CDW Corp

NASDAQ:CDW

Earnings Call Transcript 2019-Q2

[Operator]

Good day, ladies and gentlemen, and welcome to the CDW Second Quarter 2019 Earnings Conference Call. [Operator Instructions]. Later we will conduct a question-and-answer session and instructions will follow at that time. [Operator Instructions].

I would now like to introduce your host for today's conference, Ms. Chris Leahy, Chief Executive Officer. Ma'am, you may begin.

[Christine Leahy, CEO]

Thank you, Joelle. Good morning, everyone. It's a pleasure to be with you. Joining me in the room today are Collin Kebo, our Chief Financial Officer; and Beth Coronelli our VP, Investor Relations. I'll begin with a high level overview of our second quarter financial and strategic performance and share some thoughts on our outlook. Then Colin will take you through a more detailed look at the results, capital strategy and priorities and outlook for 2019. We will move quickly through our prepared remarks, to ensure we have plenty of time for Q&A.

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

[Beth Coronelli, VP, IR]

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

I'd like to remind you that certain comments made in the 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 furnish to the SEC today, and in the company's other filings with the SEC.

CDW assumes no obligation to update the information presented during the webcast. Our presentation also includes certain non-GAAP financial measures, including non-GAAP operating income and non-GAAP earnings per share. All non-GAAP measures have been reconciled to the most directly comparable GAAP, measures in accordance with SEC rules. You will find reconciliation charts in the slides for today's webcast, as well as in 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 2018, unless otherwise indicated. In addition, all references to growth rates for hardware, software and services today represent US net sales only, and do not include the results from CDW UK or Canada.

There were the same number of selling days in the second quarter of 2019 compared to the second quarter of 2018. There was one fewer selling day in the first six months of 2019 compared to the first six months of 2018. All sales growth rate references during the call will use average daily sales, unless otherwise indicated.

Replay of this webcast will be posted to our website later today. I also want to remind you that this conference call is property of CDW, and may not be recorded or rebroadcast without specific written permission from the company.

With that, let me turn it back over to Chris.

[Christine Leahy, CEO]

Thank you, Beth. Second quarter results were ,excellent with both strong top line growth and profitability. Consolidated net sales were $4.6 billion, up 10.6% above last year, 11.2% in constant currency. Gross profit increased 11.2% to $774 million. Non-GAAP operating income increased 10.7% to $358 million and non-GAAP net income per share increased 15.7% to $1.60 per share. These results reflect the combined power of our balanced portfolio of customer end markets, our full suite of offerings that address customer priorities across the IT landscape, and ongoing success executing our three part strategy for growth.

First, the balance across our customer end markets; as you know , we have five US sales channels; corporate small business healthcare, government and education. Each of these channels are meaningful businesses, generating annual sales of more than $1 billion. This scale enables us to further align sales teams into vertical customer end markets, including K12, higher ed, state and local government and federal government.

In addition, we have our UK and Canadian operations, which together delivered nearly $2 billion in 2018. These unique sales organizations, serve us well when end markets behave differently from each other. Sometimes that occurs because markets are disrupted by macro or external challenges. Sometimes it occurs when customers' behavior differ due to different priorities.

This quarter, our double-digit sales increase was driven by excellent results across all five of our US channels, each growing high single digits or better. US customers remain focused on client devices to meet growing needs from full employment, as well as refresh, driven by older equipment, new used cases and new security features. At the same time, customers continue to modernize their IT infrastructure and adopt more flexible architectures. The team did an outstanding job helping customers address these priorities.

In corporate, the team delivered just under 9% growth, as they successfully addressed ongoing demand for client devices, while overlapping last year's strong results. The small business team continued to leverage end market specific offerings and dedicated solution specialists, to deliver nearly 15% growth. The government team drove a 17% increase in sales. Federal had another excellent quarter, with sales up more than 20%. The team leveraged our distribution centers to meet customer refresh needs, and continued to deliver ongoing projects, like the Navy CANES floating cloud initiative and newer cyber security related initiatives, as they lap the impact of last year's shipping delays.

The state and local team delivered high single-digit growth, as they helped customers refresh client devices. Education's 9% increase reflected low double-digit growth in K-12 and low single-digit growth in higher ed. K12 delivered on networking needs, and overcame chip constraints to meet ongoing refresh. Higher ed continued to leverage our broad portfolio to help campuses use technology to upgrade and enhance student and teacher experiences.

Healthcare was up 14%, as the team continued to drive excellent results, helping health systems improve endpoint access and security, as well as address medical record storage and accessibility needs. Other, which represents our Canadian and UK operations, increased 8% on a reported basis. Both markets faced challenging overlaps in local currency. Canadian growth was driven by both organic and Scalar performance. The UK team delivered excellent increases in software and services, but as expected, local currency growth slowed on top of last year's more than 25% growth, and UK was flat year-on-year.

Clearly, second quarter results demonstrate the power of our balanced portfolio of customer end markets. Second quarter results also demonstrate the power of our second driver of performance, the breadth of our offerings. With over 100,000 products, services and solutions for more than 1,000 vendor partners, we are well positioned to meet our customers' total needs across the spectrum of IT.

