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CDW Corporation (NASDAQ:CDW)

Q2 2014 Results Earnings Conference Call

July 31, 2014 8:30 a.m. ET

Executives

Tom Richards - Chairman and Chief Executive Officer

Ann Ziegler - Senior Vice President and Chief Financial Officer

Sari Macrie - Vice President of Investor Relations

Christine Leahy - Senior Vice President, General Counsel and Corporate Secretary

Analysts

Ben Reitzes - Barclays

Bill Shope - Goldman Sachs

Matt Sheerin - Stifel

Brian Alexander - Raymond James

Rich Kugele - Needham & Company

Jayson Noland - Robert W. Baird

Katy Huberty - Morgan Stanley

Operator

Good morning. My name is Amanda and I'll be your conference operator for today's call. At this time, I would like to welcome everyone to the CDW 2014 Second Quarter Earnings Conference Call. All lines have been placed in a listen-only mode to prevent any background noise. After the speakers remarks there will be a question-and-answer session. (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 call.

Tom Richards

Thank you. Good morning. It's great to be with you today to report another quarter of strong results. Joining me is our CFO, Ann Ziegler; our Chief Legal Officer, Chris Leahy; and our VP of Investor Relations, Sari Macrie.

We will follow our usual format where I provide a high-level overview of our performance strategic progress and Ann provides a more detailed review of our financial results. After that we will open it up for some questions. But before we begin, Sari will read the company's Safe Harbor disclosure statement.

Sari Macrie

Thank you, Tom. Good morning everyone. Our second quarter 2014 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 would like to remind you that certain comments made in this presentation are considered forward-looking statements under the Private Securities Litigation Reform Act of 1995. Those statements are subject to risks and uncertainties that could cause actual results to differ materially. Additional information concerning these risks and uncertainties is contained in the Form 8-K we furnished to the SEC today and in the company's other filings with the SEC. CDW assumes no obligation to update the information presented during this webcast.

Our presentation also 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 we furnished to the SEC.

Please note that all references to growth rates or dollar amount increases in our remarks today are versus the comparable period in 2013. The number of selling days for the second quarter and first six months are the same in both 2014 and 2013, so there is no difference in growth rates for the average daily sales and reported sales.

A replay of this webcast will be posted to our Investor Relations Web site, investor.cdw.com by this time tomorrow. I also want 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.

Tom Richards

Thanks, Sari. As I mentioned earlier, second quarter results were strong and I am pleased to report that we reached all time records for three key financial metrics. Net sales rose 11.8% to $3.1 billion, delivering the first $3 billion plus quarter in our 30-year history. Adjusted EBITDA increased 16.3% to an all time high of $247 million and non-GAAP earnings per share increased 45.6% to $0.67.

These results reflect the combined power of our diverse customer channels, the benefit of our full suite of offerings that address customer priorities across the IT landscape, and ongoing success in executing our three part strategy. Our nearly 4% increase in sales was driven growth across all of our customer channels, ranging from a low of 6% to a high of 25%.

On a segment basis, corporate was up 7.7% and public was up 17.5%. In corporate, our medium and large business increased nearly 7% and small business was up 14%. Public segment growth was once again led by education which delivered excellent performance with sales up 25%. Education results reflected both continued exceptional performance in K-12 and low double-digit growth in higher Ed.

Government sales increased 5.9% as federal sales returned to low single-digit growth and state and local continued to deliver low double-digit growth and healthcare was up nearly 18%. Our other net revenues which represents our advanced technology services and Canadian operations increased 11.9%. Advanced technology services delivered high single digit growth. Canadian sales were up in the low-teens in U.S. dollars and nearly twice that rate in local currency.

As anticipated, customer priorities in the quarter remained squarely focused on client devices. Notebooks, laptops, tablets and desktops. Once again driven by continued strong demand for Chromebook and K-12 and PC refresh as customer address the expiration of XP support as well as the need to replace a fairly old installed base of client devices. Our full suite of offerings which includes transactional products, solutions and services, enabled us to quickly and effectively meet strong PC demand which we experienced across our entire portfolio of customer channels.

Revenue mix for the quarter reflected this demand. On a net sales basis, hardware grew 13.7%, software grew 4.2% and services grew 12.7%. Hardware growth was driven by client devices with notebook and mobile devices including Chromebook and desktops growing well into the double-digits. While client devices continued to dominate customers' mindshare, there were a few other areas that posted double-digit growth this quarter including wireless networks, network security, managed services, and enterprise storage declined by low single-digits this quarter as continued strong growth in emerging technologies was not quite enough to offset weakness in more traditional storage.

Servers were down year-over-year, although less than last quarter. Software performance was solid across all our categories with the exception of storage, as this tends to be driven by hardware sales. Virtualization, security and database software, all increased double-digit. Once again, software gross profit margin expanded reflecting higher contribution from sales that are booked net, like software assurance and software as a service.

