CDW Corporation Q2 2006 Earnings Conference Call Transcript (CDWC)

CDW Corporation (CDWC)
Q2 2006 Earnings Conference Call
July 19, 2006 8:30 am ET

Executives

John A. Edwardson – Chairman, CEO
Barbara A. Klein – CFO, Sr. VP
James R. Shanks – EVP Corporate and Public Sector Sales
Harry J. Harczak, Jr. – EVP Marketing, EVP Purchasing, EVP Business Development

Analysts

Brian Alexander - Raymond James
Richard Gardner - Citigroup
Jason Gursky - J.P. Morgan
Bernie Mahon – Morgan Stanley
Matthew Sheerin - Thomas Weisel Partners
William Fearnley - Ftn Midwest Securities Corp.
William Hand - Bear Stearns
David Manthey - Robert W. Baird & Co., Inc.
Benjamin Reitzes – UBS
Bruce Simpson - William Blair & Company, L.L.C.

Presentation

Operator

Good morning, ladies and gentlemen and welcome to the second quarter 2006 earnings conference call. (Operator Instructions) I will now like the turn the conference call over to Mr. John Edwardson. Mr. Edwardson, you may begin.

John A. Edwardson

Okay, thank you and good morning to each of you and we appreciate you taking the time to join us to discuss CDW’s record-setting second quarter results. With me here in the room today are Harry Harczak, our executive vice president, Jim Shanks, executive vice president, and Barb Klein, senior vice president and chief financial officer.

Before we begin the meeting, Barb will present the company’s safe harbor disclosure statement.

Barbara A. Klein

Thank you, John, and good morning. Statements made by management in this conference call which are forward looking, that is, not historical in nature, are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform 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 reflect the expectations of management other than as of the date of this call.

Our press release for today’s call can be accessed on our web site at CDW.com. Click on the Investor Relations link on the left side of our home page, then click on the supporting materials link under webcast.

John A. Edwardson

Okay, thank you. In the second quarter this year CDW delivered several new records.

First, we achieved our highest-ever gross profit dollars and established a new earnings per share record.

We also reached our highest-ever second quarter revenue.

This happened because of a relentless focus on the customer combined with our disciplined approach to growing profitably and achieving operational efficiency. These resulted in great performance for the quarter.

In addition, we continued to return capital to shareholders through the ongoing repurchase of CDW stock.

But most importantly, our second quarter accomplishments are a result of our more than 4,000 co-workers getting in the game every single day and giving our customers the best service this industry has to offer.

Turning the slide for the webcast presentation and you can see a comparison of second quarter 2006 to the prior period a year ago. Total revenue was $1.6 billion in the second quarter compared to $1.5 billion in the second quarter a year ago, up 6.1%.

You can see that average daily revenue was $25.5 million in the second quarter of 2006 versus $24.1 million a year ago. Each quarter had 64 billing days.

Raymond James reasonably estimated that U.S. commercial and government resellers would grow 4% in the second quarter of this year. Comparing our growth rate to this estimate, we continued to outpace market growth and did so quite profitably even while reorganizing most of our corporate sales force.

The second quarter gross profit margin was 16.2% of revenue and operating margin was 6.6% of revenue. That income increased 9% to $73.1 million.

Diluted earnings per share grew 13.8% to $0.91. The second quarter of 2006 did include stock-based compensation expense of $2.4 million after tax, which was $3.7 million pre-tax, or $0.03 per diluted share due to the implementation SFAS 123R.

I think in other words what we’re saying is, we had a great quarter. We blew away the estimates by $0.13 over the First Call average, even after taking $0.03 for the new FASB regulation on expensing stock options.

Annualized revenue per co worker did decline slightly to $1.49 million in the second quarter of 2006, from $1.53 million in the second quarter a year ago.

However, and very important, annualized gross profit margin per co-worker increased to $240,000 in the second quarter of 2006 from $236,000 in the second quarter a year ago.

If you turn to Slide 4, you can see the return on equity and return on investment capital. In the second quarter of 2006 we achieved return on equity of 22.8% and return on invested capital of 41.6%.

Second quarter of 2006 we also repurchased approximately 1.5 million shares of CDW stock. The average price was $54.51 per share and the total purchase price was nearly $84 million.

Turning to the fifth slide, you can see that we have repurchased 3.8 million shares during the first six months of 2006.

We also paid a $0.52 dividend to our shareholders in June, which totaled $41 million.

So in the first half of this year we returned $253 million to shareholders. This compares to $293 million returned to shareholders in all of 2005.

We have roughly 3.5 million shares remaining under our current share repurchase program.

We were pleased with the overall performance this quarter as we’ve begun to leverage recent investments in our business such as the expansion of our infrastructure and sales force.

However we want you to know we are still not satisfied with our current rate of revenue growth. It is not where we want to be, especially given our objective of reaching $10 billion in revenue by the end of 2008. But we are encouraged by our progress on initiatives that were launched over the past several months to better serve our customers and to drive our future growth.

For example, we completed our second full quarter of operations at our western distribution center in north Las Vegas, Nevada. The distribution center is now handling approximately 30% of our daily volume.

We are also making progress to improve efficiency of the new facility and are gearing it up to begin more complex configurations such as rack configurations and custom imaging. By the end of the year we expect to show up to 40% of our total volume from the North Las Vegas facility.

We also continue to make progress with the geographic realignment of the medium and large sales team within the corporate sector. During the first half of the year we completed the early stages of this process. This included the initial rollout of organizing account managers by district and transferring accounts among account managers according to those newly established districts. Following rollout, we then completed the transition in accounts in which account managers communicated a change to customers. Now account managers are beginning to establish relationships with their new industry customers.

