. I will now hand the call over to your host, Kevin White, Director of Investor Relations. Kevin, over to you.

Thank you, Bethany. Good morning, everyone. Joining me today to review our third quarter results are Chris Leahy, President and Chief Executive Officer, and Al Miralles, Chief Financial Officer. Our third quarter 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 would 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 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 the Form 8-K we furnished to the SEC today and in the Company's other filings with the SEC. CDW assumes no obligation to update the information presented during the 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 we furnished to the SEC today. Please note that all references to growth rates or dollar amount increases in our remarks today are versus the comparable period in 2020 unless otherwise indicated. In addition, all references to growth rates for hardware, software, and services today represent U.S. net sales only and do not include the results from CDW UK or Canada. Replay of this webcast will be posted to our website later today. I also want to remind you that the 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.

Thank you, Kevin, and good morning, everyone. I'll begin today with an overview of third quarter results and drivers of performance. Al will take you then through a more detailed look at our financials, as well as our capital allocation strategy and outlook. We'll move quickly through our prepared remarks as we always try to do to ensure we have plenty of time for questions. But before I get started, I do want to pause for a moment to honor the life and legacy of our former CEO, Tom Richards, who passed away last week after a valiant fight with cancer. I suspect most of you on this call have likely met Tom in person. I'm certain that everyone on this call has been impacted by Tom. He was a fierce competitor and equally a kind human being. Tom had a lot of what we like to call CDW Tomisms—simple ways of getting to the essence of something in a way that it stuck. One of my personal favorites is when Tom used to say, 'At CDW, we take what we do seriously, but we don't take ourselves too seriously.' That's the essence of who we are. That is our CDW culture. Tom captured those simply and amplified those strongly. Tom also had an unexpected way of signing off on our earnings calls, usually with a right comment about an upcoming holiday, like Halloween or Mother's Day, or even Valentine's Day. As a result, we always ended these calls on a high note and with a chuckle. Tom knew his audience well. In honor of Tom, I'd like to kick off this earnings call with the tagline he penned on every communication to a co-worker. Tom always signed off with 'you make a difference.' Literally injecting into each co-worker Tom's personal belief in them and their important impact. On behalf of all of our co-workers around the globe, our customers and our partners, our communities and our investors, I would like to say thank you to Tom. You made a difference. Let me turn now to Q3 performance. Once again, CDW posted strong top-line growth and profitability. Overall, demand was strong and the teams did a great job addressing customer needs. For the quarter we delivered record net sales of $5.311 billion, 0.4% higher than last year, and up 10.7% in constant currency, non-GAAP operating income of $435 million, up 12.6%, and non-GAAP net income per share of $2.13, 13.4% higher than last year on a reported basis and up 15.8% in constant currency. Our ability to deliver this strong top line and profitability was the result of three key drivers: our balanced portfolio of customer end markets, the breadth of our products and solutions portfolio, and our ongoing execution against our three-part strategy, which is focused on taking share and investing in solutions and capabilities our customers need and want. Let me walk through each one of these and share some detail about how they contributed to our performance. First, our balanced portfolio of customer end markets. As you know, we have five U.S. sales channels: corporate, small business, healthcare, government, which includes federal and state and local customers, and education with K-12 and higher ed. We also have our UK and Canadian operations, each serving public and commercial customers. All of these operations represent meaningful businesses in their own way. Often, different factors impact these diverse customer end markets. And this quarter we saw that play out as our commercial business in the U.S., our small and corporate channels, and our international operations posted significant double-digit increases, while our U.S. public business posted a mid-single-digit decline. From a macro perspective, supply remained under pressure this quarter. Demand outpaced supply and lead times extended, particularly in several solutions areas. The team continued to leverage our distribution centers, expansive logistics capabilities, deep vendor partner relationships, and strong balance sheet and liquidity position to navigate the supply environment. They did an exceptional job working with our partners to stay on top of availability status. Our sellers and technical specialists also worked with customers and, whenever possible, found alternative available products and built alternative solutions. These efforts helped mitigate some of the pressure, and our backlog increase was consistent with last quarter. The tight supply environment continued to impact prices, which our teams were generally able to pass along. Let's take a deeper look at third quarter customer and market performance. Commercial customer priorities remain the same as in the second quarter: digital transformation, security, and hybrid and cloud solutions. Customers continue to prioritize investments to enable the future and add resiliency to their operations to strengthen and secure infrastructure, platforms, and endpoints. Within this backdrop, corporate increased 25% and customer demand remained strong. While many customers delayed return to office, they continued to prepare as well as invest to facilitate hybrid work. This drove ongoing strong double-digit increases in transactions propelled by notebooks, audio visual, and desktop. At the same time, digital transformation remains a top priority. While buying sentiment was clearly there, in many cases, the product was not. Writings were strong, but with extended lead time, backlog built during the quarter. Lack of product availability, particularly in networking and storage, muted corporate solutions growth. Small business also delivered another exceptional quarter of growth, increasing almost 40%. The team continued to help customers with remote enablement, security, and video, driving strong growth across both transactional and solutions categories. As we have shared previously, small business customers tend to be more flexible in their technology requirements. So while they did see some impact from supply constraints, small business did not experience as much as corporate. A great example of the power of diverse end markets. You also see the power of our diverse end markets in our public performance. Net sales for our government channels decreased 3%. Federal declines were double-digit in large part due to the overlap of our devices and services for the U.S. Census Bureau and other client advisory programs that were particularly strong last year. Security remains robust with net sales up more than 30%. The gears of Washington were slower than typical at federal year-end, and we had contracting delays in several large contracts. This is not unusual; given the magnitude of federal contracts, timing can influence performance. You've heard us talk about federal lumpy nature in the past. This will unwind and we expect to see a reversal back to growth in the first half of 2022. State and local posted a mid-single-digit decline. Stimulus funding remained largely unallocated to the local level. This is because access to multi-year American Rescue Plan Act funding with deadlines in 2024 led to greater focus on multi-year budget planning. At the same time, state and local customers were focused on digesting last year's meaningful stimulus-funded IT investments. We continue to work with our customers, but given the complexity of the various funding opportunities and multiyear phasing, we do not expect to see projects moving ahead meaningfully until early 2022. Education increased by 2%. Higher ed delivered high single-digit growth driven by ongoing focus on campus connectivity, and