Wesco International Inc

NYSE:WCC

Earnings Call Transcript 2023-Q1

[Operator]

Hello and welcome to Wesco's First Quarter 2023 Earnings Call. I would like to remind you that all lines are in a listen-only mode throughout the presentation. [Operator Instructions] Please note that this event is being recorded.

I will now hand the call over to Scott Gaffner, SVP, Investor Relations, to begin.

[Scott Gaffner, Senior Vice President-Investor Relations]

Thank you and good morning, everyone. Before we get started, I want to remind you that certain statements made on this call contain forward-looking information. Forward-looking statements are not guarantees of performance and, by their nature, are subject to inherent uncertainties. Actual results may differ materially. Please see our webcast slides as the company's SEC filings for additional risk factors and disclosures. Any forward-looking information relayed on this call speaks only as of this date, and the company undertakes no obligation to update the information to reflect the changed circumstances.

Additionally, today, we will use certain non-GAAP financial measures. Required information about these non-GAAP measures is available on our webcast slides and in our press release, both of which are posted on our website at wesco.com.

On this call -- on the call this morning, we have John Engel, Wesco's Chairman, President and Chief Executive Officer; and Dave Schulz, Executive Vice President and Chief Financial Officer.

And now I'll turn the call over to John.

[John Engel, Chairman, President & Chief Executive Officer]

Thank you, Scott, and good morning, everyone. It's a pleasure to be with you today. We're off to a strong start this year and set a new first quarter company record for sales, backlog, margin and profitability. The power of our increased scale, our industry leading positions and our expanded portfolio of product, services and complete solutions is evident in our continued strong performance.

We delivered double-digit organic sales growth driven by secular demand trends, share gains and ongoing improvements in the supply chain. All three of our business units set new records for first quarter sales as well as gross margin. And we delivered another impressive quarter of cross-sell results, which continue to exceed our expectations.

We're confident that 2023 will be another transformational year for Wesco. We're making excellent progress on our digital transformation and expect our strong sales growth and margin expansion to continue. As you saw in our release earlier this morning, we reaffirmed our full year outlook, and we expect to generate significant free cash flow in 2023.

As Dave will discuss in more detail later in the call, we are focusing our cash generation on debt reduction in the near-term. As a result, we expect to reduce our leverage below 2.75 times, which is the midpoint of our target range by year-end. And that creates increased capital allocation optionality for us in the second half and entering next year.

Now turning to page 4. The strength of our business model and the success of our integration efforts since closing the Anixter acquisition in mid-2020 have established a track record of superior results for our company. This page highlights our first quarter record results compared to the pro forma pre-pandemic results of legacy Wesco, plus legacy Anixter in the first quarter of 2019.

As you can see, we have clearly outperformed the market, delivering impressive sales growth and margin expansion, and we've achieved record profitability, all while rapidly deleveraging our balance sheet. Most importantly, our dedicated team of Wesco associates continues to provide resilient and critical supply chain solutions for our customers around the world, capturing the benefits of our deep exposure to sustainable secular growth trends that drive our future sales and profitability.

So with that, I'll now turn the call over to Dave.

[Dave Schulz]

Thanks, John, and good morning, everyone. I'll start on slide 5 with a summary of our first quarter results compared to the prior year. As John mentioned, we delivered first quarter record sales, gross margin, adjusted EBITDA margin and adjusted EPS. Our cross-sell program again exceeded our expectations. Our ability to cross-sell Wesco and Anixter products and services contributed approximately $220 million of sales in the quarter.

On an organic basis, sales were up 11% in the quarter driven by a combination of price and volume, along with share gains. We estimate pricing added approximately five points to sales growth with the benefit primarily in our UBS and EES segments. On a reported basis, sales were up 12% as additional sales from Rahi were partially offset by a headwind due to foreign exchange rates in the quarter.

Backlog continues to be at historically high levels. In total, backlog was up 21% year-over-year and flat sequentially from the end of December, including backlog associated with the Rahi acquisition. Supply chains have started to heal and, in some instances, have returned to normal. However, we are still experiencing extended lead times in our EES and UBS segments for critical components such as switchgear, breakers and transformers.

While an improving supply chain is a positive for Wesco, our customers and suppliers, it has created some near-term timing issues around inventory. Specifically, we are adjusting our order patterns to reflect shorter lead times versus last year. Our current inventory levels support our record backlog and our expectation to deliver 6% to 9% revenue growth in 2023.

As we start the second quarter, demand has continued to be resilient on top of a tough base period comparison. In the month of April, growth continues to be led by CSS and UBS, which were both up low double digits. Preliminary workday adjusted April sales were up approximately 6% year-over-year, including the impact of a stronger dollar and the Rahi acquisition.

On a preliminary workday adjusted two-year stack basis, sales were up 28% in April. Recall that comparables in the first half of the year are particularly challenging. Gross margin was a first quarter record at 21.9%, up 60 basis points versus the prior year and in line with the fourth quarter of 2022. This result was again driven by our margin improvement program and the effective pass-through of supplier price increases.

Adjusted EBITDA, which excludes merger-related integration costs, stock-based compensation and other net adjustments was a Q1 record and 16% higher than the prior year. Adjusted EBITDA margin was also a Q1 record at 7.6% of sales or 20 basis points above the prior year. Adjusted diluted EPS for the quarter was $3.75, another Q1 record, and $0.12 above the prior year. The primary driver of this increase was core operations as we recognized higher below the line items related to interest and other expenses.

