Wesco International Inc

NYSE:WCC

Earnings Call Transcript 2018-Q3

[Operator]

Good day, everyone, and welcome to the WESCO Third Quarter 2018 Earnings Conference Call. [Operator Instructions] And please note that today's event is being recorded. I would now like to turn the conference over to Will Ruthrauff, Director of Investor Relations. Please go ahead.

[William Ruthrauff, executive]

Thank you, William. Good morning, ladies and gentlemen. Thank you for joining us for WESCO International's conference call to review our third 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 posted on our corporate website. Replays of this conference call will be archived and available for the next 7 days.

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

[John Engel, executive]

Thank you, Will. Good morning, everyone, and thank you for joining us today to discuss our third quarter results. I'll lead off with a few high-level remarks then Dave will take you through the details of the quarter. I will then return to provide our first end market outlook for 2019 before we open the call to questions. We had another strong quarter, and are very pleased with our return to profitable growth in 2018. This is the third consecutive quarter that we delivered double-digit growth in operating profit and in EPS. Strong execution drove positive momentum across our entire business. This momentum was clearly reflected in our backlog growth, sales growth, gross margin expansion, cost management and pull-through and free cash flow generation. Importantly, operating margin expanded sequentially and year-over-year reflecting the success of our value selling and margin improvement initiatives. Strong cash generation is a hallmark of WESCO, and the third quarter was no exception with free cash flow exceeding net income, driven by effective working capital management. As you've seen by our release, we have increased our current share repurchase authorization from $300 million to $400 million. After returning $25 million to shareholders in the third quarter via share repurchase, we now plan on accelerating the pace of our share buyback program. The recent market correction provides a compelling opportunity for the company to invest in itself. We're confident in the value-creation ability of our company and anticipate utilizing $175 million of this authorization through the first half of 2019. The strong free cash flow generation capability of our business supports continued investment in our differentiated, service-oriented business model and One WESCO growth initiative, including acquisitions, while providing us the ability to return capital to shareholders. The fourth quarter is off to a solid start with preliminary workday adjusted sales up low single digits in October and up double digits on a 2-year stack basis. In addition, book-to-bill has been tracking above 1.0 throughout the month. Based on our year-to-date results and our positive view of the end markets, we have narrowed the ranges of our full year expectations for sales, operating margin and EPS, and increased our full year expectation for free cash flow. With that, I will now turn the call over to Dave to provide further details on our third quarter results and our full year outlook. Dave?

[David Schulz, executive]

Thank you, John, and good morning, everyone. Let's turn to our end markets, beginning on Page 4. Industrial sales were up 1% organically, reflecting 3% growth in the U.S. and 4% growth in Canada in local currency. This marked our 7th consecutive quarter of industrial sales growth on a year-over-year basis. On a 2-year stack basis, growth has been steady with organic sales up 12% in each of the past 3 quarters. Momentum with industrial customers remains solid. Most of our global account industry verticals as well as our geographic regions in the U.S. and Canada grew over the prior year. The industrial recovery continues in our Global Accounts and Integrated Supply opportunity pipeline and our bidding activity levels remain healthy. The macroeconomic indicators remain in expansion territory, supported by increasing production levels and capacity utilization in the U.S. and Canada. Discussions with our customers confirm this view. During the quarter, we were awarded a multi-year contract to provide an Integrated Supply solution to support a large oil and gas customer's upstream operation in The United States.

Turning to Page 5. We posted a fifth consecutive quarter of growth in construction, with organic sales up 3%, reflecting sales that were flat versus the prior year in the U.S. and up 12% in Canada in local currency. Sales were up 2% sequentially from the second quarter and up 9% on a 2-year stack basis. Business activity was again strong in the quarter with the majority of our regions in the U.S. posting year-over-year sales growth. We also had particularly strong results in Canada, where we continue to take share in a strong construction market. The construction end market continues to be challenged by an extremely tight labor market in the presence of both inflationary and tariff-related price pressures, which have increased costs for certain projects, but we are helping our customers navigate these headwinds. Sales to both industrial and commercial contractors grew again this quarter. Backlog was up 7% over the prior year and down 3% sequentially, reflecting normal seasonal patterns. Importantly, margins in our backlog are up sequentially and on a year-over-year basis. Forward-looking indicators remain favorable as we are seeing continuing investment in nonresidential construction projects. The exceptionally tight labor market has placed a premium on WESCO services as our solutions enable our customers to maximize the efficiency of their teams both on and off the job site. We expect moderate growth and the uptrend in nonresidential construction to continue. This quarter, as a follow-on to winning the electrical materials scope, we were awarded a contract to provide data communications product for the construction of a new medical center in Canada.

Moving to Page 6. Our Utility business had another very strong quarter, as sales were up 11% over the prior year and 4% sequentially. Utility sales in the U.S. grew 13%, which was partially offset by a 4% decrease in Canada in local currency. On a 2-year stack basis, sales were up 20%. Again, this quarter, we gained market share by expanding our relationships with investor-owned utility, public power and utility contractor customers. Sales in the U.S. had an approximate $2 million benefit in the quarter from storm-related response versus an $11 million benefit in the prior year. We believe that the benefits received in the Utility business for storm response this quarter were more than offset by decreased activity levels in other portions of our business. WESCO remains uniquely 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. This quarter, we entered into a multi-year renewal of a contract to provide an Integrated Supply solution for the generation and transmission operations of a U.S. utility.

