CDW Corp (CDW) 2013 Q3 法說會逐字稿

Good morning. My name is Nicole and I will be your conference operator for today's call. At this time, I would like to welcome everyone to the CDW third-quarter 2013 earnings conference call.

(Operator Instructions)

I'd like to remind you that today's conference is being recorded. If you have any objections, please disconnect now. It is my pleasure to turn the call over to CDW's Chairman and Chief Executive Officer, Tom Richards. Mr. Richards, you may begin your conference

Thanks, Nicole. Good morning, everyone. It's a pleasure to be with you and to report CDW's third-quarter results. Joining me in the room today are Ann Ziegler, our Chief Financial Officer; Chris Leahy, our General Counsel; and Sari Macrie, our VP, Investor Relations. I'll begin with a high-level review our performance and comment on strategic progress, and we'll take you through a more detailed review of the financials, and then we'll go right to your questions. But before we begin, Sari will present the Company's Safe Harbor disclosure statement

Thank you, Tom. Good morning, everyone. Our third-quarter 2013 earnings release was distributed this morning and is available on our website along with supplemental slides that you can use to follow along with us 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 risks and uncertainties that could cause actual results to differ materially. Additional information concerning these risks and uncertainties is contained in the form 8-K we furnished to the SEC today, and in CDW's other filings with the SEC. We assume no obligation to update the information presented during this webcast.

Our presentation includes certain non-GAAP financial measures. All non-GAAP measures have been reconciled to the most directly comparable GAAP measures in accordance with SEC rules. You will find reconciliation charts in the slides for today's webcast as well as in our Press Release and the Form 8-K. Please note that all references to net sales today are provided in terms of average daily sales as the third quarter of 2013 had one more selling day then the third quarter of 2012. All other growth rates or dollar amount increases in our remarks today are versus the comparable period in 2012.

A replay of this webcast will be posted to our Investor Relations website, www.investor.cdw.com, by this time tomorrow. I'd like 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. And with that, let me turn the call back to Tom.

Thanks, Sari. I'm pleased to report that once again, CDW delivered industry-leading profitable growth with net sales growth of 7.5% and adjusted EBITDA growth of 5.6% within a challenging market. A market that experienced significant headwinds from the Federal Government sequestration and related budget uncertainty, ongoing uncertainty in healthcare, and continued pricing pressure. Our ability to deliver above-market profitable growth within this challenging market was the result of three key drivers. Our balanced portfolio of sales channels, the breadth of our product and solution suite, and our ability to effectively manage expenses while continuing to invest for growth.

Let me walk through each one of these and share some detail about how they contributed to our successful performance. First, our balanced portfolio of sales channels. As you know, we have five channels -- Medium and Large Business, Small Business, Healthcare, Government and Education, each generating annual sales of more than $1 billion. Given the different macro economic and external factors that impact each of these unique end markets, our channels often act in a countercyclical way.

For example, in last year's third quarter, sales within our Public segment grew significantly higher than sales in our Corporate segment. This quarter, the opposite occurred. With Corporate sales growth of 9.9%, nearly twice Public growth of 5.3%, and performance was balanced within segments as well. The power of our balanced portfolio was clearly evident.

Let me walk you through the results for each of our five channels, and you'll get a feel for what I mean. The two main drivers of this quarter's performance were continued momentum in our Medium and Large Business, which increased 12.2% with solid product performance pretty much across the board. And Education, which increased nearly 30%, driven by K-12 sales of both notebooks to support common core curriculum implementation and the related security software to keep students safe, and infrastructure to support schools' exploding bandwidth needs.

We are also encouraged by the improvement we saw in Small Business, which stemmed the declines it had been experiencing for the past three quarters. Sales in our other segment, which includes CDW's Advanced Services and Canadian operations were up 3.2% in US dollars. When adjusted for currency impact on Canadian operations, growth was in the mid-single-digits. Performance in all of these channels more than offset the impact of declines in our Federal and Healthcare channels.

There is no question that the impact of sequestration and the related budget uncertainty was meaningful on our Federal business. And just as I indicated to you, it might play out on last quarter's conference call, it was a wild card right up to the bitter end. So although State and Local had another strong quarter with sales increases in the mid-teens, the pressure from Federal drove the overall Government sales decline of nearly 10%. Of course, now we're waiting to see how much we can recover in the fourth quarter given that the Federal Government shutdown of 16 days represents about one-quarter of our total selling days so we do not expect it to be back on track in the near term.

In Healthcare, sales were down low single-digits as customers continued to rationalize their spending to address the impact of the Affordable Health Care Act and reduced Medicare and Medicaid payments from sequestration, pressures that we don't see lessening for at least the next quarter or two. That said, giving the value of technology and driving efficiency and effectiveness and our dedicated Healthcare sales team, we expect a return to growth next year. Healthcare continues to be an important part of our growth strategy. So, clearly our results demonstrated the power of our first driver of performance in the quarter, our balanced channel portfolio.