enhancing the dorm room experience with double-digit growth in both security software and servers. The K-12 team did an excellent job and matched last year's record net sales, coming in flat on top of last year's 30% plus growth. This was consistent with the expectations we shared on our year-end 2020 call, where we looked for strong non-seasonal first-half performance to be followed by a deceleration in the second half. Chromebook availability continued to improve during the quarter, and client devices increased low single-digits on top of last year's stimulus-driven growth. Overall, transactions increased low single-digits on top of last year's strong double-digit growth. Solutions declined driven by a double-digit decline in networking largely reflecting supply challenges. We continue to expect above-historical net sales against some very tough unseasonal fourth-quarter comps. Healthcare posted a 31% increase. By the second wave of COVID, staff shortages and limited ICU bed availability during the quarter, some projects that had been sidelined did resume. This was particularly the case in security as healthcare remains a target for cybercrime. Our security experts continue to guide hospital systems to find the best solutions that protect their sensitive data and security sales increased strong double-digits. Other, which represents our UK and Canadian operations, increased over 30% on a reported basis. Both the UK and Canada delivered mid-20% growth in local currency. Customer priorities in both markets remain the same as the U.S.: digital transformation, security, and hybrid and cloud solutions, as do their investments to enable the future and add resiliency to their operations. Both operations experienced increased back-orders. Clearly, the 11% plus sales growth we delivered demonstrates the power of the first driver of our performance, our balanced portfolio of customer end markets. It also demonstrates the power of the second driver of our performance in this quarter, the breadth of our products and solutions portfolio, which you can see in our major category performance. Transactions increased low double-digits driven by client device growth and video. Solutions were flat with double-digit increases in servers and collaboration. Once again, increased demand was double-digit. We saw robust growth across all three top cloud workloads: security, infrastructure-as-a-service, and productivity. We expect strong customer demand for cloud solutions to continue, and we are well positioned to deliver. And once again, given the importance to our customers, our security practice delivered and was up strong double-digits. Our teams continue to guide customers on their security posture: assess the environment, design the best approach, and deploy and manage the solutions throughout their lifecycle. Overall, for the quarter, we delivered double-digit growth in hardware, low-single-digit growth in software, and strong double-digit growth in services. Software net sales increased low-single-digit, with strong double-digit increases in security software; database software, and backup and recovery were partially offset by declines in network management software, storage software, and telephony-related software. As I have shared before, services are fundamental to our go-to-market approach and a key enabler of our value proposition. This contribution was driven by both professional and managed services. And this leads to the final driver of our performance in the quarter, the impact of investments we are making in our three-part strategy for growth. As you know, in October, we announced our planned acquisition of Sirius Computer Solutions. When we announced the acquisition, I shared how it deepens and adds scale to our services capabilities—capabilities that will ensure we remain the trusted technology advisor to our customers as they accelerate their digital transformation. Sirius' EBITDA deepens; Sirius is additive to our existing capabilities—capabilities we have built through both organic and inorganic investments. Capabilities that enable us to serve customers as their trusted advisor, whether in a physical, digital, or cloud-based environment in the U.S. and internationally. Why so many investments in services capabilities? Simply put, services are becoming an increasingly larger component of total customer IT spend. For CDW, services position us to enable the whole solution, increase our engagement with customers and stickiness, and provide insight into opportunities to further help our customers across the full IT lifecycle. Today, IT leaders are accountable for both running the business and transforming it; leaders need to invest resources where they can have the greatest impact and do so with the greatest speed. Services are critical to making this happen. To address this full-stack and full lifecycle, our technical organization has grown to more than 3,700 pre-sale specialists and engineers. Today, we can deliver complex digital transformations. Let me share an example of how our services team is helping a global online home retailer transform their business for their next wave of growth. Experience from the customer was that they opted for a combination of public cloud technologies and a new cloud-native platform. This would create the agility they needed to operate in their environment. A great idea, but accelerating cloud technology requires specialized expertise that is inefficient for customers to keep on staff, and that is where CDW helped. First, we leveraged our cloud managed services and offloaded some of the cloud projects from the customer to CDW. Then we pulled in our digital velocity talent orchestration services. Digital velocity talent orchestration supplies customers with talent to work inside the customer's existing team—talent that is becoming more and more vital in today's environment. Digital velocity talent orchestration delivers highly vetted resources, whether already employed by CDW or sourced by us. CDW services enabled the solution. But it did so much more. As you can imagine, this level of high-touch integration creates customer loyalty with ongoing relationships on the ground, and continued exchange between CDW and the customer, ultimately leading to more business. Great for the customer, and great for CDW. This is an excellent example of our three-part strategy in action and how M&A enhances our organic investments to ensure we remain our customers' number one choice as a trusted advisor. Solving key business problems for our customers in today's environment requires strong services and solutions capabilities—capabilities that when combined with our great relationships and competitive advantages of skill, scope, and disciplined execution, enable us to win in the marketplace and deliver sustainable, profitable growth today and in the future. And that leads me to our expectations for the balance of the year. We continue to look for growth in 2021 to come in between 9.25% and 10% in constant currency, split roughly between 5% IT market growth and 425 to 500 basis points of CDW market outperformance. This reflects our expectation that supply constraints do not mitigate anytime in the near future, but do not get materially worse. Remember these constraints don't just reflect component shortages, but also labor and logistics challenges—challenges we do not expect to reverse in the near term, and challenges that we do not expect to resolve all at once, but rather gradually. As far as wildcards, in addition to the fluid supply situation and the potential for another wave of COVID, given the slowdown in GDP growth in the third quarter, we will keep a watchful eye out for any slowdown in the economy. As we do, we will continue to do what we do best: leverage our competitive advantages to help our customers address their IT priorities and achieve their strategic objectives and out-execute our competition. 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 customer-specific challenges and positions us for sustainable growth. A strategy designed to continue our evolution as the leading IT solutions provider. And most importantly, a strategy that delivers profitable growth and returns to shareholders. This confidence underpins today's action by our board to increase our quarterly cash dividend by 25%. I know many of you may be wondering what we expect for next year. We're in the middle of our planning process, and as we always do, we'll provide our outlook for 2022 on our year-end conference call. And with that, let me turn it over to Al, who will share more detail on our financial performance. Al.