The scope of this initiative has been significant and we still view it as a work in progress. We know, however, that this was the right next step to further segment our customer base and to create a consistent regional framework that enables us to work better with our vendor and service partners. Jim Shanks will discuss this more in his section.

In addition, after the reorganization of our services group in the first quarter of 2006, we focused on selling basic service offerings to customers. These services around the box are primarily core services that are simple, scalable, such as configurations, maintenance, installation and warranties. We are also offering customers services that are designed for their specific needs, such as hardware and software installation and migration. We have made progress in selling more services, creating solid partner networks and simplifying our go to market strategy.

We have also challenged ourselves to reach $10 billion in revenue by the end of 2008. This is an ambitious goal but one that our co workers are enthusiastically embracing. The growth will likely result in a combination of acquisition and organic growth.

Elements of that growth could come from several sources, including the continued focus on migrating customers from initial buyers to truly loyal customers. This includes capturing a greater share of wallet and providing an unmatched customer experience.

Second, the expansion of our sales force. Currently we expect to add 150 to 200 net new account managers and specialists in this year.

Third, productivity improvements, especially our sales force as new account managers mature and build their books of business.

Fourth, the strategic deployment of resources to fast-growing customer channels like healthcare. You can expect more verticals from us in the coming years; more solution selling that involves increased utilization of our product specialist teams in partnering with local service providers. Also, expect more growth in our Canadian operations. We recently received our large account reseller status, our status from Microsoft, which allows us to sell all Microsoft licensing programs, including selected enterprise agreements to our customers in the Canadian market.

And then finally, international expansion, which could include, for example, investigating opportunities in China.

In summary, we delivered a strong second quarter but we remain focused on doing everything a little better each day, including growing revenue.

Once again, I want to recognize the outstanding efforts of our co-workers. Change is a constant in our industry and our co workers are on the front lines every single day implementing change so that we can better meet our customer’s needs and outpace market growth.

With that, I’ll ask Jim Shanks to discuss our revenue results and the sales force changes. Harry Harczak will review new product trends, and Barb Klein will address financial results. Jim.

James R. Shanks

Thank you, John. Both our corporate sector and public sector segments achieved new records for the second quarter sales.

The public sector segment, CDW G, generated total sales of $521.6 million in the second quarter of 2006, which was a 12.6% increase from the second quarter of 2005.

Average daily sales were $8.150 million in the second quarter of 2006 compared to $7.236 million in the second quarter of 2005. On an average daily basis, the public sector grew 13.4% in April, 15% in May and 9.8% in June.

All customer segments within the public sector grew in the second quarter of 2006. Our state and local government, education and healthcare channels had double-digit growth, while federal government had mid single-digit growth. We believe the public sector’s well-developed customer segmentation strategy has been key to overall performance.

In addition, we have focused on profitable growth across all customer channels.

The federal government’s fiscal year end is September 30. The buying patterns of our federal government customers can fluctuate during the year leading up to the end of the third quarter. As we head into federal’s busy season, we will continue to focus on finding opportunities and profitable business within that customer channel.

Total corporate segment sales were $1.11 billion in the second quarter of 2006, representing 3.3% growth over last year.

Average daily sales in the second quarter of 2006 were $17.373 million compared to $16.820 million in the second quarter of 2005. On an average daily sales basis, the corporate sector grew 2.5% in April, 3.4% in May and 3.8% in June.

As John indicated, we have made further progress on segmentation of the majority of our medium and large corporate customers into geographic territories. In the second quarter, we saw early indications of success as the corporate sector’s growth rate gradually improved each month.

We believe this initiative was needed to continue to improve our customer service levels and establish the next platform for future growth. By segmenting customers into five geographic regions comprised of 33 districts, we expect to better understand and respond to the needs of our customers in each district.

The advantages of the regionalization include the ability to better evaluate customer potential, allocate resources required to drive growth and deploy our inside and field sales professionals based on changes in market demand.

In addition, we are now more closely aligned with our vendor and service partners, which we expect will provide incremental sales and service opportunities.

The long-term benefits of customer segmentation are evident in our public sector. We have increasingly segmented our public sector customers into more defined channels over the years. We expect to replicate our public sector advantages in the corporate sector as well.

Corporate account managers affected by regionalization predominantly serve medium and large size business customers with 100 or more employees.

Account managers serving predominantly small business customers with fewer than 100 employees in the corporate sector were not impacted.

Corporate account managers have been supportive of the change because they recognize the advantages of regionalization. At this stage of the implementation, we are climbing the relationship curve with the customers that they received in the transition. They are just beginning to learn how to leverage this still-new district structure, including the networking opportunities among customers and vendor partners.

Because of our account managers’ commitment to this initiative, we have transitioned additional medium and large accounts during the second quarter. This has been driven by those account managers who want to have more of their accounts in district so they can get settled sooner and start building relationships with more customers in their district.

Co workers in our medium and large sales teams are working very hard to adapt to these changes but it will take time to realize; to get results. We cannot predict how soon corporate-sector growth will return to more historic rates, however we are making progress and we know this is the right strategy for future growth.

On June 30, 2006, our sales force numbered 2,179 co workers, representing an 11.1% increase compared to June 30, 2005. Included in the sales force count is approximately 270 advanced technical specialists. We are on track to add 150 to 200 net new sales force co workers in 2006.