US transactions increased mid teens led by high teens increases in client devices. US solutions increased mid single digits, led by double-digit growth in Netcomm hardware, which drove excellent increases in associated services and software. On a net sales basis, hardware increased 11%, software increased 5%, and services increased 26%. Hardware performance was fueled by client devices and Netcomm, both up double digits. Lapping last year's supply constraints, Netcomm growth was driven by data center, modernization and campus refresh, including investments to support ongoing digital transformation initiatives.

On the client side, the team did an exceptional job leveraging our unique ability to provide high value services like pre-orders, configuration and staging, in a supply constrained environment. Video also increased double digits, driven by both displays and digital signage.

Performance was lumpy in datacenter hardware, both enterprise storage and servers posted mid-single digit declines. Server performance was mixed across channels . Once again hyperconverged infrastructure posted meaningful double-digit growth. Flash represented nearly one-third of total storage hardware in the quarter, with customer adoption, aided by expanded offerings and improved economics.

Software net sales increased 5%. As you know, software is becoming a larger component of IT solutions. Success helping customers adopt new technologies and infrastructure refresh, drove double-digit growth in network management, storage management and operating system software.

Cloud also contributed to this quarter's results, with double-digit increases in customer spend, and gross profit. Growth was driven by productivity, collaboration mobility and security workloads. Services' 26% increase was led by professional services, warranties and configurations.

And this leads to the final driver of our performance in the quarter, the impact of investments we are making in our three part strategy for growth investments made to ensure we continue to serve our customers' IT needs in this evolving markets, whether in a physical virtual or cloud-based environment, in the US or internationally.

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 work in tandem. Each is crucial to our ability to profitably deliver the integrated technology solutions our customers want and need today and in the future. The first pillar focuses on continuous productivity improvement. This is vital to our ability to achieve our overall strategy. Continuous productivity gains fuel our ability to invest, while delivering profitable growth.

A key way we do this, is through disciplined sales management programs, like category penetration goals and book management. Prescriptive programs don't work unless we have the talent in place to execute them. So for CDW, a key way we drive productivity, is by hiring and retaining the right talent. This is more critical than ever in today's tight labor market, and we have several innovative programs in place to help ensure we continue to hire develop and retain the best talent.

Our sales residency program is a great example. Launched in November 2016, the program drive increased performance both through engagement and enablement initiatives. Residency focuses on CDW account managers between five to 24 months length of service. After completing four months in sales academy, residents are placed on their permanent sales team and assigned to a dedicated resident sales leader. The program includes mandatory formal training across multiple dimensions, all focused on building both technology and sales skills, with a focus on building solution skills early on our sellers career.

Results have been excellent to date, customer spend for residents within 13 to 24 months of service was 40% higher this quarter than in the second quarter of 2016. Solutions as a percentage of total sales for account managers in the program are 300 basis points higher than in 2016. At the same time, the attrition rate for account managers with zero to 24 months length of service, has declined nearly 25%.

Of course, retaining the right coworkers requires hiring the right coworkers. In this competitive market, we are implementing innovative approaches to ensure we continue to attract targeted talent. We are currently piloting artificial intelligence solutions to identify top talent within an applicant pool. AI tools identify high potential candidates, by finding applicants with characteristics demonstrated by high performing CDW sales professionals. When there is a high match, recruiters target the candidate for more intense activity.

Our AI pilots build on other investments we are making to drive recruiting productivity, combining texting software to stay in touch with applicants with our collaboration platform, to conduct video interviews, has helped us hire 35% more highly qualified and diverse candidates year-over-year. For our entry level sales role, integrating video interviews into our process resulted in a 25% percent increase in the number of candidates screened.

These are just a few handful of the ways we are investing to hire, train and retain talent. These investments, coupled with the strength of our value proposition, contribute to both seller and customer retention. At the end of the quarter, nearly 30% of our sellers had at least 10 years of CDW experience. Longer tenured account managers have longer relationships with customers, and that has a direct impact on sales.

Customers with more than 20 years with us represented just under half of this quarter's spend. Clearly our investments in our coworkers contribute to our profitable growth. Investments we have made to enhance our solutions and services capabilities, our second and third pillars, are also contributing to our profitable growth. These pillars are designed to ensure we remain relevant to our customers and to our partners.

Our acquisition of Canadian solutions provider, Scalar, a great example of our second and third pillars in action. Scalar has locations across Canada and brings strong capabilities in fast-growing areas, like security, cloud, infrastructure and digital transformation, with deep services capabilities. Our investment thesis is straightforward with Scalar; accelerate our solutions capabilities, and expand our geographic reach within Canada.

Let me share an example of how we are already benefiting from Scalar's solutions expertise. As CDW Canada customer needed to upgrade their security environment, key to the need was the desire to safeguard how they interacted with their clients. The customer had been with CDW Canada for some time, but we had limited success penetrating their solutions business.

