Wesco International Inc Q3 FY2020 Earnings Call

Good day, and welcome to the WESCO Third Quarter 2020 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, Director of Investor Relations and Corporate Communications. Please go ahead.

Thank you, Andrew. Good morning, ladies and gentlemen. Thank you for joining us. Joining me on today's call are John Engel, Chairman, President and CEO; Dave Schulz, Executive Vice President and Chief Financial Officer. This conference call includes forward-looking statements, and therefore, actual results may differ materially from expectations. Please see the webcast slides for additional risk factors and disclosures. 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 call. I'd like to start out by saying on behalf of WESCO, I hope that all of you have been staying safe and healthy. I'll start with the third quarter highlights, then I'll provide an introduction to our three new strategic business units. And I'll be emphasizing their strong positioning to deliver above-market sales, margin and profit growth. Dave will then take you through our third quarter results. The excellent progress we're making on our second half commitments and synergy capture efforts and our increased synergy targets for the transformational combination of WESCO and Anixter. So let's first start with an update on our business and third quarter results. WESCO's new era is off to an absolutely exceptional start. As our results exceeded our expectations across the board for sales, cost, margins, profit, EPS, free cash flow generation and reduced financial leverage. This was our first full quarter of results after completing the acquisition of Anixter in June and clearly highlights the substantial value creation potential of this transformational combination. Our management actions and strong execution were effective in this COVID-driven environment. We expanded margins, reduced costs and grew profits, both sequentially and versus prior year. Business momentum improved through the quarter as we took market share and built an all-time record third quarter backlog. Our positive momentum has continued into the fourth quarter with October Workday adjusted sales down just 3% versus prior year and a book-to-bill ratio remaining above 1.0. Free cash flow generation was exceptional at over 300% of net income and demonstrates our resilient business model and strength through the cycle. Notably, net debt was reduced by $280 million, consistent with our capital allocation priorities. More importantly, financial leverage was reduced to 4.8 times at the end of the third quarter, marking a reduction of about 1.5 turns over the four-month period since closing the Anixter acquisition. Again, this quarter, I'd like to recognize and thank all of our associates for their inspirational dedication, commitment and hard work in effectively managing in this COVID-driven environment. Now turning to Anixter. We accelerated our integration planning execution and synergy realization efforts and made outstanding progress in the third quarter. The strong cultural alignment between WESCO and Anixter is proving to be a key driver in our initial success. And as Dave will explain in more detail momentarily, just four months since closing the acquisition on June 22nd, we have already initiated actions that will deliver 100% of our year one cost synergy target of $68 million. I could not be more pleased with the team's execution of our integration plan. As a result, we are raising our year one, year two and year three cost synergy targets to $100 million, $180 million and $250 million, respectively. Our initial integration progress gives us confidence that we will revisit our synergy targets as we build success upon success. We're also realizing initial sales synergies through leveraging our expanded global footprint and cross-selling our broader product and services portfolio. We believe our sales synergy efforts will support important incremental sales growth in the years ahead. As we build on these early successes, we are increasingly confident in our ability to achieve significant upside potential and exceed our three-year cost savings, sales growth, margin expansion and cash synergy targets. So let's turn to Page four. We're reporting our results for the first time under our organizational structure that we announced in June. And these are our three strategic business units or SBUs as we call them, outlined on this page. So first is Electrical and Electronic Systems, or EES, which is a little more than 40% of our company's total business. Second, Communications and Security Solutions, or CSS, which is roughly one-third of our company's total business. And then third, Utility and Broadband Solutions or UBS, which represents the remaining one-fourth of our overall combined company business across the enterprise. The respective industries and types of customers that these SBUs serve are outlined on this page. We'll provide a high-level summary for each of these