Turning to Slide 6, average daily sales per average sales force co worker were approximately $11,900 for the second quarter of 2006 compared to approximately $12,200 for the second quarter of 2005. This metric is impacted by the timing of new hires and a continuing decline of average selling prices of technology products. We remain focused on improving productivity across our entire sales organization by doing things better, faster and cheaper.

Slide 7 shows a similar sales force productivity analysis using gross profit dollars on an average daily basis. Average daily gross profit dollars per average sales force co worker were approximately $1,920 for the second quarter of 2006 compared to approximately $1,880 for the second quarter of 2005.

In the second quarter of 2006 the percentage of sales force turnover was in the mid 20s, an improvement slightly compared to one year ago.

Slide 8 shows that the web generated approximately $494 million in direct, online sales for the second quarter of 2006, representing a 16.8% increase compared to the same period a quarter ago and comprised 30.2% of total sales.

Harry will now comment on product trends and financial results.

Harry J. Harczak, Jr.

Thank you, Jim, and good morning.

On Slide 9, we show our product mix for the second quarter of 2006 compared to our product mix for the second quarter of 2005.

Software remained our largest product category, comprising 17% of sales. Data storage devices and desktop computers and servers were tied for second at 13.4%. The notebooks and accessories category was fourth at 13.2%, and the printer category came in fifth at 11.5%.

Growth rates by product category are shown on Slide 10.

The memory category increased 15.4%. The increased adoption of virtualization software drove server memory. In addition, notebook memory was strong due to higher notebook sales and customers adding memory to the standard 512 config to their core dual systems in preparation for the launch of Microsoft’s Vista.

Revenue for the combined notebook and accessories category increased 11%. The overall category was driven by stronger notebook sales, which make up most of the category.

Video products revenue increased 9.3%. Continuing the recent trend, average selling prices of large-format LCD monitors have declined significantly year over year. The more affordable prices have driven unit volume.

Input devices, which are products used to get information into a computer, increased 8.8%. Demand for wireless Bluetooth products such as mice and keyboards positively impacted this category.

NetCom products grew 8.6%. Customers are continuing to upgrade their networks with new features such as improved security and class of service by implementing vantage switches.

Data storage devices increased 4.3% versus the prior year period. Demand is being driven by customers’ need to store increasing amounts of data and create redundancy. We continue to increase customer awareness of our storage area network capabilities through product campaigns, customer events and our specialty teams.

Revenue growth for software was 2.5%. Sales of application suites were enhanced by vender promotions and database software continued to benefit from new product launches from the fourth quarter of 2005.

We had strong growth in Microsoft enterprise agreements in the second quarter. We do not record top line revenue for enterprise agreement sales, but instead receive commission fees that favorably impact our margins. Customers have continued to migrate to enterprise agreements, which has somewhat confused previous peaks in software assurance renewals that we experienced in the second quarters of 2002 and 2004.

Revenue in the printer category declined 0.7%. The category was negatively impacted by declining average selling prices for color printers and reduced unit buying for ink jet printers.

Slide 11 shows the change in revenue, unit volume and average selling prices for notebook CPUs and desktop and server CPUs. Notebook CPU revenue increased 12.4% and unit buying increased 17.5%, while the average selling price decreased 4.4% from a year ago.

We continue to execute on a penetration strategy to sell notebooks to current customers who have not previously purchased the category from us. In addition, our top partners have provided strong support for these programs.

Many customers are migrating from desktops to notebooks due to the affordability of notebooks and the shrinking price gap between notebooks and desktops. Customers continue to buy more thinner, lighter notebooks as well as tablet PCs.

While dual core processors are not a large portion of our sales, we expect demand to ramp for this product. The benefits of dual processors include slightly higher performance for a reasonable price.

Revenue from desktop computers and servers increased 2.1% and unit volume increased 1.2%, while the average selling price increased .9% from the prior period.

Customers are continuing to adopt virtualization as a way to consolidate and increase server utilization. The trend is to either buy single processor machines or upgrade to blade servers.

Customers have also been moving into AMD more often, typically with lower average selling price machines.

Barb Klein will now review our financial results for this quarter.

Barbara A. Klein

Thank you, Harry. As John indicated, we delivered solid financial performance in the second quarter of 2006 due to our focus on the customer and our disciplined approach to growing profitably and operating efficiently.

Gross profit was 16.2% of sales in the second quarter of 2006, compared to 15.4% in the second quarter of 2005, and increased 11.2% compared to the prior year. The change was primarily due to the following four factors, each of which had approximately a similar impact:

First, we had higher commission revenue in the second quarter of 2006. This was driven primarily by the fees we received from selling Microsoft enterprise agreements, both new contracts and contract renewals.

Second, we performed well against vendor incentive program objectives. As we have stated before, these programs can change from quarter to quarter depending on design and objectives set by the vendors. Our objective is to understand the parameters of the programs, track our progress against the goals, and qualify for the incentive.

Third, our net service contract revenue was higher compared to last year, due primarily to increased sales of software assurance, custom services and configuration.

Fourth, delivery charges contributed more favorably in the second quarter of 2006 compared to the prior period. This was due to our offering delivery promotions more broadly in the second quarter of 2005 compared to the second quarter of 2006.

To reflect our recent performance, we are increasing our stated objective for gross profit margin by 25 basis points to a range of 15.25% to 16% from the previous range of 15% to 15.75%.

Slide 12 shows our operating statistics. Selling and administrative expenses were 7.7% of sales in the second quarter of 2006, compared to 6.8% in the second quarter of 2005 and increased 19.8% compared to the prior year. The increase in selling and administrative expenses in the second quarter of 2006 is primarily due to the following factors:

First, we had incremental expenses of approximately $6.3 million associated with the operation of the new western distribution center in North Las Vegas and additional leased office space in the Chicago area.

