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Executives

John Edwardson - Chairman and CEO

Barb Klein - SVP and CFO

Jim Shanks - EVP

Henry Harczak - EVP

Analysts

Matt Sheerin - Thomas Weisel Partners

Brian Alexander - Raymond James

Jason Gursky - J.P. Morgan

Ben Reitz - UBS

David Manthey - Robert W. Baird

Bill Fearnley - FTN Midwest

Bruce Simpson - William Blair

Scott Craig - Banc of America

Andy Hargreaves - Pacific Crest Securities

Richard Gardner - Citigroup

CDW Corporation (CDWC) Q3 2006 Earnings Call October 18, 2006 9:30 AM ET

Operator

Good morning, ladies and gentlemen, and welcome to the third quarter 2006 earnings conference call. (Operator Instructions) I would now like to turn the call over to Mr. John Edwardson, Chairman and Chief Executive Officer of CDW. Mr. Edwardson, you may begin.

John Edwardson

Good morning and thank you very much for being with us to discuss CDW's third quarter 2006 results. With me here today are Harry Harczak, Executive Vice President; Jim Shanks, Executive Vice President; and Barb Klein, our Senior Vice President and Chief Financial Officer. Always present, of course, is Cindy Klimstra, our VP of Investor Relations. Before I begin, Barb will present the Company's Safe Harbor disclosure statement.

Barb Klein

Thank you, John and good morning. Any statements made by management in this conference call which are forward-looking, that is, not historical in nature, are made pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. Please be cautioned that such forward-looking statements involve risks and uncertainties, and are based on the Company's current expectations. Actual results could differ materially from such expectations. Certain risks, uncertainties and other factors affecting the Company's business are contained in its filings with the SEC, and are discussed in this conference call.

Also, if you are listening to a playback of this conference call, please be advised that our statements on this conference call are made as of the date of the call, are subject to future events, and should not be considered to represent the expectations of management other than as of the date of this call.

Our press release and slides for today's call can be accessed on our website at CDW.com. Click on the investor relations link on the left side of our homepage; then click on the supporting material link under webcast.

John Edwardson

Thank you, Barb. Thanks to the efforts of our CDW coworkers, we once again delivered another quarter of profitable growth and achieved record revenue, record gross profit dollars, record net income and record diluted earnings per share. The third quarter of 2006 was also a landmark quarter as the public sector produced outstanding results, and we also entered into an agreement to acquire Berbee Information Networks.

We are also working diligently to accelerate growth in the corporate sector. Across the Company, we do remain focused on creating an unmatched experience for our customers, improving our competitive positioning and generating profitable growth for you, our shareholders.

If you look at slide 3 of the webcast presentation, it compares third quarter of 2006 results to the previous quarter a year ago. As you can see, total revenue was $1.74 billion in this year's third quarter, compared to $1.67 billion in the third quarter of 2005, up 4.1%. We had one less billing day in the third quarter of 2006 compared to the prior-year quarter. In addition, average daily revenue was $27.6 million in this year's third quarter, versus $26.1 million a year ago, representing a 5.8% increase year-over-year.

Gross profit margin for the quarter was 15.4% of revenue and operating margin was 6.4% of revenue. Net income increased 6.3% to $77.7 million, and diluted earnings per share grew by 11.4% to $0.98 per share.

The third quarter of 2006 includes stock-based compensation expense of $0.03 per diluted share, due to the implementation of FAS 123R, and $0.05 per diluted share from a lower effective corporate income tax rate.

Revenue per coworker declined slightly to $1.57 million in the third quarter of 2006, from $1.62 million in the third quarter a year ago. Gross profit margin per coworker also decreased slightly, to $241,000 in the third quarter of 2006 from $247,000 in the third quarter a year ago; again, growth in coworkers of about 240 coworkers year-over-year, which about 148 are in the sales organization. So, we have been beefing up as we have gone through this quarter the number of people in sales, particularly trying to grow in corporate sales to get our growth rate back on track there.

Slide 4 shows our return on equity and return on invested capital. In the third quarter of 2006 we achieved return on equity of 22.6% and return on invested capital of 40%. In this year's third quarter we bought back 300,000 shares of CDW common stock for a total purchase price of $16 million. As you can see, in the first nine months of 2006 we repurchased a total of 4.1 million shares, returned 269 million to shareholders through both share repurchases and dividends on our common stock.

Our third quarter of 2006 was characterized by accomplishments and opportunities. A key accomplishment during the quarter was the outstanding performance of our public sector. Over the years, as you know, we have invested a significant amount of time and resources into segmenting our public sector customer base and creating a sales organization to better serve those customers. These results did not happen overnight, but the advantages of this well-developed segmentation strategy are clear as the public sector has far outpaced market growth this year.

One of CDW's greatest opportunities is to execute its similar customer segmentation strategy in our corporate sector. In the first half of this year, the corporate sector was reorganized in geographically realigned account managers who predominantly serve medium and large customers.

Considering the time we invested in developing the public sector's customer segmentation strategy, the corporate sector is still in the early stages of implementation, as we are somewhat disappointed with the corporate sector's revenue results this quarter. However, we do remain confident that this is the right long-term approach to facilitate future growth. As the geographic realignment has unfolded, we are learning better how to adapt and sharpen our tactics to ensure success. Jim Shanks will talk about this further in his participation later on.

Our announcement to acquire Berbee Information Networks is both an accomplishment as well as an opportunity. It is an accomplishment to join forces with such a highly-respected and well-managed organization as Berbee. Berbee is one of the nation's biggest independent IT service providers and is well known for its best-in-class engineering capabilities and advanced technologies. Our ability to execute on our acquisition strategy with a company of the quality of Berbee will help us achieve our stated growth objectives. Berbee will also help us grow our customer base, capture a larger share of our customers' IT budget, as well as increase our addressable market.

We're also optimistic about the future growth opportunities that we have with Berbee. Berbee will enhance our offering of advanced technology, products and services. This will give us a competitive advantage, since customers are looking for ways to solve their increasingly complex business requirements. We're also especially excited that Berbee will provide a scalable platform to grow our solutions and services capabilities.