Thanks, Chris, and good morning, everyone. I will start my prepared remarks with more detail on the third quarter, move to capital allocation priorities and then finish up with the 2021 outlook. Turning to our third quarter P&L on slide 8, consolidated net sales were $5.3 billion, up 11.4% on a reported basis and on an average daily sales basis. On a constant currency average daily sales basis, consolidated net sales grew 10.7%. Net sales in channels most impacted by COVID-19 last year—corporate, small business, and international—continue to rebound, posting strong double-digit growth in the quarter and delivering sales above 2019 levels. This quarter's growth also benefited from strong double-digit performance in healthcare, but was tempered by a slowdown in education and declining government. On the supply side, overall backlog increased several hundred million dollars in the quarter and continues to be elevated year-over-year. The team did a great job leveraging CDW's competitive advantages so the backlog did not increase even more. Gross profit for the quarter was $915 million, an increase of 10.8% on a reported basis. Gross margin was 17.3%, down approximately 10 basis points versus last year. This is primarily driven by lower product margin, partially offset by an increase in the mix of net service contract revenue, primarily in software and services, in addition to strong professional and managed services performance. Turning to SG&A on slide 9, non-GAAP SG&A increased 9.2%. The increases were primarily driven by payroll costs, including sales compensation, which moves with gross profit growth, and performance-based compensation, consistent with higher attainment against financial goals. Finally, it reflects investments in the business, including increased co-worker counts, focused on execution of our strategy. Co-worker count at the end of the third quarter was 11,098, up 432 from the second quarter, and 1,118 over the prior year. The increase in co-worker count reflects organic and inorganic investments to support high-growth solution areas and our own digital transformation. GAAP operating income was $386 million, up 21.6%. Non-GAAP operating income, which better reflects operating performance, was $435 million, up 12.6%, and non-GAAP operating income margin was 8.2%. Moving to slide 10, interest expense was $36 million, down 9.4%. The decrease was primarily due to savings from last year's refinancing. Our GAAP effective tax rate, shown on Slide 11, was 23.9%. To get to our non-GAAP effective tax rate, we adjust taxes consistent with non-GAAP net income add-backs as shown on Slide 12. For the quarter, our non-GAAP effective tax rate was 25.3%, up 200 basis points versus last year's rate, primarily due to a one-time impact of state and foreign tax benefits recognized in the prior year. As you can see on slide 13, weighted average diluted shares outstanding were used to calculate GAAP net income per share of $1.91, up 43.2%. Our non-GAAP net income was $298 million in the quarter, up 12.3%, and non-GAAP net income per share was $2.13, up 16.4% from last year. Turning to year-to-date results in slides 14 through 19, net sales were $15 billion, an increase of 13.1% on a reported basis, and 13.7% on an average daily sales basis. We had one fewer selling day year-to-date in 2021, which will be made up in Q4—we have one extra selling day compared to the prior year. On a constant currency average daily sales basis, year-to-date consolidated net sales were 12.6% higher than the prior year. Gross profit was $2.6 billion, up 11.3%, and gross profit margin was 17%, down approximately 20 basis points year-over-year. Operating income was roughly $1.1 billion and non-GAAP operating income was $1.2 billion, up 18.7%. Net income was $773 million and non-GAAP net income was $834 million, up 20.7%. Non-GAAP net income per share was $5.89, up 23.5%. Turning to the balance sheet on slide 20, at September 30th, cash and cash equivalents were $245 million, and net debt was $3.8 billion. Liquidity remains strong with cash plus revolver availability of approximately $1.4 billion. Year-to-date free cash flow was $341 million as shown on slide 21. This is lighter than last year's record $1.2 billion of free cash flow, which benefited from timing and one-time items. Year-to-date, we saw some of the timing reverse as we moved away from vendors with extended payment terms. Additionally, working capital increased to support our strong year-to-date growth, and we continue to make strategic investments in inventory to support our customers through this choppy supply environment. Moving to slide 22, the three-month average cash conversion cycle was 25 days, up 9 days from last year's third quarter. The increase was primarily driven by changes in vendor payment cycles, in addition to holding customer-driven stocking positions, and the timing of receipts and shipments. Turning to capital allocation on slide 23, our 2021 priorities remain the same. First, increase the dividend in line with non-GAAP