We expect incremental expenses for the western distribution center and additional office space to be approximately $18 million in 2006 compared to 2005. This represents total expense of approximately $21 million in 2006. During the first half of 2006, cost for these facilities totaled $11.3 million.

Second, we recorded $3.7 million of expense due to the required implementation on January 1, 2006 of the new accounting standard, SFAS 123R, related to the expensing of stock options. We still estimate that stock option expense related to the new accounting standard will be between $16 million and $17 million pre tax for 2006. During the first half of 2006, our stock option expense totaled $7.9 million.

Third, payroll costs increased because of continued investment in expanding CDW’s sales force and additional co workers to support a larger and growing business.

Finally, sales commission expense increased due to the achievement of a stronger gross profit margin compared to the prior year period. Our sales co workers are compensated based on the gross margin generated on sales.

In the first quarter of 2006 we provided a breakout of incremental payroll taxes on option exercised and on the impact of options that were exercised as a result of accelerated vesting as of December 31, 2005 for co workers through the manager level.

In the second quarter of 2006 these co workers did not exercise a significant number of the accelerated options. Approximately 1.6 million options remain on which vesting was accelerated as of December 31, 2005.

Advertising expense was $30 million in the second quarter of 2006, and $29.7 million in the second quarter of 2005, an increase of 1.2%. As a percent of revenue, advertising expense was 1.9% of sales in both the second quarter of 2006 and the second quarter of 2005.

Operating margin in the second quarter of 2006 was 6.6%, compared to 6.7% in the second quarter of 2005. Operating margin in the second quarter of 2006 includes stock option expense associated with the implementation of SFAS 123R as well as the other items previously discussed.

For the remainder of 2006 our stated objective range for operating margin is 6% to 6.5% on a GAAP basis. This reflects a 10 basis point increase from the previous range of 5.9% to 6.4%. Prior to the implementation of the new accounting standard relating to the expensing of stock options, our historical operating margin objective range was 6.5% to 7%. The implementation of SFAS 123R has the impact of lowering this range to 6.3% to 6.8%. As previously discussed, our objective beyond 2006 is to return to our historical operating margin objectives of 6.3% to 6.8%, as adjusted for the impact of expensing stock options. As we had that historically, we will update our objectives only during our quarterly earnings calls.

The effective tax rate for the second quarter of 2006 was 35.4%. This compares to 36.7% for the second quarter of 2005 and 37.4% for the first quarter of 2006. The year over year and quarter over quarter decreases reflect the resolution of a tax audit in the second quarter of 2006. This change in effective tax rate increased earnings per share in the second quarter of 2006 by $0.02 per share, compared to the second quarter of 2005 and by $0.03 per share compared to the first quarter of 2006. We evaluate our effective tax rate each quarter, but for the second half of 2006 we currently estimate the tax rate will be approximately 37.1%.

As John mentioned, we repurchased 1.5 million shares in the second quarter of 2006. In the first quarter of 2006, we repurchased 2.2 million shares, which were more heavily weighted towards the latter part of the quarter. The average number of diluted shares outstanding in the second quarter of 2006 fully reflected our first quarter repurchases. Comparing the second quarter of 2006 to the second quarter of 2005, share repurchases positively impacted earnings per share by approximately $0.04 per share.

Turning to the balance sheet, inventory turns on an annualized basis were 23 times in the second quarter of 2006, which includes the impact of the western distribution center, compared to 25 times in the prior year. As we previously indicated, we expected that the western distribution center could temporarily lower our inventory turnover, but our objective remains 25 turns annually as we continue to ramp up and balance inventory between the two distribution centers.

Accounts receivable days sales outstanding were 38 days at the end of the second quarter of 2006 compared to 37 days at the end of the second quarter of 2005. Our DSO target is 35 to 37 days. We were slightly above our objective, primarily due to the stronger sales growth in the public sector this quarter.

We ended the quarter with approximately $504 million in cash, cash equivalents and marketable securities.

Cash flow from operations was approximately $38 million and capital expenditures were $9 million in the second quarter of 2006. We still expect capital expenditures to be in the range of $45 to $50 million for the year.

Turning to segment results, corporate sales increased 3.3% and operating income increased 9.1% in the second quarter of 2006. Operating income for the corporate sector increased at a faster rate than sales, primarily due to improved gross margin. Corporate sector operating margin was 8% in the second quarter of 2006 compared to 7.6% in the second quarter of 2005, and 7.8% in the first quarter of 2006.

Public sector sales increased 12.6% in the second quarter of 2006, compared to the second quarter of 2005, while operating income was approximately equal to last year, primarily due to investments in additional selling resources. Public sector operating margin was 5.6% in the second quarter of 2006, compared to 6.3% in the second quarter of 2005 and 3.4% in the first quarter of 2006.

Before we conclude I would like to remind everyone that we will have 63 selling days in the third quarter of 2006, compared to 64 selling days in the third quarter of 2005. For reference, our fourth quarter of 2005 earnings press release included a month-by-month schedule of the number of selling days in 2006 and 2005.

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

John A. Edwardson

All right. Thank you, Barb, and for those of you who are on our question queue, we have quite a few of you and if you could limit the number of questions to two per person, that would be helpful.

Question-and-Answer Session

Operator

Thank you. We will now begin the question-and-answer session. (Operator Instructions) Your first question is from [Ben Esau] with Northern Trust. Please state your question.

John A. Edwardson

Okay, we can’t hear the question and we are showing nobody from Northern on our question list.

Operator

Can you hear us then?