Berbee will operate as a separate strategic business unit of CDW. Now that the transaction has closed, a transition team is in place and will help determine how our two organizations will work together. This will not be a complete integration as we had with Micro Warehouse, and Berbee will continue to operate much as they have independently.

However, we do expect to leverage the knowledge bases of each of our organizations to create revenue growth synergies. These include utilize learnings about Berbee solutions in their enterprise offerings and technical expertise to create additional new revenue incentives for CDW; and also to create cross-selling opportunities between Berbee and CDW customers to leverage Berbee's proprietary applications; and to expand Berbee's offerings by leveraging CDW's customer base and sales relationships, which we can do both organically and potentially through more acquisitions of companies like Berbee.

The key advantage of the Berbee acquisition is the opportunity to leverage their core competencies that drive top line growth. As previously announced, for the trailing 12 months ended July 31, 2006, Berbee's revenue was $309 million, and earnings before interest, taxes, depreciation and amortization were $22 million. Our objective is to double Berbee's revenue within five years on an organic basis. While a significant amount of Berbee's revenue comes from products, Berbee grows its business primarily by leading with the services it offers.

Due to the higher services component in Berbee's revenue base as compared to our revenue base at CDW, Berbee's gross margins tend to be a little higher than CDW's and Berbee's operating margins tend to be a little lower than CDW's. In her section, Barb will discuss the expected impact of Berbee on our financial statements.

We are extremely pleased to have the Berbee team join CDW. We look forward to building upon both of our best-in-class traditions and complementary strengths to become the industry's leader of IT services and solutions.

The accomplishments of the public sector, the opportunities that exist within our corporate sector, and the new opportunities that we will have with Berbee are all building blocks to reach our revenue run rate goal of $10 billion by the end of 2008. We are taking the right steps to achieve this objective, and we believe the growth will come from a combination of acquisition and organic growth within the Company.

We are pleased to announce another quarter of records today and we welcome the challenge of developing areas of opportunity for future growth. After all, nobody does it better than CDW coworkers. We thank all of them again for their hard work and efforts this quarter.

Jim Shanks will now discuss revenue results and sales force issues, Harry Harczak will review product trends, and Barb will address financial results.

Jim Shanks

Thank you, John. The public sector segment, CDWG, generated total sales of $651.1 million in the third quarter of 2006, which was a 17.6% increase from the third quarter of 2005. Average daily sales were $10.335 million in the third quarter of 2006, compared to $8.649 million in the third quarter of 2005, representing a 19.5% increase from the prior year.

On an average daily sales basis, the public sector grew 17.5% in July, 23.9% in August, and 17.6% in September. All customer channels within the public sector had double-digit revenue growth in the third quarter of 2006. The healthcare and education channels had particularly strong results.

We attribute the public sector's accomplishments to years of investing in our customer segmentation strategy, understanding the specific IT needs of each customer, and focusing on profitable growth by getting in on the early stages of opportunities.

September is the federal government's fiscal year end. The buying patterns of our federal customers can fluctuate somewhat throughout the year, but the overall patterns in 2006 were similar to previous years. Our success is based on understanding customer procurement plans throughout the year, and uncovering the funded opportunities before a busy season hits. We were very pleased with the public sector's performance.

Total corporate segment sales were $1.088 billion in the third quarter of 2006, representing a 2.5% decline over last year. Average daily sales in the third quarter of 2006 were $17.276 million, compared to $17.448 million in the third quarter of 2005, which was a decrease of 1%. On an average daily sales basis, the corporate sector declined 1.1% in July, 0.2% in August, and 1.4% in September. We were disappointed with the corporate sector results. We still have work to do to gain similar advantages in the corporate sector that we have in the public sector. The segmentation of the majority of our medium and large customer accounts into geographic territories was a necessary first step down this path. Everyday we focus our efforts to execute this strategy and generate growth in the corporate sector.

Our long-term objectives for the entire sales organization are to:

  1. Maximize our sales coverage model through customer segmentation;
  2. Better understand customer needs and enhance our products and service offerings;
  3. Deepen existing customer relationships and increase share of spend;
  4. Increase visibility of market opportunities;
  5. Strengthen relationships with vendor partners to create more sales opportunities;
  6. Finally, capitalize on Berbee's skills and engineering methodologies and develop Berbee into a nationwide organization.

When we launched the geographic realignment of the corporate sector earlier this year, we expected to gain several benefits. Some of those benefits have begun to happen, and some will take more time to realize. Benefits we are currently experiencing include better relationships with our vendor partners and better deployment of sales resources.

Our vendor partner activities are at their highest levels ever, because our partners in the regions now have a dedicated CDW sales team for both the public sector and corporate sector. As a result, our partners are bringing us into more opportunities at earlier stages. This helps us fill our pipeline and gives us an advantage to win incremental business. In addition, we have better deployment of our sales resources. Our corporate field account managers used to be responsible for their own sales, but now they are teamed with their inside regional teams. This allows us to deploy sales resources that have the highest probability to capture the opportunity.

Benefits just beginning to materialize include more defined accountability for results and better visibility into regional market drivers. We have increased the accountability for performance objectives for the medium and large teams, as well as the specialist teams. Sales and profit rules are clearly defined at each level, from account manager up to regional directors. This approach is used in the public sector and is a proven way to communicate expectations and better manage results.

We are also gaining better visibility into regional market drivers. As our regional teams learn more about their specific markets, they are beginning to understand which industries and economic drivers are affecting customers' IT purchases in different regions. For example, pharmaceutical customers in the East Coast have significantly different buying patterns than homebuilding companies in the West Coast.

An example of a benefit on the horizon is the ability to target new customers. Targeting has been very successful for us in the public sector, but a prerequisite is customer segmentation and knowledge of what drives customer decision-making. As our regional teams gain this understanding and build presence in their territories, we expect to hone our ability to pursue incremental business in a targeted manner.

We have been working with our new structure for several months now. The magnitude of this undertaking is larger than anything we've done previously, since thousands of accounts were transferred. We have definitely made discoveries along the way and have worked to respond to those learnings. For example, as we have taken inventory of how the entire corporate sales process works, we have identified areas where account managers could improve their product knowledge. In response, we created a new program called Product Wire that tests all account managers' product knowledge. If an account manager needs to sharpen his or her skills in a particular product category, we provide that training through online education.