The second driver of our successful performance was the balance of our product portfolio. Looking at our broad product categories, Hardware grew 9%, Services grew 10%, and Software grew 2% in the quarter. The impact of our balanced product portfolio was evident as we had winners and losers in virtually every category. For the most part, the winners represented product sets that weren't impacted as much by the declines in Federal and Healthcare. Net [comp] sales increased nearly double-digits as did Telephony which was up over twice that amount.

On the other hand, Enterprise Storage and Servers were both down single-digits as the impact of the Federal slowdown hit them disproportionately hard. Demonstrating the continued importance of desktops to our broader customer set and the significant increase in notebook sales in K-12, we experienced strong double-digit PC growth. Federal Government results also impacted our Software category. Significant sales, increases in security software and Telephony software weren't enough to offset significant declines in virtualization and storage software in the Federal Government.

Application suite results also impacted Software declining more proportionately across the Business. This primarily reflected the move by a major partner to delivering application suite software in the Cloud where we book revenues on a net basis and receive an annuity stream. Our balanced product performance is a direct result of our strategy to increase our solutions sales by enhancing our capabilities, including our services footprint. As we continue to execute against this strategy, we are seeing more and more integrated solutions built around our managed services capability.

A great example of this is the solution sale we implemented for a Fortune 500 company that was integrating a large acquisition. This customer needed to quickly and cost-effectively build a new infrastructure to support the acquired company, migrate applications to the new environment, and manage everything up to the application layer. They needed someone they could trust to deliver a complete solution, and they didn't have a lot of time to get the job done.

Having already proven our technical expertise during a 3-month trial to run critical cloud-based e-Commerce applications for the parent Company, we were invited in to design a solution. Our answer? An integrated solution that included managing their infrastructure, both customer-owned equipment that also was purchased from CDW and utilizing and managing our CDW infrastructure as a service Cloud offering for network and backup services.

Implementation fees for this solution were $150,000. On an ongoing basis, this sale will generate recurring revenues of $120,000 per month for 36 months, and we booked $4.8 million in Hardware, Software and Field Services revenue so far this calendar year, another great example of how integrated solutions will drive our success going forward.

So, all in all, this quarter we had excellent top line growth driven by our balanced portfolio of channels and products. Both supporting solutions sales and products that are more transactional in nature like desktops and notebooks. Transactional products are more likely to experience price compression, and we clearly saw that in this quarter's overall product margin. Continued competition coupled with the client in key core categories impacted by a lack of Federal Government spending resulted in transactional product pricing pressures across all segments and all order sizes in the Business. Given the continuing market dynamics both competitive and uncertainty in Washington, we expect to see similar market conditions going forward. At this point, we don't expect to see pressure intensify, but we're going to keep a close eye on it.

And that leads me to the final driver of our performance for the quarter, our focus on our ability to effectively manage our expenses while still investing in our future. As you have heard me say before, we do not focus solely on top line growth. We know that an essential key to long-term success is to consistently deliver profitable growth. This quarter's performance provides an excellent example of our keen focus on delivering this goal. Given the volatile nature of the market this quarter, we tightly manage expenses including advertising. That said, we continued to make strategic investments in building our brand and driving sales in the coming months.

In fact we just launched our newest integrated digital, social media, print and TV campaign, once again built around the fictional Gordon & Taylor company. Called the Dome, the story of Gordon & Taylor continues with NBA Hall of Famer and All-Star IT guy Charles Barkley, who is joined by NFL Pro quarterback and Heisman Trophy winner, Doug Flutie. The Dome campaign is based on our experience delivering integrated solutions to sporting venues that include the Georgia Dome, Lucas Oil Stadium, Soldier Field and Reliant Stadium.

The Dome showcases our latest cloud computing and total mobility management solutions. While these technologies power Gordon& Taylor's high-tech stadium, they are the same solutions that deliver a better experience, improve performance and boost the productivity of our customers of all sizes every day. This integrated campaign is targeted to have 275 million impressions across TV, radio and our digital platform. The television spots are running on ESPN Monday night football, college football as well as radio. The campaign is off to a great start, with campaign website visits up 4 times last year's visits and video views at CDW.com/Barkley up 37% compared to last year.

Non-paid media placements highlighting the Dome ad campaign so far have reached more than 65 million unique viewers. If you would like to take a look at the campaign, you can find it on our website as well as the official CDW YouTube channel. Or, if you happen to attend a football game at Soldier Field, FedEx Field, Lucas Oil Stadium or Reliant Stadium, you'll find our in-stadium presence.

We balanced expense management with investment during the quarter and added 78 customer-facing coworkers, consistent with the plan we shared with you last quarter that calls for adding between 100 and 125 customer-facing coworkers during the year. We've been hard at work at building our capabilities to deliver a broad spectrum of IT solutions that includes cloud, mobility, virtualization, networking, security, unified communications collaboration, server storage and power and cooling. Today, coworkers who are primarily focused on helping our account managers deliver these capabilities, our service delivery engineers, specialists and field sellers, represent over one-quarter of our total workforce.

