CDW (CDW) Q4 2016 Results - Earnings Call Transcript

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CDW Corp. (NASDAQ:CDW) Q4 2016 Earnings Call February 7, 2017 8:30 AM ET

Executives

Thomas E. Richards - CDW Corp.

Sari L. Macrie - CDW Corp.

Ann E. Ziegler - CDW Corp.

Analysts

Matthew Cabral - Goldman Sachs & Co.

Amit Daryanani - RBC Capital Markets LLC

Matthew Sheerin - Stifel, Nicolaus & Co., Inc.

Shannon S. Cross - Cross Research LLC

Sherri A. Scribner - Deutsche Bank Securities, Inc.

Rich J. Kugele - Needham & Co. LLC

Adam Tindle - Raymond James & Associates, Inc.

Kathryn Lynn Huberty - Morgan Stanley & Co. LLC

Operator

Good day, ladies and gentlemen, and welcome to the CDW 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, and instructions will be given at that time. As a reminder, this conference is being recorded. I would now like to hand the floor over to Tom Richards, Chief Executive Officer. Please go ahead, sir.

Thomas E. Richards - CDW Corp.

Thank you, Karen. Good morning, everyone, and thank you for joining us today to discuss CDW's fourth quarter and full-year 2016 results. With me in the room are Ann Ziegler, our Chief Financial Officer; Chris Leahy, our General Counsel; and Sari Macrie, our VP, Investor Relations.

I'll begin our call with an overview our full year and fourth quarter performance and share some thoughts on strategic progress and expectations for 2017. Then I'll hand it over to Ann who will take you through a more detailed review of the financials. After that, we'll open it up for some questions.

But before we begin, Sari will present the company's Safe Harbor disclosure statement.

Sari L. Macrie - CDW Corp.

Thank you, Tom. Good morning, everyone. Our fourth quarter and full-year 2016 earnings release was distributed this morning and is available on our website, investor.cdw.com, along with supplemental slides that you can use to follow along with us during the call.

I'd like to remind you that certain comments made in this presentation are considered forward-looking statements under the Private Securities Litigation Reform Act of 1995. Those statements are subject to risks and uncertainties that could cause actual results to differ materially. Additional information concerning these risks and uncertainties is contained in the Form 8-K we furnished to the SEC today and in 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 including non-GAAP earnings per share. 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 today.

Please note that all references to growth rates or dollar amount increases in our remarks today are versus the comparable period in 2015 unless otherwise indicated. In addition, all references for growth rates for hardware product, software and services today represent North American sales only and do not include the results from CDW UK.

There was one fewer selling day in fourth quarter 2016 compared to the fourth quarter of 2015. The number of selling days for the full year was the same in both 2016 and 2015. Our sales growth rate references during the call, we'll use average daily sales unless otherwise indicated.

A replay of this webcast will be posted on our website by this time tomorrow. I also want to remind you that the conference call is property of CDW and may not be rerecorded or rebroadcast without specific written permission from the company.

And with that, I'll turn the call back to Tom.

Thomas E. Richards - CDW Corp.

Thanks, Sari. 2016 was a year of both strong financial performance and strategic progress. For the year, we delivered a net sales increase of 7.6% with excellent profitability. On a constant currency basis, net sales grew 8.3%. Adjusted EBITDA increased 9.7% and non-GAAP earnings per share increased 16.9%.

Organic constant currency net sales which exclude results from our August 2015 acquisition of CDW UK for the first seven months of the year increased 4.4%. We also delivered strong profitable growth in the fourth quarter. Net sales increased 3.8% on an average daily basis and 5% on a constant currency basis. Adjusted EBITDA increased 6.3% and non-GAAP earnings per share increased 18.2%.

This was the first quarter that CDW UK was apples-to-apples. 2016 performance was driven by the combined power of our nimble business model, balanced portfolio of customer end markets and diverse product suite.

Let me briefly walk through each of these and how they contributed. First, our nimble business model, which enables us to capitalize on current market trends. In 2016, we saw four market trends, optimization of infrastructure, designing securely, increasing use of more efficient architectures and ongoing integration of software into solutions. Each of these trends influenced our 2016 results.

The first trend, optimization of existing infrastructure is being accomplished by extending asset lives or enhancing capacity. Extending asset lives led to the customer and partner focus on warranties while focusing on enhancing capacity led to increased use of virtualization software. Customer spending for both of these categories increased by significant double-digits in 2016.

The second trend, customer focus on designing IT securely is where security is being viewed as a core object of the IT mission. Our security practice maintains excellent momentum throughout the year, also posting a significant double-digit increase.

The third trend, adopting more cost-efficient and flexible architectures is all about handling growth. To do this, customers are adopting both hyper-converged and cloud-based solutions. Cloud adoption increased across the business particularly for certain workloads.

Spend on cloud-based security increased more than 75%, while spend on mobility and backup and recovery increased more than 50%. Hyper-converged solutions which deliver more density and lower cost had excellent growth across the business and sales were roughly doubled what they were in 2015.

Finally, we saw the ongoing trend, where a greater portion of solutions are being delivered via software. With software becoming more mission-critical, customers continue to turn to software assurance to protect their investment. Again, generating strong double-digit increases in 2016.

Given our business model, which enables us to pivot where the growth is, we were very successful in capitalizing on these customer trends. 2016 sales of warranties, software assurance and Software-as-a-Service, each increased at multiples of our hardware sales. All three of these solutions are accounted for on a netted down basis, which is why we refer to them as 100% gross margin.

As always, we own the customer relationship, help the customer evaluate options, design a solution, procure it and even implement it. The only difference here is that the accounting treatment cost for only our profits to be accounted for as revenue.

Given our success helping our customers address these needs, we mixed into 100% gross margin items and the accounting for these contributed to our gross profit improvement. They also incrementally compressed our top line by more than 200 basis points compared to 2015.

Netting down primarily impacts our U.S. solutions business, which represents roughly 50% of our U.S. sales. U.S. solutions grew low single-digits for the year, gross profits increased more than twice the rate of sales.

