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CDW Corporation (CDWC)

Q4 2005 Earnings Conference Call

January 24th 2006, 8:30 AM.

Executives:

John Edwardson, Chairman, CEO

Barbara Klimstra, VP Investor Relations

Jim Shanks, EVP

Harry Harczak, EVP

Analysts:

Matt Sheerin, Thomas Weisel Partners

John Coyle, JMP Securities

Brian Alexander, Raymond James & Associates

Bernie Mahon, Morgan Stanley

Bruce Simpson, William Blair & Company

Scott Craig, Banc of America Securities

Arun Sharma, UBS Warburg

Jay Singurski (ph), JPMorgan Chase & Company

Steven Fortuna, Prudential Equity Group

David Manthey, Robert W. Baird & Company

Andy Hargreaves, Pacific Crest Securities

Chuck Thomas, Bessemer Securities

Presentation

Operator

Good morning, ladies and gentlemen and welcome to the Fourth Quarter Earnings Conference Call. At this time all participants are in a listen-only mode. Later we will conduct a question-and-answer session. Please note that this conference is being recorded. 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, sir.

John Edwardson, Chairman

Okay, thank you and good morning to each of you and thank you for joining us to discuss CDW's fourth quarter and full-year results. With me today here on the phone call are Harry Harczak, Executive Vice President, Jim Shanks, Executive Vice President, Barb Klein, Senior Vice President and Chief Financial Officer, as well as Cindy Klimstra, Vice President of Investor Relations. And, of course, before we begin the phone call, Barb will present the Company's Safe Harbor disclosure statement.

Barbara Klimstra, VP Investor Relations

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 provision for 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.

Finally, one logistical item. If you haven't received our press release or the slides for today's call, you can access them from our Website at cdw.com by clicking on Investor Relations on the left side. Click on Web slides for the supporting materials.

John Edwardson, Chairman, CEO

Okay. Thank you, Barb, and thank you to the hard work and dedication of CDW co-workers. 2005 was another record year for CDW as we continue to take market share and deliver profitable growth to our shareholders. We did set several new records this year, including revenue of 6.3 billion, average daily revenue of 24.7 million, net income of 272 million, and diluted earnings per share of $3.26.

Average daily revenue for the year was up 10.1%, outpacing market growth. Annualized revenue, a very important measure, annualized revenue per co-worker was 1.55 million this year compared to 1.50 million in 2004. We also achieved our objective of increasing that income at a rate faster than the rate of growth in revenue. During the year we returned nearly 300 million to you, our shareholders, through share repurchases, plus dividends. Our total share repurchases of 258 million were up 200% compared to a year ago.

If you turn to the third slide on the Webcast you can see our summarized financial results for the fourth quarter this year, which was our strongest fourth quarter in the history of the Company. Average daily revenue for the quarter was 25.5 million, up 8.3% over the period a year ago. Net income grew 12.5% to 70.5 million and diluted earnings per share of $0.86 was up 17.8% over the same period a year ago.

If you turn to the next overhead you can see our return on equity as well as the return on invested capital. In the fourth quarter this year we achieved return on equity of 22.4% and return on invested capital of 43.5%, both very good figures for our Company and certainly for this industry.

As we look at the year in review we accomplished quite a bit in 2005. One of the main things that was accomplished during the year was the opening of the new western distribution center in North Las Vegas. It opened on schedule in December as planned.

Operations there are ramping up on schedule and we are currently shipping. We just did ship, last evening, our first $1 million day from the new facility. By the end of the first quarter of 2006 we will be shipping about 30% of our total daily sales from the new distribution center. For those of you who are interested in our progress we will be conducting on-site tours on March 9th and March 10th in Las Vegas and we will send details of that trip to you shortly.

In addition, there were several new initiatives designed to improve customer service and drive future growth were implemented this year. For example, by further segmenting our customer base we formed our latest vertical and created the CDW healthcare team. We also implemented an industry leading new tool portfolio manager to help our account managers better penetrate existing customer accounts. In addition, in the fourth quarter of this year we began preparations to realign the corporate sector sales force into geographic territories.

While 2005 was a good year, it was not a great year by CDW standards. We do want to live by our philosophy that success means never being satisfied. While we outpaced market growth in the fourth quarter of this year we can and need to do better. In several initiatives in progress such as the geographic realignment of the corporate sales team and we will focus on those initiatives in 2006 that will drive the most revenue growth.

If you turn to the fifth overhead, you can see the long-term goals that we have at the Company. At the core of our business model is to provide a superior customer experience. That means helping our customers achieve their goals by providing them with the right technology advice and the right products they need when they need them. By doing this we be well positioned to achieve our next goal, which is to continue to outpace market growth. To create long-term shareholder value is also our goal, to deliver profitable growth, and finally it will be necessary to continue to build for the future. So we plan to leverage our investments and co-workers in infrastructure and in technology so that we can continue to improve the experience customers have with CDW. As all of you know, the IT industry is constantly changing. To continue to be a leader in our industry, we have to change as well, and we have to change some things to achieve our long-term goals.

As you can see in the overhead number six, we recently updated our growth strategies. They are to capture a greater share of our customer's IT spending, to grow the number of customers that we do business with, to grow our addressable market, to optimize our sales and marketing model, to give our customers an unmatched customer experience, and to do things better, faster and cheaper so that we can drive sales, and to use our co-workers and culture, which we think are the best in the country and the best in the industry, to help gain more market advantage.