Another example is marketing. Given what we've learned about regional differences and customer sets, there is a clear opportunity to create more target marketing based on those differences. We are working with the marketing team to develop programs that will be more aligned with our regional efforts to drive future sales.

To summarize, while the corporate sector's third quarter results were below what we expected, we are confident that customer segmentation is the foundation for our future success.

On September 30, 2006, our sales force numbered 2,211 coworkers, representing a 7.3% increased compared to September 30, 2005. Included in the sales force count is approximately 300 advanced technology specialists. We have recently added approximately 30 specialists to focus on software and warranty renewals. Our goal is to add approximately 150 net new sales force coworkers in 2006.

Turning to slide 6, average daily sales per average sales force coworker were approximately $12,600 for the third quarter of 2006, compared to approximately $13,000 in the third quarter of 2005.

Slide 7 shows a similar sales force productivity analysis using gross profit dollars on an average daily basis. Average daily gross profit dollars per average sales force coworker were approximately $1,940 in the third quarter of 2006, compared to approximately $1,980 in the third quarter of 2005. In the third quarter of 2006, the percentage of sales force turnover was in the mid-20s and improved slightly compared to one year ago.

Slide 8 shows that the web generated approximately $496 million in direct online sales for the third quarter of 2006, representing a 9% increase compared to the same period a year ago, and comprised 28.5% of total sales.

Harry Harczak will now comment on product trends.

Henry Harczak

Thank you, Jim, and good morning to everyone. Turning to slide 9, we compare our product mix for the third quarter of 2006 to our product mix for the third quarter of 2005. Software was our largest product category, comprising 17.6% of sales. Notebooks and accessories was second at 14.2%; data storage third at 13.4%, desktop computers and servers fourth at 12.3%, and the printer category was fifth, at 11.3%.

Slide 10 shows product category growth rates on an average daily basis. Revenue for the combined notebook and accessories category increased 17.1%, due primarily to strong notebook sales, which account for most of the category. Netcom products grew 12.2%. Customers are continuing to adopt more advanced network capabilities, such as voice over IP, which requires more managed switches. Strong growth in telephony sales was positively impacted by our recent Cisco Gold certification for CDWG, which allows us to sell a broader array of Cisco products to our public sector customers.

Revenue growth for software was 7.9%. Security and database software helped drive the category. We also had growth in Microsoft enterprise agreements, as customers continued to move into licensing agreements that provide upgrade benefits. Video products revenue increased 7.9%. The continued average selling price decline of desktop LCD monitors and large-format LCD and plasma displays drove strong unit volume. Customers are adopting 19-inch LCDs as their desktop standard due to the minimal price difference between 19-inch and 17-inch LCD monitors. We also some positive trends in both the LCD and plasma television categories. As prices have declined, more customers are using televisions for digital signage in office entryways and conference rooms.

Revenue from memory products rose 7.1%. The category was positively impacted by strong growth in server memory. Both desktop and notebook system growth was driven by customers adding memory to the new Core Duo systems in preparation for Microsoft Vista. Input device revenue grew 6.7%. We have implemented attach rate programs to sell wireless input devices and notebook accessories to our core notebook mobility customers.

Data storage devices increased 2.8% versus the prior-year period. Recent trends in this category continue, as customers need to store larger amounts of data, protect against threats of data loss, comply with increasing government legislation, and be able to access and secure stored data. There's also a general trend of customers shifting from tape-based storage to disk-based storage and more automated products. Compared to tape-based storage, disk-based storage is generally easier to use, and average selling prices have continued to decrease.

Revenue in the printer category declined 0.7%. Unit sales increased, as customers are buying more color laser printers and decreasing average selling prices to make acquisition more affordable. Another trend we see are customers migrating from single-function devices to multi-function printers.

Slide 11 shows the change in average daily revenue, average daily unit volume, and average selling prices for notebooks, CPUs and desktops. Notebook CPU revenue increased 19.1% and unit volume increased 24%, while the average selling prices declined 3.9% from a year ago. As the price difference between notebooks and desktops continues to narrow, customers are increasingly replacing their desktops with notebooks. Popular features include products that are thinner and weigh less, and widescreen notebooks. We've continued to emphasize penetrating existing accounts by selling notebooks to customers who have not previously purchased this category from CDW.

Revenue from desktop computers and servers decreased 4.9% and unit volume declined 1.5%, while the average selling price decreased 3.4% from the prior period. Customers continue to look for ways to efficiently add capacity and improve productivity. Server revenue and unit growth has declined as customers migrate to server virtualization, consolidated servers, adopt blade servers and buy AMD-based servers. While server consolidation has negatively impacted this category, the trend has positively affected sales in other categories, such as software.

In the desktop category, even though customers are replacing desktops with notebooks, we will continue to promote desktop sales. For example, in the fourth quarter we plan to offer promotions from some of our top partners to enhance our penetration program to customers who have not previously purchased desktops from us.

Barb Klein will now review our financial results.

Barb Klein

Thank you, Harry. As John mentioned, we delivered several new records in the third quarter of 2006, including revenue, gross profit dollars, net income and diluted earnings per share. In addition to providing details of our results, I will also discuss how we expect the addition of Berbee to impact near-term results.

Gross profit was 15.4% of sales in the third quarter of 2006 compared to 15.3% in the third quarter 2005, and increased 5.1% compared to the prior year. The change was primarily due to improved product margin. In the second quarter of 2006, gross profit margin was 16.2%, compared to the third quarter 2006 gross profit margin of 15.4%. The quarter-over-quarter decline was primarily due to strong seasonality of commission revenue and volume incentives in the second quarter, which were primarily driven by fees we receive from selling Microsoft enterprise agreements.

Also, since the third quarter represents the end of the federal government's fiscal year, we had a larger proportion of federal sales, which typically have lower margins, and thus had less of an impact on the gross margin percentage. In addition, the amount of cooperative advertising reclassified to gross margin from advertising expense was similar in amount in both the third quarter of 2006 and the second quarter of 2006; but due to higher revenue in the third quarter of 2006, it was a lower percent of sales.