The second driver of our performance this year was the power of our balanced portfolio of end markets. With five U.S. channels, each with over $1 billion in 2016 net sales, and an additional $1.4 billion from our Canadian and UK operations, our diverse end markets help us absorb macro and exogenous impacts on the business.

This diversity was clearly evident in 2016 as Public grew 7.8%, while Corporate increased 1%. Diversity of end markets also impacted Corporate performance. MedLar was flat, while Small Business increased 5%. Public's excellent year was the result of strong Government and Education performance, both of which increased low double digits for the year. Healthcare also increased 3%. Both our Canadian and UK businesses grew high single digits in local currency in 2016.

Our balanced portfolio contributed to fourth quarter results as well. Corporate increased 2.5%. Small Business increased 9% as customer confidence and sales picked up after the election. MedLar increased just over 1%, although MedLar customers seemed encouraged by the potential of an improved economy, and going into 2017, they adopted more of a wait-and-see approach.

Given the slow economy and the ongoing impact on budgets, MedLar customers remained focused squarely on optimization solutions and the use of more efficient architectures, so they could spend what they did have on key priorities like security. That said, we did begin to see the signs of improvement we anticipated, but we did not experience a large year-end budget flush.

Public continued its momentum, up 4.6%. Once again, performance was excellent in K-12, higher ed, and state and local with all three increasing high single-digits or better. These results were tempered by federal performance as several very large client purchase orders were pushed into 2017 for delivery. As expected, Healthcare continued to see lumpy results, up 3% in the fourth quarter.

U.S. solutions, again, mostly impacted by our success in 100% gross margin, were up 1% approximately while transactions increased high single digits. Our international business had a very strong quarter with both Canada and the UK growing double digits in local currency. The final driver of our performance was our diverse product suite of more than 100,000 products from over 1,000 leading and emerging brands, which ensures we are well positioned to meet our customers' evolving needs and market trends.

Our broad portfolio enables us to follow our customers and capitalize on market trends, and ultimately that is what determines the drivers of our growth. You can see the impact of these trends in both our full year and fourth quarter growth where hardware increased 3%, software increased 8% and services increased 12%.

Let's take a quick look at some of the drivers in the quarter. We had strong results in notebooks, mobile devices and desktops. Together, they delivered double-digit growth. While we saw increases in netcomm, hardware and federal state and local and small business, they were not sufficient enough to offset the clients in K-12 resulting from continued delays in E-Rate funding and MedLar where customers were extending the lives of network assets via warranties.

Both service and storage increased in Public. Meaningful increase in emerging technologies like flash storage and hyper-converged were not enough to make up for the delays I mentioned in Corporate purchases. Another key driver of hardware sales was strong growth in both video projection and collaboration. Everywhere you go today, either in the classroom or the corporation, you see AV or video conferencing equipment to enable collaboration and communication. And we are following our customers here as well.

Growth in video projection hardware including digital signage and video screens was excellent throughout the year and the fourth quarter was no exception, posting increases across all of our customer end markets and growing high-single digits. Collaboration hardware increased low-double digits in 2016 and continued its strong performance in the quarter. Growth from these two categories combined more than offset the declines in storage and servers, a great example of the power of our diverse portfolio.

Software continued to be powered by strong performance in security. Focus on optimization also drove excellent gains in virtualization and software assurance. We continued our double-digit growth in services in the fourth quarter. We had meaningful increase in warranties that cover network infrastructure, storage and servers. Combined warranty growth was in the high teens.

2016 was a year of both financial and strategic progress. During the year, we achieved three key strategic milestones. First, we surpassed $1.5 billion in customer spend on workloads delivered via cloud solutions. As you would expect, security was one of the top five workloads we delivered via cloud in 2016.

Cloud-based solutions clearly contributed to the second 2016 milestone we achieved, surpassing $1 billion of customer spend on security. That is just one piece of the mosaic. Our security practice delivers solutions across multiple platforms: cloud, hardware, software and services, for more than 50 different partners, including new partners in emerging growth areas like next-gen endpoint protection and incident response.

Let me share an example of how our broad portfolio of products and deep technical expertise is helping our customers. A long-term global consumer products customer needed to strengthen its defense strategy against sophisticated cyber attacks. Working with their IT team, we formulated the strategy, created the project charter, the scope, the goals and roles. We designed a full-scale global incident response plan that delivers enterprise-wide visibility, detection expertise and investigation workflows that leverages a cloud-based threat analytics platform. While developing the plan, we found breaches that led to new approaches for endpoint security, firewall segmentation and implementation, and improved user authentication tools.

We also migrated the customer's contact center to a new platform and help deploy a production pilot for private cloud. This comprehensive approach reached across our entire security portfolio and included consulting, hardware, software and cloud. It generated nearly $1 million in 2016 net sales. In addition, it will generate roughly $200,000 in annual recurring revenue over the next three years.

The third milestone we achieved in 2016 relates to CDW UK. In 2016, we generated over $75 million of customer spend in cross referrals from the U.S. to the UK and from the UK to the U.S., great results so far, and this is only the beginning.

These milestones were possible because of our ongoing investment in our three-part strategy for growth. In 2016, we made progress against all three. Our first strategy is to capture market share and acquire new customers. In 2016, we continued to invest in our co-workers. Investments included seller productivity tools that add capacity including ongoing training and tools and enablement infrastructure like our new services recommendation engine.

We launched our new IT Orchestration Campaign, highlighting the role we bring in bringing the right people and solutions and partners together to simplify IT for our customers and delivering exceptional customer outcomes. We extended it to the UK when we rebranded CDW UK. Our Dell partnership plan moved ahead as planned, and we easily delivered our target of 150 basis points of incremental growth.

We made outstanding progress against our first strategy in 2016, though our final market numbers are not yet available, given U.S. GDP growth of 1.6%, we estimate our customer spend growth easily exceeded our annual target of outgrowing U.S. IT market by 200 to 300 basis points on an organic constant currency basis.

Our second strategy is to continuously enhance our ability to deliver high-growth integrated solutions. This is vital to our ability to stay relevant to our customers, and we accomplish this by adding new partners and capabilities and leveraging our deep technical resources, so we meet our customer's priorities as they evolve. In 2016, we added more than 70 new partners in fast-growing categories like endpoint security and hyper-converged appliances.

