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Wesco International Inc
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Good morning, and welcome to the WESCO Q4 and Full Year 2018 Earnings Call. All participants will be in listen-only mode. [Operator Instructions]. Please note this event is being recorded.
I would now like to turn the conference over to Will Ruthrauff. Please go ahead.
Thank you, Brandon. Good morning, ladies and gentlemen. Thank you for joining us for WESCO International’s conference call to review our fourth quarter and fiscal year 2018 financial results. Joining me on today’s call are John Engel, Chairman, President and CEO; and Dave Schulz, Senior Vice President and Chief Financial Officer.
This conference call includes forward-looking statements, and therefore, actual results may differ materially from expectations. For additional information on WESCO International, please refer to the company’s SEC filings, including the risk factors described therein. The following presentation includes a discussion of certain non-GAAP financial measures. Information required by Regulation G of the Exchange Act with respect to such non-GAAP financial measures can be obtained via WESCO’s website at wesco.com. Means to access this conference call via webcast was disclosed in the press release and was posted on our corporate website. Replays of this conference call will be archived and available for the next seven days.
With that, I’ll turn the call over to John Engel.
Thank you, Will. Good morning, everyone, and thank you for joining us for today’s earnings call. I’ll lead off with a few high-level remarks and Dave will take you through our fourth quarter and full year 2018 financial results. He will then close with our 2019 outlook before we open the call for questions.
Moving to Slide 3. Building on the positive momentum generated in our business in the second half of 2017, our top priorities in 2018 were to expand margins, deliver strong profitable growth and increase cash generation. We delivered on these priorities last year, and this was against an economic backdrop that was more challenging than we expected. In the fourth quarter, organic sales grew approximately 2% over the prior year, and that was 12% on a two- year stack basis. And notably, both gross margins and operating margins expanded over the prior year. We also generated strong free cash flow and repurchased $100 million of shares in the quarter.
Looking at the full year. First, we strengthened our business and achieved record sales of $8.2 billion with all end markets and geographies growing. Second, we expanded operating margin, driven by strong pull-through and with above 50% on an adjusted basis, coupled with effective operating cost leverage and sequentially improving gross margins in the second half. As a result, we delivered double-digit growth in both operating profit and EPS in all four quarters.
Third, we generated free cash flow, which, again, exceeded net income. After paying down debt and accelerating the pace of our share repurchases last year, we exited December with financial leverage at the lowest levels since early 2015. Strong free cash flow generation is the result of effectively operating our business model and remains a hallmark of WESCO throughout the economic cycle. Over the last five years, we have generated approximately $1.2 billion in free cash flow, which is more than a 105% of net income.
Finally, and most importantly, we strengthened our channel base through new additions and internal moves and promotions, including adding a new Chief Human Resources Officer and a U.S. business leader to our senior management team and also adding a new member to our WESCO Board of Directors. I’m very proud of our WESCO team for their extra effort and commitment to partnering with our suppliers, providing exceptional service and value to our customers and delivering strong operational improvements and financial results in 2018.
Our 2019 plan builds on this positive momentum in the business and includes continued execution of our profitable growth initiatives, investments in our people and processes and maintaining our cost in cash management discipline.
With that, I will now turn the call over to Dave to provide further details on our fourth quarter and full year results as well as our outlook for 2019. Dave?
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 flat sales in the U.S. and 10% growth in Canada in local currency. This marked our eighth consecutive quarter of industrial sales growth on a year-over-year basis. On a two-year stack basis, sales were up 15% and increased in all four quarters of 2018. We are encouraged that sales increased sequentially from the third quarter by 4% as normal seasonality is for industrial sales to decrease in the fourth quarter.
Momentum with industrial customers remain solid. Most of our global account industry verticals grew over the prior year, including metals and mining, food processing and pulp and paper, partially offset by a decline in the petrochemical end market. The macroeconomic indicators remain an expansion territory, supported by increasing production levels and capacity utilization in U.S. and Canada. We continue to expect growth in industrial end markets in 2019. Discussions with our customers confirmed this view, and the opportunity pipeline and bidding activity remains healthy with our Global Accounts and Integrated Supply customers. During the quarter, we were awarded a three- year contract valued at more than $30 million to provide an Integrated Supply solution for MRO materials to support multiple facilities for a metals manufacturer here in the U.S.
Turning to Page 5. Sales in the construction end market were up 1% in the quarter, reflecting 1% growth in U.S. and 3% growth in Canada in local currency. Sales were flat sequentially from the third quarter, which is stronger than the seasonal sequential decline that we normally see in the fourth quarter. On a two-year stack basis, construction sales were up more than 10%. Business activity was, again, solid in the quarter, with the majority of our regions in the U.S. posting year-over-year sales growth. We also had solid results in Canada, where we continued to take share in an expanding construction market.
The construction end market challenges continued to be driven by a tight labor market in the presence of both inflationary and tariff-related price pressures, which we have increased cost for certain projects. We are helping our customers navigate these headwinds and sales to both industrial and commercial contractors grew again this quarter. Backlog and constant currency was down 3% versus the prior year and declined 5% sequentially, reflecting typical seasonality.
