Earnings Call Transcript - WCC Q3 2022

Operator, Operator

Hello, and welcome to WESCO's Q3 2022 Earnings Call. Please note that today's event is being recorded. I would now like to hand the call over to Scott Gaffner, SVP, Investor Relations, to begin.

Scott Gaffner, SVP, Investor Relations

Thank you, and good morning, everyone. Before we get started, I want to remind you that certain statements made on this call contain forward-looking information. Forward-looking information statements are not guarantees of performance and, by their nature, are subject to inherent uncertainties. Actual results may differ materially. Please see our webcast slides, as well as the company's SEC filings for additional risk factors and disclosures. Any forward-looking information we made on this call speaks only as of this date, and the company undertakes no obligation to update the information to reflect the changed circumstances. Additionally, today we will use certain non-GAAP financial measures. Required information about these non-GAAP measures is available on our webcast slide and in our press release, both of which are posted on our website at wesco.com. On the call this morning, we have John Engel, WESCO's Chairman, President and Chief Executive Officer; and Dave Schulz, Executive Vice President and Chief Financial Officer. And now, I'll turn the call over to John.

John Engel, CEO

Well, thank you, Scott, and good morning, everyone. It's a pleasure to be with you today. As you saw from our earnings release earlier this morning, we delivered another quarter of outstanding results, further demonstrating the substantial value-creation capability of the new WESCO. We once again set company records for margin, profitability, and backlog and further reduced our leverage ratio in the third quarter. The power of our increased scale, expanded portfolio, and industry-leading positions is clearly evident in our continued strong performance. Strong demand and operational improvements are driving the record-setting performance across our company. Each of our three strategic business units again delivered strong sales and profit growth in the quarter, driven by the breakthrough results of our enterprise-wide cross-selling and gross margin improvement programs. Overall, we delivered organic sales growth of 17%, record profitability of 8.6% adjusted EBITDA margin, and record adjusted EPS of $4.49, up 64% versus the prior year. You will recall that we substantially raised our outlook for the year following our results in each of the first and second quarters. Our outstanding results in the third quarter and the continued strong execution across our business support the full-year outlook for 2022 that we previously provided. We are maintaining our organic sales growth targets, but adjusting our reported sales range with the change entirely driven by the foreign exchange rates, thus reflecting the unprecedented strength of the U.S. dollar throughout 2022. At the same time, we're increasing our outlook for EBITDA margin and narrowing our range for EPS. Our increased profitability continues to fuel our investment in advanced digital capabilities that will transform our relationship with both our customers and our supplier partners. The recent acquisition of Rahi Systems announced earlier this week underscores our strategy to maximize our exposure to these attractive secular growth trends. Our profitable execution against these sustainable trends and our investment in WESCO's digital transformation support a virtuous cycle, which is expected to result in an even higher level of performance, operating efficiency, and customer loyalty. Before I hand it off to Dave, I plan to address our transformational results versus pre-pandemic levels and our uniquely strong position to capitalize on the secular trends that we talked about in our end markets and that we presented at our recent Investor Day. So let's turn to page five. The demonstrated strength of our business model and the success of our integration efforts over the last nine quarters have established a track record of superior results for our company. The strength of the new WESCO is best measured by the value we have created since the merger closed in June 2020. This page highlights our record year-to-date 2022 results, as compared to our pro forma pre-pandemic results for the comparable period in 2019. As you can clearly see, we have outperformed the market, delivering impressive sales growth and margin expansion and achieving record profitability, all while rapidly deleveraging our balance sheet. Our resilient and critical supply chain solutions, combined with our exposure to the sustainable secular trends, will drive our future sales and profitability. As we recently conveyed during our Investor Day, we're excited because there's still substantial value embedded in a transformational combination of WESCO and Anixter. We look forward with great confidence to a future of sustained growth and market outperformance. Now let's move to page six. Providing our global customers with end-to-end solutions, and that includes the products and supply chain services that make our customers more efficient and more effective, is what drives us each and every day. We are executing at a very high level, and we are exceptionally well positioned to capitalize on the strong secular growth trends and increasing investments in public sector infrastructure outlined on this page. These long-term trends are driving secular growth in each of our three strategic business units and across our entire global enterprise. I'm pleased to report that we raised our cumulative sales synergy target again this quarter and now it stands at $1.4 billion. Our positive cross-selling momentum is fueling our market outperformance and growth. As I've said before, the new WESCO is transforming into a growth company. We have a record backlog, an expanding cross-sell program, a growing opportunity pipeline, and positive momentum overall, but we are only in the early stages of unlocking our total growth potential. Now moving to page seven. The acquisition of Rahi Systems closed earlier this week highlights our continued investment in the high-growth data center segment and further expands cross-sell opportunities across our company. Rahi is a leading global hyperscale data center solutions provider with over 900 employees in 25 countries, and a trailing 12-month sales of approximately $400 million. Rahi will be integrated within our CSS business and will provide complementary global coverage and significantly enhance our full suite of data center solutions for contractors, integrators, and end-user customers.