Knowing the breadth and scope of the Scalar portfolio, the CDW account manager brought Scalar in on the problem. Scalar's security services team did a deep dive with the customer and developed a comprehensive solution, which included hardware, software and services. The solution centered on a zero-trust security model, that utilizes cloud-based firewall virtualization, to protect both enterprise and customer facing environments. Importantly, incorporating Scalar delivered implementation and training services into the solution, meant deployment was fast. The solution generated more than C$500,000 product sales and C$100,000 in services. Great early proof points on the benefit of the technical and services investment made in Scalar.

Cloud is another area, where you see the benefit of our technical and services investments. Investments made in our cloud practice since its launch in 2011, have enabled a portfolio of solutions that span the entire life cycle, from design, migration, integration, consumption management, and managed services. Last quarter, we shared an example of how we helped a customer migrate an electronic medical records workload from the cloud, back to on-prem solution.

This quarter, let's take a look at an example of how our small business team helped a customer move a backup and recovery workload to the cloud. A small, rapidly growing global real estate support business, held their data on-site and needed a fail-safe backup solution, no downtime, right away. The customer had a cloud-based pay-as-you-go subscription for test-dev, but did not have any ongoing cloud application.

Their dedicated CDW small business account manager brought in one of our small business Technical Solutions Advisors' to help. After assessing the situation, the advisor identified that one of our pre-packaged Small Business Solutions bundles was well suited for the customers' needs. The bundle included cloud-based recovery, with design and migration services, a perfect fit for the customers' needs, including quick implementation.

Packaging solutions with services is one of the ways our dedicated small business segment is making solutions more accessible for the customer, and easier for the seller to sell. Prior to our investment in dedicated small business technical coworkers and development of small business focus packaged solutions, this solution would have required meaningful technical resources and investment of time, that would not have met our threshold for profitable growth.

Solving key business problems for our sweet spot of customers in today's environment requires the right talent and strong services and solutions capabilities. These capabilities, combined with our competitive advantage of scale, scope and disciplined execution, helped drive sustainable profitable growth for us today and in the future.

And that leads me to our expectations for growth for the remainder of the year. Through the first half of the year, we have added approximately 165 customer facing co-workers, excluding Scalar. We now expect to be at or modestly above the high end of the 125 to 175 full year range previously shared. As we always do, we will monitor the market and adjust our plans as appropriate.

Given first half market performance, our current view of 2019 US IT market growth remains in line with the expectations we shared last quarter of full-year growth, of roughly 3%. Reflecting our share gains to date, we now target constant currency organic growth between 400 and 475 basis points above the market. In addition, we continue to look for Scalar to contribute an incremental 100 basis points.

As you can see, there is no meaningful change in how we feel about the balance of the year. We continue to expect ongoing, but moderating strength in client devices, and solid growth in solutions, as we overlapped last year's second half double-digit growth.

The wildcards we spoke about last quarter like Brexit and tariffs has pushed out, but still exist. We'll keep a watchful eye, and as is our practice, update our view, as we move through the year. In the meantime, the team will continue to do what they do best, out execute the competition and leverage our competitive advantages, to help our customers address their IT priorities.

Now, let me turn it over to Colin.

[Collin Kebo, SVP & CFO]

Thank you, Chris. Good morning, everyone. As Chris indicated, our second quarter results reflect the combined power of our balanced portfolio of channels, broad product offerings, and ongoing execution of our three part strategy. They also reflect successful investments in our business, that build on our long-term financial strategy to drive strong cash flow, deliver sustained profitable growth, and return cash to shareholders.

Turning to our second quarter P&L on Slide 8; consolidated net sales were $4.6 billion, up 10.6% on a reported basis and in average daily sales basis. On a constant currency average daily sales basis, consolidated net sales grew 11.2%.

On an average daily sales basis, sequential sales increased 15.2% percent versus Q1 of 2019. This was modestly below historical seasonality, given the strength of the first quarter, which included the timing benefits from the Netcomm backlog flush in federal, but stronger than expected, driven by one client device growth, which is very strong across the business, with most US channels growing healthy double digits, notwithstanding uncertainty from tariffs and CPU constraints.

And to public, where we had really strong growth across three channels. Government was up 17%, even with the federal timing shift into Q1. Education were K-12 as up double-digits and healthcare, which was also up double digits.

Gross profit for the quarter increased 11.2% to $774 million, gross margin expanded 10 basis points, driven by an increase in the mix of netted down revenues, including warranties and software-as-a-service, partially offset by year-over-year net sales growth, outpacing the year-over-year growth in partner funding.

Turning to SG&A on slide 9; our non-GAAP SG&A, including, advertising increased 11.7%. The increase was primarily driven by sales compensation, which moves in line with gross profit growth, incremental Scalar expenses, performance based compensation, consistent with higher attainment against goals and investments in the business consistent with our go-forward strategy, including co-worker count.

Co-worker count of 9,783 was up nearly 870 coworkers from June of 2018, with almost half of the year-over-year increase from Scalar and the remaining from organic coworker investments. Roughly, two-thirds of the nearly 870 coworkers added year-over-year, were in customer-facing roles. Non-GAAP operating income was $358 million, an increase of 10.7%. Non-GAAP operating income margin was 7.7%.