Turning to Berbee's expected impact on gross margins, Berbee's business model incorporates a higher services component that results in higher gross margins. Currently we estimate Berbee will favorably impact CDW's gross margin by approximately 30 basis points. Since Berbee will operate as a separate segment, revenue and operating margin will be broken out each quarter.

In the first half of this year, we increased our stated objective for gross profit margin by 50 basis points to a range of 15.25% to 16%, due to strong margin performance. Many variables impact gross margins. Some variables are internally driven, such as pricing, and other variables are externally driven, such as vendor incentive programs. Given the ongoing variability of the factors that impact gross margin, we are reiterating our stated objective for gross margin of a range of 15.25% to 16%.

Slide 12 shows our operating statistics. Selling and administrative expenses were 7.3% of sales in the third quarter of 2006 compared to 6.8% in the third quarter of 2005, and increased 13.1% compared to the prior year. The increase in selling and administrative expenses in the third quarter of 2006 is primarily due to the following reasons.

First, we had incremental expenses of approximately $5 million associated with the operations of the new Western distribution center in North Las Vegas, Nevada and additional leased office space in the Chicago area. Total expenses were $6.4 million. During the first nine months of 2006, the total expenses for these facilities were $17.8 million. We expect incremental expenses for the Western distribution center and additional office space to be approximately $21 million in 2006 compared to 2005. This represents total expense of approximately $24 million in 2006. These estimates represent a $3 million increase from the estimates we provided in the second quarter of 2006. The increase is due to higher payroll costs for more coworkers than originally forecasted in the Las Vegas facility, and increased warehouse supplies.

Second, we recorded $4 million of expense due to the required implementation on January 1, 2006 of the new accounting standard SFAS 123R related to the expensing of stock options. We still estimate that stock option expense related to the new accounting standard will be between $16 million and $17 million pre-tax for 2006. During the first nine months of 2006, the stock option expense totaled $11.9 million.

Third, payroll costs increased because of continued investment in expanding CDW's sales force and additional coworkers to support our larger and growing business.

Fourth, sales commission expense increased due to the achievement of a stronger gross profit margin compared to the prior-year period. Our sales coworkers are compensated based on the gross margin generated on sales. Advertising expense was $29 million in the third quarter of 2006 and $29.8 million in the third quarter of 2005. As a percent of sales, advertising expense was 1.7% in the third quarter of 2006 and 1.8% in the third quarter of 2005.

Operating margin in the third quarter of 2006 was 6.4% compared to 6.7% in the third quarter of 2005. Operating margin in the third quarter of 2006 includes stock option expense associated with the implementation of SFAS 123R, as well as the other items previously discussed.

Turning again to Berbee, Berbee's operating expenses as a percent of sales are higher than CDW's. Compared to CDW's predominantly in-house sales model, Berbee's business model is more field-oriented. Higher expenses are incurred due to the investment in specialized engineers, who meet with customers on-site and customize solutions.

In addition, there will be transition costs associated with welcoming approximately 800 Berbee coworkers to CDW. For example, in the fourth quarter, we will include Berbee coworkers in our seasonal company activities, such as the annual holiday party. Finally, as a result of the transaction we will have expense related to amortization of intangibles, which will also impact the operating margin.

As John indicated, Berbee provides us additional competitive advantages and several opportunities for top line growth. However, due to Berbee's stronger emphasis on services that results in higher gross margins and lower operating margin compared to CDW, we expect the addition of Berbee to decrease our consolidated operating margin. Our previous stated objective for operating margin for the remainder of 2006 was 6% to 6.5% on a GAAP basis. For the fourth quarter of 2006, we are reiterating this objective.

For 2007, our previous stated objective for operating margin was 6.3% to 6.8% on a GAAP basis. We estimate Berbee will decrease our operating margin in 2007 by approximately 20 basis points. Therefore, our revised stated objective range for 2007 operating margin is 6.1% to 6.6% on a GAAP basis. As we have done historically, we will update our objectives only during our quarterly conference calls.

The effective tax rate for the third quarter of 2006 was 33.2%. This compares to 36.9% for the third quarter of 2005. The year-over-year decrease in the effective tax rate is primarily due to a $5 million tax benefit recognized in the third quarter of 2006 for the reduction of tax reserves due to the expiration of statute of limitations for the tax year to which they relate. This change in effective tax rate increased earnings per share in the third quarter of 2006 by $0.05 a share compared to the third quarter of 2005. We evaluate our effective tax rate each quarter, but for the fourth quarter of 2006 we currently estimate the tax rate will be approximately 38.5%.

We repurchased 300,000 shares in the third quarter of 2006. In the second quarter of 2006 we repurchased 1.5 million shares, which were more heavily weighted towards the latter part of the quarter. The average number of diluted shares outstanding in third quarter of 2006 fully reflected our second quarter repurchases. Comparing the third quarter of 2006 to the third quarter of 2005, share repurchases positively impacted earnings per share by approximately $0.04 per share.

As previously announced, in the fourth quarter of 2006 we expect Berbee to have a negative impact to GAAP diluted earnings per share of $0.01 per share, primarily due to the transition costs, amortization expense, and lower interest income. In 2007 we expect Berbee to be accretive to GAAP diluted earnings per share by approximately $0.05 per share.

Turning to the balance sheet, inventory turns on an annualized basis were 24 times in the third quarter of 2006, which includes the impact of the Western distribution center, compared to 25 times in the prior year. As previously indicated, we expected that the Western distribution center could temporarily lower our inventory turnover, but our objective remains 25 turns annually as we continue to ramp up and balance inventory between the two distribution centers.

Accounts receivable DSO were 39 days at the end of the third quarter of 2006, compared to 37 days at the end of the third quarter 2005. We are revising our DSO target to 40 days due to the growth in our public sector. We ended the quarter with approximately $571 million in cash, cash equivalents and marketable securities.

On October 11th, we completed our acquisition of Berbee for a purchase price of $184 million. Cash flow from operations in the third quarter of 2006 was approximately $78 million. Capitals expenditures were approximately $9 million in the third quarter of 2006, and $40 million in the first nine months of this year. We still expect capital expenditures to be in the range of $45 million to $50 million for the year.

