CDW Corporation (CDW) Q4 2018 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the CDW Fourth Quarter Earnings 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. [Operator Instructions] As a reminder, today's conference may be recorded. I would now like to turn the call over to Ms. Chris Leahy, Chief Executive Officer of CDW. Ma'am, you may begin.

Thank you, Chelsea. Good morning everyone. Thank you for joining us today to discuss CDW's fourth quarter and full-year 2018 results. With me on the call today are Collin Kebo, our Chief Financial Officer; and Beth Coronelli, our new VP of Investor Relations. I'll begin today's call with a brief overview of our results, key drivers, and our expectations for 2019. Collin will take you through a more detailed review of the financials. We'll then go to your questions. But before we begin, Beth will present the Safe Harbor disclosure statement.

Thank you, Chris. Good morning everyone. Our fourth quarter earnings release was distributed this morning and is available on our Web site, 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 earnings release, and 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 and adjusted EBITDA. All non-GAAP measures have been reconciled to the most directly comparable GAAP measures in accordance with SEC rules. You'll find reconciliation charts in the slides for today's webcast as well in our earnings 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 2017, unless otherwise indicated. In addition, all references to growth rates for hardware, software, and services today represent U.S. net sales only and do not include the results from CDW U.K. or Canada. Also note, that all 2018 and 2017 net sales amounts are reported under accounting standard ASC 606. The number of selling days were the same for both the fourth quarter and year-to-date in 2018 and 2017. All sales growth rate references during the call will use average daily sales unless otherwise indicated. A replay of this webcast will be posted to our Web site later today, approximately 90 minutes. I also want to remind you that this conference call is the property of CDW and may not be recorded or rebroadcast without specific written permission from the company. With that, let me turn the call back over to Chris.