net income, including today's 25% increase to the dividend. The increased annual dividend of $2 is approximately 25% of trailing 12-month non-GAAP net income through September. The Q4 2021 dividend demonstrates our confidence in the earnings power and cash flow generation of the business. It marks the eighth consecutive year of increases since our initial public offering in 2013. Our dividend has grown at a compound annual growth rate of 36% from its initial level. We will continue to target a 25% payout ratio going forward, growing the dividend in line with earnings. Second, ensure we have the right capital structure in place with a targeted net leverage ratio of 2.5 to 3 times. We ended the third quarter at 2.3 times. Third, supplement organic growth with strategic acquisitions. Sirius, which we announced on October 18th, and our recent Focal Point and Amplified IT acquisitions are great examples. And fourth, we return excess cash after dividends and M&A to shareholders through share repurchases. During the quarter, we continued to deploy cash consistent with our capital allocation priorities, returning $505 million to shareholders, including $55 million in dividends and $450 million of share repurchases at an average price of approximately $188 per share. We continue to expect to return approximately $1.7 billion to shareholders for the full year of 2021, including $1.5 billion in share repurchases with the balance from dividends. Going forward, we continue to execute against our capital allocation priorities as we have done since 2014. In 2022, post-closing of the Sirius acquisition, we expect to have an initial net leverage ratio of approximately 3.3 times. While our capital allocation priorities will remain the same, we will shift our objectives to focus on paying the dividend and reducing debt. As a result of this focus, we'll put a lower priority on M&A and share repurchases until our net leverage is in our target range of 2.5 to 3 times, which we expect to achieve by the end of 2022. We continue to expect to close the Sirius acquisition in December, and we intend to share additional thoughts on the financial impacts of consolidating Sirius into CDW on our fourth quarter call. Moving to the outlook for 2021 on slide 24. Supply and product lead times remain fluid, making it challenging to comprehensively forecast with a high degree of confidence. On the demand side, we continue to see strong activity and momentum, particularly with both U.S. and international commercial customers. On the supply side, visibility remains a challenge. Constraints continue in notebooks, desktops, video, networking, and data center categories, resulting in longer lead times and a higher backlog. With the exception of Chromebooks, the supply environment has not improved since our last earnings call. We do not expect it to improve in the near future. With that context for full-year 2021, we continue to expect the U.S. IT market to grow approximately 5% and our net sales to grow 425 to 500 basis points faster than the U.S. IT market in constant currency. This assumes a consistent supply chain environment and impact to our backlog. We feel good about the health of the business, and we continue to navigate the fluid supply environment. We continue to expect currency to contribute approximately 80 basis points to full-year net sales growth, assuming exchange rates of $1.38 to the British pound and $0.80 to the Canadian dollar. Moving down the P&L, we now expect non-GAAP operating income margin to be in the high 7% range for full-year 2021. As you've heard us say, we believe now is the time to invest in the business and expect investments made in the fourth quarter to drive an operating margin which will deliver our full-year outlook. Putting it all together, we now expect non-GAAP constant currency earnings per share growth in the high teens—call it 18% plus or minus 25 basis points. Currency is expected to contribute an additional 70 basis points to earnings per share growth. Additional modeling thoughts for annual depreciation and amortization, interest expense, and the non-GAAP effective tax rate can be found on Slide 25. For free cash flow, our long-term rule of thumb remains unchanged at 3.75% to 4.5% of net sales, assuming current tax rates. However, given the timing impacts that contributed to 2020's significant over-delivery and ongoing customer-driven stocking positions, as well as the timing of receipts and shipments, we expect 2021 free cash flow to come in slightly below the low end of the range. Additional modeling thoughts and the components of free cash flow, including capital expenditures and the cash conversion cycle, can also be found on slide 25. That concludes the financial summary. As we always do, we will provide updated views on the macro environment and our business on our future earnings calls. And with that, I'll ask the operator to open up for questions, and we would just please ask each of you to limit your questions to one with a brief follow-up. Thank you.