Turning to segment results, corporate sector sales decreased 2.5% and operating income decreased 5.4% in the third quarter of 2006. Operating income for the corporate sector decreased at a faster rate than sales, primarily due to an increase in sales compensation expense associated with an improved gross margin. Corporate sector operating margin was 7.7% in the third quarter of 2006, compared to 7.9% in the third quarter of 2005 and 8% in the second quarter of 2006.

Public sector sales increased 17.6% in the third quarter of 2006 compared to the third quarter of 2005, and operating income increased 13.7% in the third quarter of 2006. Operating income for the public sector increased at a lower rate than sales, primarily due to the investment in additional selling resources. Public sector operating margin was 5.7% in the third quarter of 2006, compared to 5.9% in the third quarter of 2005 and 5.6% in the second quarter of 2006. When we report the fourth quarter of 2006, we will include Berbee as a third operating segment from the date of acquisition of October 11th forward.

Thank you for your attention. Operator, we'll now open the lines for questions.

John Edwardson

For those of you who want to ask questions, we ask that you limit your number of questions to two.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question is from Matt Sheerin - Thomas Weisel Partners.

Matt Sheerin - Thomas Weisel Partners

A question on your gross margin guidance. So, you're basically sticking to the range that you've given previously, yet you talk about Berbee having better gross margin. So, are you expecting the core gross margin to be down, or are you just being conservative?

Barb Klein

We are comfortable that the range that we've given you is appropriate for the near term. So, the 15.25% to 16% is still going to be the range that we feel is appropriate in the near term with the inclusion of Berbee for this portion of the fourth quarter that will have them.

John Edwardson

Matt, one thing to remember here is that Berbee's annual revenues are about $400 million a year right now; ours are about whatever we’re predicting them to be. So, if you look at the weighted average increase and our change in margins, it's not big enough to move us outside of that range.

Matt Sheerin - Thomas Weisel Partners

Regarding the corporate sales re-org, you talked about it being disappointing, the results. So, I would imagine that you think that it's taking longer to see some benefits or improvements than expected. Do you have a timeframe of when you think we're going to start to see favorable year-over-year growth trends? Have you made any modifications or adjustments to the program or the process over the last quarter or so to try to get things going?

Jim Shanks

When we look at the effort that we've undertaken, it is much larger than any of the other ones that we've done in the past. So, we were able to use them as a basis for what to expect. But as we continue to go forward, we always find new learnings along the way. We have been able to successfully transition the accounts. We think that that went pretty well.

One of the things as we've transitioned accounts, it's really kind of shed the light on some of the other areas that we need to be focused on improving. That's why we mentioned with the skills of the account managers, and trying to make sure that they are trained not only to transition an account, and not only to maintain an account, but how do they get into developing an account. So, we're looking at ways to improve that skill set.

We've also done some changes in the management structure as well, trying to make sure that we have proper alignment in place. We've also done some work around making sure everyone has a very clear understanding of their revenue and profit goals around this segmented customer structure. So, we continue to find new discoveries. We continue to get tighter on what we're trying to do.

We definitely are seeing a lot of early indications that things are taking hold and they are moving in the right direction. However, with something of this size and magnitude, I know you would love for me to put a date on it, but it's impossible to do. We can reassure you that we are actively looking and executing against every opportunity that we see.

Matt Sheerin - Thomas Weisel Partners

Fair enough. Thank you.

Operator

Your next question comes from Brian Alexander - Raymond James.

Brian Alexander - Raymond James

Just to follow-up on that last question, Jim, could you share with us some of the issues that you've encountered specifically as you've gone through the sales force re-org? Specifically, are you seeing any higher than normal attrition rates of either customers or account managers, and is that perhaps what's leading you? I think you lowered your account manager hiring goal from 150 to 200 down to 150. Just trying to tie all that together and figure out what might be going unexpectedly at this point.

Jim Shanks

Our attrition is trending right along; it's actually improved from what we had last year. So we're getting people in the right spots. As we're going through and identifying account bases, a much greater amount of effort is put towards looking at the account bases, making sure that we have the right customers with the right sales coverage. That coverage could be with inside account managers, it could be predominantly with field, or some combination of both. So, as we're going through we're getting more tighter in our conversations around what are the exact needs of those customers, and how do we treat them differently?

So, it's one thing to look at segments. We've discovered that customers in the different regions, their method of procurement is quite different. However, their product set may not be that different. So, we find that dealing in the Northeast, they have a very regimented process that we have to change our sales process to match, where in other parts of the country, it's much more of our legacy type of account maintenance process.

So, these are discoveries that as we find them, we're working to adapt. We're going to continue to do things around balancing of books to make sure that account managers have the appropriate number of accounts. When you get into attrition of customers, we haven't seen an attrition of customers in any one category. We are continuing to have good coverage in that regard.

There are a few areas of improvement around certain customer sets. We're finding greater information around the expectations of enterprise customers than we ever saw in the past. So, we're looking at changing our sales coverage model to account for that as well. Hopefully that answers your question.

Brian Alexander - Raymond James

Thanks, Jim. And then, Barb, just a follow-up on, you provided a lot of really helpful information on Berbee. As we look at 2007 and you talked about the GAAP operating margin dilution of 20 basis points is there any way to break out how much of that is restructuring and amortization versus just the core operations of Berbee? I'm trying to get more of an EBITDA impact or a cash EPS impact relative to GAAP. Thanks.

Barb Klein

At this time, Brian, we're still in the process of trying to absorb the Berbee financial results, and we're not even finished with our 2007 plan. So, I'm going to take that and defer it. We'll see what comments we can make at the end of the year, because we're really not far enough along to be able to get into the details at this point.

John Edwardson

But we will take the question and try to come up with an answer to it. I know it's important to get that information to you. One of the things we have yet to do is complete the evaluation work and the asset allocation, and things like that. So, once those things are complete and we should, obviously, have all those things done by the time we do this phone call in January.

Operator

Your next question comes from Jason Gursky - JP Morgan.