Our December backlog was the second highest ever to end the year, and margins in our backlog continued to be up sequentially and on a year-over-year basis as they were in the prior two quarters. Overlooking indicators remain favorable. We are seeing continued investment in nonresidential construction projects. As an example of our success, this quarter, we were awarded a multimillion-dollar contract to provide electrical equipment to support the construction of a new LNG facility in North America.
Moving to Page 6. Our Utility business organic sales were down 5%, with the U.S. sales down 3%. The prior year period included approximately $50 million of sales, related to disaster recovery efforts of the 2017 hurricanes and California wildfire. Excluding this revenue from the prior year, sales would have been up slightly on a global basis and up 3% in the U.S. Given recent headlines in the utility marketplace regarding Pacific Gas & Electric’s recent bankruptcy filing, we want to confirm that WESCO does not have any direct sales to Pacific Gas & Electric.
In Canada, sales were 23% lower than the prior year, largely due to the nonrenewal of a contract that would have been at an unacceptable margin. As we have done in the past, we continue to exercise discipline in all of our contracting agreements and will not accept business that does not reflect the value that our services offer.
For the full year, sales in our Utility end market grew organically for the eighth consecutive year and were up 10% in 2018. Again, this quarter, we continue to expand our scope of services with investor-owned utility, public power and utility contractor customers and completed multi-year extensions with several alliance customers. WESCO remains well positioned to benefit from the secular trends in Utility sector, including continued construction market growth, higher industrial output, grid hardening and reliability projects and the increasing demand for renewable energy. This quarter, we were awarded a new five- year contract with estimated revenue of $35 million to provide electrical and MRO materials to investor-owned utility in the U.S.
Finally, turning to commercial, institutional and government, or CIG. On Page 7. We delivered 12% organic growth in the quarter, with the U.S. up 1% and Canada up 27% in local currency. For the full year, sales were up 9%. On a two-year stack basis, CIG sales were up 17% in the second, third and fourth quarters, and up 14% for the full year. This performance was driven by our strong capabilities and value-added services in LED lighting renovation and retrofit applications as well as fiber-to-the-x deployments, broadband buildouts, and network and security solutions. As an example of the continued strength we’re seeing in CIG, this quarter, we were awarded a multimillion-dollar contract to provide data communications products for an upgrade to a U.S. federal government facility.
Moving to Page 8. In the fourth quarter, we saw improvements across all key performance metrics. Sales in the quarter were up approximately 1%, which was at the lower end of our outlook of 1% to 4%. On an organic basis, sales were up 2%, 5% growth in Canada, flat sales in the U.S. and 11% growth in our international market. Pricing, again, provided a favorable impact of approximately 1%.
Gross margin was 19.4% in the fourth quarter, up approximately 20 basis points sequentially for the second quarter in a row. Adjusting for a reclassification of certain labor cost from operating expense, the cost of goods sold, gross margin was 40 basis points higher than the prior year and represented our highest gross margin over the past seven quarters on a like-for-like basis. Gross margins, again, this quarter were not impacted by geographic or end-market mix. We are pleased to see the benefits of our margin improvement initiatives, while operating effectively in a challenging environment marked by increased inflation and an unprecedented number of supplier price increases.
SG&A expenses were slightly lower than the prior year and represented 14.1% of net sale, 20 basis points lower than the fourth quarter of 2017. This was driven by our continued focus on cost controls and efficient operations. Operating profit in the fourth quarter was approximately $10 million higher than the prior year, representing an increase of 12%. As a percentage of sales, operating margin in the quarter was 4.5%, 40 basis points higher than the prior year and above the midpoint of our guidance range of 4.3% to 4.6%. Our fourth quarter results reflect exceptionally strong operating leverage as the business generated a pull-through of incremental gross profit to EBIT of approximately 133%. The effective tax rate for the quarter was 21.2%, slightly higher than our expected rate of 21%.
Turning to Page 9. Our most recent outlook was for full year sales growth of 6% to 8%. Reported sales growth was within the range at 6.5%, and organic sales were up 6.2% versus the prior year. Gross margin for the year was 19.2%, 10 basis points below the prior year on a reported basis, but flat after adjusting for the reclassification of certain labor costs to cost of good sold, as we discussed throughout last year. We are pleased with this result, given the unprecedented number and size of price increases that we experienced in 2018, which were over two and half times the number received in 2017.
SG&A expenses were $1.2 billion for the year, which was 5% higher than last year, but lower than the prior year as a percentage of sales reflecting strong operating leverage. This result was driven by our continued focus on cost controls and efficient operations. Full year operating margin was 4.3% at the midpoint of our outlook range of 4.2% to 4.4%. Operating profit was more than $33 million higher than 2017 and represented an increase of 10%, significantly higher than our sales growth, which is an indication of the operational leverage we have been able to achieve.