We intend to continue to invest prudently to ensure we are prepared to deliver the solutions that our customers need and to take advantage of the opportunities we see in the marketplace for a national solutions provider with scale and highly technical resources. But, just as we always do, we will monitor the marketplace, and if sales don't recover in the Federal market or we see weakness beyond what we expect in Healthcare, we will reallocate resources within the Business to ensure we can meet demand in other channels. Despite are continued growth, we still only have 5% market share in a highly fragmented market, and that gives us plenty of runway.

I hope you can tell from my comments that this quarter's performance reinforced our confidence that we have a winning strategy in place, a strategy that serves us well in today's challenging marketplace and positions us for strong growth in the future. A strategy designed to continue our evolution to the leading IT solutions provider in North America, and most importantly, a strategy that we have demonstrated success in executing.

We'll continue to work hard to ensure that CDW is a trusted partner. A partner with the solution suite that customers need, a partner with the cost structure, talent, deep industry and customer knowledge to deliver effective, competitive solutions that will make a true difference in our customers' performance.

Let me leave you with a few comments on our expectations for the remainder of the year. You'll remember that on the past three quarters' conference calls, we shared our expectations for US IT market growth in 2013 in the low single-digits. We still expect to see that for the full year. For us, we expect our fourth-quarter results to be impacted by the Federal shutdown as well as the continued price pressure on more transactional products. That said, we remain confident that we will achieve our full-year 2013 target of profitably growing at least 200 to 300 basis points above the market as we continue to leverage those three drivers I mentioned earlier.

Our balanced portfolio of channels, broad suite of solutions-focused IT products, and tight management of expenses. I know many of you will be wondering what to expect in 2014. We're in the middle of our planning cycle, and you should expect us to share our thoughts about 2014 during our year-end earnings call. Now, let me turn it over to Ann who will share more detail on our financial performance.

Thanks, Tom. Good morning, everyone. As Tom indicated, our third-quarter financial results reflect the benefit of our balanced portfolio and our focus on execution. The results also reflect the progress we're making against our financial strategy to drive strong cash flow, de-lever our balance sheet and delivered double-digit earnings growth.

Let me begin with our P&L. As I discuss results, I'm going to talk about both as-reported and as-adjusted. If you have access to the slides posted online, it may be helpful for you to follow along. I am on slide 7. Top line growth was excellent this quarter, with net sales of $2.864 billion, 9.2% higher than last year on a reported basis and 7.5% higher on an average daily sales basis given one additional selling day. Average daily sales grew to $44.8 million. On an ADS basis, sequential sales were up 3.1% versus Q2 2013, which is below normal historical seasonality, but it is in line with last year.

Gross profit for the quarter increased 6% to $458.4 million. Gross margin continued under pressure, down 50 basis points from last year's Q3 and 20 basis points sequentially to 16%. The decline was primarily due to the impact of lower product margin from growth in more transactional products. These negative impacts were somewhat offset by 100% gross margin revenues from commissions and net service contract revenues.

By tightly managing expenses while we continue to invest as planned in the Business, we mitigated some of this pressure. Let's take a closer look. Reported SG&A including advertising expense was $365.5 million. As I indicated we would on our Q2 call, we booked $74.1 million of IPO-related SG&A expenses in the third quarter. For those of you following along on our slides, these expenses are outlined on slide 8. IPO expenses included the payment of a $24.4 million fee for the termination of our sponsor's management services agreement, $40.7 million for non-cash equity compensation acceleration and related payroll taxes for non-senior management coworkers, $7.5 million related to a deferred compensation and another $1.5 million of miscellaneous items.

As you can see on the next slide, our adjusted SG&A for the quarter excludes these one-time IPO expenses as well as the corresponding adjustments we make to adjusted EBITDA. Specifically non-cash equity compensation of $2.3 million, a net litigation gain of $8.2 million, and $3.2 million of other expenses including historical retention costs. Total adjusted SG&A including advertising expenses was $242.8 million, up 6% versus last year. This increase reflected higher sales commissions and other variable compensation costs consistent with our increased sales and gross profit, cost associated with increased coworker count, and a portion of the $2 million to $3 million of incremental investment for growth we discussed last quarter.

Given the marketplace conditions, we reduced advertising expense by $3 million in the quarter versus last year. We ended the quarter with 6,914 coworkers, up 110 coworkers since the beginning of the year. We continue to drive sales productivity with annualized sales per coworker of $1.67 million, up 10% over Q3 2012.

Operating income for the quarter was $92.9 million. As you can see on the next slide, our adjusted EBITDA for the quarter was $216.1 million, up 5.6%, which translates to an adjusted EBITDA margin of 7.5%, down 20 basis points versus last year. So, all in on the operating side, we were able to offset half of the 50 basis points gross margin decline.