Turning to page 6. This slide bridges the year-over-year increase in sales and adjusted EBITDA. Organic sales increased 11% versus the prior year, including a 5% benefit from price in the quarter, along with volume growth in our markets. As expected, the contribution from price moderated in the quarter relative to 2022 as there have been fewer supplier price increases, and the magnitude of these increases has moderated.

Adding to this growth was the impact of the $220 million we generated in cross-sell in the quarter as well as continued share gains. Adjusted EBITDA increased 16% versus the prior year. Higher sales and expanded gross margin drove the majority of the increase, along with the realization of cost synergies in the quarter.

Consistent with 2022, we continue to experience higher volume related operating costs, including shipping and sales commissions. We also recognized higher expenses for employee compensation and benefits due to inflation and higher headcount as well as cost increases related to the operation of our facilities. SG&A came in above expectations, with the majority of the increase incurred in our EES business unit.

Finally, in accordance with our plan, we continued our strategic investments in systems and digital tools. These cost increases partially offset by the realization of integration cost synergies and lower incentive compensation expense.

Turning to slide 7. Organic sales in our EES business were up 4% year-over-year and a first quarter record. Recall that beginning in Q1, we transferred certain businesses from EES to CSS and UBS to better align our sales management of certain customer accounts. Excluding the impact of this transfer, EES organic sales would have been 6% above prior year. The year-over-year growth primarily reflects continued double-digit sales growth momentum in our industrial markets, and solid construction sales up mid-single digits. OEM sales were down low single digits driven primarily by lower specialty vehicle and manufactured structures demand.

Backlog was flat with the record December level and 14% higher than the prior year. In the first quarter, adjusted EBITDA was $183 million for EES, down approximately 5% from the prior year. Adjusted EBITDA margin was 8.6%, 60 basis points lower year-over-year. Segment gross margins were up over prior year. However, higher SG&A costs in the quarter, specifically related to higher headcount and transportation and logistics costs drove the decline in EBITDA.

We expect EES profitability to improve in the second and third quarters driven by operating leverage on seasonally higher sales. SG&A reductions initiated in the second quarter will take effect in the second half of the year.

Turning to slide 8. Sales in our CSS business were a Q1 record and up 13% versus the prior year on an organic basis. Excluding the impact of the inter-segment business transfer I mentioned a moment ago, CSS organic growth would have been 11%. Of critical importance was the strong sales growth in February and March, the two toughest comparables of the quarter.

We saw solid growth in network infrastructure, up mid-single digits, driven by data center and cloud applications, as well as very strong growth in security, which was up low double digits, and professional audio visual installations, which was up more than 30% from prior year.

Backlog, including Rahi, was up 10% over the prior year and decreased 2% sequentially as we were able again to release more projects from backlog due to improved availability of product and a return to more normal lead times across most product categories.

Profitability was also strong with record Q1 adjusted EBITDA and adjusted EBITDA margin of 9%, 40 basis points higher than the prior year, driven by operating leverage, integration cost synergies and the continued successful execution of our margin improvement initiatives.

Turning to slide 9. Record sales in our UBS business were up 18% versus the prior year on an organic basis in the quarter, marking the sixth consecutive quarter of organic growth above 15%. We experienced broad-based growth in our utility and integrated supply business with sales up over 20% and up low double digits, respectively.

Broadband sales were down low double digits as certain customers work through higher levels of inventory that were built last year. Backlog was another record in the quarter, up 46% over the prior year and up approximately 1% sequentially. Profitability was exceptionally strong with an adjusted EBITDA margin of 11.3%, up 160 basis points versus the prior year, driven by operating leverage on higher sales, our margin improvement initiatives and integration synergies. This was the fourth consecutive quarter of adjusted EBITDA margins above 10%.

Now moving to page 10. The size of the cross-sell opportunity of combining Wesco and Anixter continues to exceed our expectations. In Q1, we recognized $220 million of cross-sell revenue, bringing the cumulative total to $1.45 billion since the beginning of the program. Our pipeline of sales opportunities remains healthy and expanded again in the quarter. We are capitalizing on the complementary portfolio of products and services, as well as the minimal overlap between legacy Wesco and legacy Anixter customers.

As we look at the remaining nine months of the program in 2023, we are increasing our expected cumulative total to $1.8 billion, reflecting the strength of our value proposition against the backdrop of accelerating secular trends.

Turning to slide 11. This is a slide that we've shown throughout the integration with the realized cumulative run rate cost synergies of $188 million in 2021 and $270 million in 2022. We remain on track to meet our expected target of $315 million by the end of 2023. Our focus through the balance of the year is on our supply chain network design and field operations to drive cost synergies.

Turning to page 12. On this page, you can see a bridge of free cash flow in the first quarter, which was a draw of $266 million. The primary driver was working capital, which more than offset net income. Receivables increased sequentially in Q1 as some customers delayed payments from March into April. However, accounts receivable reserves and bad debt write-offs are at normal levels.

The increase in inventory in the quarter was due to a few factors. As we continue to see supply chains normalize, certain suppliers are accelerating their pace of shipments to us. While the improved availability of product is a positive for our customers, recall that we do not typically ship product to our customers until their entire order is available.

As we make progress shipping the backlog of projects, we expect to see a normalization of inventory levels, which will drive cash generation through the rest of the year. Payables were an $87 million use of cash following the $70 million cash generation in the fourth quarter, driven by the timing of purchases in Q1 and normal seasonal cash payments based on prior year accruals. Capital expenditures was approximately $14 million in the quarter, and other sources and uses of cash were collectively an $18 million use of cash in the quarter.