businesses, including their respective growth drivers in the additional information section of this webcast presentation. Yesterday, we also filed an 8-K with pro forma operating performance for each SBU on a quarterly and annual basis for 2019 and for the first two quarters of 2020. As I mentioned last quarter, one of the most meaningful and positive discoveries post-close is how complementary the WESCO and Anixter portfolios are. The pie charts on this page depict the legacy WESCO and legacy Anixter composition for each of the three businesses. EES is comprised of WESCO's leadership and deep roots in electrical coupled with Anixter's depth and breadth and leadership position in wire and cable solutions. And EES brings the complete electrical package and best-in-class solution offers to customers. CSS includes Anixter's leading global position, capabilities and scale in communications and security. And that's coupled with WESCO's Datacom, AV and Safety portfolio. Combined, CSS is exceptionally well positioned in high-growth markets with very attractive secular growth trends. And finally, UBS which combines WESCO's and Anixter's leading Utility and Broadband businesses is also very well positioned to outperform the market with a strong execution track record and unmatched supply chain capabilities. Organizing our company around these three global businesses enables us to leverage their industry-leading scale and highly complementary portfolios and super serve our customers. Each of these SBUs does between $4 billion and $7 billion of business annually, and they offer hundreds of thousands of products and industry-leading services, which makes them a highly valued partner to both our suppliers and our customers. In what remains a highly fragmented distribution value chain, the combined company benefits from a step change in scale and capability. And we're leveraging that to sell more products and more services to more customers in more locations all around the world. Finally, the leadership teams of these three businesses are comprised of the best of the best from each company and all possess decades of experience in our industry. Nelson Squires who was previously WESCO's Chief Operating Officer and Head of the Canadian and International businesses is leading our EES business. Bill Geary leads our global CSS business, and he previously was Head of Anixter's network and security business. And Jim Cameron leads our UBS business after running WESCO's utility business since 2014 and WESCO's broadband business since 2016. I'm very pleased that each of these leaders is off to a great start in delivering strong results in our first full quarter of WESCO plus Anixter. Now let's move to Page 5. Our SBUs, each and every one of them are extremely well positioned to benefit from the numerous secular trends that will drive future growth for WESCO. We shared these 12 evolving secular growth trends previously, but today, we wanted to specifically highlight that they will drive growth across all of our businesses. As we see an increase in automation, machine-to-machine connections, electrification of our infrastructure and demand for faster bandwidth and data center capacity, coupled with the positive impact of emerging trends such as relocation of supply chains back to North America and increased remote connectivity, all three of our strategic business units have the scale and the capabilities to capture the resultant secular growth. We've created the industry leader in electrical, communications and utility distribution and supply chain services just as these trends are poised to drive secular growth in the markets we serve. Finally, moving to Page 6. We first communicated our three-year cost savings, sales growth, margin improvement and cash generation synergy targets back in March. Since that time, we've been executing a detailed, rigorous and process-oriented plan to integrate WESCO and Anixter. Against the backdrop of a challenging COVID-driven economic cycle, this strategic combination is even more compelling as we have doubled the size of our company and are transforming our new global enterprise. With the benefit of what we have learned since the closing in June and our strong initial execution of our integration plan, we are increasingly confident in our ability to achieve these financial goals, including our updated synergy targets. And most importantly, we're increasingly confident that we'll ultimately deliver the substantial value creation associated with this transformational combination. As I mentioned in my opening remarks, WESCO's new era is off to an exceptional start. As the industry leader, we are now larger and more diverse with differentiated scale and capabilities in what remains a highly fragmented industry. We're evolving into a growth company and are exceptionally well positioned to lead the digital transformation of our business and our industry. With that, I'd now like to turn the call over to Dave for his remarks. Dave?

Thanks, John. Turning to Slide 7. During our second quarter earnings call, we outlined six second half priorities, and we want to provide you with an update on the substantial progress on each of these goals. Starting with sales, demand continued to improve, and we believe we've taken share. Sales in the quarter were down versus prior year due to COVID and up 8% on a pro forma basis from Q2. We maintained our focus on cost management and exceeded expectations. Prior to completing the merger with Anixter, we laid out our expectation to deliver $50 million of COVID-related cost actions. Between Q2 and Q3, we exceeded this target. On a pro forma basis, operating expenses were down $44 million in the third quarter versus the prior year. On gross margin, we discussed the success Anixter had expanding gross margin through a targeted improvement program, and we are deploying it to the legacy WESCO business. Gross margin was up 20 basis points on a pro forma basis, with broad-based improvement across the combined company. We are extremely pleased with the progress made on the integration. As John mentioned, we have already initiated actions to achieve the full year one synergy cost target of $68 million in the first four months of the integration and are increasing our cost synergy target. One of the areas we are most pleased with is cash generation. Free cash flow was extremely strong at $307 million in the quarter, and we reduced net debt by $280 million. Our leverage, including year one synergies, improved to 4.8 turns on an adjusted EBITDA basis. Lastly, we have fully transitioned our reporting structure to our new strategic business units that John walked you through a moment ago. We issued an 8-K yesterday, providing you with the historical WESCO-only results, recast to the new segment reporting structure as well as a pro forma, combining the historical WESCO and Anixter results, including the reconciliation of adjusted EBITDA. Again, we're very pleased with the results in the quarter against a difficult operating environment due to COVID. Moving to Slide 8. We are increasing our three-year cumulative cost synergy target to $250 million. Two drivers to the increase. First, we set internal goals that are higher than we announced publicly, and our teams are delivering. Second, there were specific areas where detailed information and analytics could not be completed until after we closed the transaction. We are finding upside to our initial estimates in all four buckets of synergies and are particularly excited about the incremental synergy opportunities in the areas of supply chain and SG&A, giving us confidence to take up our target. In Q3, we realized $15 million of cost synergies and expect to achieve $100 million in the first year of the merger. We still believe there is additional upside, and we plan to build upon our success to drive additional value capture in the areas of cost, cross-selling and net working capital synergies. I'll also mention that we continue to make progress with the divestiture of the legacy WESCO Canadian Utility and Datacom businesses, which represent less than $150 million in revenue. We engaged an investment bank and are working with potential buyers and are on track to complete the divestitures on a timely basis. Turning to our third quarter results on Page 9. This summary table compares our third quarter results to the WESCO plus Anixter pro forma results for the prior year period and sequentially, against the second quarter of this year. Sales were down 5% versus the prior year and up 8% sequentially. These sales improvements represent substantial growth above peer and indicate we are taking share. October Workday adjusted sales were down just 3% versus prior year. And as John mentioned, our book-to-bill ratio remains above 1.0. Sequentially, October Workday adjusted sales versus September were better than typical seasonality. Adjusted gross margin, which excludes the effect of merger-related fair value adjustments of $28 million, was 19.6%, up 20 basis points versus prior year and sequentially. We are clearly seeing traction from our margin improvement initiatives and are just beginning to deploy Anixter's proven gross margin improvement programs across the business. Adjusted earnings before interest and taxes was $200 million in the quarter. Reported EBIT was adjusted to remove the effect of merger-related cost of $14 million, the merger-related fair value adjustments on inventory of $28 million and a gain on the sale of an operating branch in the U.S. that was unrelated to the integration of $20 million. Regarding the branch sale, we divested a single location that primarily sold Rockwell Allen-Bradley automation equipment in a specific geography. Compared to the prior year, adjusted EBIT margin was up 30 basis points, reflecting the benefits of synergies and cost management actions in response to COVID-related demand declines. On a sequential basis, adjusted EBIT was up 60 basis points. As I mentioned on the prior slide, the legacy WESCO business expected to generate $50 million in total COVID-related cost savings in the last three quarters of the current year. This quarter, we delivered approximately $28 million of these savings. Adjusted EBITDA, which excludes the effects of the adjustments I just mentioned as well as stock-based compensation in both the current and prior year periods and other net adjustments was $252 million, 5% higher than the prior year and 19% higher sequentially. As a percentage of sales, adjusted EBITDA margin was 6.1%, 60 basis points higher than the prior year and sequentially. These exceptional results, reflecting both year-over-year and sequential improvements of both adjusted EBIT and adjusted EBITDA, reflect our continued strong execution, disciplined cost management, market share gains, industry-leading value propositions across all of our business units and the acceleration of our synergy capture. Our leading position and participation in the many secular trends discussed earlier as well as our track record of operational excellence, sets us up exceptionally well to drive substantial value creation. Adjusted diluted EPS for the quarter was $1.66. The full reconciliation of adjusted EPS is included in our press release. Turning to Slide 10. Our EES segment delivered sales that were down 10% versus prior year and up 13% sequentially. The sequential growth reflects