John A. Edwardson

No. I think the Northern person was the first person that made a phone call in, but we’re showing Brian Alexander of Raymond James as the number one person on the question list.

Operator

Okay, we do have [David Lynn] with William Blair. Please state your question.

John A. Edwardson

Then we’ll have David Lynn.

And we can’t hear the questions.

Operator? Operator?

Operator

Mr. Lynn, are you able to hear us? One moment sir.

John A. Edwardson

Okay. Thank you. I wonder why her list is different than this.

Operator

Mr. Edwardson? One moment, sir. At this time we do have Brian Alexander with Raymond James. Please state your question.

John A. Edwardson

Okay. Good morning.

Brian Alexander - Raymond James

Can you hear me, John?

John A. Edwardson

We can hear you.

Brian Alexander - Raymond James

Great. Just a question on the margins, which were obviously better than I think most of us expected and you raised your gross margin target by 25 basis points, operating margins by 10. Just trying to clarify one, why is the gross margin increase more than the operating increase and two, at the high end of both of those ranges, why that would be lower than the level that you just achieved in the second quarter?

I think there’s reasons to believe the margin should actually get better so are you just being conservative or are there some puts and takes that we need to consider for why margins may fall below the level you just achieved in the second quarter?

John A. Edwardson

Okay, the margin answer woman is Barb.

Barbara A. Klein

Brian, as we highlighted in the comments, the gross margin had some items in it for the second quarter that may or may not repeat as we go forward. We certainly were pleased with the level that we achieved in the second quarter, but we have to be conscious of the fact that the vendor incentive programs can change from quarter to quarter and we also indicated that we had some promotions last year in freight that didn’t repeat.

So we have taken into consideration some of those factors as we’ve given you our revised gross profit objective.

John A. Edwardson

I’ll go on. Nevertheless, we did move the bottom end of the margin up by 25 basis points and with respect to the operating margins, you know, we’ve not yet gotten the leverage that we need to get in Las Vegas to overcome the cost of opening that new distribution center so the key to that is more revenue growth and more throughput through Las Vegas and also the stock option expensing is hitting us. And those two things are the main reason that the operating income margins didn’t move at the same level the gross profit margins did.

Brian Alexander - Raymond James

Another question would be on the demand environment. Obviously we see monthly sales from CDW but a lot of investors are concerned about the macro environment. We’ve had some notable pre announcements in the tech sector. IBM last night made some comments about soft enterprise customer demand but more stable SMB demand.

I guess beyond the monthly sales figures, John, could you provide any commentary or perspective on the demand from your customer base? Are you seeing any changes in behavior, bidding activity, closure rates or any other metrics that might indicate some change in trend that we might not see from just looking at monthly sales?

John A. Edwardson

Jim.

James R. Shanks

This is Jim Shanks. The thing that we have seen on the enterprise, and I’d agree with what you’re hearing from IBM. Definitely on the enterprise side, there’s a lot of challenges out there.

We predominantly play in the SMB, the medium and large space. We’re seeing good demand as far as activity in the quarter. We saw a lot of bid opportunities. We were able to keep in front of those. We continue to see in the second quarter our sales pipelines; all were doing quite nice. We found in different segments, some of our segments were really performing very strong. Others, a little bit of softness but a lot of that usually relates to timing of the year.

Brian Alexander - Raymond James

Thank you very much.

John A. Edwardson

Thank you. Next question.

Operator

Thank you. At this time, we do have [Ben Esau] with Northern Trust. Please state your question.

John A. Edwardson

No you’re back to the queue of who called in, not to the question queue. We’re looking at a completely different list here.

Operator

At this time, we do have Richard Gardner with Citigroup.

John A. Edwardson

Thank you.

Operator

Please state your question.

John A. Edwardson

Okay, Richard.

Richard Gardner - Citigroup

All right. Thank you very much. I was hoping you might be able to give us a sense of what you’re seeing out there in terms of pricing environment. I think coming into your quarter there was probably a great deal of fear that Dell was going to get very aggressive in the U.S. S&D market. It doesn’t look from your gross margin like you saw that, but would like to get your qualitative commentary there.

And then also, would like to just get a sense of what your pricing strategy is. I know that you’ve had some folks in the company looking at pricing now for awhile. What have you figured out about elasticity and what you think you can do with pricing and how you view the trade-off between volume and margin. Thank you

John A. Edwardson

Okay. Very interesting questions. I think with respect to the elasticity we’re going to give our head of marketing here a little bit of time to think about that answer and I’m going to talk about the pricing environment.

You know, our sense in looking at prices overall is clearly – it is competitive, it has always been competitive, it will always be competitive, and that is the way this industry operates. But the one thing that we haven’t seen is the people that we represent in the market at their cost, where they need to be, so we are getting very competitive prices from HP, from IBM, from Lenovo, from others.

So, you know, there was a great deal of worry about what Dell was going to do. Frankly, we were not seeing that in the market and we compete with Dell every single day of the year. But we have great price points to compete against them with from our vendor partners.

Jim, any other comments?

James R. Shanks

To follow on with the pricing question, you know, what we provide is value and so we tend to be able to take it out of just a pure price [inaudible] and that’s why we’re able to compete very successfully with some of the competitors out there that only rely on price.

We find that our partners work very closely with us but when you get back to being able to provide the best the industry has to offer, there’s a lot of extra value in that for our customers and they like that sustainability and the predictability of a partner that’s going to be there for the long haul.

So we’re finding more and more customers are understanding the value proposition that we provide and how it’s very unique from the value propositions that other people can provide.

Harry J. Harczak, Jr.