Moving to Slide 13. Reducing our leverage has been a top priority since we announced the acquisition of Anixter. While leverage decreased for eight consecutive quarters through the end of last year, our leverage increased one-tenth of a turn in Q1 driven by the use of cash in the quarter. Leverage remains well within our targeted range of 2 to 3.5 turns, and we expect to generate full year free cash flow of $600 million to $800 million.

Given our current debt levels and the interest rate environment, our near-term capital allocation priority will be to pay down debt until we reach the midpoint of our target leverage range, which we expect will occur in the second half of the year.

Now moving to page 14. This slide shows the uniquely strong position of our company to drive growth and profitability in the years ahead. The end-to-end solutions that we provide to our global customer base are directly aligned with the six secular growth trends shown on the left side of this page.

Our participation in these trends, coupled with increasing public sector investments in infrastructure, broadband and partnerships with the private sector, make Wesco positioned exceptionally well.

As we outlined at our Investor Day last year, we expect to grow 2% to 4% above the market due to the combined benefit of secular trend growth and increasing share. In short, we view Wesco as a secular growth company.

Moving to page 15. We are reaffirming our 2023 outlook today based on the demand trends and record results in the first quarter. In 2023, market growth is expected to contribute approximately 4% to 6% to the top line, which is a combination of volume and price. We expect US GDP to be flat in 2023 with our secular tailwinds providing one to two points of volume growth. Price carryover in 2023 will be three to four points based primarily on pricing actions in 2022. Recall that our guidance does not incorporate any impact of future pricing actions. In addition to market growth, we believe our scale and continued cross-selling efforts will contribute an additional one to two percentage points above the market, driving total organic growth of 5% to 8%.

After factoring in the additional revenue from Rahi and the impact of working days and foreign exchange, we estimate our reported sales growth will be in the range of 6% to 9%. For our strategic business units, we expect EES reported sales increased by mid-single digits versus 2022, with both CSS and UBS up high single to low double digits.

Please note that in the appendix, we have highlighted the account transfers from EES to CSS and UBS we discussed earlier and that began taking effect in Q1. In 2022, these accounts represented approximately $200 million of sales with 85% moving to CSS and 15% moving to UBS.

For adjusted EBITDA margin, our outlook is for a range of 8.1% to 8.4%, which represents approximately 20 basis points of expansion at the midpoint. We expect adjusted earnings per share between $16.80 to $18.30 and free cash flow of between $600 million and $800 million. This free cash flow outlook of $700 million at the midpoint would represent the highest free cash flow in our history.

Through the cycle, we still expect the company will deliver free cash flow equivalent to net income. Consistent with the expectations we outlined during our Investor Day in September, we expect to generate $3.5 billion to $4.5 billion of operating cash flow during the period of 2022 through 2026.

To note, we expect positive free cash flow in Q2 to return to us net neutral cash generation for the first half and to deliver the rest of our targeted $600 million to $800 million of free cash flow in the second half of the year. We increased our expectation for interest expense for the year from a range of $330 million to $370 million to a range of $350 million to $390 million, primarily driven by higher variable rates and the timing of debt paydown in 2023.

We have detailed our expectation for other expense, which captures certain non-operating expenses, primarily related to the impact of pensions and foreign exchange. In the first quarter, these expenses were approximately $10 million, and we expect $30 million to $40 million for the full year. This expense reflects the recent devaluation of certain foreign currencies, along with slightly higher pension expense.

This outlook reflects a revised effective tax rate of about 25% to 26% for the year, lower than our prior expectation due to the benefit of certain discrete items in the first quarter. We still expect an effective tax rate of approximately 27% for the remaining three quarters of the year. This is slightly above our ETR over the past few years, primarily due to the implementation of certain rules in our Canadian business related to hybrid debt instruments.

2022 also benefited from certain one-time discrete items, primarily related to a change in US tax law regarding the valuation allowance on certain foreign tax credits and one-time discrete benefits in Canada.

In 2023, we continue to expect to spend approximately $100 million on capital, an additional $40 million on capitalized cloud-based computing arrangements related to our digital transformation. On the statement of cash flows, approximately $100 million will flow through capital expenditures and approximately $40 million will flow through changes in other assets.

For the year, the lower tax rate that we experienced in Q1 will be more than offset by higher interest and other expenses, but we continue to expect adjusted EPS will be within the outlook range. Our outlook assumes an average diluted share count of 52 million to 53 million shares for the year. This outlook reflects our expectation that 2023 will be the third consecutive year of record results, record sales, gross and EBITDA margins, EPS and a record free cash flow and is consistent with the long-term financial framework we presented at our Investor Day in September of last year.

We will complete our integration with Anixter at the end of the year and expect the results in 2023 to substantially outperform the expectations we set and raised since the time of the transaction closed.

Moving to slide 16 and before opening the call for questions, let me provide a brief summary of what we covered this morning. The first quarter was a great start to the year. We had record first quarter sales in all three of our business units, along with record gross margin, operating profit, adjusted EBITDA and adjusted EBITDA margin. We again took share through sales execution in our cross-sell program, and we are again increasing our cross-sell synergies outlook for 2023.

