Item 1B.
Unresolved Staff Comments
None.
As of December 31, 2006, we owned or leased a total of approximately 1.8 million square feet of space throughout North America. We own two properties: a combined corporate office and 450,000 square foot distribution center in Vernon Hills, Illinois, and a 513,000 square foot distribution center in North Las Vegas, Nevada. In addition, we conduct sales, services, and administrative activities in various leased locations throughout North America, including Berbee data centers in Madison, Wisconsin and Minneapolis, Minnesota.
We believe that our current facilities are suitable and adequate for the conduct of our business and that our existing distribution centers are sufficient to support our anticipated growth for the foreseeable future. For more information on lease obligations, see Note 9 to the Consolidated Financial Statements.
On September 9, 2003, CDW completed the purchase of certain assets of Bridgeport Holdings, Inc., Micro Warehouse, Inc., Micro Warehouse, Inc. of Ohio, and Micro Warehouse Gov/Ed, Inc. (collectively, “Micro Warehouse”). On September 10, 2003, Micro Warehouse filed voluntary petitions for relief under chapter 11 of title 11 of the United States Code in the United States Bankruptcy Court for the District of Delaware (the “Bankruptcy Court”). The Bankruptcy Court confirmed a plan of distribution with respect to Micro Warehouse which became effective on October 14, 2004. On March 3, 2005, the Bridgeport Holdings, Inc. Liquidating Trust (the “Liquidating Trust”) filed a civil action in the Bankruptcy Court entitled Bridgeport Holdings Liquidating Trust, Inc. vs. CDW Corporation and CDW SAC, Inc. alleging that CDW did not pay reasonably equivalent value for the assets it acquired from Micro Warehouse and seeking to have CDW’s “purchase of Micro Warehouse” set aside and an amount of damages, to be determined at trial, paid to it. On February 1, 2007, CDW entered into a settlement agreement (the “Settlement Agreement”) to resolve the above referenced action pursuant to which CDW agreed to pay $25 million to the Liquidating Trust in return for a full release and complete dismissal of the litigation, with prejudice. While CDW believed it had good defenses to the claims by the Liquidating Trust, it agreed to settle the case in order to avoid the substantial costs and uncertainties involved with further litigation. The Settlement Agreement represents the compromise of a disputed claim and does not constitute an admission of liability on behalf of CDW. A Motion to Approve the Settlement Agreement was filed in the Bankruptcy Court by the Liquidating Trust on February 1, 2007. No objections were filed with the Bankruptcy Court, and the time for filing objections has expired. An order approving the Settlement Agreement was entered by the Bankruptcy Court on February 21, 2007. That order becomes final and nonappealable on March 5, 2007. CDW’s settlement payment, and a motion by the Liquidating Trust to dismiss the litigation with prejudice, are both due on March 12, 2007.
From time to time, customers of CDW file voluntary petitions for reorganization under the United States bankruptcy laws. In such cases, certain pre-petition payments received by CDW could be considered preference items and subject to return to the bankruptcy administrator. CDW believes that the
final resolution of any such preference items will not have a material adverse effect on its financial condition.
In addition, CDW is party to legal proceedings that arise from time to time, both with respect to specific transactions and in the ordinary course of our business. CDW is also subject to audit by federal, state and local tax authorities, by various government agencies relating to sales under certain government contracts and by vendors relating to vendor incentive programs.
We do not believe that any current audit or pending or threatened litigation will have a material adverse effect on our financial condition. Litigation and audits, however, involve uncertainties and it is possible that the eventual outcome of litigation or audits could adversely affect our results of operations for a particular period.
Item 4.
Submission of Matters to a Vote of Security Holders
There were no matters submitted during the fourth quarter of 2006 to a vote of security holders.
PART II
Item 5.
Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
The following table sets forth for the periods indicated the high and low sales prices for the Company’s common stock, which is traded on The Nasdaq Stock Market® under the symbol “CDWC”. As of January 27, 2007, there were approximately 19,000 beneficial owners of the Company’s common stock.
The following table presents information on cash dividends paid during the past two years:
Although in future years we plan to announce any dividend following the annual shareholders meeting, typically held in May, the timing and amount of any future dividends will depend upon the earnings, cash requirements and financial condition of the Company and other factors deemed relevant by our Board of Directors.
We did not repurchase any shares of our common stock in the three months ended December 31, 2006.
Stock Price Performance Graph
The following stock performance graph compares cumulative total stockholder return on the Company’s common stock with the cumulative total return for (i) the S&P Midcap 400 Index and (ii) the Company’s Peer Group for the period commencing December 31, 2001 and ending December 31, 2006 where $100 was invested on December 31, 2001. The Company’s Peer Group consists of GTSI Corp., Insight Enterprises, Inc., PC Connection, Inc., PC Mall, Inc., and Zones, Inc.
Historical stock price performance shown on the graph is not necessarily indicative of future price performance.
CDW Corporation and Subsidiaries
Selected Financial Data
(in thousands, except per share amounts)
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our Consolidated Financial Statements and the Notes thereto.
Overview
CDW Corporation (collectively with its subsidiaries, “CDW” or the “Company”) is a leading provider of multi-branded information technology products and services in the United States and Canada. We focus on meeting the technology needs of our customers in business, government, and education through our extensive offering of products from leading brands and a variety of value-added services.
For financial reporting purposes, we have three operating segments: corporate sector, which is primarily comprised of business customers; public sector, which is comprised of federal, state and local government entities, educational institutions, and healthcare institutions; and Berbee, a new segment as a result of our acquisition of Berbee Information Networks Corporation (“Berbee”) in October 2006, which provides advanced information technology solutions. See Note 16 to the Consolidated Financial Statements for more information on our operating segments.
CDW management monitors a number of financial and non-financial measures and ratios on a daily, weekly, and monthly basis in order to track the progress of the business and make adjustments as necessary. We believe that the most important of these measures and ratios include daily sales, by business segment and total company, gross margin, number of orders shipped per day, number of orders shipped complete per day, inventory balance, aging, and turnover, cash, cash equivalents, and marketable securities balance, accounts receivable balance and aging, accounts receivable days sales outstanding, operating expenses, and operating margin. We also monitor certain measures and ratios specifically for the Berbee operating segment, such as realized bill rates, utilization of engineers and consultants, and employee turnover. The measures and ratios are compared to standards or objectives set by management, so that actions can be taken, as necessary, in order to achieve the standards and objectives.
The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America requires management to make use of certain estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the financial statements and the reported amounts of revenue and expenses during the reported periods. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about carrying values of assets and liabilities that are not readily apparent from other sources. Actual results could differ from those estimates, and revisions to estimates are included in our results for the period in which the actual amounts become known. The estimates and assumptions used in accounting for revenue recognition, inventory valuation and vendor transactions have the most significant impact on our consolidated financial statements, and therefore, are considered to be our critical accounting policies. The following discussion details the estimates and assumptions associated with these policies.
Revenue recognition. We record revenue from sales transactions when both risk of loss and title to products sold pass to the customer. Our shipping terms dictate that the passage of title occurs upon receipt of products by the customer. The majority of our revenue relates to physical products and are recognized on a gross basis with the selling price to the customer recorded as net sales and the acquisition cost of the product recorded as cost of sales. Software assurance products, third party services and extended warranties that we sell (for which we are not the primary obligor) are recognized on a net basis in accordance with SEC Staff Accounting Bulletin No. 104, “Revenue Recognition” and Emerging Issues Task Force 99-19, “Reporting Revenue Gross as a Principal versus Net as an Agent.” Accordingly, such revenue is recognized in net sales either at the time of
sale or over the contract period, based on the nature of the contract, at the net amount retained by us, with no cost of sales. Revenue from information technology consulting or professional services is either recognized as incurred for services billed at an hourly rate or recognized using the percentage of completion method for services provided at a fixed fee. Revenue for data center services, including Internet connectivity, Web hosting, server co-location, and managed services, is recognized over the period service is provided.