Two additional points, Richard. One is with our partners, they work very closely with us, particularly on incremental deals. A good example is we mentioned our notebook penetration point. We are going out, searching for customers that are net new so consequently our partners are very aggressive with us in pricing on those opportunities to bring new customers into the franchise.

With respect to the question that you asked, elasticity, it’s an interesting one. We’re certainly not going to share our pricing strategies with everybody. But when you look at a couple of categories the interesting thing is, the average selling prices have gotten so low that – and this is something I think some of the OEMs have learned as well – that the elasticity changed a little bit because if you have a desktop that’s selling for $400 if you drop the price, how much more can you drop it where it has an impact? But I think that’s one of the things that the OEMs have seen is that, with price drops, they haven’t driven the unit volumes that they had hoped for. So you get to lower points that have an impact on that.

John A. Edwardson

The other thing – we’ll give you lots of answers here – is our compensation for our account managers is driven by the gross profit they generate. They’re not going to go buy revenue and we’ve learned over the years that buying revenue is a trap you can get into that you then have to beat the next quarter. So, you know, our people are not going to spend their time and their effort working on deals where they can’t make any money.

Next question.

Operator

Thank you. At this time we do have Jason Gursky with J.P. Morgan. Please state your question.

Jason Gursky - J.P. Morgan

Good morning. Just one quick one for you. Given the $10 billion revenue number that you stated earlier in the call and part of the way that you’ve suggested you might get there is through acquisition, I’m just wondering if your philosophy has changed on how you view the capital structure going forward. You’ve got no debt, $500 million in cash and you’re involved in share repurchases. I’m just wondering how this might look on a go forward basis, whether your attitude towards debt has changed over time.

John A. Edwardson

Now Jason, we have worked as hard as we can get to get our cash level below a half a billion and it just seems to be nearly impossible to do that.

If you look over the last five years, we’ve now returned $1 billion, just under $1 billion, to shareholders. When you think about that for a company the size of this company given the business we’re in, that is truly a remarkable achievement. But we’ve been very aggressively buying stock back and raising the dividend.

I doubt that our Board of Directors will be too inclined to see us take on debt to have a major change in the capital structure of the company but, you know, we’re listening. We know the issue about cash accumulation and we’ve been buying a lot of the stock back, but we seem to keep getting back to that half a billion number even after we do it.

Jason Gursky - J.P. Morgan

Okay, great. Thanks, guys.

Operator

Thank you. At this time we do have Bernie Mahon, with Morgan Stanley. Please state your question.

Bernie Mahon – Morgan Stanley

Hey, good morning. A question for you, Barb. On the SG&A or basically, the selling and administrative expense line, if I look sequentially, that was actually down on an absolute dollar basis, which is pretty impressive just given that revenue actually grew, you incurred costs for the Vegas facility. Could you just talk about what’s going there and how that should trend going forward?

Barbara A. Klein

Well Bernie, I think that we’ve given you two guides in terms of what our objectives are. We’ve given you the gross margin objective that we have just stated would be 15.25% to 16%, and we’ve given you our operating margin objective of 6% to 6.5%. So I think what we try to do is to give you our objectives and then we let you all determine from your own models what you expect on the SG&A side.

One thing I would point out that I did note in my comments was that we did have payroll tax expense associated with those stock option exercises the first quarter because we did accelerate options for co workers below manager level and there were a number of people who took advantage to exercise options the first quarter. We saw significantly less activity on that in the second quarter and so some of that impact in terms of quarter-to quarter effect on SG&A can be attributed to that piece.

Bernie Mahon – Morgan Stanley

Oh, did you quantify that at all? The tax impact in the first quarter?

Barbara A. Klein

I think we did and I don’t happen to have it in front of me but Cindy Klimstra can get you that number.

Bernie Mahon – Morgan Stanley

Okay. That’s helpful. Thanks a lot.

Operator

Thank you. At this time we do have Matt Sheerin with Thomas Weisel Partners. Please state your question.

Matthew Sheerin - Thomas Weisel Partners

Yes, thanks and good morning. I just have a question on the public sector. It looks like the year over year sales growth decelerated a bit in the month of June. Is that a function of a tough year over year comparison because I know you did very well in the month of June last year in public, or did you see any push out to either state or local or federal?

James R. Shanks

As we mentioned earlier in the script, federal had mid single-digit growth and I think that’s part of it. Usually the federal, their busy season really is Q3. In some occasions you’ll see them get ahead of their budget spent and they’ll do some of it in the second quarter. Other times they’ll wait a little more and have it hit in Q3. So that was the main event we saw.

Matthew Sheerin - Thomas Weisel Partners

Okay. And then second question, on the sales force realignment. I know part of the reason was to get better support from your vendors on a regional basis. Are you beginning to see that at all and is that contributing either to sales or to the margin picture?

And you also mentioned that the realignment is “a work in progress.” At what point should we expect that realignment is complete and business would be running smoothly.

James R. Shanks

The vendor portion first. We have definitely seen a lot of excitement with our vendor partners on going out on joint calls and working on opportunities. We have had multiple events where we’ve been able to bring customers in, in joint environments. A lot of good discussion around opportunities. Clearly something that we’re very supportive of and our partners are as well, so we think that’s something that just proves one of the advantages that we felt very strongly about going into regionalization.

The second part was on realignment, thank you. You know, it is a work in progress and one of the things that we tried to make very clear in the first quarter script was that we’re really trying to make a big push to get the foundation in place. So we took a big step forward to get the structure, to get the districts established and get people, you know, in district and established around their accounts.