Let's look at the rest of the P&L. Interest expense was 26.7% lower than last year at $56.2 million and included a reduction of $4.6 million related to interest equalization from the redemption of the 12.535% senior subordinated notes this quarter. We had a tax benefit during the quarter of $2.6 million versus our effective tax rate of 39.8% in the third quarter of 2012. On a GAAP basis, we had a net loss of $2.2 million in the quarter. Looking at non-GAAP net income, which better reflects our operating performance we earned $85.2 million in the quarter, up 23.8% over last year.

As you can see on slide 12, non-GAAP net income reflects after-tax add backs that fall in four general buckets -- the ongoing amortization of intangibles from our ongoing private transaction, any nonrecurring costs related to financing including debt extinguishment and interest equalization, ongoing non-cash equity compensation, and other one-time nonrecurring income or expenses which for this quarter included IPO-related expenses and litigation gains. These adjustments are tax affected at the statutory rate of 39%. With Q3 non-GAAP fully diluted average shares outstanding of $171.9 billion, we delivered $0.50 of non-GAAP net income per share.

Quickly turning to the first 9 months of the year, revenue was $8.06 billion, an increase of 7% both on a reported and an average daily sales basis as we have the same number of selling days in both periods. Gross profit during the first 9 months was $1.312 billion, up 5.5% year-over-year. Gross profit margin was 16.3% versus 16.5% last year. SG&A including advertising expense was $945.4 million, up 9.4%. Adjusted SG&A including advertising expense was $707.4 million, up 4.7%.

Our adjusted EBITDA for the first 9 months was up 6.2% to $607.3 million, and our adjusted EBITDA margin was 7.5%, relatively flat versus last year. Net income was $72.8 million in the first 9 months compared $85.7 million in 2012. Non-GAAP net income was $220.7 million, up 21.3% over last year.

Let's turn to our balance sheet, which had a number of changes since our last call, some of which affected current results and some that will affect results going forward. As you know, our IPO closed on July 2. We had total net proceeds before expenses of $429.5 million including $56 million from the underwriters exercise of their options to purchase additional shares on July 26. We use these proceeds to fund two capital actions taken during the quarter. The July 2 redemption of $175 million of our 8% senior secured notes and the August 1 redemption of $324 million of our 12.535% senior sub notes, the latter of which was funded with both IPO net proceeds and $109 million of incremental term loan.

On October 18, we redeemed an additional $155 million of our senior sub notes. This will result in an $8.5 million loss on extinguishment of debt in Q4 and a $2.1 million reduction in our bookings expense related to the impact of interest equalization. After this redemption, we will have a $92.5 million stub remaining of our senior sub notes that we currently expect to redeem in 2014. And with that final redemption, that will be the last time you will hear me talk about the impact of interest equalization.

On September 30, we had a $350 million of cash and cash equivalents including money pending for the October 18 redemption. We had $3.06 billion of debt net of this cash on the books. $673 million left in our December 31, 2012 balance. Our cash plus revolver availability was $1.03 billion. Net debt to trailing 12 month EBITDA at the end of Q3 was 3.8 times, 1.1 turn less than the end of 2012. Pro forma for the October redemption, net debt is $3.07 billion, and our weighted average interest rate on outstanding debt is 6.1%.

In this potentially increasing interest-rate environment, I'd like to remind you that our $1.53 billion term loan facility is subject to a 1% LIBOR floor, and we have in place $1.15 billion principal amount of interest-rate caps at a weighted average rate of 2.4% which expire in Q1 of 2015. The remainder of our outstanding debt is fixed rate, so 89% of our outstanding debt is effectively fixed or hedged, and rates would have to move significantly before they had a material impact on our interest cost.

For those of you modeling our cash flows, cash interest payments in Q4 are projected to be approximately $100 million. We continue to expect to pay cash taxes on a combined State and Federal rate in the range of 25% due to certain IPO and refinancing related deductions and State tax and overpayment credits. This rate should be applied to pretax book income before acquisition-related intangibles amortization. Keep in mind when modeling our cash taxes that are approximately $40 million per quarter, intangible amortization expense is for the most part not deductible for tax purposes.

Our ability to drive returns in this Business is tied to our working capital management. This quarter we continued to deliver strong working capital metrics, the details of component by which are provided on slide 16. Using a rolling three-month calculation, our cash conversion cycle is now at 21 days, down slightly versus last year. We expect to continue to maintain our cash conversion cycle within our targeted range of the low to mid [20s] as we move through the year.

Keep in mind that our normal seasonality calls for an uptick in our cash conversion cycle in the fourth quarter, and we do have the potential for delays in Federal invoice approval and payment due to the impact of the partial Federal shutdown. Turning to the profitability for the remainder of the year, Tom mentioned the negative top line impact of the Federal Government shutdown of 16 days.