In accordance with our revenue recognition policy, we estimate the value of products that have shipped but that have not been received by the customer and record an adjustment to reverse the impact of these sales out of our results for the current period and into our results for the subsequent period. In doing so, we perform an analysis to determine the estimated number of days that product is in transit, using data from commercial delivery services and other sources. Changes in delivery patterns may result in a different number of business days used in making this adjustment and could have a material impact on our revenue recognition for the current period.
Inventory valuation. Inventory is valued at the lower of cost or market value. We decrease the value of inventory for estimated obsolescence equal to the difference between the cost of inventory and the estimated market value, based upon an aging analysis of the inventory on hand, specifically known inventory-related risks, and assumptions about future demand and market conditions. If future demand or actual market conditions are less favorable than those projected by management, additional inventory write-downs may be required.
Vendor transactions. We receive incentives from vendors related to cooperative advertising allowances, volume rebates, bid programs, price protection and other programs. These incentives generally relate to written agreements with specified performance requirements with the vendors and are recorded as adjustments to cost of sales or advertising expense, as appropriate. Vendors may change the terms of some or all of these programs which could have an impact on our results of operations. The inability to collect receivables related to these vendor transactions could have a material impact on gross margin and operating income.
Acquisition of Berbee Information Networks Corporation
On October 11, 2006, we completed the acquisition of Berbee for a total purchase price of $186.1 million, including an adjustment for working capital. For more information on Berbee, see “Acquisitions” in Item 1 of Part I of this 10-K and Note 3 to the Consolidated Financial Statements.
Recently Adopted and Newly Issued Accounting Standards
On January 1, 2006, we adopted Statement of Financial Accounting Standards No. 123R, “Share-Based Payment” (“SFAS 123R”). SFAS 123R requires the Company to measure all share-based payments to coworkers and directors using a fair-value-based method and record compensation expense related to these payments in our consolidated financial statements. We have elected to use the modified prospective method, which allows for prospective recognition of compensation expense without restatement of prior periods in the year of adoption.
See Note 11 to the Consolidated Financial Statements for further information on the adoption of SFAS 123R and the related disclosures, including pro forma information for prior periods as if we had recorded share-based compensation expense.
In June 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes - an Interpretation of FASB Statement 109” (“FIN 48”). FIN 48 prescribes a two-step process for the financial statement measurement and recognition of a tax position taken or expected to be taken in an income tax return. The first step involves the determination of whether it is more likely than not that a tax position will be sustained upon examination, based on the technical merits of the position. The second step requires that any tax position that meets the more-likely-than-not recognition threshold be measured and recognized in
the financial statements at the largest amount of benefit that is greater than 50 percent likely of being realized upon ultimate settlement. FIN 48 also provides guidance on the accounting for related interest and penalties, financial statement classification, and disclosure. FIN 48 is effective for fiscal years beginning after December 15, 2006. We do not expect the adoption of FIN 48 to have a material impact on our financial statements.
In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. SFAS 157 applies where other accounting pronouncements require or permit fair value measurements; it does not require any new fair value measurements. The effects of adopting SFAS 157 will be determined by the types of instruments carried at fair value in our financial statements at the time of adoption as well as the method utilized to determine their fair values prior to adoption. SFAS 157 is effective for fiscal years beginning after November 15, 2007. We are currently evaluating the impact SFAS 157 will have on our financial statements.
Results of Operations
The following table sets forth for the periods indicated information derived from our consolidated statements of income expressed as a percentage of net sales:
The following table sets forth for the periods indicated a summary of certain of our consolidated operating statistics:
(1)
Includes 206 Berbee sales force coworkers.
(2)
These statistics were negatively impacted, in part, by the acquisition of Berbee in October 2006. Berbee results were only included in our consolidated financial statements from the date of acquisition through the end of the year.
The following table presents net sales of products by product category as a percentage of total net sales of products. Net sales of products do not include items such as commission revenue or delivery charges to customers, and were approximately 97% of total net sales in the years ended December 31, 2006, 2005 and 2004.
Product lines are based upon internal product code classifications. Product mix for the years ended December 31, 2005 and 2004 have been retroactively adjusted for certain changes in individual product classifications.
The following table presents the change in year-over-year net sales of products by product category for each of the periods indicated. Product lines are based upon internal product code classifications. The rates of change for the years ended December 31, 2005 and 2004 have been retroactively adjusted for certain changes in individual product classifications.
Year Ended December 31, 2006 Compared to Year Ended December 31, 2005
Net sales in 2006 increased 7.8% to $6.785 billion, compared to $6.292 billion in 2005. Results for 2006 included sales made by Berbee from October 11, 2006, the acquisition date, through the end of the year. Sales of notebook computers and accessories, netcomm products, and add-on boards/memory each increased more than 10% in 2006 over 2005. Corporate sector segment sales increased 2.3%, to $4.514 billion in 2006 from $4.411 billion in 2005, and comprised 66.5% of our total net sales for 2006. Public sector segment sales increased 15.0%, to $2.162 billion in 2006 from $1.881 billion in 2005, and comprised 31.9% of our total net sales for 2006. The Berbee segment, new in 2006 as a result of the Berbee acquisition, generated sales of $109 million from the date of acquisition through the end of the year and comprised 1.6% of our total net sales in 2006.
Gross profit increased 10.6% to $1.070 billion in 2006, compared to $967.6 million in 2005. As a percentage of net sales, gross profit was 15.8% in 2006, compared to 15.4% in 2005. The increase in the gross profit margin was primarily due to higher product margins, increased net service contract revenue and commission revenue, and a higher level of vendor incentives.
Selling and administrative expenses increased 22.3% in 2006 to $530.1 million, compared to $433.5 million in 2005, while increasing as a percentage of net sales to 7.8% in 2006 versus 6.9% in 2005. The primary reasons for the increase in selling and administrative expenses were:
•
Payroll and employee-related costs increased $70.9 million. This increase was primarily due to the continued investment in our sales force, increases in administrative areas to support a larger and growing business, and increased sales commission expense due to the achievement of a higher gross profit margin. Our sales force increased to 2,589 at December 31, 2006 (including 206 Berbee sales force coworkers), from 2,153 at December 31, 2005. Our sales force consists of account managers (including field sales representatives) as well as product category specialists who provide consultation in areas requiring technical or specialized product expertise such as networking, security, data storage, and volume software licensing. Included in payroll costs in 2006 was $6.3 million related to the operation of our distribution center in North Las Vegas, Nevada, which became operational in late 2005. In addition, we recorded $15.8 million in share-based compensation expense during 2006 due to the adoption of SFAS 123R on January 1, 2006.
•
Occupancy costs increased $8.7 million, primarily due to $12.0 million of depreciation expense, rent and operating expenses, such as property taxes and utilities, related to our distribution center in North Las Vegas, Nevada and additional leased office space in Chicago and Vernon Hills, Illinois. These expenses were partially offset by $1.9 million in increased local economic development incentives related to new office locations and reductions in other areas.