Thank you. If you would like to register a question, please press the appropriate keys on your telephone keypad. The first question comes from Adam Tindle at Raymond James. Adam, your line is open.

Okay. Thank you, and good morning. Chris, I wanted to start on Sirius to see if you had some early feedback from customers now that the announcement has been out and specifically wondering if those Sirius enterprise customers are perhaps willing to broaden the conversation on utilizing CDW's transactional portfolio that Sirius didn't have? And conversely, the CDW mid-market customers more interested in Sirius' services portfolio? So a qualitative view from the customer perspective on potential revenue synergies in this deal.

Good morning, Adam. Thanks for the question. And, you know, we're in a little bit of a quiet period here as we go through the various regulatory approvals. That said, one of the areas that we focused on very quickly was feedback, and I would just tell you, it's been really, really positive on both fronts. So our customers at CDW are delighted about the acquisition, and really looking forward to the combined entity and the capabilities that they help bolster CDW, given their reputation in the market and the quality of their services. The reciprocal is true as well. I talked to Joe Martin late in the day of the announcement, and he had made his way through a lot of customers as had their front-line sellers, and it was for the most part all positive. So again, we think that— I said the word before, a home-run deal— and we're going to make it work really well, and our customers seem to be excited; our partners equally are thrilled. It's exactly what they were looking for us to do and they are thrilled.

Right. And I think that aspect of a home-run deal has some investors wondering a little bit more on Sirius' recent performance. The purchase price was very attractive, all cash in nature, and there's some skepticism on what's been going on with the business in 2021. I know you gave us color based on 2020, but maybe you could help to dispel any of that concern by talking about what you've seen out of Sirius' performance in 2021?

Well, you know, look, they're doing just fine and there are customers like us in areas like federal, which we talked about today, or enterprise customers. And as you know, that can be a lumpy business. So when we did our diligence and looked at the pipeline and the types of programs they're running with customers, they were having a similar impact that we were having with regard to our larger customers. Some things being delayed, some things being planned yet not rolled out necessarily, particularly in terms of delays in going back to the office, etc. But I would tell you that we feel very confident, Adam, in the health of the business, in the prospects of the business, in the pipeline for the business and in the opportunities for Sirius and CDW, the combined entity.