In addition, we do not expect gross margin pressure to dissipate in the fourth quarter, so we'll remain vigilant in managing expenses tightly. That having been said, as a result of our Q3 investment in coworkers and our plans for additional hiring in Q4 as we continue to invest in the future, we expect our Q4 adjusted SG&A to increase at or slightly above our rate of sales growth. Our adjusted SG&A growth, combined with our expectations for continued gross margin pressure, means that you should expect to see us deliver a Q4 adjusted EBITDA margin below our annual target rate. We do, however, continue to expect to be within the lower end of our annual target range for the full year.

Moving down the P&L, given our refinancing activity, book interest in Q4 should be a bit over $50 million. And finally, we expect our full-year effective tax rate to be a bit below our year-to-date rate.

In addition to our target to continue to profitably grow at least 200 to 300 basis points faster than the US IT market in 2013, I would like to remind you of our other medium-term financial targets. We view the medium-term as the next 2 to 3 years, and we hold ourselves accountable for delivering them on an annual, not quarterly basis. These include an adjusted EBITDA margin in the mid 7% range, mid-teens non-GAAP net income growth and delevering one-third to one-half term per year until we hit our target leverage of 3 times.

One final note, returning cash to shareholders is an important component of our commitment to build shareholder value, and I'm delighted to report that our Board of Directors declared our first quarterly cash dividends since our return to the Public market. We will pay a dividend of $0.0425 per share on December 2 to shareholders of record on November 15. We intend to revisit our dividend policy annually, and once we've achieved a leverage ratio of 3 times, we will look at our overall strategy to return cash to shareholders which depending on tax policy and other factors at the time could include share repurchases.

This concludes the financial summary. Operator, can you please provide the instructions for asking a question, and can we please ask each of you to limit your questions to one question and one follow-up. Operator?

Thank you.

(Operator Instructions)

Mark Moskowitz, JPMorgan.

Yes, thank you. Good morning, and nice execution in a tough environment.

Thanks, Mark

First question for you, Tom, I'm just curious if you talk a little more about the Healthcare vertical you talked about in 2014 returning to growth. Can you talk about what you're seeing in terms of your sales funnel that gives you the confidence? And then my follow-up question for Ann is around the near-term guidance. Historically, CDW in the fourth quarter, the quarter-on-quarter revenue growth was typically around the decline of 2% to 4%. Just given your commentary around the Government, do you expect the model to stay around that seasonal down 2% to 4%? Or could it be worse this time around? Thank you.

Okay, so thanks, Mark. So, a little bit about Healthcare. First of all, what are causing the headwinds, -- we continue to see institutions, if I could just say it that way, struggling to look at multiple priorities in their business and dealing with the lack of clarity on funding as they get used to sequestration, the impacts of Medicare, Medicaid reimbursement, the implementation of ACA. So, you have multiple things at one time all descending, if you will, on the health care segment and hospitals in particular. But, we do believe, and if we look at our activities, the implementation of EMR and what that creates inside of a business as far as the need for server storage, network capacity, all of those still are in existence. So, we believe that we're going to continue to move through this. Now, I don't have perfect clairvoyance, Mark, to know that it's going to end in the first quarter, but I do sense that the pressures to deal with some of the technological issues driven by implementation of EMR and things like that are going to drive meaningful opportunities for us. So, that's why we believe that it will continue to grow next year. We're not seeing people who are talking to us about opportunities; we're just seeing customers that are trying to sort through multiple priorities right now.

Okay, Mark, this is Ann. The fourth quarter is always a bit of a wild card for us because we're not sure how much corporate budget flush is going to come through in the fourth quarter. I think what you referenced is down 2% to 4% sequentially, which is in line with what we typically see. It could be a little bit worse than that this year, but we're not expecting it to be materially outside those bounds.

Thank you.

Thanks, Mark.

Thank you. Ben Reitzes, Barclays.

Thanks a lot, good morning, everyone. I wanted to talk about two subjects.

Education was much better than expected, and I was just wondering about the sustainability of that in the face of the weak Federal. What do you expect that to be as an offset in the future? What's the sustainability of the growth rates there? And if you could also highlight the drivers once again? It sounded like wireless infrastructure was a big part of the pop. You usually, the third quarter is a big quarter for that, but I'm not sure about the sustainability and just a lot more color about Education? Thanks a lot.

So, Ben, this is Tom, thank you. I just want to make sure, the questions about the product performance were in relationship to Education, correct?

Yes.

Okay, good. So, if you look at what happened in Education, clearly the big driver was K-12. Clearly it was institutions or schools working to prepare to deal with the core curriculum implementation and testing. Now, we saw a significant opportunity in the quarter to help school districts prepare for that. We took advantage of that opportunity. And while you're right, the general harvest season or selling season is typically the third quarter, we do continue -- we do expect them to continue to have growth, not probably in the neighborhood of what they had in the third quarter, in the fourth quarter. But, as you accurately point out, the deployment of that technology then begets opportunities for other technology, whether it's helping manage that, build up the infrastructure or build out wireless. So, we believe that for at least the foreseeable future in the near-term, we'll continue to have good growth in K-12, but it would be unrealistic to expect them to repeat what they did in the heavy buying season third quarter for the next couple quarters.