Moving to slide 10; interest expense was $41 million, up 8.7%. This was primarily driven by the interest rate caps increasing from a strike price of 1.5% to 2.375%. Our GAAP effective tax rate shown on slide 11, was 24.7% in the quarter, which is flat compared to last year. This resulted in Q2 tax expense of $65 million. To get to our non-GAAP effective tax rate we adjust taxes consistent with non-GAAP net income add backs, including excess tax benefits associated with equity based compensation, which is shown on slide 12.

For the quarter, our non-GAAP effective tax rate was 25.6%, down 40 basis points compared to last year's 26% rate, primarily due to guidance issued by the IRS in the fourth quarter of 2018 on foreign taxes creditable against global intangible low taxed income.

As you can see on slide 13, with second quarter weighted average diluted shares outstanding of 148 million, GAAP net income per share was $1.33, up 17.9%. Our non-GAAP net income, which better reflects operating performance, was $238 million in the quarter, up 11.5% over last year. Non-GAAP net income per share was $1.60, up 15.7% from last year. Currency headwinds dampened non-GAAP earnings per share growth by approximately 70 basis points in the second quarter.

Turning to first half results on slides 14 through 17, revenue was $8.6 billion, an increase of 10.2% on a reported basis and 11.1% on an average daily sales basis, as we had one fewer selling day in the first half of 2019. On a constant currency, average daily sales basis consolidated net sales were 11.8% higher than the prior year. Gross profit was $1.4 billion, up 11.3% and gross profit margin was 16.8%, up 10 basis points. Non-GAAP operating income was $646 million for the first half of 2019, up 10.7%. Net income was $350 million, and non-GAAP net income was $423 million, up 12.5%. Non-GAAP net income per share was $2.84, up 16.8%.

Turning to the balance sheet on slide 18, as of June 30 cash and cash equivalents were $195 million, and net debt was $3.1 billion. Our cash plus revolver availability was $1.2 billion. As shown on slide 19, we maintain strong rolling three-month working capital metrics during the quarter. Our three-month average cash conversion cycle was 16 days, down one day from last year's second quarter, and slightly below the low end of our annual target range of high teens to low 20s.

Free cash flow year-to-date was $407 million, compared to $188 million in the first half of 2018. The year-over-year increase in free cash flow, primarily reflects higher cash profits and mixing into vendors with extended payment terms. For the quarter, we returned $198 million of cash to shareholders, which included $43 million of dividends and $155 million of share repurchases, at an average price of nearly $104 per share.

Turning to slide 20, our capital allocation priorities remain the same and continue to reflect our intent to drive shareholder value, through returns of capital and strategic investments. In order of priority, first increase dividends annually, to guide these increases; in November 2014 we set a target to achieve a dividend payout of 30% of free cash flow over five years. For this quarter, we will pay a dividend of $0.295 per share on September 10 to shareholders of record as of August the 26, 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 2.5 to 3 times. We ended the quarter at 2.3 times, slightly below the low end of this range.

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 share repurchases.

Our capital allocation priorities support our updated 2019 outlook, which you can see on slide 21. As Chris mentioned, we continue to expect US IT market growth of approximately 3%. We now expect net sales growth of 400 to 475 basis points above US IT market growth in constant currency, on an organic basis. We continue to expect Scalar to contribute an additional approximately 100 basis points of growth on top of the 400 to 475 basis points.

Currency is expected to represent a 60 basis point headwind for the full year, assuming year-to-go exchange rates of $1.20 to the British pound and $0.75 to the Canadian dollar. Given year-to-date exchange rates, this implies currency headwinds of roughly 60 basis points in the second half of 2019, with headwinds in the fourth quarter expected to be slightly greater than the third quarter.

We expect non-GAAP operating income margin to be in the mid 7% range for 2019. We now expect non-GAAP earnings per share growth on a constant currency basis to be in the low teens, call it 13% plus or minus 50 basis points. This range is 150 basis points above our previous constant currency range of 11% to 12%. Currency headwinds are projected to save approximately 60 basis points from the constant currency rates. Please remember that we hold ourselves accountable for delivering financial targets on an annual basis.

Slide 22 provides additional modeling thoughts. Based on first half results and the expectations for the rest of the year, we look for sales in the second half to now be roughly 100 basis points lower than our historical sales, seasonality split of approximately 52% in the second half. We expect a low single-digit increase in sequential average daily sales from Q2 to Q3, which would be a couple of hundred basis points below the 3% average of the past three years.

Moving down the P&L, we continue to expect non-GAAP operating income margin to be in the mid 7% range. Total annual depreciation and amortization is now expected to be in the range of $265 million to $270 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 purchase accounting is final. Depreciation and amortization expense in SG&A, excluding the amortization of acquisition related intangibles, is expected to be in the range of $80 million to $85 million.