Very helpful. Thank you very much.

Thanks, Adam.

The next question comes from Shannon Cross at Cross Research. Shannon, your line is open.

Thank you very much. I wanted to take a bit more into backlog composition, if you're seeing any order cancellations or how it developed over the quarter, maybe linearity just to get an idea of how sustainable and sticky do you think the backlog will be?

Yeah. Good morning, Shannon. This is Al. So a couple of things that I would note. Going into the quarter, we maybe would have expected that there would be a bit of a modest view of backlog. I'd say overall for the quarter it was a bit more than modest. And let's call it similar to Q2. A couple of variants or components that maybe looked a little different, and I think Chris touched on this in his prepared remarks, is that we saw a bit more of an effect from a solutions perspective and that would have included notably networking and storage. Notwithstanding that similarity to Q2, I would just note the team did an exceptional job navigating through that and delivering on the results.

Okay, so you—but you're not seeing double orders? You're not worried about any kind of loss of backlog?

We are not. I would just note that there's likely some pull-forward component in the backlog; it's been a tenuous environment and so there are customers that probably have a perspective that knowing this doesn't have a clear end date, they may get in front of some of their projects, and so there's probably a component that's pulled forward. We're not feeling or seeing the effects of double bookings.

Okay. Thank you. And then just a quick question—Chris, maybe—how are you thinking about inflation? And clearly you can pass through higher product costs. But I just sort of in general, as you go through your budgeting and planning for 2022, are you thinking more transitory or are you planning for some of these cost increases to be here for the long term? Thank you.

I understand. And we'll share more with our planning next year as we think about it. Look, it feels like the perspective out there is maybe a little worse than transitory. And so we will just keep our eye on the economy and how this could impact, in particular, different segments of our business. For example, when you think about small business, they are really doing a terrific job right now, but we're keeping a very close eye on that segment of the market to understand how the economy might be impacting them, where their optimism is, their ability to hire, etc. So as we always do, we'll keep an eye on it. It feels a little worse than transitory but again, we think that technology is an A1 priority, and our customers will continue to invest in technology if in fact it becomes a bit more extended. And look, if we can keep the economy coming out of the pandemic with the momentum we seem to be building and the positive nature in the economy, we're feeling pretty good.

Thank you.

The next question comes from Rupplu Bhattacharya. Rupplu, your line is open.

Hi, thanks for taking my questions. Chris, I wanted to ask about the education market. In 3Q '20 and 4Q '20 you had two billion dollar quarters. And again this year in June and September you've again had two billion quarters. So there's a year-on-year headwind from the large projects you had in December and other headwinds where you've had strong year-ago quarters. Can you comment on how we should think about the education market dynamics?

Good morning, Rupplu, and thanks. Look, we called this out earlier in the year and I mentioned it again in my prepared remarks. It's really been unseasonal and we expected to see the first half of this year be quite strong; we're lapping a big back half of last year, so it will be difficult to overcome the level of growth that we saw last year. That said, if stimulus funding— for example, the Emergency Connectivity Fund— is yet another source of funds for education institutions to be able to fortify their classrooms in a hybrid environment. The one thing with that funding is schools are able to use it for orders that are placed; we're working our way through that. A large portion of that is additive to the base. The team, as they always do, has done a phenomenal job helping our K-12 customers work through that funding. So as you've heard me say before, I feel very confident in education over the long term. It is a growth area. The education market has inflection points and we have always been ahead of those inflection points—whether it's how the classroom itself changes or hybrid work. We are usually there, and Amplified IT, which we just added, is taking us to another level with their cloud-enabled capabilities and their technology that they offer for classrooms. I'll pass you to Al here, but the team is doing very well; it is a long-term growth area.

Thanks for all the details there, Chris. Maybe for my follow-up, if I can ask Al about operating margins. So you had another good quarter, another quarter of above 8% operating margin and you're guiding to an increase for the full-year to high 7s. If we just look at core CDW and not consider Sirius right now, which is accretive to the Company, but if we just look at core CDW, do you think that having a high 7s operating margin is a sustainable level going forward? What are the puts and takes that we need to keep in mind?

Sure, and thanks for the question, Rupplu. There are lots of puts and takes in any given quarter. First, put aside the supply chain environment: mix matters. Components, what's transactional versus what's solution, channel mix— all those things have an impact on gross margin and therefore operating margin. In this quarter, for example, there was a little less public mix from a channel perspective, and solutions mixes varied. Very notably, 100% gross margin items grew faster than our net sales this quarter, which had an impact as well. Then when you walk that down to operating margin, it comes down to the pace of non-GAAP SG&A spend. In this quarter, our non-GAAP SG&A spend lagged some of that growth in gross profit, which allowed a higher operating margin for the quarter. In our outlook, we expect some fourth-quarter investments that bring operating margin back to a high 7s level for the full year. Looking forward, mix components will matter as we continue to mix into services and higher-margin offerings, and that will influence where operating margin ultimately stabilizes.