Pull-through for the year was 40% on a reported basis. Recall that in the first half of the year, we restored approximately $16 million in incentive compensation cost, not incurred in the first half of 2017. After adjusting incremental EBIT for this amount, in order to make a like-for- like comparison, the company generated pull-through of approximately 60%, reflecting the financial strength of our operating model. The effective tax rate for the year was 19.8%, near the midpoint of our expected range and 510 basis point below the prior year, as adjusted to account for the Tax Cuts and Jobs Act. The reduction in this year’s effective rate was primarily due to the permanent reduction of the U.S. Federal income tax rate as well as the completion of the accounting for the income tax effects of the act.
Moving to the diluted EPS walk on Page 10 and looking first at Q4. We reported diluted earnings per share of $1.26 in 2018, an increase of $0.23 or 22% versus adjusted diluted EPS in the prior year. This increase was primarily due to the strength of the core operations of the business, but also reflected a favorable tax rate and a lower share count as well as a headwind from unfavorable foreign exchange rate.
For the full year 2018, we reported diluted EPS of $4.82, our highest result in four years and above the midpoint of the guidance we provided in early November. This represented an increase of $0.89 or 23% from the prior year adjusted EPS and was primarily due to our core business results as well as the effect of a lower corporate tax rate. The effect of our share repurchase program in both 2017 and 2018 reduced our diluted share count by more than one million share, which also contributed to the higher diluted EPS by $0.11. You will recall that our 2017 effective tax rate was adjusted to exclude the impact of the provisional discrete income tax expense of $26.4 million resulting from the Tax Cuts and Jobs Act for that year.
Turning to Page 10. Free cash flow in the fourth quarter was $110 million or 189% of net income. Full year free cash flow was $260 million or 116% of net income and was up more than 100% versus the prior year. This materially surpassed our long-term historical target of 90% and demonstrates the cash flow generating capabilities of our business, especially when we are able to drive margin increases.
Net working capital was a slight use of cash for 2018, driven by an increase in the receivables balance. Relative to the end of the third quarter, inventory was up approximately $20 million to support expanded activity with several Utility alliance customers beginning in early 2019. We lowered our debt leverage for the fifth consecutive quarter, and it is now at three times trailing 12-month EBITDA, well within our target leverage range and at our lowest level since early 2015. Leverage net of cash was 2.7 times EBITDA. We repaid approximately $39 million of debt during the quarter and $130 million in 2018.
As outlined in the appendix to the webcast deck, financial leverage includes the impact of adopting the recent accounting standards 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 $824 million at the end of the quarter. Interest and other expense was $17 million in the quarter. Our weighted average borrowing rate was 4.7%. Over the past several quarters, we had increased the percentage of fixed rate debt to 69%, and believe, we are appropriately balanced between fixed rate and variable-rate instruments.
Our capital allocation priorities remain consistent. The first priority to – is to invest cash in organic growth initiatives and accretive acquisitions, to strengthen and profitably grow our business. Second, we target our financial leverage ratio of between two times to 3.5 times EBITDA. Third, we will continue to return cash to shareholders through share repurchase under our $400 million share buyback authorization that runs through 2020. We repurchased $100 million of our shares during the fourth quarter. Consistent with our message during our last earnings call, we expect to repurchase an additional $75 million of shares in the first half of this year.
During the fourth quarter, we repatriated approximately $100 million of cash from Canada to the U.S. This cash was used to repay debt. Finally, I would also like to note that earlier in January, we repaid the remaining $25 million of outstanding debt under our term loan agreement.
Moving to Slide 12. We are affirming the full year end- market sales outlook that we provided last quarter. We expect 2019 full year sales to be up 3% to 6%, reflecting end-market growth of approximately 2% to 5% for the U.S. and Canada and low-to mid-single digit decrease for our international market, approximately 1% to 2% of market outperformance and slightly unfavorable foreign currency translation. We expect operating margin of 4.3% to 4.7% and effective tax rate of 22% to 24% and diluted EPS of $5.10 to $5.70.
Our operating margin expectation at the midpoint represents an increase of 20 basis points above 2018. Our EPS expectation at the midpoint reflects a 12% increase over 2018, with a higher tax rate of approximately 200 basis point. This outlook assumes a weighted average share count of approximately 45 million shares for the full year. As John mentioned earlier, this outlook builds on the positive momentum generated in our business last year and includes continued execution of our profitable growth initiatives, investments in our people and processes and maintaining our cost in cash management discipline.
For the quarter, we expect reported sales to be in a range of down 2% to plus 2% and operating margin of 3.5% to 3.8%. This sales range and operating margin reflect the impact of one fewer workday in the first quarter of 2019 compared to the first quarter of last year as well as the impact of a Canadian dollar exchange rate that implies a 7% headwind to our Canadian business when comparing the first quarter exchange rate of nearly $0.80 last year to $0.74 that is incorporated into our outlook for the first quarter.
The loss of a workday causes a margin headwind as certain expenses are still incurred, but are not offset by the loss workday revenue. We estimate the impact from this loss workday to be approximately $30 million in revenue and $6 million in gross profit.
Lastly, turning to Slide 13. Earlier this month, we announced the acquisition of Sylvania Lighting Solutions, or SLS, from Osram Sylvania. SLS is a leading provider of LED lighting solutions and turnkey lighting services, with annual revenue of approximately $100 million in U.S. and Canada and approximately 220 employees. It’s project management capabilities and strength in a broad array of lighting renovation applications are a natural complement to WESCO’s turnkey lighting solutions offering. We are delighted to welcome the SLS team to WESCO and look forward to combining their expertise with our own to create greater value and more comprehensive offerings for our customers.
We are acquiring the SLS assets for $28 million, subject to post-closing purchase price adjustments and anticipate the transaction closing in March. We expect the transactions being neutral to WESCO’s diluted EPS for its first year of ownership. As highlighted on the prior slide, SLS results are not reflected in our first quarter or 2019 outlook.
With that, we’ll open up the call to your questions.
[Operator Instructions]. Our first question comes from Deane Dray with RBC Capital Markets. Please go ahead.
Thank you. Good morning everyone.
Good morning, Deane.
Good morning, Deane.
Can we start with the guidance and the first quarter, it kind of jumps off the page that you’re looking at it down 2%, up 2%. We just heard that your – there is a one last day we get that. It’s also a tough comp, 11% organic that you’ll be up against. But is there anything else dynamic there in terms of the market, in terms of the macro, the visibility that you’re seeing? Because it does stand out – because you’re also looking, it looks to improve through the balance of the year, but what is it about the first quarter we should know?
The short answer to your question is, no. And no, we’re not reflecting any issues in – that we’re hearing from customers or business momentum. I think it’s just a – it’s a matter of our own comparables, and you take a look at our momentum vector, and Q4 of 2017 was a very challenging comparable. December was our most challenging monthly comparable. And we had enough closing out December with a 4% growth. Backlog, we ate into a little bit of a backlog sequentially across the fourth quarter, which is normal seasonality, but we ended up with our second highest backlog ever in the history of WESCO as we entered 2019. And when you kind of look by end market, Deane, the sequential improvement in sales from Q3 to Q4 for the company overall, and in particular, driven by industrial and construction, when you look at their normal seasonality, we’re materially stronger with that momentum vector, Q3 to Q4.
So I – and as we move into January, we’re low single digits through the 29th. We don’t have a view of yesterday’s sales yet, and this is our view. I think that we got our most challenging comparable of the year in the first quarter. We know how January is starting. We are very bullish and confident on the year relative to overall top line sales growth potential and continued, I’ll call it, margin expansion pull-through as well as the cash generation, but we think Q1 will represent the most difficult comparable, hence, the guide.
Got it. That was really helpful. And then when I look at fourth quarter results and the broad strokes that the revenues were bit lighter than what we were looking for, but profitability really good and cash flow was solid. So I always think that there are times where you will walk away from low-margin business. We heard that you walk away from an account that just an profitable enough. So, I know you’ve got the willingness to do that. Was there any – did that come into play at all in the fourth quarter?
Yes. That was the driver. I mean, you’re spot on with – I think, again, I feel – I really feel terrific about the quarter we posted, the end, a very strong year, as represented in the prepared comments I made at the beginning of the call. So again, when you look at sequential momentum for industrial, typically, industrial declined sequentially Q3 to Q4, hence, industrial was up 4% sequentially. And when you look at construction versus normal seasonality as well, construction typically declines when we move from Q3 to the deep in the winter season and the impacts on construction in Q4, but that was flat sequentially. So – and CIG, overall, was really good year-over-year and actually declined a bit sequentially, which is normal seasonality. So where is the big driver? The big driver was Utility.
We posted eight years of very strong growth. We feel terrific about our Utility franchise. But as Dave outlined in his prepared remarks, we really have two factors, Deane, that are – that represents the year – drove the year-over-year performance, and it’s an optics problem. But the underlying business is terrifically strong, and we’re very confident of this year. Those two factors are, first and foremost, in the U.S., we had some storm and hurricane and wildfire-related one-time sales in Q4 last year, which drove the U.S. side of the Utility. And when you look at the Utility sales in Q4 of last year, that was our strongest quarter. And remember, we were going against after walking away from a $100 million customer in the prior year.
So we had a tough comparable. And given that, the Utility posted really strong results in 2018, and 2018 is exceptionally strong on the back of that. And then in Canada, we have essentially – we had a current customer and in the negotiations and the expectations for – and where margins were going through that, the contract ended up not getting renewed because we have the discipline.
We’re only going to go so far. The value of our services are not valued by the customer. And that value is reflected in the margin, quite frankly. If they are not, we do have the discipline to walk away. It was a sizable customer, Deane, in Canada. It was double-digit millions on an annual basis, and that’s what drove the Canadian side. And as Dave mentioned, we had some inventory increase sequentially in Q4, it was driven by Utility. And it was upwards of $30 million of inventory increase, four Utility contracts and programs that we have the business, it’s in 2019.
Final point on Utility, we had three major renewals that we did secure in 2018, and they are in total in a triple-digit million range per year in aggregate and two significant new customer wins. So as outlined in our guidance for the year to 3% to 6%, it’s based upon momentum in industrial, continued solid results in construction, continued strong performance in Utility. 2019, we expect to be the ninth year in a row of strong results after eight years through 2018 and then CIG with solid results. So hopefully, that gives you a little better insight.
It does. That’s really helpful. And just last one for me. What we should be make of the deceleration in pricing? Is that just a difference in input cost? Or is it any sort of headwinds in getting price?
No. It’s not getting price, it’s purely – it’s mix-driven, and what’s mix, it becomes commodity. There are certain commodity categories that had some decline in prices in the quarter. And so it’s just purely – and that 1% is kind of a strong one. We don’t go to the second decimal point. So it’s a strong one, but it’s a 1%. It doesn’t round up to 2%. So – but just to give you some sense, it’s purely kind of the mix of the products and its commodities with a little bit of downward price movement as we moved across the quarter.
That’s helpful. Thank you.
Yeah.
Our next question comes from David Manthey with Baird. Please go ahead.
Hi, guys. Good morning.
Good morning, Dave.
First off, when you talk about sequential revenue trends, I think, in your filings, you indicate that second, third and fourth quarter revenues are typically 6% to 8% higher than the first quarter. Are you referring to overall revenues or daily sales there?
Overall revenue. So, over the course of time, though, the workday adjustment levels out. So we provided some guidepost in terms of what we’ve seen historically on seasonality on total revenue.
All right. Thank you. Second on OpEx. Historically, when you look from fourth quarter to first quarter, there can be a jump of as much as $10 million. And I think you said in the past that’s related to FICA, taxes, variable comp, resets, et cetera. There has been years, it has been flat. I think last year, it was up $5 million or something. Are there any thoughts you can provide on the step up of OpEx into the first quarter? And importantly, just any unusual factors that might impact that quarter-to-quarter progression?
You laid it out there, Dave. I mean, we do historically see a higher step-up in Q1 from a run rate on SG&A. If you take a look at what we saw from 2017 to 2018, it was probably more outside of our normal range because of the restoration of variable compensation, but again, we don’t have that issue as we transition from 2018 to 2019. We’ll see what I would call as a typical step up in SG&A related to things like FICA, taxes and other people costs associated with Q1.
Okay. That’s helpful. And then finally, related, if you look at an annual basis and you think about your overall operating expenses, it would seem that just due to natural inflationary pressures, it’s very difficult to keep SG&A from – over time moving up a 1% or 2%. Beyond your day-to-day efforts in Lean and cost containment, are there any specific cost-cutting efforts that would lead you to a result? But when you look at 2019, overall, there would be less than a slight increase in SG&A all else being equal?
All else being equal, we don’t. So we do see that – we will continue to drive efficiencies across our operations, but we don’t see that having a significant year-over-year impact. When you take a look at what we saw in 2018, we saw roughly a $50 million step up in our SG&A, we called out $16 million of that was the incentive compensation. Clearly, we have inflation on wages and people costs, and then we had a much higher volume-related costs in 2018. When you think about our volume being up over 6%, clearly, they were higher volume-related costs in 2017. I think that provides a little bit of a guidepost as we think about 2019 going forward. Clearly, we don’t specifically guide the number, but I think, we will see a similar type of increase in people cost due to inflation, offset by some of the efficiencies that we’ll gain from our operations.
All right. That’s very helpful. Thank you.
Thanks, Dave.
Our next question comes from Ryan Merkel with William Blair. Please go ahead.
Hey, thanks. Good morning everyone.
Good morning, Ryan.
So, first just wanted to clarify January up low single digits. Is this a total sales growth comment? Or is this organic average daily sales?
That is total sales.
Total sales.
So, what we’re seeing in terms of our revenue trend January month to date, and again, we’re looking at up through January 29, and we put that on the slide for a reason because that’s the latest data that we’ve got, but that would be on our total revenue. We don’t adjust that throughout the month for things like foreign exchange.
Okay. That sort of implies you’re not expecting a whole lot of change in February and March, but it sounds like as we get later into 2019, you do expect acceleration in the year-over-year growth rate?
We do and again, remember, we’ve got a foreign exchange headwind that’s somewhat significant here in the first quarter. That is obviously playing out as we see our sales progressing through the month of January, and we built that into our outlook for Q1.
Got it, okay. And then just secondly, I think you mentioned taking share in construction. And I was just hoping you could expand upon that comment a little bit more, given the sales were up only 1%. Can you maybe just walk us through that a little bit?
Sure. That was a comment that was specific to our results in Canada, where we believe that we are continuing to take share in the construction end market in Canada. And that’s based upon the data that’s available through that end market. So again, I think that we have been able to leverage our portfolio of services with our construction contractor partners and continued to take share within that market.
Got it. Thanks. I’ll pass it on.
Thanks, Ryan.
Our next question is from Chris Dunkirk with Longbow Research. Please go ahead.
Hey, good morning. Thanks for taking my question.
Good morning.
I though you did hit right away that no direct sales to PG&E. Is any ability to quantify sale to contractors that work in that region, just any materiality there? And then maybe looking at it more optimistically, is there any opportunity for increased maintenance, and spark prevention, similar to kind of what we’ve seen from storm hardening over the past few years here?
So, again, Dave’s commentary, PG&E is not one of our direct Utility customers – Utility alliance customers. So that’s the first point. I want to restate that as Dave commented. Are there contractors that have done some work for PG&E? I don’t – there could have been over the years, but I would say, that’s episodic based upon an individual project or two. I don’t know the answer to that, okay? But I – to our knowledge, I don’t know of anything meaningful. With respect to what ultimately happens in any, I’ll call it, hardening and upgrade and modernization efforts that result, we do have another major utility customer in that state that we’re serving with a – basically, it’s our Integrated Supply business model.
So we have tremendous strength and assets and resources, and our value propositions are alive and well, I’ll say, in that state as well as have a distributed number of branches on industrial construction and data com side across the state. So I think as – depending on what the – any repair, rebuild, monetization efforts look like, there will be potential opportunities, I mean, available in the market, and we will go after those in earnest.
Understood. Good to hear. And then just thinking about rebates, the impact of charge-backs in the fourth quarter, was there anything unusual to call out that’s pretty much in line of your expectations there?
So our volume rebates came in line with our expectations for the quarter. Again, we’ll be disclosing the percentage of sales that we have from volume rebates. That range is unchanged is what we put in our 10-K in previous years. No material change in the impact to the gross margin rate, year-over-year.
Got it. Thanks so much guys.
Yes.
Our next question is from Robert Barry with Buckingham. Please go ahead.
Hey, guys. Good morning.
Good morning, Robert.
First, I guess I just didn’t want to clarify why 4Q tracked a little weaker. I think 1:4 was ex price and you had price of 1. So it’s a couple of points weaker than you were expecting?
Yes. Rob, it’s Dave. So, one of the things that, very clearly, we saw within the fourth quarter relative to our expectations was a higher impact from the foreign exchange rate. So on a reported sales basis, very clearly, we had a higher impact on our top line relative to FX. I think the other thing that we saw was we were not expecting November to come in the way that it did. When you take a look at the bi-month progression, even against the tough comps that we had in the base period, we were actually down on an organic basis in November. So clearly, that was below our expectations. We believe that was just a minor impact, nothing significant or nothing that we believe is not going to fix itself here as we go forward. And again, I think that shows up in our December number. So even though November was a little bit off, December was a plus 4%. So very strong against a very difficult comp.
Right, right. Got it. I guess, I’m just trying to think about what would drive the acceleration that I think the guide implies to get to the midpoint, given what we have been seeing the growth rates have been recently? And now it also sounds like you got this headwind that I assume it will last for the next three quarters of the Canada contract ending. I think you mentioned that you’re now assuming international is down. And I think you would have had assumed it was up low to mid-single. Like where do you see the acceleration coming from in the top line as we move through the year?
Yes. Unfortunately, I think 2019 is shaping up a lot like what we saw in 2017 and 2018, just given the base period comparison. So as I think about the guidance for 2019 on revenue, we’re comping a 12% reported sales in Q1 of 2018 and then we’re comping a 10% reported sales in Q2 of 2018. So clearly, that’s going to have an impact on a two-year basis. And we would anticipate that we will see higher growth rates in the back half of 2019, just based on the comparison periods. We don’t see anything fundamentally different in terms of the macroeconomic environment and our ability to generate that 3% to 6% sales growth in 2019. Backlog is again, a second highest we’ve ever had entering a year in my – in WESCO history, period. Bid activity levels are strong.
We know what new customers we won. We know what new renewals we’ve secured, or let’s say, what renewals we secured, as I referred to earlier. In Global accounts, we had essentially 100% renewal rate in 2018. So it’s, again, this is – we have decent visibility on the year. We know where some the big kind of opportunities are with certain customers. And it does presume a view that the market continues to expand this year, which is our view. I’ll be very clear, right? The guidance that we gave assumes an underlying economy that’s still expanding in the U.S. and in Canada. And given that foundation and a strong business that we built, that we further strengthened last year. We’re confident we can post the mid-single-digit growth we’ve outlined a range. I think it’s a very, very doable range that we have. We haven’t stretched that range at all. Outside of North America, we foreshadowed a little stiffer headwinds. And I think we don’t have much exposure there any way, as you know, on a percentage of sales basis. But I think that’s consistent with what others are foreshadowing around the globe, in terms of other economies and countries.
Got it, got it. Just lastly, could you tell us what the pull-through assumption is in the guidance – margin guidance?
Consistent with our long-term growth algorithm, when we’re above 3% organic sales, we expect to get approximately 50% pull-through, that’s what we’ve assumed in our 2019 outlook.
Got it. All right. Thank you.
Our next question comes from Ryan Cieslak with Northcoast Research. Please go ahead.