Equity-based compensation is expected to be approximately $5 million to $7 million higher than 2018. Interest expense is expected to be in the range of $165 million to $167 million, with the year-over-year growth driven primarily by the caps increasing from a strike price of 1.5% to 2.375%.

Our 2019 non-GAAP effective tax rate is anticipated to be near the lower end of the 25.5% to 26.5% range. We expect share repurchases to drive non-GAAP earnings per share growth, approximately 350 to 200 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 the topline.

Additional modeling thoughts on the components of cash flow can be found on slide 23. Our free cash flow rule of thumb remains unchanged at 3.75% to 4.25% 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 to be slightly below 25.5% of pre-tax income adjusted for amortization of acquisition related intangibles. We expect to deliver a cash conversion cycle within the annual target range of high teens to low 20s.

That concludes the financial summary. With that, I'll ask Joelle 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.

[Operator]

[Operator Instructions]. Our first question comes from Matt Cabral with Credit Suisse. Your line is now open.

[Matt Cabral, Credit Suisse]

Thank you. I wanted to start off on a broader demand environment. So you're continuing to see healthy double digit growth, but some of your vendor partners are starting to see a little bit of softness, particularly on more solutions-oriented categories. So I guess, just wondering if you could talk a little bit about what you're hearing from your customer base, in terms of their budget plans and just what you think may be driving that disconnect?

[Christine Leahy, CEO]

Yeah. Hi, Matt. Look our -- in conversations with our customers, they are still feeling bullish, and they are still looking to spend. When you think about our customer base, and take a step back and think about some of the exposure that others have, that we don't have, things like China, things like consumer certain other end markets, hyperscaler is another example. But -- that are more challenged, that's not what our customer base is facing. And so we've got a broad portfolio, as you know and we can help our customers, wherever there IT priorities are.

The other thing I would just say is, that in an environment like this, where the economy feels pretty strong and customer sentiment remains strong in our view, our competitive advantages allow us to drive even bigger share gains, as we do things like leverage our scale and our distribution centers, as I mentioned.

So look, the outlook for the rest of the year is pretty consistent in our view, with how we felt at the beginning of the year. Not a lot of data points out there that has given us any reason to perceive it differently. If you look at -- as you said, peer results, competitive results, the VAR survey, CIO surveys, economic data, there's stuff that's kind of lining up on both sides of the ledger and net-net, we still see a 3% market rate of growth and pretty healthy demand from our customers.

[Matt Cabral, Credit Suisse]

Got it and then government was a stand-out vertical for you in the quarter. Just wondering if you could dig a little bit deeper into what drove the strength there, and just how we should think about the sustainability of it going forward?

[Christine Leahy, CEO]

Yeah. Federal is doing a terrific job across refresh of those agencies, that didn't -- more mandated and refreshed under the Department of Defense. So we've seen refresh now in agencies that didn't have that mandate, and that's been strong. But what I really say about the Federal team, is they have focused their go-to-market investments over the past several years, on solution capabilities and we're seeing that come to fruition in the types of transactions that they're working on.

So if you look at this quarter, they are driving strong results across, not just refresh, but strategic solutions, transactions for cyber security, for modernization of infrastructure, etc. And those are deals that take a long time to develop, and looking at the pipeline, continue to remain strong. So they will got the go-to-market in place to go after those deals. They have got the trust with the customer, that takes long time to develop.

We've got the technology and support to be able to help them with that and expand those. And the other thing that they're doing is, they're creating really strong proof-of-concepts for certain agencies, that we're finding, we're now able to take this proof-of-concept and transport them to other agencies that are looking at similar types of problems they are trying to attack, and we have credibility because we've built it for different agencies.

[Operator]

Thank you. And our next question comes from Amit Daryanani with Evercore. Your line is now open.

[Amit Daryanani, Evercore]

Thanks a lot. Good morning, guys. Two questions from me as well. I guess first one, if my math is right, I think your share gains have been in the neighborhood of about 600 basis points in the first half of the year, and that's much better than the historical trend lines you've typically talked about. So I am wondering if you could maybe just touch on what are the levers that are enabling this outsized share gain growth rates in the first half, and what elements of that might be sustainable, versus not, as you go forward?

[Christine Leahy, CEO]

I will start with that. When you think about the first quarter of the year. Remember, we had some one-time events there with the Netcomm flush that was the normalization of the lead time. So that's kind of a one-time that happened in the first quarter, that we wouldn't expect to see a repeat in the back half of the year.

Certainly, we had a pull forward with some federal deals. But federal is doing a really good job. But at the end of the day, when you think about client devices, we think about that continuing to be strong but moderating. We think about solutions continuing to be solid. But we're also looking at really tough overlaps. And so if you look at the last year, we've got a number of our businesses and practice areas comping double-digit on double-digit. And so we're quite attuned to that, when we think about the back half of the year.

[Amit Daryanani, Evercore]

Got it. That's fair. And then I guess, when I think of the gross margins -- is there a way for us to think about how much of the benefit you're getting on a year-over-year basis or perhaps from increasing contribution from reoccurring business streams or revenue streams on a year-over-year basis. And then I guess broadly is there a way to think about what percent of your gross profit dollars today are reoccurring in nature, and what that trend line or growth rates look like?