Jason Gursky - JP Morgan

Just a quick question on Berbee and then a question on customer satisfaction, the feedback that you're getting from customers in the corporate segment.

First on Berbee, can you just give us a little bit of color about how their quarter may have ended, and just remind us of what their seasonality looks like, whether it's pretty similar to yours?

On the customer satisfaction feedback, can you give us a sense of what kind of metrics you're using to measure feedback from your corporate segment customers, and whether those metrics are improving or degrading as we're going through this process, and types of things that you might be particularly concerned about as you're going through this process?

Henry Harczak

On the Berbee side, we can't comment on how they finished the quarter; it's not part of our financials. But in terms of seasonality for Berbee, fourth quarter does tend to be their larger quarter because of the fact that they do deal with a lot of large accounts who have budget considerations at the end of the year, and also relationships with manufacturers such as IBM and Cisco, and those vendor relationships tend to drive some year-end deals. So the fourth quarter seasonally tends to be a little bit stronger than their other quarters, but not that dramatic.

On the second part, on customer satisfaction, we do a number of surveys throughout the year and loyalty work with our customers. In any given year we are getting a lot of detail back in terms of opportunities we have to improve.

That said, when we look at our customer loyalty scores this year, as with any year, there are a few items that we've identified to improve, but there is nothing dramatically different in our loyalty scores from what we have had in the past. We do those on a regular basis throughout the year, so we're always identifying issues that we can improve on. The scores that we have, our loyalty scores, still do remain better than the norms that the agency that does this for us has in the technology industry.

John Edwardson

One comment on that. When we did the corporate geographic reorganization that is exactly what happened year after year when we did it in the public sector, and they got better because we got closer to the customer.

One statistic which we normally don't give, but we'll just mention here for the first time this year on business customers, we did have a year-over-year increase this quarter in new business first-time customers. We did not have that year-to-date as we've gone through this reorganization. So we did have a bump up in first-time buyers in corporate in Q3 versus Q3 a year ago.

Operator

Your next question comes from Ben Reitz - UBS.

Ben Reitz - UBS

First of all, can you just clarify what caused the slowing sales in September, maybe outside of the sales force re-org? Was there any particular sector, business segment, or anything that you would put a finger on that caused the slower growth market environment?

Jim Shanks

When we looked at it we saw, really, softness across most of our [Medlar] business. We saw a little harder headwinds, if you will, on the very large enterprise customers that made up our portfolio.

Ben Reitz - UBS

Any reason behind that given from them?

Jim Shanks

The information we heard back wasn't that we missed out on opportunities; it's just we weren't able to get the opportunities driven to ground within the quarter constraint.

Ben Reitz - UBS

Any comments on the competitive environment? It seems that Dell may be pricing a little less aggressively. Anything that's happening there versus your expectations?

Jim Shanks

We've been dealing with Dell for a long period of time, and their approaches vary quite a bit from region to region. What we still continue to find is that the value-added resellers are the ones that we go up against more and more.

Ben Reitz - UBS

With regard to Vista, any thoughts there on just how that transition towards Microsoft Vista in January will play out for CDW? Are you going to offer any promotions? Is there any way in our modeling that we should think about it in terms of just big picture?

Henry Harczak

We've had a lot of work internally going on jointly with Microsoft around the release. Licensing is going to be released on Vista and Office in November, and then OEM product will start sometime early in the first quarter; we do not have a definitive date yet.

All of that said, as you know, Microsoft has really tried to move many corporate customers to a subscription model, where they're on licensing agreements that allow them to upgrade. So, for those customers that are on EA agreements or Select agreements, they already have the rights to upgrade to Vista, so there's no real revenue impact there. Yet to be determined what happens with the OEMs and how it rolls out on the OEM equipment.

What we're hearing in discussions with Microsoft and customers is that there are some distinct advantages for Vista in Office, but in many cases, customers are going to take a wait-and-see attitude. So, we don't anticipate any great acceleration in licensing in November or early in the first quarter, but I think it will be a wait-and-see.

As we go downstream and customers do begin to migrate, customers who have old equipment installed are going to find a need to add new equipment due to required processor speed, memory speed, and hard drive requirements for Vista. So, no short-term impact, but over time, we think, it will have some impact longer term on hardware upgrades.

Ben Reitz - UBS

Thank you very much.

John Edwardson

Nonetheless, in terms of when the impact is going to happen, we will be sending over 2,000 account managers to Vista School in the month of November. So, we're going to have a major, major training effort across the Company to get people up to speed on Vista.

Operator

Your next question comes from David Manthey - Robert W. Baird.

David Manthey - Robert W. Baird

I was wondering if you could talk about the split in recent hires at the account manager level between corporate and government sales force. Jim, I think you made some comment about wanting to re-accelerate from a low level. I know you may not want to give us the exact number. Could you just talk qualitatively about what that's been in the last two or three quarters?

Jim Shanks

With the amount of resources we're bringing in, we don't break it out specifically between public sector and corporate. However, what we have done is we've invested where the strength is at. It's important for public sector to get those hirings done early on in the year, so that they're up to speed and they can be performing in time for the busy seasons to hit. So, we tend to invest heavily into that.

As we're doing more and more discovery in the corporate sector, we're finding that there's a lot of opportunity that we can get some new resources engaged in. This kind of triangulates back to the question that was asked earlier on some of the issues.

One of the key things that we're finding as a result of the segmentation is we still have a lot of small business customers in our medium and large sales organization. And it's important for us to continue to move those customers into the proper segment, because that way they will get the proper marketing coverage and the proper exposure to the sales force that is trained to meet their needs. It will also free up resources in our medium and large business to focus and leverage their unique skill set against those medium and large customers.

So, one of the things that as we find opportunities, back to your main point, we are going to continue to find ways to bring those resources in. I would like to accelerate the hiring. We're making a lot of changes in our selection process and our hiring process so that we can ramp up to those expectations and capitalize on the opportunities that we have even existing in our current books of businesses.

David Manthey - Robert W. Baird

I guess from what you said, it's safe to assume that the hiring you have done on the corporate side this year is less than the overall number, particularly since you've added to the sales specialists also, right?