To achieve these long-term goals I recently announced changes and responsibilities for several executives of the Company, and I would like to go through those quickly again with you.

First, Jim Shanks, Executive Vice President, is now heading the entire sales organization, both the corporate and public sector sales group for the Company. He will be working to motivate the sales team to achieve further productivity gains to improve sales, tools and training and to advance the skills and sales management team. Jim will also be responsible for driving revenue growth through the further segmentation of CDW's customer base and for refining and implementing the geographic realignment of the corporate sales organization.

Harry Harczak, Executive Vice President, is now responsible for our purchasing, marketing and business development activities. Harry will leverage his experience as CDW's Head of Corporate Sales and Chief Financial Officer in the past to further improve our partner relationships. He will also evaluate incremental sources of growth for the Company including potential acquisition candidates.

Diane Primo, Vice President and Chief Marketing Officer will continue in the role of developing and executing CDW's marketing strategies and programs. Diane will work with Harry and with Jim together to execute the strategies that she has put in place designed to enhance customers' experience and to drive revenue growth of the Company.

Doug Eckrote, Senior Vice President Operations will continue to lead our operations and customer service functions of the Company. A key focus for Doug this year will be keeping the ramp-up of the operations of the western distribution center on schedule, balancing the operations between our two distribution centers for optimal efficiency and improving service to each location.

In addition, Doug's responsibilities will continue to improve and expand our customer services, and we will be looking for new things to do in customer services that our customers are requesting of us as we go through the year.

So once again, we had a great year. We attribute that solid performance to our 4300 co-workers who are constantly striving to provide the best customer service in the industry and deliver profitable growth for you. As a testament to their spirit, we'd like to point out that CDW once again made the Fortune Magazine's esteemed list of the 100 Best Companies to Work For, for the eighth consecutive year. We are very proud of this accomplishment.

Jim Shanks will now address revenue results and items related to the sales force. Following him, Harry Harczak, will discuss product trends and Barb will address financial results. Here is Jim.

Jim Shanks, Executive Vice President

Thank you, John. The corporate sector achieved a new quarterly sales record in the fourth quarter of 2005. Total sales were 1.129 billion in the fourth quarter of 2005 which had 63 billing days, compared to 1.073 billion in the fourth quarter of 2004, which had 64 billing days. Average daily sales for the corporate sector in the fourth quarter of 2005 were 17.925 million, representing a 7% growth over last year. The quarter ended on a weak note partially due to softness in product categories of notebooks and accessories and desktops and servers.

Our public sector, CDWG, achieved a record fourth quarter and generated total sales of 478 million in the fourth quarter of 2005 compared to 435 million in the fourth quarter of 2004. Average daily sales for the public sector segment in the fourth quarter of 2005 were 7.583 million representing an 11.7% growth over last year. Areas of particular strength included our healthcare and state and local government customer channels.

As John mentioned, we launched a number of new initiatives in 2005. Some of these had a direct impact on the sales organization, such as the consolidation and transfer of all healthcare accounts to public sector, which was completed in the third quarter.

During the fourth quarter, we had additional initiatives in progress. We focused on those projects that we believe will best drive further growth. We are working quickly and efficiently to begin implementation of these projects as soon as possible. One such undertaking is the geographic realignment of the corporate sector sales force which is designed to further segment our customer base by geography similar to the public sector.

We are on track to launch the geographic realignment of corporate sector in the first quarter of 2006. While it is difficult to quantify, we believe the uncertainty surrounding the structure and implementation of the geographic alignment was a factor in the corporate sector sales results in the fourth quarter of 2005.

On December 31, 2005, our sales force numbered 2,153 co-workers, which was a gain of 7% from December 30, 2004. During the year, we increased our sales force by a net new 141 co-workers, exceeding our previously stated target of 100 to 125. We also increased the number of our advanced technology specialists which are included in the sales force count, to 275, compared to 200 last year. Sales force retention also improved versus last year. In the fourth quarter of 2005 the percentage of sales force turnover was in the mid-teens while one year ago it was in the mid-20s. For 2006 we plan to add 100 to 200 net new sales force co-workers.

On Slide 7, average daily sales per average sales force co-worker was approximately $12,100 for the fourth quarter of 2005. On a year-over-year basis we were able to maintain our productivity levels even as the average selling price of products continued to decline. This metric is affected by both the timing of new hires and sales seasonality. As we continue to grow the sales force, we remain focused on improving productivity across our entire sales organization.

Slide 8 shows that the Web generated approximately 454.6 million in direct on-line sales for the fourth quarter of 2005, which was just shy of our record in the third quarter of 2005 of 455.3 million. Direct online sales were 28% of the sales in the fourth quarter of 2005, and increased 17% over the fourth quarter of 2004.

Harry will now cover product trends.

Harry Harczak, Executive Vice President

Thanks, Jim, and good morning all. Turning to Slide 9 you will see our product mix for the fourth quarter of 2005 compared to our product mix for the fourth quarter of 2004. Once again, software was our largest product category comprising 17.1% of sales, desktop computers and servers were second at 14.5%. Data storage devices were third at 13.9%. Notebooks and accessories was our fourth largest category at 11.9%, with printers the fifth largest category at 11.4%. Growth rates by product category are shown in slide 10.

Net count products grew 16.4% and data storage devices increased 14.5% versus the prior year. These categories were positively impacted by continued demand for security products, routers and switchers, power and telephony. Storage demand has been positively impacted by customers' needs to store more data and protect against data loss.