•
Other selling and administrative expenses increased $17.1 million. This includes $1.0 million in expenses related to our distribution center in North Las Vegas, Nevada. In 2006, we recorded severance expense of $2.8 million in connection with payments to several individuals who left the Company. In addition, we had increased administrative expenses required to support a larger business, such as professional fees, general insurance, and travel and entertainment expenses.
Advertising expense increased to $118.3 million in 2006, compared to $114.5 million in 2005. As a percentage of net sales, advertising expense was 1.8% in 2006 and 2005.
In the fourth quarter of 2006, we recorded a one-time expense of $25.0 million in connection with the negotiated settlement of the previously disclosed litigation involving our 2003 purchase of selected assets of Micro Warehouse. This expense was 0.4% of net sales in 2006.
Consolidated operating income was $396.4 million in 2006, a decrease of 5.5% from $419.6 million in 2005. Consolidated operating income as a percentage of net sales decreased to 5.8% in 2006, compared to 6.7% in the same period of 2005. The decrease in operating income as a percentage of net sales was primarily due to the increased selling and administrative expenses and the litigation settlement, partially offset by the increased gross profit. Corporate sector segment operating income was $350.6 million in 2006, an increase of 2.6% from $341.8 million in 2005. The increase in corporate sector segment operating income was primarily due to improved gross profit margin, partially offset by the recognition of share-based compensation expense due to the adoption of SFAS 123R. Public sector segment operating income was $106.7 million in 2006, a decrease of 3.4% from $110.4 million in 2005. The decrease in public sector segment operating income was primarily due to lower gross profit margin, increased selling and administrative expenses related to the investment in additional sales resources, and the recognition of share-based compensation expense due to the adoption of SFAS 123R. Headquarters expenses increased to $64.7 million in 2006 compared to $32.6 million in 2005, primarily due to the litigation settlement expense of $25.0 million, a larger number of coworkers, and the recognition of share-based compensation expense due to the adoption of SFAS 123R.
Interest income increased 30.6% in 2006, to $19.8 million compared to $15.2 million in 2005. This increase was primarily due to higher interest rates in 2006 compared to 2005.
The effective income tax rate, expressed as a percentage of income before income taxes, decreased to 35.8% in 2006 compared to 37.2% in 2005. This decrease was primarily attributable to the resolution of an audit of the Company’s 2003 federal income tax return in the second quarter of 2006 and a benefit relating to the reduction of tax reserves due to the expiration of the statute of limitations for the 2002 tax year in the third quarter of 2006. The change in the effective tax rate increased diluted earnings per share in 2006 by approximately $0.07 compared to 2005.
Net income in 2006 was $266.1 million, a 2.2% decrease from $272.1 million in 2005. Net income in 2006 included the litigation settlement expense of $15.4 million after-tax.
Diluted earnings per share were $3.30 in 2006, an increase of 1.2% from $3.26 in 2005. The litigation settlement expense in 2006 decreased diluted earnings per share by approximately $0.19. The change in the weighted-average number of common shares outstanding in 2006 compared to 2005 increased diluted earnings per share by approximately $0.12.
Year Ended December 31, 2005 Compared to Year Ended December 31, 2004
Net sales in 2005 increased 9.7% to $6.292 billion, compared to $5.738 billion in 2004. Sales of desktop computers and servers, software, data storage devices and netcomm products each increased more than 10% in 2005 over 2004. Corporate sector segment sales increased 7.4%, to $4.411 billion in 2005 from $4.105 billion in 2004, and comprised 70% of our total net sales for 2005. Public sector segment sales increased 15.2%, to $1.881 billion in 2005 from $1.633 billion in 2004, and comprised 30% of our total sales for 2005.
Gross profit increased 11.2% to $967.6 million in 2005, compared to $870.1 million in 2004. As a percentage of net sales, gross profit was 15.4% in 2005, compared to 15.2% in 2004. The increase in the gross profit percentage was primarily due to a larger amount of cooperative advertising funds classified as a reduction of cost of sales and improved product margins, partially offset by reduced customer charges for delivery and a lower level of vendor incentives.
Selling and administrative expenses increased 12.1% to $433.5 million in 2005, compared to $386.6 million in 2004, while increasing as a percentage of net sales to 6.9% versus 6.7% in 2004. Included in selling and administrative expenses in 2004 were $3.9 million of transaction and integration expenses related to the Micro Warehouse transactions (see Note 18 to the Consolidated Financial Statements for more information on the Micro Warehouse transactions). The primary drivers of the increase in selling and administrative expenses are discussed below.
•
Payroll costs increased $38.3 million, primarily due to our continued investment in our sales force and increases in administrative areas to support a larger and growing business. Our sales force increased to 2,153 at December 31, 2005, from 2,012 at December 31, 2004. Our sales force consists of account managers (including field sales representatives) as well as product category specialists who provide consultation in areas requiring technical or specialized product expertise such as networking, security, data storage, and volume software licensing. In addition, payroll costs for 2005 include $3.7 million of compensation expense in connection with the acceleration of vesting of stock options for coworkers through the manager level. Payroll costs for 2004 included $1.5 million of expenses for former Micro Warehouse employees performing transition services.
•
Employee-related costs (which include items such as profit sharing, incentive awards, and insurance) increased $2.8 million, primarily due to $4.0 million of additional profit sharing expense related to the additional contribution to the 401(k) plan in conjunction with a modification to the Company’s stock option program and increased expenses to support a larger number of coworkers. These expenses were partially offset by a reduction of $5.3 million in an accrual for a company-wide incentive bonus program. The accrual was adjusted based on certain program modifications which provided for specific payout levels for partial achievement of full year financial objectives.
•
Occupancy costs increased $1.7 million. This increase was primarily due to increased depreciation related to asset additions for new sales offices and new financial systems, partially offset by reduced rent. Occupancy costs for 2004 included $0.8 million of facility expenses related to the Micro Warehouse transactions.
•
Other selling and administrative costs increased $4.1 million. The increase was primarily due to increased administrative expenses required to support a larger business, such as professional fees and travel and entertainment expenses. Other selling and administrative costs for 2004 included $1.6 million of costs related to the Micro Warehouse transactions.
Net advertising expense increased to $114.5 million in 2005, compared to $90.8 million in 2004. This was due to an increase in gross advertising expense and an increase in cooperative advertising funds classified as a reduction of cost of sales rather than as a reduction of advertising expense in 2005 compared to 2004. As a percentage of net sales, net advertising expense increased to 1.8% in 2005, compared to 1.6% in 2004.
Consolidated operating income was $419.6 million in 2005, a 6.8% increase from $392.8 million in 2004. Consolidated operating income as a percentage of net sales was 6.7% in 2005, compared to 6.9% in 2004. Corporate sector segment operating income was $341.8 million in 2005, a 4.4% increase from $327.5 million in 2004. The increase in corporate sector segment operating income was primarily due to an increase in sales, partially offset by increased expenses related to the ongoing investment in the sales force. Public sector segment operating income was $110.4 million in 2005, an 18.2% increase from $93.4 million in 2004. The increase in public sector segment operating income was primarily due to a 15.2% increase in sales during 2005 compared to 2004. Headquarters expenses increased to $32.6 million in 2005, compared to $28.2 million in 2004, primarily due to a larger number of coworkers and increased depreciation expense, partially offset by $3.9 million of integration expenses related to the Micro Warehouse transactions incurred during 2004 that did not repeat. Headquarters expenses also included $3.7 million of compensation expense in connection with the acceleration of vesting of stock options for coworkers through the manager level and the impact of a $5.3 million reduction in an accrual for a company-wide incentive bonus program.