Profitability was also strong in the quarter as gross margin and EBITDA margin both expanded versus the prior year. We continue to expect 2023 will be a transformational year with continued execution of our digital initiatives, strong sales growth and continued margin expansion. Lastly, we remain on track to deliver record free cash flow of $600 million to $800 million to support our capital allocation priorities.

With that, we'll open the call to your questions.

[Operator]

We will now begin the question-and-answer session. [Operator Instructions] Our first question today comes from Deane Dray with RBC Capital Markets. Please go ahead.

[Deane Dray, RBC Capital Markets]

Thank you. Good morning, everyone.

[John Engel, Chairman, President & Chief Executive Officer]

Good morning Deane.

[Deane Dray, RBC Capital Markets]

We're hearing lots of consternation about channel inventory and customer inventories and whether there's destocking going on. And I was hoping you could just take us through from your perspective, supply chain normalization is allowing companies and customers to be able to release buffer inventory. They're all talking about that. But anytime you see or hear about destocking, it raises concerns, is that the early sign of a slowdown? So look, you're right in the ground zero of all of this because you're getting inventory from the suppliers, taking that in, you're seeing the pace with the customers as well. So please share with us what you're seeing with regard to that question. Thanks.

[John Engel, Chairman, President & Chief Executive Officer]

Yeah. Deane, very good question. I -- look, I think we had a very strong quarter. We built a plan for the year. We essentially delivered our plan. The mix was a little different than what we thought. UBS and CSS a bit stronger than an EES, a little bit of headwinds there, but still grew in the quarter.

So overall, we're seeing very strong demand levels still. Backlog was held flat in the quarter. We do expect because our backlog is running at over two times a normalized rate, and that was built over the last couple of years, and we're running with elevated inventories as well. We expect backlog to start to go down. That's working our business back to a more normalized state, but we did not see that yet in Q1, even with the 12% reported -- 11% organic growth. And that's a reflection of very strong demand levels. Bid activity levels remained at a record high. Our opportunity pipeline continues to grow. The cross-sell synergies we took up meaningfully, again, had terrific cross-sell results in the quarter. So this is really a strong quarter.

In terms of the destocking, the only area where we're seeing material destocking at the customer level is in broadband. And I think if you look at some companies that are heavily exposed to broadband value chain, you'll see that in their results, the other publicly traded companies. There was very strong growth last year. And what customers did was run with higher levels of inventory knowing that the secular growth trends are there, but also concerns about the overall supply chain, which was very constrained through the pandemic. So they're working through that a bit. This is for broadband. It's our anticipation -- it will take one to two quarters for customers to work down those inventory levels, and we expect broadband to return to growth in the second half.

I remain very bullish on broadband over the mid to long-term driven by strong secular growth trends, 24/7 connectivity, automation, IoT applications, as well as government spending in both US and Canada, RDOF and ND [ph], to name two drivers of that. So that's really the only other area, Deane.

I think the other point I will make, which is incredibly important, I think, many folks are missing, remember that our purchases are our suppliers' sales. Our purchases are our suppliers' sales. We grew our inventories over 30% in Q1 2023 versus Q1 2022.

And that's because our suppliers have been recovering quickly. Their production rates have been coming up. Their past dues have been coming down, and their shipments to us accelerated. But I think that's incredibly important to understand, because their shipments to us, which reflect -- is reflected in our inventory growth, is their out-the-door sales.

And with that, our out-the-door sales had strong double-digit growth, and we've got, again, maintaining this record backlog. So very highly, highly confident as we look through the second half -- through the second quarter, through the second half of this year, and that's why we reaffirm the guide. Hopefully, that gives you the color.

[Deane Dray, RBC Capital Markets]

It's really helpful. I appreciate you taking us through all of that. And just if we could drill down a bit on EES, and I like hearing the expectations that second quarter and third quarter are projected to be better. We don't often hear about specialty vehicle and manufactured housing as verticals. But take us through to the extent that, that's meaningful, but more importantly, what you're seeing in the construction markets. Thanks.

[John Engel, Chairman, President & Chief Executive Officer]

Yes. Well, we've got three really -- parts of that business, Industrial, Construction and OEM comprise our EES business. And I'll start with Industrial because up mid-teens, very strong. We're seeing a large number of mega CapEx projects. We've got a record backlog. That backlog includes construction, but it also includes big industrial projects that we do with the end-user customer.

The secular trends are very strong and intact, especially reshoring. Remember, we sell to 90% of the Fortune 500 companies directly. I can tell you, all our customers are looking at reshoring, nearshoring as supply chains begin shifting structurally back to North America.

I believe fundamentally -- and we're seeing this. We're in the early innings of a multiyear Industrial up cycle or even super cycle. So Industrial, strong momentum theme, that's in EES, again, double digit growth in the quarter.

Moving to Construction, up mid-single digits in the quarter, both in US and Canada, record backlog, as I mentioned. The secular trends give us great confidence. Remember, we're non-resi essentially, very little residential construction exposure, but the secular trends of electrification, IoT and automation. Again, the reshoring, very positive drivers of our business.

And it's important to understand, too, the big infrastructure spending and investments that have been approved through various bills in Congress, that's not in our numbers yet. That's not driving the market yet. So that's 2024, 2025 and beyond. So really solid start, I think, on construction.

It's also important to remember that construction overall for the company is only 17% of our total sales now. So the cyclicality of construction is only 17% when you look at the balance of our business, just incredibly strong secular growth driving most aspects of the business.