[Christine Leahy, CEO]

Yeah, I'll start and I will let Collin talk a little bit more about the accounting rules. But at a high level, what I will say is, the accounting rules for where we fit in the channel, are really specific. They are complicated and there is not a one size fits all. So where we are fitting in as a service and how that's recognized is complicated. What I would say and what's really important, is that as our customers are having conversations about transactional on-prem-as-a-service other consumption models, we're agnostic to that.

So we are having the conversations with them and we're advising them along the way, in terms of assessing, designing, implementing, consuming managing etc. How that reflects in our financial statements, I will let Collin talk through. But it's important to recognize, that we are part of those conversations in driving, as our partners business models change, we are driving what it is that they are bringing to market and bringing to our customers.

[Collin Kebo, SVP & CFO]

Yeah Amit, I would say the traditional pure subscription or recurring revenue is still a relatively small percentage of our business. If you look at the amount of revenue that we're recognizing, that's booked over time rather than upfront or at a point in time, it's probably around 3% of sales. What I would say though is, because of the accounting that Chris mentioned and again, how we participate in this ecosystem, if you look at the percentage of our gross profit that is netted down, it was about 28% in the quarter.

So a lot of those things that are getting netted down or things that have a finite term, we're selling a warranty, we're selling software-as-a-service, software assurance, etc. So I think that can give you some idea of the magnitude of what's flowing through our gross profit, in some of those transactional streams.

[Amit Daryanani, Evercore]

That's really helpful. Thanks a lot and congrats on the quarter guys.

[Operator]

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

[Katy Huberty, Morgan Stanley]

Thank you. Good morning. As you highlighted free cash flow has doubled in the first half of the year, and if you look at historical first half versus second half seasonality, it would put you potentially well above the target range for the full year. Can you just talk about what is maybe driving the better first half seasonality, and what might slow free cash flow in the back half of the year?

[Collin Kebo, SVP & CFO]

Yes, sure Katy. You're right. Q2 is typically a seasonally low free cash flow quarter for us, because sales grow sequentially and we have two tax payments we have to make. This year was unusual. I would say the stars aligned for us from a vendor mix perspective, and that's really what drove the free cash flow favorability in the quarter. I'd expect that will normalize, as we move into the back half of the year, would expect us to be within our 3.375% and 4.25% of sales rule of thumb for the full year.

[Katy Huberty, Morgan Stanley]

And then, Microsoft expressed the view that Windows 10 upgrades will continue past the January 2020 support expiration, especially for the small-medium business market where you have exposure. Do you tend to agree that you'll continue to see the upgrade cycle in 2020, or do you think that it's difficult to continue growing the client segment, as you annualize the comps from this year?

[Christine Leahy, CEO]

Hi, Katy, it's Chris. I think it's not unreasonable to think that we will continue to see some of that spill into 2020 into the first quarter, for example, and maybe a little bit beyond. What that looks like over the course of all of 2020, hard to predict, but certainly some of it is spilling into the front half of the year.

[Katy Huberty, Morgan Stanley]

Thank you.

[Operator]

Thank you. And our next question comes from Adam Tindle with Raymond James. Your line is now open.

[Adam Tindle, Raymond James]

Okay, thanks and good morning. I just have two related strategic questions Chris. In the past you've mentioned being open to a large acquisition, I think over $1 billion. On your slides Scalar is an example and obviously of M&A and it's much smaller than this. So the first question is just kind of update on your thoughts related to executing M&A over $1 billion, and I just mentioned this particularly in light of one of your largest competitors making a sizable transaction recently.

That deal was arguably more of a financial transaction, or sizable cost synergies could drive that below five times EBITDA, which kind of leads me to my second question, it sounds like CDW's focus is more on capabilities. So just wanting to understand the part of not pursuing something like an Insight-PCM, given it would be significantly accretive based on where CDW trades relative to others?

[Christine Leahy, CEO]

Yeah. Thanks Adam. Great question. Yeah, we're still focused on M&A. I think if you look at our track record, Kelway, and even the early proof points with Scalar. Our discipline around the right targets and then our methodical approach to integrating and our focus on getting it right for the customer right off the bat, and empowering our coworkers to deliver for the joint customers, is leading and has led to really positive success.

So the model is working. We are in the market. We're looking, constantly, we are proactive. We tend not to be reactive, as you know. But, yeah our -- the way we think about it from a strategy perspective, is kind of pretty straightforward. Two things, expand our solutions capabilities or extend our services capabilities. Those two things plus geo expansion, that's essentially how we think about M&A.

As far as the notion of a large, kind of more financial play. Look we have to look long and hard at that, because of the, the difficulty of integrating an organization. As I know, you know, we take that very seriously. That's why cultural fit leadership is so important, and we tick through the things that matter. So that's something we just have to take a look at. But we're really focusing on the capabilities and geographic reach always in the market. But it's got to make sense.