construction demand that continues to improve in North America, and which was up double digits in the U.S. and Canada. Our backlog, which primarily reflects construction activity was a third quarter record, consistent with the trend we have observed of project delays due to COVID-19 but not cancellations. We continue to see increasing momentum in our OEM business as well as in many industrial verticals that we serve. It is important to note that oil and gas, which previously represented approximately 7% of WESCO's business prior to the combination with Anixter, is now a low single-digit percentage of the combined company's revenue. Adjusted EBITDA of $108 million was 6.5% of sales, approximately in line with the pro forma prior year results and 70 basis points higher sequentially, which is an excellent result given the lower sales versus the prior year. During the quarter, we were pleased to be awarded multiple contracts to provide switchgear and electrical materials, including lighting for the upgrade of a water treatment facility in Ontario, Canada. Turning to Slide 11. Our CSS segment delivered an exceptional quarter. Sales were down 2% versus prior year against a broader market that was down substantially more and up 10% sequentially. We are clearly taking share in these markets. As with EES, we saw continued positive momentum throughout the quarter. Security sales were up low-single-digits versus a market that was down mid-single digits. Our global accounts activity was up low-single digits, reflecting strong performance with hyperscale data centers, global security and system integrators. Profitability was also strong. Adjusted EBITDA of $121 million was up more than 8% versus prior year, and adjusted EBITDA margin improved 80 basis points above the prior year. In the second quarter, we were pleased to be awarded a multimillion-dollar contract to provide a comprehensive solution of products and material management services for the construction of two data centers in Mexico. Turning to Slide 12. Sales in our UBS segment were flat sequentially and down 2% versus the prior year. This result reflects strong growth from broadband sales, offset by weakness in the industrial-focused areas of our integrated supply business. Broadband sales were up mid-single digits versus the prior year and high-single digits sequentially, driven by continued 5G build-outs and fiber-to-the-x deployments. Utility sales were flat on a pro forma basis compared to the prior year. Storm response activity contributed to this growth as there were a number of hurricanes and tropical storms that made landfall in the U.S., especially in September. Adjusted EBITDA of $86 million was up more than 11% versus prior year on a pro forma basis and represented 7.8% of sales, 100 basis points above prior year and 30 basis points above Q2. As an example of our recent success, we were awarded a multiyear contract to provide electrical transmission and distribution materials and inventory management services for a public utility. Moving to free cash flow and liquidity on Slide 13. This quarter, WESCO generated $307 million of free cash flow or 315% of adjusted net income. This exceptional result highlights our countercyclical cash flow generation, which is one of the many reasons we are highly confident in our ability to reduce leverage throughout all phases of the economic cycle. Year-to-date, the Company has generated $462 million of free cash flow or 292% of adjusted net income. Our capital allocation priority remains unchanged. We will allocate capital to support the integration and invest in our business. Our priority is to rapidly delever the balance sheet and be within our long-term target leverage range of two to 3.5 times net debt-to-EBITDA by the end of year three in June, 2023. We made substantial progress on this goal in the quarter as we reduced net debt by $280 million. Our leverage ratio, including the revised target of year one synergies was 4.8 turns, about half a turn below the comparable metrics in Q2 of 5.3 turns. Our liquidity, which is comprised of invested cash and borrowing availability in our bank credit facilities is exceptionally strong and totaled approximately $1.1 billion at the end of the third quarter. A reminder that we will remit the first cash interest payment on the 2025 and 2028 senior notes, and expect to pay the quarterly dividend on the preferred stock in December. Exceptional free cash flow throughout the economic cycle remains a hallmark for WESCO. That, along with strong liquidity supports our future growth. Moving to Slide 14. Before opening the call to your questions, I'd like to just walk you through a quick summary. We've also provided additional information about the business units and the slide that answers some FAQs regarding the upcoming quarter. This quarter was clearly an exceptional result on all fronts for WESCO against a COVID-driven economic backdrop. We increased margin across the board despite the challenge of COVID-driven low sales. This was driven in part by decisive actions to reduce costs given the uncertainty of demand. We see core demand continuing to improve across our businesses, noting that we typically see a seasonal effect to Q4 sales and have three fewer workdays sequentially in the current quarter. We restored salaries and benefits effective October 1, and we are incredibly proud of how our team has responded to the crisis and has continued to service our customers. In just four months since closing the transaction, we have initiated actions to meet the initial full year one cost synergies. We have increased our year one target from $68 million to $100 million and are increasing our total cost synergy target from $200 million to $250 million. In addition to the substantial cost synergies, we are already generating revenue synergies from our cross-sell pilot program. As a result of this excellent position and continued integration of Anixter, we expect to exceed our value creation targets of sales growth, margin expansion and cash generation. Our free cash flow was also exceptional, demonstrating our resilient business model and cash generation ability throughout the cycle. Each of the new strategic business units that we reported on today are extremely well positioned to capitalize on several continued and emerging secular growth trends. And with that, we look forward to taking your questions.