From that, we wanted it to be more of a national progression and that’s why we call it a work in progress.

As we also pointed out, the account managers have really rallied in support of what we’re trying to do with regionalization. They do see the benefit and so a lot of the transitions we’re doing right now are at their request. They’re analyzing their customer base more closely than they have in the past. They’re looking at the opportunities that make sense for them in this structure going forward and as an organization we’re being supportive of that because it aligns with our overall strategy.

Matthew Sheerin - Thomas Weisel Partners

Okay. Thank you.

Operator

Thank you. At this time, we do have Bill Fearnley with Ftn Midwest Securities. Please state your question.

John A. Edwardson

Good morning, Bill.

William Fearnley - Ftn Midwest Securities Corp.

Yeah, good morning, John. On the Las Vegas distribution facility, I had a question for you regarding the ECC in Las Vegas. How’s it performing versus your expectations? What capacity or percentage of capacity is it at and what percentage of capacity is Chicago running at currently because you have Las Vegas? Then I have a follow up.

John A. Edwardson

If we look at Vegas, one of the things that is difficult still to project is what kind of operating efficiency are we going to get there because at a level of probably, with 30% of our volume, it’s less than 20% to 25% of it’s rated capacity, maybe even less than that. So as we look at it, we’re able to move more volume through it and move everything that we ship west of the Mississippi and in some cases we’re even doing a few things east of the Mississippi. But if we go too far east, the transportation cost just isn’t worth it.

So one of the things that we know is that we will get better productivity there than in Vernon simply because of the way that it is laid out and the new equipment and new methods of doing things there. But it’s going to take another $1.5 billion of revenue for the company or something before we can really get Vegas up into a mode of operating enough capacity to have a good test.

William Fearnley - Ftn Midwest Securities Corp.

Thanks. And then, no earnings call would be complete without a question about acquisitions. You know, how should we be thinking about the profile of an acquisition target? Any change regarding domestic or international or would you go large, with a large sales force, or smaller, so you could add for solution specialist role? Any additional color you can give on if your targets or views of targets have changed, that would be helpful. Thanks.

Harry J. Harczak, Jr.

This is Harry. I’m going to stay at a very generic level and I would say our view hasn’t changed in terms of our focus on finding something that either delivers market share gains or something that is added to the business.

When I say added to the business, we look at a couple of fillers there. We’ll look at something that has a customer base that we perhaps are not strong in, a product set or product area that we’re not particularly strong in, or perhaps a geographic region, which could include a geographic region that’s concentrated in the States or could potentially include something out of the States.

But really looking for things around those kind of fillers and ultimately also we always talk about the importance of our culture, making sure that whatever we look at from an acquisition perspective is a good cultural fit with CDW.

William Fearnley - Ftn Midwest Securities Corp.

Do valuations concern you, John? You’ve said that some stuff you were looking at was pricey. Have you noticed any changes in the valuations of potential targets?

John A. Edwardson

No. As we look at this, you look at market caps, at least the public companies that we could have an interest in, none of those concern me. What concerns me is the unrealistic nature of owners of businesses on what they think their businesses are worth to CDW.

Everybody believes that we can run their business better than they’re running it currently and they want most of that value to go to their shareholders. So it is a work, you know, it’s a huge negotiation. But I think given where we are and where we want to be, we’re certainly spending a lot of time looking and sooner or later we’ll find the right combination.

William Fearnley - Ftn Midwest Securities Corp.

Thank you.

Operator

Thank you. At this time, we do have Bill Hand with Bear Stearns. Please state your question.

William Hand - Bear Stearns

Thank you. Recognizing that you’re currently seeing a negative impact from the corporate sales force reorganization which has admittedly slowed your growth, what else do you think is going on under the covers in terms of your growth rate, which has been coming down a little bit over the last couple of quarters? Do you think it’s just higher penetration within existing accounts? Is it slower end market demand? Just any color you can give beyond the corporate sales force reorg?

John A. Edwardson

I think if you look at this and you look where corporate was before we announced the reorganization, what it dipped to and it’s been coming back each month a little bit, there is clearly more demand there.

If you look at a number of indices, it looks as if our world is growing in the U.S. somewhere around 4% or 5% on a year over year basis. So the market is still huge.

As we look at the addressable market we believe that it is still $125 billion or some number like that and our revenues as a percent of that, there are tremendous growth opportunities. So the way that we look at this is we want to grow above market rates, there’s 95% of the market that we don’t own and a lot more to go after.

But you do have to admit, given where fuel prices are, given where world politics are, you know, given a lot of issues, it is a difficult world out there. But that means we just have to work a little bit harder to make it happen.

William Hand - Bear Stearns

Thank you.

Operator

Thank you. At this time, we do have David Manthey with Robert W. Baird. Please state your question.

David Manthey - Robert W. Baird & Co., Inc.

Yes, good morning everyone.

John A. Edwardson

Hello.

David Manthey - Robert W. Baird & Co., Inc.

I was wondering if you could just comment on Vista. I think in terms of the ultimate impact on software revenues may not be great just given the fact that a lot of your customers are now on licensing programs, but can you talk about the hardware impact and just when you might expect to see that based on previous examples?

Harry J. Harczak, Jr.

I think that based upon our previous experience, we think there’s going to be a lag. There will be some early adopters. The information we have is that Vista will require hardware upgrades so we think there will be a pull up. But I think there will be a lag on adoption as people wait, as many organizations do, to see how the system is performing and make sure that the bugs are out of it.

David Manthey - Robert W. Baird & Co., Inc.

