CDW Corp
NASDAQ:CDW
Earnings Call Analysis
Q4-2023 Analysis
CDW Corp
Christine Leahy opened the call highlighting the company's fourth quarter and full-year performance, with insights into strategic developments and outlook for the forthcoming year. Although detailed specifics on 2024 expectations weren’t provided, the focus was on a narrative of strategic progress and preparation for the future.
The fourth quarter saw net sales of $5 billion, a decrease of 7.7% compared to the previous year. Despite this decline, the company successfully maintained its profitability. Gross profit stood at $1.15 billion, only 2% lower year-over-year, showcasing resilient margins. Non-GAAP operating income was marginally lower by 1% at $519 million, while non-GAAP net income per share actually saw an increase of 3% year-over-year to $2.50. This performance illustrates the company's ability to protect its earnings even when top-line growth is challenged.
The company's results reflect a strong execution strategy, financial rigor, and ability to adapt to customer demand that has been shifting towards as-a-service and consumption-based solutions such as cloud and SaaS offerings. This adaptability mitigated some of the negative impacts on net sales from traditional hardware, which saw further pressure over the year. Despite a top-line net sales reduction of over $2 billion from 2022, the company managed to maintain flat non-GAAP operating income and a 1% increase in non-GAAP net income per share, which speaks to the strength of its business model and strategic investments made over the past five years.
A balanced portfolio across various customer end markets has helped the company navigate market dynamics. Corporate net sales decreased by 8%, Small Business net sales by 13%, and combined U.K. and Canada business by 14%. Public sales decreased by 4%, although there was a noted increase in government sales. Healthcare net sales decreased 5%, and Education net sales fell by 12%. Despite these reductions in net sales, gross margins increased across all customer end markets, indicating a focus on high-margin offerings.
The absence of the expected stabilization in hardware sales led to a decline in the hardware portfolio by high single digits, driven by significant declines in NetComm. However, there was an improvement in client device performance. Notably, customer spend on software increased by high single digits, and cloud spend increased across all end markets, signaling the value of the company's broad and deep portfolio despite the shift in consumer preferences and the challenging market environment.
The company's steadfast commitment to its growth strategy, particularly the expansion of solutions and services capabilities, was underscored by investments made over the past five years. These have included 10 acquisitions, aimed at bolstering expertise in areas such as cloud migration and cybersecurity. Such strategic moves have been essential for supporting its comprehensive go-to-market approach and extended its service footprint across the U.S. and Canada.
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[Audio Gap] we posted to our website later today. I 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 over to Chris.
Thank you, Steve. Good morning, everyone. I'll begin our call with an overview of our fourth quarter and full year performance and share some thoughts on our strategic progress and expectations for 2024. Then I will hand it all -- hand it over to Al, who will take you through a more detailed review of the financials as well as our capital allocation strategy and outlook.
We'll move quickly through our prepared remarks as always to ensure we have plenty of time for questions. Fourth quarter net sales were $5 billion, 7.7% below 2022. Strong growth and operating income margins mitigated the impact of top line performance on profits, and we delivered gross profit of $1.15 billion, 2% lower year-over-year, non-GAAP operating income of $519 million, 1% below prior year and non-GAAP net income per share of $2.50, up 3% year-over-year. Our results reflect consistent strong execution by the team, our financial rigor and our ability to deliver solutions and services across the full life cycle full stack. Results delivered under uneven commercial and international market conditions, which continue to drive cautious customer behavior. Customer priorities remained laser focused on operating efficiency and expense elasticity, priorities increasingly met by as-a-service and consumption-based solutions like cloud and SaaS as well as nascent ratable on-premise solutions. The team's ability to pivot to address these priorities drove excellent performance across solutions, including categories that commonly net down on a revenue basis. The impact of this success, combined with ongoing softness in traditional hardware categories resulted in further pressure on net sales. When this happens, we experienced what we saw this quarter, meaningfully dampened net sales growth with very strong gross margins. This phenomenon was not unique to the fourth quarter. Market dynamics drove hardware deprioritization and preference for solutions that net down throughout 2023. And our net sales of $21 billion were over $2 billion less than 2022. Notwithstanding our muted top line, strong execution by the team, underpinned by our full stack, full life cycle, full outcomes go-to-market approach delivered flat non-GAAP operating income, a 1% increase in non-GAAP net income per share and strong adjusted free cash flow of $1.4 billion, outcomes driven by the strategic investments we have made over the past 5 years to increase the value we deliver to our customers. That is the power of our strategy when combined with our resilient business model. 2023 was the year that truly pressure tested our strategy. The fourth quarter is an exemplary example of this in action. There were 3 main drivers of results, our balanced portfolio of customer end markets, breadth of our product solutions and services portfolio and relentless execution of our 3-part strategy for growth. First, the balanced portfolio of our diverse customer end markets. As you know, we have 5 U.S. sales channels: Corporate, Small business, health care, government and education. Each channel is meaningfully -- is a meaningful $1 billion-plus business on its own. Within each channel, teams are further segmented to focus on customer end markets, including geographies and verticals, we also have our U.K. and Canadian operations, which together delivered sales of USD 2.6 billion. Often, our customer end markets performed differently given macroeconomic or industry-specific headwinds or tailwinds. This quarter, all but one customer end market experienced a decline in net sales. The profit story was very different, with gross margin increasing across all customer end markets. Let's take a look at the puts and takes of how each end market performed in the quarter. Corporate net sales decreased 8%. Top line performance continued to reflect the impact of both netting down and hardware pressure. Momentum remained for projects focused on increasing productivity as well as projects focused on enhanced customer