Finally, turning to commercial, institutional and government or CIG on Page 7. We delivered 8% organic growth in the quarter, with Canada up 12% in local currency, along with continued strong growth in International. On a 2-year stack, CIG sales were up nearly 17%. Flat sales in the U.S. reflect the timing impact of certain projects. Overall, this market remains quite strong and we see growth continuing in 2019. 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 build-outs and cyber and physical security infrastructure solutions. As an example, this quarter, we were awarded a contract to provide lighting and electrical materials for an upgrade to an airport in the United States.

Moving to Page 8. Our outlook for the third quarter sales growth was between 3% and 6%. Reported sales for the quarter were at the lower end of this range and organic sales were 4.2%. As with the prior quarter, this growth was broad-based with 8% organic growth in Canada and 4% in the U.S. Pricing again provided a favorable impact of approximately 2%. Gross margin was 19.2% in the third quarter, up approximately 20 basis points sequentially. Adjusting for a reclassification of certain labor costs from operating expense to cost of sales, gross margin was up 10 basis points versus prior year and represented our highest gross margin over the past 6 quarters on a like-for-like basis. It is clear that we are seeing the benefits of our margin improvement initiatives, while effectively pushing supplier price increases through to our customers. SG&A expenses represented 13.7% of sales, 30 basis points lower than prior year and 20 basis points lower than prior quarter. This was driven by our continued focus on cost controls and efficient operations. We also benefited from the impact of favorable foreign exchange rates, gains associated with the sales of certain physical assets and the absence of a bad debt charge that we discussed last quarter. Operating margin was 4.7%, above the midpoint of our outlook range of 4.5% to 4.8%. This result was 30 basis points higher than the prior year and 40 basis points higher than the second quarter. Similar to Q2, our third quarter results reflect favorable operating leverage as the business generated a pull-through of incremental gross profit to EBIT of approximately 70%. The effective tax rate for the quarter was 17.2%, materially lower than our expected rate of 21%. This decrease was primarily attributable to a discrete benefit resulting from certain prior year audit settlements.

Moving to the diluted EPS walk on Page 9. We reported diluted earnings per share of $1.41, an increase of $0.29 or 26% versus the prior year. This increase reflects favorable operating results, a lower tax rate, the benefit of share repurchases made primarily in the prior year and a net unfavorable foreign exchange rate.

Turning to Page 10. Free cash flow in the third was $80 million or 121% of net income. Year-to-date, free cash flow was $151 million or approximately 90% of net income. This is in line with our historical target and driven by strong sales and effective working capital management. Year-to-date, net working capital increased less than 4% in support of reported sales growth of 8.5%, reflecting the positive impact of our asset management initiatives. Our debt leverage ratio is 3.1x trailing 12-month EBITDA and is well within our target leverage range. Leverage net of cash was 2.8x EBITDA. We repaid approximately $38 million of debt during the quarter and have repaid $90 million of debt year-to-date. 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 on leverage over the trailing 12 months. We maintained strong liquidity, defined as available cash plus committed borrowing capacity of $828 million at the end of the quarter. Interest and other expense was $17 million in the quarter. Our weighted average borrowing rate was 4.6%, consistent with historical averages. Over the past several quarters, we have increased the percentage of fixed rate debt to 67% and believe we are appropriately balanced between fixed-rate and variable-rate instruments.

Moving to Page 11. WESCO has a history of generating strong free cash flow throughout the entire business cycle and we expect that to continue. Our capital allocation priorities remain consistent. The first priority is to invest cash in organic growth initiatives, to strengthen and profitably grow our business. Second, we invest in acquisitions. Third, we target a financial leverage ratio of between 2 to 3.5x EBITDA. And fourth, we will continue to return cash to shareholders through share repurchase under our now $400 million share buyback authorization that runs through 2020. As John mentioned at the top of the call, the recent volatility in the equity markets has created an opportunity for WESCO to increase and accelerate our repurchase program, not only is our stock currently priced at an extremely attractive value, but our cash generation enables us to opportunistically repurchase shares and still maintain the balance sheet capacity to pursue other sources of value creation when they are available, including acquisitions. We continue to evaluate options to repatriate cash held in foreign jurisdictions. We expect that use of any repatriated cash will be consistent with our existing capital allocation priorities.

Now let's turn to our outlook for the fourth quarter and full year 2018 on Slide 12. Starting with our current full year outlook in the center column. We are narrowing the range of our expected sales growth to 6% to 8%. This reflects our expectation of continued sales growth in the fourth quarter. At the midpoint, this outlook is 250 basis points higher than our original 2018 outlook of 3% to 6% growth. We are narrowing the operating range outlook to 4.2% to 4.4%. We have slightly decreased our effective tax rate to a range of 19% to 21%, largely to reflect third quarter favorability. We expect average shares outstanding of approximately $47.5 million for the year comparable to the prior year. Note that this excludes any benefit from our increased share repurchase authorization. As a result of these adjustments, we have narrowed our expected EPS range to $4.70 to $4.90, representing at the midpoint, a 22% increase over 2017. As previously mentioned, we expect strong fourth quarter free cash flow and are increasing our full year expectation to approximately 100% of net income. For the fourth quarter, we expect sales growth of 1% to 4%, reflecting seasonality and more difficult comparisons. Recall that in the fourth quarter of the prior year, sales were up 11%, which included the onetime benefit of $50 million related to national disaster recovery efforts in Puerto Rico and California. Operating margin is expected to be 4.3% to 4.6%, including continued strong pull-through. We expect the fourth quarter effective tax rate to be approximately 21%. With that, let me turn the call back to John.

[John Engel, executive]

Thank you, Dave. Turning to Page 13. And as we outlined last quarter, we are providing our first end market outlook for 2019 today. We expect all of our end markets to remain healthy and to continue to provide excellent profitable growth opportunities for WESCO. Our outlook includes above-market sales results, execution of our profitable growth initiatives, continuing to invest in our people and processes and maintaining our cost and cash management discipline. As a result, we expect sales growth in the range of 3% to 6% for next year, and we plan on providing the balance of our 2019 outlook during our fourth quarter earnings call in January. Our customers are seeking continuous improvement in their -- and supply chain stability in a world that is becoming increasingly complex and is rapidly changing. Our talented team of associates and our robust portfolio products and value-added services continue to differentiate WESCO in providing our customers with the complete solutions for their MRO, OEM and capital project needs. So with that, we'll now open up the call for questions.

[Operator]

[Operator Instructions] And our first questioner today will be Deane Dray with RBC.

[Deane Dray, analyst]

As I was kind of clicking through, John, during your prepared remarks of where the key wins in the quarter were between the pull-through, the buyback announcement and the free cash flow. I really want to talk about pull-through because you had drawn the line in the sand 6 months ago and said, "Wait for the second half, you're going to start seeing the pull-through come in." And we see it loudly here in the third quarter. So just talk about how you got to this point, the sustainability into the fourth quarter and expectations in 2019?

[John Engel, executive]

Yes. Thanks, Deane. Yes, overall, we're very pleased with the quarter. And I think it does represent firing on all cylinders of the business and it's consistent with our expectations. Starting on the top line, we're within the range we said, and by end market and by geography, everything was pretty much on track. I think the only delta was U.S. construction. I'm sure I'll get more questions about that. We'll come back to that. But exiting the quarter with a record backlog and then when you look inside the quarter, and this supports the pull-through, our sales growth was in the range, but it was at the lower end of the range we outlined. And so it's particularly strong pull-through given the sales level that we had. And many of you know us well and can go back and look at our reported results. There's been quarters when we've been in the 70% range of pull-through, but in all cases, we've had sales growth higher -- at higher levels. And I think this begins the talk about the power of margin expansion. And so we've also been working real hard at that, Deane, and we've got sequential margin expansion at the gross margin line. Year-over-year, when you adjust for the reclass it expanded as well. That drove good operating margin expansion and double-digit growth in EBIT and EPS, and obviously, we had very strong free cash flow. I'll come back to that later. So I would just start up by saying we feel really good about kind of the composition of the quarter. It's really a testament to the team. We have -- our DNA, our culture is very strong cost management and productivity. And so getting really good, I'll call it exceptional, pull-through on that sales level is encouraging. And then to your point about the fourth quarter and as we get into 2019, if you look at the outlook that we have for the fourth quarter, again, you'll see a top line that represents low single-digit range similar to -- and it is what we foreshadowed all year. We have much, much tougher comparables in the second half, Q3 and Q4, versus last year. We've come off of 4 quarters of double-digit top line growth, Q3, Q4, Q1, Q2. And so what we see in our outlook is a Q4 that looks kind of similar to a Q3, quite frankly. Sales at kind of a low single-digit range expect to have margins under control, leveraging the strong backlog, record all-time at Q3 entering the quarter. And by the way, the margins are up in our backlog both year-over-year and sequentially, which is a positive. And pull-through, the inherent pull-through that's in the outlook is very strong, Q4 looks like a Q3, right, in terms of the range of pull-through. And we expect strong cash, which is why we took the cash up for the year. So I think we've got -- we haven't closed the books on October yet, but we've got the momentum continuing from Q3 in October. And so we're going to build on that momentum. I think when it's all said and done, we'll close out the fourth quarter, it will have played out as -- the year will have played out as we expected. And we put out our initial outlook for 2019, you can see it includes a positive outlook on the end market growth. Our end markets are essentially at 2 to 5 -- up 2 to up 5, and we expect growth in all 4 end markets and we expect outperforming end markets as we have been throughout 2017 and 2018. And the rest of our outlook, I think that -- we'll provide as part of our Q4 earnings release as we said. I think that will be all the other elements of our outlook for '19. But we do expect the core profit generation capability and cash generation capability of our business model to be intact and reflected in the 2019 guidance, ultimately.

[Deane Dray, analyst]

That's real helpful. And a number of follow-up points in your answer there. The one I'd like to pick up on is on the construction deceleration in the third quarter. Look, everyone is on the edge in terms of where might there be any slowdowns. We just got the ISM numbers this morning and those continue to look healthy. So that doesn't raise any alarms there. But when you see the slowing in construction, can you comment on that? And the backlog that's up in the prepared remarks, backlog margins were up, was that also true in construction?

[John Engel, executive]

Yes. So, thanks, Deane. And I figured we'd get this question. I think that's the 1 area in the quarter versus how we thought the quarter would play out, there was a little bit -- that had some softness versus expectations when we originally gave them for the third quarter. Let me start with -- the strongest part of construction is Canada. I'll start kind of north of the border. Very strong results in Canada. Double-digit growth in construction and strong growth across really all the Canadian businesses, very strong growth in ECO and in WESCO and so -- and strong growth across the region. So we feel good about our overall Canadian business, in particular, and it's more -- has a heavier construction mix. The backlog in Canada grew double digits. We took share again and really strong set of growth drivers, there's oil and gas coming back, mining, infrastructure and such. So that's really strong and positive and building on the momentum that we've had in Canada built across 2017 and 2018. When you come down to the U.S., we -- I would say, overall in aggregate, I'm disappointed that the sales came in at flat. I will tell you now, I'm very disappointed with that. When you go underneath that and look at the composition, we had really -- the majority of the regions in the U.S. had positive construction sales growth and had expansion of billing margins. And so that's really encouraging. And as I said, our backlog built in a nice way. Well, year-over-year, our backlog is up 7%, and so against all prior respective third quarters, it's at an all-time record level, which bodes very well for entering the fourth quarter and really for 2019. I'm not concerned with construction in the U.S. It's -- when you look at it for us, Deane, at the end of the day, what drove Q3. There are projects based upon execution, and I'll come to that in a minute, not to -- based on us, but overall based on the contractors. That can move around timing wise, when they start and when they complete and that can -- that dictates timing of sales. So I don't get particularly concerned given all the other macro indicators, the health of our backlog and our bid activity levels. Bid activity levels are very high. What the real driver is, I think, in construction, and we're seeing this with customers in other verticals is there's labor shortages. And so there's pressure. There's significant pressure on contractors, in particular, that have record backlogs as well, like us. And they do have market confidence, like we do. But given the labor shortages, it's putting particular pressure on them in fulfilling their current obligations that are reflected in the projects they've won and are in backlog. And then with all the price increases, clearly that puts some -- creates a set of challenging conditions for them as they're bidding new projects with record backlogs and labor shortages. And so that does create some challenge and pressure for them on kind of the front end of projects. I think we're exceptionally well positioned to help them with that because we've got a lot of our supply chain solutions for construction are focused on the job site to improve job site productivity and as well as supply chain efficiency and getting materials to the job site. So I feel really good about our value proposition and our solutions. And so my takeaway is I'm disappointed in the reported number, but I'm still bullish on where we are in the construction cycle, the macros. And the outlook for 2019 that we gave assumes low to mid-single-digit growth in construction, consistent with how we outlined it for 2018.

[Deane Dray, analyst]

John, that's real helpful. That's it for me. But I just want to give a shout-out to Dave and the team for their working capital management and nice free cash flow this quarter.

[Operator]

And the next questioner today will be from Ryan Merkel with William Blair.

[Ryan Merkel, analyst]

So I want to talk about organic growth, the guidance for the fourth quarter at up 1 to 4 and presumably there's 2% price in there. So volume is kind of up 1 to 2. Is that at market or kind of talk through why it would be so low?

[John Engel, executive]

So I'll let Dave take you through the pieces. And again, we don't guide price as you know. But I would say the 1 to 4 is better than advertised when you take a look at sales we had called out in Q4 last year, that we had an exceptionally strong Q4 relative to normal seasonality. And in addition, we had a significant headwind on FX through the third quarter, a little under a full point of headwind on FX translation in Q3. And that also -- that same headwind existed in October and appears that it's going to be in play for the balance of the quarter. So with that, I'll hand it to Dave. But, I think the 1 to 4 as advertised is really better than that by a couple points.

[David Schulz, executive]

Correct. So, as John mentioned, 1 to 4 is on a reported sales basis. There's 2 impacts that we called out. One is foreign exchange. And so we do anticipate that foreign exchange will be a headwind in the fourth quarter. We're already seeing that in the month of October. The other issue is, we did have storm recovery in Q4 of the prior year. So that adds to the difficult comp. Add in the FX and the storm-related recovery in the base period, you're a little north of a point on sales growth. And one of the other things to keep in mind is that fourth quarter last year was also our strongest growth quarter at just north of 10%. So organic growth in the base period was a plus 10. So we're still looking at a significant 2-year stack delivery in Q4 based on the guide.

[Ryan Merkel, analyst]

Got it. That's helpful. Okay. And then, I do want to follow up on construction. I just want to know, John, how worried should we be just given labor shortages, rising costs and rising rates? Do you think on the margin, this could slow the pace of construction projects in 2019?

[John Engel, executive]

No, I think, based on -- I guess, a lot of the leading indicators on a macro basis that you see and I see, we see them together, would suggest that things are still healthy. And what I can share with you is, and we are doing this on a continuous basis, right, because this is how we run our business as we engage and perform with contractor customers. They're very positive still on their outlook for the balance of '18 and into '19. And this is still an expanding cycle relative to construction. They've got record backlogs. There's some -- become some execution challenges on the labor front, but honestly, Ryan, that's a good problem to have versus the other kind of problem. And we've been there at the trough of a great recession, right? So -- and that just creates a set of conditions for companies like a WESCO to provide our solutions that are very focused on job site productivity and overall supply chain efficiency in getting materials to the job site and ensuring projects are executed on time, under budget and with greater productivity, which directly addresses the labor shortage issue. So we're having the highest level of discussions around that, those services and solutions that we've ever had. And I think that bodes very well for us. So I, again, I -- based on my view of overall momentum, discussions with contractor customers and the final piece would be end user customers that -- and I didn't talked about this yet, but we're seeing more small and mid-sized project activity with our direct end user customers, both industrial and CIG, which is what we expected as we move through this year. And that's encouraging as well. And I think we're still in the middle innings, at the latest, in terms of the industrial cycle. That's my view, and I maintain that view and all the indicators would suggest that and our discussions with customers would suggest that. So all that gets baked into, Ryan, our outlook for that we put out there for 2016, which was consistent with the first outlook for the top line that we put out for 2018 -- for 2019 -- for 2018, right? And so which is plus 3 to plus 6. And we think that the market grows roughly 2 to 5. So that's my view. And we get, as you know, we get an awful lot of data points and measurement points across our customer base, and so this view is informed by that.

[Ryan Merkel, analyst]

Okay. Maybe just lastly, before I turn on -- or turn it over, on tariffs. How exposed are you to China sourcing? And what level of price increase do you estimate you will need to cover the announced tariffs at the 25% rate?

[John Engel, executive]

Yes, I think Dave will take you through the numbers and we anticipated this question. The good news is, I'll just frame it by saying relative to our competitors, or let's say, other distributor peers that are kind of investor peers. Let's call them investor peers, we are a rounding error, but with that, Dave will take you through the numbers.

[David Schulz, executive]

Yes. Ryan, our direct exposure to the tariffs that have been announced is low single digit. That would be items that we are purchasing directly from those countries in which there is now going to be the higher tariff rate. Obviously, as we take a look at our relationships with key suppliers, as they're sourcing some of their materials from the tariff countries, that is going to come to us as a price increase. And that's consistent with what we've been seeing year-to-date. We've been seeing the level of price increases have almost tripled versus the previous years. Obviously, we've done a good job of passing through the supplier price increases year-to-date. That's showing up in our billing margins and in our gross margins that we publish. And so again, we will continue to focus on passing through any of the impacts to tariffs. What we see directly is minimal but we will be seeing some impact from our suppliers.

[John Engel, executive]

Yes, again, our direct sourcing from Asia is very -- is de minimis. And so what we see is the impact -- when it impacts our suppliers, it ultimately impacts us. I think Dave raised an important point. The level -- the number and level of price increases we saw in the third quarter are markedly higher than what we would see in a typical third quarter. They were roughly at 2x the rate that we saw in the second quarter. That's not -- that is not typical. So I think if there's increased price increases, the tariffs are an inspiration for some portion of that clearly, but inflation has picked up too. That ultimately is good for a distributor. It's always a challenge to pass these through. I think what I feel, probably I feel the best about of all the elements of the quarter, the cash flow is bedrock and that's always strong: it's the margins. And the fact that we've got sequential gross margin expansion in the face of much tougher headwinds, sequentially, as we've moved through this year is a testament to the WESCO team and the traction we're getting on our margin improvement initiatives.

[Operator]

And the next questioner today will be Christopher Glynn with Oppenheimer.

[Christopher Glynn, analyst]

John, last quarter, you talked about, I think, the price/cost equation being at the crest of the wave. It looks like you're in balance right now. The kind of terminology there, crest of the wave, to me, it implied you may be starting to break to net positive. Can you update where you see that crest of the wave, how that forms or crashes in the next couple quarters?

[John Engel, executive]

So I think the statement I just made, Chris, the fact that we got the sequential margin improvement in gross margins Q3 versus Q2 is a testament that we're overcoming those headwinds, and so we're riding on top of the wave and kind of launching, so to speak, if I stay with that analogy. The other pulling to make which is really important, and Dave made in his prepared comments, I alluded to it previously, is the margins of our backlog, and we said our backlogs are at record Q3 level. Those margins have expanded both sequentially and year-over-year as well, which is also a reflection of our margin improvement initiatives. So with all that said, as Dave mentioned and I just alluded to, the rate and the number of price increases in Q3 was above normal seasonality and higher than Q2. So I think we're in a general inflationary phase of the business cycle. The tariffs exasperate that. But given that increased headwind, that plays through -- that's all through the whole supply chain, I'm particularly pleased with how we're managing the margin equation now. I think -- and Deane kind of got to this. This is what drove the pull-through when you really sit down and look at it. So and then you do the -- you always have to compare and contrast this to others. And so you look at where others have reported price versus cost and where their margins are. I think this is notable in terms of the momentum vector we have that has been demonstrated in Q3 and exiting Q3.

[Christopher Glynn, analyst]

Great. That's helpful. And then on the bridge to the next year outlook implies an acceleration from the fourth quarter growth outlook in, certainly in the midpoint even from the third quarter. So what's kind of the thought process framed up for what -- to how you transition into sort of bit of a reacceleration there?

[John Engel, executive]

So again, I would -- we'll give you more guidance in terms of how the year phases out as well as full outlook kind of guidance as part of our Q4 call. But as we're initially thinking about it, think about where we stand right now. We exit Q3 with a record backlog. Our bid activity levels are really strong. We've had a series of new wins, both in Global Accounts and in utilities. We've got 100% contract renewal rate so far in Global Accounts in 2018. And when you look at industrial for that matter, we've had growth across the majority of the verticals. And as I mentioned earlier, I think we're, from a -- I know this question of cycle is out there, and I still see us as kind of the mid part of the cycle at the latest. That's true for industrial and it's also true for construction. And therefore, I think, the market is set up well and our execution versus the markets, Chris, I feel particularly good about the last 5 quarters. The last 5 quarters is where we've returned to growth overall, and I just think we've got really nice momentum.

[Operator]

And the next questioner today will be Steven Winoker with UBS.

[Steven Winoker, analyst]

So I just want to come back to the question of pricing pass-through, which is so important. You're very explicit about kind of the thinking around dollar for dollar pass-through inflation that's broader than tariffs. What are you thinking about demand elasticity? I mean, this is obviously hard to tell in terms of what pressure, if any, this is applying -- this is resulting in on the volume level. But do you have a sense at all as you look across the portfolio and as you sort of think about what you're seeing if, in fact, this is something that's being really well absorbed by your customer base? Or is it -- differ very much in each of the segments, the customer segments? How are you -- what are you seeing?

[John Engel, executive]

So I -- let me answer, first kind of set the stage by saying that, I would say here we are exiting Q3, entering Q4, and clearly, as we move through the year, customers are beginning -- we're able to get these moves through and customers are absorbing them. I think there is an overall recognition and understanding by the customers, ultimately they're at the end of the value chain, whether it's an end user or a contractor who is doing a job for an end user, that inflation has ticked up and everything is ultimately relative to what your competitors do with pricing. But this rising tide of inflation has impacted all our supplier partners. It's impacted us and all the other distributor supply chain partners in our part of the value chain, and we're all working collectively to move the price through. I think the bigger -- the more important thing for the WESCO associates, the sales force and our account managers and such is, I have them very focused on selling our value. And so it's focused on our supply chain solutions and our services and not making it -- not competing purely on price. And now there's certain parts of the portfolio where they're more commodity driven, Steve, and they're going to absolutely be -- it's a price competition. But even though areas, like wire, cable and conduit, we try to add value-added services like color feeder and kitted assemblies and couple that into our job site services. So that's the dynamic. 2018 is different than '17. There is more price increases. They are at a higher level, but also we are much more effective in getting them pushed through. And I mentioned this in 2017, there's this time lag when inflation starts to pick up and it takes a while for us to work it through. And remember, we're not a catalog business. So we're not list minus discount pricing, an exceptionally important point, unlike some other, I'll call them, industrial distributors. And we have a big percentage of our business direct ship, a big project component and then we have Global Accounts agreements. In many cases, these are multi-year in nature, same with our Utility alliance agreement. So our ability and mechanism to move price through, there is always a time lag. I think you're seeing the benefit -- you're really seeing the results now of the hard work, our team, all the margin improvement initiatives and we're getting traction on that. And that's why we're seeing the gross margins expanding sequentially.

[Steven Winoker, analyst]

And that '19 early growth outlook that you have, I mean, did you factor in contingency from this dynamic at all?

[John Engel, executive]

I mean, our view of 2019 right now is, we still are in an expansionary portion of the cycle. That's true for industrial, it's true for construction. Relative to Utility, that market is not growing 2 to 5, it's lower than that. But we have an exceptional set of solutions, and we've been taking share consistently. And CIG offers a wealth of growth opportunities, right? And that's a much broader and diverse set of customers in that market vertical. So I think we've got a pretty darn good outlook of what we think the opportunities are setting up for 2019 because we're going through our detailed 2019 planning processes as we speak, and so we've done some deep dives on that already. And so we're putting that out there. It's consistent with how we viewed entering '18. So I mean, the way to look at that is, our view of entering '18 -- our view of entering '19 is not that much different than our view of entering '18 in terms of what the market will provide and our ability to execute. We ended up doing a bit better on the top line in '19 -- or in '18 than we originally guided. But that's how we think about it. And we'll update this when we have our Q4 call. And by then, we will have closed the fourth quarter and have an expanded view of 2019.

[Operator]

And the next questioner today will be Hamzah Mazari with Macquarie.

[Mario Cortellacci, analyst]

This is actually Mario Cortellacci filling in for Hamzah. Could you give us a sense of how you're thinking about your inventory levels as you head into 2019? And whether you view that as -- or your working capital as a source or use of cash next year?

[John Engel, executive]

So I'm not going to tell you what -- because that would be giving additional guidance on '19 beyond just the end markets and our top line and that's all that we're providing at this point. But I will say this, and as Dave mentioned in his remarks, I think we've had really strong and effective working capital management this year. We've had a lot of initiatives focused on how we engage with customers and our terms with customers and how we ensure we're reaching entitlement. We've always had real strong processes around how we manage the suppliers' portion of working capital, AP. And inventory is, for us, we've -- these are the optimization metrics, inventory availability and fill rate, that's vital for us based upon the customers we're serving. And a lot of times, we have a pretty good sense of that, if it's a Global Account agreement, Integrated Supply agreement or kind of Utility alliance customer. So given all that, we've focused real hard on our operational footprint over the last couple of years and really shrinking the order-to-cash cycle time and realizing those benefits. Those benefits get realized in working capital and in inventory as we optimize our footprint. This is a multi-year journey that we're still on, and I'm particularly pleased with the progress we've made in inventory this year. Again, the key metrics are availability and fill rate, but we've streamlined our inventory. Think of it as kind of picked up our turns a bit, and we're still serving customers at the service levels we would like. That's bedrock. That's priority one. So we'll continue to -- I think we have more opportunities to continue to streamline, let's say, accelerate our working capital turns. And we're good at this. This is -- and look at our free cash generation ultimately, right? So to the extent we can do even better here, that just adds to our free cash generation, which has been a driver this year clearly.

[Mario Cortellacci, analyst]

And just one more and I'll turn it over. At your Analyst Day, you highlighted about 55% of your business is project oriented, 10% OEM, with the balance being MRO. Just want to see if you think -- or if you see that mix changing at all? Or would you like to shift it over time? Or do you think it will stay pretty consistent?

[John Engel, executive]

The best way to look at that is not quarter-by-quarter, but over kind of on an annual basis. And we'll have our next Investor Day in 2019, and we'll give a comprehensive update on that. I would say, in general, as we move through this year, the mix really hasn't moved much. And because there are 2 -- 3 fundamentally different demand streams in terms of what the customers' needs are and the array of supply chain solutions, both the products and the services that we put together that serve them for each of those, we're not strategically trying to adjust that mix. We, in fact, want to grow all 3 types of demand streams, the business for that with each customer. That's actually the good news for WESCO because there's -- many of our competitors are much more wrapped around, don't have the OEM component, for example, or don't have anywhere near the breadth and depth of the MRO and they're more project driven. So I think we have that opportunity to serve all 3 demand streams well with all customers. And when you take a given customer in an end market, there's expansion opportunities based upon what we've been currently -- what we've been historically doing. And that's one -- that's part of our One WESCO focus is selling all our products and services to each and every customer in every location, but it's for those 3 demand streams. This is really important. So we may be underrepresented in OEM and there could be a huge OEM expansion opportunity with a given customer, where we already do significant project and MRO. So no -- there's no strategic intent to shift to change the mix. The mix hasn't really evolved much in 2018. And when we get to Investor Day in 2019, that's -- we update that on an annual basis.

[Operator]

And our next questioner today will be Nigel Coe with Wolfe Research.

[Nigel Coe, analyst]

Obviously, the sales slowdown is causing a lot of -- creating a lot of attention. I just wanted to come back to that. One of your suppliers, Eaton, talked about large project activity, a little bit softer in September. Did you see that as well? And maybe just address the impact of price increases, inflation and tariffs and whether that's brought forward some demand into 2Q at the expense of 3Q. And if that's the case, then it does work out over time, but if you think you have seen some pull-forward that would be interesting.

[John Engel, executive]

Yes. I don't think there's -- I would not, as we went through Q2, Q3, I would not signal any pull-forward. We didn't see that. So when you look at our sales by month in the quarter, we -- organically, that's in our webcast, we're 5, plus 5, plus 5, plus 3. So September was a little lower than July and August. On a 2-year stack basis though, we were flat across the entire quarter month-by-month. So the comparables got tougher because we had an exceptionally strong September last year. So Nigel, I'll come back to the comments I made earlier. We exit the quarter with an all-time record Q3 backlogs. Our bid activity levels are very high. The dynamic that our contractor customers are facing is that it's labor constrained. Prices are increasing, so they're always trying to figure out relative to new projects or even projects that are underway, how do they best deal with that. We try to help them with that. And project starts and stops, can kind of -- based on that moving around, it can move sales across quarters. So I don't want to signal that we're seeing this kind of wholesale shift slipping out of projects, not at all, not at all. I feel -- I'm very comfortable with our momentum vector, as I said earlier. And for us, it's just kind of how it lined up in the quarter, quite frankly, in the U.S. -- in the U.S., in particular. In Canada, you can see strong double-digit growth. So yes, there is no additional insight there really, Nigel. I kind of -- I hit that earlier and that's our view there. We're not seeing a wholesale shift.

[Nigel Coe, analyst]

Okay. That's great. And then quick one on lighting. List 3 is hitting lighting imports pretty hard. And I'm just wondering if you're seeing from your perch, a change in behavior from -- in the industry in response to these tariffs, whether it be market share or pricing, any change that you're seeing out there?

[John Engel, executive]

So I think, lighting, it's really important. I'll try to keep my comments short because I know we're -- this is a passionate area for me. For WESCO, it's one of our top growth opportunities and top growth engines. And lighting is -- it's going -- undergoing significant changes. So it's not so much this -- that wave of tariffs, recent wave of tariffs that is causing anything that's extraordinary. It's got -- it's the whole LED solid state shift and also the ability for nontraditional lighting players to come into the market and access certain applications for certain types of customers, where those customers are willing to buy strictly on price and where that supplier brand doesn't have the same value that it used to have. And that's not by -- for all customers in all segments. So there's still tremendous power in our preferred supplier brands and we partner with them, and we think that that's exceptionally important. So with respect to lighting overall, what's exciting about it is, it used to be -- for a century, I'll just kind of bookend it. For a century, it was driven by construction, new construction. And then you get fixtures ballast and the controls and okay, the lamps initially and then you had a replacement lamp business, okay? That's not what the lighting -- biggest lighting market opportunity is now. It's the entire installed base and the amount of LED penetration in any given local market is single-digit percent. When you look at all structures, all facilities, you just look out your window at everything that's lit up indoor and outdoor, and so there is a huge opportunity for retrofit and renovation and upgrades. And that's what we're focused on. There's a lot of numbers out there. It's triple digit billions in terms of what that retrofit and renovation upgrade market is, very exciting. And because LED, it's LED-driven now. It's more semiconductor capital economics, so prices are coming down, okay, overall and performance is improving, right? So -- and like any other semiconductor-driven market, whereas lighting for a century that was not the case. So it's very exciting, but there's no doubt that the competitive landscape of that whole value chain and how it's working has -- is rapidly evolving. So stay tuned on that. The tariffs just create opportunities for certain players to be a little bit better positioned versus others, but that -- I still think that's swamped out by the overall macro trend of this shift to solid state and the opportunities being where the controls are the differentiator with an LED application and other functions that can be performed in terms of facilities management, energy management. It's a tremendous opportunity for all of us.

[Operator]

And the next questioner today will be Patrick Baumann with JPMorgan.

[Patrick Baumann, analyst]

Just -- I think I heard earlier that you expect your incremental pull-through framework for 2019 to be intact despite tariffs and that will be reflected in your 2019 guidance ultimately. Just want to confirm that I heard that right.

[David Schulz, executive]

Patrick, it's Dave Schulz. That's correct. So our pull-through model is intact and so our objective is, based on a long-term growth algorithm, that we would get greater than 50% pull-through, and that's based on a sales level that's low single digit. So that's very consistent with how we've talked about it in the past. When it comes to the price increases, whether it's from a pure price increase from a supplier and/or related to the tariff, we need to push that through to our customers. And that's our full intent as we enter 2019. We'll provide you more details on our January earnings call.

[Patrick Baumann, analyst]

That's great. And then just on that pull-through question, you mentioned some items that impacted SG&A in the quarter, just wondering if you could quantify the impacts?

[David Schulz, executive]

We haven't historically quantified those impacts. I mean, I think it's safe to say that as you look at our financial results there, we delivered the pull-through. We had been talking about this all year. This is the first quarter where we did not have that variable compensation comparison relative to the prior year. And so again, we're pleased with the cost controls, with the margin expansion that we've gotten in the quarter. That related to the pull-through that we posted for Q3.

[Patrick Baumann, analyst]

And what were those numbers again? You mentioned, you said -- what you say, gain and some FX dynamics and bad debt, those are the 3 things...?

[David Schulz, executive]

I think if you look at it sequentially, we had a bad debt charge that was above and beyond what we would normally book, and that occurred in the middle of July and we reflected in our June quarter. So we did not have that issue in the third quarter. We had our typical bad debt expense. So we laid it out in our prepared remarks. It was primarily -- we had good cost controls. We had a benefit from foreign exchange. We had the absence of that bad debt charge and then we did have a gain on a sale of an asset.

[Patrick Baumann, analyst]

Got it. That's helpful. Okay. And then, just a couple quick housekeeping items. The -- looks like you have less workdays for 2019, does that 3% to 6% take that into account? And then also on the tax rate, 19% to 21%, is that kind of a sustainable rate, which will be modeling into next year as well?

[David Schulz, executive]

We do take into account the number of workdays for 2019, and we will be providing further guidance for 2019 during our January call. We've not made any comments about the tax rate for '19.

[John Engel, executive]

Again, what we're providing today is only end market and our -- our end market assumptions and then our sales results given those end market assumptions, where we'll continue to outperform them by 1 or 2 points and have some -- we do anticipate some FX headwinds and that supports the 3% to 6% growth. But beyond that, we're not providing any 2019 outlook items until the Q4 earnings call.

[Operator]

And this concludes our question-and-answer session. I would like to turn the conference back over to John Engel for any closing remarks.

[John Engel, executive]

Thank you for your time this morning. I appreciate it. Brian Begg and Will will be available to take your questions. And we do have a busy investor engagement schedule throughout the balance of the quarter. We hope to be able to see many of you at one of the investor outreach events we have planned, including the Baird Global Industrial Conference and the Morningstar Behind the Moat Conference that we will be participating in next week. Thank you for your time this morning and your interest in WESCO. Have a great day.

[Operator]

The conference has now concluded. Thank you for attending today's presentation, and you may now disconnect your lines.