And then for OEM, that's our value-added assemblies business. That's traditionally been a lumpy business. No structural issues. It's just -- it has been lumpy over time if you were to look at that historically. We remain bullish on OEM ultimately and our value added, though, capabilities. Because when you look at the fundamental drivers for Industrial, they also apply to OEM. When you think about OEM being value-added assemblies that feed a variety of end markets, including Industrial. So that takes you through the pieces, Deane.

[Deane Dray, RBC Capital Markets]

Thank you.

[Operator]

The next question is from Sam Darkatsh, and he's with Raymond James. Please go ahead.

[Sam Darkatsh, Raymond James]

Good morning, John. Good morning, Dave. How are you?

[John Engel, Chairman, President & Chief Executive Officer]

Good morning, Sam.

[Sam Darkatsh, Raymond James]

A couple – two, three questions, I suppose. First, I'm trying to reconcile your flat sequential backlogs with the commentary for some of your primary suppliers. Some on Eaton as an example was talking about their backlog sequentially being up high single digit sequentially. Are there certain mega products that your vendors are seeing that are not going through distribution per se that they're more vendor direct, or what else might explain that delta?

[John Engel, Chairman, President & Chief Executive Officer]

I mean, the short answer is no, Sam. And so I think what I'd suggest is take a look at the -- look across the entire electrical, I'll call it, channel or value chain space. There's a number of suppliers. They have different performance levels, and there's a number of distributors. You look at us versus our competitive period, we think we had a very strong quarter, outperformed the market. You look at the suppliers, there's a range of formats. Again, I think what's most important is remembering that our suppliers -- our purchases are our suppliers' sales. And I'm not going to speak to a specific supplier, with respect to how they measure order -- kind of their front-end pipeline or order book.

I can tell you what our pipeline looks like. It's at record levels. It continues to expand. Our bid activity levels are very strong. And again, we remain bullish on the secular growth trends as they impact the construction end market vertical and our mix, which is non-resi predominantly.

[Sam Darkatsh, Raymond James]

And then my second question is, I guess, more high level and piggybacks on, I think, what Deane might have been getting at. As it stands right now, are you expecting organic sales growth in 2024? I mean we're seeing, obviously, EES softening a bit, and that's your most economically sensitive segment, but your backlogs are obviously very large and stable. So what would have to realistically happen in '24 not to show organic sales growth?

[John Engel, Chairman, President & Chief Executive Officer]

We'd have to go into a severe economic down cycle. We're not out there with a 2024 guide, except I will tell you that -- or outlook. But I'll tell you, these strong secular growth trends that we're facing into are weak, and they're enduring. These are not short-term, midterm. We believe these are long term. We believe they're structural. We also believe fundamentally, the mix shift of this company to a higher growth set of end markets, and we are a growth company now. When you look at the portfolio evolution and what the mix of our businesses are today and end market exposure today versus pre Anixter and then go back longer term, look at 10, 15, 20 years ago, this has been a fundamental portfolio shift in the higher growth markets.

So I remain very bullish on the secular growth trends and our market outperformance.

We've done an exceptional drive of cross-sell. We raised it again this quarter. And that's the hardest thing to get when you get -- put through companies together. So I think that speaks to the power of the combination, which is unique to us. That's a special cost driver, plus the rigor of the process we put in place in our operating model that we're figuring out to really leverage our sales force to pull in other aspects and capabilities of our company in each and every customer opportunity to sell a much more complete solution and a more complete basket.

And I think -- I've made the statement. I think that's the largest value creation lever as a result of putting these two companies together, and that has tremendous lengths to it. It's the hardest thing to get, and we're still building momentum there with tremendous opportunity for upside execution.

[Sam Darkatsh, Raymond James]

Dave, if I can sneak a real quick one in here. The April, up six. By my math or at least my notes, I think May and June are considerably easier comparisons, maybe like five or 10 points or so. Does that hold?

[Dave Schulz]

Yeah. Just to ground everyone on the call, when you take a look at our second quarter of 2022, we had organic sales growth that was up 21%. So again, as we've talked about, if you go back to what we said for April of 2022 on this call, a year ago, we were up 22% in the month of April. So by the math, yes, the comparisons get slightly easier as we progress through May and June.

[Sam Darkatsh, Raymond James]

Thank you both. Appreciate.

[Operator]

The next question is from Nigel Coe with Wolfe Research. Please go ahead.

[Nigel Coe, Wolfe Research]

Hi. Thanks John. Thanks Dave. Thanks Scott. Good morning.

[Dave Schulz]

Good morning.

[Nigel Coe, Wolfe Research]

Yeah. So just going back to your questions, Dave, on second quarter free cash flow. So it looks like we're back to neutral, which is I think, where we were initially. So roughly $3 million of free cash flow in the second quarter. Maybe just -- I mean, obviously, I'm assuming ARR will unwind through the second quarter, but what is your ambition on inventory? Do you expect to be cutting inventory through the quarter, or is that still more of a second half phenomenon?

[Dave Schulz]

We do anticipate making progress on inventory, primarily as the supply chains continue to heal and our order lead times return back to normal. And so our expectation is that we're going to begin seeing our inventory reduce month-over-month. We actually did see the inventory in the month of March did come down sequentially versus February.

[John Engel, Chairman, President & Chief Executive Officer]

March.

[Dave Schulz]

March? March versus February came down sequentially.

[John Engel, Chairman, President & Chief Executive Officer]

Right.

[Nigel Coe, Wolfe Research]

Okay. That's helpful. Thanks. And then on SG&A, you talked -- obviously, you mentioned the pickup in SG&A investments, particularly within ESS. And it looks like we're making some, or rather you're making some adjustments in the second quarter that's going to have second half benefits. Just maybe just talk about some of the investment spending you made there. It sounds like maybe sales -- maybe you're overstaffed or over-invest there. Maybe just talk about some of the adjustments you're making and it will be a good run rate for SG&A in the back half of the year? Thanks.

[Dave Schulz]

Significant SG&A increase in EES. We did have across the entire company. We did have both year-over-year and sequential increases. I think the issue that we saw across the entire company was a little bit more severe in EES primarily as we did have to increase some headcount to support the high sales growth. We've also been investing in some new capabilities as well, which has come through. And of course, across the entire company, we continue to invest in our IT and digital transformation.

So, not necessarily at the EES level, but you're seeing that at the enterprise level. The other thing I'll highlight is in the first quarter, we did experience some unexpected costs, we would consider onetime in nature, particularly related to benefits. So, we're not expecting that to continue as we enter the second quarter.

[Nigel Coe, Wolfe Research]

Great, Thanks Dave.

[Operator]

The next question is from Tommy Moll with Stephens. Please go ahead.

[Tommy Moll, Stephens]

Good morning and thanks for taking my questions.

[John Engel, Chairman, President & Chief Executive Officer]

Good morning Tommy.

[Tommy Moll, Stephens]

I don't want to make a mountain out of a molehill here on EES, but just I do want to clarify one point. I mean your full year outlook on revenue is unchanged in the mid-singles.

And then there was some commentary just around the margin compression and adjustments to the cost structure there. If we think about any change to the revenue trajectory, was it really limited to that weakness in the OEM piece of the business there, or was there anything else you would call out for us?

[John Engel, Chairman, President & Chief Executive Officer]

That was a topic in Q1.

[Tommy Moll, Stephens]

Great. Thank you.

[John Engel, Chairman, President & Chief Executive Officer]

And one other point, Tommy, just to amplify, and I know it's clear, but I want to -- so the cost - - increases a little bit -- got ahead a little bit of where the sales ended up coming in, and I said the sales came in a bit lower, but gross margins, record level, gross margins, the record level for all three SBUs, including EES in Q1. Very important point.

Fundamentally, the margin expansion improvement program is enterprise-wide. And I know that's been a question may have had, the proverbial over-earning question. We're thrilled with our gross margin trajectory, and we continue to do a great job executing that enterprise-wide program.

[Tommy Moll, Stephens]

And John, that's where I was headed for my next question, just on price/cost. It sounds like there's little or maybe even no incremental price assumed in your guide for the year. How would you characterize the environment there on price and then also on any inflationary pressures or lack thereof? What can you give us for an update on that side of the equation? Thank you.

[Dave Schulz]

Tommy, it's Dave Schulz. So, we did see the number of supplier price increase notifications came down in the first quarter, and the average percentage increase also came down substantially of what was published in the first quarter.

So, as we took a look at how pricing impacted each of our business units, we mentioned both UBS and EES experienced most of the benefit, much less so within our CSS business, but I also want to highlight that the pricing benefit that we saw in the first quarter for EES moderated versus what we saw in 2022.

And reporting 8s and 6s as a price benefit throughout the quarters in 2022, that came down to a 5, and that came down even more so within our EES business, which, of course, is impacting the sales growth. But overall, we continue to work closely with our suppliers to understand what is their expectation for price increases.

There have been some of our large suppliers that have announced that they expect to take additional price increases. But again, we've not included that until we actually see it impacting our revenue. And we just didn't see a lot of incremental pricing in our first quarter results.

[Tommy Moll, Stephens]

Thanks, Dave. I’ll turn it back.

[Operator]

The next question is from Christopher Glynn with Oppenheimer. Please go ahead.

[Christopher Glynn, Oppenheimer]

Thank you. Good morning. So got a lot of demand questions. Just wanted to talk about some of the kind of non-operating cost items. On the $30 million to $40 million other expense range, sounds like foreign exchange is a big part of that. But my experience, non-operating FX adjustments are often very unpredictable, period-specific and even end-of-quarter mark. So curious what's going on there with that $30 million to $40 million? And then on interest, with the quarter in the books and better view on the cash flow linearity, curious why that's still a $40 million range interest line item.

[Dave Schulz]

Yes. Chris, let me address the other non-operating. So in the first quarter, we recorded $10 million, which was primarily related to the Egyptian pound, where we saw a significant devaluation occur in the beginning of January and then another devaluation 10 days later. So that is the balance sheet revaluation of the assets and liabilities that we have within that market.

To put that into context, all of 2022, we had a $10 million other expense non-operating. So we've matched the full year 2022 in just the first quarter. It is an estimate at this point that we are going to continue to see additional devaluation, particularly upon that Egyptian pound currency. Again, it's our estimate at this point. That will be impacting. But as you mentioned, Chris, it is extremely volatile and very difficult to predict, but we at least wanted to call that out that if this continues, we have at least $10 million already in the first quarter. There could be additional risk. We've included that in our assumptions for the outlook.

On the interest expense, when you take a look at where we were relative to the guidance we provided in February, we have borrowed more money here in the first quarter. We've also seen interest rates increased about 35 basis points. So from that perspective, we've assumed that we will be carrying higher debt levels in our initial assumption, but then also the interest rate environment continues to be volatile and has been increasing. So we've reflected that appropriately in our assumptions.

[Christopher Glynn, Oppenheimer]

Thanks for that Dave. And just to stick with the other expense. Are you hedging against additional Egyptian pound devaluations during the year essentially?

[Dave Schulz]

At this point, we are not because it's extremely expensive in order to provide that. And in some cases, the instruments are not even available is our current view of the market.

[Christopher Glynn, Oppenheimer]

Sorry. I meant the guidance hedge against that risk. I wasn't talking about a financial hedging instrument.

[Dave Schulz]

Yes. We've provided you with what we believe is the appropriate range given that risk. Obviously, the additional non-operating other expense is a headwind to our EPS guide at the midpoint, but we believe we've got the right outlook for EPS for the full year, not changing it this early in the year.

[Christopher Glynn, Oppenheimer]

Thank you.

[Operator]

The next question is from David Manthey with Baird. Please go ahead.

[David Manthey, Baird]

Good morning. Thank you. First, I was wondering if you could outline the puts and takes…

[John Engel, Chairman, President & Chief Executive Officer]

Good morning, David.

[David Manthey, Baird]

Good morning. Could you outline the puts and takes relative to the 60 basis points year-to-year gross margin increase? And specifically, can you address, do you think there's any inflationary inventory benefit in the first quarter gross margin? And then secondarily, could you discuss the contribution there from rebates and what's the typical high low range? I know that's a lot, but hopefully, you can touch on those.

[Dave Schulz]

Certainly. So the 60 basis point improvement in gross margin year-over-year was -- only had a benefit of about 10 basis points from supplier volume rebates versus the prior year. Remember, when we booked our supplier volume rebates in the first quarter of 2022, we had a much different forecast for the full year, and that contribution of supplier volume rebates as a percentage of sales was increasing throughout the back half of the year.

So as we think about the synergies that we've built in to 2023, particularly as it relates to supply chain, and we've built in the expectation on our supplier volume rebates, we've got about a 10-point benefit versus Q1 of 2022. The real driver of the gross margin enhancement has been the gross margin improvement program, and we have continued to push that across our organization, make adjustments and improvements to how our field is able to better understand how to price for value for the products and services that we're providing. So it was really much more of that transactional margin improvement.

Going back to your question on are we seeing any of the profit and inventory being one of the drivers, we're not. I think, one of the reasons that our pricing came down is we did see some commodity costs come down in the back half of 2022 and in the beginning of 2023.

So actually, we had a headwind on some of our pure commodity categories, again, very small percentage of our business, maybe mid single-digits, but that was a headwind on those commodity-based products given the global market environment. So we don't believe that this is a profit and inventory issue. It's really the benefit we're getting from our margin improvement program.

[David Manthey, Baird]

Okay. Thank you for that. And then second, to hit on the cash conversion cycle here, but my calculation is something like 84 days. It looks like historically, they've been in the 60 to 70 range. I mean how many days do you think you can take out by year end? Is there a target? Do you suppose to get back to that previous range? And maybe you could just discuss where that might come from, where the days will come from, whether it's DSO, DPO inventory days.

[Dave Schulz]

Yes. Let me address specifically on inventory. And depending on the calculation that you're looking at, we essentially saw our inventory days increased by 11 days in 2022. We don't believe it's prudent to assume that we can get all of that back in 2023, give some of the challenges with the supply chain. What we are expecting, though, is that we will get about half of that improvement back, and we will continue to grow net working capital at less than half the rate of sales.

So our primary focus when it comes to net working capital is really on the inventory. When I take a look at our receivables and our payables days, they've been relatively stable. We know that there were some higher accounts receivable balances through the end of March, just looking at our collections the last two weeks of March versus the first two weeks of April, we saw a nice pickup in our collections in April.

So our primary focus when it comes to net working capital is inventory.

[David Manthey, Baird]

I appreciate, Dave. Thank you.

[Operator]

The next question is from Chris Dankert with Loop Capital. Please go ahead.

[Chris Dankert, Loop Capital]

Yeah. Good morning guys. Thanks for taking the question. I guess, looking at the comments you guys have had on UBS specifically, I mean, you're still expecting high single-digit organic growth for the year. I mean, pretty hot start in the first quarter. I mean, you're implying a pretty sharp deceleration mid-singles for the rest of the year kind of a thing. Is it the broadband piece -- like can you walk us through what you're expecting shape for the year in UBS, just a little of the deceleration is so dramatic?

[John Engel, Chairman, President & Chief Executive Officer]

Yeah. I think what we said specifically, Chris, was high single to low double. And so clearly, we're at a nice double-digit start. It would have been much stronger had it been -- had we not had a low double-digit decline in broadband. Now that's not a large piece of the portfolio, but it's very attractive secular growth trends, and we're very bullish on mid to long-term.

So I don't want to guide our guide and tell you where we are in those ranges. But just to put a fine point on it, we have outstanding momentum in our UBS business overall driven by the new part of UBS right now. We're incredibly bullish on utility. I believe it's a secular growth end market now, never used to be if you go decade ago, but clearly is going forward, and so is broadband.

We also have our integrated supply business inside UBS, which technically serves in the industrial end market, and we've taken you through this before. Why is it there? Because it's that business model we took as a starting point and evolved it on how we serve these utility, IOU customers and public tower customers directly with a customized integrated supply model utility that we're attempting to bring that into the broadband value chain, too, which we think has tremendous upside. That integrated supply business grew double digits in the quarter, and that's industrial. So I guided the guide, even though I'm not going to technically officially guide the guide. There you go.