Software grew 13.6%. Storage, security and document management categories were particularly strong in this category. Revenue growth for video was 9.3%. Declining average selling prices helped drive double-digit unit growth as demand for wide format, LCD and plasma products continues to increase. Printers increased 4.3%. ASPs continued to fall and demand continued to shift to faster mono lasers, faster color lasers and multi-function printers.

Slide 11 shows the change in revenue, unit volume and average selling prices for notebook CPUs as well as desktop and server CPUs. The notebook and accessories category decreased by 7.7%. The overall category was impacted by lower sales of handhelds and PDAs. To enhance our competitive position we have shifted most of our sales of Blackberry devices and smartphones to a carrier model. This means we are bundling the sales of these products with carrier service contracts in which we only recognize a commission fee, not the sale of product. This positively impacts margins but we do not recognize the hardware sale on the top line in this type of transaction.

Notebook CPU revenue decreased 4.7% and unit volume was down 2%, while the average selling price decreased 2.7% from a year ago. ASPs continued to fall on certain product lines, and we saw a slight decrease in unit volume. One key manufacturer continues to struggle with their product line and competitive pricing position, which we expect to be resolved in the first quarter of 2006. In addition, Apple continued to move business to direct sales channels. Even though we still have a strong percentage of their channel business, Apple's overall channel sales are lower compared to a year ago.

We have a two-pronged attack to improve our notebook performance. The first element of our refresh, renew and upgrade program, which is targeted to existing customers who buy notebooks from us. The second prong of attack is our notebook penetration strategies, which are focused on current customers who do not buy the notebook category from CDW. All efforts are collaborative programs built with our top partners.

Revenue from desktop computers and servers increased 2.8% and unit volume increased 1.5%, while the average selling price increased 1.4% from the prior period. In the desktop category demand increased for thin, quiet products and workstations while Apple desktop sales continued to decline as a result of Apple moving business to direct sales channels. In the server category results were influenced by a number of factors. In general, we saw certain products impacted by increased adoption of virtualization and overall server consolidation. In addition, we had certain allocation issues from one key vendor on one type of server due to product transitions.

Barb Klein will now comment on other key items effecting fourth quarter financial performance.

Barbara Klimstra, VP Investor Relations

Thank you, Harry. As John mentioned, we outpaced market growth and delivered record financial results in both the fourth quarter of 2005 and for the year 2005. Gross profit margin in the fourth quarter of 2005 was 15.5% compared to 14.8% in the fourth quarter of 2004, and within our stated objective range of 14.75% to 15.5%. The increase over 2004 was primarily due to stronger product margin, increased net service contract revenue and a larger amount of cooperative advertising funds classified as reduction of cost of sales.

We had an increase in marketing activities and related cooperative advertising in 2005 and virtually all cooperative advertising funds were reclassified from selling, general and administrative expense to a reduction of cost of sales. The positive impact from these items was partially offset by a lower level of vendor incentives due to changes by vendors in their programs.

Advertising expense was 28.5 million in the fourth quarter of 2005 and 23.3 million in the fourth quarter of 2004, an increase of approximately 23%. We continue to execute the integrated branding campaign that was launched in early 2005.

Slide 12 shows our operating statistics. Selling and administrative expenses were 7% of sales in the fourth quarter of 2005 compared to 6.5% in the fourth quarter of 2004, and increased 15% compared to the prior year.

The increase in selling and administrative expenses in the fourth quarter of 2005 is primarily the result of increased payroll costs as the result of a continued investment in expanding CDW sales force and increased payroll cost for a larger number of co-workers to support a larger and growing business. The increase also included approximately $1.3 million of startup costs related to the opening of the Company's new distribution center in North Las Vegas, Nevada.

In addition, items associated with the previously announced modifications to the Company's stock option program were reflected in selling and administrative expenses, including $1.3 million of expense went into additional profit sharing contribution for 2005 to the 401(k) plan of $1,000 per co-worker, and a 3.7 million charge in connection with the acceleration of vesting of options for co-workers through the manager level on December 31, 2005.

The expense for these items was partially offset by a reduction of $5.3 million for an accrual of a company-wide incentive bonus program based on a partial achievement of specific financial objectives for 2005. Our operating margin of 6.7% in both the fourth quarter of 2005 and 2004. Our operating margin objective for 2006 is 6.1% to 6.6%. As we indicated on our third quarter earnings call, we expect to be at the lower end of that range in the first quarter of 2006 and at the upper end of the range by the end of 2006, and to return to the objective of 6.5% to 7% in 2007.

As a reminder, the objective for 2006 excludes the impact of stock option expense under the new accounting standard that became effective for CDW on January 1, 2006. It also excludes payroll tax expense applicable to any stock option exercises relating to stock options for which vesting was accelerated as of December 31, 2005.

We previously indicated that stock option expense related to the new accounting standard was estimated at $16 million pretax for 2006. As you would expect, this calculation continues to be refined and we now expect that the expense for 2006 will be in a range of $16 million to $17 million pretax. This expense will be approximately equally phased over the quarters in 2006. As is true for all U.S. companies, when options are exercised payroll tax applies to both individuals and the Company. We do not know how many of our co-workers will decide to exercise their now vested options or how many options they will exercise. However, we wanted to give you an idea of the potential increase in payroll tax expense associated with any stock option exercises from the accelerated stock options.