Services growth was driven by increased warranties and configurations for both client device refresh and Chromebook solution sales as well as cloud services like aggregation. While our mix of business was influenced by lower product margin client devices, we maintained excellent operating profitability. The variable nature of our cost structure combined with our ongoing focus on cost control enabled us to convert our 11.8% net sales growth into adjusted EBITDA growth of 16.3%.

Our ability to deliver sustained, profitable growth is underpinned by the success we have had in executing our three part strategy. Which is to first capture market share from existing and new customers, second expand our solutions suite, third, build our service capabilities. Our go to market strategy is a key driver of our ability to increase share of wallet and acquire new customers. And you see the benefit of our vertical go to market strategy in this quarter's results where education and healthcare grew substantially faster than our overall 4% growth.

By focusing resources on a specific vertical, we develop deep industry knowledge. Knowledge that enables us to develop custom solutions, like our solution for the common core curriculum challenge in K-12 or our mobile card technology solution for healthcare. Building the expertise and reputation required to deliver these solutions takes years and resources. For example, we just moved financial services into MedLar as a standalone sales organization. Over the past few decades, we have helped more than 15,000 banks, credit unions, capital markets and specialty financial service companies assess and align their IT infrastructures with growth strategies, manage regulatory compliance and reduce cost.

Over that time we have build deep industry knowledge around the technology needs of financial services companies. When you combine this industry expertise with all of our competitive advantages and advantages that include our scale, our scope, meaningful relationships with our partners, you can see why we are able to drive growth substantially faster than the rest of the market.

Let me share an example of how this combination helped us win a capital market customer. Our scale enables us to allocated resources at a fairly granular level. And we have done that inside of our financial service vertical where we have further segmented into three teams. Capital markets, banks and credit unions. Our capital markets firm that provides trading services to multi-asset clients is highly dependent on technology to meet their clients' needs for both speed and reliability. Certainly an excellent prospect for CDW given our experience low latency trading solutions.

Technology is the company's competitive advantage and understanding the roadmap of their major vendors is critical to their ongoing success. But the local VAR they were working with couldn’t get the right people on the phone when they needed help. That’s where our competitive advantage came in. Given our significant relationship with their major technology provider. Remember we have more than 15 partners with whom we do more than $100 million on an annual basis. We were able to set up face to face meetings between our customer's CTO and our partners head of industry standards within a week of our first meeting. The value of our industry specific expertise and access we provided was immeasurable. Today this company is not only a great customer taking advantage of IT solutions designed specifically low latency trading, but a major source of new business as they refer their small and medium sized capital markets customers to CDW.

In addition to vertical alignment, geographic alignment is also a key part of our go to market strategy to help us gain share. You can see the impact of that in small businesses' 14% increase this quarter. Late last year we completed a new geographic alignment mapping small business sellers to our MedLar regions. Now in addition to the knowledge they bring to the market around unique issues facing small business, sellers and technical specialists can work more effectively with our partners who tend to be aligned with us by geography and drive more local events for customers which are a very cost effective way for us to help small business customer get up to speed on new technology.

Of course, the great go to market strategy isn't worth anything if you don’t have the products and services your customers need. And that is where our second and third strategies come in. Our second strategy is to continuously expand our solutions capabilities. Clearly our success in meeting customer needs for client devices was a primary driver of our results this quarter. But we did see continued excellent growth in cloud offerings albeit from a small base, to our overall sales as well as in mobility and security in the quarter.

Our ability to deliver complex integrated solutions also contributed to our robust client device sales this quarter. Let me share with you an example of how that works in our healthcare channel. A newly designed multi-hospital health system in the Southwest with two data centers and more than 10,000 co-workers needed to refresh more than 5,000 desktops across fairly old infrastructures. There CIO was a prior customer of CDW in another healthy system and knew our healthcare expertise would help them develop a solution that would work specifically for their needs.

We assessed their current environment and determined that the devices needing refresh were shared resources and used primarily for data input by nurses and doctors at group workstations. This fact coupled with their aging infrastructure led us to a VDI solution. We architected the workflow and sizing for a new VDI infrastructure and presented several options for implementation. In the end, we determined that the best for their situation was a converged infrastructure solution. This need for a client refresh drove over $2 million of revenues in the second quarter. Approximately $150,000 in professional service revenue, $1 million for converged hardware, software and maintenance and $1 million for [their clients] (ph).

With two data centers, the customer will be adding a second converged infrastructure solution to ensure forward (indiscernible) this quarter, as well as a new server platform and wired and wireless infrastructure. With so many projects on the place and the integration of the two IT systems that customer decided to have us provide remote managed services of the new VDI environment, which will generate annual recurring revenues of nearly $200,000.