Thank you, Beth. It's a pleasure to discuss CDW's results and strategic progress with you today. I'm please to report that CDW posted another excellent quarter, with strong sales and profitability. Fourth quarter results include an 8.6% increase in average daily sales, with net sales of $4.1 billion, up 9% in constant currency, an 8.8% increase in adjusted EBITDA to $323 million, and a 34.4% increase in non-GAAP earnings per share to $1.32. The strong performance contributed to an excellent 2018. For the year, we delivered 9.5% net sales growth with $16.2 billion of net sales, 9.8% adjusted EBITDA growth, and 35.1% to non-GAAP earnings per share growth. Our ability to deliver the strong fourth quarter and full-year performance was the result of three key drivers, our balanced portfolio of customer end-markets, the breadth of our product and solutions portfolio, and our ongoing execution against our three-part strategy. Let's take a look at how each of these drivers helped deliver profitable growth. First, our balanced portfolio of customer end-markets, as you know, we have five U.S. channels, Corporate, which serves customers with coworkers from roughly 250 and up; Small Business, which serves customers with roughly 20 to 250 coworkers; and Healthcare, Government, and Education. Within each channel we have teams further focused on customer end-markets and verticals. For example, in Government we have Federal with teams focused on serving the Department of Defense, and across civilian agencies, as well as state and local teams. Each of our U.S. channels generated more than $1.3 billion of net sales in 2018. We also have our U.K. and Canadian operations which together delivered nearly $1.9 billion of net sales in 2018. Our customer end-markets often act counter-cyclically given the different macroeconomic and external factors that impact each one. You see the benefit of our diverse customer end-markets in our fourth quarter results with four of our five channels as well as the U.K. and Canadian local markets increased high single digits or better. Taking a closer look at the fourth quarter performance, our corporate team delivered a 15% increase in net sales. Strength in the economy with healthy employment continued to create a significant customer demand for client devices. Our unique ability to meet these needs drove client device growth of over 25% in the quarter. This was on top of last year's high-teens growth. Client devices and video contributed to excellent double-digit transactional growth. At the same time, we continue to leverage our technical capabilities and strong solutions portfolio to help customers modernize their IT infrastructure and adapt more flexible architectures. This drove double-digit solutions growth. Server, storage, and NetComm were the leading growth categories in Corporate. Small Business delivered an 18% increase. Customers remained optimistic about the economy and their businesses. This clearly impacted their buying this quarter. At the same time, we continue to benefit from the focus we created with the standalone segment and investments made in our go-to-market approach. The team delivered double-digit growth in both transactions and solutions. Within solutions, NetComm was strong as we helped customers realize the benefits of more flexible architectures. Public high single-digit increases in healthcare and education were offset by government, which was down 12%. Solid growth in solutions across public drove a mid-teens increase in gross profit. Our government channel results reflect a high-teens decrease in federal. As we've discussed, the team faced strong comparisons throughout the year as a result of their success in 2017 meeting Department of Defense demand for Win 10 devices, which had a significant ramp in the fourth quarter of 2017. The federal team once again delivered excellent solutions performance this quarter with growth of over 20%, as they helped customers with continuing priorities around modernizing infrastructure and cybersecurity. The government shutdown did not have a meaningful impact on our fourth quarter results. State and local is down low single digits. The team drove strong growth in software as a service and services supporting infrastructure projects, both of these moderate top line growth as software as a service and certain services are accounted for on a netted down basis. Education increased 8%; K-12 was up mid single digits, posting a solid quarter on the heels of strong growth in Chromebooks in the third quarter of last year. Our ability to convert demand for client devices drove mid-teens growth. This growth was partially offset by declines in networking, which we expected given timing of E-Rate funding letters in Q4 of 2017 versus Q3 of 2018. Higher education has strong growth in the quarter, up low double digits. Creating connected campuses and a secure IT environment remain top priorities for our higher education customers. Success addressing these priorities drove solutions to grow nearly twice as fast as transactions, which were up high single digits. Solutions growth was driven by meaningful increases in NetComm and security. Healthcare was up nearly 8% as we helped customers modernize their infrastructure to streamline operations and enhance patient experience. This drove solutions growth of over 20% in the quarter. Our international teams continue to deliver strong growth, with combined sales up over 10% in U.S. dollars. In local currency, the U.K. was up high teens, and Canada was up high single digits. In Canada, solutions growth continues to outpace transactions, benefiting from investments we've made in technical capabilities. Our recently announced acquisition of Scalar Decisions Inc., which I'll speak to in a moment, supports our strategic focus and efforts to expand our solutions capabilities. In the U.K., we captured strong customer demand for both datacenter and client devices which drove excellent growth in the quarter. As in the U.S., customers are evaluating hybrid solutions with interest in both on-premise and cloud-based offerings. US-to-UK referrals were again up significantly. To date, we have not seen an impact on demand from Brexit. We have implemented the contingency plans I mentioned last quarter to address the event an agreement or transition plan is not in place by the end of March. We've established a presence on the continent so that we can continue to support customers with similar service levels and minimal disruption. This is an action we would have taken anyway given CDW UK's success to date and future growth opportunities, supporting our customers with IT needs in the EU. Our results also demonstrate the power of the second driver of performance, our broad portfolio of more than 100,000 products and solutions and more than 1,000 leading and emerging partners. Fourth quarter performance was strong across hardware, software, and services. Hardware and software both increased nearly 8%, and services grew in excess of 20%. Solutions grew faster than transactions. We've talked before about the longer sales cycles and the lumpiness of solutions. And this quarter, we saw the positive impact of solutions projects coming to fruition across many of our end markets. In transactions, we continue to capture share with client device sales up high single digits, on top of last year's growth of more than 20%. Our teams were able to manage through supply constraints in the quarter by leveraging our competitive advantage of scale and use of our distribution centers. In certain products we did see extended lead times and pockets of dislocation, but we were generally able to meet the customer demand. Hardware solutions growth reflected customers executing on datacenter and networking projects driven by the strength and