If we assume that all accelerated options that can possibly be exercised are exercised, assuming the stock price of $50 on the low end and $60 on the high end, payroll taxes associated with the exercise could be in the range of $2.5 million to $3.5 million for the year 2006.

If all of these accelerated options are exercised in a particular quarter the impact could be $3 million to $4 million in that quarter. The reason it could be larger for a given quarter than for the year is that co-workers would then reach the earnings limit on which FICA is calculated earlier in the year.

We chose a price range of $50 to $60 just as a means to provide an example and it is not in any way predictive of where we think the stock price will be in 2006. As we have done historically we will not update our objectives during any quarter.

The effective tax rate for the fourth quarter of 2005 was 36.3% compared to 39.5% for the fourth quarter of 2004. The tax rate of 36.3% for the fourth quarter of 2005 reflects an adjustment to the overall effective tax rate to arrive at a combined rate of 37.2% for full-year 2005.

The primary reason for the year-over-year decrease is a result of collecting state sales tax, which began in the second quarter 2005. CDW had to register to do business in all states in order to collect sales taxes, which makes the Company subject to state income tax. Income tax rates and apportionate factors vary across states.

This change in effective tax rate increased earnings per share in the fourth quarter of 2005 compared to the fourth quarter of 2004 by approximately $0.04.5 per share. The decrease in the effective tax rate from 2004 to 2005 had a positive impact on earnings per share of approximately $0.13 for full-year 2005. On a sequential quarter basis, the effective tax rate that we provided in the third quarter for the remainder full-year 2005 of 37.4% compared to the actual rate of 36.3% for the fourth quarter, increased earnings per share by approximately $0.01.5 per share.

The effective tax rate for 2005 is estimated at 37.5%. This increase in the effective tax rate from 2005 to 2006 is due primarily to increases in certain states' tax rates. We repurchased about 700,000 shares of our stock at a total cost of $39 million in the fourth quarter of 2005.

As shown in slide 13, during 2005 we spent approximately $258 million to repurchase 4.6 million shares at an average price of $56.52 per share. Compared to the prior year, share repurchases made throughout 2006 had a positive cumulative impact on earnings per share of approximately $0.03 a share in the fourth quarter and $0.06 per share for full-year 2005. On a sequential quarter basis, this positively impacted earnings per share for the quarter by approximately a half a cent per share.

We have 2.2 million shares remaining under the current share repurchase authorization which expires in April 2007. Slide 12 shows our share repurchase and dividend history.

In total we returned nearly $300 million to our shareholders in 2005.

Turning now to some balance sheet metrics. Inventory turns on an annualized basis were 25 times in the fourth quarter 2005 compared to 24 times in the prior year. Our objective remains 25 turns annually. We do expect that inventory turns will be lower than this objective as the western distribution center continues to ramp up and inventory is balanced between the two distribution centers. Accounts receivable day sales outstanding were 36 days at the end of the fourth quarter of 2005 compared to 35 days at the end of the fourth quarter of 2004. Our DSO target remains between 35 to 37 days.

We ended the year with approximately $610 million in cash, cash equivalents and marketable securities. Cash flow from operations was approximately $65 million in the fourth quarter of 2005 and $304 million for full-year 2005. Total capital expenditures in 2005 were $49 million.

With regard to segment results in the fourth quarter of 2005, corporate sector sales increased 5.3% and operating income increased 5%. Public sector sales increased 9.9% in the fourth quarter compared to the fourth quarter of 2004 while operating income increased 11.5%. Operating income for the public sector increased at a faster rate than sales primarily to improve gross margins.

Headquarters and other expenses increased from $6.7 million in the fourth quarter of 2004 to $8 million in the fourth quarter of 2005, primarily due to a larger number of co-workers to support a larger and growing business and increased depreciation expense related to capital investment expense made in 2004 and 2005.

Headquarters expense also included $3.7 million of expense for acceleration of unvested stock options as of December 31, 2005 for co-workers through manager level, and a reduction of $5.3 million for an accrual of a company-wide incentive bonus program based on partial achievement of specific financial objectives in 2005.

John already talked about the second distribution center in North Las Vegas, Nevada, which began operations as planned in December 2005. We incurred approximately $1.3 million of startup costs in the fourth quarter and $2.7 million of startup costs in 2005 relating to this facility. The operations of the new distribution center are being ramped in a controlled and deliberate manner. On our previous third quarter earnings call, we said that we expected the new distribution center and additional office space would impact selling, general and administrative expenses in full-year 2006 by approximately $17 million incrementally over 2005. This assumption for expenses is still appropriate at this time.

Total capital expenditures for the western distribution center are estimated between $33 million and $35 million. Approximately $26 million was incurred in 2005 and we expect the remainder to be spent in 2006. By the end of the first quarter of 2006 we anticipate that approximately 30% of CDW's shipments will be made from this facility.

In 2006 we anticipate that capital expenditures will be in the range of $45 million to $50 million. This includes approximately 15 to $20 million for office space buildout, approximately 7 to $9 million for carryover spending on the western distribution center and approximately $7 million for IT-related projects.

Thank you for your attention and we will now open the line for questions.

Questions & Answers

Operator

Thank you. We will now begin the question-and answer session. Operator Instructions The first question is from Scott Craig from Banc of America. Please go ahead.

Q - Scott Craig

Good morning. Just quickly, the one comment you guys had discussed with regards to the fourth quarter finishing a little bit weaker than expected, John, can you provide some color around that? Is it a particular segment base, particular geography? Et cetera?