This leads me to our third strategic priority, which is continue to build our service capability. Service capabilities are an integral part of many high-end solutions sales and one of the key ways solutions add to customers' stickiness. By expanding our service delivery capabilities, we deepened relations with both customers and our vendor partners. Let me share a great example of the power of our services offering when combined with our solutions portfolio.

A financial management software company that provides SaaS based solutions to their customers, was expanding overseas. A relatively small firm, they wanted to maintain control over their production environment while minimizing time to market and cost. With the delivery of software mission critical to their business, they couldn’t sacrifice security of clients or performance. Our hybrid solution helped them achieve these goals by combining a part of the solution they put out and built cost effectively themselves within their infrastructure.

First we mapped out the hardware they needed, a converged infrastructure solution. Then we help them chose the right global co-location and cloud partner, including making sure they found the best premise to cloud hybrid solution for disaster recovery and offsite disk space data archive. Finally, we helped them get started by providing configuration services and employed in-market engineers to help them set up the environment. This solution drove hardware, software and professional services revenue of $1.8 million and aggregation fee of $60,000 per month for a 36-month term.

Delivering long-term-sustainable profitable growth requires a constant focus on balance between expense and investment. During the quarter we continued to invest to ensure we can help our customers address an increasingly complex IT landscape adding 65 additional customer facing co-workers. We now have a 121 additional customer-facing co-workers on the team since the beginning of this year, on target with the plan we shared with you last quarter that calls for adding between 150 and 200 customer-facing co-workers during 2014, likely to be at the high end of that range.

Once again, this quarter's performance reinforced our confidence and our ability to deliver consistent sustained profitable growth. The combination of our full suite of offerings, our diverse customer channels with our scale and scope, go to market strategy and long-lasting customer and partner relationships, continues to position us to both capitalize on current market conditions and deliver profitable growth well into the future.

With approximately 5% market share in a highly fragmented market, we have plenty of runaway. Let me conclude by sharing some thoughts on the remainder of the year. As you can see from our results this quarter, we continue to reap benefits from our efforts to build our capabilities and capacity to deliver high growth technology solutions. But there is no doubt we benefitted from client devices tailwind. While we expect to see client devices growth significantly above trend from the remainder of the year, we do expect the rate of growth to slow, both from a significant year-over-year overlap in K-12 perspective and some other signs that the PC refresh is moderating slightly. By no means a halt but a slight moderation.

Given expectations for client device sales in the back half of the year and our first half performance, we now expect to grow 400 to 500 basis points above U.S. IT market, which at this time we see growing slightly above 4% for the full year. If client devices sales don’t moderate as much as we think, then we would expect to see an increase in the U.S. IT market growth above that level.

And with that, let me turn it over to Ann who will share more detail on our financial performance. Ann?

Ann Ziegler

Thanks, Tom. Good morning, everyone. As Tom indicated, our second quarter, financial results reflect CDW's ability to deliver a full suite of solution offerings that address customer priorities across the IT landscape, the power of our diverse customer channel and the ongoing success of our three part strategy. They also reflect the progress we are making against our financial strategy to drive strong cash flow, delever our balance sheet and deliver double-digit earnings growth.

Let me begin with our P&L. If you have access to the slides posted on line, it will be helpful to follow along. I am on Slide 7. Top line growth was excellent this quarter with net sales of $3.11 billion, 11.8% higher than last year on both a reported and average daily sales as we had the same number of selling days in both the second quarter of 2014 and 2013. Average daily sales grew $48.5 million. On an average daily sales basis, sequential sales were up 15.3% versus Q1 2014, which is well above normal seasonality.

Gross profit for the quarter increased 10% to $496.9 million. Similar to Q1, gross margin remained under pressure with our gross margin at 16%, down 20 basis points from last year's Q2. The decline was primarily due to the ongoing impact of both mix and pricing pressure from growth in lower margin to more transactional products.

Reported SG&A, including advertising expense, was $308.7 million, up just 3.6% over last year. Advertising expenses remained fairly constant as a percentage of sales, increasing $3.2 million in the quarter versus last year. We ended the quarter with 7151 coworkers, up 184 workers since the end of 2013, and up 341 since the end of last year's second quarter. Annualized sales per coworker were $1.75 million, up 7% over Q2 2013.

Our adjusted SG&A including advertising was $250.7 million, up 4.5% over the last year. This increase reflected higher coworker cost related to higher compensation consistent with increased coworker count and attainment based compensation plans tied to adjusted EBITDA consistent with our year-to-date performance. These increases were partially offset by lower compensation generally associated with transactional products. Expense leverage from the overall increase in sales and the tilt in business towards more transactional sales coupled with continued tight cost control and timing of investments, enabled us to more than offset our gross margin pressure.

As you can see on the next slide, Slide 8. Adjusted SG&A for the quarter excludes $4.3 million of non-cash equity compensation, $2.2 million of historical retention costs and other expenses, and costs related to our May secondary offering. To make it easier to calculate our adjusted EBITDA, which is essentially our growth profit plus adjusted SG&A expenses, we also adjust for depreciation and amortization.

