Wesco International Inc

NYSE:WCC

Earnings Call Transcript 2023-Q2

[Operator]

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

I would now hand the call over to Scott Gaffner, Senior Vice President, Investor Relations to begin.

[Scott Gaffner, Senior Vice President, Investor Relations]

Thank you and good morning. 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 well 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 and in our press release, both of which are posted on our website at wesco.com.

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.

Now I'll turn the call over to John.

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

Thank you, Scott. Good morning, everyone, and thank you for joining the call today. The power of our portfolio and mix-shift into higher growth markets is clear in our record second quarter sales, although sales were below our expectations in the quarter due to our EES business.

Continued strong growth and record sales in our CSS and UBS businesses more than offset a quarterly drop in our EES business. The decline in EES was largely the result of unprecedented supply chain rebalancing in the electrical industry, leading to customer destocking, along with weakness in certain sectors, including commercial construction and manufactured structures.

Our long-term secular growth drivers remain intact and they are reflected in our continued sales growth in the utility, data center, security and industrial sectors. On the strength of our industry-leading customer value proposition, strong cross-sell execution continued in the quarter and we're now raising our sales synergy target again we've had a series of these, a string of these since we put the two companies together, we're raising it from $1.8 billion to $2 billion.

Lead times for most product categories have returned to 2019 levels. The extraordinary supply chain disruptions and customer purchase patterns driven by the pandemic over the last few years are now correcting with the rapid reduction in supplier lead times. Against these supply chain rebalancing conditions, our gross margins remain healthy and stable. While economic conditions remain positive, consistent with the soft landing, we did see pockets of underperformance in certain end markets served by our EES business.

Even with the increased overall sales in the second quarter, I'm very happy to say our free cash flow generation of $293 million was very strong and brought us back in the positive territory for the first half of 2023, and that's back in line with our expectations. During the second quarter, we reduced our inventories and we paid down debt.

Our financial leverage now stands at 2.8 times, near the midpoint of our target range, and it is the lowest level since the Anixter acquisition in June 2020. Given our anticipated free cash flow generation in the second half of 2023, we stand in a very good position to use that cash flow to increase value to our shareholders with stock buybacks and that is our plan.

We remain confident in and focused on the transformational steps that we are taking to improve our digital capabilities, capture additional market share and create value for all our stakeholders. We continue to invest in our digital transformation plan, and we are working to deliver digital capabilities to benefit our customers and supplier partners that will be game-changing.

We've already taken steps to address our cost versus current market conditions through the $25 million annualized cost reduction set of actions. They were taken in June and they will begin to benefit our second half.

Given our EES results in the second quarter, we are revising our full year outlook. It is important to note that our revised outlook still delivers record sales, record EBITDA and record free cash flow on a full year basis at the midpoint. The power of WESCO's scale, industry-leading positions and expanded portfolio of product services and solutions positions us to capture the benefits of enduring secular growth trends as well as the anticipated increased infrastructure investments in North America.

We are committed to and remain very confident in our ability to deliver the financial objectives presented at our Investor Day, including our long-term margin expansion, profit growth and cash generation targets.

Now turning to page four. 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 exceptional results for our company. Our second quarter results compared to the pro forma pre-pandemic results of legacy WESCO plus legacy Anixter in the second quarter of 2019 clearly highlight the successful combination of these two Fortune 500 companies.

Over the past three years, we were outperforming the market, delivering impressive sales growth and margin expansion, all while rapidly deleveraging our balance sheet. The combination of these two organizations has led to a more diverse portfolio of higher growth and higher-margin businesses with deep exposure to long-term secular growth trends that will drive our future sales and profitability.

With that I will now turn the call over to Dave.

[David Schulz]

Thanks, John. I'll start on slide five with a summary of our second quarter results compared to the prior year. As John mentioned, the company delivered record second quarter sales. Year-over-year increases in our CSS and UBS businesses were partially offset by a decline in sales in certain EES markets.

On an organic basis, sales were up 3% over the prior year, driven mostly by a low single-digit contribution from price as volume was flat. The flat volumes in the quarter represent a modest year-over-year decline in market volume that was fully offset by our strong cross-sell results.

During the quarter, we experienced some negative impacts from supply chain rebalancing and the normalization of product lead times. As lead times extended at the start of the pandemic, customers increased purchases to offset the impact. As the supply chain heals, we are now seeing a rapid reversal of those behaviors, which has led to destocking and a temporary decline in our stock and flow activity levels in certain customer verticals, while underlying end market growth remain stable.

Project backlog continues to be at historically high levels, supporting our outlook in the second half of 2023 into 2024 and beyond. In total, backlog was up 6% year-over-year and down approximately 2% sequentially from the end of March.

Gross margin of 21.6% was stable year-over-year after adjusting for the impact of business unit mix during the quarter. We continue to prioritize profitable top line growth. And, as the industry leader, we intend to protect the progress we've made on gross margin with continued execution of our enterprise-wide margin improvement program.

Adjusted EBITDA was flat with the prior year. Higher SG&A costs, which have been addressed through our cost-reduction actions was the primary driver of the reduction in EBITDA margins year-over-year.

Adjusted diluted EPS for the quarter was $3.71, 11% below the prior year as the contribution from Rahi was offset by foreign exchange rates, higher interest expense, a higher effective tax rate and higher share count.

As we start the third quarter, end market demand trends are sequentially in line with the seasonality of the past two years. July preliminary sales were up 3% with growth in CSS and UBS, partially offset by a decline in EES, driven by construction and OEM, consistent with what we experienced in the second quarter.

Turning to page six. This slide bridges the year-over-year changes in sales and adjusted EBITDA. As I mentioned a moment ago, organic sales increased 3% versus the prior year, including a 3% benefit from price, while volumes were roughly flat.

Market volumes declined and were offset by higher incremental cross-sell gains. As expected, the contribution from price moderated again in the quarter relative to 2022 as there have been fewer supplier price increases and the magnitude of these increases has been smaller. Additionally, decreases on pure commodity products was a headwind to pricing in the quarter.

Adjusted EBITDA was flat versus the prior year as the benefit of higher sales was offset by higher compensation and volume-related costs and higher costs associated with our digital and IT transformation. We have already taken steps to address the higher costs through a series of actions taken in June that will benefit the second half of the year. These actions will generate $25 million of annualized cost savings.

Turning to slide seven. Organic sales in our EES business were down 5% year-over-year or down 3% excluding the impact of the intersegment business transfers that we initiated in the first quarter. The 3% like-for-like reduction in sales versus the prior year was primarily driven by the combination of two factors.

First, construction was down mid-single digits due to supply chain rebalancing, leading to lower stock and flow sales with contractor customers as well as lower wire and cable sales. Second, we experienced continued weakness in manufacturing structures in our OEM operating group.

Our industrial sales were up low single-digits driven by continued growth in general industrial, metals and mining and petrochemical markets. Backlog was up 9% over prior year, up 3% sequentially, driven by strong bookings for large projects. More than a third of the backlog supports top line growth in 2024 and beyond as we are now beginning to win larger mega projects associated with the unprecedented levels of infrastructure investments in North America.

In the second quarter, adjusted EBITDA was down approximately 20% from the prior year. Adjusted EBITDA margin was 8.6%, 150 basis points lower year-over-year. The reduced profitability in EES was driven by the lower sales level and higher SG&A. We expect EES adjusted EBITDA margins to improve modestly in the second half of the year, driven by operating leverage on seasonally higher sales, along with the SG&A reductions initiated in the second quarter.

Turning to slide eight. I mentioned that EES backlog was up in the quarter driven by larger project wins. This page provides an example of the scale, scope and power of one of those mega project wins. We were awarded a $120 million multiyear contract to support the construction of a new electric vehicle manufacturing facility.

The initial award was specifically focused on switchgear. However, due to our total solutions offering and cross-sell initiatives, we were able to substantially increase the scope of products and solutions that we are supplying. This project win is an excellent example of the success of both our cross-sell program and the secular trends of electrification and reshoring. Shipments are scheduled to begin in the second half of this year.

Turning to slide nine. Sales in our CSS business were a quarterly record and up 16% versus the prior year on a reported basis. Organic sales were up 7%. We saw good growth in network infrastructure, up low double-digits, driven by data center and cloud applications. We saw substantial growth to hyperscale data center customers, driven by both Rahi and growth in our legacy data center business. Sales to Internet service providers who supply 5G, fiber and satellite connectivity were down mid-single digits.

Security sales were up high single-digits and professional audio visual installations were also up double-digits, driven by strong international sales. Profitability was also strong with record Q2 adjusted EBITDA and adjusted EBITDA margin of 9.7%, 30 basis higher than the prior year, driven by operating leverage, integration cost synergies and the continued successful execution of our margin improvement initiatives.

Turning to page 10. We noted the strong growth in data center demand for CSS in the quarter. The long-term trends remain healthy as global data center customers provide dynamic and exciting business opportunities due to accelerating data consumption, increased adoption of the cloud and ongoing demand for data storage and management. As our data center customers increased their scale, footprint, scope and complexity, our ability to service them as the best tech-enabled supply chain solutions provider is paramount.

With our new WESCO data solutions team, inclusive of Rahi, we provide more solutions and focused expertise around the clock and around the world. This business enables us to support all data center environments, including the rapidly expanding AI-driven new build and upgrades by offering complete end-to-end product and service solutions and supporting customers on a global basis. The combined sales of this business represent approximately half of our network infrastructure revenue and is on track to reach approximately $2 billion in sales by the end of the year, with an outlook for strong double-digit growth in 2024 and beyond.

Turning to slide 11. Record sales in our UBS business were up 10% versus the prior year on an organic basis in the quarter. We experienced broad-based growth in utility, up low double-digits and integrated supply up mid-teens versus the prior year.

Broadband sales were down low double-digits as certain customers continue to work through inventory and delay restocking until government infrastructure funds are allocated. We now expect broadband sales growth to resume in 2024 as customers and the supply chain continue to work through inventory rebalancing and destocking in the second half of this year.

Backlog was up 15% over the prior year and down approximately 2% on a sequential basis. Profitability was exceptionally strong with a Q2 record adjusted EBITDA margin of 11.1%, up 20 basis points versus the prior year, driven by operating leverage on higher sales, our margin improvement initiatives and integration synergies. This was the fifth consecutive quarter of adjusted EBITDA margins above 10%.

Turning to page 12. As we have said before, the Utility business has some of the strongest secular trends of any of our businesses. Three of the most significant secular trends that are driving growth in our utility business, grid hardening and modernization, investments in renewable power sources and the need for increased grid capacity are a reality today. As we mentioned at our Investor Day last fall, we are seeing the acceleration of grid modernization trends.

The US electric grid will require up to $2 trillion of investments over the next 10 years merely to sustain the current level of reliability. That, combined with direct government funding for investments in renewable generation will continue to provide outstanding growth opportunities for our Utility business for many years to come. Collectively, we expect that these trends will double historical utility industry growth rates over the long-term.

Now moving to page 13. The size of the cross-sell opportunity continues to exceed our expectations. This quarter, we recognized more than $300 million of cross-sell revenue, the highest in the 12 quarters since acquiring Anixter, and bringing the cumulative total to $1.75 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 six months of the program in 2023, we are increasing our expected cumulative total to $2 billion, reflecting the strength of our value proposition against the backdrop of accelerating secular trends.

Turning to slide 14. 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 supply chain network optimization and field operations to drive cost synergies.

Turning to page 15. Recall that after our cash draw in the first quarter, we said we expected to generate significant free cash flow in the second quarter and be approximately neutral through the first half of the year. We generated $293 million of free cash flow in the second quarter or 141% of adjusted net income and are now positive on a year-to-date basis. The primary driver was working capital management, specifically lower inventory, which represented a source of cash of $150 million.

Moving to slide 16. Reducing our leverage has been a top priority since we announced the acquisition of Anixter and we are pleased that leverage is now at its lowest level since closing the transaction in June of 2020. Notable this quarter was that our strong cash flow enabled us to reduce net debt by more than $250 million, which was the primary driver of the lower leverage.

We previously indicated our intent to operate with leverage at the midpoint of our targeted range of 2 times to 3.5 times trailing 12-month EBITDA, and we expect to reach the midpoint in the second half of the year.

Given that we are close to our target leverage ratio, our capital allocation priorities will be more balanced between share repurchases and debt reduction. Based on the current interest rate and economic environment, we will look to continue paying down debt while opportunistically funding share buybacks in the second half of 2023.

Now moving to page 17. 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, position WESCO 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.

Moving to page 18. We are updating our 2023 outlook today based on the results of the first half of the year and current market conditions. For the year, we now expect organic sales to be up approximately 4% to 6% versus 5% to 8% previously. The change in our outlook is entirely driven by a down-shift in our expectation for market volume growth. We now expect our market volumes to be relatively flat year-over-year as gains in CSS and UBS are offset by declines in EES, with price driving total market growth of approximately 3% to 4%.

Our share gains and cross-sell initiatives remain a powerful driver of our performance and will provide another one to two points of organic growth. After factoring in the additional revenue from Rahi, the impact of one less workday in 2023 and the impact of foreign exchange rate differences, we estimate our reported sales growth will be in the range of 5% to 7%.

For our strategic business units, we now expect EES reported sales to be approximately flat year-over-year, versus our prior expectation for mid-single-digit growth. As we noted earlier, we have experienced headwinds in our EES markets that were largely the result of unprecedented supply chain rebalancing that drove customer destocking in the electrical industry, along with select weakness in certain sectors, including the stock and flow portion of commercial construction and manufactured structures.

Our outlook for UBS remains unchanged from our prior outlook, with top line expected to be up high single to low double-digits. And lastly, for CSS, we now expect reported sales to be up mid-teens year-over-year versus our prior expectation of high single to low double-digit growth.

For adjusted EBITDA margin, our outlook is for a range of 7.8% to 8%, which represents a decline of approximately 30 basis points at the midpoint. This primarily reflects the top line and SG&A margin headwinds experienced within EES.

We took actions to address total company costs in June, which will have an annualized benefit of $25 million. Gross margin in the first half of 2023 was stable year-over-year. Sequentially, we expect stable gross margin in the second half of the year as we overcome notable year-over-year headwinds related to supplier volume rebates. Based on current assumptions, supplier volume rebates in the second half will be a headwind of approximately 40 basis points.

With the lower EBITDA forecast, we are also reducing our outlook for adjusted earnings per share to $15 to $16 and free cash flow between $500 million and $700 million. Despite the lower expectations for the remainder of the year, this outlook still reflects record adjusted EBITDA, record adjusted diluted EPS and a record free cash flow at the midpoint of their respective ranges.

In the appendix of this presentation, we have shown our revised underlying assumptions for certain items on the income statement. We increased the low end of our expectation for interest expense for the year from a range of $350 million to $390 million, to a range of $370 million to $390 million, primarily driven by higher variable rates and the timing of debt paydown in 2023. Additionally, we now expect other expense to be approximately $20 million to $30 million for the full year versus $30 million to $40 million previously.

Regarding the quarterly cadence in the back half of the year, we expect Q3 reported revenue to be down low single-digits sequentially. This is in line with the quarterly cadence in 2022 and the trends we experienced in July. In addition, there is one less workday in Q3 versus Q2. Similar to the last two years, we are expecting a low single-digit sequential increase in revenue in the fourth quarter versus the third quarter.

Before opening the call for questions, let me provide a brief summary of what we covered this morning. Overall sales were below our expectations in the second quarter. We delivered record sales in both CSS and UBS, which more than offset the impact of supply chain rebalancing and select market weakness within EES. We again took share in most of our operating groups through sales execution in our cross-sell program, and we are again increasing our cross-sell synergies outlook for 2023.

Free cash flow was particularly strong in the quarter as we delivered approximately $300 million of cash flow, bringing our year-to-date total to positive. We reduced our leverage this quarter to the lowest level since acquiring Anixter in 2020 and we are approaching the midpoint of our target range. We expect to generate significant cash flow in the second half of the year, enabling continued investment in our strategic objectives and increasing shareholder returns.

We continue to expect 2023 will be a transformational year with continued execution of our digital innovatives, strong sales growth and substantial cash generation supporting our value creation initiatives.

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

[Operator]

Thank you. We will now begin the question-and-answer session. [Operator Instructions] Today's first question comes from Deane Dray at RBC Capital Markets. Please go ahead.

[Deane Dray, RBC Capital Markets]

Thank you. Good morning, everyone.

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

Hello, Deane.

[Deane Dray, RBC Capital Markets]

Maybe we can start with your expectations about the timing of the destocking process, how long do you think it takes in terms of quarters. Well, we've been asking the manufacturers, and many of them your suppliers, they're saying their releasing buffer inventory in a process of over several quarters. So would be interested in hearing your perspective how long do you think this process takes?

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

Well, thanks for that question, Deane. It started in CSS actually in the second half of last year. So you'll recall that as we move through last year, CSS' results were a little bit below what we thought momentum vector-wise compared to both EES and UBS. For CSS, it's -- I think by and large, the process is complete. Supplier lead times across the board are back to pre-pandemic levels. So we feel good about that. EES started at the very end of last year, but it really picked up momentum here moving into this year and especially in the second quarter. And so I think that, for EES, I do want to make a few comments specifically. Our EES comparisons are the most difficult from March to June of this year, I think we know that. If you look at EES last year, their strongest quarter was by far Q2. It is our expectations that we returned to growth in the second half of this year in EES based upon our view of the market conditions, and it gets to your question, Deane, as well as the strength of our backlog. We do believe strongly EES has outstanding long-term growth potential driven by the secular trends as Dave outlined in his prepared comments. So that's, EES, I'm sure we'll double-click on that some more in terms of the components of EES and UBS has both very strong results in the quarter for utility, the beat goes on, as well as our integrated supply business. Broadband, we saw -- as we expected, we saw some challenging conditions in the Broadband value chain in the second quarter. When we had our first quarter earnings call, we thought that would start to recover in the second half, but it's our view now that, that moves out to next year. So I think that gives you a sense being by business. Is that helpful?

[Deane Dray, RBC Capital Markets]

Yes, it does give a sense of the calibration by segment. But the duration, most of it's happening in EES this quarter, any sense of the percent of that de-stocking that has happened so far?

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

Yes. So again, let's talk duration. I think the way to just think about this, and I'll take a moment to set the stage for the answer. Post-pandemic as the supply chain rebalances, we're experienced what I'll call that kind of a whipsaw or bullwhip effect, and that's occurring with this rapid reduction of supplier lead times. So it enables customers, and we're seeing it most acutely in EES, particularly contractor customers, to delay their purchases for our stock and flow business. That's what we saw in EES in Q2. Our project sales grew in the quarter, grew in the quarter, while the stock and flow sales were down, and it was principally in the wire and cable category. Also note that in EES, our backlog grew sequentially in Q2, which reflects recent wins of larger or more mega projects, I'll call it. And that bodes very well for 2024 and beyond. You'll recall the last several quarters, we've been getting questions about what -- when do we start seeing these bigger project wins, the mega projects, so to speak, that are tied to the two bills that were passed through Congress. We had been saying we originally thought we wouldn't see any meaningful wins until next year. But we're very encouraged with the recent wins that we had in this quarter, one of which we highlighted in our webcast materials. And I'll note that the shipments actually start in the second half of this year. So we would expect with that as a backdrop, Deane, we'd expect the rebalancing conditions to occur through the third quarter and return more normalized value chain in the fourth quarter. I gave you by segment, I think CSS is there. EES is moving in that direction despite the challenges we had in Q2 with respect to that. And so that's our view.

[Deane Dray, RBC Capital Markets]

All right. John that was exactly what I was looking for. That's also the time frame that we're thinking. And just so we're clear, this idea of the shortening of lead times and normalization of supply chain, this is the risk that happens, all this buffer inventory gets released. You're at the end of that whip of this, we get it. And as long as end market demand stays strong, you've got to weather this period of destocking. We get that. We flagged that as a big risk for the whole sector this quarter. We're fine there. But I did want to touch on my follow-up question on the demand side, just the end market demand and the weaker commercial construction. And thank you for flagging that, that is the stock and flow business, not related to projects. So that is destocking related in the stock and flow business, it's not any sort of project delays or labor issues or weather or anything like that?

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

Correct. So again, I'll put an exclamation point on this, and it's important. Our project business, that's part of the business in EES, it's project and stock employment, right, two different business models. The project business grew year-over-year in Q2, while backlog also grew sequentially. So again I'll make the comment that with our EES business, true in our construction portion of it, solutions as well as the broader EES business unit, we think we're uniquely positioned to participate in the secular trends. And that's the good news with regards to the quarter. Now the stock and flow piece of the EES business was down, and it was down larger than the reported EES year-over-year decline because the project business grew. And that is the temporal or temporary effect that we just talked with. We're at the end of that bullwhip. We're seeing that. I did make a few comments about the overall supply chain, and it's important to understand because I think we'll write about this pandemic period for years and even decades to come. The level of supply chain disruption through this pandemic period is truly. I know this word is often overused, truly unprecedented. So when you analyze what happened in 2020 through '21, '22, '23, again, we're seeing -- we've only seen a bullwhip effect to a much smaller magnitude through an economic cycle, but this one is more pronounced due to what happened at the front end of the pandemic cycle. I also want to highlight, Deane, that there's some very strong growth engines that are driving other parts of EES. The industrial business was strongly up in the quarter, and we have a growing and record backlog with our industrial customers. Our bid activity levels are at record levels. So we're bidding tremendous number of opportunities. And I called out as well our integrated supply business. It is part of UBS, but recall the end markets there, their all industrial, was up double-digits in the quarter, grew double-digits. So the industrial, I think, portion of our portfolio, which is most represented in the EES, but also the list business in UBS, is a strong call out. And I mentioned this comment last quarter. I think we're at the front end of this industrial super cycle. And again driven by onshoring, the supply chain consolidation, it all manifests itself in these mega projects to support electrification and higher degrees of automation.

[Deane Dray, RBC Capital Markets]

Okay. John, thank you. I appreciate all that color and context. And I'll hand it back. Thank you.

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

Thanks, Deane.

[Operator]

And our next question comes from Sam Darkatsh with Raymond James. Please go ahead.

[Sam Darkatsh, Raymond James]

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

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

Hello, Sam.

[Sam Darkatsh, Raymond James]

Dave, a couple of questions for you. So at least if my math holds. So it looks like pricing was down about 2% sequentially from the first quarter on a two-year stack and your decremental margins implied with your lower sales guidance are also pretty high. They're like 20%, 30% or so. Now I'm guessing, at least if my math holds, the reason why the decremental margins on the lowered sales guide are so high is because of the SVR, the incremental SVR pressure, now 40 bps instead of 20 bps prior. But are you assuming any sequential pressure in pricing in the back half versus the second quarter also contemplated within the guide?

[David Schulz]

Sam, we are. It's -- if you take a look at what we've experienced year-to-date, we posted a 5% in Q1. We posted a 3% here in Q2. We do expect there to be still positive pricing in the back half of the year, but an additional step down in the back half. We're confident in the 3% to 4% for the full year. From an overall pricing perspective, we have continued to see the number of price increase notifications decrease sequentially as we've continued through this year. So as we take a look at what's known for the back half, the number of price increases, the rate increase, behind those increases is also lower than the prior year. And as I mentioned in the prepared remarks, we also do have some pure commodity categories where we do have a headwind when it comes to price.

[Sam Darkatsh, Raymond James]

I think you're talking year-on-year, though, I was talking sequentially. Are you expecting lower prices in the back half versus the second quarter?

[David Schulz]

No, no. And again, for the commodities, you're right, it was a year-over-year comment in the prepared remarks. We don't project or predict what the commodities are going to do. But as we think about the pure supplier price increase benefit to our top line, it will continue to be positive, but less than what we have in the first half.

[Sam Darkatsh, Raymond James]

Got you. And then my follow-up question. Can you remind us at this point what percentage of your overall backlog is EES versus UBS? And then same question as it relates to the inventory within your backlog, I'm guessing that's more overweight EES because a lot of UBS is direct ship. But can you put a little bit of help around the mix of your backlog right now between your segments?

[David Schulz]

Certainly. So the -- again, we've never broken out the specifics by strategic business unit within our backlog. There are varying levels of project business, and recall that only project business is in the backlog. So we've not provided that. But as you can see, what we've been seeing in our backlog over the last couple of quarters is we've been seeing the CSS backlog has continued to come down. That's primarily because their supply chains heal faster than the balance of the business. And within UBS, we've been relatively consistent. You've seen some slight moderation in their backlog versus the prior year. Where we continue to see the growing backlog within EES. I would characterize EES makes up about half of our total backlog. And again because of some of the supply chain issues that we've been dealing with, even though some product categories have gotten better, we still have some extended lead times in our backlog based on certain product categories, including switchgear within EES.

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

I mean that's an important point, Sam. I mentioned that lead times have come back to pre-pandemic level pretty much across the board in CSS. We've seen rapid reduction lead times for both UBS and EES as well across the majority of the portfolios. But we're still seeing well extended lead times for switchgear, which is part of EES, breakers and transformers in Utility, as well as rubber goods. So when you take those categories, we're talking about we're still seeing significant extended lead times. Think of it as more of the engineered components, the engineered subproducts and solutions.

[Sam Darkatsh, Raymond James]

That's all I was getting at, John. I was trying to figure out, all right, if we wave the magic wand and switchgear availability is normalized and transformer availability is normalized, how much of your inventory can you monetize, can you liquidate?

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

Yes, that will accelerate our ability to ship against that backlog. We've been saying we expect backlog to come down sequentially, right? We've been very clear about that, because, again, that's the other end of the supply chain cycle as the lead times of collect. We're seeing that effect in CSS, those backlogs are coming down sequentially. We haven't seen that in EES yet or in UBS materially. But again, you're on the right point. As switchgear and the engineered components and EES, transformers and other engineered components in UBS come back to equilibrium, well, that creates an acceleration effect in terms of us being able to ship against our backlog and relieving inventory. Correct?

[Sam Darkatsh, Raymond James]

But is there any quantification of that for some direct --

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

And I think it's completely a function, Sam, of how those lead times come in. We're still seeing a year-plus leads on gear and transformers.

[Sam Darkatsh, Raymond James]

Okay. I'll defer to others. Thank you for the help.

[Operator]

Thank you. And our next question today comes from Nigel Coe with Wolfe Research. Please go ahead.

[Nigel Coe, Wolfe Research]

Thanks. Good morning.

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

Hello, Nigel.

[Nigel Coe, Wolfe Research]

Can you hear me okay? Hey, guys.

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

Yes, we can hear you.

[Nigel Coe, Wolfe Research]

John, just want to go back to the bullwhip concept. Obviously, your suppliers are part of that bullwhip and arguably they should be more impacted by the sort of the inventory sequencing through the channel. So just would love your perspective on how some of your major suppliers like Schneider and Eaton, are showing mid to high teens growth in North America versus low single-digit growth for the use. So any perspective there would be really helpful. And there's been some questions coming in about some of your suppliers, you're using different channels or going direct to customers. Is there any change that you're seeing in the way the product is getting to customers?

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

On the latter part of the question is absolutely not. And I know that there's been some commentary out there, a little bit of noise around that. We're not seeing that. Because, again, our bid activity levels, Nigel, are at record levels. And we specifically spiked out one of the recent wins in EES, and showed it in our webcast deck, which is one of these newer, let's call it, mega project wins that just shows, and again, that's -- if you look at how we bid and won that, we did it by providing a combined solution across numerous product categories and the strength of the broader WESCO. So I think -- I can tell you, with our bid activity levels, our customer engagement, I couldn't be more pleased with. The opportunity pipeline that we're managing is at a record level. And that includes more complete solutions, where we're cross-selling inside each SBU intra, because of the WESCO Anixter combination, and increasingly across the SBUs. I think we're uniquely positioned with our portfolio to provide a complete solution and one-stop shop for these larger mega projects. So that's the last part of your question. I've seen no evidence of that as yet. And I don't expect to see it quite frankly. The reality is I've been in this industry over two decades. And for engineered components and products, there's always been a portion that has gone direct versus through distribution. That dynamic is not a new dynamic. So back to your first part of your question, I don't -- I typically won't go specifically -- talk about an individual supplier or competitor. I will say, I'd encourage you to look at the complete composite of our supplier base. We obviously have large suppliers for our Electrical business. We have very large suppliers for our Utility business. We have very large suppliers for our communication or our UBS business. We have very large suppliers for a CSS business. And when you look at that -- if you look at that complete composite, you see a lot of different things occurring. If you look at our CSS business and look at those major suppliers, it will remain nameless, you know who they are, dramatic disparity in growth rates in terms of what we're doing versus them. Again, good we're at the other end of that supply chain whipsaw effect. When you look at utility and then you move into electrical, we have one supplier in particular that has both utility and electrical who's reported results this quarter line up directly with us and it's a good proxy. And we have other large suppliers in electrical that go through us and a global supplier that goes through our major competitor in the US. And if you look at their growth rates, that's a private company, it's an ESOP. One of the top five in the US. You'll see that we're in the same ZIP code range in terms of results. So and delta also in terms of what the supplier is doing versus the distributor competitor. So I'll end on this note. Our project sales grew in the quarter. What is down is our stock inflow. And our major supplier partners to Electrical have two components of their business, they have, they feed our stock and flow via our purchases, but they also have project business that goes through us and some goes around us. And so we're seeing the strength in our project business, and we expect that we're at the front end of that super cycle.

[Nigel Coe, Wolfe Research]

Thanks, John. There's a few more pieces to the jigsaw there, so thanks for the help there. And then, Dave, just my follow-on is just look at the math you gave on the back half sequential, which is really helpful. It looks like you're implying sort of year-over-year growth in 3Q and 4Q of roughly 2%, 3% organic, I think it is. Number one, is that correct? And then thinking about that July prelim sales of 3%. If we take out Rahi, it looks like organic is closer to 1% to 2%. So just wondering the confidence that we have that organic accelerates from July into the back half of the year.

[David Schulz]

Very confident. We are -- first of all, the way that you frame that from the math is absolutely correct. When you take a look at the first half results from an organic sales relative to what we provided for our full year outlook, we do have the expectation, as we mentioned earlier, that we will see EPS growth in the back half of the year. We would still expect that we would see a continued performance from both our CSS business and our UBS business. Again, they've had very strong first half of the year. So from that perspective, we also indicate that July was a two-speed month. We saw things very, very slow the first couple of weeks. The second half of the month did pick up dramatically across all of our businesses. Again, from our perspective, we've incorporated the July results, along with our outlook for the performance by operating group to inform our outlook for the second half.

[Nigel Coe, Wolfe Research]

Okay. Thanks, Dave. Thanks, John.

[Operator]

Thank you. And our next question today comes from Christopher Glynn with Oppenheimer. Please go ahead.

[Christopher Glynn, Oppenheimer]

Thanks. Good morning, guys. I had a question on free cash flow. A lot of times a little lower sales outlook enables a higher free cash flow in the distribution model and particularly with the past couple of years, investment in inventory growth. So curious what the rub is there.

[David Schulz]

Yes, Chris, it's Dave Schulz. So one of the things that we indicated was we do expect our fourth quarter to be sequentially stronger than the third quarter. So a lot of this will be the timing of the sales that we have in our outlook by quarter. And given the stronger sales that we would expect in the fourth quarter that would lead to a higher receivables balance. So that is a drag on our typical model where we would see seasonal declines in the fourth quarter, therefore releasing more net working capital. We've built into our outlook that we don't expect that to happen this year at the same level.

[Christopher Glynn, Oppenheimer]

Okay. So would you expect that set up for a particularly strong free cash flow next year, again, given the backdrop of a couple of years of pretty pronounced working capital growth?

[David Schulz]

That is correct. Typically, we see our first quarter sales down sequentially versus the fourth quarter. Depending on the timing of projects, we would expect to release that accounts receivable build in the fourth quarter.

[Christopher Glynn, Oppenheimer]

Okay. Thank you.

[Operator]

Thank you. And our next question today comes from Steve Volkmann with Jefferies. Please go ahead.

[Stephen Volkmann, Jefferies]

Great. Good morning, guys. Just a couple of kind of follow-ups here. Dave, how are you thinking about opportunities to pay down some of the sort of higher coupon debt? I know it's not due for a year or two. But are there ways to do that in the shorter term?

[David Schulz]

Yes, Steve. We're always looking at what are the opportunities for us to refinance. We do have a $1.5 billion note that is maturing in 2025. And we've talked about this previously that now that the break fees for calling that bond or further reduced, we're always looking at that. It's really the difference between the break fees versus the interest rate arbitrage. So that is something that we're looking at consistently.

[Stephen Volkmann, Jefferies]

Okay. Great. And then I'm curious how we should think about -- you've been talking about some of these project wins and mega projects that certainly -- I think we all see that opportunity. But how do we think about the margin mix as those start to come in? Maybe are they a little lower gross margin, but also lower SG&A? I'm just trying to think about how that plays out over the next couple of years.

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

That's a great, great question. So, yes, if the project -- there'll be portions of fulfilling the project demand, Steve, that will fill out of our stock and flow. But then there'll be other -- the engineered components, the engineered solutions that are part of that total solution, in some cases, not all, but in some cases, gets directly shipped from our supplier partner to the customer's job site where that construction is occurring or the build is occurring. So when the fulfillment method for that particular category is what we'll call direct ship, there's a portion of that project, we run, it's lower gross margins, inherently lower gross margins. But the operating cost to run that business model is also inherently lower. So we're relatively agnostic at the EBITDA margin line. So just I wanted to make that point. Second point I'll make, which is very important is -- and we didn't get this question at, but we typically get it, what's the backlog of what is -- what's the margin of what's sitting in backlog, what's the trend on that. And the trend on that remains strong. They're holding up. Up slightly. So call it very stable, actually up slightly. So that's a very good indicator of our value-based pricing, the margin improvement program as we're winning these bigger projects that have increased scope. Some are longer in duration. We're selling the value proposition just beyond the products that are prior to product solution. If they're services, hence the ability to execute that project consistent with all the customers' commitments, that we're doing a better job increasingly of getting paid for.