Our third strategic priority is to expand our service capabilities. In 2016, we opened another market and now have technical specialists, service delivery and sales co-workers in more than 25 major metro markets in the U.S. and UK. We also added managed services for Azure to our service portfolio, leveraging our 24x7 enterprise command center and launched a new network security services team.

These excellent results would not have been possible without the efforts of our dedicated and talented team of 8,500 co-workers including more than 1,000 CDW UK co-workers who joined us in late 2015. Our customers and partners tell us that our co-workers are a true source of advantage in a highly competitive market, and are a key reason why we are successful delivering industry-leading profitable growth quarter-after-quarter and year-after-year.

Let me close with a few thoughts about what we expect in 2017. We are cautiously optimistic that U.S. GDP will accelerate in 2017 and currently look for the U.S. IT market to grow somewhere between a little above 2% and a little above 3%. With economic forecasts calling for acceleration throughout the year, we expect faster growth in the back end of the year.

For CDW UK and Canada, we currently expect IT growth in local currency for both markets to come in below the U.S. in the 1% range. We expect performance of at least 200 to 300 basis points better than each market in local currency. With an improved economy, we expect hardware sales to accelerate.

At the same time, we expect customers to remain focused on optimization, secure design, efficient architectures and embedded software.

We continue to target outperforming the U.S. IT market by 200 to 300 basis points in constant currency. As we always do, we will refine our views of market growth as we move through the year.

Given our outlook for improving market conditions, we currently looked at between 100 and 125 net new customer facing co-workers in 2017. You may recall we added nearly 200 new North American customer facing co-workers and just over 700 from the UK in the second half of 2015. We shared on our fourth quarter call last year that given the uncertainty in the economy, we liked the flexibility this gave us to either absorb the capacity and onboard these new co-workers or add additional co-workers depending on market conditions.

As we move through the year, we opted to focus on on-boarding and productivity initiatives, ending up the year with 12 internal customer-facing co-workers supplemented by 77 full-time service equivalents. We're off to a good start on our 2017 hiring plan with 47 new starts in our January sales class. You should expect us to refine our hiring plan as we move through the year and adjust as necessary.

In 2017, you should also expect us to continue execute on our three-part strategy to ensure we are well-positioned to continue to generate profitable growth. A great example is the January 1 launch of our new Small Business segment. By separating Small Business from our Corporate segment, we expect to drive increased focus and accountability for both segments. Our new Small Business unit is focused on going to market the way their customers do.

To achieve our vision to be Small Business customers' first choice for technology, we are aligning co-workers and digital resources that point directly at this fast-growing market which is why we moved our e-commerce team to Small Business. As we execute on all three of our strategic priorities, we will enhance our value proposition to both customers and partners, ensure we evolve with the market, and continue to capitalize on current trends. By doing so, we intend to continue to profitably grow faster than the market while generating superior returns today and in the future.

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

Ann E. Ziegler - CDW Corp.

Thanks, Tom. Good morning, everyone. As Tom indicated, our full year and fourth quarter financial results reflect the combined power of our nimble business model, balanced portfolio of channels, and breadth of product offerings. They also reflect the progress we are making against our long-term financial strategy to drive strong cash flow, deliver double-digit earnings growth, and return cash to our shareholders.

Turning to our P&L, if you have access to the slides posted online, it will be helpful to follow along. I am on slide 8. Consolidated net sales were $3.5 billion, 2.2% higher than last year on a reported basis, and 3.8% on an average daily sales basis as there was one less selling day this quarter than last year. Average daily sales were $56.3 million.

On a constant currency basis, consolidated average daily sales were 5% higher than last year. Currency in Q4 was driven by the British pound to U.S. dollar translation, shaving 120 basis points off of growth. Currency impact was 60 basis points higher than last quarter as we experienced a full quarter's impact from British pound translation. There was no currency impact from the Canadian to U.S. dollar translation.

On an average daily sales basis, North American sequential sales were down 3.7% versus Q3 2016, which is a slightly greater decline than recent Q4 seasonality and higher than we expected due to the delay in federal shipments.

Gross profit for the quarter increased 3.6% to $578 million. Gross margin in the fourth quarter was 16.5%, 20 basis points above last year, and was once again favorably impacted by a higher mix of netted down revenues including SaaS, software assurance, and warranties. Gross margin expansion also reflected higher vendor partner funding. Together, these increases more than offset a decline in product margin.

Turning to SG&A on slide 9, consolidated reported SG&A including advertising expense was roughly 1% higher than last year, and includes $11.1 million of non-cash equity compensation, $1.1 million of acquisition and integration expenses, and $1 million of historical retention costs and other expenses. Non-cash equity-based compensation expense remained flat year-over-year. Our adjusted SG&A which also increased 1% was primarily driven by advertising. Co-worker count was up roughly 50 to just over 8,500 as of December 31, 2016.

Our adjusted EBITDA for the quarter was $273.7 million, up 6.3%. This delivered a margin of 7.8% up 30 basis points over last year driven in large part by the impact netted down revenues had on gross margin.

Turning to the rest of the P&L on slide 10. Interest expense was $33.9 million, $4.5 million lower than last year's Q4 level, reflecting the impact of a positive mark-to-market for our interest rate caps, and a 25-basis point lower LIBOR floor rate on our term loan, which we refinanced in the third quarter.

Turning to taxes, our effective tax rate was 36.6% compared to 37% in last year's Q4. This resulted in a tax expense of $59.6 million versus $52.4 million. Fourth quarter tax expense included the positive impact of mixing into international earnings.

On a GAAP basis, we earned $103.2 million of net income. Our non-GAAP net income, which better reflects our operating performance, was $140.4 million in the quarter, up 13.4% over last year.

As you can see on slide 11, non-GAAP net income reflects after-tax add-backs that fall in four general buckets: the ongoing amortization of purchased intangibles, non-cash equity compensation, acquisition and integration expenses and other non-recurring or infrequent income or expenses. With Q4 weighted average diluted shares outstanding of 163 million, we delivered $0.86 of non-GAAP net income per share, up 18.2% over the prior year.