confidence in the economy, a need to replace aged infrastructure, and the desire to take advantage of more efficient and flexible architectures, both on-premise and cloud-based. Results also reflect investments we have made in technical resources. Services, enterprise storage, and NetComm all increased double-digit. New architectures are also driving software performance as it becomes a larger component of IT solutions. You clearly see that in our performance this quarter. Software net sales increased nearly 8%, while gross profit increased high teens. Our top three software growth categories were network management, storage management, and security software. Services increased more than 20%, led by professional services, warranties, and other services provided to help customers implement integrated solutions. Our ability to provide cloud solutions to customers also contributed to this quarter's strong results. We drove robust double-digit increases in customer spend and gross profit, led by productivity, platform collaboration, and security workloads. Fourth quarter gross margin expanded 60 basis points year-over-year driven by mix. This reflected strong growth in netted down including cloud, software, and services, as well as solutions hardware. As you can see, 2018 was a year of excellent financial performance. It was also a year of continued strategic progress, which is the third driver of our performance. For CDW, our strategy starts with our customers, what do they need, how are they evolving, and how can we evolve with them to meet their needs. Our customers know that taking advantage of all productivity and growth benefits that integrated technology solutions can provide is critical for them to achieve their strategic objectives. But given limited IT resources and the ever-increasing pace of technology change, customers must evaluate their allocation of resources, and they need help making technology decisions, implementing solutions, and then managing their technology investments. Our three-part strategy is designed to make sure that customers turn to us for the help they need to make the right decisions for their businesses. Our three-part strategy for growth is to first acquire new customers and capture share. Second, enhance our solutions capabilities, and third, expand our services capabilities. Importantly, these three pillars intersect with each other. Each enhances our ability to profitably deliver the integrated technology solutions our customers want and need today and in the future. The first pillar focuses on productivity improvement. We do this through enhanced systems and data, sales force productivity initiatives, and investments in our brand and marketing. This underpins our ability to achieve our overall strategy. Productivity gains fuel our ability to invest, while delivering profitable growth. The second pillar ensures, we stay relevant to our customers and to our partners by investing in solutions capabilities that enable us to be that trusted partner for our customers. And our third pillar ensures, we have the value added services capabilities to deliver many of today's integrated end-to-end solution. The combination of these 3 interconnected pillars with our scale and scope creates a powerful differentiation in the market. Let me share a few examples of our strategy in action. The first example is the solution we are bringing to the US Census Bureau. Our services capabilities were one of the key reasons, we won the award to provide a Device as a Service as a solution for the 2020 US Census. But it was the combination of our service and logistics capabilities with our broad product portfolio and deep partner relationship that enabled to win. We were uniquely positioned to handle the provision of mobile devices and accessories, custom device configuration, wireless services deployment and secure asset management along with help desk and field support for an end-to-end solution to the field technology required to support as once every 10 year event. We're working closely with the Census Bureau on timing and expect to begin deploying devices into the field later this year. The second example is our acquisition of the Canadian solutions provider Scalar, which closed on February 1st. Scalar brings strong capabilities in areas such as security, cloud infrastructure and digital transformation. Scalar also expand our in market presence with locations across Canada. Scalar had strong local relationships in nearly 350 co-workers that at deep technical expertise, with little overlap between our customers and there's, we intend to grow our combined customer relationships and add new dimensions to the work we're already doing for them. And similar to CDW UK, we see a strong cultural fit and customer approach. And like CDW UK, we expect to drive a smart and successful integration. The final example, I wanted to share demonstrate how our ability to deliver integrated solutions help customers to achieve their strategic objectives, leveraging technology to provide an outstanding customer experience both in-store and online is a competitive imperative for retailers today. While straight forward to articulate it is extremely complex cost effectively and seamlessly deliver an end-to-end solution. We're helping a large retailers, do just that thorough our design and implementation of the hyper converged solution. That will deliver increased performance, capacity and availability of the IT infrastructure supporting their 200 stores. This modernized infrastructure will enable them to better serve their customers throughout the shopping experience from checking the availability of a product to picking up online orders to checking out at the store. Clearly, the execution of a three-part strategy contributed to 2018 excellent performance. In addition, our earnings growth benefited from a strong economy, healthy employment and a lower tax rate. We currently -- and that lead me to our expectations for growth for 2019. We currently expect the US IT market to grow approximately 3%. We expect top line performance to be between 200 basis points to 300 basis points better than the US IT market in constant currency on an organic basis. This excludes the incremental sales growth from the Scalar acquisition. Given our outlook in the market, we currently plan to add between 125 to 175 customer facing co-workers. On top off approximately 165 added in 2018. For 2019, we expect non-GAAP earnings per share growth of approximately 10% on a constant currency basis, with capital allocation contributing to the amplification of operating earnings. To close, I feel good about where we stand today for several reasons. First, we have confidence in our strategy. A strategy that positions us a strong growth, serves us well then confronted with macro channel or partner challenges and leverages our competitive advantages to deliver strong profitability and cash flow. This confidence our strategy has let our Board to increase our share repurchase authorization by $1 billion and to declare a $0.40 increase over last year's dividend. Second, the team is executed well against our strategy and we are committed to remaining focused on execution to drive our performance versus the market and strong financial results. Finally activity in the business field healthy, of course, we are mindful of the uncertainty regarding another government shutdown, product availability, Brexit and tariffs. We can't control these things, so we will do what we always do. Regardless of the potential outcomes impact on IT demand, we will focus on what we can control and hold ourselves accountable to outgrow in the market. As we always do we will update our views of market growth and hiring as we move through the year. With that, let me turn it over to Collin.