Jim Shanks

Based on seasonality, the majority of our hiring has been going into public sector.

David Manthey - Robert W. Baird

Final question. In terms of the hiring trends into next year, when you say you want to accelerate on the corporate side, any preview you can give us in terms of the overall number? If we're talking about 7% this year, do you plan at some point to re-accelerate that back into the double-digit range, just given your relatively small market share of this vast market?

John Edwardson

Dave, one of the things we have not yet finished is the budget for next year. We're in the midst of that right now. But I'll tell you, the number one area of hiring in the Company next year in terms of percentage growth is probably going to be the number of engineers in the Berbee group. As you may remember, we have about 300 engineers, and we are going to significantly increase that number as we go through the year next year. So, they have big plans for hiring additional engineers to fuel more services growth in that group.

Operator

Your next question comes from Bill Fearnley - FTN Midwest.

Bill Fearnley - FTN Midwest

A quick question on corporate sales here. Your largest OEM partner continues to post strong results. Shouldn't we expect some positive benefit for CDW from the market success versus Dell? Then I have a follow-up.

Jim Shanks

As you look at the market opportunities that are out there, I think one of the key benefits for segmentation was for us to get closer relationships with our OEM partners. As we're doing that we're starting to get involved in more and more opportunities, and we'll continue to capitalize on that.

Are we pleased with the results with corporate sector? No. Do we think that there is opportunity out there that we can capitalize on? Yes. And we are altering our strategy each and every day to try to capitalize on those opportunities more and more.

Henry Harczak

I would also say that with our largest partner, there are product lines where we are performing at or above where they are in the market, and you have to break that down by customer segment for our largest partner as well as by product lines.

Bill Fearnley - FTN Midwest

A quick follow-up on Berbee. Our understanding is that Berbee has 300 service staffers. How many salespeople do they have, and is there any risk here that the acquisition complicates the account reorganizations in a meaningful way, especially on the corporate side? Thanks.

John Edwardson

If you look at the Berbee group, I believe the number of salespeople adds about 100 and about 300 engineers. As we look at, does it complicate the reorganization? To a limited extent it does. But remember a couple of things: I believe we gave you these numbers, in terms of the number of customers that Berbee has and the number that we overlap with. I'm looking at Cindy here. I thought that we talked about those. Did we not before? So, we only have about 1,100 customers where we overlap with Berbee. Compare that to 300,000 or 400,000 customers at CDW and you can see the overlap is not that huge.

What is huge is the opportunity for Berbee. As they want to open new offices in new cities, we can move into those cities, and we have a big base of accounts with CDW in nearly every major city in America that we can then work with the Berbee group on those accounts most qualified to use Berbee services. So, there will be tremendous opportunities for growth there.

Henry Harczak

I would like to add one thing. The fact that we've gone through the re-org actually enhances our ability to work with Berbee. Because of the fact that our account managers are now geographic. This is one of the byproducts of the re-org that we had anticipated, it allows us to tightly align with the Berbee team, because our account managers are now geographic. In the Central region where Berbee is based, there's a much smaller number of account managers for the Berbee team to interface with than there would have been had we not gone through the geographic reorganization. So, it actually enhances the ability to leverage the Berbee acquisition.

Operator

Your next question comes from Bruce Simpson - William Blair.

Bruce Simpson - William Blair

A couple of questions for Barb. Can you give us any more specifics on what drove the tax benefit, and if there's any of that left moving forward?

Barb Klein

The tax benefit related to the fact, as we indicated, that the statute of limitations expired for the year that the tax reserves related to. And as a result, those tax reserves are no longer needed. That's the reason for the release of those tax reserves, which decreased the effective tax rate in the third quarter. So, that's the change for the tax rate. It's as simple as that.

John Edwardson

Bruce, at this time, although it will be different in the near future, we're not going to release our tax reserves because we don't think it's appropriate to do so. But under new accounting standards, you'll be getting them, I think, beginning next year.

Barb Klein

As you know, there's a new accounting standard that's going to be effective in January of '07 that will require a significantly increased amount of disclosures relating to tax reserves that companies carry, the changes in those reserves, and the reasons for those reserves. That's coming in first quarter of '07.

But with respect to this particular quarter, that was the reason for the reduction in the tax rate for the quarter. As I indicated in the script, because we are not anticipating that's going to continue, of course, because that specific year is now closed, the tax rate is expected to go back to about 38.5% in the fourth quarter.

Bruce Simpson - William Blair

As a separate question, Barb, what drove the increase to the expected distribution expenses and occupancy expenses?

Barb Klein

It's about $3 million more then we thought it was going to be when we gave you the projections at the beginning of the year. It's really a combination of things related to the West Coast distribution center. First, they're using more temp to perm employees than we originally anticipated. That seems to be a quite common methodology of the way things go in Las Vegas. So, we'll bring in some people to a temp agency. We basically have a 90-day period in which to have them work with us, and then we will determine which of those coworkers we would like to hire on a permanent basis. So, that's driving a little more of the increase.

The other piece was just some increased warehouse supplies over what we originally anticipated, primarily just to get the facility up and running.

Bruce Simpson - William Blair

So at this time, with that increase in warehouse supplies, does that mean that you are going to meet the targets that you had earlier said, about 30% to 40% of total distribution being routed through the second distribution center?

Barb Klein

At the end of the third quarter we were around 30% of our total unit volume was being shipped out of the distribution center in Las Vegas.

Bruce Simpson - William Blair

So, with the increase in the expected expense for the fourth quarter then, at that point does it feel like its inventory will be at a stable level as a percentage of all distribution flowing through it? Or is there still more incremental expense that we haven't counted on so far?

Barb Klein

The two things are really unrelated. The warehouse supplies are for things like ladders and things like that, that just have to be part of the distribution center. So, it's not related to the volume of products as much going through that distribution center. The distribution center, as we've told you before, has the capacity to take on significant more volume just with respect to the build-out that we have now, and then we add more modules over time.

So, as we grow sales in the future, hopefully, and depending on where those customers are, of course, the anticipation is to continue to serve our customers basically from the West of the Mississippi from the distribution center in Las Vegas. And then the ones East of the Mississippi would primarily be served out of the distribution center in Vernon Hills.