Turning to year-to-date results on slide 12. Revenue was $13.9 billion, an increase of 7.6% on a reported and average daily sales basis. On a constant currency basis, consolidated net sales growth would have been roughly 60 basis points higher. Gross profit for the year was $2.3 billion, up 10%. Gross profit margin was 16.6%, up 30 basis points, reflecting the impact of netting down end partner funding. Adjusted EBITDA was $1.1 billion, 9.7% above 2015. Net income was $424 million in 2016, and non-GAAP net income was $569 million versus $504 million in 2015, up 13%.

Turning to our balance sheet on slide 13. On December 31, we had $263.7 million of cash and cash equivalents and net debt of $3 billion as compared to $3.2 billion at December 31, 2015. Our cash plus revolver availability was $1 billion. Net debt to trailing 12-month adjusted EBITDA at the end of Q4 was 2.7 times within our target range of 2.5 to 3 times.

Our current weighted average interest rate on outstanding debt is 4.3%, 10 basis points below last year. During the quarter, we purchased interest rate caps on an additional $200 million notional amount and now have 1.5% caps on our term loan in the amount of $1.4 billion that will expire in December 2018. With these caps in place, roughly 95% of our outstanding debt is either fixed rate or hedged.

As you can see on slide 14, we maintained strong rolling three-month working capital metrics during Q4. For the quarter, our cash conversion cycle was 19 days, down 2 days from last year's fourth quarter and below our annual target of the low-to-mid 20s. Year-over-year, DPO increased four days and DSO increased three days. DPO increased due to mixing into partners with longer payment terms as well as mixing into sales being netted down, which drives increases in both DSO and DPO. This is because these sales are booked net on the P&L, but our receivables reflect the gross billings to the customer. At the same time, payables are matched against zero cost of goods sold. So, both measures increased. That is why we focus on our cash convergence cycle, because it is the best measure of our working capital efficiency.

Cash taxes paid for the quarter were $94.7 million and cash interest was $27.6 million. Free cash flow for the quarter which we calculate as operating cash flow plus the net change in our flooring agreement less capital expenditures, was $186.2 million (sic) [$186.7 million] (27:59) compared to $9.6 million in Q4 of 2015. For the year, free cash flow was $684.2 million, $400.9 million more than last year. As you may recall, free cash flow in 2015 was impacted by one-time items and timing, which pulled forward roughly $100 million of cash flow to Q4 2014. So 2015 cash flow was $100 million lower than it should have been.

In 2016, in addition to strong operating results, free cash flow was also driven by the addition of CDW UK, mixing into vendors with longer payment terms, new extended terms for a few key vendors that we negotiated in Q4, an year-end payment and invoice timing. The impact of timing which we expect to reverse was approximately $35 million.

During the quarter, we continued to execute against our capital allocation strategy and repurchased 276,000 shares for $12.2 million at an average cost of $44.27 per share. Our capital allocation strategy is comprised of the following four components, which you can see on slide 15.

First, increase dividends annually. To guide these increases, in November 2014, we set a target to achieve a dividend payout of 30% of free cash flow over five years. For this quarter, we will pay a dividend of $0.16 per share on March 10, to shareholders of record as of February 24, up 49% from a year ago. Since the IPO, our dividend has increased nearly fourfold the initial annual level of $0.17 per share.

Second, ensure we have the right capital structure in place. We have set a target to generally maintain net debt to adjusted EBITDA leverage in the range of 2.5 to 3 times. We ended Q4 at 2.7 times. Third, supplement organic growth with tuck-in acquisitions. Our CDW UK investment is an excellent example of this.

And fourth, return excess cash after dividends and M&A to shareholders via share repurchases. During the year, we repurchased 8.7 million shares for $367 million at an average cost of $42.06 per share. At the end of December, we had $642 million remaining on our current share repurchase authorization. In 2016, we returned nearly $450 million to shareholders via dividends and share repurchases.

Our capital allocation priorities support our 2016 to 2018 medium-term target, which you can see on slide 16. These are to grow constant currency 200 to 300 basis points faster than the U.S. IT market, with a targeted adjusted EBITDA margin in the mid-7% range; maintain our net leverage at 2.5 to 3 times; and deliver low double-digit EPS growth in constant currency. You should expect us to use share repurchases and accretive acquisitions to amplify operating results and help achieve this target. Keep in mind that we hold ourselves accountable for achieving our medium-term target on an annual, not a quarterly, basis.

Let me provide you with a few additional comments for those modeling our 2017 financials. I am on slide 17. We expect full-year constant currency growth within our annual medium-term target of 200 to 300 basis points above U.S. IT market growth. Currency headwinds are expected at an annual average rate of roughly 75 basis points in 2017, with greater impact earlier in the year at roughly 110 basis points in the first half. This assumes average annual translation rates of $0.75 to the Canadian dollar and $1.20 to the British pound.

For seasonality, we expect to deliver sales roughly in line with our historical average split of 48% to 49% in the first half, and 51% to 52% in the second half. Keep in mind that based on the normal rhythm of our business, first quarter sales are typically sequentially below our fourth quarter. We will have one less selling day in the third quarter and one more selling day in the fourth quarter.

Given we expect the incremental impact of netting down to stabilize this year as we mix into hardware sales, we look for our annual adjusted EBITDA margin to come in at roughly the same percentage as 2016, which would be above our medium-term target range.

In 2017, we expect our effective GAAP tax rate to be between 34% and 35%. Note that we have not assumed any reduction in the U.S. corporate tax rate. The expected reduction is due to tax benefits related to equity and deferred compensation.

Since we add back non-cash equity expenses to non-GAAP net income, these tax benefits will be excluded from our non-GAAP net income. You should expect us to use our capital allocation priorities, share repurchases and accretive tuck-in acquisitions to help us achieve our low double-digit non-GAAP EPS growth target in constant currency with similar currency headwinds as our top line as we move through the year.