And then do you guys just mind clarifying what Federal is as a percent of total and what your expectations are for the fourth quarter? Just so we understand what that exactly is given this unique environment we're in where we don't know what's going on and so we're not confused in three months, but maybe give us a little clarity there? If you can?

Yes. There's so much in that question, Ben. Let me start with -- it's about 10% of our business. And I wish I had the clairvoyance to demystify the impact, but suffice it to say, if you just think through this sequential event. You have in the third quarter, we did see a flush, but it started much later than we might normally see. Where you might normally start high selling activity in August, that didn't happen in September. And so that last end of the quarter flush was there, but not as material as it normally is. Then you put on top of that the shutdown for the 16 days in October and then the Federal Government trying to ramp back up after the shutdown. So, when we say -- look, we think there's going to be an impact on the fourth quarter in Federal, I would be -- look, it wouldn't be right for me to try to forecast what that's going to look like because I really don't know how quickly they'll ramp back up again.

And then look, we all know that the story's not over. We have some new discussions in the first part of next year, and you're not really sure how that's going to impact it. So, we are operating in uncharted waters. What I feel good about is that when I talk to our sellers in the Federal market, they're continuing to engage in discussions. But a lot of that question comes back to we're not sure when we'll have the authority, what the authority is going to look like, what the new budget as far as continuing resolution is going to impact our authority to spend. So, it is a wild card for all of us, Ben, unfortunately.

Okay, thanks a lot.

Bill Shope, Goldman Sachs.

I have a question on Federal as well. Is it fair to say that the hit from the Federal weakness is probably the largest individual headwind to gross margins as we close out the year? And given that it's such a wild card as we head into next year, assuming we may not get a major rebound here, can you talk about some of the mitigating efforts you can put in place to counter specifically the gross margin pressure? I understand you have plenty of flexibility on the OpEx side, but if you could talk more on the specifically managing the gross margin line, that would be helpful.

Okay, it was a meaningful part of the gross margin compression because you don't have the ability to sell some of the solution products that have higher margins. And so that clearly has an impact on margin going forward. I think one of the things I hope this quarter demonstrates to people is our ability to reallocate resources and reallocate focus and look at other areas of the Business where we can have growth. One of the things we're really excited about is our success in selling cloud-based solutions. As you know, that's a really margin-rich part of the Business for us, albeit small, but growing.

I think the other thing is our service business continues to grow, and we're excited about what's happening with that part of the Business. That's another opportunity for us to offset that. And then the third would be one of the exciting things about the strategy that we've been deploying, and in particular take a look at K-12, if you think about some of those downstream products if things play out the way we would like, they will be solutions that will sit on the back end of that strategy which all have higher margins. So those are just maybe two or three ideas, Bill, that we got on our radar screen as far as offsetting any potential pressure from Federal.

I guess just a follow-up on your cloud solutions commentary, we get a lot of questions on that. How is that trending relative to your expectations? When do you think it starts to actually become more material? As you said, it's high-margin but still pretty small.

It's succeeding -- I would tell you that it's exceeding our expectations, but for a $10 billion business, it's going to be a while until it becomes material. I think that thing that -- this isn't so much a financial answer as a strategic answer -- the thing I'm excited about is the number of engagements we're having with customers, the number of times we're selling cloud solutions whether they're SaaS based solutions, hybrid solutions or even private cloud. We don't count private cloud because it's too hard to differentiate where private cloud sits. That's actually in our normal business, and we would see those sales in our server and storage.

Okay, great, thank you.

Thanks, Bill.

Brian Alexander, Raymond James.

I know you're not providing formal guidance for next year, Tom and Ann, but do you think the gross margin can get back to your targeted level in the next few quarters of 16.5%? And if you don't think that, do you think you can still achieve your targeted adjusted EBITDA margin goal with lower gross margin but continued expense controls? Are you saying that is still uncertain for next year?

Brian, so first, we don't give a gross margin target, so I'll assume your question is like what we've been performing at. And clearly, as we talk about our strategy, one of the reasons we're so focused on expanding our solutions and service capability is so we have the flexibility to offset pressures in the marketplace. And as far as -- we continue to demonstrate the ability to deliver the adjusted EBITDA targets that we put out there for people. That's one of the benefits of the breadth and the balance of the scale inside of this business.

We will continue to do that, but I would tell you if you look at this quarter, you really want to get underneath gross margins, there were a lot of things going on. You had obviously the Federal and Healthcare tsunami hitting at one time, and you had our success in some of the more transactional products. We don't expect that all those perfect storm things to happen in the future, but we also can't predict, Brian, as you know, what's going to happen in the competitive marketplace and how aggressive players will be in order to get some top line revenue growth. So, it's, as you know, a combination of factors, but we do feel confident and feel like we've demonstrated that we're going to continue to deliver on that adjusted EBITDA target we've given you.

