Wesco International Inc

NYSE:WCC

Earnings Call Transcript 2022-Q3

[Operator]

Hello, and welcome to WESCO's Q3 2022 Earnings Call. [Operator Instructions] Please note that today's event is being recorded.

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

[Scott Gaffner, SVP, Investor Relations]

Thank you, and good morning, everyone. Before we get started, I want to remind you that certain statements made on this call contain forward-looking information. Forward-looking information 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 we made 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 slide 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.

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

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

Well, thank you, Scott, and good morning, everyone. It's a pleasure to be with you today. As you saw from our earnings release earlier this morning, we delivered another quarter of outstanding results, further demonstrating the substantial value-creation capability of the new WESCO. We once again set company records for margin, profitability and backlog and further reduced our leverage ratio in the third quarter. The power of our increased scale, expanded portfolio and industry-leading positions is clearly evident in our continued strong performance.

Strong demand and operational improvements are driving the record-setting performance across our company. Each of our three strategic business units again delivered strong sales and profit growth in the quarter, driven by the breakthrough results of our enterprise-wide cross-selling and gross margin improvement programs.

Overall, we delivered organic sales growth of 17%, record profitability of 8.6% adjusted EBITDA margin and record adjusted EPS of $4.49, up 64% versus the prior year. You will recall that we substantially raised our outlook for the year following our results in each of the first and second quarters. Our outstanding results in the third quarter and the continued strong execution across our business support the full-year outlook for 2022 that we previously provided.

We are maintaining our organic sales growth targets, but adjusting our reported sales range with the change entirely driven by the foreign exchange rates, thus reflecting the unprecedented strength of the U.S. dollar throughout 2022. At the same time, we're increasing our outlook for EBITDA margin and narrowing our range for EPS.

Our increased profitability continues to fuel our investment in advanced digital capabilities that will transform our relationship with both our customers and our supplier partners. The recent acquisition of Rahi Systems announced earlier this week underscores our strategy to maximize our exposure to these attractive secular growth trends. Our profitable execution against these sustainable trends and our investment in WESCO's digital transformation support a virtuous cycle, which is expected to result in an even higher level of performance, operating efficiency and customer loyalty.

Before I hand it off to Dave, I plan to address our transformational results versus pre-pandemic levels and our uniquely strong position to capitalize on the secular trends that we talked about in our end markets and that we presented at our recent Investor Day.

So let's turn to page five. The demonstrated strength of our business model and the success of our integration efforts over the last nine quarters have established a track record of superior results for our company. The strength of the new WESCO is best measured by the value we have created since the merger closed in June 2020. This page highlights our record year-to-date 2022 results, as compared to our pro forma pre-pandemic results for the comparable period in 2019.

As you can clearly see, we have outperformed the market, delivering impressive sales growth and margin expansion and achieving record profitability, all while rapidly delevering our balance sheet. Our resilient and critical supply chain solutions, combined with our exposure to the sustainable secular trends, will drive our future sales and profitability. As we recently conveyed during our Investor Day, we're excited, because there's still substantial value embedded in a transformational combination of WESCO and Anixter. We look forward with great confidence to a future of sustained growth and market outperformance.

Now let's move to page six. Providing our global customers with end-to-end solutions, and that includes the products and supply chain services that make our customers more efficient and more effective, is what drives us each and every day. We are executing at a very high level, and we are exceptionally well positioned to capitalize on the strong secular growth trends and increasing investments in public sector infrastructure outlined on this page.

These long-term trends are driving secular growth in each of our three strategic business units and across our entire global enterprise. I'm pleased to report that we raised our cumulative sales synergy target again this quarter and now it stands at $1.4 billion. Our positive cross-selling momentum is fueling our market outperformance and growth. As I've said before, the new WESCO is transforming into a growth company. We have a record backlog, and expanding cross-sell program, a growing opportunity pipeline and positive momentum overall, but we are only in the early stages of unlocking our total growth potential.

Now moving to page seven. The acquisition of Rahi Systems closed earlier this week highlights our continued investment in the high-growth data center segment and further expands cross-sell opportunities across our company. Rahi is a leading global hyperscale data center solutions provider with over 900 employees in 25 countries, and a trailing 12-month sales of approximately $400 million. Rahi will be integrated within our CSS business and will provide complementary global coverage and significantly enhance our full suite of data center solutions for contractors, integrators and end user customers.

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

[Dave Schulz]

Thanks, John, and good morning, everyone. I'll start on slide nine with a summary of our third quarter results compared to the prior year. As John mentioned, sales were a third quarter record and cross-sell in the quarter again exceeded our expectations. Our ability to cross-sell WESCO and Anixter products and services contributed $237 million of sales in the quarter.

On an organic basis, sales were up 17%, driven by a combination of strong price and volume along with share gains largely attributable to our cross-sell initiatives. We estimate pricing added approximately 8 points to sales growth, in line with the two prior quarters, with the benefit primarily in our EES and UBS businesses. On a reported basis, sales were up 15% as differences in foreign exchange rates represented a 170 basis point headwind in the quarter.

Supply chain challenges have continued to impact certain pockets of our business. We estimate that the lack of availability of certain products reduced sales by approximately 1% to 2%, consistent with the first and second quarters. We continue to strategically invest in inventory in the quarter to address these challenges, as well as to support our increased backlog of future sales growth opportunities.