Finally, a few notes for those of you modeling cash flows. First, we expect our annual cash flow to come in between 3% and 3.5% of net sales, above our 2.5% to 3% of net sales rule of thumb, as we continue to benefit from extended terms and netted down revenues. Second, our capital expenditures will be about 0.5% of net sales on an annual basis. We also expect to deliver a cash conversion cycle at the low end of our target range coming in at the low 20s.

As you know, with our typical cash flow pattern, we have strong cash flow in the first quarter due to our sequential sales decline from Q4 and the payment of Q1 cash taxes in Q2. While we expect this pattern to continue, the Q1 2017 amount should be lower as the positive impact we had in Q4 from payment and invoice timing reverses.

For the full year, we expect a cash tax rate in the 32% range to be applied to pre-tax book income before acquisition-related intangibles amortization which is approximately $45 million per quarter. In addition, we continue to pay approximately $20 million in tax annually related to the cancellation of debt income we incurred in 2009. Cash taxes will be lower in 2017 versus 2016, primarily due to tax deductions from discrete items related to equity and deferred compensation payout.

That concludes the financial summary. Before we open it up for Q&A, let me briefly address the SEC investigation we disclosed in 2015, relating to vendor partner program incentives. We have no further updates since the last conference call. We continue to cooperate fully with the SEC, and although we cannot predict the outcome based on what we know to date, we do not expect this matter to have a material impact on the company.

With that, 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 brief follow-up. Operator, please provide the instructions for asking a question.

Question-and-Answer Session

Operator

Certainly. Our first question comes from the line of Matt Cabral from Goldman Sachs.

Matthew Cabral - Goldman Sachs & Co.

Yeah. Thank you. So, I wanted to dig a little bit deeper into your Corporate segment. There's been a pretty big pickup in SMB optimism following the election according to some of the third-party surveys that are out there. So I guess with that in mind, Tom, you touch on this a little bit in the prepared remarks, but just curious how you saw demand change as you went through the quarter, particularly thinking about the month of December versus maybe more October or early November. And then looking ahead to 2017, how do you think about the potential for some of this optimism to translate into some accelerating spending going forward?

Thomas E. Richards - CDW Corp.

All right. Good morning, Matt. So, there was a lot there. Let me see if I can kind of go in sequence here. So the first thing is, you're right, as I alluded to, we did see and did feel the increased optimism more quickly in Small Business. And I think that's logical just because of the size of the dollars involved and the amount of investment. But we also did see increased optimism in the Corporate segment too.

As we had hoped to, I think we alluded to this on a number of different calls, there clearly was increased activity. It hasn't quite played out yet. I think there's a little more caution in the larger enterprises and they had spent so much of the year focused on software assurance, virtualization to optimize that infrastructure. But I think everybody kind of has guarded optimism. And I think it's guarded because I do think people understand the complexity that it will take to implement some of the things that's driving the optimism.

And I feel a little bit like Groundhog Day, because this time last year we were talking about there was optimism, we were going to have improving economic activity and was going to accelerate in the back half of the year, right? Exact same story. I think this time, there's probably a little more rationale for it. And so, we would expect there to be increased growth.

And I think the other connection I want to make sure you heard in the script was, we'll see a lot of that we think in the hardware side of the business. We think we're going to continue to see that focus on the optimization, securely designing and kind of protecting your investment, but will be coupled with some increased focus on hard work.

Matthew Cabral - Goldman Sachs & Co.

Got it. And then the international business was up pretty strong in Q4. Just wondering if you could dig a little bit deeper into the drivers behind that performance? And then, just thinking a little bit more broadly about your international strategy, it's more than a year past the acquisition of Kelway. So, how are you thinking about the potential for further international expansion going forward into other geographies like maybe Western Europe or Asia Pacific over time?

Thomas E. Richards - CDW Corp.

Okay, Matt. So I'm not sure how many we're into, three or four. Let me try to take them one at a time. Look, CDW UK and Canada, both of our international organizations had great fourth quarters. And I don't know thing – it's anything more than just focus and execution. I think in the case of UK, kind of the further we got away from the reality of Brexit and people understanding kind of the longer-term play, it enabled people to get back focused on their companies, their businesses, and we clearly capitalized on that.

I think there's benefit from the ongoing integration of CDW UK into CDW, benefiting from some of the things that this company has kind of used to continue to outperform the market, but you can't deny they had a great finish to the year, I'm just really proud of that team.

If you think about international expansion, kind of go back to what our strategy was. This was about following our U.S. customers and making sure we had the capabilities to help them with some of their international needs and we have had already success, as I alluded to. We will continue to look opportunistically for expansion opportunities, but it's not driven by, hey, is there a part of the world we need to go and get, it's more of where are our customers taking us and where would they want us to go.

Matthew Cabral - Goldman Sachs & Co.

Thank you.

Thomas E. Richards - CDW Corp.

Okay. Thanks, Matt.

Operator

Thank you. And our next question comes from the line of Amit Daryanani from RBC Capital Markets.

Amit Daryanani - RBC Capital Markets LLC

Good morning, guys. I have a question and a follow-up as well. Starting on the Federal segment, you mentioned there were certain large customer orders that were pushed out into 2017. Could you just talk about the size or the magnitude of these orders? And do you expect it to come in – the revenues we recognized, I guess, in the March quarter or some of the out quarters in 2017?

Thomas E. Richards - CDW Corp.

Good morning, Amit. I think they're going to come in, based on what we know today, throughout the year. I'll just say, it was a meaningful dollar value; let us go with that. It was north of $50 million. And it was just a function of – they had an initiative to move to Windows 10 in certain parts of the federal government and had issued the purchase orders.

We were kind of working aggressively to get those done. They wanted them shipped by the end of the year. And then we found out in December that based on some internal, I'll just call it, challenges, they asked us to delay shipping those into 2017. I think it's going to take – it's not going to happen all in one quarter, I think it's going to be spread out over the year. But it is a meaningful number.