[Stephen Volkmann, Jefferies]

Great. That's helpful. And then just a final quick one. I think you laid out sort of a long-term target, 100% free cash flow to net income over sort of a longer period, and we can all sort of try to guesstimate sort of what's what quarter-to-quarter. But are you still committed to that sort of long-term 100% free cash flow target?

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

100% committed. If you look back at the company, let's just go kind of premerger close back in 2020, and you were to look back on a five or 10 year cumulative basis, legacy WESCO averaged over 100% of net income, free cash flow and Anixter was right in the same zip code. So the answer is absolutely, yes, together. I think, obviously, this pandemic has driven some unique, let's call it, some unique results in our business on how we had to manage the supply chain and our inventories through the most disruptive period, the front end of it. I mentioned as bullwhip effect at the back end of it. But as we get back to equilibrium, with the power of our portfolio, the scale in particular, and the digital transformation that we're executing that we haven't talked a lot about that, fundamentally, that will improve our ability to increase our working capital terms, in particular inventory. So I'm not raising the 100% of net income. I'll just tell you that we have shown with a long successful track record of consistently doing across the entire economic cycle. What's new is, as we put these two companies together with our scale and this digital transformation, we think we'll have increased cash generation opportunities versus what either company could do on a premerger basis once the digital transformation is complete. We'll leave that for a future discussion because that will be a bit out there. But in the short to medium, yes, the 100% were locked and loaded as a commitment.

[Stephen Volkmann, Jefferies]

Great. Appreciate the color. Thank you.

[Operator]

Thank you. And our next question comes from David Manthey with Baird. Please go ahead.

[David Manthey, Baird]

Thank you. Good morning, everyone.

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

Hello, David.

[David Manthey, Baird]

First off, John, you mentioned that you expect to return to growth in EES in the second half, and then you further said you expected to double-click on those EES trends. So just wondering if you can give us some color on trends within the three subsegments of EES and how you see those playing out in the back half, OEM, industrial construction.

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

Dave, could you repeat the last piece of that? I missed the very end of it, sorry.

[David Manthey, Baird]

Just wondering if you can give us color on how you see OEM, Industrial and Construction rolling out in the back half of the year.

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

Got you. Got you. Thank you. Okay. So I'll start with Industrial. Very strong momentum in the first half, very strong opportunity pipeline, increased backlog, we expect that continues. And I mentioned, Dave, that I think we're at the front end of an industrial super cycle. So I would say we remain, for the EES business, we remain very bullish on the industrial portion of that business. Relative to construction, again, look at the backlog that grew sequentially. So we're encouraged by the opportunity pipeline and the wins that we're putting on the board. As we shared with you in the last two quarters, we thought EES backlog would decline sequentially as we started to burn it off, we've not seen that yet. So I think we expect very strong contributions and strong growth from the project portion of EES that serves construction at value chain. And as I mentioned in response to Deane's question, we think these temporary supply chain whipsaw effects on the stock and flow business continue through Q3, but then have improved materially as we move into Q4. And then relative to OEM, the manufactured structures business is a very unique sector or value chain is cyclical. That will be a downturn through the second half of this year. But you look at the balance of OEMs, the balance of OEM is -- there's a [Technical Difficulty] we sell that into many different industrial end market verticals, including semiconductor. So I think as we move forward with OEM through the second half, but more importantly for next year, we remain very bullish on the solution capabilities that we have with our OEM business.

[David Manthey, Baird]

That's helpful. Thank you. And then just for completeness here. What percentage of EES segment revenue specifically or stock and flow?

[David Schulz]

David, it's Dave Schulz. So right now, our stock and flow business is running about 60% on our EES business.

[David Manthey, Baird]

Okay. Thanks very much.

[Operator]

Thank you. And ladies and gentlemen this concludes our question-and-answer session. I'd like to turn the conference back over to Mr. Engel for any closing remarks.

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

Well, thank you all. We are at the top of the hour. Thank you all for your support. It is much appreciated. We look forward to speaking with many of you. I know we have many calls scheduled over the next several days. And also, over the next two months, we have a robust schedule. We will be participating in the Jefferies Industrial Conference, the RBC Global Industrials Conference and the Morgan Stanley Laguna Conference during the third quarter. Thank you all for joining our call. Have a good day.

[Operator]

Thank you, sir. This concludes today's conference call. We thank you all for attending today's presentation. You may now disconnect your lines and have a wonderful day.