The effective income tax rate, expressed as a percentage of income before income taxes, decreased to 37.2% in 2005 compared to 39.6% in 2004. On April 1, 2005, we voluntarily began
collecting sales taxes on sales to all corporate customers in all states that impose sales taxes. Prior to April 1, 2005, we collected sales tax when applicable on sales to corporate customers only in states where the requisite nexus existed. In conjunction with collecting state sales tax, we began filing state income tax returns for all of our legal entities in all states. Due to differences in state income tax laws, including differences in how income is apportioned, we expected our overall effective tax rate to be lower in 2005 than 2004. The change in the effective tax rate increased diluted earnings per share in 2005 by approximately $0.13 compared to 2004.
Net income in 2005 was $272.1 million, a 12.7% increase from $241.4 million in 2004. Diluted earnings per share were $3.26 in 2005, an increase of 16.8% from $2.79 in 2004.
Seasonality
Sales in our corporate sector segment, which primarily serves business customers, have not historically experienced significant seasonality throughout the year. In contrast, sales in our public sector segment have historically been higher in the third quarter than in other quarters due to the buying patterns of federal government and education customers. If sales to federal government and education customers increase as a percentage of overall sales, the Company as a whole may experience increased seasonality in future periods.
Legal Proceedings
For a description of certain legal proceedings, see Item 3
Item 7A.
Quantitative and Qualitative Disclosures About Market Risk
The Company’s investments in marketable securities as of December 31, 2006 all mature before December 31, 2008 and are concentrated in U.S. Government and Government agency securities, municipal bonds and corporate fixed income securities. As such, the risk of significant changes in the value of these securities as a result of a change in market interest rates is minimal.
Item 8.
Item 8.
Financial Statements and Supplementary Data
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rule 13a-15(f). Under the supervision and with the participation of our management, including our chief executive officer and our chief financial officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our evaluation under the framework in Internal Control - Integrated Framework, our management concluded that our internal control over financial reporting was effective as of December 31, 2006.
Management’s assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006 excluded Berbee Information Networks Corporation, which was acquired by the Company in October 2006 in a purchase business combination. Berbee Information Networks Corporation is a wholly-owned subsidiary of the Company whose total assets and total net sales represented 16.6% and 1.6%, respectively, of consolidated total assets and consolidated net sales of the Company as of and for the year ended December 31, 2006. Companies are allowed to exclude acquisitions from their assessment of internal control over financial reporting during the first year of an acquisition under guidelines established by the Securities and Exchange Commission.
Our management’s assessment of the effectiveness of our internal control over financial reporting as of December 31, 2006 has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their report, which is included herein.
CDW Corporation
Vernon Hills, Illinois
March 1, 2007
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and
Shareholders of CDW Corporation:
We have completed integrated audits of CDW Corporation’s consolidated financial statements and of its internal control over financial reporting as of December 31, 2006, in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.
Consolidated financial statements and financial statement schedule
In our opinion, the consolidated financial statements listed in the index appearing under Item 15(a)(1) present fairly, in all material respects, the financial position of CDW Corporation and its subsidiaries at December 31, 2006 and December 31, 2005, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2006 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the index appearing under Item 15(a)(2) presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
As discussed in Note 11 to the consolidated financial statements, the Company changed the manner in which it accounts for share-based compensation in 2006.
Internal control over financial reporting
Also, in our opinion, management’s assessment, included in Management’s Report on Internal Control Over Financial Reporting appearing on Page 27 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2006, that the Company maintained effective internal control over financial reporting as of December 31, 2006 based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control - Integrated Framework issued by the COSO. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting based on our audit. We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating
effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
As described in Management’s Report on Internal Control Over Financial Reporting, management has excluded Berbee Information Networks Corporation from its assessment of internal control over financial reporting as of December 31, 2006 because it was acquired by the Company in a purchase business combination in October 2006. We have also excluded Berbee from our audit of internal control over financial reporting. Berbee is a wholly-owned subsidiary whose total assets and total revenues represent 16.6% and 1.6%, respectively, of the related consolidated financial statement amounts as of and for the year ended December 31, 2006.
/s/ PricewaterhouseCoopers LLP
PricewaterhouseCoopers LLP
Chicago, Illinois
March 1, 2007
CDW CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(in thousands)
The accompanying notes are an integral part of the consolidated financial statements.
CDW CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(in thousands, except per share data)
The accompanying notes are an integral part of the consolidated financial statements.
CDW CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
(in thousands)
The accompanying notes are an integral part of the consolidated financial statements.
CDW CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
The accompanying notes are an integral part of the consolidated financial statements.
CDW CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1.
Summary of Significant Accounting Policies
CDW Corporation (collectively with its subsidiaries, “CDW” or the “Company”) is a leading provider of multi-branded information technology products and services in the United States and Canada. We focus on meeting the technology needs of our customers in business, government, and education through our extensive offering of products from leading brands and a variety of value-added services.
Presented here is a summary of the most significant accounting policies used in the preparation of our consolidated financial statements. Our most significant accounting policies relate to the sale, purchase, distribution and promotion of our products. Therefore, our accounting policies in the areas of revenue recognition, inventory valuation, vendor purchase and merchandising arrangements and marketing activities, among others, are discussed.
Principles of Consolidation
The accompanying consolidated financial statements include the accounts of CDW Corporation and our wholly-owned subsidiaries. All intercompany transactions and accounts are eliminated in consolidation. As described in Note 14, one of our wholly-owned subsidiaries, CDW Capital Corporation (“CDWCC”), owned a 50 percent interest in CDW Leasing, LLC (“CDW-L”) until CDWCC sold its interest in CDW-L effective August 1, 2004. In accordance with Financial Accounting Standards Board (“FASB”) Interpretation No. 46 (revised December 2003), “Consolidation of Variable Interest Entities, an interpretation of ARB 51,” we consolidated CDW-L, beginning on December 31, 2003, until our interest was sold.
Use of Estimates
The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America requires management to make use of certain estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reported periods. We base our estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about carrying values of assets and liabilities that are not readily apparent from other sources. Significant estimates in these financial statements include allowances for doubtful accounts receivable, sales returns and pricing disputes, net realizable value of inventories, vendor transactions, loss contingencies and intangible assets. Actual results could differ from those estimates.
Allowance for doubtful accounts receivable. We provide allowances for doubtful accounts related to accounts receivable for estimated losses resulting from the inability of our customers to make required payments. We take into consideration the overall quality and aging of the receivable portfolio along with specifically identified customer risks. If actual customer payment performance were to deteriorate to an extent not expected, additional allowances may be required.
Sales returns and pricing disputes. At the time of sale, we record an estimate for sales returns and pricing disputes based on historical experience. If actual sales returns and pricing disputes are greater than estimated by management, additional expense may be incurred.
Inventory valuation. Inventory is valued at the lower of cost or market value. We decrease the value of inventory for estimated obsolescence equal to the difference between the cost of inventory and the estimated market value, based upon an aging analysis of the inventory on hand, specifically known inventory-related risks, and assumptions about future demand and market conditions. If future demand or actual market conditions are less favorable than those projected by management, additional inventory write-downs may be required.