Operator

Your next question comes from Scott Craig - Banc of America.

Scott Craig - Banc of America

Just a couple of quick questions here. In the government business, in the public business, can you help explain to me, with sales growing so rapidly on both a year-over-year basis and on a quarter-over-quarter basis, why we're not getting any leverage there? The margins seems to be flattish to down, if I look at it on an apples-to-apples basis, taking the impact of options out of there, or trying to take it out.

Secondly, on the advertising expense, it was a little lighter than what I thought it was. You had been increasing it for the most part over the past year-and-a-half, yet it looks like we're taking it down a little bit here. What should we expect on that line going forward? Is there something going on there?

Jim Shanks

I'll take the question as far as on the public sector, first. When you look at the reason why you're not seeing the leverages, we're continuing to invest ahead of the curve on that. We think that there is continued opportunity there. We want to make sure that we're investing the necessary headcount to capitalize on that opportunity as we continue to go forward.

Henry Harczak

On the ad expense question, some of our increases prior to the third quarter this year were on specific programs funded by partners. They are continuing some of those programs but at a lesser rate. The other thing that we're doing is taking a hard look at our ad expenditures and trying to determine the famous old question of what's working and what's not. We're trying to redirect some spending into activities that will drive results, including what John mentioned earlier, that we did have an increase in customer acquisition in the corporate sector this quarter for the first time. Throughout this year we had re-directed some spend towards customer acquisition.

Scott Craig - Banc of America

Sorry; just one more real quickly. Barb, on the tax rate, why is it going all the way up to 38.5%? We had it down into kind of the 35% to 37% range over the past year or so.

Barb Klein

Two primary reasons for that. First of all, the mix of Berbee adding to CDW's mix, in terms of the way the revenue is coming from, is going to change it a little bit going forward. So, part of it is just due to the fact that Berbee is going to be wrapped in.

The second reason is, as you know, we paid out $184 million for Berbee in October. That decreases the total amount of dollars we've got in our investment portfolio. We do use tax-advantaged investments, primarily municipal bonds, in that portfolio. To the extent we have lower dollars invested in municipal bonds because the total portfolio is lower, we will have less tax-advantaged investment income as well. Those are the two primary reasons for the change.

Scott Craig - Banc of America

So, that's more of a permanent level that we should consider going forward, then?

Barb Klein

We're giving you the guidance for the fourth quarter at 38.5% as our expected rate. Because of the new accounting rules, that's going to have to be assessed and re-assessed every single quarter. So, overall for all U.S. companies, you'll probably see more variation in tax rates on a quarterly basis because of that new standard.

Operator

Your next question comes from Andy Hargreaves - Pacific Crest Securities.

Andy Hargreaves - Pacific Crest Securities

I just wanted to ask a couple of questions again on Berbee, not to focus too much attention on 5% of the business. Has your acquisition criteria changed at all with Berbee? It seems like now that you're focused more on building that business, and building it both organically and through acquisitions. You said that they had had a very successful history, so I'm wondering if their criteria is any different than what your criteria had been?

John Edwardson

If we look at the acquisitions that they have done, they clearly fit within the criteria that we have as a company. If you look at our overall criteria a significant opportunity for us is to get more throughput through the Las Vegas distribution center. So, one of the things that Berbee does not help with is that. For those of you who will be coming to the analyst meeting in a few more weeks, you'll have a chance to look at the Las Vegas distribution center. You will see a very big, very highly-advanced technical building with a lot more room to put more product through.

Andy Hargreaves - Pacific Crest Securities

My second question, can you help us with any of the working capital metrics for Berbee?

Barb Klein

At this point, we haven't included the effect of Berbee in those working capital statistics that we talked about earlier. First of all, they don't carry inventory, so there's really nothing there to expect on inventory turns, because they're using primarily a drop-ship model for product.

With respect to accounts receivable, because they deal with services business, and those services sometimes get billed out over a period of time, or sometimes may be subject to billing at the time that the work is finished, there may be an impact on days sales outstanding for CDW overall just because that will probably be a longer collection period than we might experience with our typical transactional business.

Andy Hargreaves - Pacific Crest Securities

That's helpful. Thank you.

Operator

Your next question comes from Richard Gardner - Citigroup.

Richard Gardner - Citigroup

Barb, in your discussion of sequential gross margin decline, I think you cited two primary factors. One was the mix shift toward public, and the second was the decline in Microsoft license fees. I wanted to ask you, were changes in vendor incentives and/or pricing strategies significant factors in the sequential gross margin decline as well? Or were there others that you can talk about that would provide some additional color?

Barb Klein

We did indicate at the end of the second quarter that we had a strong quarter with respect to vendor incentives, and some of that was driven by the finish with Microsoft, because Microsoft has its fiscal year end in the June quarter. So, yes; we did have an impact. We indicated at that time that might not continue. So, the impact of Microsoft not only related to the actual commission revenue that we're getting, but also on the rebates as well, or the vendor incentives that we earned because this is not the end of their fiscal year, it's not the end of a six-month period, and we had all those renewals that were generated from four years ago when Microsoft started these programs.

John Edwardson

With that we'll take no more questions because we are out of time. I have a couple of things. One of the things I do want to mention is that over the last couple of weeks I have spent quite a bit of time with sales managers at the Company. I just want to make one final comment on the corporate activity. We are confident that the geographic reorganization will work and will make a huge difference. The attitude is very, very good at the sales manager level. This was the right thing to do. It is taking us a little more time than we thought it would take to get it back where we want it to get to, but we are confident that it will.

With that, I want to say thank you once again to the CDW coworkers for their ongoing hard work. I want to give a big welcome to all of our new Berbee workers. I want to remind you on the phone call that our analyst meeting is in Las Vegas on November 8 and we would love to host you there.

If you are not doing business with CDW, we want your business. Give us a phone call at 1-800-800-4CDW. Thank you very much for being on the call today.

Operator

Thank you, ladies and gentlemen. This concludes today's teleconference. Thank you for participating. You may all disconnect.

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Source: CDW Q3 2006 Earnings Call Transcript
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