CDW Corporation (CDWC) is the largest reseller of computers and equipment in the US. The company recently opened its second distribution center, effectively doubling its overall capacity. However, its timing in doing so may be unfortunate, as the rate of sales growth has moderated significantly in the last year.
As a result of the slowing sales, as well as the working capital and fixed capital needs to open the new facility, cash flow from operations declined significantly in the first quarter compared to the same period last year. Given the importance of this relationship as an earnings quality indicator, investors may want to wait for an improvement in the relationship before buying shares. It should be noted, however, that the company does not appear to share that concern and is continuing its share repurchase program at a fairly consistent and aggressive pace.
Income statement analysis
Sales growth – 7.6 per cent year/year, led by double-digit growth in networking, video, and “other” products. Computer products, which account for 26 per cent of revenue, grew only 3.1 per cent. Corporate sector sales (72 per cent of total) grew 5.7 per cent, leaving the public sector segment (which is lower margin) to make up the difference.
Seasonality - the public sector segment tends to be strongest in the third calendar quarter due to the timing of the federal fiscal year and the education calendar.
· Operating margins declined from 6.6 per cent in Q105 to 5.9 per cent in Q106, due to the requirement to expense stock options as well as expenses related to opening the new distribution center. The company’s long term operating margin goal is 6.4-6.7 per cent, but is running below that due to the opening of the new distribution center. The company anticipates margins reaching the lower end of the target range by year-end 2006.
· Net margins – net margins declined from 4.2 per cent last year to 3.9 per cent in Q106 due to the decline in operating margins, partly offset by a decline in the tax rate.
· Stock options reduced EPS by $0.03 in the first quarter, compared to no recorded expense last year (and a $0.06 pro-forma impact.) If the large decline in option expense was not properly communicated it could indicate that earnings quality was somewhat poorer than expected.
· Anomalous tax rates – company began collecting sales tax from customers in April, 2005. This had the effect of lowering the company’s effective income tax rate due to lower overall state sales taxes. In future quarters the comparison should be equal.
Other – Company has been aggressively repurchasing shares over the last several years, and the share count declined by 2.5 million (three per cent) compared to March 2005. Some of the shares are reissued on option exercise, but the overall effect has been a steady reduction in shares outstanding.
Balance sheet analysis
Debt load and maturity schedule - $25 million. Company has two lines of credit totaling $70 million, one of which expires in June. The company plans to renew the line and should be able to do so.
Value of unexercised options – intrinsic value is $173 million, which is the minimum value of what some analysts consider to be an off-balance sheet liability.
· Doubtful accounts – the allowance was held constant sequentially, which seems appropriate given the modest increase in receivables and the modest decrease in sales sequentially.
Inventory trends [DOH] – inventories were up six per cent sequentially despite a modest seasonal sales decline. This is somewhat worrisome given the overall sales environment, but largely reflects the January opening of the company’s second distribution center, which needed to be stocked up.
Receivables trends [DSO] – Receivables were up modestly despite a seasonal sales decline.
Long-term or unbilled receivables – company has an item called “miscellaneous receivables” which ballooned from $28 million at year-end 2005 to nearly $54 million as of March 31. It would be interesting to know what that consists of.
Cash flow analysis
Operating cash flow and net income trends – first quarter cash from operations declined year/year from $159 million to $86 million despite essentially flat net income at about 61.5 million. Although CFFO still exceeds net income, the working capital increases will be a concern if sustained. To some extent they may merely be reverting to normal after a particularly strong cash flow year in 2005, as cash flow exceeded net income last year for the first time in three years.
Free cash flow and net income trends – despite the decline in operating cash flow and the expenses surrounding the opening of the new distribution center, operating cash flow remained well ahead of capital spending requirements, resulting in quarterly free cash flow of $66 million. Free cash flow steadily increased from 2003-2005.
Capital investment relative to depreciation – Capital spending has been running much higher than depreciation as the company built out the new disty center. Going forward capex should moderate (the company expects $45-50 million will be spent in 2006, of which $21 million was spent in Q1.) At the same time, the recent spending will boost depreciation expense going forward.
Legal issues – suits against company as to whether CDW paid the appropriate value in its acquisition of Micro Warehouse assets from bankruptcy.
CDWC 1-yr chart: