Wesco International Inc

NYSE:WCC

Earnings Call Transcript 2018-Q2

[Operator]

Good day, and welcome to the WESCO International Second Quarter 2018 Earnings Conference Call and Webcast. All participants will be in a listen-only mode. After today's presentation, there will be an opportunity to ask questions. Please note this event is being recorded.

I would now like to turn the conference over to Will Ruthrauff. Please go ahead.

[William Ruthrauff, WESCO International, Inc.]

Thanks, Mia. Good morning, ladies and gentlemen. Thank you for joining us for WESCO International's conference call to review our second quarter financial results. Joining me on today's call are John Engel, Chairman, President and CEO; and Dave Schulz, Senior Vice President and Chief Financial Officer. This conference call includes forward-looking statements, and therefore, actual results may differ materially from expectations. For additional information on WESCO International, please refer to the company's SEC filings, including the risk factors described therein.

The following presentation includes a discussion of certain non-GAAP financial measures. Information required by Regulation G of the Exchange Act with respect to such non-GAAP financial measures can be obtained via WESCO's website at wesco.com. Means to access this conference call via webcast was disclosed in the press release and was posted on our corporate website. Replays of this conference call will be archived and available for the next seven days.

With that, I'll turn the call over to John Engel.

[John J. Engel, WESCO International, Inc.]

Thank you, Will, and welcome to WESCO. Good morning, everyone. Thank you for joining us today to discuss our second quarter results. I'll lead off with a few high level remarks and Dave will take you through the details of our second quarter.

Q2 marked our fourth consecutive quarter of above market sales growth and represented the highest quarterly revenue in our company's history. Our positive business momentum, which began in June of 2017, continued in the second quarter with organic sales up 9%. On a very positive note the growth was again broad-based as all of our end markets and geographies delivered higher sales growth on both a year-over-year and sequential basis.

Momentum was strong throughout the quarter as organic sales increased 11%, 10% and 7% in April, May and June, respectively. Sales in the U.S. and Canada each grew 8%, while International grew 30%. Backlog increased sequentially on year-over-year as well and reached another record level for the company this quarter.

On a two-year stack basis, Q2 monthly sales grew 9%, 10% and 11% in April, May and June respectively, reflecting the continued positive momentum in our business. More importantly, for the second quarter in a row, operating profit and EPS both grew on a double-digit percentage basis versus prior year, reflecting the strong operating leverage of our business. The third quarter is also up to a strong start with preliminary sales growth in the mid-single digits range in July or double-digits on a two-year stack basis and book-to-bill that has been tracking above 1.0 throughout the entire month.

Based on our second quarter results and our positive view of the end markets we have increased our full year sales outlook to reflect growth of 6% to 9% and raised the low end of our diluted EPS outlook $0.10 to a range of $4.60 to $5. We expect operating margin to be in the range of 4.2% to 4.5% and strong free cash flow generation of more than 90% of net income.

We're very pleased with our first half results, and we remain laser focused on executing our 2018 plan. It's a plan that includes continued above-market sales results, execution of our profitable growth initiatives, investments in our people and processes and maintaining our consistent discipline on cash management – or cost management and capital deployment.

With that, I will now turn the call over to Dave to provide further details on our second quarter results and our updated outlook for 2018. Dave?

[David S. Schulz, WESCO International, Inc.]

Thank you, John, and good morning everyone. Let's turn to our end markets beginning on page 4. Industrial sales were up 6% organically, including 5% growth in the United States. In local currency, sales were up 7% in Canada and 16% in our International markets.

This represents our sixth consecutive quarter of year-over-year improvement. Momentum with Industrial customers was again broad-based, as several end markets posted double-digit growth, including technology, petrochemical, metals and mining, food and beverage and aerospace.

Our Global Accounts and Integrated Supply opportunity pipeline and our bidding activity levels remain healthy. WESCO is helping our Industrial customers reduce costs, operate more efficiently and better manage their projects through our extensive portfolio of supply chain solutions.

During the quarter we were awarded a multiyear contract to supply electrical MRO materials and support capital projects for a large food and beverage manufacturer in the United States.

Turning to page 5. We posted a fourth consecutive quarter of growth in Construction with organic sales up 8%, including 8% growth in the U.S. and 9% in Canada in local currency. Sales growth was again broad based across the U.S. and Canada with continued strong business momentum. Sales to both Industrial and Commercial contractors grew again this quarter.

Backlog was up 10% year-over-year to a new record level and up 2% sequentially, providing a positive outlook for the second half of the year and 2019.

With the current outlook for continued non-residential construction growth and demand for skilled trades, more of our customers are seeking productivity gains from their supply chain partners. WESCO is supporting customers with value-added services that provide job site efficiencies and help to deliver projects on time and under budget.

This quarter, we were awarded a contract to provide high voltage materials to a contractor for an upgrade to a wastewater treatment facility in the United States.

Moving to page 6. Our Utility business had another very strong quarter, as sales were up 19% over the prior year and 7% sequentially. Utility sales in the U.S. grew 22%, which was partially offset by a 2% decrease in Canada in local currency.

Again this quarter we gained market share by expanding our relationships with investor-owned utility, public power and utility contractor customers.

Over the past six years, we have established a track record of success by expanding our scope of products and services, while creating value for our Utility customers.

We are well positioned to benefit from secular trends in the Utility sector, including continued Construction market growth, higher Industrial output, continued consolidation and the increasing demand for renewable energy. As an example of the expanded scope of our service offerings, this quarter we were awarded a multiyear contract to provide material management logistics services for an existing investor-owned utility customer in support of an infrastructure improvement project.

Finally, turning to Commercial, Institutional and Government, or CIG, on page 7. We delivered 9% organic growth in the quarter with Canada up 14% in local currency along with strong growth in International. Our technical expertise and supply chain solutions continue to drive growth with our technology customers who rely on WESCO for their data center, broadband and cloud technology projects.

We are continuing to add value to our customers through our LED lighting renovation and retrofit applications, fiber-to-the-x deployments, broadband buildouts and cyber and physical security infrastructure solutions. As an example, this quarter we were awarded a contract to provide outside plant materials in support of a fiber-to-the-home network build-out for an electric cooperative.

Moving to page 8. Our outlook for the second quarter sales growth was between 7% and 10%. Actual reported sales for the quarter came in at the top end of our range. As with the prior quarter and as John mentioned earlier, this growth was broad-based with all end markets and geographies posting year-over-year and sequential revenue increases. This included 8% organic growth in the U.S. and in Canada and 30% in International. Pricing again provided a favorable impact of 2%.

Gross margin was 19.0% in the second quarter, down approximately 20 basis points versus the prior year and fewer than 10 basis points sequentially.

The decline in gross margin from the prior year was due to two factors. First, business mix reflecting an increase in the proportion of sales from traditionally lower gross margin International and Utility businesses. And second, as mentioned last quarter, to align with the company's cost recognition policies, we reclassified labor costs associated with certain of our Integrated Supply services from operating expense to cost of sales. We will continue this classification in future quarters. On a combined basis, these factors reduced gross margin by approximately 30 basis points.

Adjusting for these two factors, gross margin improved 10 basis points versus prior year. Margins have stabilized over the past five quarters, as we continue to execute our margin improvement initiatives while pushing supplier price increases through to our customers.

SG&A expenses represented 13.9% of sales, 10 basis points lower than the prior year. The benefit of operating leverage from higher sales was partially offset by an increase of approximately $8 million for the planned restoration of variable compensation and an unanticipated bad debt charge of $2.5 million related to a long term Canadian customer. We were informed in July that this customer was placed into receivership by their lender, resulting in the customer ceasing operations.

Operating margin was 4.3% at the midpoint of our outlook range of 4.2% to 4.5%. This result was in line with the prior year and 60 basis points higher than the first quarter. Excluding the just mentioned bad debt charge, operating margins would have been 4.5% which is at the top end of our guidance range. Similar to Q1, our reported results reflect favorable operating leverage for the second quarter, which was reduced by the planned cost of restoring variable compensation compared to the prior year. Adjusting the base period for this expense and the bad debt charge, we achieved a pull-through of incremental gross profit to EBIT of over 50%.

The effective tax rate for the quarter was 21.5%, approximately 50 basis points higher than our outlook as we recorded a valuation allowance against certain deferred tax assets for one of our South American entities. The tax rate was 3.8 percentage points lower than the prior year due to the impact of the Tax Credit and Jobs Act of 2017.

Moving to the diluted EPS walk on page 9, we reported diluted earnings per share of $1.22, an increase of $0.20 or 20% versus the prior year. This increase reflects favorable operating results, a lower tax rate, the benefit of our share repurchase program and a net favorable foreign exchange rate.

Turning to page 10, year-to-date free cash flow was $70 million, up 24% versus prior year or approximately 70% of net income. This is a bit below our target as higher sales drove increased accounts receivable. Year-to-date net working capital increased under 4% in support of reported sales growth of 11% reflecting the positive impact of asset management initiatives. Our debt leverage ratio is 3.3 times trailing 12-months EBITDA and is back within our target leverage range. Leverage net of cash was 3.0 times EBITDA.

As outlined in the appendix to the webcast deck financial leverage includes the impact of adopting the recent accounting standard for net periodic benefit costs. This had a relatively minor impact over the trailing 12-months on leverage.

We maintain strong liquidity defined as available cash plus committed borrowing capacity of $772 million at the end of the quarter. Interest and other expense was $18 million in the quarter including the accelerated amortization of certain debt discount and issuance costs of approximately $800,000 associated with repayments of our term loan. Our weighted average borrowing rate was 4.5% for the quarter, consistent with historical averages. We believe our debt is appropriately balanced between fixed rate and variable rate instruments.

WESCO has a history of generating strong free cash flow throughout the entire business cycle and we expect this to continue. Our capital allocation priorities remain consistent. The first priority is to invest cash in organic growth initiatives and accretive acquisitions to strengthen and profitably grow our business. Second, we target a financial leverage ratio of between 2 times and 3.5 times EBITDA. Third, we return cash to shareholders through share repurchase under our three-year $300 million share buyback authorization.

We said previously that we intend to purchase stock under our buyback authorization to offset dilution from equity grants. We expect to do so later this year the timing of which is subject to market conditions. We continue to evaluate options to repatriate cash held in foreign jurisdictions. We expect that our use of any repatriated cash will be consistent with our existing capital allocation priorities.

Now let's turn to our outlook for the third quarter and full year 2018 on slide 11. For the third quarter we are projecting sales growth to be in the range of 3% to 6% and an operating margin of 4.5% to 4.8%. As we have previously discussed, third quarter EBIT comparison will not be unfavorably impacted by lower variable compensation expense in the base period. We are expecting an effective tax rate of approximately 21% in the quarter. We are increasing our sales growth outlook in the midpoint of our diluted EPS guidance range. We now expect sales growth in the range of 6% to 9% and diluted EPS in the range of $4.60 to $5 excluding any share repurchase activity. We are adjusting the midpoint of our operating margin outlook 5 basis points to reflect the bad debt charge that I discussed a moment ago and now expect operating margin to be 4.2% to 4.5%. And we continue to expect an effective tax rate of between 21% and 23%.

Note that certain impacts resulting from the Tax Cuts and Jobs Act remain subject to further guidance from the IRS. Discrete items including adjustments to the provisional estimates booked in 2017 to comply with the TCJA could ultimately cause our effective tax rate to differ from this expectation. We are also reaffirming our expectation of generating free cash flow of more than 90% of net income.

John would like to make a few additional comments before we open the call to questions. John?

[John J. Engel, WESCO International, Inc.]

Thanks, Dave. I'd like to share with you two strong additions to our WESCO team. In June we were pleased to welcome a new member to our senior management team. Chris Wolfe joined WESCO as Senior Vice President and Chief Human Resources Officer. I have always said that people are the foundation of our success and our source of our competitive advantage. I'm confident that Chris will do an outstanding job overseeing our critical human resources and talent management functions for the company.

In addition we are pleased to announce that Eash Sundaram has been elected to the WESCO Board of Directors effective August 15. Eash has extensive experience in digital tools and applications, cybersecurity and global supply chain management. He is currently Executive Vice President and Chief Digital and Technology Officer at JetBlue Airways and previously held senior leadership roles at Pall Corporation and McKesson as well. We are delighted to welcome Eash to our board.

With that, we will now open it up for questions.

[Operator]

And the first question is from Deane Dray with RBC Capital Markets. Please go ahead.

[Deane Dray, RBC Capital Markets LLC]

Thank you. Good morning, everyone.

[John J. Engel, WESCO International, Inc.]

Good morning, Deane.

[Deane Dray, RBC Capital Markets LLC]

Can we start with price cost since that is such a headwind for industrial companies and especially distributors, but you all tend to like periods of inflation. So, 2% increase in price in the quarter, you called that out. Where do you stand so far year-to-date in expectations? Last quarter you said you were raising prices dollar for dollar but that still gets you some margin pressure. But an update there for starters would be helpful.

[John J. Engel, WESCO International, Inc.]

Yes, Deane, maybe I'll start out. Great question. I will start out with a context of the environment. When you look at the price increases that our supplier base attempted to push through to the market directly and through the channel in the second quarter, if I were to compare that to historical seasonality, Q2s in prior years and where – and let's call it this phase of the cycle, they were greater, they were greater in number and more in line with what we typically see in Q1, quite frankly. So, the pace and volume and kind of range of supplier price increases in Q2 are consistent with Q1 and normally Q1 is the busiest quarter of the year for price increases. So, that's the first point I'd make.

I think that as Dave outlined on a year-over-year basis and sequential basis, I think we are seeing the traction of our margin improvement initiatives. Because if we pass the price increases through one for one just based on strict math we'd actually have some margin compression. So, I actually feel really good about the progress we're making with our margin improvement initiatives. And I think coming out of the first half, in retrospect, we faced a larger number and greater supplier price increases than we thought we would have. Margins remain stable. On a sequential basis, we didn't get any step-down in margins from Q1 to Q2. And so, now I think we're well-poised seeing it – we are first seeing the traction of our margin improvement initiatives and I think we are well-poised to see margin improvement sequentially as we execute in the second half of the year, and that is our intent which is explicitly built into our outlook for Q3 and the full year.

[Deane Dray, RBC Capital Markets LLC]

Let's just stay with margins and the expectation has been that pull-through would show a meaningful uptick in the second half and you've been moving in that direction. I think Dave was helpful in giving us that adjusted pull-through, which gets you to that 50%. And just frame for us the expectation second half on pull-through?

[John J. Engel, WESCO International, Inc.]

Yes, the answer is absolutely yes. That's explicitly in our outlook. And look, I'll take you back to last year, we didn't return to growth until the month of June and we didn't return to growth in a quarter until Q2. It was a two-speed year. We pulled a lot of cost levers in the first half, variable compensation was a significant lever on actions that we took in the first half. Those got reset as we started to experience the return to growth in the second half posting very strong organic growth numbers we think outperforming the market measurably in Q3 and Q4.

When we gave our outlook for 2018, we clearly provided a profile the year that said we'd have stronger top-line growth in the first half, but that we would have, on a reported basis, the pull-through would be a bit a challenged because we're lapping the comparable period of the first half last year where we didn't have the variable compensation. And so, that's to the tune of $8 million per quarter or $16 million in the first half. And so, we've now lapped that. And by the way on an adjusted basis, adjusting for that we are at the 50-plus-percent pull-through in the first half. So, our long-term growth algorithm and profit growth algorithm is intact in the first half. In the second half we don't have that comparison and that's explicitly built into our outlook, Deane. Thank you for that question.

[Deane Dray, RBC Capital Markets LLC]

Yes. That's really helpful. Thank you.

[Operator]

And the next question is from the line of Ryan Merkel with William Blair. Please go ahead.

[Ryan J. Merkel, William Blair & Co. LLC]

Hi. Thanks. Good morning, everyone.

[John J. Engel, WESCO International, Inc.]

Good morning, Ryan.

[Ryan J. Merkel, William Blair & Co. LLC]

So, I want to ask about organic growth. The slowdown in June and July is a little surprising to me. Is there anything, John, that you can call out either in terms of end markets or geographies?

[John J. Engel, WESCO International, Inc.]

Thanks, Ryan. I don't see it as a slowdown. I think we've posted very strong results in Q3 of last year, Q4 of last year, Q1 of this year and now Q2 of this year and our view is – now that's four quarters in a row we think we've significantly outperformed the market. And our framework for the year – we've taken up our sales guide twice. We had an outlook that we gave in December. After Q1 earnings we took up our full year's sales guide. After Q2, we've just taken it up again and it's based upon two factors. One is the markets have strengthened a bit. We thought they'd be stronger, but they're a bit stronger.

But more importantly, it's our outperformance. And we had a construct of – in terms of market outperformance of 1%, 1% to 2%. Now we've taken it to 2% to 3% and that's what supports our new full year outlook on the top line.

So I don't see it as a slowing at all. In fact, I feel really good about coming out of the first half and entering the second. The year has turned out to be – the markets we thought would improve, they have. And our strength of execution we were highly confident in, given our return to growth in the second half last year. And we built upon that in the first half.

And so as I shift to the second half our comparables become significantly more challenging. And so when you look at June on a two year stack basis, it actually shows greater sales growth than April or May.

July, we had preliminary sales because we haven't fully closed the month yet, but on a year-over-year basis it's mid-single digits growth. On a two year stack basis it's low-double digits and it's stronger than June.

So we are building very nice momentum. And I would – I feel very strongly the way to look at this is on a two-year stack basis. And even these posted numbers I think in an absolute sense just on a year-over-year basis are very strong.

And then look at the balance, we're growing across all end markets. We're growing across all product categories. I will make that comment. That's not included in the webcast. And we're growing across all geographies.

And furthermore, we have set a new all-time record in backlog. And we have done that four quarters in a row now. We've set a new successive all-time record in backlog. And that's a good indication of our project business principally into the construction and contractor markets.

So look, honestly, I couldn't be more pleased with how our team is performing and executing. We're taking advantage of a little improving market. But I feel very good about our execution of our top line and growth initiatives. And I think we're very well positioned as I mentioned to Deane earlier to realize on a reported basis the pull-through in the second half. On an adjusted basis we've demonstrated that it's there in the first half.

[Ryan J. Merkel, William Blair & Co. LLC]

So I think I hear you. So it's more that the end markets are fine. You're not noting a slowdown. It's more just the comparisons are starting to get more difficult. But the view is look at the two-year stack, things are still pretty firm.

[John J. Engel, WESCO International, Inc.]

Absolutely. My view of the end markets was positive entering the year. They turned out a little bit stronger than I thought, but our execution is the real delta here. I think we've built a strong execution momentum taking share second half last year. We've built on that into the first half.

And my view remains the same, Ryan. As I've spoken at EPG and various conferences in the year I've shared this view. Now that the first half is behind us, my outlook for the second half is very positive in terms of the market and our execution vector.

[Ryan J. Merkel, William Blair & Co. LLC]

Okay. That's helpful. And then my second question, I know that guidance implies that EBIT margins are going to be a lot a stronger in the second half. But I wanted to ask about gross margins, because as you know investors are focused on that for distribution companies. Is the message that we should expect stable gross margins in the second half kind of at this 19% level that you reported this quarter?

[John J. Engel, WESCO International, Inc.]

So we clearly have – you see what our Q3 outlook is. And obviously you see where our full year outlook is. And we are – it's math. Our operating margins are going to be stronger in the second half, that's clearly what we're saying. And if you look at our typical front-half, back-half weighting that's consistent with historical seasonality. So that's the first point.

The second point is I've got very good confidence that we're getting traction from our margin improvement initiatives. And as I mentioned to Deane's question earlier, we got hit with many more price increases than we would have expected in Q2. And the fact that we were successful in pushing those through, if we had not been, our margins would have degraded significantly Q1 to Q2 sequentially.

So I think we're on top of the wave right now. We don't guide in terms of the recipe of gross margin versus operating costs. But we do expect good operating cost leverage and we expect to build off the traction of our margin improvement initiatives and begin to see an improvement in gross margins as we move forward.

[Ryan J. Merkel, William Blair & Co. LLC]

That's helpful. Thank you.

[John J. Engel, WESCO International, Inc.]

Yes.

[Operator]

Next question is from the line of Sam Darkatsh with Raymond James. Please go ahead.

[Sam J. Darkatsh, Raymond James & Associates, Inc.]

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

[John J. Engel, WESCO International, Inc.]

Morning, Sam.

[David S. Schulz, WESCO International, Inc.]

Hi, Sam.

[Sam J. Darkatsh, Raymond James & Associates, Inc.]

Two questions if I might. First off, inventories are a source of cash both in Q1 and Q2, which you normally wouldn't see obviously when you're growing like this. I'm trying to understand why that might be. Are vendor lead times extending? Or did you load up on inventory at the end of last year to maximize on volume rebates or to pre-buy ahead of price increases? I'm just trying to understand why it's a source of cash?

[John J. Engel, WESCO International, Inc.]

So the answer on both questions is no and no. So what is driving it? And it's a great question, insightful.

We're getting traction on our operations and supply chain initiatives that are focused on both inventory – principally inventories. So it's strong operating execution out of our business and operations teams on just improving our asset velocity.

So quality of inventory is very strong. I think I've spoken about this over the years that we're very focused on two major variables or metrics let's call it, inventory availability and inventory accuracy or fill rates to our customers. And those metrics are within – in great shape.

It's really the direct result of a focused set of initiatives to improve the management of our inventory and our asset velocity. And I think that we previously have identified – we've never talked about it externally. But I will tell you we identified that we thought we had some cash opportunity that was held up in inventory. We had been focused on the other levers of the P&L.

But this is an area that we did put into our operating plan. And I'm very pleased with the execution we're getting. So the answer was no, no and the short answer of the driver, it's self-help. It's our own initiatives.

[Sam J. Darkatsh, Raymond James & Associates, Inc.]

And then just a clarification question, John. You mentioned that you are passing through greater than expected price pressures here in the second quarter but the reported price was up 2% which was the same as the first quarter off of the similar comparison year ago. So, where would we see that externally? Would it show up in the third quarter pricing, or how would that reflect itself in what you're going to report on a price basis?

[John J. Engel, WESCO International, Inc.]

Yes. I mean my statement on price wasn't that measure but just in terms of the number of price increases and the size of those that we saw in Q2 versus Q1 typically, Sam. It's just this was not a normal second quarter. I'll expand upon this a bit. Part of it is I think that the tariffs and it's not so much the tariffs are having a direct effect, they have a direct effect on certain commodities. And look we understand that, our suppliers do, customers understand that and we are working those through, but it also it creates the opportunity also for suppliers as well as us to work additional price increases through the channel. So, mine was a more of a qualitative comment, Sam.

[Sam J. Darkatsh, Raymond James & Associates, Inc.]

So, you think that price is going to be up more than 2% or so back half?

[John J. Engel, WESCO International, Inc.]

I'm not going to forecast pricing, but I want to give you a sense of kind of just what the momentum vector looked like throughout the second quarter versus normal seasonality.

[Sam J. Darkatsh, Raymond James & Associates, Inc.]

Got it. Thank you very much. Very helpful.

[John J. Engel, WESCO International, Inc.]

Yes.

[Operator]

Next question is from the line of Christopher Glynn with Oppenheimer. Please go ahead.

[Christopher Glynn, Oppenheimer & Co. Inc.]

Yes. Thanks. Good morning, guys.

[John J. Engel, WESCO International, Inc.]

Morning.

[Christopher Glynn, Oppenheimer & Co. Inc.]

Just looking at what seems to be a little peculiar in the guidance. If we take the high end for revenue of the third quarter and the full year, the fourth quarter growth actually accelerates a bit from the third quarter versus tougher comps. Just curious what the thought is there?

[David S. Schulz, WESCO International, Inc.]

Christopher, it's David Schulz. So, again as we take a look at the momentum that we are seeing across our end markets and with the execution of some of our initiatives to drive above-market performance on sales, again we are confident that we are going to continue to see broad-based growth across the back half of the year. And so, again as you take a look at the midpoint for the guide that we put out for the third quarter again it's roughly in that 4.5% range. If you back into that, I mean I would expect that we would see similar growth rates at the high end of our full year in the fourth quarter. But again it's is based on what we are seeing in our backlog and in the end markets that we serve.

[Christopher Glynn, Oppenheimer & Co. Inc.]

Okay. And then a question on International. You just put up 30% organic against a 27% comp last year. Just wanted to revisit what's going on there. How long in the making this unprecedented penetration trend? And does it suggest to you any different options about how you think about ROW strategically?

[John J. Engel, WESCO International, Inc.]

Yes. Great question. First, let me level set by saying you all recall that when we gave our original guidance/outlook for the year in December, in our Outlook call, in our December Outlook call, that we had International at flat. So, we thought International actually was going to be flat in 2018 over 2017. And obviously we had a very strong Q1 because it's in the record books and a very strong Q2 that significantly outperformed our expectations.

And so, what happened was as we went through the balance of December into the first quarter we got very good traction on a number of our growth initiatives and a series of select Global Accounts and Integrated Supply customers we just – and there were some as well as some capital projects globally stepped up significantly. And the backlog for International really grew substantially as we moved through the first quarter into the second and in the middle of the second quarter it reached by a very all-time high versus history. Now, we began to eat into that backlog through the balance of the second quarter entering the third. So, that's a little bit of the dynamic in terms of where we're seeing it.

Global data center activity remains strong, and I think you may see that from Others reported results. Oil and gas downstream activity is increasing globally. And mining was now beginning to and we hadn't really seen this kick-in in a major way coming off a market cycle bottom. There is increased quoting activity, significant increased quoting activity. And that's more of a 6- to 12-month cycle for new projects. So, that's a potential driver for 2019. So, there is a bit of the dynamics.

Strategically, we've constrained our growth outside of U.S., Canada, Mexico, and we have a support – our National Account, Global Account customers, Integrated Supply customers globally and we'll follow that growth. But we make money internationally. We've always made money internationally. But we do believe where we have the greatest scale and synergies is in U.S., Canada, Mexico as the three primary geographies. So, any incremental growth there that we get we're able to leverage our synergies, our infrastructure and get better pull-through quite frankly. So, that strategy has not changed – has not changed. But we just enjoyed some really strong results, good execution by the team, and it's driven by a number of Global Accounts and Integrated Supply customers and capital projects.

As we move to the second half, as Dave alluded to in his commentary, we don't see International growing at the same rate. And we have, supportive of our new full year guide, we have International on a full year basis growing low-single digits as a market. So, hopefully that's helpful.

[Christopher Glynn, Oppenheimer & Co. Inc.]

Yes. Thank you.

[Operator]

Next question is from the line of David Manthey with Baird. Please go ahead.

[David J. Manthey, Robert W. Baird & Co., Inc.]

Hi, guys. Good morning.

[John J. Engel, WESCO International, Inc.]

Morning, Dave.

[David J. Manthey, Robert W. Baird & Co., Inc.]

First off, Dave, I'm wondering is there anything unusual about the fourth quarter a year ago or this year that would drive a higher level of incrementals? And I guess as it relates to the fourth quarter of this year, should we anticipate anything unusual in terms of spike-up in gross margin or spike-down in OpEx that's out of the ordinary?

[David S. Schulz, WESCO International, Inc.]

There was nothing out of the ordinary. I mean, again if you go back to some of the comments we've been making since our Outlook call, the big we've got in the front half is the variable compensation. That comparison goes away as we paid out the amounts in the second half of 2017. So, there is nothing unusual there. I think the one thing that I will highlight is that again we talked a little bit about some of our margin initiatives. And as we take a look at our internal initiatives, the supplier price increases, we continue to see expansion of our billing margins across sequentially 60% of our businesses. And so, about two-thirds of our business is still growing that billing margin sequentially, and we made a comment about that during our first quarter earnings call. We're seeing the same amount of momentum from those initiatives and from the supplier pass-through on prices. So, again as we think about the back half, we're taking a look at it overall on an EBIT margin expansion, but there is nothing unique or out of the ordinary that occurred in the fourth quarter of 2017.

[David J. Manthey, Robert W. Baird & Co., Inc.]

Okay. Thank you. And John, when you referred to backlog trends, historically you've mentioned that there's typical seasonal declines in the third and fourth quarters. Could you talk about what a normal sequential backlog trend would look like from fourth quarter to first quarter and then from first into second?

[John J. Engel, WESCO International, Inc.]

Yes. So, thank you, Dave, for that. Yes, we broke the normal pattern last year and it's very striking a bit, WESCO more than just a couple of years now. It was very striking in terms of how we moved through the second half. And normally going from – we normally eat in the backlog throughout the third quarter sequentially and significantly in the fourth quarter. And most notably the backlog really comes down as we move through the second part of the fourth quarter and close out December. That's normal seasonality. We did not see that in Q3 and Q4 last year. We didn't see it in the second half and I have been calling that out and spiking that out because of how notable that really is versus just our normal seasonality. And I would say it's a combination of the markets improving but it's also a reflection of our growth initiatives. As our growth initiatives get traction some of it turns into immediate sales but it's also being reflected in the backlog growth.

So, as we came in 2018 backlog continued to step up in January, February, let's say Q1 kind of stepped up a bit and now Q2 stepped up further. We normally do have some backlog build in a normal year throughout the first quarter and second quarter. But we did not have a strong backlog build in 2015 or 2016 when we faced the Industrial downturn. You'd have to go back to 2014 where we had that backlog, more normal backlog build in the first half.

And as we go through the second half, a normal seasonality is we begin to eat into our backlog across Q3 and Q4 as I've outlined. I'm not going to forecast backlog. But now we do have and we are not fully closed at the month. We do have one month under our belt with July and we have book-to-bill rates above 1 throughout the entire month of July which is an encouraging sign. It's one month of the third quarter, it's the first month of the third quarter. So. I think the vector is positive, Dave. But we've been breaking historical patterns by and large in terms of how it's performed the last four quarters, in terms of direction and also magnitude.

[David J. Manthey, Robert W. Baird & Co., Inc.]

All right. Thanks for the detail, John.

[John J. Engel, WESCO International, Inc.]

Yes.

[Operator]

Next question is from the line of Nigel Coe with Wolfe Research. Please go ahead.

[Nigel Coe, Wolfe Research LLC]

Thanks. Good morning, guys.

[John J. Engel, WESCO International, Inc.]

Morning.

[Nigel Coe, Wolfe Research LLC]

I'm going to probably read through a lot of the ground covered already here. But just going back to July, and you've answered that question very well I think, John. But thinking about the businesses, the business mix, I was a little bit surprised that Industrial D sales (42:46) down to roughly 5% in 2Q. So, I'm just wondering how that's tracking into July? And would you call out Industrial as an area where you're seeing slower trends as opposed to just tougher comps?

[John J. Engel, WESCO International, Inc.]

No. No, I'm not – absolutely no slowing trends in Industrial. We are not seeing that. We are not seeing it in terms of – so I'll expand on my comments earlier. Bid activity levels are very strong. Our discussions with customers are positive in terms of where their backlog of business is. They have very strong backlog. Their outlook for growth is in the mid-single digit range. These are our customers in the second half. So, this is again for Industrial. So, it's absolutely are comparables and on a two-year stack basis you can see Industrials holding up very strongly. I mean, that's the real important point.

Look, this is an important point, I think we are – from my perspective we are about six quarters in an Industrial up cycle. I know not everyone shares that view. It's clearly reflected in WESCO's numbers. I think that's indicative of the market as well. Our short cycle indicators are very strong and have remained strong throughout these last six quarters and through July. And the long cycle and CapEx sentiment is very strong as well. And I'll make this comment, one of the drivers now is labor supply has really become tight. I don't think that's a negative thing. For those companies that can provide productivity solutions for customers like WESCO. I think it's going to spur investment and productivity projects. There is clearly a need to address these manufacturing assets and as we move through time IoT applications.

So, I remain very bullish on Industrial. If you double click and go underneath Industrial inside the second quarter, we had broad based growth again as we've outlined. And we're up double-digits in a whole series of verticals, double-digits in the quarter in a whole series of verticals. And Dave called out a number of those. So no slowing of the market, and our execution I feel very good about.

[Nigel Coe, Wolfe Research LLC]

Great. That's very clear, John. Thanks for the color. And then I just wanted to kind of attack the price/cost question from a slightly different angle. I should know this, but how much of the 2% pricing that you reported both this quarter and last quarter would you describe as proper pass-through pricing? So some of your competitors do have proper pass-through pricing. So how much of that is proper pass-through?

And look, what I'm trying to get at here, John, is how much of that do you capture with lower comp prices as we go into the back half of the year. And then maybe just touch on as well the 301 tariffs and the degree to which WESCO is impacted by those proposed tariffs?

[John J. Engel, WESCO International, Inc.]

So I'll make a comment. I know Dave may want to expand as well. I think many years ago we had taken the investor community through our portfolio of end markets product categories. And then for product categories what our exposure is to various commodities like copper, steel, PVC, and such.

And so remember that we have very little direct exposure to residential. We have a second derivative driver for our Utility business. And over the years we've focused on diversifying our product categories. And so it's part of Wire, Cable and Conduit, but Wire, Cable and Conduit includes aluminum wire, copper wire, all types of conduit, et cetera.

And we've said it's been roughly – it's roughly 5% of the portfolio, and so it's a small percentage. And so it doesn't swing us, Nigel. It really doesn't.

And I think we have a smart way with how we manage that. There's been no change in that over the years. We're very focused on maintaining appropriate margin levels. And I just – I won't go into detail. I've taken investors through this in the past. But suffice to say certain of our competitors will play that commodity game, and they'll chase sales dollars at much lower margin rates.

And for WESCO, and this is what we've ingrained in our sales force, that spot market business, we don't want it. We don't want it. We think of that – where we're selling wire and cable, we're adding value-added services. It's part of a broader customer relationship.

And so that's something we worked on for over a decade, quite frankly. We could always unleash greater sales growth if we changed the strategy or philosophy for how we manage true commodity wire products. We've never done that. It's not our strategy. We're not going to do that.

In terms of tariffs, I won't comment on specifically on any tariffs, except to say that as they hit our suppliers directly, we're having those discussions, we work in conjunction with them to try to pass them through to customers.

I will make a comment. I don't know if it is your question, but I'll use it to make a comment. We've seen – I know there's been a few that have asked the question, has there been any new impact on our Canadian business? You can see from our Canadian results and the strong backlog growth as well, we've seen zero impact in terms of, I'll say, cross border flows or impact in terms of our Canadian business – impacting our Canadian business.

So we feel again this is another very strong quarter that we posted in Canada. And remember, Canada returned to growth ahead of the U.S. We returned to growth a couple quarters ahead of the U.S. back in early 2017.

[Nigel Coe, Wolfe Research LLC]

Okay. Thank You.

[David S. Schulz, WESCO International, Inc.]

Nigel, I'll just address, provide a little bit more color on your question about the commodity. So Wire, Cable, Conduit for us, roughly 15% of our sales. We have a process where we're constantly getting feedback on the commodity costs. And then we're passing that through to our customers.

Obviously, we do have some near term contracts for which we are not able to fully pass through the commodity impact. But generally, we have a good success record of passing through that wire, cable commodity markup. So yes, that's how we approach it, and we've been successful thus far.

[Nigel Coe, Wolfe Research LLC]

Thanks again.

[Operator]

Next question is from the line of Hamzah Mazari with Macquarie. Please go ahead.

[Kayvon Rahbar, Macquarie Capital (NYSE:USA), Inc.]

Hi. This is Kayvon Rahbar in filling in for Hamzah Mazari. Can you comment on your M&A pipeline, specifically which segments or regions are seeing a more robust deal pipeline and where your focus is?

[John J. Engel, WESCO International, Inc.]

So we're very robust pipeline. We continue to manage our M&A process. It's a phase gated process so we've got a number of very attractive opportunities in our pipeline that we're working.

Our M&A strategy is unchanged in terms of priorities. I'll reiterate that we did take a bit of a pause in Canada over the last couple years, and because we wanted to digest and integrate and leverage the acquisitions we did.

I'll remind all of you that we never did our first acquisition in Canada till December of 2010 when we acquired TVC. And then we acquired five other companies since then. We feel terrific about our Canadian market position, the strength of that business and the execution. And so our focus shifted to the U.S.

We're not looking at acquiring anything outside of North America principally for that purpose. Sometimes when we acquire a competitor, they may have operations in addition to the U.S. and Canada that are outside of North America. And if we get that benefit, we do, and that's fine, like we did with EECOL.

So I would say the focus is still strengthening core electrical and adding selective product categories that we can take to our market, to our customers through our business models, Global Accounts, Integrated Supply and the like and supplement them by wrapping our broad array of supply chain solutions around them.

[Kayvon Rahbar, Macquarie Capital (NYSE:USA), Inc.]

Thanks. That's helpful. One follow-up and one kind of sort of related is, could you comment on the Utility business in Canada? It was down 2% in local currency. So based on some of the comments you made earlier about Canada, could you maybe put some color on that?

[John J. Engel, WESCO International, Inc.]

Yes. First of all in terms of our overall Utility business and value proposition we think we have an industry leading value proposition. We've grown our Utility business six years in a row. It's very strong growth. I would say this quarter is another quarter of I would call it significant outsized growth overall, principally driven by the U.S. and growing over 20%. Again just really strong growth numbers. Canada was down a couple of points. No concern by us there. We've got solid backlog. It was really just some year-over-year timing issues. Zero concern. Again we think we've got an industry leading value prop.

[Operator]

Our next question is from the line of Steve Barger with Keybanc Capital Markets.

[Ryan Mills, KeyBanc Capital Markets, Inc.]

Good morning, guys. This is Ryan on for Steve.

[John J. Engel, WESCO International, Inc.]

Hey, Ryan.

[Ryan Mills, KeyBanc Capital Markets, Inc.]

Yes. Just going back to the sales guidance. I didn't see an update on expectations for drivers of that. So, I was just wondering if you could provide both by segment total market growth, market outperformance and FX impacts expectations?

[John J. Engel, WESCO International, Inc.]

Yes. And so, look I'll remind everyone. After our outlook call for 2018 that we did in December, we've taken our guidance, our outlook up twice, well, actually three times technically. When we announced our fourth quarter results we adjusted our EPS range up and that was to reflect the tax reform.

When we announced our Q1 results we took up both sales and EPS. And here's the second quarter in a row where we've taken up sales again in Q2 and EPS again. So, we've actually taken up the EPS outlook range three times since our December call, one time to reflect tax reform, two times to reflect strong operational performance as well as top line growth that is significantly exceeding the market, we think.

Our framework for the market growth we updated last quarter when we took the guide up. Remember our original sales growth guide for the year was 3% to 6%. At the end of Q1 we took it to 5% to 8%. I'll give you the pieces. U.S. we originally framed at low-single digit to mid-single digit growth, we took it to mid-single digit growth. Canada was flat to low-single digit growth, we took it to low-single digits to mid-single digit growth. International, we had originally assumed flat back in our outlook call we took it to low-single digit growth.

Those remain unchanged for Q2, for us raising the full year from 5% to 8% to 6% to 9%. I'll come back to what the delta is. By end market, we originally thought Industrial will be low-single digits to mid-single digits. Last quarter when we took up our full year outlook, it's now mid-single digits. It remains unchanged for this – as a supporting for this raise.

Construction was flat to mid-single digit growth, now it is mid-single digit growth, same thing. Utility was flat to low-single digit growth, now it is a low-single digit growth to mid-single digit growth. And CIG was unchanged throughout. So, we don't forecast pricing. I will comment on FX last. But where we've seen the meaningful changes our market outperformance and we are now saying what's built into our 6% to 9% is 2 points to 3 points of market outperformance as opposed approximately 1 point or 1 point to 2 points. That's a significant change. That's the only change that we are making in support of this the full year raise as a result of Q2 results.

In terms of exchange rate, we had a slight tailwind in the first half and we don't forecast exchange rate, but we do provide our assumption on what it is as we move quarter-to-quarter. We actually see that turning to a slight headwind in the second half, and I probably didn't amplify this point enough. So, we are going from a slight tailwind in the first half to a slight headwind in the second half and even with that we still raise our full year sales guide and our EPS guide. So, hopefully, that's helpful.

[Ryan Mills, KeyBanc Capital Markets, Inc.]

Yes, yes. And then going to free cash flow year-to-date it's about 7% of net income. John, it sounds like the momentum there is still strong. So, I'm thinking that might lead to more working capital investments. But on the other hand, with improved inventory management system sounds like you might be able to bleed the inventories out a little bit for a source of cash. So, just hoping maybe you can get the puts and takes on achieving the 90% net income for free cash?

[John J. Engel, WESCO International, Inc.]

Well, look if you look at where we are through the first half and compare it to the first half of last year, we grew our free cash flow 24% right? And in terms of converting net income to free cash, we are in very good shape. So, I think – and then last year what did we face? We faced a second half where we went from flat sales to double-digit organic roughly, rounding, for the second half and we still delivered our strong cash flow. So, we've got great confidence in that. I would say that's a bedrock. That's a bedrock of our business model. And really the full growth year-over-year is AR as Dave mentioned and that's a high quality assets, right, our customer AR. So, great confidence in that number.

[Ryan Mills, KeyBanc Capital Markets, Inc.]

Thanks for time, guys.

[Operator]

In interest of time we take one more question from Steven Winoker with UBS. Please go ahead.

[Steven Winoker, UBS Securities LLC]

Thanks very much for fitting me in. Good morning. Just on the 9% growth in the quarter, any way you could break that out between the half of the business that's sort of capital project oriented in the half that is MRO, OE if you just cut across all the verticals?

[John J. Engel, WESCO International, Inc.]

I don't want to wing that. So, I think that's something we would need to go back and do the analytic on that. It's not how we've been casting it. So, but we'll take that under advisement and be thoughtful of that going forward. Very good question though.

[Steven Winoker, UBS Securities LLC]

Fair enough. And can you give us an idea of visibility into pricing in the backlog I mean given the book-to-bill that you've been talking about?

[John J. Engel, WESCO International, Inc.]

Yes. Well, I will make this comment, and our margins and our backlog have stepped up. So, the momentum vector on those as we've been growing the backlog – I'll make this comment, as we've been growing the backlog through the first half the margin rate of our backlog at this point coming out of June is at a higher rate than it was entering the year.

[Steven Winoker, UBS Securities LLC]

Okay. That's helpful. And one more just on all the initiatives around Integrated Supply solution offerings, value-added services, John as you sort of think about not just exiting the year and what kind of help you're getting from those, I know it's probably hard to exactly parse them out on margin. But in terms of what it takes to break 5% in the future, how do you see that the success of those initiatives helping you get there and how – I should use the word, how quickly?

[John J. Engel, WESCO International, Inc.]

No, I think that's a great question. That's probably a type of question that's best developed in an Investor Day for us to really lay out how that works. But we have a wide array of business model that's true across WESCO. It's also true in terms of our Integrated Supply implementations. And so, where we're really delivering strong value and wrap services around it, that's highly EBIT accretive and EBIT margin accretive. I'll just leave it at that, for our most sophisticated relationships where we are really adding value and we've got a high service component in the relationships. So, I see it as being very supportive.

As we grow with the multi-location customers and implement our Global Accounts, Integrated Supply business models, that's supportive of our margin expansion goals and it supports our long-term investment thesis on the pull-through.

[Steven Winoker, UBS Securities LLC]

All right. Great. Look forward to more details there. Thank you.

[John J. Engel, WESCO International, Inc.]

Yes. Thank you, everyone. I'll make two comments. There is a few – there is one specific comment I have prepared but two comments that didn't come out in the call so I'd like to get that out there. And speaking of two categories, on communications and security we didn't get a lot of questions. We did have some good questions on Utility and I shared how strong our results were. We also had very strong set of results for communications and security as a category. We grew double-digits and that included growth with broadband data com – broadband communications, data communications as well as security. So, really solid. And as I said all the product categories grew.

Secondly, lighting, I am surprised I didn't get any questions about lighting. But lighting, we actually had a very strong quarter. We were up – we grew high-single digits in lighting. Again, we are seeing the benefit of our retrofit and renovation solutions. And now to the extent Construction continues to kick-in in projects that will just be kind of a double driver of growth. But we feel very good about our lighting solutions and again up high-single digits. So, you can calibrate that versus others. We think we are taking share there.

So, let me shift to my final comment and one is noteworthy. I do thank you for your time this morning. But before we conclude, I wanted to highlight that we are going to discontinue the practice of hosting a full outlook call in December for our next fiscal year. For this fall and into next year here's our plan. We are going to provide you with an outlook for our end markets during our third quarter earnings call in November and then we will provide our full year 2019 outlook when we report our fourth quarter and 2018 earnings next January.

Thank you for your time, this morning. Brian Begg, our Treasurer and IR leader, and Will, who was introduced at the beginning of this call, will be available to take your questions. And thank you for your time today. We appreciate your support and we look forward to seeing you at one of our investor marketing events that we have upcoming in the third quarter, including the RBC Global Investors Conference in September. Have a great day.

[Operator]

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.