Thank you, Chris. Good morning, everyone. We delivered another quarter and full-year of results consistent with our long-term financial strategy to drive strong cash flow, deliver sustain profitable growth and return capital to shareholders. Before I begin, I'd like to remind you our results reflect the adoption of ASC 606 providing an apples-to-apples comparison for 2017 and 2018. Turning to our fourth quarter P&L on Slide 10, consolidated net sales were $4.1 billion an increase of 8.6% on a reported and average daily sales basis compared to last year. In constant currency, consolidated net sales grew 9%. Currency had a 110 basis points swing moving to a headwind of 40 basis points in Q4 2018 from a tailwind of 70 basis points in Q4 2017. As expected our sequential average daily sales decline of 6.8% was greater than historical seasonality given the strength in the third quarter. Gross profit for the quarter increased 13.1% to $694 million. Gross margin expanded 60 basis points driven by mixing into net revenues including software-as-a-service, warranties, commission revenue and other services and product margin which benefited from the strength in solutions categories as well as the overlap of client devices shipped to the Department of Defense last year. Turning to SG&A on slide 11, our adjusted SG&A including advertising increased more than sales the 17.1% increase was driven by three factors. Increased sales compensation which is directly tied to gross profit growth, performance based compensation consistent with higher attainment against goals and the balance of the strategic investments we announced at the beginning of 2018 which were funded by Tax Reform. Our co-worker count of 9019 was up nearly 300 from the fourth quarter of 2017. Adjusted EBITDA for the quarter was $323 million an increase of 8.8% compared to last year with an adjusted EBITDA margin of 7.9%. Reflected on Slide 12, interest expense was $37 million flat compared to the prior year quarter. Our GAAP effective tax rate included on Slide 13 for the quarter was 22.9% compared to an effective tax rate of negative 5.8% last year. This resulted in Q4 expense of $47 million versus $11 million benefit last year which reflected the implementation of the Tax Cuts and Jobs Act in December of 2017. If you recall, the adoption of the Tax Cuts and Jobs Act resulted in a positive one time impact of reducing our deferred tax liability partially offset by one-time expense related to the foreign income transition tax. With both adjustments nonrecurring, the net benefit was excluded from non-GAAP net income. You see the impact of the changes effective tax rate on slide 14, were our fourth quarter GAAP net income was $159 million, a decrease of 18% compared to last year. When you apply our non-GAAP effective tax rate to our non-GAAP pre-tax income, we delivered non-GAAP net income of $201 million in the quarter up 31.5% from last year. To get to our non-GAAP effective tax rate, we adjust taxes consistent with non-GAAP add backs, including excess tax benefits associated with equity based compensation. For the quarter, our non-GAAP effective tax rate was 23.7% down 12.8 percentage points compared to last year's 36.5% rate primarily due to the lower federal tax rate. The non-GAAP effective tax rate in the fourth quarter includes the impact of chewing up the full year rate to 25.7%. Our full year tax rate was favorably impacted by recently issued guidance from the IRS on foreign taxes creditable against Global Intangible Low Taxed Income. As you can see on slide 15, that fourth quarter weighted average diluted shares outstanding about $152 million. GAAP net income per share was $1.05, down 16.4%. Non-GAAP net income per share was $1.32 up 34.4% from last year. Currency headwinds had a 40 basis point impact on fourth quarter earnings per share growth. Turning to full year results on slide 16 through 19, we exceeded our financial targets for the year. Revenue was $16.2 billion, an increase of 9.5% on a reported and average daily sales basis. On a constant currency basis, consolidated net sales increased 9.2% compared to the prior year. Full-year gross profit was $2.7 billion up 10.5%. The gross profit margin was 16.7% up 20 basis points compared to 2017. Adjusted EBITDA was $1.3 billion an increase of 9.8% compared to last year. Full year GAAP net income was $643 million while non-GAAP net income was $794 million up 31.1% from 2017. Non-GAAP net income per share was $5.17, an increase of 35.1%. Full-year currency tailwinds added 30 basis points of growth to non-GAAP net income per share. Turning to the balance sheet on Slide 20 as of December 31, cash and cash equivalents were $206 million, and net debt was $3 billion. Our cash plus revolver availability was $1.3 billion and the total net leverage ratio was 2.3x. The weighted average effective interest rate on outstanding debt at year end was 4.5%, 20 basis points higher than last year. In 2018, interest expense benefited from the 1.5% caps in place. These caps expired at year end were replaced by an interest rate caps with the strike price of 2 and 3/8s that hedged the term loan in 2019 and 2020. With the caps in place, we are well-positioned to continue to manage the uncertain rate environment. Roughly, 96% of our outstanding debt at year-end 2018 was either fixed rate or hedged. As shown on Slide 21, we maintain strong rolling three-month working capital metrics during the quarter. Our three-month average cash conversion cycle was 19 days flat from last year's fourth quarter and within our annual target range of high teens to low 20s. Full-year free cash flow was $752 million or 4.6% of sales, 35 basis points above the high-end of our free cash flow rule of thumb of 3 3/4% to 4 1/4% of sales. The over-delivery primarily reflects higher cash profits, and favorable changes in other assets and liabilities. For the year we returned over $660 million of cash to shareholders, which included $139 million of dividends and $522 million of share repurchases at an average price of $82.49 per share. Before I discuss our 2019 financial targets and capital priorities, I would like to introduce a new pretax profit metric non-GAAP operating income shown on Slide 22. This will replace adjusted EBITDA as our internal and external metric for operating profitability. Our success helping customers adopt flexible consumption models, more solutions delivered as a service such as device as a service is the main driver of this change. Some of these solutions may be underpinned by CDW-owned equipment, and it is the associated capital expenditures and depreciation that make this new profit metric more meaningful. That is because it captures all costs associated with delivering new solutions including the depreciation and amortization associated with the revenue, which would be excluded from an EBITDA based metric. We