Dave Schulz, CFO

Thanks, John, and good morning, everyone. I'll start with a summary of our third quarter results compared to the prior year. As John mentioned, sales reached a record for the third quarter, and our cross-sell exceeded expectations. Our ability to cross-sell WESCO and Anixter products and services contributed $237 million in sales this quarter. On an organic basis, sales increased by 17%, driven by strong prices, volume, and market share gains primarily due to our cross-sell initiatives. We estimate pricing added about eight points to sales growth, consistent with the previous two quarters, mainly benefiting our EES and UBS businesses. On a reported basis, sales rose by 15%, with foreign exchange rates posing a 170 basis point headwind this quarter. Supply chain challenges have continued to affect some areas of our business, with product availability reducing sales by around 1% to 2%, similar to the first and second quarters. We are strategically investing in inventory to address these issues and support future sales growth opportunities, with backlog reaching a record level this quarter, up 5% sequentially from June and over 60% from the previous year. Every business unit saw backlog increases of more than 40%. We have not encountered any project cancellations in the backlog, though some projects are delayed due to current supply chain constraints, similar to the first half of the year. As we enter the fourth quarter, demand remains strong. Preliminary October results are promising, with sales up about 12% year-over-year, including the impact of a stronger dollar, which may negatively affect fourth quarter sales by about 3%. Our gross margin reached an all-time high of 22.1% in the quarter, up 80 basis points compared to the previous year and up 40 basis points sequentially, driven by our gross margin improvement program, supplier price increases, and the absence of a COVID-related PPE inventory write-down from the prior year. Adjusted EBITDA, excluding merger-related costs and other adjustments, was 41% higher than the prior year, representing 8.6% of sales, which is 50 basis points above the record set in the second quarter and 160 basis points higher than last year. This improvement was fueled by increased gross margin, the benefits of higher sales scale, and realized cost synergies from our merger with Anixter. I'll outline the main drivers of this improvement shortly. Adjusted diluted EPS for the quarter reached $4.49, an all-time record, and up 64% from the previous year. Core operations contributed $1.92 to this increase, although foreign exchange rates, interest expense, and a higher share count collectively reduced adjusted diluted EPS by $0.17. The adjusted effective tax rate was higher than our fiscal year outlook due to reduced benefits from intercompany financing and discrete tax items. Moving on, organic sales in our EES segment increased by 15% year-over-year, reflecting strong construction sales due to the ongoing recovery in the non-residential market. We also saw good momentum in our industrial and OEM businesses, bolstered by widespread market demand. Bidding activity contributed to further increases in our EES backlog, which remains at record levels. Our cross-sell initiatives continue to make progress, capturing demand influenced by the secular growth trends discussed earlier. Adjusted EBITDA for EES was $226 million, a record for the third quarter, and up 30% year-over-year, with an adjusted EBITDA margin of 10.1%, reflecting effective price cost management, strong cost synergy realization, and operating cost leverage. In our CSS segment, organic sales increased by 10% compared to last year, with significant growth in network infrastructure and security solutions driven by security integrators, cloud applications, and data center projects. While we are pleased with these results, CSS sales growth did not match that of EES and UBS, primarily due to ongoing supply chain constraints. Pricing in CSS provided a low single-digit benefit year-over-year but improved sequentially. Profitability remained strong, with adjusted EBITDA at 9.8% of sales, up 80 basis points from last year. In our UBS segment, organic sales were exceptionally strong, rising 29% compared to the previous year. Utility demand has stayed robust as both investor-owned utilities and public power customers continue to invest in grid modernization and green energy initiatives. Sales growth in our Broadband business was also strong, driven by continued demand for data services and high-speed connectivity. Adjusted EBITDA for UBS increased by 62%, with the adjusted EBITDA margin expanding by 250 basis points to 11.6% of sales, driven by sales scale benefits and gross margin expansion. The cross-sell opportunity between WESCO and Anixter continues to exceed our expectations, with $237 million in cross-sell revenue recognized this quarter — our largest to date. Our