Operator Instructions: The first question comes from Deane Dray of RBC Capital Markets. Please go ahead.

I really like the new segmentation and all these disclosures in the slide deck. I mean, it's very helpful to see the continuity, like on Page 4, where you show legacy WESCO combined with legacy Anixter. So it's a big help to us. And if we start, I think the surprise for me is how much we're seeing share gains in the quarter right out of the blocks. So, you referenced it in the communication and security as well as utility segment. So, if we could just start there and frame for us, any specifics around the share gains, but is it coming in the combined go-to-market? Are there new products? And if we can start there, please.

Yes. Well, thanks for that. Yes. I would say that it's, we're seeing the results of really two things. And I referred to both of these at the last quarterly call. Remember, we closed on June 22. So we really couldn't get a look at all the details of the portfolio. And so, one major and meaningful positive surprise that we obviously became aware of post-close was the complementary nature of the portfolio. So, I'll come back to that in a minute. Yes, we thought we competed in the market, and we did, predominantly in utility. But even in utility, these are highly complementary portfolios, when you look at the array of services that each company has. Secondly, it's the cultural match which I find would be also just a major new learning or surprise and just this relentless focus on the customer and delivering value. But to specifically get at your point, I think the team has come together exceptionally well. There's a spring in our step. We're very focused externally on the customer and taking this new broader and stronger portfolio of products and services to market. And we did, once we stood up the new organization, we've launched a series of cross-sell pilots. And we'll report on these as we move forward. It's always, it typically proves to be the most elusive synergy to get when companies come together. But, we're really excited and encouraged by the initial results. And so, we launched a series of cross-sell pilots in each of the three businesses. So specifically in EES, we're taking our lighting capabilities, turnkey retrofit renovation and upgrade and applying those capabilities to Anixter's customer base. And we're taking the tremendous depth, breadth and strength that Anixter has in wire and cable, which is where their deep roots are, and bringing that to the WESCO customer base. And as I mentioned in my prepared remarks, we have the complete electrical package now we can bring to customers. So thrilled about that. In CSS, we're leveraging that global footprint and bringing additional categories to those customers in terms of AV and safety. And fundamentally, what we're realizing, this is even without the new secular trends that have been accelerating due to COVID: 5G, rural broadband build out, data center growth, in-building wireless, we're just seeing really strong growth in the end markets and customer applications. And now, we have the most comprehensive and leading portfolio of products and services to bring to bear on those applications. And finally, for Utility and Broadband, we've got two very strong leading companies coming together. And so I think, in conjunction with our supplier partners, we're able to offer even more value now. The real key insight was the array of services that we have as part of the overall solution offering is broader than we fully appreciated pre-close. So, hopefully that gives you some color, Deane.

It really does. And, just to clarify on that last point because it was really interesting, you didn't highlight the services that are part of the sales offering in the combined entity. And I know that was important to WESCO before. Do you have a data point on how much services are attached to the revenues? I remember you were saying before, it was like 70% or in that neighborhood before. What does it look like as a combined company?

Yeah. What I'd like to do, Deane, is not answer that yet because I think as we build out these businesses, we are planning on some additional teach-ins at Investor Day in 2021. And, I think the best way to get to that is as opposed to one aggregated number, we'll give you kind of insight business by business and what exactly those services are. And I would say that Anixter also had very similar to WESCO, just a tremendous service value proposition and some specific service offerings that were at the heart of their end-user relationships. So, at that level, being to give you some answer to the question, very similar. But I think the entire portfolio is much more valuable as a result of the two coming together, and this will increasingly become one of our key value drivers going forward.

Great. And then separate question for Dave. It is an offering we see over 300% free cash flow conversion, especially in a quarter where 100% was considered to be good. Can you take us through the dynamics in that high cash conversion? Are there any one-timers? Is there anything tax payment related? So just trying to get a sense of what the run-rate should be. Thanks.

Yes, Deane. Good morning. Probably the one thing to keep in mind is in our free cash flow statement. We do have accruals in our income statement for the expected interest payments that we'll be making here in the fourth quarter. So that's the one thing to keep in mind is we do have those interest payments that will be coming out. So that's in that other line on the free cash flow statement that's in our press release.

Terrific. And you have room to increase the free cash flow target? I know we increased the cost synergy target, but what's your sense on free cash flow target on three years?

Yeah. We've already gone out, and we've talked about there being $75 million of net working capital improvement through the integration of the companies. And as I mentioned during our prepared remarks, we are working on upside to that. And that's one of the things that we're most pleased with is as we brought the companies together, there's—as John mentioned—a very, very strong cultural alignment when it comes to bringing the Company together from a customer perspective, but also how we think about working capital. And we do believe that there is going to be substantial upside across all three elements of our synergies, including net working capital going forward.

Great. Thank you and congrats to everyone.

Thanks, Deane.

The next question comes from Sam Darkatsh of Raymond James. Please go ahead.

I had two observations following the disclosures of your new segment reporting yesterday, if we could score them a little bit. The first one had to do with corporate overhead. Anixter, roughly the same size as WESCO, but had, and I'm looking specifically in 2019, had nearly twice the overhead, why, and it's kind of a big number, $80 million to $100 million or something higher. Why is that? And, I'm wondering if your overhead synergies should be considerably higher than the $35 million to $40 million that you've highlighted based on just simply rightsizing the overhead between the companies?

Well, thank you for that question, Sam. I love your question. Look, two comments. One is, yes, there's opportunity. Two, if you get underneath the covers and look at the composition of that, there were some functions that were more centralized, Sam, than distributed into the businesses. So the answer is, you should take both of those into account. There were certain corporate-level or administrative processes that they had centralized and within that corporate cost bucket but your insights are right. We saw that as an opportunity for synergies as we worked the financial commitments to the model well in advance of closing and we're beginning to realize those synergies already. I mean, I think we're absolutely thrilled, thrilled is the word with the integration. The progress we've made with the integration teams on synergies, why we've raised the $200 million to $250 million. But, we also took the year one from $68 million to $100 million. So, and as Dave mentioned, that's in the G&A area as well for our supply chain is where we've got some really strong momentum. With that said, we have increased confidence that we'll be able to deliver upside against these new higher targets. And we are still running to, which I mentioned before, substantially higher targets internally. So the teams right now, the numerous integration teams that are executing have targets that are well above our new revised external targets.

Second question, the other observation I had. I mean, obviously, John, you've mentioned repeatedly that higher scale means higher margins. And I think that's really intuitive for a distribution business. What else was interesting to me though is Anixter's EES business, clearly subscale versus you folks. It's like half the size. You folks, WESCO, half the size and yet it consistently had one point or two higher margin than legacy WESCO. Wondering why that is. I'm guessing some of that's wire and cable product mix, but I'm wondering if there's also some branch or labor productivity in there. I'm just curious as to how Anixter could consistently get higher margins with a much smaller business and if there's any either learnings or takeaways as to how to capture that more holistically.

The way you frame the question, you actually have the answer. So, they're absolutely undisputed leader in wire and cable. If you go back and look at Anixter's deep roots: wire and cable, connectivity solutions. This is pre-fiber. Then they pivoted into fiber organically and have built out that business globally organically, and now have the preeminent leadership position in communications and security. But in that category, wire and cable and all that that means, they are the industry leader with size, scope and scale that garners higher margins, and that gives us the complete electrical package. The balance of their electrical business, Sam, is what they picked up through the HD Supply Power Solutions acquisition. And so, the other categories that I'll call the more complete electrical package were more regionally focused. The legacy HD Supply Power Solutions business was more concentrated in certain geographies. They did not have broader-based electrical capabilities across all regions. So, your insights are right. It's really wrapped around that category. And the value-added capability around wire, cable and connectivity solutions and the services delivers tremendous value to customers, and that shows up in margins. On a combined basis, the important point is this was a competitive gap in WESCO's broad-based electrical offering. We had strength in wire and cable in some local geographies, but we didn't have the size, scope or scale across the U.S., Canada, and internationally. That's what Anixter gives us. So, that is the leverage point for the EES business. It's something I've always wanted, and now we've got it. On a combined basis, we've got the complete package.