And then secondly, with regards to the sales metric productivity-wise, it's been, you haven't got much growth in it in the last, let's call it two years. I was wondering when we expect to see a productivity improvement on an average daily sales versus average sales force? Thanks.

A - John Edwardson

A couple of things. As we look at where the softness happened to be, and you can see it in product categories mostly in and around the CPU category, and it affected really all the different units. And so it wasn't as if it was isolated in just a single unit. With respect to the productivity issue, we are looking at it two different ways. One is revenue per co-worker, or revenue per sales worker, and the other is the gross profit generated, because much of the newer businesses that we are doing, warranties, service business and some of the software packages, accounting for those is not on a gross revenue basis but on a gross profit basis. So as you look at that in different ways there continues to be productivity improvement, but I have to admit it is difficult, it is like swimming upstream. We've had and continue to have significant price decreases in certain product categories.

Q - Scott Craig

Thanks.

Operator

The next question is from Matt Sheerin from Thomas Weisel Partners. Please go ahead.

Q - Matt Sheerin

Yes, thanks. Just a couple questions regarding the geographic alignment. You said that it had some disruption to the sales activity at the end of the quarter. Can you tell us when the sales workers were told about that and do you expect continued disruptions here or a little bit of a slowdown in sales growth here in the first quarter as a result of that change?

A - Jim Shanks

They were first notified of it about the end of October, and we're working through some of the different roles trying to get them details on account transitioning and the entire process that we'll be using. That should be coming here very shortly. As we mentioned on the call, it's our intention is to get the project underway and started in first quarter.

A - John Edwardson

Matt, one of the things, as you could imagine here, we're talking about hundreds and hundreds of account managers, and literally hundreds and thousands of customers. One of the -- we went through a number of the reasons that it was important to do this on the phone call three months ago, but given the amount of work that we are doing it was necessary to talk to our sales people about this. It was just not possible to keep this quiet until it was time to implement, but it is a massive thing. We think the benefits will be significant, mostly in terms of really identifying where potential growth is and also in working with our partners' field sales forces.

Q - Matt Sheerin

So you're continuing, are you continuing to see some distractions here in the first quarter?

A - John Edwardson

Jim?

A - Jim Shanks

Our comments today are based around the fourth quarter, so we definitely, as we called out, we feel that it was a little bit of distraction during the fourth quarter and we're working very closely with all the account managers as well as management to really take the opportunity to look at some of the best practices that we identified at every other time that we've done realignments like this. This is not something new to the organization. It's important to point out that this is a best practice that we've had for many, many years. It started when we created G, it continued when we split off federal, it evolved even more when we broke state, local, and education apart. And I think we've proved, again, that we have the core capability when we successfully transitioned all of the healthcare accounts into a completely different business unit. So that's what, what we're doing right now is working very closely with the entire sales force making sure that we've identified all those best practices so that when we come out of the gate with the realignment we have done everything possible to mitigate the risk.

Q - Matt Sheerin

Okay. Great. And then could you just give us an idea of what your plans for expanding the sales force this year? You had some good growth last year. Could you give us any specific number that you're targeting?

A - Jim Shanks

Yes, the number that we're looking for 2006 is net new between 150 to 200.

Q - Matt Sheerin

Okay. And would that come later? In other words, not this quarter, because of all the changes taking place?

A - Jim Shanks

Yes, it will come a little later. The main reason why is we want to make sure that we get the alignment done. As a result of the alignment we'll start to identify untapped opportunity and then we'll be able to, we'll be set up to staff our sales force in the areas where we feel we have the best opportunities.

Q - Matt Sheerin

Okay. Thank you.

A - John Edwardson

Thank you.

Operator

Thank you. The next question is from John Coyle from JMP Securities. Please go ahead.

Q - John Coyle

Thank you. Good morning. Jim, just on the geographic realignment I was wondering if you might, as you highlighted, CDW has done in the past particularly with the, in the government sector, and I was wondering if could you just provide a little color on how long that actually took and how that process flowed through?

A - Jim Shanks

It varies quite a bit. When you look at how we did some of the other transitions they were. When we did federal, we did that very quickly. State and local, we evolved to regions over about a two-year time period. That is, when we looked to healthcare, however, we did the entire healthcare realignment within 30 days, 60 days, so we were able to apply some of the lessons learned and get through it quite quickly to really do everything possible to get rid of the uncertainty that goes along with that kind of a transition period.

A - John Edwardson

John, one of the issues is that when we have done this over the years, we have typically done with it 5% to 10% of the revenue, and this is a little bigger project. We'll be trying to get it done as quickly and with as little disruption as possible, but there will be a number of customers accounts that we'll be moving and that will be affected, but we're trying to minimize that as much as possible. We obviously wouldn't be doing this if we didn't believe the long-term benefits would be significant.

Q - John Coyle

Sure. Okay. Then just changing, I was wondering, Harry, if you could possibly, it sounded like there were access to some products was limited during the quarter. I was wondering if you could provide a little more color on that?

A - Harry Harczak

The one area we commented on limited access was really on a particular server product. It's not our main server category where there's some product transitions. Beyond that, when you get into the notebook line, there's one manufacturer that over the past 18 months or so has been having some difficulty in getting product at the right price points and competitive positioning. They are working through those and we're optimistic that they're going to come out with some new programs in the first quarter.

A - John Edwardson

Okay, John, thank you. Next question.

Operator

The next question is from Brian Alexander from Raymond James. Please go ahead.