Hey, good morning. I wanted to just go back to the first quarter guidance really quick. I think I sort of get where you are, as it relates to sales, given the difficult comps and FX and all that. But when you look at the operating margin guidance, I think, at the midpoint, it’s roughly flat year-over-year. What specifically is going on there, maybe, constraining the op margin? I think, you called out the working day as being an impact. But is there anything else rolling through this first quarter that is different or that we should keep in mind as we’re thinking about the first quarter trends?
Ryan, there is not. So, as you mentioned, this is really driven by the one less workday and the impact of the one less workday on our gross profit dollars. As we mentioned earlier in the call, we do see a typical step up in the SG&A costs between Q4 and Q1, so that is also included in how we think about our outlook for Q1.
Okay, great. And then just at a high level, if you can maybe give some color around how price cost trended through the quarter? I think you guys were making some progress there as the year progressed. Maybe just an update, how you looked in the fourth quarter? And then sort of what the assumption is that you’re thinking at a high-level, maybe directionally, here into 2019? I think you mentioned the type of price increases you saw last year were 2.5 times 2017. How do we think about that trend going into 2019?
Yes, Ryan. Terrific question. I’m glad you asked this, because it allows me to kind of expand upon a bit, just the momentum vector and what’s occurring. If you take a look at 2018, in total. I’ve been with this company now since 2004, I’ve seen few cycles. I’ve seen some inflationary times and sometimes where, let’s just say, some contracting economic times. 2018 was absolutely more challenging than we anticipated entering the year. The number and rate of supplier price increases was the highest that we’ve seen in my time at WESCO. It’s notable. The tariffs obviously were not foreshadowed. We don’t have a first derivative impact on that, but nonetheless, it does stoke up inflation overall, right?
So we’ve been working real hard on margins and have given some outline to all of you before initiatives that we’re working on to improve margins. I could not be more pleased, honestly, particularly given the headwinds in 2018, of the traction we’re getting on our margin initiatives. And it’s best represented when you just take a look at the year and look at first half, second half and look at gross margins. And if you go back – and lot of you know WESCO real well, looked at us over a long-term time frame, we’ve not always had better margins in the second half than the first. If anything you would say is based on mix than margins would be a bit weaker gross margins as you move through the year.
We strengthened as we moved through the year. So let me come to Q4 now. The Q4 supplier price increases were also at a record number, for Q4, from our perspective and we were able to post gross margins that were up year-over-year, important. But I’ve only said you, most important is that sequential momentum. We had gross margins up 20 basis points sequentially.
So, we’ve got good margin momentum entering 2019. Dave made the comment in his prepared remarks that the margins in our backlog, and it’s the second highest backlog we’ve ever had are also up, end of 2018 versus end of 2017, and they’re up materially. So that portends well also for 2019. And again, as a reflection of the work we’re doing on margin improvement, because those orders that are sitting in backlog, it will shift as a reflection of all the initiatives and the execution against us. And then you’re last part of your question is, how do we see 2019 starting out. I mean, 2019 starting out with – so far, January is not over. I mean, we’ve got today, right, but we’ve seen a record number of price increases in January to start the year. It’s at a very high level.
So I would categorize what we’ve seen thus far as an extension of what we saw throughout last year and through Q4. How do we expect it to play out? I think that we’re going to continue to have some inflationary pressures. I think a lot’s going to depend with really how the economy unfolds as we go through the year. I do think – again, our view is that the economy is expanding in the U.S. and Canada, which will support some continued inflation. And I think, again, we’re just doubling down on our margin initiatives to take advantage of the momentum that we have and drive that hard to get the expansion. Hopefully, that gives you some color?
That’s actually a really good color. I guess, just a follow-up really quick on that. I just want to make sure we’re clear. The progress you made and the momentum you saw in the back half of this year with margins, there’s nothing that you’re saying that is – comes in the first quarter or the second quarter, that may pushes you back, again, as it relates to maybe on a incremental wave of inflation. It sounds like there is ongoing supplier inflation, but there is enough momentum to just continue to sort of go on this path for you guys going forward. Is that what you are saying?
Based on everything we see thus far, absolutely. And – I just tell – I’ll say this, at times, we’ve also given this a little bit of color. We’ve given where sales are in January, and I’ll just tell you, margins are tracking in a positive sense, just relative to the margin momentum vector we had, that we built in the second half and through the fourth quarter. Margins are off to a solid start at the low-single-digit sales growth rate in January.
Okay, great. And my last question, I’ll get back in the queue. Any color you can provide on – when you think about your 2018 top-line outlook, Any color on – by end market, particularly within Utility, it seems like the cadence there would be a little bit volatile in the first half versus the second half? Just how we think about your sales by end-market this year? Thanks.