And if I could sneak one more in real quick, Dave, not to forget about you. Can you help us on a pro forma basis in the fourth quarter as to how we should think about incremental, decremental margins?

Yes, Sam, that's something that we're not going to get into too much detail on. I mean, we're not providing any guidance for the fourth quarter. One of the things that I would point you back toward is prior to the acquisition with Anixter, during our first quarter call, we had targeted on a WESCO-only basis that our Q2 through Q4 decremental margins would be in the range of 10%. And I would just highlight that we indicated back during our Q2 call that we were well within that range. We are within that range again here in the third quarter, but we're not providing any specifics for the fourth quarter. We're really focused on driving value for the shareholder on a combined company basis now.

The next question comes from David Manthey of Baird. Please go ahead.

So I'm hoping to understand the key factors behind the very strong gross margin. And if the mid '19s is sustainable from here? Was the majority of the $15 million you achieved in synergies related to supply chain? That is the first question.

No. The majority of what we're seeing in that $15 million is really related more to the SG&A. Just given some of the changes that we've made to the organization, plus duplicative corporate overhead costs. So, we've not really seen the full benefit of our supply chain initiated actions here in the third quarter.

I would say the supply chain benefits, we are in the very early days in terms of realization, David. But based on the work we've done, that was a factor that gave us increased confidence on why we raised the $68 million to $100 million and the $200 million to $250 million.

Okay. Makes sense. And just construction. I know it's a smaller percentage of your business today, but it's just surprising to me that you're seeing growth when no one else in the world seems to be seeing growth. Maybe you could give us some examples, maybe it's mix that's driving that. Could you give us some examples of particular construction verticals you're seeing growth in?

Yes. Let me address that. First, at the aggregate level, the backlog is a record exiting the third quarter, and we came through October, the momentum is improving overall for the business, and our book-to-bill stayed above one as we exited October and entered November. So we had sequential improvement from Q2 to Q3 that was notable. Construction was up double digits sequentially in both U.S. and Canada, Q2 to Q3. That's above normal seasonality. Typically, as we move into Q4 and the winter season, we start tailing off. We saw pretty good momentum across all our construction branches and focused businesses. From a product category standpoint, we had growth in distribution equipment, growth in wire and cable, growth in motor and controls, sequential growth in lighting, and sequential growth in solar. Non-residential construction at the aggregate level is still challenged, but it's a very large market and some verticals are more challenged than others. Our current momentum vector is encouraging. We haven't seen any meaningful cancellations of projects, only some projects that slipped earlier in the year. Net-net, sequential sales growth and backlog holding up nicely, it's a good position to be in given the broader market backdrop.

The next question comes from Christopher Glynn of Oppenheimer. Please go ahead.

Yes, thanks. Good morning. Congrats on the fast start, especially the cash statement on getting delevered under way.

Thanks, Chris.

Had a question on the ranges of investment you're contemplating for the digital B2B value chain initiatives. Is that included in the $140 million cost to execute? And also, how you're thinking about guardrails around complexity, potential disruption of IT transitions?

Yes. There's a couple of questions there. As we go back to the integration update page in the deck, we show cost synergies and we also show one-time operating costs to deliver the higher synergies. That's an important item. On digital and IT, we have a dedicated IT/digital team comprised of WESCO and Anixter talent as part of our integration office. In addition, we have a separate dedicated consulting partner beyond the overall integration partner to help on this effort. We're looking at all current systems, identifying how to best leverage digital applications and our combined big data to create competitive advantage. We're completing the assessment of systems and digital investments. You may recall we originally outlined approximately $120 million per year in capital expenditures for the first three years post-close. Our base capital run rate was around $90 million. We had built in incremental capital in the original financial targets. We believe everything we expect to do can fit within our current financial parameters. As an initial proof point, we have two digital use cases under way; we're not describing them here but will in future investor communications. We have agile development under way leveraging our combined data in a data lake to support these use cases. I'm thrilled with initial progress and expect interesting results as we move through Q4 and into early Q1. Near to midterm, this is an integration execution story focused on cost synergies, cross-selling and cash generation. In the mid to long term, it's a digital transformation story, and we've already begun standing up initiatives.