Backlog reached another record level this quarter and was up 5% sequentially from June and up more than 60% from the prior year. Each business unit posted backlog increases of more than 40%. We have not experienced any cancellations of projects in the backlog. Given current supply chain constraints, we are seeing some projects delayed, similar to what we saw in the first half of the year.

As we start the fourth quarter, demand has continued to be strong. Preliminary October results are encouraging, with sales up approximately 12% year-over-year, including the impact of a stronger dollar, which is expected to negatively impact fourth quarter sales by about 3%.

Gross margin was our highest ever at 22.1% in the quarter, up 80 basis points versus the prior year and up 40 basis points sequentially. This result was driven by our gross margin improvement program, the [Technical Difficulty] pass-through of supplier price increases and the absence of a COVID-related PPE inventory write-down in the prior year period. Recall the impact of the PPE write-down was 10 basis points in the prior year quarter.

Adjusted EBITDA, which excludes merger-related and integration costs, stock-based compensation and other net adjustments, was 41% higher than the prior year and represented 8.6% of sales, 50 basis points above the record level set in the second quarter and 160 basis points higher than the prior year. This result was driven by the combination of increased gross margin, a scale benefit of higher sales and realized cost synergies from our merger with Anixter. I'll walk you through the main drivers of this improvement in a moment.

Adjusted diluted EPS for the quarter was $4.49, also an all-time record and up 64% from the prior year. The primary driver of this increase was core operations that contributed to $1.92, partially offset by headwinds related to foreign exchange rates, interest expense and a higher share count, which collectively reduced adjusted diluted EPS by $0.17 in the quarter. The adjusted effective tax rate in the quarter was higher than our fiscal year outlook, due to lower benefits from intercompany financing and discrete tax items.

Turning to page 10. This slide bridges the year-over-year increase in sales and adjusted EBITDA. Organic sales increased 17% versus the prior year, including an 8 point benefit from price. Compounding this growth was the impact of the $237 million we generated in cross-sell in the quarter, as well as continued share gains.

Adjusted EBITDA increased 41% versus the prior year. Higher sales and expanded gross margin drove the majority of the $116 million increase in adjusted EBITDA. We also recognized the benefit of incremental cost synergies of $68 million in the quarter on a run rate basis or $18 million incremental to the prior year quarter.

As you would expect in the strong demand in an inflationary environment, we continue to experience higher volume-related operating costs, including shipping and sales commissions, as well as expenses for employee benefits and incentive compensation. Given our strong results, we continue to accrue short-term incentive compensation above target.

Finally, in accordance with our plan, we incurred higher expenses related to our investment in systems and digital tools. Overall, we delivered strong operating leverage as we generated a 41% increase in adjusted EBITDA, more than 2 times our organic sales growth of 17%.

Moving to slide 11. Sales in our EES segment were, up 15% year-over-year in the third quarter on an organic basis. This growth reflects continued strong construction sales driven by the ongoing recovery of the non-residential market. We also continue to see good momentum in our industrial and OEM businesses, supported by broad end market demand. Strong bidding activity drove a further increase in our EES backlog from its record level in the prior quarter. We also made progress on our cross-sell initiatives and are capturing demand driven by the secular growth trends that John discussed earlier.

Adjusted EBITDA was $226 million, a record level for the third quarter for EES and up 30% from the prior year. Adjusted EBITDA margin was 10.1%, 130 basis points higher year-over-year. This increase reflects effective price cost pass-through, strong cost synergy realization and operating cost leverage.

Turning to slide 12. Sales in our CSS segment were up 10% versus the prior year on an organic basis. We saw strong growth in both network infrastructure and security solutions operating groups, driven by growth with security integrators, cloud applications and wireless, as well as data center and hyperscale projects. While pleased with these results, CSS sales growth was not as robust as EES and UBS, primarily due to ongoing supply chain constraints in certain pockets of the industry that we discussed last quarter.

Additionally, pricing in CSS was a low single-digit benefit versus the prior year but improved sequentially. Profitability was strong with adjusted EBITDA of 9.8% of sales in the quarter, 80 basis points higher than the prior year, driven by operating leverage, integration cost synergies and the execution of our margin improvement program.

Turning to slide 13. Organic sales in our UBS segment were exceptionally strong, up 29% versus the prior year. Given the timing, there was no material impact to revenue in the quarter from Hurricane Ian. Utility demand has remained consistently strong as both our investor-owned utility and public power customers continue to invest in grid hardening and modernization, as well as green energy and electrification.

Sales growth in our Broadband business was also strong again this quarter, driven by continued demand for data and high-speed connectivity, including requirements for fiber-to-the-X applications. We continue to benefit from sales activity related to the federal government's rural digital opportunity fund.

Adjusted EBITDA in the quarter was up 62% for UBS and adjusted EBITDA margin expanded 250 basis points to 11.6% of sales. This outsized growth was driven by the scale benefit of sales and gross margin expansion.

Now moving to page 14. The size of the cross-sell opportunity of combining WESCO and Anixter continues to exceed our expectations. In Q3, we recognized $237 million of cross-sell revenue, our largest quarter to-date. Our pipeline of sales opportunities continues to expand and our cross-sell initiatives continue to deliver. We are capitalizing on the complementary portfolio of products and services, as well as the minimal overlap between legacy WESCO and legacy Anixter customers. The size of this opportunity has turned out to be one of the most significant value drivers of the combination of WESCO plus Anixter, as you can see from the steady increase in our expected target.