define non-GAAP operating income as GAAP operating income adjusted for the amortization expense for acquisition related intangible assets, equity-based compensation, and other nonrecurring or unusual income and expenses. These adjustments are consistent with the corresponding adjustments in non-GAAP net income. We will report non-GAAP operating income in our disclosures beginning in the first quarter. Moving to our thoughts on 2019, starting on Slide 23, we continue to target net sales growth of 200 to 300 basis points above U.S. IT market growth in constant currency on an organic basis. As Chris mentioned, we currently expect U.S. IT market growth of approximately 3%. We closed the acquisition of Scalar on February 1, and expect Scalar to contribute an additional approximately 100 basis points of growth on top of the 200 to 300 basis points. Currency is expected to represent a 60 basis point headwind for the full-year, assuming exchange rates of $1.25 to the British pound and $0.75 to the Canadian dollar. Non-GAAP operating income margin is expected to be in the mid 7% range for 2019. Our capital spending has historically trended around half a point of sales so our non-GAAP operating income margin is expected to run approximately 50 basis points below our adjusted EBITDA margin. Non-GAAP earnings per share growth on a constant currency basis is expected to be roughly 10%. Currency headwinds are projected to shave 60 basis points from the constant currency rate. Please remember that we hold ourselves accountable for delivering these financial targets on an annual basis. Moving to slide 24, our capital priorities remain the same and continue to reflect our intent to drive shareholder value through the returns of capital and strategic investments. In order of priority, first increased dividends annually to guide these increases in November of 2014, we set a target to achieve a dividend payout ratio of 30% of free cash flow over five years. For this quarter we will pay a dividend of $0.295 per share on March 12 to shareholders of record as of February 25, up 40% from a year ago. Second, ensure we have the right capital structure in place with a targeted net leverage ratio in the range of 2.5x to 3x. We ended 2018 slightly below the low end of this range subsequent to year-end, we financed the Scalar acquisition with that. Third, supplement organic growth with strategic acquisitions. The acquisition of Scalar is a great example of this, and fourth, return excess cash after dividends and M&A to shareholders through repurchases. To support this priority, our board has approved an incremental $1 billion share repurchase authorization. This approval augments the balance remaining on the prior $750 million authorization on which there was $336 million as of December 31. Given 2018's over-delivery of free cash flow relative to our 3.75% to 4.25% of sales rule of thumb, we expect to deploy cash above our rule of thumb in 2019. Slide 25 provides additional modeling thoughts. We expect sales in the first half of the year to be slightly below our historical norm of 48% to 49% of full-year sales as we have one selling day shifting from Q1 to Q3. Keep in mind that the normal rhythm of our business is for first quarter sales to typically be the lowest dollar amount in sequentially below our fourth quarter. Over the past three years on an average daily sales basis, the Q4 to Q1 sequential decline has averaged down approximately 8%. We expect this year's first quarter sequential decline to be generally in line with historical seasonality. As I mentioned earlier, annual currency headwinds are expected at a rate of roughly 60 basis points on net sales. The expected headwinds are greater in the first quarter at 120 basis points as we lapse stronger pound and Canadian dollar exchange rates. Moving down to P&L, non-GAAP operating income margin is expected in the mid 7% range. Total annual depreciation and amortization is expected to be in the range of $270 million to $275 million. This includes approximately $180 million of amortization expense for acquisition related intangible assets including a preliminary estimate for Scalar that could change slightly once the purchased accounting is final. Depreciation and amortization expense and SG&A excluding the amortization of acquisition related intangibles is expected to be around $85 million. Equity-based compensation is expected to be in line with 2018. Interest expense is expected to be in the range of $165 million to $167 million with the year-over-year growth driven by the caps increasing from a strike price of 1.5% to 2 3/8% in the financing of Scalar. Our 2019 non-GAAP effective tax rate is anticipated to be in the range of 25.5% to 26.5%. We expect share repurchases to drive non-GAAP earnings per share growth of 350 to 400 basis points faster than non-GAAP net income. Non-GAAP earnings per share growth is expected to have currency headwinds of 60 basis points similar to our top line. We expect first quarter constant currency non-GAAP earnings per share growth to be lower than our full-year 10% constant currency target as we have one fewer selling day. This is timing as we will recoup the extra day in the third quarter. One fewer selling day adversely impacts first quarter profit growth by approximately 200 basis points. In addition, we expect first quarter currency headwinds of approximately 120 basis points. Additional modeling thoughts on the components of cash flow can be found on Slide 26. Our post tax reform free cash flow rule of thumb remains unchanged at 3 3/4% to 4 1/4% of sales. Expectations for capital expenditures excluding the census remain unchanged at slightly more than half a point of sales. We expect the cash tax rate in the 25.5% to 26.5% range of pretax income adjusted for amortization of acquisition related intangibles, and we no longer have tax related to the cancellation of debt income. We expect to deliver a cash conversion cycle within the target range of high teens to low 20s. Finally, the new leasing standard, ASU 2016-02 topic 842 is effective in 2019. There is no impact to the income statement, but the balance sheet will be grossed up for right of use assets and lease liabilities where we are the lessee. Additionally, CDW will be a lessor for the census device as a service offering with most of the revenue being recognized as lease revenue. Our team is working closely with the United States Census Bureau on timing. We currently expect the census to account for approximately 40 basis points of 2019 net sales growth, but could see revenue recognition and capital expenditures shift between 2019 and 2020 depending on the final rollout schedule. That concludes the financial summary. With that, I'll ask the operator to open it up for questions. Can we please ask each of you to limit your questions to one with a brief follow-up? Thank you.