[Adam Tindle, Raymond James]

Okay. Maybe just as a quick clarification for Collin on financing for an acquisition. I mean, is there a scenario where it might make sense to use equity in a larger transaction? Stock valuation is quite healthy and it would still be accretive?

[Collin Kebo, SVP & CFO]

Yeah, Adam, given where we sit with our leverage profile, we are 2.3 times below the 2.5 to 3 times, I think that gives us plenty of headroom. And if we had to go above that 3 times and temporarily step out of that range, I think our investors and our rating agencies would give us the flexibility or latitude to do that, as long as we show the clear path to deleveraging and a reasonable amount of time in getting back within the target range. We demonstrated throughout our past, that if we set a leverage target, we'll get there. So I think our preference would be to use leverage, but obviously it will be dependent on situation.

[Adam Tindle, Raymond James]

Makes sense. And congrats on the continued strong results.

[Operator]

Thank you. And our next question comes from Param Singh with Merrill Lynch. Your line is now open.

[Param Singh, Merrill Lynch]

Hi, good morning everybody and thanks for taking my question. So just wanted to get a sense of your productivity here. If I just look at sales per coworker, it was growing at 1% year-over-year this quarter, which is a slowdown from the last year quarters. Is that because you've had incremental co-workers coming in from Scalar, that you need to integrate and get up in productivity, or is there another reason behind that, and do you think the addition of coworkers is, while you're outperforming your competitors? And then I have a follow-up.

[Collin Kebo, SVP & CFO]

Hi Param and welcome to the call. Glad you could join. Yeah, I would say a couple of things are driving that. One is Scalar, because of the high services mix and the service delivery co-workers that go along with it, the sales per coworker productivity isn't comparable to CDW, given the different business mix.

Also we're in the summer, so there's a little bit of seasonality, where we bring in a lot of interns. This summer and this year, we brought in more than the prior year so that's impacting it. But I think if you looked at kind of apples-to-apples organic, regular CDW coworkers, you would see productivity levels more in line with historical levels.

[Param Singh, Merrill Lynch]

Understood, thanks. And then, I mean, just specifically on the educational segment, it was much stronger in seasonality then you've typically seen in prior years. Is it because the March quarter was weaker in education, or were there additional wins in the quarter, and would you expect that to persist?

[Christine Leahy, CEO]

Yeah. I would describe the K-12 as really strong quarter and when you think about the constraints in the marketplace around client advices, and the summer months being very important for education to buy and implement those devices. We had a couple of things going on. First, the constraints were more severe in K-12, because of Chromebook and where Intel placed their priority around higher performing chips. So the team did really an extraordinary job of working with customers, working with our partners around what the options are, when to get things in, etc. and we're able to deliver over the summer months, which is really quite impressive.

In addition, we've seen some net working positivity, and when you think about E-rate and where that falls throughout the -- any given quarter, it's really bumpy. It never falls in the same quarter it seems to be, because of some lag or some paperwork issue. But we did see some growth under the E-Rate program this quarter as well. So I would just say, all in all, solid quarter doing -- executing on the priorities that we typically execute on.

[Param Singh, Merrill Lynch]

Okay. All right, thank you so much. Really appreciate it, Chris, Colin.

[Operator]

Thank you. And our next question comes from Matt Sheerin with Stifel. Your line is now open.

[Matt Sheerin, Stifel]

Yes, thanks and good morning. So a question regarding your commentary on the UK and EMEA regions being somewhat slower growth. Could you give us some more color on what you're seeing? Obviously there is some economic concerns across Europe, but we're still obviously in an upgrade cycle from a corporate standpoint. So any help there would be would be great.

[Christine Leahy, CEO]

Yeah. Sure, Matt. Thanks for the question, and obviously we watch this closely. First, I would say that the team has been executing extremely well. When you look at overlap, double-digit on double-digit, and we are talking meaningful, last year plus 30%, the year before, high double digits. They're executing well. That said, I would say a couple of things. First, the market outside of the US probably feels marginally a little softer, a little more uncertain than it does in the US, and we're watching that.

We hadn't seen in Q2, different buying behaviors but from our customers. But you got to believe Brexit on their mind, given that it's 90 days away, and we've got some new rhetoric and new leadership in place. So it's hard to believe that it's not on their mind. But that said, I'll tell you, our referral business continues to be very healthy. Our international meaning Rest of World business outside the UK, continues to be very healthy, and the team continues to be optimistic in terms of their conversations around customers.

So look with the wildcard of Brexit looming, we are just being very cautious. The good news is, we've run this table-top before -- before the October 31st extension. Earlier in the year, we worked with customers to map their need, so that we would be prepared to help them. And we've also opened an office in The Netherlands, and we've got a number of customers actually that are transacting through the Netherlands. So we are getting more and more confident with our ability to deliver to the same service level agreement.

So we're doing everything we can to be prepared, but we can't control what happens in the environments, and we'll just keep, I think, out executing as the team has been doing.

[Matt Sheerin, Stifel]

Okay, that's helpful. And then just a follow-up question regarding your Census contract. Could you give us an update there in terms of contribution relative to expectations?