Okay. Thanks for all the details. Appreciate it.

The next question on the line comes from Jim Suva at Citi. Jim, your line is open.

Thank you. Probably a question for Chris, but when we think about stimulus, the timing of it and the political nature of it is a little bit hard to pinpoint. But then when we layer in the supply chain challenges and deal with schools and local governments and smaller municipalities who may not be as tech savvy as the Fortune 50 or 500, can you talk a little bit about visibility? Are they starting to place smart orders or starting to say, hey, if this gets approved and if we get this amount, here's what I want— because it seems like with the long lead times, if they say they want to implement something in the summer for education, we're getting to a point of a window where you won't be able to procure the items so you need to plan.

There's many different segments, so let me start. It's complicated. We've got the supply ecosystem that has some impact to it right now so we're trying to manage through all of that. Here's what I'd say about K-12. We have a lot of experience understanding funding, stimulus funding, and other types of funding for educational institutions. So we sit side-by-side with our customers to make sure they understand both where the dollars can be used, for what products or outcomes, because sometimes it's outcome-based, and what the deadlines are and what those deadlines mean. Do you have to have the product in-house, or do you have to have the product order placed? So there's a lot of navigating that's going on, and I feel highly confident that the team is doing a phenomenal job with our customers and that our K-12 customers are not going to lose out on any funding. That's really clear. In the state and local space where we've got stimulus funding coming down, it's been a bit complicated because the funding packages were delivered at different times. The CARES Act package had an earlier deadline, then there were other packages later, and as we all know, for state and local it's about budget cycles and funding deadlines. The spending that's taken place in 2021 is primarily from the CARES package with a deadline this year. What we're seeing now is a moderating and planning environment: state and local governments now have funding they don't have to spend until the end of 2024, so they are taking a multiyear approach. We're helping them with that; there's a lot of complexity. It's very solutions-based in terms of what customers are trying to do, but we don't expect that to meaningfully come to fruition until early next year. But there's just a lot of tentacles and they're all different based on the stimulus package and the market we're talking to. Again, this is something we do; it's a core capability to understand federal, state and local, education, and healthcare funding, what it means, what the deadlines are, and how to use it, and then to walk our customers through it.

That was exactly what I was looking for. Thank you so much.

The next question on the line comes from Katy Huberty at Morgan Stanley. Katy, your line is open.

Thanks. Quick backlog commentary—can you talk about the gap between net sales growth and orders or writing growth in 3Q and maybe how that compared to the second quarter? Then I have a follow-up.

Sure. Hi, Katy. Good morning. We won't quote the exact delta, but it's safe to say we continue to see strong written demand and that continues to show up, which bolsters our confidence. Shipments have lagged that demand. The mix looked similar to the second quarter, with the caveat that solutions were a little worse versus Q2 given networking and storage constraints.

Okay. Thank you. And then maybe a follow-up for you. The ending cash balance of $245 million is lower than your typical buffer. Can you just talk about your plan to rebuild that buffer and also fund the Sirius acquisition? Thank you.

Sure. On the Sirius acquisition, we have committed financing in place, so we expect to finance that acquisition fully. From a cash balance perspective, compared to where we were at the end of last year and a year ago, we look lower for a couple of reasons. We completed debt refinancing earlier in 2021, which bolstered cash previously. Also, we've used a fair amount of cash this year for acquisitions and share repurchases. The combination of our cash balance and revolver availability leaves us comfortable with where we stand, and we feel good about our ability to generate free cash flow in 2022.

That's great. Thank you.

The next question comes from Matthew Sheerin at Stifel. Matthew, go ahead.

Yes. Thanks and good morning. Chris, I wanted to ask about the strong cloud growth that you're seeing, particularly infrastructure as a service. I'm wondering if some of that is positively impacted by customers moving or accelerating toward the cloud because of the product and infrastructure on-prem shortages. Are you seeing customers say now is the time to move because we don't want to wait?

Great question. We've been asking ourselves that as well. Given the persistent nature of the supply chain and the fact that it continues to extend, customers are rethinking and considering accelerating some movements to public cloud and potentially re-architecting some solutions to public cloud environments versus on-prem. But I wouldn't characterize it as a wholesale shift. Customers are still strategic about flexibility, scalability, and cost. They're still looking for the absolute best solution and therefore not making wholesale moves in all cases. So yes, we are having conversations and seeing some decisions to accelerate to public cloud, but it's not a universal or wholesale shift yet.