Okay and then, just in terms of the margins at CDW-G, we really had a nice snap back here sequentially and I was checking my notes on the first quarter and I really didn’t have a reason as to why those margins were so low. I didn’t know if it was the allocation from the new distribution center or what the cause was.

Could you talk about the difference in EBIT margins from 1Q06 to 2Q06 and what the effects were that led to the jump?

Barbara A. Klein

Dave, we indicated in the first quarter I think that there were a couple of factors that impacted the public sector margins. One was gross margin and then there was the investment in selling resources that we made in the back half of last year, including the healthcare up channel, and then there were also some changes in allocation methodology for some of our corporate-type expenses.

And we had indicated that we were, you know, hoping to see that smooth out as we went forward so gross margin has continued to improve and we also have continued to leverage on those selling resources that were added, but we still highlighted that as a factor for year over year change in the second quarter. Then the impact from the allocation changes has begun to smooth out.

David Manthey - Robert W. Baird & Co., Inc.

Okay. Thanks very much.

Operator

Thank you. At this time we do have Ben Reitzes with UBS. Please state your question.

Benjamin Reitzes - UBS

Thanks. Well I guess that’s been asked. How about repurchases? Shall we assume that 84 is a pretty good pace per quarter given that you have so much remaining, or is it something that you do opportunistically based on, you know, the current stock price and maybe if the whole market sold off recently you maybe bought a little more than you wanted to?

John A. Edwardson

I think you’ve answered the question, Ben, and you know, we do look at this opportunistically and as we look where the market is it looked as if it was very, very attractive and so we have been aggressively in the market. At the same time, we make no predictions about what we’ll do in the current quarter.

Benjamin Reitzes - UBS

I just, to conclude and get my two –

John A. Edwardson

Sure.

Benjamin Reitzes - UBS

There was the question earlier about Dell. I just would like to hone it down. I mean, is the quick answer, you’re not seeing much and that, you know, they’re sabre rattling from Dell, that they’re going to do something? You know, we don’t seem to be seeing it impact HP much at all. I mean, is there – what’s the simple answer to that question?

John A. Edwardson

I think the simple answer is that Dell’s competitors have done a lot of work to get their products competitive with Dell so that when Dell moves, Lenovo, IBM, Acer and a number of others can move with them and so we can stay with Dell if they make the move. At the same time, as was mentioned earlier, at these low price points, you know, they’re low enough that they’re not creating a lot of elasticity.

Benjamin Reitzes - UBS

Thanks a lot.

John A. Edwardson

Okay. There’s time for one more question and then we have to get back to work to do this again in Q3.

Operator

Okay. At this point, we do have Bruce Simpson with William Blair. Please state your question.

Bruce Simpson - William Blair & Company, L.L.C.

Hi. Good morning, and congratulations to your whole team.

John A. Edwardson

Okay. Thank you, Bruce.

Bruce Simpson - William Blair & Company, L.L.C.

I want to try to focus a little bit on the impact of Microsoft programs and its contribution to gross profit in the quarter. Barb, when you went through your laundry list of items that had boosted gross profit you mentioned that specifically and you talked about how, I think you mentioned how it’s kind of an echo of the 2Q02 and ’04 and so I’m trying to find out, was there a specific licensing program which fell disproportionately into this quarter that might have boosted you that’s sort of unsustainable?

Then I think another specific program you mentioned was software assurance so if you could just kind of tell me how much those low revenue, high GP programs stemming from Microsoft fell into this quarter and how sustainable you think that is.

Harry J. Harczak, Jr.

Bruce, this is Harry. I’ll take the question. There’s really two programs that impact us and while we cannot provide you with the revenue or margin breakdowns, the difference in the programs, software assurance, we’re in a renewal period for software assurance so we had good growth rate in software assurance.

Software assurance we bill to the customer, but we only record the margin as revenue. We, of course, have debt. So the growth rate was strong there. Not quite as strong as prior periods because what we do have is, we do have customers that are migrating to enterprise agreements which cover all applications across the enterprise.

But enterprise agreements are actually billed to the customer by Microsoft and we get a fee back from Microsoft for those enterprise agreements, and our growth there was extremely strong. We have been having consistent growth in enterprise agreements each quarter as more customers are migrating to enterprise agreements. It’s something we focused on. We’ve done very well with it, not just the second quarter but each quarter over recent time.

Bruce Simpson - William Blair & Company, L.L.C.

So is there a way – I’m not trying to pin you down into giving any kind of change to guidance. Is there a way for me to boil that down into saying how much of it might have been Q206 specific such as programs that expired, and how much of it is probably sustainable moving forward?

Barbara A. Klein

Bruce, I think what we’re trying to tell you with our new objective for growth margin from 15.25% to 16% is that’s what you should focus on as you look into the latter half of 2006.

Bruce Simpson - William Blair & Company, L.L.C.

Okay. Thanks.

John A. Edwardson

Okay. Thank you very much. With that, we’ll conclude the call in one minute. First, I really want to say a big thank you to CDW co workers. I can tell from your questions and from the initial reactions that I read over the email during the call that these were great results. They didn’t happen by accident. They happened by a lot of people working very, very hard and I just want to thank the CDW team for making that happen and for those of you who are not doing business with CDW currently, we can have an even better quarter if you begin to do some business with us. So give us a phone call. 1 800 800 4CDW or go on our web site at cdw.com. We would love to show you the CDW difference. Thank you very much.

Operator

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

Copyright policy: All transcripts on this site are copyright Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY’S CONFERENCE CALL AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE CONFERENCE CALLS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY’S CONFERENCE CALL ITSELF AND THE APPLICABLE COMPANY’S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.