Vendor transactions. We receive incentives from vendors related to cooperative advertising allowances, volume rebates, bid programs, price protection and other programs. These incentives generally relate to written agreements with specified performance requirements with the vendors and are recorded as adjustments to cost of sales or advertising expense, as appropriate. Vendors may change the terms of some or all of these programs which could have an impact on our results of operations.
Loss contingencies. We accrue for contingent obligations when a loss is probable and the amount can be reasonably estimated. As facts concerning contingencies become known, we reassess our position and make appropriate adjustments to the financial statements.
Intangible assets. We have recorded intangible assets, such as goodwill and customer relationships, and account for these in accordance with Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” (SFAS 142). SFAS 142 requires an annual test of goodwill and indefinite-lived assets for impairment, unless circumstances dictate more frequent assessments. SFAS 142 also requires that intangible assets with determinable lives be amortized over their respective estimated useful lives and reviewed annually for impairment in accordance with Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (SFAS 144). If circumstances change or a triggering event were to occur that would indicate impairment, we would be required to review our intangible assets for impairment and write-downs may be required.
Reclassifications
Certain reclassifications have been made to the prior year financial statements to conform to the current year presentation.
Cash and Cash Equivalents
Cash and cash equivalents include all deposits in banks and short-term, highly liquid investments that are readily convertible to known amounts of cash and are so near maturity that there is insignificant risk of changes in value due to interest rate changes.
Marketable Securities
We classify securities with a stated maturity, which we intend to hold to maturity, as “held-to-maturity,” and record such securities at amortized cost. Securities which do not have stated maturities or which we do not intend to hold to maturity are classified as “available-for-sale” and recorded at fair value, with unrealized holding gains or losses recorded as a separate component of Shareholders’ Equity. We do not invest in trading securities. All securities are accounted for on a specific identification basis.
Our marketable securities are concentrated in securities of the U.S. Government, U.S. Government agencies and municipal bonds. Such investments are supported by the financial stability and credit standing of the U.S. Government or applicable U.S. Government agency or municipality.
Accounts Receivable
Trade accounts receivable are recorded at the invoiced amount and do not bear interest. As previously discussed in this footnote, the allowance for doubtful accounts is our best estimate of losses resulting from the inability of our customers to make required payments.
Merchandise Inventory
Inventory is valued at the lower of cost or market. Cost is determined on the first-in, first-out method.
Property and Equipment
Property and equipment are stated at cost. We calculate depreciation using the straight-line method over the useful lives of the assets. Leasehold improvements are amortized over the shorter of their useful lives or the initial lease term. Expenditures for major renewals and improvements that extend the useful life of property and equipment are capitalized. Expenditures for maintenance and repairs are charged to expense as incurred. The following table shows estimated useful lives of property and equipment:
Goodwill and Other Intangible Assets
We account for goodwill and other intangible assets in accordance with SFAS 142. Under SFAS 142, goodwill and indefinite-lived intangible assets are not amortized but are tested for impairment on an annual basis or if impairment indicators exist. Intangible assets with definite lives are amortized on a straight-line basis over their estimated useful lives, which range from 2-14 years.
Revenue Recognition
We record revenue from sales transactions when both risk of loss and title to products sold pass to the customer. Our shipping terms dictate that the passage of title occurs upon receipt of products by the customer. The majority of our revenue relates to physical products and are recognized on a gross basis with the selling price to the customer recorded as net sales and the acquisition cost of the product recorded as cost of sales. At the time of sale, we also record an estimate for sales returns based on historical experience. Software assurance products, third party services and extended warranties that we sell (for which we are not the primary obligor) are recognized on a net basis in accordance with SEC Staff Accounting Bulletin No. 104, “Revenue Recognition” and Emerging Issues Task Force 99-19, “Reporting Revenue Gross as a Principal versus Net as an Agent.” Accordingly, such revenue is recognized in net sales either at the time of sale or over the contract period, based on the nature of the contract, at the net amount retained by us, with no cost of sales. Revenue from information technology consulting or professional services is either recognized as incurred for services billed at an hourly rate or recognized using the percentage of completion method for services provided at a fixed fee. Revenue for data center services, including Internet connectivity, Web hosting, server co-location, and managed services, is recognized over the period service is provided. In accordance with EITF 00-10, “Accounting for Shipping and Handling Fees and Costs,” we record freight billed to our customers as net sales and the related freight costs as a cost of sales.
Vendor rebates are recorded when earned as a reduction of cost of sales. Price protection is recorded when earned as a reduction to cost of sales or merchandise inventory, as applicable.
Advertising
Advertising expense was $118.3 million, $114.5 million and $90.8 million in 2006, 2005 and 2004, respectively. Advertising costs are generally charged to expense in the period incurred. Cooperative reimbursements from vendors are recorded in the period the related advertising expenditure is incurred. We classify vendor consideration as either a reduction of advertising expense or as a reduction of cost of sales in accordance with Emerging Issues Task Force Issue No. 02-16, “Accounting for Consideration Received from a Vendor by a Customer (Including a Reseller of the Vendor’s Products).” Most vendor consideration received by CDW for cooperative advertising is considered a reduction of cost of sales. Advertising expense is offset by cooperative advertising funds when the reimbursement represents specific, incremental and identifiable costs.
Earnings Per Share
We calculate earnings per share in accordance with Statement of Financial Accounting Standards No. 128, “Earnings Per Share” (“SFAS 128”). Accordingly, we have disclosed earnings per share calculated using both the basic and diluted methods for all periods presented. A reconciliation of basic and diluted per share computations is included in Note 12.
Share-Based Compensation
On January 1, 2006, we adopted Statement of Financial Accounting Standards No. 123R, “Share-Based Payment” (“SFAS 123R”). SFAS 123R requires the Company to measure all share-based payments to coworkers and directors using a fair-value-based method and record compensation expense related to these payments in our consolidated financial statements. We have elected to use the modified prospective method, which allows for prospective recognition of compensation expense without restatement of prior periods in the year of adoption.
See Note 11 for further information on the adoption of SFAS 123R and the related disclosures, including pro forma information for prior periods as if we had recorded share-based compensation expense.
Fair Value of Financial Instruments
We estimate that the fair market value of all of our financial instruments at December 31, 2006 and 2005 are not materially different from the aggregate carrying value due to the short-term nature of these instruments or the nature of the underlying securities.
Treasury Shares
We intend to hold repurchased shares in treasury for general corporate purposes, including issuances under various stock plans. We account for treasury shares using the cost method.
Foreign Currency Translation
Our functional currency is the U.S. dollar. The functional currency of our Canadian subsidiary is the local currency, the Canadian dollar. Assets and liabilities of this subsidiary are translated at the spot rate in effect at the applicable reporting date and the results of operations are translated at the average exchange rates in effect during the applicable period. The resulting foreign currency translation adjustment is recorded as accumulated other comprehensive income, which is reflected as a separate component of shareholders’ equity.
2.
Recently Issued Accounting Standards
FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes - an Interpretation of FASB Statement 109” (“FIN 48”)
In June 2006, the Financial Accounting Standards Board (“FASB”) issued FIN 48. FIN 48 prescribes a two-step process for the financial statement measurement and recognition of a tax position taken or expected to be taken in an income tax return. The first step involves the determination of whether it is more likely than not that a tax position will be sustained upon examination, based on the technical merits of the position. The second step requires that any tax position that meets the more-likely-than-not recognition threshold be measured and recognized in the financial statements at the largest amount of benefit that is greater than 50 percent likely of being realized upon ultimate settlement. FIN 48 also provides guidance on the accounting for related interest and penalties, financial statement classification, and disclosure. FIN 48 is effective for fiscal years beginning after December 15, 2006. We do not expect the adoption of FIN 48 to have a material impact on our financial statements.
Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (“SFAS 157”)
In September 2006, the FASB issued SFAS 157. SFAS 157 defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. SFAS 157 applies where other accounting pronouncements require or permit fair value measurements; it does not require any new fair value measurements. The effects of adopting SFAS 157 will be determined by the types of instruments carried at fair value in our financial statements at the time of adoption as well as the method utilized to determine their fair values prior to adoption. SFAS 157 is effective for fiscal years beginning after November 15, 2007. We are currently evaluating the impact SFAS 157 will have on our financial statements.
3.
Acquisition of Berbee Information Networks Corporation
On October 11, 2006, we completed the acquisition of Berbee Information Networks Corporation (“Berbee”) for a total purchase price of $186.1 million, including an adjustment for working capital. Through the purchase of Berbee, our business strategy has evolved to include providing information technology solutions and engineering capabilities in advanced technologies.
Berbee provides information technology solutions and engineering capabilities in advanced technologies primarily across the Cisco, IBM, and Microsoft platforms. Areas of expertise include strategic technology planning, network infrastructure and unified communications, systems and storage, security, productivity applications and managed services. Berbee’s customer base includes corporate, healthcare, education, and state and local government customers. Berbee operates as a separate strategic business unit of CDW with its current product and service offerings.
The acquisition was accounted for as the purchase of a business and, accordingly, the results of operations of the acquired business subsequent to the completion of the purchase are included in the accompanying consolidated financial statements, and the acquired assets and liabilities were recorded based upon their fair values at the date of acquisition. The excess of the purchase price over the net assets acquired is recorded as goodwill. The following table summarizes the purchase price and the fair values of the assets acquired and liabilities assumed at the date of acquisition (in thousands):
The following table presents details of purchased intangible assets (dollars in thousands):
The $117.5 million of goodwill was assigned to the Berbee operating segment. None of this goodwill is expected to be deductible for tax purposes.
Pro Forma Results
The results of the Company include the results of Berbee from the date of acquisition. The following unaudited pro forma financial results present the combined results of operations of the Company and Berbee for the years ended December 31, 2006 and 2005 as if the acquisition had occurred at January 1, 2005 (in thousands, except per share amounts).
The unaudited pro forma financial results are not intended to represent or be indicative of the Company’s consolidated results of operations that would have been reported had the acquisition been completed as of the beginning of the periods presented and should not be taken as indicative of the Company’s future consolidated results of operations.
The following table presents the gross unrealized losses and fair values of our investments in marketable securities, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position as of December 31, 2006 and 2005 (in thousands):
Because the Company believes that unrealized losses on fixed income securities are primarily attributable to changes in interest rates, and because the Company has the ability and intent to hold
these investments until a recovery of fair value, which may be maturity, the Company does not consider those investments to be other-than-temporarily impaired as of December 31, 2006.
Net unrealized holding losses on available-for-sale securities are determined by specific identification and are included in accumulated other comprehensive income, which is reflected as a separate component of shareholders’ equity. The gross realized losses on marketable securities that are included in other expense in the Consolidated Statements of Income are not material.
The following table summarizes the maturities of our fixed income securities as of December 31, 2006 and 2005 (in thousands):
6.
Goodwill and Intangible Assets
The following table presents the changes in the carrying amount of goodwill by segment during the year ended December 31, 2006 (in thousands):
7.
Financing Arrangements
We have an aggregate $70.0 million available pursuant to two $35.0 million unsecured lines of credit with two financial institutions. One line of credit was renewed in June 2006 and expires in June 2007. The other line does not have a fixed expiration date. Borrowings under the first credit facility bear interest at the prime rate less 2.5%, LIBOR plus 0.45% or the federal funds rate plus 0.5%, as determined by the Company. Borrowings under the second credit facility bear interest at the prime rate less 2.5%, LIBOR plus 0.45% or the federal funds rate plus 0.45%, as determined by the Company. The Company does not incur any facility fees associated with either line of credit. At December 31, 2006, there were no borrowings under either of the credit facilities.
8.
Trade Financing Agreements
We have entered into security agreements with certain financial institutions in order to facilitate the purchase of inventory from various suppliers under certain terms and conditions. The agreements allow for a maximum credit line of $150 million collateralized by the inventory purchases financed by the financial institutions and certain other assets. We do not incur any interest expenses associated with these agreements, as we pay the balances when they are due. At December 31, 2006 and 2005, we owed the financial institutions approximately $108.1 million and $43.8 million, respectively, which is included in trade accounts payable.
9.
Lease Commitments
We are obligated under various operating lease agreements for office facilities that generally provide for minimum rent payments and a proportionate share of operating expenses and property taxes and include certain renewal and expansion options. For the years ended December 31, 2006, 2005 and 2004, rent expense was $14.9 million, $11.4 million and $13.8 million, respectively.
In connection with the acquisition of Berbee, we assumed certain capital lease obligations for office equipment. At the date of acquisition, the equipment subject to capital leases was recorded in property and equipment at fair value, which was $0.9 million. From the date of acquisition through December 31, 2006, we recorded $0.1 million of depreciation expense related to this equipment.
Future minimum lease payments are as follows (in thousands):
The portion of the net deferred tax asset relating to employee stock plans results primarily from the compensatory stock option grants under the CDW stock incentive plans. Compensation expense related to these plans is deductible for income tax purposes in the year the options are exercised.
The net operating loss in Canada of $0.8 million was utilized in 2006. The state net operating loss of $8.4 million, acquired with Berbee, may be carried forward to 2007 - 2022. The capital loss of $0.9 million, acquired with Berbee, may be carried forward to 2010.
The Company has not recognized deferred income taxes on undistributed earnings of its international subsidiary. The earnings are considered to be reinvested permanently.
11.
Share-Based Compensation
Share-Based Compensation Plan Descriptions
We have established certain share-based compensation plans for the benefit of our coworkers and directors. The Company’s share-based compensation plans are intended to 1) align the interest of the Company’s shareholders and the recipients of awards under the plans, 2) attract, motivate, and retain coworkers and directors, and 3) motivate such persons to act in the long-term best interests of the Company and its shareholders.
At the 2006 Annual Meeting of Shareholders, the CDW 2006 Stock Incentive Plan (“2006 Plan”) was approved. The 2006 Plan allows our Compensation and Stock Option Committee to grant stock options, restricted stock, restricted stock units and other equity-based awards to coworkers, including executive officers, and consultants. The 2006 Plan replaces the CDW 2000 Incentive Stock Option Plan (“2000 Plan”) and the equity award provisions of the CDW Senior Management Incentive Plan (“SMIP Plan”). With the approval of the 2006 Plan, no additional awards are allowed under the 2000 Plan or the SMIP Plan. Awards previously granted under these and prior plans remain outstanding in accordance with the terms of the plans under which they were granted. Upon adoption, there were 4,660,000 shares of common stock available for grants under the 2006 Plan. Shares not issued due to the expiration, termination, cancellation or
Grants to non-employee directors are made pursuant to the terms of the 2004 Non-Employee Director Equity Compensation Plan (“2004 Plan”). The 2004 Plan provides for the grant of stock options and restricted stock to non-employee directors on the terms set forth in the 2004 Plan.