I got it. Okay. Thanks for that. And then on the PC shortages, particularly on the commercial side. What are your thoughts there in terms of the PC cycle? Are you seeing any early signs of adoption of Windows 11, and do you see that as a driver going forward?

I wouldn't say we've seen early adoption yet. As always, there will be early adopters and later adopters and we'll help our customers through that. You're familiar with end-of-life timing for Windows 10 and the timing for Windows 11 around the 2024–2025 period. So it will be a driver but it's not been a driver yet. I continue to believe in PCs: we have more PC density and will see replacement cycles for wear and tear and because client devices are increasingly important to productivity. The hybrid work model is driving PCs. We feel good about PC growth and Windows 11 will be a driver over a multi-year period.

Okay. Thanks a lot.

The next question comes from Samik Chatterjee at JPMorgan. Samik, your line is open.

Great. Thank you. Chris, I wanted to start off and go back to your comments. You mentioned monitoring the SMB segment for economic activity given the increase in cases, etc., and you mentioned you haven't seen any sizable impact yet. But is there something more on a regional basis across the U.S. or in international markets where there's a stronger correlation to how cases are trending? Any insights on that, please? I have a follow-up.

We're watching it and we're cautious. We put it in the category of wildcard because nobody knows exactly what's going to happen. There has been more momentum around vaccinations and antivirals and overall vaccination rates in many regions. We're thinking and investing to get back to a robust environment and economy. The tone has changed from last year's winter months: customers are saying they need to invest and build for the future. So that's what we're seeing—more of a forward-looking investment mindset rather than general pullback right now.

Okay. Quick follow-up. You indicated that the operating margin in Q3 doesn't fully repeat in Q4 due to some incremental spend. How much of the incremental SG&A is timing-related versus durable investments that we should annualize into next year's model?

As we look to Q4 and into 2022—we'll provide more guidance on that in the fourth-quarter call. For Q4 specifically, the non-GAAP SG&A spend is an unevenness or timing effect; some spend lagged in Q3 and will pick up in Q4. There's also a component as we think about the Sirius combination—how that combination impacts our investment spend. That being said, we'll continue in Q4 with investments in our digital transformation and to support high-growth solutions and services areas. We'll provide more clarity on what is durable versus timing on a future call.

Okay. Thank you.

The final question comes from Keith Housum of Northcoast Research. Keith, your line is open.

Thank you. Good morning, guys. Chris, I'm thinking through the investments that companies are making or are making in technology based on the supply chain constraints that they are seeing. Is there a willingness from your customers to move to other solutions or hardware solutions that can be fulfilled by the end of the year? A lot of companies have IT budgets they want to spend anyways. Are people willing to convert to other projects in order to spend that money? Or are they holding onto the projects until the specific products are available?

It really depends on the customer set. Small businesses have always been more nimble and less tied to particular requirements, and we have seen success there; supply constraints didn't impact them as much because we could help them find alternatives. When customers are tied to specific requirements, it creates more work within the organization. We have worked with customers to get in-line earlier and to plan. Many customers are working very hard to get product by year-end. Anywhere that's not mission-critical, we can often help them find alternatives—whether it's a different brand, whether it is the cloud, or other options. You can bet we're doing that. There will be pressure in the back half of the year to get product out, and we expect we'll be able to help customers do it.

Got you. A follow-up: in terms of the shortages you're experiencing, are you finding those shortages easing in certain product areas over the quarter, or is it kind of a game of whack-a-mole where one area eases but another tightens?

You've got the whole supply chain ecosystem: capacity, components, logistics, labor—all of it impacts availability. It has shifted through the course of the year. On the transactional side, notebooks, video, and monitors have been constrained; Chromebooks have started to ease up a little. More recently we've seen solutions products become more constrained—networking and storage in particular. That is a problem when customers need comprehensive solutions rather than just pieces. So 'whack-a-mole' is a fair description.

Great. Thank you.

We have no further questions registered on the lines. We'll hand the call back to Chris Leahy to conclude the call.

Bethany, thank you. I want to recognize the incredible dedication of our co-workers around the globe and thank all of CDW stakeholders. Thank you to our customers for the privilege and opportunity to serve you. And to our investors and analysts attending this call, we appreciate you and your continued interest in and support of CDW, and we look forward to talking with you again next quarter. Have a good day.

This concludes today's conference call. Thank you for joining. You may now disconnect your lines.