Amit Daryanani - RBC Capital Markets LLC

Got it. That's really helpful. And I guess, just a follow up. You spent some time talking about the cyber security business and it's certainly I think a big investment theme for customers in the year. Could you just talk about the breadth of your presence over here that you have in terms of revenue size? What's the growth trends are you seeing? And broadly, how much of your cyber security business do you think is actually reoccurring in nature versus a one-off transaction?

Thomas E. Richards - CDW Corp.

Okay. So, first of all, we use kind of the broader term of security. I know it's maybe a nuance, but it's much of cyber security, so to speak. And we don't share the size of that business. I think I have shared a number of cases kind of how fast it's been growing. And look, I don't know what term to use other than meaningful double digits it continues to grow.

I think the example I gave, Amit, was kind of more of a normal, what happens for us in cyber security. We were asked to come in and assess the environment and that assessment includes everything from diagnostics to actually putting devices in to monitor opportunities as far as breaches, and then we kind of come in on the back end and build out a combination of both services and delivered solutions.

I would say the business is still – it's not a recurring revenue business yet in a major way, although, I think what you're seeing and you picked up on this when I alluded to the fact that there's now a $200,000 annual monthly recurring revenue, that's kind of vision into the future for us.

Amit Daryanani - RBC Capital Markets LLC

Perfect. Thank you and best of luck in 2017, guys.

Thomas E. Richards - CDW Corp.

Hey, thanks again, Amit.

Operator

Thank you. And our next question comes from the line of Matt Sheerin from Stifel.

Thomas E. Richards - CDW Corp.

Good morning, Matt.

Matthew Sheerin - Stifel, Nicolaus & Co., Inc.

Yes. Thanks. Good morning, Tom, and everyone. Just a couple questions from me. Regarding your EBITDA guidance of the high end or above your mid-7% target where you've been last year, how does that play against your expectation for accelerating growth in the back half which seems like it's more skewed toward hardware and you expect some acceleration of hardware. So, should we think about EBITDA margins trending downward somewhat in the back half because of that mix?

Ann E. Ziegler - CDW Corp.

We think about our EBITDA margin as being relatively flat as we move through the year to 2016. While we are looking for some hardware acceleration, we continue to expect to see good performance in the things that we referred to as netted down revenues. So we would expect that mix to hold, not necessarily shift toward hardware. What we're expecting as that the mix shift into the netted down, you won't see the impact that you saw in 2016. So, flattish adjusted EBITDA margin.

Matthew Sheerin - Stifel, Nicolaus & Co., Inc.

Got you. So, still accelerating growth of those other areas. Got that. And then, regarding your commentary, Tom, on K-12 with that E-rate push out, it sounds like we're hearing that few quarters here. What's your expectations this year? Do you think that's finally going to start to accelerate?

Thomas E. Richards - CDW Corp.

Well, Matt, it is. It's a little bit like Groundhog Day on that subject too, it feels like. So, as we think about the nuance of E-rate, you look at – let's look at years 2015 and 2016. And in 2015, I think we captured like 7.1% of the projected opportunity. In 2016, we captured another one of – I think it was 8%. So we continue to increase our capture rate.

What really slowed it down this year was, USAC went to a new system, if you will. I think it's ironically called, EPC. Just leave it. Got that. And let's just say, EPC didn't perform the way it was supposed to. So therefore, they got behind in sending out the funding letters which it seems like it keeps happening every year.

And so, I don't want to forecast when it's going to get to a point where they stay within their targeted guidelines. My guidance to our team is, look, we can't control that. All we can do is focus on being named the highest percentage of times as the partner and then executing against that. But it did impact our netcomm business this year. And – but we do expect it to kind of flush out and to get that growth back next year. But I don't want to get in the business of predicting E-Rate.

Matthew Sheerin - Stifel, Nicolaus & Co., Inc.

Got it. All right. Thanks a lot.

Thomas E. Richards - CDW Corp.

All right. Thanks, Matt.

Operator

Thank you. And our next question comes from the line of Shannon Cross from Cross Research.

Thomas E. Richards - CDW Corp.

Good morning, Shannon.

Shannon S. Cross - Cross Research LLC

Good morning, and thanks for taking my question. The first one is with regard to the growth in hardware in the second half. I'm just curious, when you look at that, obviously when desentives (45:47) is playing in and I'm guessing this contract may be will help you that you're talking about in the federal side. But just in general, how much of this is more sort of PC-related versus data center? And what are you hearing from your customers in terms of their willingness to shift some dollars over to hardware?

Thomas E. Richards - CDW Corp.

Well, it's interesting. I think in some cases, it's a function of value. And where do they see the greatest value and the opportunity, and I think it's tied to economy, especially in the Corporate segment, right? If you just kind of think about the connective tissue there. When you have GDP for the year was 1.6%, right? You're going to be more cautious about where you spend your dollars, which I think was the insight when we look back at 2016, and we said, why are we doing so well in these warranties and software assurance, I think those two things, Shannon, are linked to what I'll call where am I going to spend my money?

As we go into next year, I would expect some of the uplift in some of the solutions area of hardware like we've seen in netcomm. But as I also alluded to, we've had incredible growth, if you think about hyper-converged just as one example of a great growth area, flash, like everybody else is experiencing incredible growth.

And we also would expect – we had a pretty good year in our client business, it had a meaningful of double-digit growth, we would expect that to continue going forward.

Shannon S. Cross - Cross Research LLC

Okay. And then with regard to the SMB initiatives that you have, can you talk a bit more about sort of the drivers behind it, how you'll approach things differently than your traditional Corporate business, and what kind of metrics we should look out for success within that initiative?

Thomas E. Richards - CDW Corp.

Yeah, this was something that I've been personally thinking about and contemplating for some period of time, and that is if you really think about that marketplace and how they're consuming IT, and what I'll call the economic dynamics of being a Small Business and the value we bring relative to helping them procure IT to facilitate their growth. It struck me as it was kind of separating itself from how we serve and go-to-market with what we'll call the MedLar customer.

There is a much greater utilization of online digital resources both on the consultative end and on the purchasing end. And so, what I wanted us to do is to have a group of people who got up every day and have the resources at their disposal, be it a marketing resources, the technical resources and an e-commerce to kind of maximize the opportunity. I think we're going to look at it and measure it pretty much the same way, what their net sales growth, what kind of profitability they're generating and continue to look at what kind of solutions are they delivering in the marketplace.