Yes. We don’t lay out by end market by quarter. We have given clearly what our framework is for the guidance. We did that in the last earnings call, and it essentially remains intact. We expect all four of our end markets to grow low to mid-single digits. And we also expect growth in U.S. and Canada, geographically. So end market, while for end market is growing low to mid-single-digits and the two major growing low to mid-single-digits and then we expect to, again, perform – outperform the market by a point or two, and then as David mentioned, we expect FX to be a headwind and that is the one delta, I think, since we gave the initial 3% to 5% last quarter. FX rates, now well, I don’t know – we’ll see how they evolve as we move through 2019. But just since we gave the original 3% to 6%, the FX headwind is much stiffer. And so again, we did not change the 3% to 6%.
Okay. Thanks guys. I appreciate the help.
Yes.
Our next question is from Steve Barger with KeyBanc Capital. Please go ahead.
Hey, good morning guys.
Good morning.
Good morning.
You’ve guided free cash flow to 90% of net income for 2019, so down from 2018, even though you expect operating margin will increase. Is the variance there are all working comp? Or is there some other factor in there beyond conservatism that could affect free cash flow?
Steve, it’s Dave. So, again, we had a great year in 2018, there were a couple of things that obviously were moving around, given tax reform. But there is nothing materially different in terms of the composition of our free cash flow generation. Again, given that the sales growth outlook, we do have an expectation for working capital being a use of cash. That’s what we’ve included in that 90% outlook for free cash in 2019.
Got it. Thanks. Good to see the acquisition. Can you talk about the margin profile or the opportunities for top line or cost efficiencies, given SLS has about half the revenue per employee that WESCO itself does?
Yes. Thank you for that question. First of all, I want to be clear, we’re very excited about this acquisition. Terrific capability. And this is a talent addition. What we’re acquiring is a terrific team of lighting talent, domain knowledge, project management capability and to build a really terrific business model around, kind of, turnkey renovation retrofit, kind of, upgrade solutions based upon LED. So very complementary to what we acquired a few years ago, our Aelux/Lumigent business, that has grown substantially. We’re experiencing very attractive double- digit growth rate for our lighting retrofit business, based on LED. LED is little over 50% of our sales now. We still face – we still have a traditional lamp business that’s declining at a double- digit rate, so – but we continue to work through that.
So I’m very bullish on lighting. This acquisition, I think, is unique and that this was a strategic carve out by OSRAM. The gross margins are higher than WESCO has reported gross margins, and they are in line with the margins that we’re getting in our lighting retrofit and renovation business. So there are attractive at the gross margin line. And because it was essentially, I think of it as kind of this captive distribution model inside of manufacturing company. We’re very familiar with that, because that was WESCO back in the Westinghouse days. It gets – it has to deal with, I’ll call it, the business processes and costs that are part of the larger enterprise that are allocated to it.
So it wasn’t a stand-alone business, it’s a carve out, a strategic carve out. OSRAM had it and discontinued operations. And we’re thrilled that – we haven’t closed it yet, but we’re thrilled that it’s going to – the SLS team is going to become part of the WESCO team. We are on track to close in March time frame as we said, and we’re really focused on this. There will be some cost opportunities, no doubt about it. But the bigger play here, which is why we’ve outlined an EPS guidance, and you can say that’s conservative of being essentially neutral in the first year. We’re very focused on the talent addition and really supercharging our solution capabilities and lighting retrofit renovation and upgrades and driving the growth.
That’s great. And can you just give us your updated thoughts on the market opportunity for that LED lighting and retrofit and maybe – yes, go ahead?
There is a lot of numbers that pop around out there. It’s very large. I think most folks would agree, it’s in the total renovation retrofit and upgrade markets in the triple-digit billion range. I’d say, there is not a common consensus on the number but most numbers are around $300 billion mark. I think what’s notable and what’s different is, since lighting was invented, a century plus lighting business, it was always tied to new construction until LED.
I mean when it was new construction, the way you got lighting is, something was being built or upgraded or renovated and you’d get the fixtures, the balance, the controls and then you have a replacement lamp in. But now with solid – with lighting going "analog-to-digital to solid-state," which is essentially what happened, by going to LED, you got semiconductor capital economics that are kind of – and all the benefits that, that provides in terms of price performance to the solution set.
And now the addressable market is the complete installed base. I always say, Look out where ever you sit. Look out the window, and every structure you see, the percent of LED penetration is single digit percent. That’s the market. And so it’s a terrific market. It’s a tremendous growth engine, and there’s a lot of really interesting developments and dynamics occurring in that market. And there is a lot of pressure, but for someone like WESCO, and where we – where we are in the value chain and the type of turnkey solutions we provide to customers, coupled with our large percentage of end-user customers, it represents a terrific growth opportunity for us.
That’s great. Thanks for the detail.
This concludes our question-and-answer session. I would like to turn the conference back over to John Engel for any closing remarks.
Thank you for your time this morning. Brian Begg and Will are going to be available to take your questions. I know a number of sessions have been scheduled already. We look forward to seeing many of you at one of our investor marking events that we will be participating in, including the Raymond James Institutional Investors Conference in March. Thank you for your time this morning and your interest in WESCO. Have a great day.
The conference is now concluded. Thank you for attending today’s presentation. You may now disconnect.