Yes. No, thanks. That's great. I was asking all of that. And a follow-up, as you're driving cost synergies and managing sales synergy strategies, wonder if you've seen any pockets of issues around key retention or workforce with the integration environment? Or any kind of fallout around those types of issues?

No. We've had no issues. I'm absolutely thrilled with the cultural combination and the extra effort being applied to customer focus. We've come together terrifically. You'll recall in our initial targets we had assumed some revenue dissynergies; we have not seen any revenue dissynergies to date. So far, we're exceeding expectations in both workforce retention and minimal disruption.

The next question comes from Chris Dankert of Longbow Research. Please go ahead.

Hey. Good morning, everyone. And again, congrats on a really great quarter here. Can't help but notice with the increased synergy targets, only $10 million more coming from field operations. Is that more a function of, Hey, we just have so much opportunity elsewhere, let's focus on those areas? Or are you just being conservative on the field operations saves? Any commentary on that mix would be great.

One of the things I'd highlight is that as we started to come together, particularly in year one, we anticipated that the majority of the synergies in the first year would come from SG&A and corporate overhead. We planned to work on supply chain and field operations initiatives as we obtain more information and transform the Company. We're actively working synergies in those areas. We have gotten additional synergies in supply chain based on what we've been able to identify, particularly in indirect procurement. Most of what we're seeing in year one is related more to G&A and corporate overhead.

Got it. And on the gross margin improvement front, that cross-pollination of best practices, is there a way to size how much of that knowledge has been disseminated? How long will it take to get those best practices out into the field? Any timetable there would be great.

We're in the process of implementing that now. It will be organic over a few quarters. Legacy Anixter had eight consecutive quarters of gross margin expansion—three years of a comprehensive gross margin improvement program—and we're deploying that enterprise-wide. That has not fully impacted all parts of legacy WESCO yet. I would expect it to be a contributor going forward; it could start as early as Q4 incrementally, but clearly will be a 2021 driver.

Got it. Thanks so much for the color. And John, congrats again.

Thank you.

The next question comes from Nigel Coe of Wolfe Research. Please go ahead.

Hi, John. Good morning. This is Cristian Ramos filling in for Nigel. A lot of ground's been covered, but I really wanted to touch on cost synergies given your excitement for continued cost synergies. Two questions. First, could you maybe size or talk about what the pipeline potential of cost synergies is? I know you raised it to $250 million total, but really interested in hearing what the pipeline sounds like. And then secondly, I think you've spoken about sales synergies in the realm of 100 basis points. And again, it sounds like you're pretty confident about how you could accelerate that. Can you just also touch on that as well?

So we're not going to size the pipeline. We have internal targets that are substantially higher than the public numbers; those targets have been worked in great detail and are scheduled and the teams are executing to them. We went from $200 million to $250 million publicly, but our internal targets are substantially above $250 million. One of the biggest pleasant surprises is the top line. We had high confidence in delivering cost synergies and some margin improvement; what was a surprise was the top-line strength and initial success in cross-selling. We have high confidence across all four buckets—cost, margin expansion, sales growth, and free cash flow—and our confidence increased through the quarter that we'll overdeliver our three-year targets.

That's very helpful, John. And if I could follow up, can you comment on the cadence of demand throughout the quarter? It seems like the back half of September was really strong. Any incremental color there would be helpful. Thanks.

We finished the quarter strong, and that momentum has continued into October as I mentioned earlier. We have a positive momentum vector in bookings, pipeline, book-to-bill above one and sales. We had a strong close in September.

Right. We also had indicated when we were through the quarter that we had talked about being down year-over-year about 8%, and we did get the benefit of an extra workday. But as John mentioned, we also finished strong. A lot of that goes back to when we combined with Anixter, both companies had been working on how to grow share, and we saw that beginning to take place here as we brought the companies together in the third quarter. We had a strong close in September.

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

Well, thank you all for your time this morning. Brian and Will are available to take your questions. I know we have a number of follow-up sessions scheduled already, and we look forward to being able to spend some additional time with you at our upcoming investor events. That includes the Baird Industrial Conference next week and the Stephens investor conference later this month. Thanks again. In the meantime, please stay safe and healthy. Have a great day.

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