Thank you. [Operator Instructions] And our first question will come from the line of Matt Sheerin from Stifel. Your line is open.

Yes, thank you, and good morning. Just a question regarding your outlook for this year, specifically relative to the transactional business and client device, looks like we're going into year-three of a fairly positive refresh cycle, both on the notebook-PC side and servers. I know we're up against some deadlines with some Microsoft operating system support changes early next year. So, what's your thought on the cycle? Are we in the last innings here? And as you see potentially lower transactional business, and it sounds like there's momentum on the solutions side, will we continue to see positive mix helping your gross margin?

Morning, Matt. Thank you for that question. I think there's a lot in there, so let me just take it piece by piece if I could. So, if we take a step back and think about client, you're right. We're seen really healthy demand there, and obviously watching that closely. A challenge to predict what inning we're in and I would say that the data points seem to be indicating that there are more factors impacting client refresh than have traditionally been the case. So, for example, we certainly do have the normal lifecycle refresh, older client devices out there, and some time-sensitive operating system upgrades coming up Win 10, Win 7, et cetera. But we're also seeing customers seeking competitive advantages through new technologies in this area to elevate productivity obviously, and to drive efficiency with their coworkers. So, in terms of taking advantage of that, the cycle seems like it's a little different frankly than it has been. So those time-compelling events are important and will continue to drive demand, but we're also seeing what I say is a little bit of a smoother level of demand across the years. Now that's obviously tied to budget and the ability to have that budget to spend, and we're seeing healthy budgets out there. So, on the client I would say we're going to continue to see strong demand, but we are overlapping some healthy growth last year and the year before, so we might see that moderating a little bit, but again, continuing on a more consistent basis than really time sensitive. On the solutions side, there's a lot going on there as well. We obviously have some Microsoft end of service coming around in the next year or so. And that will drive upgrades in the datacenter infrastructure, but equally, the advances in the technology and innovation is very interesting to customers, and we continue to have conversations with them about investing across the full spectrum, whether it's on-cloud, on-prem, et cetera. So, I think you're going to see a healthy environment. That said, when we look at 2019, there seem to be more external uncertainties than we had going into 2018. And so our perspective, sitting where we are today, is that the IT rate of market growth might be a little lower than what we saw in 2018.

Okay, thanks. That's very helpful. And just a quick follow-up regarding the federal business, you talked about tough comps in Q4, and you'll still have some tough comps this quarter. You didn't talk about any disruptions or delays relative to the federal shutdown, anything there to share with us?

Yes, on the federal shutdown, which started, as you know, at the end of last year, really no impact to Q4 results. We did have some projects slip because they were placed; orders weren't placed at the end of December. And we've obviously missed about a month worth of writing. Now, the good news is we had a holiday in there, we're in the period when our customers are really evaluating, as opposed to buying quite as much. And our teams were, frankly, on the phone with those customers during the shutdown to help them be ready when they got back. So we could see some shift in timing if orders aren't getting out. Now that they're back at working we could see some shift. But we don't expect that to be business that's lost, we just think projects might shift into Q2. Obviously, with the possibility of another shutdown looming there would be more concern because that could have longer-term effects and it could start to impact the rest of the economy. The other point I do want to make is, when you look at our federal business, we have Department of Defense teams and civilian teams, I think I mentioned in my prepared remarks. And if you look at the mix of that business, a lower portion of that business is civilian. And civilian agencies are the ones that were primarily shutdown because it's a partial shutdown. And even for the agencies that were shutdown there were some essential workers working, and so we tried to take advantage as best we could of that.

Okay, great. Thank you.

Thank you. And our next question comes from the line of Katy Huberty with Morgan Stanley. Your line is open.

Good morning, Katy.

Hi, good morning. Can you talk to whether you think there was any push out of demand -- or sorry, pull-in of demand around price increases due to tariff-related impacts in segments like networking during the quarter?

Yes, thanks for the question, Katy. We did have conversations with customers around that. And we reached out to customers, frankly, proactively to see how we could help. But at the end of the day, we did not feel any significant pull into the fourth quarter as a result of tariffs. We just didn't feel it.

Okay, thank you.

Thank you. Our next question comes from the line of Adam Tindle with Raymond James. Your line is open.

Okay, thanks and good morning. I just wanted to start on the solutions as a service, looks like that's a little bit of a change here. And hoping that you can talk about how this change could potentially change the competitive environment. Is there advantages that CDW has versus others in terms of scale, balance sheet, et cetera, versus small competitors? And if you could touch on how we can think about the key metrics as this picks up, is it deflationary to revenue growth but similar profit dollars? Thanks.

Yes, thank you, Adam. Yes, when we think about as a service generally, it's -- I'll start with, it's compelling to our customers. It's complicated in how you'll see it in our financial results because of the various ways that it can appear. So, if you have software as a service, for example, that's pretty clear, and that's down. We have a broad portfolio of software as a service that we offer our customers, and we are heavily involved in helping them to implement where they see fit, something like device-as-a-service. And I went through the Census example, the multiple advantages that we have that all work together, frankly, in a solution like device-as-a-service, is what won us the trust of the Census to actually get it done. Now, how that looks on the balance sheet and how it looks in the financial statements, I'll have Collin take you through, because it is constructed in such a way that it will be reflected in the financials in a certain way. But we've got other device-as-a-service deals that are constructed slightly differently and they will show up separately in the financial statement. So, let me have Collin just jump in on that one.