Recall that two quarters ago, we increased our cumulative cross-sell target to $850 million and last quarter, we increased it again to $1.2 billion. Due to the continued growth of the pipeline, we are raising our cumulative cross-sell target to $1.4 billion by the end of 2023. To-date, we have generated $966 million of that target.

Turning to slide 15. On the left side of the slide, you can see in the gray boxes that we realized cumulative run rate cost synergies of $188 million through 2021. Due to continued progress, we are increasing our 2022 target slightly from $265 million to $270 million of cost synergies and we remain on track to meet our expected target of $315 million by the end of 2023.

Recall that these savings are relative to the 2019 pro forma base. On the right side of the slide, we've outlined the $315 million of cost savings target by synergy type. And in the chart, you get a sense for the synergies that have been realized to-date in each category. For example, the estimated $45 million in corporate overhead savings have now been fully realized. The largest remaining synergies are those that take longer to execute, including those related to supply chain and field operations.

Turning to page 16. On this page, you'll see a year-to-date bridge of our free cash flow. Starting with adjusted net income and moving right, the $139 million source of cash primarily reflects a combination of D&A, interest and income taxes. In total, working capital has been a $1.1 billion use of cash to-date, driven by increases in receivables and inventory. In response to the exceptionally high level of sales growth we have experienced this year, we invested in inventory to ensure we maintain best-in-class service levels and continuity of supply for our customers. The unprecedented backlog, up for the seventh consecutive quarter, supports this increase.

Lastly, the CapEx and IT spend reflects the investments related to our ongoing digital transformation and is consistent with our plan. In addition, a key driver of the increased CapEx year-to-date is related to our supply chain network optimization strategy.

Moving to slide 17. Reducing our leverage has been a top priority since we announced the acquisition of Anixter. In the third quarter, we reduced leverage by 0.2 times trailing 12-month adjusted EBITDA and brought our leverage ratio down to 3.2 times. This represents a decrease of 2.5 leverage turns since closing the acquisition in June of 2020. We are now well within our target range of 2 times to 3.5 times, which represents a significantly faster pace of deleveraging than the target then provided prior to the closing of the Anixter merger.

Moving to page 18. We are updating our full-year outlook based on this quarter's results. As John mentioned at the top of the call, our expectation for full-year organic sales growth remains unchanged. We are revising our outlook for reported sales growth to 15% to 17% to reflect a larger headwind due to foreign exchange rates. This headwind is now expected to negatively impact full year revenue by 2% versus our prior expectation of 1%.

The rest of our sales growth assumptions remain unchanged. We continue to expect market growth of 12% to 14%, including a benefit of 8 points due to price, 5% from cross-sell and share gain and the benefit of an extra workday in 2022. We expect the demand environment for our products, services and solutions to continue to be strong. However, we recognize that supply chain constraints and the pace of inflation present some uncertainties for the fourth quarter of the year.

With regard to our business units, we expect that UBS will be above the upper end of our sales range, EES to be within the range and CSS to benefit -- to be below the lower end of the range due to they're experiencing less of a benefit from price as well as a larger impact to sales from supply chain disruptions.

Also recall that included in our outlook is a contract with a utility customer that will shift from a full revenue model to a service fee model, which will negatively impact sales by approximately 0.5 point with no impact to EBITDA. I'd like to point out that this outlook does not include sales from the acquisition of Rahi Systems, which we expect will contribute $65 million to $80 million of sales in the final two months of the year.

For adjusted EBITDA margin, we are increasing the midpoint and narrowing the range of our outlook to 7.9% to 8% of sales, at the upper end of our prior range, primarily reflecting continued benefit from our gross margin improvement program. At the midpoint of the sales and EBITDA margin range, our full-year outlook for adjusted EBITDA remains unchanged at $1.68 billion.

We are maintaining the midpoint and narrowing the range for our adjusted EPS outlook of $15.80 to $16.20, which represents growth versus the prior year of approximately 58% to 62%. Lastly, we are adjusting our expectation for free cash flow to approximately 10% of adjusted net income.

As noted earlier, the primary drivers of our net working capital increase are accounts receivable and inventory. We are adjusting our free cash flow forecast to reflect balances as of September 30th and increased inventory to support growth to the backlog. We expect fourth quarter sales to be down sequentially, releasing net working capital and generating positive free cash flow. There is no change to the long-term free cash flow conversion capability of the company, and we continue to expect to generate 100% of net income through the cycle.

This outlook reflects a handful of assumptions that I would like to remind you of. First, based on our year-to-date results and outlook for the year, our short-term compensation structure is reflected in our margin outlook at an above target payout. We have also included the impact of an increase in transportation and logistics costs that we mentioned last quarter.

On cash flow, we now expect to spend approximately $130 million in combined capital expenditures and IT digital investments. On the statement of cash flows, approximately $75 million will flow through CapEx and approximately $55 million will flow through changes in other assets.