As you can see on Slide 9, adjusted EBITDA for the quarter was $247.1 million, up 16.3% year-over-year, which translates to an adjusted EBITDA margin of 8%, up 40 basis points from last year.

Let's look at the rest of the P&L on Slide 10. Interest expense was 31% lower than last year at $48.5 million, reflecting reductions given by repayments and refinancing activity completed in 2013 and 2014. Our effective tax rate was 36.9% versus 36.2% in Q2 2013. On a GAAP basis we earned $86.6 million of net income. Our non-GAAP net income which better reflects our operating performance, was $115.9 million in the quarter, up 46.3% over last year. As you can see on Slide 11, non-GAAP net income reflects after-tax add backs that fall into four general buckets.

The ongoing amortization of intangibles from our going-private transaction, any non-recurring cost related to financing including debt extinguishment and interest equalization, on-going non-cash equity compensation, and other onetime non-recurring income or expenses. These adjustments are tax effected at statutory rate of 39%. With Q2 non-GAAP weighted average diluted shares outstanding of 172.7 million, we delivered $0.67 of non-GAAP net income per share, up 45.6% over the prior year.

Turning to the first half results on Slide 12. Revenue was $5.8 billion, an increase of 10.9% on both a reported and average daily sales basis, as average daily sales grew to $45.3 million. Gross profit during the first quarter of 2014 was $922.1 million, up 8%. Gross profit margin was 16%, down 40 basis points from 2013. SG&A including advertising expense, increased by $18.2 million or 3.1%. Adjusted EBITDA was $440.8 million, 12.7% above first half 2013. Non-GAAP net income for the first half of 2014 was $197 million versus $135.5 million in 2013, up 45.4% driven by our higher operating results and lower interest expense which was down $43.8 million.

Turning to our balance sheet on Slide 13. On June 30, we had $227.6 million of cash and cash equivalents. As I indicated on our last call, on May 9 redeemed the remaining $42.5 million of our 12.535% senior subordinated notes. This resulted in a $2.2 million loss from extinguishment of debt and $0.5 million reduction in our interest expense related to the impact of interest equalization. We finished the quarter with $2.9 billion of net debt, $665 million less than the beginning of the year. Our cash plus revolver availability as $1.18 billion; net debt to trailing-12 months EBITDA at the end of Q2 was 3.4 times, 0.1 turn less than the end of Q1.

As we have shared with you in the past, we continuously evaluate opportunities to improve our capital structure. To take advantage of favorable terms and rates currently available in the marketplace, this morning we launched the offering of a new $600 million senior unsecured note facility. We intend to use the funds from this offering to redeem the entire outstanding $325 million 8% senior secured notes and pay down $235 million of our 1.28 billion 8.5% senior notes. This proposed refinancing is designed to deliver a reduced interest rate in future periods and a more favorable covenant package which both better reflect the improvements we have made to the balance sheet over the past few years and also provides us with greater financial flexibility. For more information about the proposed GAAP transaction you can access the press release posted on cdw.com.

Not taking into account the proposed refinancing we announced this morning, our weighted average interest rate on outstanding debt is 5.9%. In this potentially increasing interest rate environment, I would like to remind you that our $1.52 billion term loan facility is subject to 1% LIBOR floor and that we have in place on $0.15 billion principal amount at interest cap at a weighted average rate of 2.4% which expires in Q1 of next year. The remainder of our outstanding debt is fixed rate, so approximately 88% of our outstanding debt is actively fixed or hedged and rates would have to move significantly before they have a material impact on our interest cost.

Consistent with normal seasonality, cash flow from operations plus the net change in our flooring agreement, was down sequentially in the quarter. Remember that Q2 and Q4 are our lowest cash flow quarters of the year as our interest expense on our 8% and 8.5% note is paid on April 15 and October 15. Also remember that our cash flow generally drops in Q2 as we cash taxes for Q1 and Q2 in the second quarter. Cash taxes paid in the quarter were $102 million and cash interest was $84 million.

During the quarter, we had net investment in working capital commensurate with our higher rate of growth over the period as well as the impact of a strategic stock position we took in Chromebook to ensure we could meet customer demands in a market that is beginning to show a few pockets of supply constraint. Recall that it's similar to when we took advantage of our distribution and warehousing capability to make sure that we had hard disk drives for our customers during the Thailand flooding shortage.

Our normal seasonality coupled with these investments in working capital resulted in free cash, flow which we calculate as operating cash flow plus the net change in our flooring agreement less capital expenditures, of negative $20.6 million in the quarter. While our accelerated rate of growth drover increased working capital investment at the end of the quarter, as you can see on Slide 14, we maintain strong rolling three-month metric. For the quarter, our cash conversion cycle was 19 days, down 1 day versus last year's second quarter. We expect to continue to maintain our cash conversion cycle within our target range of the lower mid-20s for the remainder of the year.