[Christine Leahy, CEO]

Yeah. Well Census is going well. Contribution relative to expectations hasn't changed. We still expect 40 basis points of revenue growth, as a result of Census. I would give a shout out to the team, that it's a lot of hard work, a lot of collaboration, not just at CDW, but with a number of partners as well. And again, think about the number of devices that we have running through our configuration center. At the same time, we've got K-12 busy season. We've got inventory in there under constrained conditions, and we're really doing a great job of getting it in and moving it out. So 40 basis points for the year, so far so good.

[Operator]

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

[Paul Coster, JPMorgan]

Yeah, thank you for taking my questions. I just wanted to touch on a couple of prior subjects. First up on the client device front, to what extent do you see customers sweating asset beyond the Windows 10 upgrade dates, and is that yielding a service opportunity for you?

[Christine Leahy, CEO]

Yeah, thanks for the question. You know, we have seen a number of customer -- a very large number of customers now converting to Win 10. And so, I don't know that I would see that as an opportunity that there is going be a number of customers' sweating the assets after this conversion. It just doesn't feel that way with the activity we've seen with current customers, what we're hearing from Microsoft, etc. it doesn't feel like the market is going that way.

[Paul Coster, JPMorgan]

Got it. And then, Chris, just on this point of Europe -- a massive plan now, but still small in the context of the overall market. There is obviously a huge opportunity to scale up. But I'm wondering whether you think there is a limitation to how far you can go, given how important the sales culture is, and it's maintaining its integrity? Do you see a natural limitation to the growth?

[Christine Leahy, CEO]

Yeah, it a spot on question because that sales culture is so important to an acquisition working. I can tell you that we have looked at a number of players. This is a constant rhythm for us, which is meeting with and talking to people, and it's very clear that there are some organizations out there, where there is not a fit. But equally there are organizations where we feel culturally, particularly on the sales side, they could be a really good fit.

So is there a natural limitation? Sure there is, because organizations are all different. But we think that is not going to impair our ability to find a good solution or a good expansion path at all.

[Paul Coster, JPMorgan]

Okay. Thank you.

[Operator]

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

[Keith Housum, Northcoast Research]

Good morning. Thanks for the opportunity. Chris, client devices have been strong for a better part, two years now, and if it's the Windows 10 refresh or if it's the full employment. It kind of seems like it's getting more difficult to grow on top of that, just because kind of -- two years into it. Is there a concern or perception that client devices will be slowing down, or do you still see an opportunity for that to grow? And if so, how?

[Christine Leahy, CEO]

Yeah. We definitely, when we look at client device and we look at the compares over the last couple of years and the quarters, it's going to be tough to grow at those kinds of rates. So we wouldn't expect -- we would expect our client device growth to be at a more muted rate, yet healthy, because we do have customers who continue to -- who are new refresh cycles frankly or continuing to expand their use of client devices for different things in the business, new use cases, etc. But certainly we are facing very difficult comparisons, and we expect that growth to moderate.

[Keith Housum, Northcoast Research]

Got you. And then if I could just ask a bit more strategic question, following up on the question before regarding acquisitions. Is there assuming -- are your capabilities that you are not going to be able to either grow internally or to acquire, I mean, on the same front geographically is there -- sort of geographics areas that you're more targeted to expansion than others?

[Christine Leahy, CEO]

Yeah I think when you think about capability, it would be the same areas that we frequently talk about, and you know, Scalar is a great example, infrastructure, security, managed services, digital transformation, those are all areas where -- when you think about bolstering our current capabilities, areas we'd look at. In terms of geographic, that's really driven primarily from what, where our current customers have needs, and that's been our strategy all along.

So we look at our UK, US, Canadian customers and where the pipeline is growing, and where they're telling us, they really could use some help. And there certainly are some places on the continent that makes sense, but there are some places in other areas of the world that make equal sense. And at the same time, we do have smaller presence in a variety of locations. Dubai, for example, in Asia, in Singapore, Hong Kong, and we're also focused on bolstering those, to ensure that we can deliver on the current needs that our UK multinationals have

[Keith Housum, Northcoast Research]

Great. Thank you.

[Operator]

Thank you. I'm not showing any further questions at this time, I would now like to turn the call back over to Chris Leahy for closing remarks.

[Christine Leahy, CEO]

Well, thank you and let me close by once again thanking our 9.800 coworkers around the globe for their ongoing dedication to serving our customers. They are true competitive advantage and the heart, soul and reason why we consistently deliver meaningful value to exceed our customers needs and expectations. They are the reason we have and will continue to lead the industry. Thank you to our customers for the privilege and opportunity to serve and repeatedly earn your trust, and thank you for your continued interest in CDW.

I also want to send a shout out to Gary Woodland, winner of this year's US Open Championship, CDW is the official technology partner to the PGA Tour, and Gary has been a terrific CDW technology ambassador since 2014. Gary, we couldn't be more thrilled for you.

With that I'd like to say thanks again and Collin and I look forward to talking to you next quarter.

[Operator]

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