[Chris Dankert, Loop Capital]

No, I really appreciate the color there. Thanks so much for that. And then just secondly, on the digital investment costs, it looks like yields were up $30-ish million year-over-year give or take. Can you just talk us through some of the key priorities on the digital investment side and where you're really focusing the investment there?

[Dave Schulz]

Yeah, Chris. It's Dave Schulz. So we have some enterprise programs that we're implementing. We've talked about some of those already. That includes some of the -- our financial systems, along with some of our HR systems. We also have a series of digital applications that we have been working on. So think about this as not only improvements to our margin improvement program, which is heavily digitalized, but there are some other applications that we're providing to our field reps to allow them to better sell our value proposition. So there are a series of investments that we have continued to make in that area. I know we gave you a little bit of an overview of that during the Investor Day. And as we learn more and we're able to provide you more details as they begin to launch, we intend to do so.

[Chris Dankert, Loop Capital]

Perfect. Thanks so much.

[Operator]

The next question is from Ken Newman with KeyBanc Capital Markets. Please go ahead.

[Ken Newman, KeyBanc Capital Markets]

Hey good morning guys. Thanks for squeezing me in.

[Dave Schulz]

Good morning, Ken.

[Ken Newman, KeyBanc Capital Markets]

Good morning. Dave, curious if you could talk a little bit about -- in the past, on past calls, you talked about the margin profile of some of the new orders that were taken into backlog. I'm curious, any color on whether the orders taken in the first quarter at -- or at or above 1Q corporate margin average?

[Dave Schulz]

Hey Ken. I would say that the margins in our backlog are consistent with how we just reported our results. So again, there's some volatility there, depending on the end unit and the type of project. But for the most part, I mean, we're not seeing any significant change of the margin in the backlog.

[Ken Newman, KeyBanc Capital Markets]

Got it. And just to clarify on some of the inventory challenges you mentioned earlier. I'm curious if you could just dig into what you're seeing specifically relative to the backlog portion of your business versus the stock and flow portion. Any change in momentum across those, whether it’d be in the quarter or even on April to-date?

[Dave Schulz]

We haven't seen any significant change in the composition of our inventory between stock and flow versus project. I would tell you that our expectation is that as these supplier lead times normalize we will be able to be holding less inventory for fewer months in order to ship a complete order. And so a lot of the spike that we've been seeing in our inventory, going back to late 2021, has really been as we have built our backlog, which -- a reminder, our backlog is a firm customer order.

So as we built that backlog, and we've got a Stage Kitten store for some of those larger projects, we've had to hold inventory for a longer period of time just to ensure that we can meet the customer service metrics. So as those supply chains normalize, our expectation is that we'll be holding inventory for fewer weeks. And therefore, our net inventory will be coming down.

We are always looking at what is the right mix between stock and flow inventory by location, by business. And we are tweaking that all of the time. But right now, I would tell you that our inventory issue is a large number, because we have a large backlog. Those are customer orders that we expect to ship. So that is a key driver of our inventory days reduction plan going through 2023.

[Ken Newman, KeyBanc Capital Markets]

Right. That's very helpful. Maybe if I could just squeeze one more in, more higher level. John, looking at slide 14 of the deck, I think these are -- this is helpful to kind of see just the drivers from secular trends. I'm curious if you guys have done any work on just quantifying the actual exposure or benefit you expect from these secular drivers either in 2023 or 2024. You kind of mentioned none of the benefit from infrastructure heading quite yet. How do you guys think about that opportunity going forward?

[John Engel, Chairman, President & Chief Executive Officer]

Yes. Ken, it's a great question. Thanks for that. I'd point you back to our Investor Day because what -- we didn't show you the detail by secular trend, but we did so in aggregate what our outlook was in terms of market growth and market outgrowth, i.e., market outperformance driven -- and that was a result of the secular growth trends as well as our cross-sell execution. And we gave a framework where we increased our expectation of market outperformance, i.e., how much will we outperform the market by. So we've done substantial work and continue to do substantial work internally, but we haven't detailed and taken that externally yet, but you can -- I will tell you that was behind and supporting what we outlined at our Investor Day last year. Good question. Thanks.

These are long term in nature, too, Ken. I think just to give you a sense, they are secular. And so I think just as we continue to move forward into 2024, 2025, 2026, because secular trends are enduring, they're strong, they're expanding, and then we have the increased infrastructure investments that are not in our value chain yet. If you look at where we play in the value chain, I put a fine point on it, when ground is broken, our packages go in, typically six, 12, 18 months later, depending on the size and complexity of the project.

[Ken Newman, KeyBanc Capital Markets]

That’s helpful. Thank you.

[Operator]

This concludes our question-and-answer session. I'll now turn the conference back over to John Engel for any closing remarks.

[John Engel, Chairman, President & Chief Executive Officer]

So I think we're at the top of hour. I'll bring the call to a close. Thank you all for your support. It's greatly appreciated. We do have a robust calendar this quarter in engagement. We look forward to speaking to many of you. We will be participating in the Oppenheimer Industrial Growth Conference, the Wolfe Research Global Transportations and Industrial Conference as well as the KeyBanc Industrials and Basic Materials Conference during the second quarter. So with that, I know we've got a lot of follow-up calls scheduled. We look forward to engaging with you. Thanks. Have a great day.