Q - Brian Alexander

Yes, just a couple of follow-ups and a couple of questions. On the changes in the geographic alignment for the sales force, I know there's been quite a few questions on this, but John you just alluded in to previous experiences maybe you were impacting 10% of your sales. What do you estimate the percent of sales to be impacted from this move?

And just to make sure I understand, the actual transition will be beginning in the first quarter? None of this was done in Q4 other than informing the sales force?

A - John Edwardson

Yeah, Brian, you can calculate the number of sales in corporate and amount in the public sector pretty easily. We don't know exactly what we will do in corporate at this point in terms of the number of accounts that will be moved. So because we're talking about, you know, what we're trying to determine here is, you know, which individuals will move into which geographic groups, and there's a huge amount of effort here to do this in the least disruptive manner possible. So we'll be looking at where their customers are and moving people accordingly to where they have the most business. So it really isn't possible to make that prediction.

Q - Brian Alexander

Okay. And then another clarification. I thought I heard two different estimates for the net adds in 2006. I thought I heard earlier 100 to 200.

A - John Edwardson

Jim did mention 100 to 200, I think, and it was 150 to 200.

Q - Brian Alexander

Okay. So 150 to 200 is the right range.

A - John Edwardson

Okay. This is his first time at doing this. You have to give him a stake or two, here…

Q - Brian Alexander

I guess another question for Jim. I know the role of, you know, being in charge of the entire sales force is new, but any initial impressions or anything that we should expect that you might do differently than Harry on the corporate side, and I guess as a follow-up to that how committed to the solution edge initiative are you?

A - Jim Shanks

On the first question, this was kind of announced to the entire organization I think it's a little over a week now, week and a half ago, so it's been a lot of time spent making sure that I didn't have the incorrect perceptions. It's one thing to be tightly integrated with the group versus kind of observing them from a distance. It's an excellent team throughout the entire sales force, and the thing that I think we'll find the most is there's a lot of synergy that we're not leveraging right now. So as we get the groups together we're going to start to share best practices back and forth. We're also going to make sure that we're not doubling our efforts. There are some core support opportunities that are currently in individual areas that we can consolidate together and continue to leverage, which will also not only help from a cost standpoint, but identify new opportunities that we may not have seen before. So we're going to make sure that the whole main theme for what we're trying to do is really alignment making sure that as a sales force we are aligned, all pointed in the same direction, and that we're going to also make sure that we have a structure in place that gets everyone focused and targeted on the opportunities.

Right now, prior to segmentation, the opportunity is to kind of really hunt wherever you want, and this way we'll be able to target and focus our sales force to go after opportunities and discover things that they might have missed before.

A - John Edwardson

Brian, we're going to have to keep moving here because we have to have a limit. We have so many people who have questions. So one quick one then we'll move on.

Operator

Sir, please press star one again to ask your question. Your line is now open.

Q - Brian Alexander

Barb, on the 5.3 million accrual, I'm just trying to understand the timing here. Was this something that you anticipated coming into the quarter when you indicated that operating margins would be at the high end of the 6.1 to 6.6, or was it a surprise? And if it was a surprise and it helped margins by over 30 basis points, just trying to understand how you expect it to get to the high end of the range if you weren't expecting this accrual reversal.

A - Barbara Klimstra

Brian, we were working to achieve the financial objectives on which the program was based throughout the year, so it wasn't until we finalized our numbers for the year that we would know where we finished, so we weren't anticipating an accrual reversal because we were working to achieve the objective to pay out the full amount. So, no, we didn't anticipate the accrual reversal because we were working for the objective. I just want to point out, too, that that number has some offsets to it going the other direction. That $3.7 million of stock option expense goes the other direction. That relates to the acceleration of the options that we talked about related to the changes in the option program made earlier this year.

Q - Brian Alexander

I'll leave it at that. Thanks.

A - John Edwardson

Okay. Thanks.

Operator

Thank you. The next question is from Bernie Mahon from Morgan Stanley. Please go ahead.

Q - Bernie Mahon

Hey, good morning.

A - John Edwardson

Good morning.

Q - Brian Alexander

Question for you, Harry, on the products. It seems like notebooks have been pretty weak if you look at on a year-over-year basis for probably the last three quarters or so, and December was particularly weak, down 7% year-over-year, also, desktops this past quarter. Are we going to be able to see kind of a reacceleration and growth there, and do you think they'll get back to, say, double-digit growth, or do you think it's more kind of mid single digits for those two product categories?

A - Harry Harczak

I'm not going to predict the growth rate, but I think as John said in the comments, there's some things that we're not satisfied with in terms of performance and those two categories are key so we're going to have a lot of efforts focused around them. Part of it is working close with our partners. We do have one partner that has negatively impacted whole categories for moving more towards a direct model. We're going to focus on those partners that are willing to work with us. We do have campaigns on around refresh, renew, and upgrade, and we also have some new campaigns in terms of penetrating customers that have not bought those categories from us, which is a significant amount of our customers. So we will have a lot of focused efforts across the organization and with our partners to grow those categories, and we do have a couple of new programs that some of the partners have initiated. Over the past year we've had a couple of our large partners that have come out with some real aggressive price points on entry level models that should help us continue to push some growth there so we'll work closely with them.

Q - Bernie Mahon

So do you think that we're going to see kind of a resumption in growth? I mean, I don't need to know the number, I'm just trying to figure out if we're going to continue to see kind of deceleration or weaker results here.

A - Harry Harczak

Our objective is to grow these categories.