Turning to the rest of 2014. As Tom mentioned, for our top line we now expect 2014 growth between 400 and 500 basis points higher than the U.S. IT market, which we currently believe is tracking slightly above 4% for the year. We also continued to target these medium term financial measures you see on Slide 15. Adjusted EBITDA margin in mid-7% range, mid-teens non-GAAP earnings growth per share which we expect to repeat again this year, now likely hitting below-20s and deleveraging 1/3rd to 1/2 times per year until we hit our target leverage of three times. Keep in mind that we view the medium term as the next two years and we hold ourselves accountable for delivering these targets on an annual basis not quarterly.

Let me provide a few additional comments for those of you modeling our second half 2014 financials. As you can see on Slide 16, the realignment of or financial services and legal verticals at the beginning of this year resulted in a shift of approximately $115 million of revenues inside our corporate segment from small business into MedLar for 2013. For the second quarter of 2013 the impact was $37 million. Not taking into account the proposed refinancing announced this morning, we expect our cash interest to be approximately $96 million for the remainder of 2014. For full year 2014, we now expect a cash tax rate of 40%, up slightly versus our prior expectation of 39%, to be applied to pre-tax book income before acquisition related intangibles amortization which is approximately $40 million per quarter.

In addition, beginning this year and continuing through 2018, we will pay $20 million to $21 million of taxes per year related to the cancellation of debt income or CODI we incurred in 2009. As I shared with you in the past, 2013 free cash flow reflected the benefit of lower cash taxes primarily due to deductions associated with our IPO and refinancing related expenses. This year, tax payments ramp up as we lose those deductions and begin making the CODI payments I just referenced.

Given the absence of 2013 tailwinds and the incremental impact of CODI, while you should expect excellent free cash flow in 2014, it will likely be below that of 2013 and at the low-end of our normalized targets of 2.5% to 3% of net sales. Again, don’t forget that our cash flow will tend to increase sequentially into the third quarter and then decline sequentially in the fourth quarter due to our semi-annual interest payments. On the expense side, consistent with the past couple of years, we expect our adjusted SG&A to increase at a rate more in line with sales for the balance of the year as we absorb costs related to higher coworker count and infrastructure and productivity initiative investments in the second half of the year.

Sales compensation also should return to a more normalized percentage of gross profit as client devices both moderate and represents a lower percentage of sales growth. Increased sales to the federal government, which tend to be lower margin at the end of their fiscal year, should offset any potential lift in product margins from improved mix. All of these puts and takes bring us to a lower adjusted EBITDA margin for the balance of the year with the full year margin hitting our mid-7% target range. Given seasonality and the timing of our investments, we expect our fourth quarter EBITDA margin to be below our full year target range.

Moving down the P&L. We expect book interest for the remainder of the year to be in the $95 million range and we continue to expect our 2014 effective tax rate to be higher than last year in the 37% to 38% range. Given the overlap of the 27.5% tax rate we had in Q4 of 2013 and lower interest expense savings as we lap last year's big reductions, you should expect 2014 non-GAAP net income growth to be significantly stronger in the first three quarters of the year than in our Q4.

One final note. Returning cash to shareholders is an important component of our commitment to build shareholder value and I am delighted to report that our board of directors declared our fourth quarterly cash dividend since our return to the public market. We will pay a dividend of $0.0425 per share on September 10 to shareholders of record on August 25. We intend to revisit our dividend policy annually and once we achieve our current target leverage ratio of about three times, we will look to our overall strategy to return cash to shareholders, which depending on tax policy and other factors at that time could include share repurchases.

That concludes the financial summary. Let's go ahead and open it up for questions. Can we please ask each of you to limit your questions to one question and one follow-up. Operator, can you please provide instructions for asking the questions?

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Ben Reitzes from Barclays. Your line is now open.

Ben Reitzes - Barclays

Can you talk about drivers -- and by the way, Ann I appreciate that color on the cash flow, so that’s still what I was going ask. I am going to ask about drivers for the second half. You mentioned that PCs could temper a little bit. But I was wondering what you thought about a potential server cycle as a driver. And also can you talk about the sustainability of the public revenue streams that have been -- that really were higher than expected in the quarter? And then particularly touch on that eRate program and how that impacts your business. Thanks.

Tom Richards

So there is kind of three parts to that, Ben. First on the PC refresh. I think we are fairly comfortable that it's going to continue through the end of the year and the comment on the moderation in part is just the number of customers that have already done the refresh. You have got some interesting comps going on for K-12, to say the least, during the second half of the year. But we do, I think to user your term, we do expect PC refresh to continue to be a driver for the remainder of 2014.