As of December 31, 2006, there were 4,250,159 shares of common stock available for future grants under these plans.
Stock Options
Stock options awarded under the 2004 Plan and the 2006 Plan have an exercise price equal to the fair market value of a share of common stock on the date of grant. Option awards under these plans vest ratably over five years and have a ten year contractual life. There are outstanding options that were awarded under prior plans that have vesting periods of seven to ten years and contractual lives of 20 years.
Restricted Stock
Under the terms of the 2004 Plan, newly elected or appointed directors receive a restricted stock grant of 1,000 shares upon the commencement of service on the Board of Directors. Restricted stock issued under the 2004 Plan vests in full after five years of continuous service.
Restricted stock awards granted under the 2006 Plan vest ratably over five years.
Recipients of restricted stock awards granted under these plans possess the rights of shareholders, including voting rights and the right to receive dividends.
Restricted Stock Units
The restricted stock unit awards that have been granted under the 2006 Plan obligate the Company to issue a specific number of shares of the Company’s common stock upon the vesting of the award. Restricted stock units vest ratably over five years from the date of grant.
Employee Stock Purchase Plan
We have established an Employee Stock Purchase Plan (“ESPP”) which provides that eligible coworkers may contribute up to 15% of their eligible compensation towards the quarterly purchase of our common stock. Effective January 1, 2006, we changed the provisions of the ESPP so that it is non-compensatory under the provisions of SFAS 123R. The coworkers’ purchase price is 95% of the fair market value of the stock on the last business day of the quarterly offering period. Coworkers may purchase shares having a fair market value of up to $25,000 per year but not to exceed 325 shares per quarter. No compensation expense is recorded in connection with the ESPP and the tables in this note exclude the impact of the ESPP unless otherwise noted. At the 2006 Annual Meeting of Shareholders, the Company’s shareholders approved an amendment to the ESPP pursuant to which 500,000 additional shares were added to the ESPP, increasing the number of shares available under the plan to 1,000,000. As of December 31, 2006, we had issued 393,992 shares over the life of the ESPP and the number of shares available for future issuance under the ESPP was 606,008.
Valuation and Expense Information under SFAS 123R
Under SFAS 123R, the value of share-based compensation awards must be attributed to the various periods during which the recipient must perform services in order to vest in the award. Upon adoption of SFAS 123R, the Company changed its method of attributing the value of share-based compensation expense from the accelerated approach specified in FASB Interpretation No. 28, “Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans” to the straight-line method. Compensation expense for awards made prior to January 1, 2006 will continue to be subject to the accelerated expense attribution method while compensation expense for share-based awards made on or after January 1, 2006 will be recognized using a straight-line method.
The fair value of each stock option grant made after April 1, 2005 was estimated on the grant date using a lattice-binomial model. The fair value of each stock option grant made prior to April 2, 2005 was estimated on the grant date using the Black-Scholes model. The weighted-average estimated grant date fair values and the assumptions used to value option grants and compensatory stock purchase rights under the ESPP for the years ended December 31, 2004, 2005, and 2006 are as follows:
The Company estimated the expected future volatility used in the lattice-binomial model valuation based on a combination of historic and implied volatility of the Company’s common stock. The Company believes that this blended approach provides a better estimate of the expected future volatility of the Company’s common stock over the expected life of its stock options. The lattice-binomial model takes into consideration early exercise behavior or patterns based on stock price appreciation. The Company estimated early exercise behavior patterns based on an analysis of historical exercise behavior. The risk-free interest rate assumption was based upon observed interest rates appropriate for the term of the Company’s stock options. The expected life of the options granted is derived from the output of the lattice-binomial option valuation model and represents the weighted-average period of time that options granted are expected to be outstanding. The dividend yield is based on the Company’s history and expectation of dividend payouts.
•
Cash proceeds related to stock option exercises were $74.3 million.
•
The intrinsic value of stock options exercised was $85.5 million.
•
The fair value of Restricted Stock that vested was $0.2 million.
•
The tax benefit realized from the exercise of stock options and the vesting of Restricted Stock was $30.5 million.
For the year ended December 31, 2006, the share-based compensation expense of $1.18 million related to Restricted Stock would also have been recorded as an expense under APB 25. Prior to the adoption of SFAS 123R, we presented all tax benefits for deductions resulting from the exercise of stock options and disqualifying dispositions as operating cash flows in our consolidated statement of cash flows. SFAS 123R requires the benefits from tax deductions in excess of recognized compensation expense to be reported as a financing cash flow, rather than as an operating cash flow. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after adoption. Total cash flows will remain unchanged from what would have been reported under prior accounting rules.
12.
Earnings Per Share
At December 31, 2006, we had 78,769,186 outstanding common shares. We have granted options to purchase common shares to the directors and coworkers of the Company as discussed in Note 11. These options have a dilutive effect on the calculation of earnings per share. The following table is a reconciliation of the numerators and denominators of the basic and diluted earnings per share computations as required by SFAS 128 (in thousands, except per share amounts):
Additional options to purchase common shares and Restricted Stock were outstanding during the years ended December 31, 2004, 2005, and 2006, but were not included in the computation of diluted earnings per share because they were antidilutive in that either: 1) the exercise price of the options were greater than the average market price of common shares during the respective periods or 2) the deemed per share proceeds under the treasury stock method (the sum of the option exercise price, if applicable, any future compensation expense under SFAS 123R, and any related “windfall” tax benefits) for the options or Restricted Stock on a per share basis exceeded the average market price of common shares during the respective periods.
amount of damages, to be determined at trial, paid to it. On February 1, 2007, CDW entered into a settlement agreement (the “Settlement Agreement”) to resolve the above referenced action pursuant to which CDW agreed to pay $25 million to the Liquidating Trust in return for a full release and complete dismissal of the litigation, with prejudice. While CDW believed it had good defenses to the claims by the Liquidating Trust, it agreed to settle the case in order to avoid the substantial costs and uncertainties involved with further litigation. The Settlement Agreement represents the compromise of a disputed claim and does not constitute an admission of liability on behalf of CDW. A Motion to Approve the Settlement Agreement was filed in the Bankruptcy Court by the Liquidating Trust on February 1, 2007. No objections were filed with the Bankruptcy Court, and the time for filing objections has expired. An order approving the Settlement Agreement was entered by the Bankruptcy Court on February 21, 2007. That order becomes final and nonappealable on March 5, 2007. CDW’s settlement payment, included in other current liabilities on the Consolidated Balance Sheet as of December 31, 2006, and a motion by the Liquidating Trust to dismiss the litigation with prejudice, are both due on March 12, 2007.
From time to time, customers of CDW file voluntary petitions for reorganization under the United States bankruptcy laws. In such cases, certain pre-petition payments received by CDW could be considered preference items and subject to return to the bankruptcy administrator. CDW believes that the final resolution of any such preference items will not have a material adverse effect on its financial condition.
In addition, CDW is party to legal proceedings that arise from time to time, both with respect to specific transactions and in the ordinary course of our business. CDW is also subject to audit by federal, state and local tax authorities, by various government agencies relating to sales under certain government contracts and by vendors relating to vendor incentive programs.
We do not believe that any current audit or pending or threatened litigation will have a material adverse effect on our financial condition. Litigation and audits, however, involve uncertainties and it is possible that the eventual outcome of litigation or audits could adversely affect our results of operations for a particular period.
16.