Yes, sure. Thanks, Chris. Adam, as we're taking these offerings to market the one consistent thing is that there is no standard approach to the accounting. All of these deals are being structured differently. In some instances it may come on to our balance sheet, in other instances we may lease from someone else, and in other instances it may just simply be a financing transaction where we're bringing in a third party to arrange financing and then through our financial statements it just looks like a normal product sale. But we did make the decision to move forward to non-GAAP operating income on a go-forward basis so that in those instances where we are putting capital to work, that we're including that depreciation expense, which is effectively the cost of goods sold on the offering. We felt that that was the right way to look at it. In terms of how it changes the model, I think because it's unclear exactly how all of these are going to be structured. It depends on each individual transaction. The Census is effectively a full revenue transaction, we are not netting down much on that. So I wouldn't expect that as an example to have a muted impact on the top line. I did make some comments on capital expenditures where we expect to be at our regular CapEx excluding the Census. We're not exactly sure when that CapEx will go out depending on the timing for the Census, whether it be later this year or early 2020, but I think the important point is that we don't expect it to change our free cash flow percentage [technical difficulty] So, whatever that CapEx number is we're still committed to the post tax reform free cash flow grew -- three-and-three-quarters to four-and-a-quarter percent.

Okay, that's helpful. Just as one quick follow-up, since adjusted EBITDA margin is going away I want to ask one last question on it. Gross margin has been increasing. I would imagine that this could continue to be a trend as the mix towards net seems more secular in nature. Just want you to maybe touch on how we can think about the impact to adjusted EBITDA margin if this continues to occur. I know there's some offsets, but how can we think about drop-through, and could we see another level of adjusted EBITDA margin beyond the high sevens as you continue to ratchet up?

Yes, as you know, there are a variety of factors that impact our gross margin. Chris mentioned mix and there are all these other different mix of products, mix of netted down revenues, mix of channels, mix of are you selling newer or more mature technologies, all of those things impact our gross margin. And then I think the other thing to keep in mind is we have a compensation structure that's tied to gross profit dollars, and we pay on that. And our solutions business does have a higher cost to serve. So, not all of that gross margin is going to drop down to EBITDA margin because of our variable cost structure. And so what I would say is it depends on how all of those things come together over time. Obviously, in the fourth quarter of this year we have a confluence of positive factors that caused a very strong increase in that gross margin. We'll see how that plays out over time depending on how all of those factors interact with each other. Continuing with EBITDA margin, you know we had mid sevens for a long time. And at our analyst day, a year-and-a-half ago, we did increase our outlook for that from mid-sevens, to high-sevens, to eight because of those factors that you mentioned. So, we'll see how that plays out over time.

Thank you, and congrats on the solid results.

Thank you.

Thank you.

And our next question comes from the line of Shannon Cross with Cross Research. Your line is open.

Thank you very much. I wanted to talk a bit more about the Canadian acquisition. I'm curious, is there anything that you expect to leverage from what they're doing that perhaps you can take into CDW? And then vice-versa, sort of how are you looking at the integration of that asset over the coming year? And then I have a follow-up. Thank you.

Yes, no, thanks for asking. We're really excited about Scalar. I would say that this is really an organization with an exceptional fit. And when you tick through what we look for in an acquisition that works, Scalar really hit all the boxes. You think about their deep technical expertise in areas that our customers are looking to us for advice in, including services capability; they add in-market sellers and technical folks with business up and running. And they have a great cultural fit, as I mentioned before. One of the things that was really interesting to us is the non-overlapping customer base. So, when you think about the value that we can bring to each others' customers immediately it's pretty attractive. Scalar has been really primarily a solutions-focused and based organization. And CDW, as you might remember, in Canada, our transactional business has been very robust, and we've been investing in the solutions area for some time. So, by bringing those two together we've got a nice base of customer that we can now offer a more fulsome group of IT solutions. In terms of Canada-to-U.S., if that was part of the question, like we've done across the board, even with the U.K., where we find opportunity to take best practices in the U.S. or in the local market and bring it back, we certainly will do that. And I think one area you can think about is operating efficiency. So, while this acquisition is really all about growth and bringing value to our customers, as we combine the two we would look to get some good operating efficiency down the road.

Thank you. And then I'm curious, I think you added about 300 coworkers last year, and I believe you mentioned you plan to add about 50% of that this year. Is that because you made this acquisition, that maybe you're not as aggressive in terms of hiring, or is that just the potential for upside if you find the right people?

Yes, I think there -- there was a number that I mentioned in my prepared script, was the 350, and that's a Scalar coworkers that are joining our family. We brought in about 165 customer-facing coworkers last year, and so we're looking to about 125 to 175 this year. So, reflecting the same level of confidence in our ability to execute.

Okay, thank you.

Yes, I think some of the confusion may have been, I gave a number on total coworker account up about 300, and Chris was referencing just the customer-facing coworker count.

Okay, great. Thank you.

Thank you. And our next question comes from the line of Keith Housum with Northcoast Research. Your line is open.

Good morning. Thanks for the question. And just a follow-up on Scalar, can you provide a little bit color in terms of their margin profile and the impact to the bottom line?