and coworker experiences. The team's ability to meet customer demand for these priorities with as-a-service and ratable solutions drove strong cloud performance. Year-over-year client device declines moderated down mid-single digits compared to the double-digit declines of the first 3 quarters. For Netcom, while network modernization stayed a top priority, customers focused on digesting investments made over the past few years, leading to a long expected backlog normalization and sales declined year-over-year. Small Business net sales declined 13%. Market conditions were consistent with the first 3 quarters of the year, and customer behavior remained cautious. Priorities remain squarely focused on cost management and projects that need to get done. Once again, projects that were launched, the needs remain paused. Customer demand for projects with shorter-term return on investment drove excellent performance in cloud and in total security -- total software, excuse me. Security remains a top priority, and the team delivered strong performance across our broad portfolio of hardware, software and services security offerings. Similar to corporate, small business client device declines moderated in the quarter, down high single digits compared to the prior 3 quarters double-digit declines. Public sales decreased 4% year-over-year as government's mid-single-digit net sales increase was more than offset by declines across our other public end markets. The federal team delivered a double-digit net sales increase as they continued their success helping agencies implement more efficient solutions to manage and protect data. This drove excellent NetCom performance up strong double digits. The team continued its efforts to help agencies optimize their existing cloud environments as well as deliver new cloud solutions. The state and local team delivered a mid-single-digit increase. The team's success enabling cloud-based solutions, especially with budget constrained cities delivered a triple-digit increase in cloud performance. For the second quarter in a row, the team delivered sales growth in client devices. Healthcare net sales decreased by 5%. Augmenting talent needs, modernizing data centers, driving cost savings and efficiency projects all remain focus areas for our customers. The team drove a significant increase in cloud performance, growth driven by their success helping systems adopt deep cloud portfolio, which includes proprietary health care solutions. Our broad portfolio of solutions also contributed to security growth as the team helped customers address heightened cybersecurity needs. Education net sales decreased by 12%, with K-12 posting a mid-single-digit decline and higher ed down mid-teens. For K-12, the team continued their success helping schools and their efforts to sustain technology gains over the past several years. This delivered excellent growth in services and cloud, both posting double-digit gains, gains that were offset by the combined impact of a double-digit decline in net comp and low single-digit decline in client device sales. The Hyatt team's success helping universities to address business process transformation efforts contributed to double-digit growth in services and cloud. Client devices showed stability. These encouraging trends were more than offset by declines in NetComm this quarter. Other, our combined U.K. and Canada business declined by 14%. While the teams continue to execute well, market conditions were as expected. And sales in both the U.K. and Canada decreased by double digits in local currency. Once again, our diverse end markets contributed to our performance amid an uncertain and uneven environment. The second driver of performance was our broad and deep portfolio. Let's take a look at how each category performed. The market did not experience the stabilization in hardware we expected and net sales of our hardware portfolio declined by high single digits. This was primarily driven by double-digit year-over-year declines in NetComm as the normalization of backlog adversely impacted year-over-year growth. Client device performance improved sequentially with a low single-digit decline. Software customer spend increased by high single digits but given the significant portion of the category that nets down, net sales declined. Strength was broad-based across software as we continue to help customers manage data, enhance productivity and secure their IT environment. Growth was particularly strong across security, virtualization and application suites. Cloud remained an important driver of performance across the business and was a meaningful contributor to gross profit. Customer spend increased across all end markets with roughly half of spend from commercial customers. Infrastructure as a Service, productivity and security were the top 3 cloud workloads during the period. Security remains top of mind for our customers as cyber threats continue to emerge, evolve and increase and customer spend increased by low single digits. Our teams continue to conduct vulnerability assessments, implement by Getty and access management solutions and provide training to our customers to help manage cloud deployments and enhance endpoint and application security. Services was a standout category this period with double-digit increases in professional and managed services. Integral to today's complex technology solutions, customers continue to lean into CDW as an extension of their own teams and leverage our services capabilities as part of their strategies. Our portfolio performance leads to the third driver of our results this quarter, relentless execution of our growth strategy. Core to our growth strategy are our objectives to expand and enhance our solutions and services capabilities. Over the past 5 years, investments, both organic and nonorganic, including 10 acquisitions have bolstered our expertise and resources in these 2 key areas to support our full stack, full life cycle, full outcomes go-to-market approach. Investments that have grown our capabilities in high-growth complex areas like cloud migration and cybersecurity that have enhanced capabilities like full stack and cloud-native software development, DevOps engineering, robust consulting and cloud-based workflow automation, expertise and resources and investments that have expanded our services footprint across the U.S. and Canada. As you can see, each investment we made is purposeful and delivers a specific capability that furthers our strategy, a strategy designed to ensure we evolve with the market and constantly fortify our leading position as trusted adviser to our customers and vendor partner of choice. Evolving with capabilities that underpin our relevance and ensure we are there for our customers today and as new technologies come to market, new technologies like artificial intelligence. With its extremely short high cycle, our customers are increasingly seeking opportunities to use AI to achieve their objectives. And while most customers are in the discovery phase, some are already adopting AI with our help. Here's a great example. An industry-leading semiconductor and software designer needed training and development for a domain-specific large language model to support a range of internal use cases. The data-intensive and highly proprietary nature of the company's designs and intellectual property made the use of a hyperscaler LLM and cloud-based compute and storage resources less optimal. The CDW hybrid infrastructure team worked with the customer to build a custom platform that supports both training and inference workloads for generative AI. The team designed the underlying architecture, which included a best-in-class 60-node supercomputer with a high-performance parallel file system storage solution. The successful installation and customer handoff resulted in a multimillion dollar hardware and software engagement and services opportunity. With both usage and use cases growing quickly, the company has engaged CDW to support further expansion of their existing infrastructure and to evaluate new solutions. Clearly, investments in our customer-centric growth strategy have elevated our relevance to customers to the highest level it's ever been. Our focused and disciplined execution of our strategy continues to make us a vital technology partner, whether enabling customer priorities that require high complex or transactional solutions. And that leads us to our 2024 outlook. The uneven market conditions we experienced throughout 2023 have persisted into 2024. Customer decisions remain deliberate and restrained with ongoing project scrutiny pursuit of short-term ROIs and continued buying hesitancy particularly around hardware. With this backdrop, we currently look for the U.S. IT market to grow by low single digits in 2024 on a customer spend basis, including the expectation of a slow start to the year, a view that incorporates the potential impact of some of our recent wildcards, including upcoming elections and geopolitical issues. For CDW, these conditions set up a year that thematically looks much like 2023, and our outlook assumes the growth of customer spend outpaces our net sales growth. Our customers face proliferating data and ever-expanding cybersecurity needs. They face expanding workloads and hardware obsolescence and they face the potential and promise of exciting new technologies. With our broad and deep portfolio of solutions and services, we are there for our customers today and tomorrow, wherever their priorities lie.
We are there for our customers as their trusted adviser to help them navigate increasingly complex technologies. Whether growth comes from consumption-based or as-a-service solutions or from hardware sales, we are well positioned to continue our track record of profitably outpacing U.S. IT market growth by 200 to 300 basis points. As we always do, we will provide an update -- an updated perspective on business conditions and refine our view of the market as we move through the year. In the meantime, we'll continue to do what we do best, leverage our competitive advantages and out-execute the competition. Now let me turn it over to Al, who will provide more detail on our financials and outlook. Al?
Thank you, Chris, and good morning, everyone. I'll start my prepared remarks with detail on fourth quarter performance, briefly touch on full year 2023 results, move to capital allocation priorities and then finish with our 2024 outlook. The team's strong execution and our financial discipline delivered very strong quarterly gross and operating margins and growth in our fourth quarter earnings per share on a diluted basis. We achieved these results on consolidated net sales of $5 billion, which were 7.7% below 2022 on a reported and average daily sales basis. Fourth quarter net sales performance reflected both our ongoing success providing cloud and SaaS-based solutions that drove meaningful customer spend and profits and the continued impact of uneven market conditions that we experienced throughout 2023. On a sequential average daily sales basis, fourth quarter net sales decreased 10.8%, while historically, fourth quarter net sales are lower than the third quarter, the sequential decline this quarter was more significant than we expected, reflecting a lack of hardware spending recovery, a continued mix shift into solutions that net down and generally softer economic conditions impacting our international end markets. Fourth quarter gross profit was $1.2 billion, down 2.3% versus prior year, with our gross margin increasing 130 basis points year-over-year and partially offsetting the impact of lower net sales volume. Gross margin of 23% was driven by one factor, a higher mix into netted down revenues, which while dampening net sales growth also enhanced gross profit margin. Cloud and SaaS-based revenue streams once again outpaced overall net sales growth. For the quarter, this category represented a high 35.4% of our gross profit compared to 30.7% in the prior year fourth quarter and was also up from the third quarter's 32.6% level. While we expect the mix of netted down revenues to be an important long-term durable trend within our business, it is important to recognize that this mix may fluctuate with customer priorities and product demand. Turning to expenses for the fourth quarter. Non-GAAP SG&A totaled $635 million, down 3.5% year-over-year. Prudent and diligent management of discretionary expenses and our overall fixed cost base helped to hold the line on profitability amidst the challenging IT spending environment. Coworker count at the end of the fourth quarter was approximately 15,100, up slightly from the third quarter and flat relative to year-end 2022. We continue to expand our solutions and services capabilities while concurrently driving efficiency and cost leverage from our broader operations. Following along on Slide 9, our flexible business model and financial discipline helped to deliver non-GAAP operating income of $519 million down 0.8% versus the prior year despite our contraction on the top line. Non-GAAP operating income margin reached 10.3%, up 70 basis points from the prior year and up 40 basis points from last year's 9.9%. As reflected on Slide 10, our non-GAAP net income was $349 million in the quarter, up 1.7% on a year-over-year basis. With fourth quarter weighted average diluted shares of approximately $136 million, non-GAAP net income per diluted share was up 2.8% year-over-year. Shifting gears briefly and moving to Slide 11 to review full year results. We experienced a persistently challenging environment in 2023. Uncertainty for our customers cause reevaluation and optimization of their tech spending, which combined with a marked shift in spending mix, led to a full year decline in our net sales of 10% on both the reported and average LA sales basis. Despite the top line decline, gross profit was approximately flat, down 0.7% for the year. This gross profit stability exemplifies the impact of our strategy over the last 5 years with both organic and inorganic investments, underpinning the team's ability to pivot to our customers where customers need us no matter the environment. Enhanced gross margin combined with effective cost controls resulted in a full year non-GAAP operating income margin of 9.5% with non-GAAP operating profit dollars similarly down just 0.6% year-over-year.
Moving down the P&L. Our net interest expense was slightly below our full year expectations, driven by higher interest income earned on our cash balances. Our tax rate was within our expected range. As shown on Slide 12, our non-GAAP net income was $1.3 billion, up 0.4% and non-GAAP net income per diluted share was $9.88, up 0.9% from the prior year. Moving ahead to Slide 13. At period end, net debt was $5.1 billion. Net debt declined by approximately $200 million from the third quarter, reflecting our increased cash position and modest debt repayment during the quarter. Liquidity remains strong with cash plus revolver availability of approximately $1.8 billion. Moving to Slide 14. The 3-month average cash conversion cycle was 17 days, down 4 days from the prior year and within our targeted range of high teens to low 20s. Our cash conversion reflects our effective management of working capital particularly with respect to our inventory levels. As we have mentioned in the past, timing and market dynamics can influence working capital in any given quarter or year. We continue to believe our target cash conversion range remains the best guidepost for modeling working capital longer term. Strong profits and effective working capital management drove a record full year adjusted free cash flow of $1.4 billion on shown on Slide 15, representing 106% of non-GAAP net income and well above our stated rule of thumb at 6.7% of net sales.
For the quarter, we utilized cash consistent with our 2023 capital allocation objectives, including returning approximately $83 million to shareholders through dividends and $50 million in share repurchases. For the full year, this translated to $322 million in dividends and $500 million in share repurchases, a combined $822 million return to shareholders or approximately 58% of adjusted free cash flow. This was within our initial target range for the year and slightly below our updated range due to stronger-than-expected cash flow in the fourth quarter. That brings me to our capital allocation priorities on Slide 16. Our first capital priority is to increase the dividend in line with non-GAAP net income. Last November, we announced a 5% increase of our dividend to $2.48 annually, our tenth consecutive year of increasing the dividend. In 2024 and beyond, we will continue to target a 25% target ratio growing the dividend in line with earnings. Our second priority is to ensure we have the right capital structure in place with targeted net leverage ratio. We ended 2023 at 2.4x down from 2.6x at the end of 2022 and within our targeted range of 2 to 3x. We have rigorous processes in place to proactively manage liquidity while maintaining flexibility. Finally, our third and fourth capital allocation priorities of M&A and share repurchases remain important drivers of shareholder value. For 2024, we will target returning 50% to 75% of adjusted free cash flow to investors through dividends and share repurchases. In lockstep with this, we've announced the Board's authorization for a $750 million increase to our share repurchase program. Combining our prior authorization with this new additional authorization, we currently have approximately $1.1 billion of availability under a share repurchase program as we start 2024. And that leads to our outlook on Slide 17. The uncertain market conditions we operated under 2023 have persisted into early 2024, and customer sentiment remains cautious and prudent. And while indicators suggest a compelling need to address workload in data growth, rising security threats and eventual client device obsolescence, our current expectations for a slow start to the year for IT spending and full year growth in the low single-digit range. With this customer spend scenario as our baseline, we additionally expect to profitably gain 200 to 300 basis points of share in 2024. As you know, when we mix in and netted down solutions, the impact is fully reflected in our gross profit, but it is muted in our net sales growth. Conversely, when hardware volume was strong as we saw in 2021 and 2022, our net sales growth is stronger as these products are accounted for on a full gross accounting basis. Given the impact of shifting customer priorities on our net sales and the inherent accounting differences that result from different business mix, we believe that gross profit has become a more effective barometer for gauging our growth expectations. As such, beginning with 2024 and go forward, we will align our outlook with a view on gross profit in lieu of net sales. Based on our current view of mix and margin rates across our portfolio, our expectation for 2024 is for low to mid-single-digit gross profit growth. This assumes a flat to modestly higher gross margin relative to full year 2023. Finally, we expect our full year non-GAAP earnings per diluted share to be up mid-single digits year-over-year. Please remember that we hold ourselves accountable for delivering our financial outlook on a full year constant currency basis. Additional modeling thoughts for annual depreciation and amortization interest expense and the non-GAAP effective tax rate can be found on Slide 18. Moving to modeling thoughts for the first quarter. We anticipate gross margin comparable to 2023's level albeit lower than Q4 and leading to low single-digit gross profit growth on a year-over-year basis. Moving down the P&L. We expect operating expenses to be higher to begin 2024 compared to Q4 as we accrue for a reset of compensation expense that was more muted at the end of 2023 along with other seasonal workforce expenses. We expect operating expense leverage as a percentage of gross profit to gradually improve as the year progresses and expenses even out. Finally, we expect first quarter non-GAAP earnings per diluted share to be in the low to mid-single-digit range year-over-year. As we start the new year, we are also adjusting our approach on the outlook for adjusted free cash flow. Again, given the variability of mix of business and the corresponding impact on net sales, we believe the relationship between adjusted free cash flow to non-GAAP net income will provide a more consistent metric going forward. For 2024, we expect adjusted free cash flow to be in the range of 80% to 90% of our non-GAAP net income. It is important to note that while we continue to operate in a cautious and uncertain environment, we remain confident in our ability to deliver profitability margins and cash flow to our stakeholders just as we did in 2023.
That concludes the financial summary. As always, we will provide updated views on the macro environment and our business on our future earnings calls. And with that, I will ask the operator to open it for questions. We'd ask each of you to limit your questions to one with a brief follow-up.
Thank you.
[Operator Instructions] Our first question comes from Matt Sheerin of Stifel.
Yes. My first question is just regarding your comments on weakness in infrastructure products, particularly NetComm products after a very strong first 3 quarters with that backlog down. Do you get a sense of how long it's going to take in terms of digestion period from customers and when that might pick up again?
Yes, this is Al. I would say, Matt, the first just -- I think you hit it right we would expect some headwinds on the net comp front. I'd say underlying demand is solid with some strength in some pockets but not significantly strong. The bigger headwind there would really be the compares when you look back in 2023 and particularly the first few quarters, the growth in Netcom was between 20% and 40%. So with those type of growth numbers from 2023, we would expect that we'd see declines, at least for the next few quarters.
Okay. And then on the PC demand and client devices, it looked like the year-over-year decline was much better or less worse, if you will, in Q4. What are your expectations in terms of client device upgrades? It doesn't sound like you're super optimistic at least for the first half. So what's the outlook there?
Sure. I'll take that as well, Matt. I think that's right. For at least the first half, what we're calling for is similar trends to what you've seen in the last few quarters that is continued strength in netted down revenues, specifically cloud and SaaS. And we would not see strength on the hardware side, including PCs. What our outlook calls for is a modest recovery in the back half and that includes PCs. And look, I'll just add the -- while we still believe that there is impetus and catalyst for PCs to return, it becomes just basically a matter of when, not if, we think we're a few quarters off from that.
Our next question comes from Adam Tindle of Raymond James.
Okay. I just want to start at a high-level question, maybe Chris or Al could answer. But as we think about CDW from an investor perspective, a lot of us have thought of this as a compounder that generally experiences double-digit earnings growth with an algorithm of kind of mid-single-digit top line, some leverage, some capital allocation, you kind of get to this double-digit earnings growth. You just finished the year with flattish earnings growth. And then this year, your initial guidance for 2024, I think, is mid-single-digit earnings growth. So I'm just wondering if you could revisit that and how should investors think about CDW's earnings algorithm. At this level of size and scale, should we sort of reset our expectations and think of this more as a mid-single-digit compounder at this point? Why or why not?
Sure. Thanks, Adam. This is Al. Look, I do think that we're in this transitory period, right? We've gone through periods of extremity with the pandemic and with returns that were significant. Obviously, there's been some digestion and quite a bit of mix shift as we've eased in the post-pandemic period. I would continue to call 2024 a transitory period, right? We are just not seeing the strength or the return to demand on the hardware side of things as customers have essentially decided to ration their spend to items that they believe will optimize their cost, create the greatest ROI, et cetera. That being said, all cycles kind of have their beginning, and we do believe that on the backside of this, there are significant catalysts that will balance things out and include a return to growth on the hardware side. So I think what you're seeing from our outlook and what you saw in 2023 is something like a transitory period. And when we look beyond that and some of the catalysts that we think are on the other side, we believe the returns will look more significant.
Yes. Al, thanks. I would just add, if you take a big step back, Adam, what are our customers facing? They're facing proliferating data. They're doing ever expanding cyber threats, expanding workloads, hardware obsolescence, the incredible promise of new technologies. And so the landscape that they're facing and the essential nature of technology to every single walk of life is not going away. So as we look forward to these catalysts that Al mentioned, think about digital transformation. That's a durable trend and it's continuous process, and many customers have really paused on their investment and evolution in 2023. That's going to come back when uncertainty abates. Network modernization continues to be top of mind. And once that digestion gets through the process, then there's only going to be a need for greater -- to handle greater network traffic and data, et cetera. Security threats continue to grow, and they're more sophisticated kind of exclamation point. Client devices are just aging and even the pre-pandemic devices are coming on 4 years old, and then we've got Windows 10 sunsetting. So you've got all of those things that are catalysts that we're going to see coming down the pike and then just add AI, still early innings, use case is not quite proven out yet, but we're seeing incredibly exciting opportunities for the services and execution of adoption around those. So I think we couldn't be more excited about the technology industry generally.
Okay. That's helpful. Maybe just a quick follow-up, Chris. Obviously, net leverage is about at optimal levels. Cash flow has certainly been a bright spot for the business. I understand the share repurchase authorization today, but I wanted to ask more from a strategic M&A standpoint since that's been sort of a core competency of CDW, I would say. As you think on a forward basis, obviously, there's been some moves around you from some competitors moving into some more cloud-based strategic areas. Wondered how you were evaluating or thinking about the strategic road map from an M&A perspective. On one hand, I think in the past, we've talked about perhaps expanding more internationally after such strong success with the Kelway acquisition years ago. On the other hand, obviously, expanding strategic capabilities would be another direction. Just how you're thinking about strategic road map from here?
Yes. No problem, Adam. Thanks for the question. The vectors you hit would be still consistent with how we're thinking about it, whether geographic expansion, larger acquisitions to bolster capabilities and tuck-ins, which we've been doing. And I would just reiterate, look, M&A is a strategic driver of our value prop and our growth strategy. And you've seen us do 10 acquisitions over the past 5 years. And those have been very valuable in terms of driving value to our customers. So as we think about where we focus our efforts, driving capabilities and solutions that are high growth and high relevance and in services capabilities, there's a plethora of areas that we could focus, including areas like security and cloud and AI. And so I would just say, look, at the end of the day, we said it before, we're always looking. And we've got a number of identified targets in our pipeline, but it also has to be opportunistic. The one thing I would say, Adam, is when you think about the success in evolving our business to be able to deliver the profitability that we did this year with the hardware pressure and the other dynamics happening in the market that's due to bringing on capabilities that are highly strategic, highly relevant and then executing against them. So when I think back 5 years versus now, our cloud business has grown on a compound annual growth basis by 30%, and we did it again in 2023. I look at security, another area that we are very focused on maiden acquisition in addition to internal investments, and that business has doubled in 3 years. So we really are investing behind the most important capabilities, and we're seeing great results as a result.
And Adam, let me just add one element. You hit it on the front end. We take pride in our ability to compound and you noted about free cash flow. In the environment we've been in, there's a bit of a kind of hunkering down, focus on margins, focus on cash flow. You'll note that we've increased our cash position. We're excited about what's on the horizon from a capital perspective when we think about the cash optionality we have in front of us, and that would certainly include M&A.
Next question comes from Asiya Merchant of Citigroup.
Great. How do you guys think about market share gains in the current environment? And if you could maybe peel back a little bit on the gross profit linearity looks like that's going to be a key metric, and I could read it a rightful metric. Maybe if you can walk us through the confidence and what's driving the confidence in improving gross profit growth rate from the low single digits at the start of the year and as you ramp through the year?
Yes. Thanks for the question. I'll start on market share gain. Look, we hold ourselves accountable consistently to deliver 200 to 300 basis points above IT market rate of growth. And we have a track record of doing just that, and we are confident that in 2023, we did gain share. If you look at our net sales versus what customers spend with CDW, we've talked about that delta widening significantly, and we're basis points now. So we're very confident that we've taken share even in this very cautious and uneven market environment. And that's to the team's excellent execution, and the value of our full stack full life cycle portfolio. Now I'll turn it to you for the gross profit question.
Yes. So yes, on the gross profit front, obviously, like Chris said, there is a focus in this environment, thinking about customer spend and that spread between customer spend and net sales has been significant. We also feel confident about the continued trend of items such as netted down revenues, which we think will bolster gross margin. There may be a bit of an evening outs on the gross margin front in the back half as we see additional mix of hardware start to kick in. But all things considered, I think that the seasonality and the pacing of GP would not be dissimilar to what you've seen in historical seasonal trends.
Okay. And so just to recap, you guys are thinking about some perhaps modest recovery in the second half on client devices. And against that backdrop, you guys are still kind of thinking about gross profit improving sequentially on a year on -- sequentially as you progress through the year?
Yes, I think that is broadly correct on the mix front in terms of the modest recovery in the back half. And with that, our GP would accelerate through the year?
Our next question comes from Amit Daryanani of Evercore ISI.
I have 2 as well. I guess, Chris, maybe just to start with, I'd love to understand, as you engage and talk to customers, what are the top priorities from an IT spend perspective in calendar '24? And I'm sure AI is a very hot topic, but the part I'd love to understand is are the investments for AI, the dollars for that, are they coming from some other bucket, i.e., that cannibalistic or do you think the will be net incremental to IT budgets?
Yes, in terms of priorities, they're consistent with what we've said in the prepared remarks. I mean customers in the commercial space, in particular, are focused on cost optimization, customer employee experience and things that revolve around that. There's still a heavy focus on digital transformation, obviously, and security as well. AI, which is where you're getting to AI, it's a hyper focus. I think last call, we mentioned that you can't have a conversation with the customer without AI coming up. And it's been very exciting because we've had a data AI practice for several years. And that practice, I would say, we deepened it and we scaled it particularly when we brought IGNW and Sirius into the CW family. And currently, I'd say the burgeoning demand for consultative services, in particular. And I'm talking deep technical capabilities as well as industry-specific capabilities. And so we're seeing quite a bit of momentum in our practice there. What I would tell you is that a number of customers are at the front end of their experiences. And we're helping them through use cases and what the efficiencies are to be had. And then we've got customers who are actually piloting some really interesting capabilities, and we're helping them work through those. Here's what we're not seeing. We're not seeing a budget shift out of IT. What we are seeing and hearing is that budgets are coming from elsewhere in the organization, the functional areas that are going to be improved through AI, innovation like HR, like finance, like marketing, literally across the organization. Organizations are using budgets there to allocate to AI improvements because they're thinking about it nearly as business transformation. So we haven't seen it a shifted, frankly, we're not expecting that to happen. We're very excited about the opportunities that lie ahead, though.
Perfect. And I guess, Al, if I could ask you a question, gross margins in '23 are up about 210 basis points. I think if I go from '21 to '23, they're up [ north ] to $400 million. I guess I always get a question on like what is the right gross margin range for CDW? But as you look at this performance, maybe for time to '23, to the extent you can parse out, how much of this do you think the gross margin expansion is secular versus cyclical? And is there a normalized range once you think about gross margin?
Look, if I peel back '23 -- would be the pickup and mix shift to note down revenues and particularly SaaS and cloud. That was the most significant component. Number 2 would be that hardware was softer. And therefore, that less mix of hardware and particularly PCs benefited us from a mix perspective. And then three, and we've noted this before, overall product margins were firm in 2023. And so that was a positive contributor to the gross margin story. So if I scroll that for, which I think is the logical question on it. We expect that the net down revenue trend is durable and will continue. And particularly, we would know we expect strength in the first half, and then you'll get some balancing out with hardware. Number two, on the hardware front, we are expecting a modest recovery in the back half on hardware, including PCs. So that would have the effect of diluting margin somewhat. To be candid, though, we don't believe that, that shift and what we're calling modest would significantly move the gross margins. And then finally, on the product margin front, but we study this closely and really our assessment at this point would be that product margins are holding firm. And I think that's a reflection of both a competitive environment but not any rational environment from a pricing and margin perspective. And then I've mentioned this before, but there's a trend of, I'll call it, richer configurations on the product front, right, customers moving up the value chain. And we do feel like that trend is and will persist. And so really, that's the rationale overall for our outlook and gross margins being substantially similar to 2023, maybe a tick up.
Our next question comes from Keith Housum of Northcoast Research yours.
Great. As we think about AI, I understand it's very nascent still for you guys and the rest of the industry. Is this more of a solutions or a hardware or a software or consulting opportunity for CDW. And how does that evolve over the next several years? How should we think about that?
Yes, it's a great question. And I would say, currently, Nathan, the opportunity in the burgeoning demand right now is because of the complexity and the speed and trying to figure out and test use cases. So we are seeing most of the activity for us in our advisory and consulting services. I think I used the word burgeoning. It's -- the momentum has been significant. But as you think longer term, this is a full stack play, and that's why CDW is a scaled, full stack, full life cycle provider with expertise, not just technically but deep into each industry vertical is -- positions us well to help our customers. And as you know, when we think about CDW's strategy and the growth over the years, we have been moving our capabilities to ensure that we're moving closer to the front end of the value chain. AI is a great example of that strategy in action given the consultant -- consulting momentum that we've been seeing. But at the end of the day, we're talking about the need for power consumption and data center enhancements and up and down the stack. So in terms of timing across the next several years, it's hard to say exactly when the various components of the stack will have -- It's just like any kind of revolutionary technology. We're seeing AI as an accelerate in our business and one that we think will play out fairly quickly over the next 24 months.
Great. And maybe as a follow-up, maybe to touch on a little bit here, but during the quarter, you guys announced some optimization charges within the EPS. So perhaps, Al, you can perhaps touch on the genesis of what those items were?
I'm sorry, can you say that one more time?
Yes. Just when we look at your non-GAAP EPS, we see that you had some amortization charges or restructuring charges in there. Perhaps you can just highlight what those items were made up of?
Yes. Yes sure. So a category of workforce optimization, really 2 components to that. We did have, as you know, some coworker events during 2023, and that was really about aligning our fixed cost base and our coworker count base with the level of the business and activity we were seeing. So that's one, call that more really onetime nature. The other element within that category would be real estate, as you would expect, and you're seeing more broadly, we are and continue to take a hard look at our real estate portfolio where we are in the hybrid phase, if you will, of our workforce and making sure that we constantly rationalize our real estate portfolio. And so there are some charges that are coming through that front.