Segment Information
We have three operating segments: corporate sector, which is primarily comprised of business customers; public sector, which is comprised of federal, state and local government entities, educational institutions, and healthcare institutions; and Berbee, a new segment as a result of the Berbee acquisition in October 2006, which provides advanced technology solutions. In accordance with Statement of Financial Accounting Standards No. 131, “Disclosure about Segments of an Enterprise and Related Information,” the internal organization that is used by management for making operating decisions and assessing performance is the source of our reportable segments.
In the first quarter of 2005, we revised the operating segments which reflect the basis for making operating decisions and assessing performance. Under the revised structure, centralized logistics and headquarters functions that were formerly provided by the corporate sector segment to the public sector segment were separated from the corporate sector segment. The logistics functions include purchasing, distribution, and fulfillment services to support both the corporate and public sector segments, and costs and intercompany charges associated with the logistics function are fully allocated to both of the operating segments based on a percent of sales. The centralized headquarters functions provide services in areas such as accounting, information technology, marketing, legal, and coworker services. Certain of the headquarters function costs that are not allocated to the operating segments are included under the heading of “Headquarters/Other” in the tables below.
In July 2005, the Company announced the creation of a dedicated healthcare sales team. In creating this team, we consolidated healthcare accounts from across our entire sales organization and transferred these accounts to the new team in the public sector group. This new team focuses on IT solutions addressing the unique needs of a range of customers within the healthcare field. For financial reporting purposes, results of operations and assets related to healthcare customers are reported as part of the public sector segment.
The accounting policies of the segments are the same as those described in Note 1, “Summary of Significant Accounting Policies.” We allocate resources to and evaluate performance of our segments based on both sales and operating income.
We have restated 2004 segment information to conform to our revised segment reporting structure. The following tables present information about our reportable segments (in thousands):
As of December 31, 2006, 3.2 million shares remained available for repurchase under our current program. Repurchased shares are held in treasury pending use for general corporate purposes, including issuances under various employee stock plans.
18.
Micro Warehouse Transactions
During September 2003, we purchased selected U.S. assets and the Canadian operations of Micro Warehouse, a reseller of computers, software and peripheral products. The U.S. transaction, completed on September 9, 2003, was accounted for as a purchase of assets, with the $20.0 million purchase price allocated to the assets purchased, including inventory, fixed
assets and customer lists, based upon their fair values at the date of purchase. Subsequent to the completion of the U.S. transaction, sales made by former members of the Micro Warehouse U.S. sales force who joined CDW in conjunction with this transaction, along with the associated costs, are included in the accompanying consolidated financial statements. The Canadian transaction, completed on September 23, 2003, was accounted for as the purchase of a business and, accordingly, the results of operations of the acquired business subsequent to the date of purchase were included in our consolidated financial statements, and the assumed assets and liabilities were recorded based upon their fair values at the date of purchase. The Canadian operations were purchased for $2.7 million.
During the years ended December 31, 2003 and 2004, we recorded $22.3 million (pre-tax) and $3.9 million (pre-tax), respectively, of transaction and integration expenses associated with these transactions. These expenses were primarily comprised of severance and outplacement costs, payroll expenses for former Micro Warehouse employees performing transition services, customer satisfaction expenses, customer communications and advertising expenses, legal and accounting advisory fees and a reserve established for the equipment in a Wilmington, Ohio distribution center leased by Micro Warehouse as discussed below.
In February 2004, we purchased the equipment in the Wilmington, Ohio distribution center leased by Micro Warehouse and forfeited leasing the facility in exchange for $8.25 million. During 2003, we recorded a $5.0 million reserve related to the purchased equipment in accordance with FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” At March 31, 2004, we increased this reserve by $2.0 million due to a change in the scenarios used in estimating the Company’s exposure. During the third quarter of 2004, substantially all of this equipment was liquidated at values in line with our expectations.
19.
Selected Quarterly Financial Data (Unaudited)
The following information is for the years ended December 31, 2006 and 2005 (in thousands, except per share data):
Item 9.
Item 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
Evaluation of Disclosure Controls and Procedures
As required by Rule 13a-15(b) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), the Company’s management carried out an evaluation, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of December 31, 2006. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, as of December 31, 2006, the Company’s disclosure controls and procedures were effective to ensure that information required to be disclosed by the Company (including its consolidated subsidiaries) in the reports the Company files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms.
Design and Evaluation of Internal Control Over Financial Reporting
We have included Management’s Report on Internal Control Over Financial Reporting as part of this Annual Report on Form 10-K. This report, which is found on page 27 herein, contains management’s assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006. The Company’s independent registered public accounting firm has audited management’s assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006 and the effectiveness of our internal control over financial reporting as of December 31, 2006 as stated in its report which is included on page 28 herein.
Changes in Internal Control Over Financial Reporting
There was no change in the Company’s internal control over financial reporting that occurred during the Company’s fiscal quarter ended December 31, 2006 that materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.
None.
PART III
Item 10.
Item 10.
Directors, Executive Officers and Corporate Governance
Except for the discussion in the following paragraph regarding the code of ethical conduct, the information required by this item is incorporated by reference from the discussion in our proxy statement (the “Proxy Statement”) for the 2007 Annual Meeting of Shareholders under the headings “Proposal 1 - Election of Directors;” “Audit Committee;” “Shareholder Recommendations of Candidates for the Board of Directors;” “Section 16(a) Beneficial Ownership Reporting Compliance;” and “Management.”
We have adopted a code of ethical conduct for directors, executive officers and other senior financial personnel which is available on our Web site at CDW.com.
The information required by this item is incorporated by reference from the discussion in our Proxy Statement under the headings “Director Compensation;” “Employment Related Agreements;” “Executive Compensation;” and “Compensation and Stock Option Committee Report” provided that the Compensation and Stock Option Report shall not be deemed “filed” in this Annual Report on Form 10-K.
Item 12.
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
The information required by this item is incorporated by reference from the discussion in our Proxy Statement under the headings “Stock Beneficially Owned by Directors, Certain Executive Officers and Our Largest Shareholders;” and “Equity Compensation Plan Information.”
Item 13.
Item 13.
Certain Relationships and Related Transactions, and Director Independence
The information required by this item is incorporated by reference from the discussion in our Proxy Statement under the headings “Certain Transactions” and “Director Independence.”
Item 14.
Item 14.
Principal Accounting Fees and Services
The information required by this item is incorporated by reference from the discussion in our Proxy Statement under the heading “Proposal 2 - Ratification of the Selection of Independent Registered Public Accounting Firm.”
PART IV
Item 15.
Item 15.
Exhibits, Financial Statement Schedules
(a)
The following documents are filed as part of this report:
1.
Financial Statements (See Index to Consolidated Financial Statements on page 26 of this Report);
All other schedules are omitted since the required information is not present or is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the consolidated financial statements or notes thereto.
*
Indicates management contract or compensatory plan or arrangement.
(b)
The Exhibits required by Item 601 of Regulation S-K are reflected above in Section (a) 3. of this Item.
(c)
The financial statement schedule is included as reflected in Section (a) 2. of this Item.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
CDW CORPORATION
Date: March 1, 2007
By:
/s/ John A. Edwardson
John A. Edwardson
Chairman and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
CDW CORPORATION
SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
Years ended December 31, 2006, 2005 and 2004
(in thousands)
Note:
(a)
Represents balance from businesses acquired.
(b)
Uncollectible items written off, less recoveries of items previously written off.
S-1