As far as the server business and for that matter our overall solutions business, we would -- I do think there is a mindshare issue that goes inside of both our sellers and customers when it comes to how many big projects can I take on at one point in time. We are a little bit of encouraged by the end of the second quarter increase in some of our solutions business, including servers and how that started in July. We will see if that remains. But a big wildcard for us I think this second half of year will be what happens with federal. And because, as I have said, we had our first positive growth quarter in a while, we are very excited about that and we are seeing, Ben, some increased, what I will call sales activity in the federal channel. You know quotes, RFPs requested, contract meetings, all of those tend to make you believe we are going to see some uptick and that could influence a lot the second half of the year.

But you know as you know, we have had six or seven quarters of tough (indiscernible). So that’s a little bit of a wildcard. In the overall public driver, it is segment specific. So the eRate access or helping customers find and how to use eRate to fund different products and programs. It is part of our vertical expertise, if you will. It kind of demonstrates the vertical strategy. We continue to think that will be something that will be a tailwind for people buying technology.

I would tell you that K-12 is the segment that continues to surprise. I have been getting asked how much more of this core curriculum tailwinds do we have and we recently read the statistics somewhere have been -- where it said something like 18% of the school districts are kind of prepared or full prepared and then another 30% or kind of prepared. So to me, my math is that’s 50% that still need help in getting ready for the core curriculum. So we are continuing to look to K-12 to be a growth. And then the last one that makes up the public group or is an important part is healthcare. We had nice returns, so a strong growth. And we do see that continuing for the rest of the year and again the PC refresh will be part of that.

Operator

Our next question comes from Bill Shope from Goldman Sachs. Your line is open.

Bill Shope - Goldman Sachs

I guess first question. Could you give us a little bit more color on your thoughts around the refinancing strategy, both today's announcement and your thoughts on the future? And I guess related to that, the debt reduction definitively end at three times leverage or with refinancing presumably becoming through the call dates after that, or do you still think you may have some capacity beyond that? That would be my first question. I have a second question after that.

Ann Ziegler

Yes. I am not sure I understood the last part of that question but let me. The refinancing strategy is, you know as we approach the early call dates and you begin to look out at where interest rates might move, it just makes sense to take up a piece of the risk off of the table by doing a piece of the refinancing today. So that’s what we did. We will continue to monitor the marketplace and as it makes sense, opportunistically begin to refinance the remainder of the debt that’s outstanding and become callable in April of next year.

Bill Shope - Goldman Sachs

Okay. And I guess the question I has asked, the second question, was really the question we ask quite often. Which is how to think about your capital allocation strategy after you hit three times leverage. I know you have several options buybacks, dividends, potential for more deleveraging. But how are you thinking about that today given the environment we are in.

Ann Ziegler

Absolutely. So as we have indicated, we will revisited our dividend annually. So that will come up because we are about to anniversary the first dividend we paid. But then on top of that when we get to three times leverage, we will revisit the strategy more globally, looking at potentially a significant step function change in the dividend as well as initiating stock buyback. But all that’s going to depend on the marketplace at the time, tax policy, interest rates etcetera.

Bill Shope - Goldman Sachs

Okay. Great. And then my final question would be, on how to think about absolute OpEx trends through the back half of the year. You gave a ton of details on the call, I am not sure I got them all but in particular, if you could focus on how we should think about the absolute OpEx trends over the next two quarters and particularly how variable comp effects that given the stronger than expected revenue performance.

Ann Ziegler

Yes. I think the best way to think about it is, that we expect our OpEx to grow, or adjusted SG&A to grow more in line with sales for the second half of the year as we continue to add coworkers through the year that OpEx growth, and we also have some initiatives that were simply funded or some funds to be invested in second half of the year. So as you think about the second half, you would expect OpEx adjusted SG&A to grow more in line with top line growth.

Operator

Our next question comes from Matt Sheerin with Stifel. Your line is now open.

Matt Sheerin - Stifel

Just wanted to focus on your services. Tom, you gave some pretty good examples of some of the solutions that you are providing for both small and large customers. If you look at your infrastructure, your network operations centers and data centers, what's your capacity look like and are you expecting to expand that? And as a related question, could you talk about CapEx plans for the year.

Tom Richards

Okay. So let me start with the second quarter first. You know we typically spend about 0.05%, I think in CapEx spending for the year. I think we are going to be in that range. We have been in the, I think what, $40 million to $50 million range. We are pretty steady eddies when it comes to spending on CapEx. We do have some projects interesting enough, that Ann alluded to, that are important drivers of growth in our cloud business that we will be working on during the second half of the year and delivering. As far as the first question about capacity, I don’t see any capacity constraints. When it comes to expanding our services business and in particular where you would think about that is in our managed services and some of our hosting strategies. And we feel very comfortable we have the capacity to meet whatever demand is going to be in the marketplace.

You are instinctively on point, so to speak. We are getting increasing demand from customers to help them think about infrastructure as a service or remote network management, managed services as the hybrid IT blueprint continues to be the prevailing discussion point with most of our customers.