But I firmly believe that having the ability and I gave them kind of the clean sheet of paper focus, when it comes to how do you serve this market? And I'll just give you one thought as we think about this. If you think about people today and how we consume information, it's not just talking to someone live, right? We're consuming it online. We're actually consuming it verbally through devices and artificial intelligence. I think all of that eventually is going to be part of how do you go to market with that segment.

Shannon S. Cross - Cross Research LLC

Great. Thank you.

Thomas E. Richards - CDW Corp.

Okay. Thank you.

Operator

Thank you. And our next question comes from the line of Sherri Scribner from Deutsche Bank.

Sherri A. Scribner - Deutsche Bank Securities, Inc.

Hi. Thanks very much.

Thomas E. Richards - CDW Corp.

Morning, Sherri.

Sherri A. Scribner - Deutsche Bank Securities, Inc.

Hi. Tom, thinking about the cloud business, it seems like based on the $1.5 billion, that cloud is now 10%-11% of your sales on an annual basis. Can you give us some detail on how that cloud business breaks out between your hardware solutions and software and how weighted it is to some of your different end markets, is it more Corporate? And then also, can you give us a sense of how recurring that business is?

Thomas E. Richards - CDW Corp.

Sherri, first thing is, we use the term customer spend. That's kind of the way our partners measure how we're doing, so that $1.5 billion is in customer spend. It has the impact of all the netted down aspects I talked about earlier.

Sherri A. Scribner - Deutsche Bank Securities, Inc.

Okay.

Thomas E. Richards - CDW Corp.

So you got to be careful thinking about that. And then let me kind of go. The second part of the question is most – we don't even count in our cloud spend number private cloud, because to me, private cloud is delivered kind of on-prem primarily via hardware. Now, I know we have some nuances where people are using Azure and thinking about using Azure on top of on-prem equipment. We're not even going to try to be that cute. So, when we're talking about cloud, it's primarily, as you think about it, Public cloud in the form of SaaS or infrastructure-as-a-service.

Now, growth is – what we look at is what workloads. That's the thing we pay attention to. And you heard me mention the kind of top – some of the top workloads being security, productivity, backup and disaster recovery, mobility, those are the workloads that we're finding are increasingly going to our cloud-based solutions. I don't know if that helps.

Sherri A. Scribner - Deutsche Bank Securities, Inc.

That helps. And how much is recurring of that? How often does it recur?

Thomas E. Richards - CDW Corp.

I would say it's still non-recurring, if that's the way to say it, the majority of it, although much like the example in security, the rate of growth of the recurring is increasing really aggressively.

Sherri A. Scribner - Deutsche Bank Securities, Inc.

Okay, great. Thank you.

Thomas E. Richards - CDW Corp.

All right. Thank you.

Operator

Thank you. And our next question comes from the line of Rich Kugele from Needham & Company.

Thomas E. Richards - CDW Corp.

Good morning, Rich.

Rich J. Kugele - Needham & Co. LLC

Good morning. Thank you. So, first, great quarter and great year. I guess, what I wanted to understand a little bit better was the lack of the budget flush in the fourth quarter. Was that both MedLar as well as SMB, or where did you see that and was it strategic because of what they were trying to deploy in the sense that as you get into 2017, will they be able to overcome that and grow faster if it's consistent with your commentary there?

Thomas E. Richards - CDW Corp.

Yeah, Rich, here's what I would say is, it was more of a comment on the MedLar part of Corporate than it was Small Business. And I think, intuitively that kind of make sense, we don't really ever notice the big budget flush in Small Business, I think, in part because of the size and complexity of those organizations and how they're trying to go-to-market. We did see a budget flush, we just didn't see a meaningful budget flush.

But as an example, some of that is influenced by the unique submarkets that sit inside of MedLar. A good example is oil and gas, big submarket for MedLar, as you might guess, really struggled as far as having the kind of money available to invest in IT, you're starting to see those people now come back into the fold, have discussions with us about their spending and their expectations for 2017. And they did – we did see some green shoots later in the quarter, which is I think encouraging. But I think the MedLar business is going to be more watching what happens with taxes and immigration and some of those things that more impact their business, which is why I think there's this cautious optimism in MedLar.

Rich J. Kugele - Needham & Co. LLC

Thank you. And then, Ann, should something meaningful happen here with domestic tax rates, you're a full tax payer today. Should we just assume that you would spill it over the same capital strategy or could it enhance one area over another?

Ann E. Ziegler - CDW Corp.

No. I think we would, one, obviously it depends on what the actual tax rate is, and how it gets delivered. But if our cash flow increases, right, we would look to continue to follow the capital allocation strategy that we have in place. The one thing I would say is, right now, we say leverage is 2.5 to 3 times. I've always said if interest rates skyrocket and tax rates go down significantly, we would look at the right leverage ratio for the company. So keep that in mind as well.

Rich J. Kugele - Needham & Co. LLC

Excellent. Thank you.

Thomas E. Richards - CDW Corp.

Thanks, Rich.

Operator

Thank you. And our next question comes from the line of Adam Tindle from Raymond James.

Thomas E. Richards - CDW Corp.

Good morning, Adam.

Adam Tindle - Raymond James & Associates, Inc.

Hey, Tom. Thanks. I just wanted to ask, I think you mentioned that Dell easily delivered the 150 basis points. I think that implies that the Corporate revenue would have perhaps been down for the year. And if I think about the trends that you talked about, server and storage remains tough. Do you think this is just replacement cycles extending or is Public cloud having an impact, and perhaps you can tie that to the comment that you expect hardware sales to accelerate?

Thomas E. Richards - CDW Corp.

First, Adam, I don't think the connection between Dell and Corporate is appropriate, or is maybe accurate might be (55:19) a better way to say it. It can be appropriate, but I don't think it was accurate. The relative connection, I think, you said was that there was a tie between Dell's success and Corporate being down. I don't think you should connect that dot.