Q - Bernie Mahon

All right, thanks a lot.

Operator

Thank you. The next question is from Bruce Simpson from William Blair. Please go ahead.

Q - Bruce Simpson

Good morning. Good morning. Two questions. First for Jim. Jim, I wonder as you take the reigns here of the broader sales force if you think it's realistic that we might get some acceleration of sales force productivity over the next year or two, and if so what is realistic? Is that likely to be flat year-over-year? Can it go up mid to low single digits? And then I've got a follow-up for Barb.

A - Jim Shanks

Bruce, I'd hate to speculate on that. The one thing I can tell you, though, is we are looking at not just the accounts and the alignment, but we're also going to be looking at that the activities that our sales force performs currently. We're going to be to focusing on the selling activities versus the non-selling activities and trying to make sure that we're leveraging all the resources of the organization to make sure that we're supporting the sales force effectively.

A - John Edwardson

Bruce, on another thing that we hope will have an impact in it is early is the reduction in the amount of turnover in sales force, and as you remember back to Jim's numbers, we have had a significant reduction in turnover in the past 12 months and we are hoping that will bode well for productivity in the future.

Q - Bruce Simpson

It would be really helpful, particularly as you shift to commission-based model in certain product categories, if you could give us some kind of a, like a restated record or a longitudinal record of gross profit dollars per sales person, because if that's really close meter that you think we should be watching, because of the changes in the 02-16 accounting, there's almost no way that we can back that out. So I don't know if you guys want to go back over the last couple of years and give us something that we can begin to track moving forward.

A - John Edwardson

We'll take a look at that. We do it internally. In fact, just did it for the board of directors meeting this week, and Cindy will make a decision about whether that is something she would like to give. Then you've got a question for Barb as well, Bruce?

Q - Bruce Simpson

Yeah, I did. Maybe I misunderstood the guidance but I thought that in the fourth quarter you were anticipating $3 to $4 million in incremental startup expenses for the second distribution center after like about a million in the third quarter.

A - Barbara Klimstra

First of all, it wasn't guidance. We give you an estimate of what we thought we would spend in the fourth quarter and we spent a little bit less than we had estimated, primarily because we didn't hire quite as many people as we had originally anticipated. We're continuing to ramp that up, though, and we're still going to be hiring as we go into the first quarter here of 2006. And we had a little bit lower expenses on rent and utilities as well. So we did our best at giving you an estimate of what the expenses would be, we just came in a little lower than what we thought.

Q - Bruce Simpson

And what was that number in the fourth quarter?

A - Barbara Klimstra

The number was about 1.3 million of costs that we incurred related to the Las Vegas distribution center in the fourth quarter.

Q - Bruce Simpson

Okay. So the balance of whatever didn't get spent in this quarter and will be spent in '06 is still integrated within your 6.1 to 6.6 guidance for the upcoming year?

A - Barbara Klimstra

Yes, as we indicated, we expect about $17 million of incremental expenses relating to the Las Vegas distribution center and the new office space that we're taking in Vernon Hills and downtown Chicago in the 2006 numbers.

Q - Bruce Simpson

Okay. Thanks.

A - John Edwardson

Okay, thank you, Bruce.

Operator

Thank you. The next question is from Ben Reitzes from UBS. Please go ahead.

Q - Arun Sharma

Hi, it's Arun Sharma calling for Ben. Just two quick questions. You mentioned how you saw some ASP decline and difficulties toward the end of the fourth quarter. I was wondering if you would comment on how demand and pricing trends seem thus far into 1Q? And also if could you provide a little more color on the impact of movement of Apple going direct.

A - John Edwardson

We were having a little bit of difficulty hearing you. I think the question was what our demand trends and price trends in the first quarter, and really what we're here to talk about today is the fourth quarter and we just don't have much to say about Q1 at this point.

Q - Arun Sharma

Okay. Second, the follow-up question was, just if could you provide a little more color on the impact of Apple going direct in the quarter, 4Q, if you could quantify that or just provide some more color on that.

A - John Edwardson

Well, I hate to do this again. We really don't want to give too much individual information about different OEMs and partners that we represent. I will say that there was a significant drop year-over-year in Apple revenue and Apple has made a serious effort at moving business away from channel partners and into their source.

Q - Arun Sharma

Okay. Thanks.

Operator

Thank you. The next question is from Jay Singurski (ph) from JP Morgan. Please go ahead.

Q - Jay Singurski

Thanks, good morning. John, just a quick question on the slide on growth strategies.

One of the things that disappeared from the slide was selectively pursuing strategic transactions and the one that kind of came into the slide was grow addressable markets. I was wondering if you could just give us a little bit of color on what your thoughts are now on acquisitions going forward and what exactly you mean by growing addressable markets?

A - John Edwardson

A couple of things. As we look at acquisitions development opportunities, clearly the move of Harry into a position where we could put more effort into this is a signal. It is not on here because we look at it as a way to do a number of things that are listed here.

So, you know, an acquisition could help us move into a product category that we're not in, which would help us get a greater share of customer spending. It could clearly help us grow the number of customers. Growing addressable market would be moving into different services, moving into more sophisticated equipment, so as we look at, we look at the addressable market we have around 115 to 120 billion, so our efforts are getting a bigger share of that market, but the total U.S. market is nearly double that, closer to 240 billion. So what we want to do is move into categories that we're not in, and so that was what we mean by growing the addressable market.