Matt Sheerin - Stifel

Okay. That’s helpful. And then looking at your vertical strategy which is obviously benefitting the growth. Could you talk about any other areas? You talked about financials, are there any other verticals that you are looking at and potentially building out as a sub-sector of one of your other segments?

Tom Richards

Not at this point. We still consider the finance and the legal verticals to kind of be in their embryonic stage if I would say it that way. You know we just moved them into the MedLar sales channel, kind of graduating from the pilot phase. And so we will concentrate on those right now and getting those into being full productive sales channels. And then -- that doesn’t mean we aren't thinking about it, but I don’t think I am at a point where I could share anything this specific. But I think another point is, we do continue to subs-segment, as I alluded to. And that is a huge benefit because as you might imagine, even inside of healthcare or finance, your ability to get underneath that segment level and provide unique solutions is a real asset to customers.

Operator

Our next question comes from Brian Alexander with Raymond James. Your line is now open.

Brian Alexander - Raymond James

I just wanted to clarify the growth outlook for 2014. So based on what you see today it sounds like CDW, you expect CDW to grow 8% to 9% for the year versus I guess 11% growth in the first half. So just trying to back into the second half growth expectation of around 6% to 7%, just to make sure that I heard that right. And then I have a follow-up.

Tom Richards

Yes. It's going to be, if you just think about it, just do the 400 to 500 on top of the slightly above 4. But I did allude, the PC refresh continues, Brian, stronger than I think. It could be slightly above the 4 number, which could than push us a little higher than the number you talked about.

Brian Alexander - Raymond James

And then just on the slower growth in client devices. Is that based on sales trends that you are experiencing or is it more of an expectation based on customer conversations or just intuition based on how strong it has been in the first half?

Tom Richards

Probably the correct answer is, all of the above that you mentioned. It's a little bit some looking at the math and knowing the overlaps some of those segments have. Some of it is just looking at the rest of the market that has the opportunity to do that. Although I would tell you that, we haven't seen it moderate yet in a meaningful way but your instinct would tell you, by the time you get to the end of the year, you are going to see some moderation in that growth rate.

Brian Alexander - Raymond James

Okay. And then just a final clarification for Ann on the margins. So if I heard your comments, it sounds like gross margin you think stays around 16%, OpEx grows in line with revenue. And so if we kind of look what that means for adjusted EBITDA margins, around 7.5% for the year, flattish year-over-year in the third quarter but down in Q4. Is that right?

Ann Ziegler

Yes. I think you have it right conceptually. I mean we don’t provide that specific level of guidance. We certainly expect to hit our medium term target in the mid-7% range on a full year basis. I want to be clear, we don’t expect to hold the margin at the 8% range. We delivered this quarter with OpEx growing more in line with sales in the back half of the year. Right. It's certainly going to be lower than it was in Q2. And in Q4 in particular, because of some of the overlaps, we expect to be below the medium term annual target.

Operator

Our next question comes from Rich Kugele with Needham. Your line is open.

Rich Kugele - Needham & Company

So, two questions. First, you talked about continued pricing pressure especially on the transactional products. I am just interested, in this rising demand environment here domestically, what do you think is the driver for that? Is there not enough business going around for some of these small regional players that you are competing against or are they also trying to gain share? Are they trying to compensate for other areas? Any additional color on the price competition. Then I have a follow-up.

Tom Richards

Well, I think part of it, Rich, is driven by as certain parts of the IT infrastructure get commoditized. Pricing pressures always becomes the bigger and bigger part of the discussion. And I think -- I don’t know if I could comment on other peoples strategies but I do know that when there is an opportunity in the marketplace and people feel like they need to either maintain their share or protect their share, that pricing tends to be the strategy some people run to. So we have experienced that now for a period of time. I am going to say, it feels like the last 18 or 24 months on the transaction part of the business. Not quite as much on the solutions side but more on the transaction side. And the connective tissue there is, we just expect that part of our business to continue to grow and therefore you are going to continue to see that pricing pressure.

Rich Kugele - Needham & Company

Okay, and then just on the Chromebook tightness. Do you feel you've got a diverse supply of those in terms of vendors? What has been the vendor response when you have relayed the demand issue that has led you to stock some extra product?

Tom Richards

Well, the answer to your first question is, yes. That’s one of the great benefits of a company like CDW, is the diversity of options. That also is a great operating benefit for us because it enables us to sent a pretty strong message about our ability to consume those devices. And I will tell you, the partners have been very good. I think one of the things that has helped is our ability to give them specific forecast and our confidence level in those forecast. And when you can have that kind of dialogue, it tends to be a pretty good equation.

Rich Kugele - Needham & Company

How long do you expect that tightness to continue?