sales opportunities pipeline is expanding, and our cross-sell initiatives are yielding results. We are leveraging the complementary nature of our product and service portfolios, with minimal overlap between WESCO and Anixter customers. As a result, we have increased our cumulative cross-sell target to $1.4 billion by the end of 2023, having generated $966 million towards that goal so far. Due to ongoing progress, we have slightly raised our 2022 target for cost synergies from $265 million to $270 million, remaining on track to achieve the expected target of $315 million by the end of 2023. Cumulative run rate cost synergies reached $188 million through 2021. Turning to our free cash flow, through September 30th, we reported a source of cash of $139 million mainly from depreciation and amortization, interest, and income taxes. Year-to-date, working capital has seen a $1.1 billion cash outflow, driven by increases in receivables and inventory. This investment in inventory aims to maintain service levels and supply continuity for our customers, supported by a record backlog. The increased capital expenditures reflect our ongoing digital transformation and supply chain network optimization strategy. In the third quarter, we reduced leverage by 0.2 times trailing 12-month adjusted EBITDA, bringing our leverage ratio down to 3.2 times, a decrease of 2.5 turns since closing the Anixter acquisition. We are within our target range of 2 to 3.5 times, demonstrating a faster pace of deleveraging than initially anticipated. Our full-year outlook is being updated based on this quarter's results. While we maintain our expectation for organic sales growth, we are adjusting the reported sales growth outlook to a range of 15% to 17% to account for a more significant foreign exchange headwind, now expected to negatively impact revenue by 2%. Market growth is still anticipated at 12% to 14%, with an 8-point price benefit. We expect strong demand for our products and services but acknowledge potential uncertainties due to supply chain constraints and inflation rates in the fourth quarter. Looking at our business units, we predict UBS will exceed our sales range, EES will perform within the range, and CSS may fall below the lower end due to price benefits being limited and supply chain disruptions affecting sales. This outlook also accounts for a contract with a utility customer transitioning from a full revenue model to a service fee model, which will reduce sales by approximately 0.5 points without affecting EBITDA. We expect the acquisition of Rahi Systems to contribute $65 million to $80 million in sales in the last two months of the year, and we are increasing the midpoint of our adjusted EBITDA margin outlook to 7.9% to 8% of sales, influenced by our gross margin improvement program. Our adjusted EBITDA forecast remains unchanged at $1.68 billion at the midpoint of sales and EBITDA margin. We are maintaining our adjusted EPS outlook range of $15.80 to $16.20, reflecting growth of approximately 58% to 62% from the previous year. We are adjusting our free cash flow expectations to around 10% of adjusted net income due to increases in accounts receivable and inventory. Fourth quarter sales may be lower sequentially, which would free up net working capital and generate positive free cash flow, although the long-term cash flow conversion capabilities remain intact. Our short-term compensation structure reflects an above-target payout, and we expect combined capital expenditures and IT digital investments to total approximately $130 million this year. In the fourth quarter, preliminary October sales saw a 12% increase compared to a challenging comparison to October 2021. With that, let's open the call to your questions.

Operator, Operator

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

Deane Dray, Analyst

Thank you. Good morning, everyone.

John Engel, CEO

Good morning, Deane.

Deane Dray, Analyst

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

John Engel, CEO

Yes. I would characterize it as the beat goes on, Deane. Seeing the strongest growth from UBS, but all three businesses grew. And we're very pleased with the momentum we have. The backlog growth that we had that is 5% at the end of Q3 sequentially versus the end of Q2 is another exceptional, much better than the historical seasonality growth. And we continued in October with a book-to-bill ratio above 1.0, which is also not typical. Because typically, we eat into the backlog, I think as you know, as we go through the fourth quarter. So there is a bit of color. Bottom line is the beat goes on. The demand environment, what I would tell you, that it's really the opportunities that are coming to us and that we're also generating that are captured in an expanding opportunity sales pipeline, of which the cross-sell execution and momentum, again, just continues to increase. And I couldn't be more pleased with that.

Deane Dray, Analyst

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

Dave Schulz, CFO

Yes, Deane. We have shown through various cycles that we can consistently generate over 100% of free cash flow on average. We are confident that our model remains effective, as indicated by our expectations for cash flow generation in the fourth quarter. If you review our projections for the year, you will notice a sequential decrease in sales. This will free up working capital and lead to significant free cash flow in the fourth quarter based on our current demand expectations. We are comfortable that our free cash flow model is solid. Of course, during periods of strong sales growth, particularly throughout 2022, we have invested in net working capital. As sales growth levels out toward our long-term growth expectations, we anticipate that we will continue to achieve that 100% free cash flow. Regarding capital allocation, our approach remains unchanged. We are consistently focused on reducing our leverage. Additionally, we have started to invest again in some of the long-term growth trends, as demonstrated by our recent acquisition of Rahi.

John Engel, CEO

The only addition I would make, Dave, thanks for that, Deane, is that during our recent Investor Day, which was our first since merging WESCO and Anixter, we shared some important updates regarding our long-term investor outlook. In terms of cash generation, we have significantly increased our expectations for the new WESCO to between $3.5 billion and $4.5 billion over the next five years. This supports our $1 billion buyback program and the common dividend we plan to initiate in early 2023. We have strong confidence in our cash generation capabilities. By the end of this year, looking back, we noted exceptional growth in backlog as a result of winning new business and good conversion into sales. We made a deliberate choice to support backlog growth with investments in inventory. The growth in inventory and accounts receivable this year has been substantial. The quality of our inventory and accounts receivable remains consistent with our long-term standards, which are high-quality. Those receivables will be collected, and the inventory will convert to sales backed by orders in our order book and a strong backlog. Consequently, this will convert to cash, giving us strong confidence in the inherently stronger cash flow characteristics of the combined company.

Deane Dray, Analyst

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

Dave Schulz, CFO

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

John Engel, CEO

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

Deane Dray, Analyst

Thank you.

Operator, Operator

The next question comes from David Manthey with Baird.

David Manthey, Analyst

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

John Engel, CEO

Thank you for the question, Dave. Regarding pricing, I can share insights from the quarter and our current perspective. I expect that as we progress through this quarter, we'll gain a clearer understanding of 2023 pricing for our suppliers. Currently, the pricing trends are consistent with what we've seen in the last two quarters, Q2 and Q3 of 2022. This continuity also applies to 2024. Looking into 2023, especially the early part, we're likely to have a better sense of pricing after the next four to six weeks, as our suppliers are actively working on this, which may result in some minor adjustments. The key takeaway is that the average price increase is stabilizing in Q4 compared to Q3 and Q2, and it seems this trend will continue into 2023. While the number of price increases for individual SKUs is lower in Q4 than in Q3 or Q2, this is expected.

David Manthey, Analyst

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

John Engel, CEO

Price level, Dave.

David Manthey, Analyst

Yes.

John Engel, CEO

Yes, that will source.

David Manthey, Analyst

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

Dave Schulz, CFO

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

David Manthey, Analyst

Great. Thanks, Dave. Thanks, John.

John Engel, CEO

Thanks, Dave.

Operator, Operator

The next question comes from Sam Darkatsh with Raymond James.

Sam Darkatsh, Analyst

Good morning, John, Dave. How are you?

John Engel, CEO

Good morning.

Dave Schulz, CFO

Good morning.

Sam Darkatsh, Analyst

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

John Engel, CEO

Sam, I’ll respond this way since we haven’t provided guidance for 2023. When we do, it won’t be at the gross margin line; instead, we will provide guidance for the EBITDA margin, sales, EPS, and cash flow. That said, we believe we have strong momentum in our enterprise-wide gross margin improvement program. There’s no doubt that the inflationary environment has impacted everyone across the value chain. However, we are intensely focused on promoting the value of our comprehensive supply chain solutions. The margin improvement program we implemented is delivering significant benefits and is designed to motivate everyone on the front end of our business, including all our account managers and sales representatives, to increase margins both sequentially and year-over-year, and we are incentivizing them accordingly. Anixter had a similar program before the merger with WESCO, which yielded positive results, and we revised and expanded it enterprise-wide after the close. We believe there is still ample opportunity for our gross margin improvement program. While we don’t have control over the external market, I have consistently stated my perspective on this; I believe we are in an inflationary cycle that will persist into 2023. Despite this backdrop, we are concentrating on what we can manage, and we are confident in our gross margin program, which is comprehensive, and we will continue to push it forward.