Our next question comes from Samik rate of JPMorgan.
And maybe for the first one, if I could just follow up on the AI question and -- so the question Amit asked. We -- I understand sort of your comments about being more heavy towards consulting in sort of the early days of these AI sort of discussions with your customers. But when you think of a full stack solution or envision one in the future -- in sort of when the customers deploy, does it really take you further down the road of netted-down revenue mix increasing as overall mix of you business or does it really bring back -- sort of pull back the netted-down revenue mix in terms of balancing out the hardware and the software sales? Just curious about how you see a full stack solution playing out. And I have a quick follow-up.
Yes, I'll start and then Al can jump in. I think it's hard to say at this point. What I would say is when we think about AI as a tool to increase productivity and results. Just like we say, technology is essential to every component of every organization, being competitive and winning and delivering on their mission. AI is going to be central to that proposition because artificial intelligence is going to be embedded in every component and everything that we sell from the edge to the core. And so however that plays out in terms of how our customers consume it, how they purchase it and how they consume, we will be able to deliver across the full stack to them. In terms of what that looks like in netted down revenue specifically, again, hard to -- hard to really have a crystal ball as to how it's going to play out in that regard. Al, I don't know if you have thoughts on that.
Yes, I think that's right. And Samik, look, we will see exactly how this evolves. At this point, like you said, it is a bit -- which is not -- this is ultimately a full stack opportunity for us, and that would certainly include hardware. So we think that will be meaningful. As I would contemplate the netted out component, that would likely show up in spend associated with cloud and SaaS. So is it conceivable that we would see that come through, certainly. It just becomes kind of a matter of when and the pacing and track, if you will, for customers and how they ultimately deploy AI.
And for my follow-up, I mean, just curious, given the change we've had here in the inflation backdrop -- more side in relation to their discussions around pricing. How they think about pricing? Or are you preparing for a different sort of pricing regime that we've been in the last sort of couple of years?
Sure, Samik. I'll start and then Chris may want to add environment that's irrational on the pricing or the margin front ASPs have largely held firm. So looking forward at this point, we wouldn't see any drastic changing. We're not seeing activities from partners or customers that we -- that would suggest that we're going to see any sharp movements up or down. So our outlook is based on the presumption that would be largely firm here.
Our next question comes from Erik Woodring of Morgan Stanley.
Maybe, Chris, to start off. It's been a few quarters now where you've been clear that the spending environment is challenging. And in some cases, some of that hardware spend hasn't come through in the way that you perhaps thought it was. As you talk to your customers or you look at your pipeline, what is that catalyst that will unlock the recovery in the second half right now. What gives you confidence? What are you hearing or what are you seeing that allows you to take that view as we sit here today? And then I have a follow-up.
Yes, Eric, it's a great question and when we actually face here at C&W. At one point, do we loosen the first springs? Here's what I'd say, 2 things. One, there is definitely pent-up demand. Our customers are ready to start putting plans in action 2, they're looking to be more confident in the expectations for the rest of the year. So while there have been some more positive indicators currently around the economy, I mean we still have elevated inflation and elevated interest rates and they're just merely waiting to feel more confident in where the economy is going. I hate to make it that simple, but frankly, it is. But we're also equally confident of the pent-up demand and the desire for our customers to get moving on those projects. I'm talking about the commercial space in particular, but get moving on those projects that they have delayed and deferred for some period of time.
Okay -- cash flow conversion of 80% to 90%. That's a bit lower than it's just been over the last 2 years, realized, again, puts and takes this year. But if we -- if you could just address anything that we should think about that you'd call out this year specifically when it comes to either working capital changes, that would be helpful. But really longer term, is there a rule of thumb that we should be thinking of for free cash flow conversion is 80% to 90%, how we should think 3, 5 years down the line? And that's it for me.
Sure. Thanks, Eric. At this juncture, 80 to 90% is the rule of thumb that we would give you. As you will recall [Audio Gap] right, as growth softened EBIT, if you will. So I would say the other element that I would add for 2024, Eric, is the -- we don't know exactly how the year will play out and what the pacing of business would look like. And so we try to give a little bit of space for use of working capital. Our inventory is at very low levels, and you can look at that both on a DIO and just inventory balance dollar basis. And so look, we just want to take a prudent view out of the gates here that we may be more active users of working capital. And certainly, we'll update you as the year progresses. And I would just finally just say that it is and will continue to be a high priority for us of continue to drive cash flow, convert profits and ultimately have the optionality in our capital decisions to deploy it.
With that, I'll hand back to CEO, Chris Lay, to begin -- to end. Chris, please go ahead.
Well, thank you very much, Taylor. And let me close by recognizing the incredible dedication and hard work of our coworkers around the globe. Their ongoing commitment to serving our customers is what makes us successful. Thank you to our customers for the privilege and opportunity to help you achieve your goals, and thank you to those listening for your time and continued interest in CDW.
Ladies and gentlemen, this concludes today's call. Thank you for joining. You may now disconnect your lines.
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