Tom Richards

I don’t know that I could comment on that. Quite honestly, I really don’t know enough about the back end of the manufacturing process. All I know is, we want to make sure that we have the product for our customers and that’s why we were aggressive in building a stock position.

Operator

Our next question comes from Jayson Noland from Robert W. Baird. Your line is now open.

Jayson Noland - Robert W. Baird

Tom, a question on taking the growth rate to 400 to 500 above the IT market growth from 200 to 300. That implies share gain. What is the primary driver of that? Is it mostly a function of end market exposure for CDW?

Tom Richards

Jayson, I am sorry, what was the last part of your question? I didn’t quite -- what's the...

Jayson Noland - Robert W. Baird

Why are you gaining share? Is it a function of where your end market exposure is?

Tom Richards

Yes. I would say it's a couple of things. One is, you know we have been working on a number of different initiatives that are beginning to kick in. You heard me talk about the geographic realignment in small business. I think a second part of it is, we are anticipating federal will continue to return to growth and we are looking at some other initiatives and some of the things we talked about earlier, the success of our vertical markets. So I think all of those have been part and parcel of why we have experienced the share gain in both existing customers, which I think it's important to keep this to mind, that when we talk about share gain, it's both within share of wallet inside of an existing customer and then acquiring new customers. And as I have, I think mentioned on a couple of these calls, cloud computing and some of the other initiatives that we have implemented in small business have been huge factors in helping us acquire new customers.

Jayson Noland - Robert W. Baird

Okay, thank you. And a follow-up on data center. I think you said storage and server were a little soft. What are you seeing in the networking market right now?

Tom Richards

Network was pretty good. It wasn’t anywhere near the client tailwind but the network business has been pretty consistent for us. Within the network business, I think alluded to this in my comments. So wireless networking continues to be a pretty area of strong interest by our customers. I think a lot of that has to do with, they deal with kind of the mobile world, the deal with maybe Ethernet kind of landline restrictions when it comes to capital investment. The wireless part of the network continues to be a growth area.

Operator

Our next question comes from Katy Huberty from Morgan Stanley. Your line is now open.

Katy Huberty - Morgan Stanley

As you noted, hardware growth significantly above software growth. Is there any historical relationship whereby strong hardware sales will lead to an acceleration in software growth in coming quarters? Or is the PC dynamic less likely to drive software and services attach?

Tom Richards

Katy, I think the answer is, in some parts of the hardware world, the answer is yes. Like in storage and that implication on storage software. But with more of the cloud-base solutions, they are almost independent growth driver in the business, not necessarily tied to a particular hardware refresh. So we saw, as I think I alluded to, we saw growth across our virtualization practice, our security software practice and obviously our cloud-based solution practice. And I don’t know that those were driven as much by hardware as just independent decisions inside the business.

Katy Huberty - Morgan Stanley

Okay, got it. You made a couple of comments about federal returning to growth in the second quarter. We are heading into the fiscal year-end for federal. What are your expectations as it relates to any budget slash in the September quarter?

Tom Richards

Katy, I am so hesitant to give federal expectations based on what we have been through in the last couple of years. I do feel, if you kind of look at happened, civilian really had a strong quarter and DOD started to see the increased activity. That would suggest to you increased momentum. But I think I would careful suggesting we will have a normal, if you can say that word anymore, normal end of the year federal budget flush. But activity would suggest continued growth.

Operator

(Operator Instructions) Our next question comes from Bhavan Suri with William Blair. Your line is open.

Unidentified Analyst

This is (indiscernible) on behalf of Bhavan. And I just kind of wanted to ask a question about the geographic alignment success you saw in small business. I was just kind of wondering if you really change anything in your go to market strategy there and kind of how you see this progressing in the back half of the year.

Tom Richards

Well, yes, we did. One of the things we have been working on is the benefit of geographic alignment to the small business team, I tried to call it out in the comments. It now gives us the ability, since our partners are generally aligned geographically, to have the small business team participate in in-market technology, seminars. In-market technology, sales opportunity. That’s a huge benefit for them because it really become the cost effective way to get your message to multiple customers at a single time. When they were not geographically aligned with MedLar, it made it hard for them to take advantage of that. So I don’t want to suggest that just that single initiative drove the improved performance. But it was clearly a contributor in the go to market -- excuse me, the success of the small business.

Operator

I am showing no further questions at this time. I would like to turn the call back to Tom Richards for further remarks.

Tom Richards

Okay. Thank you. Thanks again to everybody for your time today. We are thrilled with the quarter. Obviously, the growth rates and the profitable performance are important parts of what we expect of ourselves. And we are excited about what the second half of the year suggests for us. So as always, if we can help your companies solve some of these technology problems, please let us know. And enjoy the rest of your summer and we will see you in the fall. Thanks, everybody.

Ann Ziegler

Thank you.

Operator

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

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Source: CDW's (CDW) CEO Tom Richards on Q2 2014 Results - Earnings Call Transcript

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