Okay, just a quick follow-up. I guess typically when pricing pressure intensifies like it has here in the last couple quarters, you're able to turn to your vendors to mitigate that impact. I'm just wondering if you found any change in the vendor community's willingness to step in and support your growth initiatives at all?

No, our Partners have been great. And I think in part because of their confidence in CDW's ability to execute for them.

Okay, thanks a lot

Chris Whitmore, Deutsche Bank.

Thanks very much. Tom, I wanted to follow-up on that last question with respect to pricing. From a quarter ago, it sounded like most of the pricing pressure was in the notebook side or the PC side, mobility side? Is it fair to say that pricing has expanded into other product areas like server storage, networking, et cetera, or is it still relatively confined to the client side?

I would say there's no perfect answer on that. I'll tell you what I would say -- pricing pressure had existed across all of the categories, but you got to keep trying to pull out the Federal Healthcare implication on things when you're looking at it. And I would say that it's been pretty consistent to your point across several quarters now. We see it more heavily in our transaction products than we do our solutions products, but I don't think that's a surprise.

Got it, thanks for the color. And a follow-up, I wanted to ask about the PC strength, the double-digit growth in PCs. What's behind that, and how do you view the XP exploration in early 2014 as impacting your business? Do you think that's pulling some demand and driving some upgrade activity ahead of that Microsoft ended support for XP? And if so, how does that shape your view for 2014? Thanks a lot.

All right, Chris, let me see if I got all those. One was what's driving PC. Two is do we see the XP expiration driving the PC growth, does that get it?

Yes, basically is that driving demand today, and what happens after Microsoft stops supporting XP next year?

Let me take the first one. We did see certain applications like you heard me talk about K-12 and that being a big, big driver of what's going on in PC and mobility marketplace. I would tell you that while I think people are planning to deal with the XP expiration and moving to 7 at this point mostly, I don't know that I would consider it a big driver of our performance at this point. Now, I hope it becomes a big driver going forward as we think into the early part of next year because people are clearly going to plan for what happens when that support declines a little bit. And so I don't want to get too far into 2014 in projecting that, but I think your instincts are right that you would expect to see some movement because of that.

Thanks a lot.

Thanks, Chris.

Katy Huberty, Morgan Stanley.

Thanks, good morning. Did you see any spillover effect of the Federal Government headlines on the MedLar business? Grew double digits but did not accelerate on an easier comp. And within MedLar, were there any product categories that accelerated or decelerated?

The first one, Katy, we didn't see what I would call a material -- I mean clearly if you're a business and you happen to be geographically in Washington, there was some impact there, but I think it would be a stretch to call it material. And I would say if you look at our success across product categories inside of MedLar, it was pretty much across the board. It was spread from transaction all the way through solutions, so I don't know that I would call out a particular product category

Okay. And as a follow-up, I think Dell has been an agitator on price. Now that they have gone private, do you think that can help the pricing environment moving into 2014?

Katy, we don't comment on particular competitors, but I'll say what said last time. It all depends on the investment pieces. And so I don't know enough to predict that, I can't really tell you how that's going to play out unfortunately.

Thanks.

All right, Katy.

Jayson Noland, Robert Baird.

Great, thank you. Maybe a clarification first on gross margin. Tom and Ann, you mentioned pricing pressure a couple terms, but how much of this is also a function of mix is given the double-digit growth in PCs.

It is a result both of pressure and of mix. The transaction business accelerated in the quarter, that PC strength, so you see that in the mix on gross margin.

And a question on cloud, you mentioned a large deal. And this business is small, but meaningful growth. I guess there's some unique income statement dynamics here, but curious how these large deals are structured? What do they look like, how many years, how many different aspects of your portfolio are included in something like that?

Well, it depends on the deal. I hate to sound opaque, but it depends on what are the components of the deal. For example in this case, you have managed services aspect of it, infrastructure as a service which tends to get built out as a multi-year annuity monthly revenue stream. You also have a part of it, some of the hardware acquisition that went into upgrading the data center. So when you say is there a generic trend, I think it's really hard, especially -- and you have heard me say this -- I believe hybrid solutions are going to continue to be the dominant part of cloud-based implementation as people look at what their capital investments have been, how they manage end of life, how they manage technological obsolescence. And so you're going to get everything from pure SaaS through SaaS plus IAS through managed services, and it's is really hard to say what's the single perspective, truthfully

Thanks, Tom.

Okay.

Bhavan Suri, William Blair

Hello Tom, hello Ann. Just a couple questions. One to follow-up on the previous question, if you look at that large deal and you've got components of services, obviously hardware and software sales and the managed services part of it, could you just give us some color on how the gross margins vary between those various pieces? The overall gross margin obviously appears to be better, but on the managed services side, it feels like the gross margins could be a little worse compared to the other piece of that mix?