We expect depreciation and amortization of between $175 million and $180 million for the full-year or $40 million to $45 million for the fourth quarter. We expect interest expense to be approximately $285 million to $290 million for the year or $80 million to $85 million for the fourth quarter. This outlook incorporates the potential effects of higher short-term interest rates. Our outlook assumes an average diluted share count of approximately 52 million to 53 million shares for the year. And lastly, this outlook does not reflect any potential changes to applicable tax laws.

As it relates to the fourth quarter, preliminary October sales were up 12% against a very difficult comparison versus October 2021. Additionally, recall that the fourth quarter of 2021 had the highest sales per workday of any quarter last year, which included an exceptionally strong December, making for a difficult year-on-year comparison. We anticipate sales remain strong in the fourth quarter, but more normal seasonality, depending on supply chains and the ability for us to continue to supply products to our customers.

Moving to slide 19. Before opening the call for questions, let me provide a brief summary of what we covered this morning. This has been an exceptional three quarters and we have strong momentum across our business. We delivered very strong financial results across the board, including record third quarter sales, an all-time record operating profit, adjusted EBITDA, adjusted EPS and the strongest quarter since the Anixter transaction closed in June of 2020. Every segment of our business grew versus the prior year and sequentially in the quarter as well as compared to 2019 levels.

We delivered adjusted EBITDA margin expansion of 160 basis points over the prior year, driven by our value-based pricing execution, accelerated cross-sell and continued cost synergy generation. Our pace of deleveraging has exceeded our expectations, and we are now back within our target leverage range, just nine quarters after closing the acquisition of Anixter.

And lastly, we're making excellent progress on our IT and digital road map and are exceptionally well positioned to benefit from the secular growth trends and increasing public sector investments that John discussed earlier.

With that, let's open the call to your questions.

[Operator]

We will now begin the question-and-answer session. [Operator Instructions] Today's first question comes from Deane Dray with RBC Capital Markets. Please proceed.

[Deane Dray, RBC Capital Markets]

Thank you. Good morning, everyone.

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

Good morning, Deane.

[Deane Dray, RBC Capital Markets]

Hey, can we start with the cadence of demand since the New York Analyst Meeting? We've got the look into October against the tough comps. But John, any context, daily stock and flow, bid activity? Any kind of color taking us through October would be really helpful.

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

Yes. I would characterize it as the beat goes on, Deane. Seeing the strongest growth from UBS, but all three businesses grew. And we're very pleased with the momentum we have. The backlog growth that we had that is 5% at the end of Q3 sequentially versus the end of Q2 is another exceptional, much better than the historical seasonality growth. And we continued in October with a book-to-bill ratio above 1.0, which is also not typical. Because typically, we eat in the backlog, I think as you know, as we go through the fourth quarter. So there is a bit of color. Bottom line is the beat goes on.

The demand environment, what I would tell you, that it's really the opportunities that are coming to us and that we're also generating that are captured in an expanding opportunity sales pipeline, of which the cross-sell execution and momentum, again, just continues to increase. And I couldn't be more pleased with that.

[Deane Dray, RBC Capital Markets]

That's great to hear, and that's consistent with what we've heard from your key suppliers. And my follow-up question is for Dave on the free cash flow guidance. How do you expect this kind of when and where does it normalize? I appreciate you're saying you still expect 100% free cash flow conversion over the course of the cycle. You all have the ability to flex up and down working capital as needed throughout the cycle, so I've seen that for years. And then just added to this, in any way, crimp your capital allocation optionality with the ‘22 free cash flow guidance having been cut?

[Dave Schulz]

Yes, Deane. So again, we have demonstrated through cycles that we're able to generate above 100% of free cash flow on average. We're very confident that the model is still intact, as represented by our expectation for fourth quarter cash flow generation. So if you take a look at our implied guide for the year, you'll see a sequential step down in sales. That will release working capital and will create significant free cash flow in the fourth quarter based on our current expectation for the demand profile. And so we're very comfortable that our free cash flow model is intact.

Obviously, when sales are growing as strong as they have been all throughout 2022, we have been investing in net working capital. As that sales growth normalized more to our mid-term -- or I'm sorry, more to our long-term growth algorithm, then you would expect us to continue to deliver that 100% free cash flow.

On our capital allocation, we have not changed how we view capital allocation. We have been consistently focused on driving down our leverage. And as you can see, we have begun to invest again in some of the secular growth trends with the recently announced acquisition of Rahi.

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

The only thing I would add, Dave, thanks for that, Deane, is that with our recent Investor Day, which was the first one we had since bringing together WESCO and Anixter, we were -- we provided a very set of critical updates, I would call them, in terms of our long-term view investor thesis.

With regards to cash generation, you'll recall, we significantly raised our cash generation expectations for the new WESCO to $3.5 billion to $4.5 billion of cash generation over the next five years. That supports our $1 billion buyback program and also supports -- we’re initiating a common dividend which we expect to initiate in early 2023. So we have great confidence in the cash generation characteristics.

When this year is done and we look at it, and we said this as we move through the year, the exceptional growth in terms of backlog growth, which is a result of winning this new business, and we're getting good conversion to sales in terms of sales generation, but we made a conscious decision to support that backlog growth with the investment in inventory. And you look at the amount of inventory growth and AR growth in the calendar year, it's substantial. The quality of our inventory, the quality of AR is consistent with what we've had over the long-term. So high-quality.

That AR will get collected. That inventory will convert to sales, because it's backed by orders that are in our order book and the firm backlog. And then consequently, that will convert to cash. So very, very strong confidence in the inherent and fundamentally stronger now cash flow characteristics of the combined company.

[Deane Dray, RBC Capital Markets]

That's great to hear. And just one quick clarification. Because of the size of the inventory investment you've made, I think it would be helpful just to clarify that this inventory is not speculative. You're not just hoping the customers show up and buy it, but they are tied to projects. And explain the customer, the obligation, contractual obligation for these project inventory investments that you've made?

[Dave Schulz]

Yes, Deane, it's Dave again. So just one thing to point out is our stock and flow inventory has been relatively unchanged throughout 2022. Our inventory increase is really being driven by our project backlog. Those are firm orders that we bring the inventory in. Given the supply chain constraints in the current economic environment, we have had to bring in inventory when available and, in some cases, making sure that we have what is committed on that order to the customer. And so we're just hanging in our inventory longer than we would typically see. But given the supply chain constraints, we're making sure that we can service the customer. That is inventory that will be released as part of a sales order, and we're confident that will still occur.

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

I mean a very important point, thanks for raising that, Deane, and the way we look at it internally, we have a strong view on this, how we're performing versus market is a function of the growth in our firm backlog, that's orders on the books supported with customer POs and [Ps and Cs] (ph), in conjunction with plus our out-the-door sales growth. And if you look at the backlog growth that we've been generating since we put these two companies together and particularly over the last four to six quarters, it's absolutely exceptional. It's well above our out-the-door sales growth rate. And that is the driver of our inventory build.

[Deane Dray, RBC Capital Markets]

Thank you.

[Operator]

The next question comes from David Manthey with Baird.

[David Manthey, Baird]

Thank you. Good morning. I was wondering if you could share with us what you're hearing from your suppliers relative to list prices for 2023 any directional thoughts there?

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

Dave, thanks for the question. Pricing, I'll tell you, pricing in the quarter and our current look on pricing, but I do expect as we go through this quarter we'll get a -- let's call it, a much more robust view of 2023 pricing for our suppliers. But at the present moment, when you look at where pricing is landing and what they're anticipating, the price increases on average are relatively consistent with what we've had across at least the last two quarters, Q2 and Q3 of 2022. That is the case for 2024.

And I would say, as we look into 2023, at least the front end of it is starting to look like -- we'll have a much better sense of that once we once we go through the next four to six week period, because they're all working that in earnest now and there may be some revisions here or there. But the key messages and the answer is, the average price increase is holding relatively steady in Q4 versus Q3, Q2 and it appears that's what it looks like as we enter 2023. Now the number of price increases on individual SKUs in terms of being impacted is less in Q4 than Q3 or Q2, but that's typical.

[David Manthey, Baird]

Right. Okay, and just to clarify that. When you say that it's holding, are you referring to a price level then? And so as we come up against pretty difficulty comps?

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

Price level, Dave.

[David Manthey, Baird]

Yes.

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

Price level.

[David Manthey, Baird]

Yes, that will source [Multiple Speakers] Okay, all right. And then again, as we're looking to 2023, without pinning down specifics here, you've outlined things like incentive comp and the Anixter synergies, of course. Are there any other sort of unusual costs or benefit factors we should consider as we look into 2023 relative to ’22? Really like higher digital road map expenses or lower rebates, anything that you can talk about today that might influence that delta?

[Dave Schulz]

Dave, just to add to that, so the one area that we're experiencing like every company is the inflation on labor costs. And so while you are correct that we will have a tailwind from lower incentive compensation returning back to target, we are seeing some higher market rates as we look to plan for merit increases for 2023. I think everything else that you've captured there is correct. I mean, we are also seeing some variability in our logistics costs, primarily the cost of warehousing. And we are going through a supply chain network design, that's part of our synergy drive. So that is coming in at a higher rate than we had initially anticipated.

[David Manthey, Baird]

Great. Thanks, Dave. Thanks, John.

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

Thanks, Dave.

[Operator]

The next question comes from Sam Darkatsh with Raymond James.

[Sam Darkatsh, Raymond James]

Good monring, John, Dave. How are you?

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

Good morning.

[Dave Schulz]

Good morning.

[Sam Darkatsh, Raymond James]

Two questions. The first, directionally, as it relates to 2023 gross margin. I know you indicated rebates will be a little bit of a headwind, although I'm guessing purchasing synergies might offset much of that, so outside of continued outsized growth in UBS which would hurt mix, what would have to happen for ‘23 gross margins to be down? And how likely is that to occur based on what you can see right now?

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

Sam, I'll answer it this way because we haven't provided a guide for 2023. And when we do, we won't guide at the gross margin line, as you know. We'll guide at the EBITDA margin line, as well as sales in EPS and cash flow. With that said, we feel we have outstanding momentum in our enterprise-wide gross margin improvement program. There's no doubt that the inflationary environment has affected everyone in the -- up and down the value chain. But we are laser-focused and myopically focused on selling the value of our, I'll call it, industry-leading value proposition around our complete supply chain solutions.

And that enterprise-wide margin improvement program we put in place, we're seeing tremendous benefits on. And that is completely focused and incentivizes everyone in the front end of our business, including all our account managers and sales reps, both inside and outside sales reps, to expand margin, and expand margin versus sequentially and year-over-year, and we are paying them for that.

Anixter, as you know, had a program in place two years plus prior to the close of Anixter and WESCO, and they were enjoying very good gains from that, and we revised that and drove it enterprise-wide post close. And we think there's a lot of legs left to our gross margin improvement program. We don't control the external market. I've told you, I have a strong view on this. I said this the last two quarters at an Investor Day, I think we're in an inflationary cycle. And I think that continues in 2023. But given that backdrop, what we're focused on is what we can control, and that gross margin program, we feel good about, it's enterprise-wide and we're going to keep the pedal to the metal of it.

[Sam Darkatsh, Raymond James]

Second question regarding the CSS backlogs, I think they're sequentially flat despite the supply chain constraints continuing. Trying to get a sense, is that like a decent leading indicator? Or is it something one-off happening in CSS that would lead that to perhaps show different backlog trends than what would be seen in the other two segments and that holistically for the enterprise as a whole?

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

No, not a leading indicator, I would -- we remain very bullish on the short, mid and long-term growth prospects of the CSS business given the secular trends that face that business. The backlog is at an exceptionally high level. And so when you go quarter-to-quarter, if it's up -- if it's flattish, that's not something that's not out of the norm when you look at it over years of basic historical seasonality over numerous years over the cycle, Sam, so no leading indicator there whatsoever.

We feel really good about the momentum in CSS. I think Dave mentioned this that we get a little bit better price pass-through there. So the trend on that is positive. And that's a good sign when you look up and down the value chain, starting with our supplier partners. In addition, very nice growth rate on CSS, comparably, speaking versus what we did in Q1 and Q2, that's on a year-over-year basis, so I feel terrific about that business.

And the final validation point which should speak volumes is the fact that we went out and acquired Rahi Systems, it should be a strong statement to everyone that we're investing in these secular growth trends. That is going to be an exceptional addition to our CSS portfolio. And we expect this to realize significant cross-sell synergies globally with our data center customers.

[Sam Darkatsh, Raymond James]

So to paraphrase, so EES, despite -- I know there's some secular trends there, but that's still the most economically sensitive business. And so that would be more instructive for us to look at the backlog trends there to get a sense of how the macro might affect you going forward?

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

Yes, yes. So if we pivot to the other two, I would say the UBS business now, characteristics of the end market and the whole value chain are fundamentally different than five or 10 years ago. I'll start there and then go to EES, Sam. We believe what has been basically utilities have been a GDP-led business when you look at it over multiple decades, no longer. We believe, fundamentally, utility is a secular growth business [Technical Difficulty] industry secular growth fundamentally.

And secondly, broadband is facing into some very strong and will leverage very strong secular growth trends. So that business has completely shifted. And so you've seen our commentary and the results are backing it up. Just we got exceptional momentum there and we have very strong results and we're very bullish on that. When you look at EES, we've been enjoying terrific results as well. That has a mix of businesses, Sam, which is where your question was. Good industrial end market exposures in that business for MRO supplies, as well as industrial capital-driven projects, as well as OEM solutions. And that's where our construction exposure is as well.

And just to remind everyone, very little residential construction exposure on a first derivative basis were non-resi. Broad indeed across nonresi, and so typically -- to answer your question succinctly, Sam, EES gives a look into the portion of the business that's construction-driven and will give a look into that cycle or -- and as well as the industrial cycle.

With that said, we got very strong demand for both the industrial and construction portion of that business. And I must say that the various deals that have passed through Congress, we're not seeing any of that in our results yet. So when you look at 2023, 2024, 2025 and beyond, that's going to represent a significant step-up in demand that will benefit EES as well as UBS and CSS for that matter.

[Sam Darkatsh, Raymond James]

Very helpful. Thank you both.

[Operator]

Our next question is from Nigel Coe with Wolfe Research.

[Nigel Coe, Wolfe Research]

Thanks. Good morning, everyone. Thanks for the question.

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

Good morning, Nigel.

[Nigel Coe, Wolfe Research]

Maybe, David, -- good morning, one John, on just on the pricing, I think you mentioned 8% price carrying forward. Just maybe clarify that. I'm assuming that's not a 2023 comment. I think you probably just meant prices at these levels will carry forward. But can you just maybe clarify that?

And then my question really is around, going back to the cash flow. Your fourth quarter implied free cash is roughly [$500] (ph) million. Demand remains very strong and supply chains remain pretty tight. So I'm just wondering the degree of confidence in that generation in fourth quarter?

[Dave Schulz]

Sure, Nigel, let me address first pricing. So we provided you some insight that we estimate 8% price benefit in the third quarter. That's consistent with what we saw in the second quarter. So we really haven't seen a material change sequentially in the price benefit to our top line. Our comments were not intended to imply anything related to 2023.

The free cash flow, you're absolutely correct. It does indicate our free cash flow guide at 10% of adjusted net income indicates a substantial cash flow generation in the fourth quarter. And as I said earlier, I really believe that this is driven by our expectation for demand by month within the fourth quarter. It will be very different than what we saw last year. Last year, we saw continued strength and the fourth quarter was up 6% sequentially on a workday adjusted basis versus the third quarter of 2021. So we're against a tough comp. We do expect that sequentially in the implied outlook we provided you today.

Sequentially, fourth quarter sales will come down. That will lead to a substantial release of the net working capital, along with our earnings. That's what gives us the confidence that we can generate positive free cash flow for the full-year 2022.

[Operator]

It appears that our questioner has dropped his line. So we will move on to the next questioner, which comes from Christopher Glynn with Oppenheimer.

[Christopher Glynn, Oppenheimer]

Thanks. Good morning, guys.

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

Good morning, Chris.

[Christopher Glynn, Oppenheimer]

So a little bit on the free cash flow, harkening to the reiteration of 100% through the cycle. Given the working capital investment this year, if ‘23 were to come in at a bit more normalized, a mid-single-digit top line, would you expect to overshoot on free cash flow from that type of environment?

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

Yes, hey Chris, it would really be dependent upon the environment with supplier constraints and making sure that we still have the right inventory. But based on what we currently are working through with our suppliers, given that we are within -- if we're back over the long-term to a more reasonable sales growth rate, again, over the long-term, we're not guiding 2023, but over the long-term, that's why we have confidence that our model has not changed, and we'll be exiting 2022 with cash flow generation that will demonstrate again the validity of our model. So we're confident that the model is intact.

If we do see sales over the longer term moderate back to that long-term growth algorithm of mid-single-digit plus, then we're very confident that we'll be able to manage our inventory appropriately. Given the current supply constraints, we're still going to take a look at what 2023 looks like. We'll provide you more details at the end of our fourth quarter call.

[Christopher Glynn, Oppenheimer]

Okay. And the leverage reduction ahead of pace, the absolute debt balance is up just a touch from when you closed the deal and EBITDA growth has been the terrific debt reduction level. Would you anticipate actual gross debt reduction in some aggressive measure when cash flow kind of kicks into gear?

[Dave Schulz]

We would, and again, we've been consistent with our communication of our capital allocation. The gross debt number is up through the third quarter, primarily because we've been borrowing against our facilities for net working capital. We just increased the capacity under our existing facilities, partly to support the acquisition of Rahi. But as we think about capital deployment going forward, we want to make sure that we are maintaining a reasonable leverage around the midpoint of our range. We also want to support our aspiration is to continue to acquire capabilities. And then, of course, we've got our share buyback and the dividend that we announced that would commence in 2023.

[Christopher Glynn, Oppenheimer]

Okay. Great. Last one from me. Is Rahi's profitability, EBITDA and operating margins consistent with the CSS segment?

[Dave Schulz]

Yes, it’s consistent with our total company. And again, we just closed, so we've got to do some work and really understand what the synergies will look like from that perspective. But we're really excited to have Rahi part of the WESCO team. They will bring a fantastic capability in that data center space. Again, they have grown rapidly. So we're very much looking forward to getting in there and I'll be spending some time out there next week with the management team, and we'll provide you more details as we learn more ourselves.

[Christopher Glynn, Oppenheimer]

Sounds great. Thanks, guys.

[Operator]

Our next question comes from Tommy Moll with Stephens.

[Tommy Moll, Stephens]

Good morning and thanks for taking my questions.

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

Good morning, Tommy.

[Tommy Moll, Stephens]

I wanted to start on fourth quarter sales. So October, up 12%, I think you said. And then the implied full-year guide -- or rather the full-year guide implies November and December would be lower than that. You've called out some of the comp issues from last year. FX has an impact in the quarter that you also called out. I just want to make sure, is there any conservatism baked in here? Is there any deterioration in underlying demand baked in? Or is there any other factor that you would want to call out as to that implied step-down in the comps as you go through the quarter?

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

No degradation. Dave cited this, and I want to put out a kind of an explanation point on it. Last year's fourth quarter was truly unprecedented. To sequentially be up 6% versus -- end of Q4 versus the end of Q3, our typical seasonality is flat to down 2 points. It was exceptional. So what you summarized there, Tommy, is correct. It's that challenging comparable plus the additional FX impact in the quarter that speaks to it. The underlying demand is exceptionally strong. Our backlog grew sequentially entering this quarter. Got great momentum in the 3 businesses overall. And then you look at it on a two-year stack basis, very exceptionally strong. So we feel very good. There is no degradation.

[Tommy Moll, Stephens]

Okay. Thank you for clarifying. To follow-up, Dave, we don't often talk about interest rates or interest expense on these calls, but I did note that your revised guidance there implies a significant step-up in Q4. You called out that there is some floating rate sensitivity to that expense line. And just playing it forward for a quarter from now, when we'll have an EPS guide that may have been a significantly higher interest expense run rate, can you frame for us, does Q4 reflect today's rate environment fully? Is there some lag there? Is there any way you would just frame the sensitivity to rates?

[Dave Schulz]

Yes, Tommy, we've included in the outlook, and we provided you some additional detail about the interest expense given the unprecedented increases to the rates that we've been seeing all year. So we've provided you with our best view of what those rates are going to look like and the impact on our interest expense in the fourth quarter.

The one thing that I'll highlight is we did call out that we expect $80 million to $85 million of interest expense in Q4. That does not include the impact of the borrowings for Rahi. So again, given the timing of that close, that would probably add another $2 million to our interest expense that is not reflected in the outlook today. But again, we've tried to get our view of where the rates are going to be. We have been seeing substantial increases, of course, particularly given our exposure to our facilities and the amount of money that we had been borrowing against those facilities. So again, the $80 million to $85 million does not include Rahi. That would be about another $2 million in the fourth quarter.

[Tommy Moll, Stephens]

And that $2 million, Dave, am I right that when you have a full quarter starting in 2023, that, that $2 million would actually be a number higher than that?

[Dave Schulz]

I'm not going to speculate at this point, because, again, we increased our facilities for the acquisition of Rahi to fund that deal. And our expectation -- and again, we're not guiding 2023, but our expectation is that we're going to generate free cash flow in the fourth quarter. And we will continue to generate free cash flow through the cycle at 100% of adjusted net income. That will provide us with available cash to pay down the facilities. That will obviously impact the interest expense guide for 2023. We'll provide you more details on that at the end of the fourth quarter.

[Tommy Moll, Stephens]

Great. That’s helpful context. Thank you and I’ll turn it back.

[Operator]

The next question comes from Ken Newman with KeyBanc Capital Markets.

[Ken Newman, KeyBanc Capital Markets]

Hey, good morning, guys. Thanks for taking the question.

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

Good morning, Ken.

[Ken Newman, KeyBanc Capital Markets]

So I know you aren't ready to guide to 2023 yet, but just given how strong the backlog is, I'm curious if you have any color of just how much the current backlog is for '23 delivery at this point. And as a follow-on to that, maybe any color on whether the orders you're taking into backlog today are at or above margins that you posted in the third quarter.

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

I'll answer the second part, but we're not going to guide the guide. So we’re pretty guide, let's say. The margin rate in the backlog is strong. If you were to look at it over time, we've had a rising trend of what the margins were in the backlog, which has been very encouraging. So I'm giving you kind of the nine quarter views post Anixter and Wesco coming together. When you look -- in general, when you look at the margin that's in our backlog, it had a rising trend which is terrific. And that's really reflecting the positive results, I mentioned this to Sam's question earlier, response to his question, the gross -- enterprise-wide gross margin, kind of, improvement program that we have we're incentivizing the sales force, you're going to see the margin rate and the backlog go up first before you see it in the out-the-door sales for those projects that are in backlog.

So that -- I will answer that part of it. And that gives us, again, confidence in the margin generation characters of the business entering 2023. But I'm not going to preguide the year. The only thing I will say is last quarter, I made a strong statement with conviction, and Dave as well did, that we're going to grow in 2023. We talked about that at our Investor Day, which occurred between the Q2 earnings release and this release. And we gave you some additional support for that.

As I sit here today, I can tell you, I've got even greater confidence in the underlying growth characteristics of the business and the margin generation characteristics of the business and inherently the cash flow generation characteristics of the business, even greater confidence of that and greater confidence with respect to 2023. That's without giving you the guide.

[Ken Newman, KeyBanc Capital Markets]

That’s helpful color. For my follow-up here, I just wanted to clarify on the inventory growth questions from earlier, but is there any way to quantify just how much of that inventory growth is really driven by backlog growth versus through supply chain issues with some of your suppliers. Just trying to get a better sense of how much is a pull forward in that spend because of visibility that you see rather than just purely the orders being so much stronger than you anticipated.

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

There's no way to precisely quantify that with a number, but it's more -- it's disproportionately driven by the latter point that you made. What Dave mentioned on our stock and flow business, our stock and flow business, we've got -- we've been maintaining our days. And so that think about -- that's the business that is in and out. It's in and out. We're quoting it, and we have the inventory and let's fill the order. So we're shipping in relatively short order after taking the order, that's for stock and flow business.

And so our days there has been held relatively constant, it's being maintained. And that's Deane's question earlier. We are -- we didn’t do any speculative buys that would take up the days supply for stock and flow. And that machine is working very well. What has driven the inventory increase is it is a product of the backlog growth. This is tremendous growth in orders. We secure the order, we get pricing, we get terms are protecting, we load it into our order book. And then we go and work our supplier base in the entire supply chain to ensure we got that full solution on order to support the committed dates we committed to.

And that process is an intricate process that we're managing. So in many cases, we're shipping multiple subsystems that in aggregate form a system solution and it's with numerous suppliers. So we've got to work over in respective dates. And in some cases, we're bringing that inventory and [kidding] (ph) it, staging it, storing it as we get the full solution together to meet the customers' committed dates that we committed to. So that's what gives us great confidence, Ken, around the quality of the backlog and ultimately shipping and converting the sales. In fact, the growth is backed up by our order book which is in backlog.

[Ken Newman, KeyBanc Capital Markets]

Very good. Thank you.

[Operator]

This concludes our question-and-answer session. I would now like to turn the conference back over to John Engel for any closing remark.

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

Well, we are at the top of the hour. So it's -- I just want to thank you all for your support. It's very much appreciated. We look forward to speaking with many of you in the coming days. We've got a robust list of calls scheduled, and we look forward to that in the next several days. We'll also be participating in the Baird Global Industrials Conference next week and the Stephens Annual Investment Conference that we [indiscernible]. So we look forward to engaging with you.

Again, thank you for your support, and we'll talk to you soon.

[Operator]

The conference is now concluded. Thank you for attending today's presentation and you may now disconnect.