I think you have to separate them into saying what happened in the segment relative to what's going on in the marketplace and we had positive Dell impact on all parts of our business. Some parts of our business more than other and some of that's just where the market opportunity was. So, don't connect those two.

Could you give me the second part of the question again, because I want to make sure I answer it?

Adam Tindle - Raymond James & Associates, Inc.

Yeah. I was just asking if the – I was trying to tie how you talked about server and storage trends remained tough in the Corporate segment, and is it just replacement cycles or is it Public cloud having an impact, because you talked about expecting hardware sales to accelerate?

Thomas E. Richards - CDW Corp.

Yeah. I think it's interesting, Adam. I think the answer is all the above, if I would think about your characteristics. One of the things that led us to really kind of dig in to what's happening is the kind of lumpiness, if you will, one of my favorite term, even in subparts of our business. Like, if you remember last quarter, servers were up 5% and this quarter they're down low-single digits and you start to peel the layer of the onion back and say what's driving that, and what you see is a number of different things.

For example, even in a quarter when servers were slightly down in the aggregate, five of our seven segments had server growth. So, just think about that. So, what that tells you is, there is a part of the marketplace that's saying, hey, we still have opportunities for what I'll call traditional servers. Then you couple on top of that hyper-converged doubling year-over-year, right? And you're saying, okay, so some people are clearly sitting back, saying, how am I going to handle growth? Some of it is going to be, I'm going to add virtualization software, expand capacity [audio skip] (57:29) existing asset.

When I do that, I'm probably going to invest in protecting the asset with a warranty. Some people were saying, you know what? I'm going to handle it by what I'll call traditional server growth. My sense is, that driven the specific units within their business where they can say we're going to serve that unit with a server. And then some of them are actually saying, hey, I'm actually going to go to a new architecture.

So, it gets really hard, I think, unless you dig down into it to really kind of say, there's one thing influencing what's going on, I think it's multiple.

Adam Tindle - Raymond James & Associates, Inc.

Okay. I just wanted to see if I could give one follow-up on the SMB initiative, because you talked about...

Thomas E. Richards - CDW Corp.

Sure.

Adam Tindle - Raymond James & Associates, Inc.

...customer's changing buying patterns. And you've made a move to include the e-commerce, which I thought was interesting. Could you talk about the competitive set in SMB and are you perhaps competing more with the Amazon's of the world here?

Thomas E. Richards - CDW Corp.

No, I don't think it's changed. It's kind of like – it's a free-for-all. There're so many people competing in the marketplace. And everybody tries to differentiate what I think is, is that CDW has the ability to have this incredibly unique value proposition that will have the digital capabilities, should customers consume to acquire knowledge, technical support, and even purchase. And supplemented with what I'll call the benefit of having the high touch model, where as those things get more complicated, and that is one of the reasons Adam, let me just use your question to reinforce them.

When we say Small Business, we're talking about organizations that generally have more than 20 co-workers up to 250 co-workers. We don't really go below 20, which is where you see a lot of people like Amazon, and part of that's because our value is, as things get more complicated, then we have the ability because of the combination of delivering product and services and solutions from simplifying IT. So, we think we've been fairly thoughtful about where we focus and where we have the greatest value, and now we're just going to enhance the way we do it.

Adam Tindle - Raymond James & Associates, Inc.

Okay. Thanks, Tom.

Thomas E. Richards - CDW Corp.

Yeah.

Operator

Thank you. And our final question for today comes from the line of Katy Huberty from Morgan Stanley.

Thomas E. Richards - CDW Corp.

Good morning, Katy.

Kathryn Lynn Huberty - Morgan Stanley & Co. LLC

Good morning. Thanks for the question. Just speaking of Dell, now that you have a little more clarity around the EMC Dell roadmap, is the long-term opportunity from that partnership the same or does the shutting down of some of the product portfolios change the overall opportunity?

Thomas E. Richards - CDW Corp.

No. I'd still remain really excited about the long-term growth prospects there. I think you kind of assumed, at least we did, Katy, going into this, that when you have a acquisition of that size that there's going to be rationalization of a lot of things relative to their go-to-market strategy and their product suite.

So, it wasn't like it's been a surprise. I also think that as you would expect, that kind of merger is going to have an impact in the year that it happens. As we get further away from that year, I really expect the opportunity even increase going forward.

Kathryn Lynn Huberty - Morgan Stanley & Co. LLC

Okay. Great. And then just as a follow-up, it was helpful to hear upfront you talk about the four areas of strong double-digit growth. As you think about those into 2017, are any of them building or entering the year with more momentum, and are there any new trends that you think are emerging that will impact the business in 2017 in terms of driving growth?

Thomas E. Richards - CDW Corp.

Yeah. I would say they were pretty consistent growth throughout the year, Katy. I mean it did feel like as we got later into the year, and I think people saw the economy wasn't going to be as robust as they thought that you might have had more people saying, you know what, we're going to go ahead and make sure we have this warranty on this or we have software assurance on this, or we're going to add capacity.

I don't expect that to change. I think the number of options people have which plays to our benefit quite honestly is going to continue, and I would be surprised if you saw a major deceleration. But again, I'm giving you just my gut reaction. I don't know that I'm smart enough to come up with any additional emerging trends at this point. That's kind of the assessment. I'm really – I'm like the weatherman, I get to give you the assessment after the weather has gone through, so.

Kathryn Lynn Huberty - Morgan Stanley & Co. LLC

Okay. Great. Thank you. Congrats on the quarter.

Thomas E. Richards - CDW Corp.

All right. Thanks, Katy.

Thomas E. Richards - CDW Corp.

All right, is that it? I think we're done. Okay. Hey, look everybody, two sights here; one is thank you again for your interest in CDW and your questions. They are helpful to us in making sure we are thinking about the right things. And I do want you to know that we scheduled this earnings call exactly one week in advance of Valentine's Day. There is no excuse for not to be remembered, and I want to share with you my new motto on Valentine's Day, we get forgiven if we remember and we get massacred if we don't. All right. Valentine's Day is not an optional sport. Okay. Good luck, everybody.

Operator

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

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