Keith, we're not going to provide that information. As we said, we don't expect them to be accretive this year, but we would look for them to be accretive next year, but we are not going to get into the details of the margin and frankly, it can fluctuate very much like CDW. It's based on the type and mix of solutions that they're selling at any given point in time during a quarter. But we're excited about the opportunity together and what we'll be able to drive overall in CDW U.K. as we bring the operations together.

Okay. And just as a follow-up question, in terms of the census project with regards to devices and service, what happens after the end of the product and the service becomes -- it comes back to you? Is there an opportunity to sell the product and perhaps have a gain or loss on the product, or is there an opportunity to recycle that into another project?

Well, that's actually part of the full spectrum of everything that's happening in this product. We are not the third party that will be taking the devices back, but another organization will be taking the devices back and then you know through resale benefiting from that. But that's part of the -- from soup to nuts, the entire project includes a repatriation if you will, of the devices, but by a third party, not CDW.

Yes, Keith, there is an assumption because of the accounting on this. There's a residual value that'll be assumed and ultimately what that is -- you know, there could be a minor variance, but I wouldn't expect it to be material.

Okay, thank you.

Thank you. Our next question comes from the line of Jason Rogers with Great Lakes Review. Your line is open.

Yes, just following up on the M&A questions. Are you finding more opportunity in Canada as far as the potential for new customers, view that as more of a focus for the M&A or do you see just opportunities widespread geography wise?

Thanks for that question. I wouldn't say that we find more or less opportunity up in Canada or in the U.K. or in the U.S. for that matter. I mean, we have a process where we're always engaged in knowing and looking at what is out in the marketplace. And frankly, given our institutional knowledge, we tend to scout outside what's on the market anyway and we see a lot in the U.S. and we assess a lot, but as I think many of you know, we're really quite disciplined about an acquisition and we look for something to complement our strategy. The cultural fit is really quite important to us. Is it going to enhance value for our existing and prospective customers, and then ultimately at a compelling price and you know, the compelling price is quite important to us. And when you look in the market, there can be a lot of interesting opportunities, but if the price isn't right it's not something that we're going to move forward on if we can build ourselves.

And I wonder if you can make some comments around your cloud growth in the quarter, if you're seeing any material acceleration as far as shifting offsite and any potential cannibalization of your historical offering?

Yes. We're not going to give that number this quarter. I think a couple -- maybe three quarters ago, we let you all know that our -- the customer spend which will be gross sales, gross revenue, customer spend was in the $3 billion area, so I would say it's a robust and mature practice with a broad selection. I think the question specifically around seeing growth in the cloud at the expense of on-prem, you know, we have always been, for several years now, a fan of the hybrid model, and you know, I think our view has always been that the world is going to land in a hybrid place, and I do think that's what we're seeing in the market. For us, it's opportunity across the board, we're not seeing -- certainly, some customers are repatriating back to on-prem for a variety of reasons as you know, but not at the expense of actually moving other workloads to the cloud. So I think we're seeing very balanced assessment by our customers. We're trying to help them understand what's best for them and their particular business, because obviously, the different businesses can take advantage of different types of technologies, but strengthen those and not one at the expense of the other is what we're feeling.

Okay, thank you.

Thank you. And our next question comes from the line of Paul Coster with JPMorgan. Your line is open.

Hi, thanks, this is Paul Chung on for Coster, thanks for taking my question. So just on operating margins, I know you are investing in the sales force and probably create some noise, but how should we think about areas where you can see some operating leverage beyond fiscal year '19? Sounds like, from the comments you made earlier, gross margin should stay in the 516% range? Thank you.

Yes, thank you. So our thoughts on 2019 are that our non-GAAP Operating income margin will be in the mid 7 -- again, I know it's a new metric, but if you think that our CapEx has historically run around half a point of sales, you can take 50 basis points and add it to that to give you kind of a comparable adjusted EBITDA margin. I made some comments earlier about some of the factors that impact our gross margin and how they interact with each other and also we do have a highly variable cost structure. So as the business does grow, and we generate more gross profit dollars, even if they come from solutions we have additional variable expense that goes along with that. And then secondly, we continue to make investments in the organization in terms of adding customer facing coworkers and other investments to ensure that we continue to drive that top line outperformance to market of 200 to 300 basis points. So yes, we feel good about our ability to deliver that mid-7 non-GAAP operating income margin and you know, depending on how the market evolves over the next several years, we could potentially update that, but for now it's 7.5%.

Thank you.

Thank you. And this concludes today's question-and-answer session. I would now like to turn the call back to Ms. Chris Leahy for closing remarks.

Thank you. As we wrap up the call today, I'd like to thank our 9,000 plus coworkers for taking care of our customers every single day, and for focusing on our customers' success thereby ensuring CDW's continuing success, and for those customers listening in, thank you for trust in CDW. We never forget that your success is our success. To our new Scalar coworkers, welcome to the CDW family, we are truly excited about the future and the opportunity to serve our customers together. Thank you for everyone who participated. We appreciate your questions and we'll look forward to next time. Thanks.

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