Sam Darkatsh, Analyst

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

John Engel, CEO

We do not see it as a leading indicator. We remain very optimistic about the short, mid, and long-term growth prospects of the CSS business due to the ongoing trends affecting it. The backlog is at an exceptionally high level. So, when you compare it quarter-to-quarter, if it remains flat, that is not unusual when looking at the historical seasonality over many years. We feel confident about the momentum in CSS. Dave mentioned that we’re experiencing improved price pass-through, which indicates a positive trend as we look at our supplier partners. Additionally, we are seeing a strong year-over-year growth rate in CSS compared to Q1 and Q2, which is encouraging. Furthermore, our acquisition of Rahi Systems underscores our commitment to these growth trends and is expected to enhance our CSS portfolio significantly. We anticipate considerable cross-sell opportunities globally with our data center customers.

Sam Darkatsh, Analyst

To summarize, EES is still the most economically sensitive business despite some enduring trends. Therefore, examining the backlog trends will provide insight into how the macroeconomic environment may impact us in the future.

John Engel, CEO

The UBS business has fundamentally changed compared to five or ten years ago, particularly regarding the characteristics of the end market and the entire value chain. Utilities have transitioned from being primarily GDP-led businesses over the decades to being seen as a secular growth industry. Likewise, the broadband segment is now experiencing strong secular growth trends. Our commentary and results reflect this significant shift, and we are very optimistic about this momentum. Regarding EES, we are also seeing excellent results. This segment encompasses various businesses, including good exposure to industrial end markets for maintenance, repair, and operations supplies, as well as projects driven by industrial capital and OEM solutions. Additionally, we have some construction exposure here, but it's important to note that we have minimal involvement in residential construction on a first derivative basis; our focus is primarily on non-residential projects. To succinctly address your question, EES provides insights into the construction-driven segment of our business, reflecting both the construction and industrial cycles. Currently, there is robust demand for both these segments, and we anticipate a considerable increase in demand due to the deals that have passed through Congress, which we have yet to see reflected in our results. Looking ahead to 2023, 2024, 2025, and beyond, this will significantly benefit EES, UBS, and CSS as well.

Sam Darkatsh, Analyst

Very helpful. Thank you both.

Operator, Operator

Our next question is from Nigel Coe with Wolfe Research.

Nigel Coe, Analyst

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

John Engel, CEO

Good morning, Nigel.

Nigel Coe, Analyst

Maybe, David, good morning. John, regarding the pricing, you mentioned an 8% price carry forward. Could you clarify that? I assume you’re indicating that prices at these levels will continue, rather than commenting specifically on 2023. Also, I want to ask about the cash flow. Your implied free cash flow for the fourth quarter is approximately $500 million. Demand continues to be very strong, and supply chains are still quite tight. How confident are you in generating that amount in the fourth quarter?

Dave Schulz, CFO

Sure, Nigel, let me address first pricing. So we provided you some insight that we estimate 8% price benefit in the third quarter. That's consistent with what we saw in the second quarter. So we really haven't seen a material change sequentially in the price benefit to our top line. Our comments were not intended to imply anything related to 2023. The free cash flow, you're absolutely correct. It does indicate our free cash flow guide at 10% of adjusted net income indicates a substantial cash flow generation in the fourth quarter. And as I said earlier, I really believe that this is driven by our expectation for demand by month within the fourth quarter. It will be very different than what we saw last year. Last year, we saw continued strength and the fourth quarter was up 6% sequentially on a workday adjusted basis versus the third quarter of 2021. So we're against a tough comp. We do expect that sequentially in the implied outlook we provided you today. Sequentially, fourth quarter sales will come down. That will lead to a substantial release of the net working capital, along with our earnings. That's what gives us the confidence that we can generate positive free cash flow for the full-year 2022.

Operator, Operator

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