No, I would say that when you're looking at managed services and some of the pure SaaS solutions, those are obviously going to be stronger margins. And you might see if it were just a pure hardware type solution. So, the instincts that you see, or maybe a better way to say it is the result you see in looking at our overall business where you have richer margin services, richer margins in software solutions, richer margins in integrated solutions will carry forward as you execute hybrid solutions for customers.

Okay, and then the software business has been one of the underperformers of the Business now for a little while. Any sense and if we might see an uptick on that and sort of what the pipeline might indicate there?

Yes. I -- when I look at it, there's a lot going on in software obviously. And again, you got to look at this quarter and pull out what was the Federal Government impact on software. If you take -- that's a big segment to take growth out of. That's one thing I'd like you to keep in mind when you think about our software performance. The second is, as you begin to implement more and more cloud-based solutions, you're going to see some short-term pressure until the annuity stream builds up. But you see gross margin enrichment, if I could set that way, that's playing out in software as we go forward.

That's helpful, thanks for taking my question, guys.

Thank you.

Rich Kugele, Needham and Company.

Thank you, good morning. I just wanted to focus my question on one particular area, and that's share gains and opportunity per share gains. And Tom, in your experience, do you think that when there's pent-up demand situations such as what we have with the unique Government shutdown situation, that tends to lead to greater opportunities for you given the breadth of your products? And, any thoughts?

Interesting. My instinct would say it's not so much it leads to expanded because the opportunity is there almost independent of when the customers pull the string on buying. It does make there to be variability within quarters, but I don't know that I think I would take the leap that says when it's pent-up, you get more of your fair share when it eventually flushes. I think I'd be uncomfortable making that statement. What I am comfortable in saying is the underlying thesis that says our reach, and our scale and our breadth of capabilities does give us a significant opportunity to leverage and get share gain in the marketplace

Okay, thank you.

Yes.

Matt Sheerin, Stifel.

Yes, thanks and good morning. Tom, I'm hoping you could provide more color on the Small Business market where sales have been sluggish for you for a few quarters now. Do see any signs of life there? Do we need a particular technology catalyst, or is that more macro related? And, related to that, do you see any cloud activity in that space you?

All right, so Matt, let me make sure I get these one at a time. The first one is, I think in my formal comments I alluded to the fact that we did see some slight improvement this quarter stemming the declines we have seen for three quarters. And while one quarter does not a trend make, we're encouraged by what we're seeing performance wise in the Small Business group. Some of that was some initiatives we took on inside of the Business to improve our alignment and our go-to-market strategy. Some of it was -- and I'm talking about some of the performance declines that you alluded to -- some of it was a particular partner who took away an opportunity to settle that market. That was in our base, and when it was taken away, you had to earn on it without it being in your portfolio so to speak. We feel like we've gotten through most of that, although on a macro level I think there's still is a mixed signal coming out of Small Business consumers.

And remember for us, small business really is small. It's organization that have less than 100 coworkers. That's not a definition that ubiquitous, so - and I think what we're seeing in that space is look, they're dealing with a lot. They're dealing with Healthcare costs and understanding that. They're dealing with a volatile economic climate. And while we're seeing some signs of encouragement, I feel good about our go to market model when there is an uptick in confidence in spending, we're going to be there to capture the opportunity.

Okay, great thanks. And as a follow-up, your comments on software vendor moving to cloud-based model was pretty interesting. Have you seen other vendors move to that model, and do you expect that going forward, and how does that change internally your structure?

I think everybody if they're focused on the end-user market and what customers are looking for, are introducing cloud-based solutions. Now everybody is doing it a little differently, which is somewhat of a challenge, but I would say in this case, that was probably the most direct movement. And so that's what I was trying to call out there. But everybody that's in the world of software is developing cloud-based solutions to help customers make decisions on CapEx and OpEx. Fortunately for us, we have been investing and focusing and building out capabilities so we can actually help customers think through what their options are and build implementation. And the last thing is, as you go to -- again the SaaS part of cloud tends to be subscription-based, monthly revenue based, annuity stream based, and that will be a little different than just selling straight-up box software.

Okay, thanks a lot.

Okay.

(Operator Instructions)

I'm showing no further questions at this time. I'd like to turn the call back over to Management for any further remarks.

Okay, everybody, thank you again for your interest this morning, thank you for your questions. And we appreciate you taking the time this morning to hear about a quarter that we're obviously pretty proud of. When I told you in the third quarter call that I thought the Federal Government was a wild card, I didn't really realize how much of a wild card that could be. But obviously extremely proud of this team's ability to deal with the exogenous factors in the marketplace and still deliver and execute across our business.

So again thank you for today, and as always, if we can help your companies with their IT needs, we'd love to talk to you. See you next quarter, thank you.

Ladies and gentlemen thank you for participating in today's conference. This does conclude today's program. You may all disconnect. Have a great day, everyone.