Q - Jay Singurski

Okay. And then just a quick follow-up for Barb. In the release you talked about gross margins up this quarter on stronger product margins, increased net service contract revenue and larger amount of cooperative advertising. I was just wondering if you could give us a little bit of color on where you saw the most contribution and whether this is sustainable going forward?

A - Barbara Klimstra

We don't break out the components of the gross margin. The three items that we listed had the most significant impact of the factors that impact gross margin, and with respect to going forward, what we're telling you is that our objective is to remain in that 14.75 to 15.5% objective. There can be pluses and minuses but that's our objective overall.

Q - Jay Singurski

Thank you very much.

Operator

Thank you. The next question is from Steven Fortuna from Prudential Equity. Please go ahead.

Q - Steven Fortuna

Good morning. Two areas. Two quick areas. First of all, John, as you know, the street kind of has an implicit 10% ADS growth bogey for you guys month in, month out, and you've missed that now in five of the last eight months. I'm wondering, and otherwise a pretty good demand environment for SMB, at least in terms of our take on it. Has there been any change in the competitive dynamics of in terms of the competitive landscape or any change, perhaps, in customer perception of your value proposition? That would be the first question. I've got a follow-up.

A - John Edwardson

If there has been a change we, you know, are certainly not aware that there's been. We do a lot of focus groups and obviously have a lot of interaction with customers. As we're looking at this, we know there's a bogey out there of about 10%, and we are doing everything we believe we can do to get above that number. The market rate of growth is clearly an issue, and as we looked at IDC numbers, you know, over the last seven or eight months, and as we look at their predictions for certain product categories we think we are still doing significantly better than then market, and in most areas double the market rate of growth. So part of this is a market rate of growth issue, and part of it is, we think we can do better, and clearly in Q4 we were not happy with our rate of revenue growth.

Q - Steven Fortuna

And then one follow-up, John. In terms of, maybe you can give us some sense about how much focus does the sales force have on mining new business versus trying to more deeply penetrate existing accounts. And then on that point, do you have some metrics you can share with us that kind of talk about how share of wallet has increased with a particular existing customer over, say, two or three-year period?

A - Jim Shanks

Regarding the customers, our primary and main focus has been getting deeper with our customers. A lot of attention on penetration. We are also looking at customer acquisition as well. We have unique programs that we have in place to try to go out and identify new customers in each of the different segments that we have, not only in public sector but also small business and also medium and large. So as a focus on both the primary has been on penetration, we're going to do more and more on the acquisition side. As far as share of wallet, I don't believe there are any metrics that we share externally as far as where we are share of wallet with our customers.

Q - Steven Fortuna

Thanks.

Operator

Thank you. The next question is from David Manthey from Robert W. Baird. Please go ahead.

Q - David Manthey

Thank you. Good morning. First of all on acquisitions, you mentioned the desire that you have to make them. I was wondering if you'd talk about the opportunities that you're seeing out there? And it's been awhile since we've seen one. What is the, is it your desire to make acquisitions at a certain price, or is it that the opportunities are presenting themselves as the primary issue? And then I just had one second question.

A - John Edwardson

David, we'll have to move on to the second question, and I just won't even try to beat around the bush on this one. I apologize. But this is just a topic that, as you know, is just something that we just can't talk about.

Q - David Manthey

Okay. And then on, so the second question is on attrition rates being lower. You mentioned an overall number. Do you make adjustments or look at that number as it relates to the different strata of the sales force, for example, is the attrition rates in zero to 1-year-old reps also lower?

A - Jim Shanks

We do analyze that at the different stratas, as you referred to it, under different lengths of services, and we did see improvement across the entire board. One of the areas that was always kind of a harder target for us were the newer co-workers to the organization and we definitely saw marked improvement in that category.

Q - David Manthey

Great. Okay. Thank you.

A - John Edwardson

Thank you, David.

Operator

Thank you. The next question is from Andy Hargreaves from Pacific Crest. Please go ahead.

Q - Andy Hargreaves

Wondering on the hardware, the slow growth in hardware. Industry growth seemed to be pretty good. Do you think there was something specific to the SMB space, or was it just specific to you guys?

A - Harry Harczak

I don't know that there's anything specific to SMB. We saw softness across all customer segments, both our small, medium and large segments. So I don't know there's anything specific to SMB in particular.

Q - Andy Hargreaves

Okay. And then from a capital allocation standpoint, do you think that growth opportunities domestically are still the most efficient for you guys to go after as opposed to internationally?

A - John Edwardson

We are looking at growth opportunities both domestically as well as international, and in terms of capital allocation, you know, the amounts of money that we would need to do this do not appear to be significant compared to the resources we have in the Company.

But clearly as we look at risk, we believe there would be less risk closer to home, so we would be looking at domestic opportunities, international. We'd clearly look in Canada since we are already doing business there, but we also are looking in Asia as well.

Q - Andy Hargreaves

Okay. Thanks.

Operator

Thank you. The last question is from Chuck Thomas from Bessemer. Please go ahead.

Q - Chuck Thomas

Thank you. My question was already answered.

A - John Edwardson

Okay, Chuck, thank you. With that, that concludes the phone call. I would like to thank you for your support, and one last comment, if you are already a customer of CDW, we appreciate your business. If you are not, we would welcome the opportunity to earn your business. Give us a phone call at 1-800-800-4 for CDW or visit us on our Website. Thank you very much. We will be back in three more months.

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 Corporation Q4 2005 Earnings Conference Call Transcript (CDWC)
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