WESCO International, Inc. (WCC) Earnings Call Transcript & Summary

Welcome, everyone. Thanks for joining us. My name is Dave Manthey. I'm the senior analyst on the industrial distribution team, along with Quinn Fredrickson. Really pleased to have WESCO International here today. WESCO, of course, is an electrical and datacom distributor with a low teens market share of the $100 billion fragmented market. With us today, we have the Chairman, President and CEO, John Engel; and CFO, Dave Schulz, who is standing in for Scott Gaffner, who couldn't make it today. It's a pretty good lineup. So thank you for coming. We really appreciate it. What we're going to do here is we'll -- as usual, we'll take questions via the iPad. If you would like to send a question up here, I can field it and then relay it to management and you send that to session 2 at rwbaird.com. Lastly, and then I'll turn it over. I want to let you know that there will not be a breakout session. So if you do have questions, please get the answer here because this is our last opportunity. So with that, I'll turn it over to John Engel.

Thank you, Dave. Pleasure to be here. We always enjoy coming to your conference. It's -- I know you set new records again this year and congratulations, and this is just a terrific conference. We had some terrific meetings today. I'll make a few opening comments. We do have presentation materials available. We will not be flipping slides per se. I'll make a few comments, and we'll get right into the Q&A. It's been a busy 2-plus years for us in WESCO. We doubled the company by acquiring Anixter International. We announced in January 2020 pre-pandemic. We closed it in June of 2020, literally doubled the company, combined 2 Fortune 500 companies of equal size. We're now a Fortune 200 company, we're 200 on the Fortune 500 list with $20-plus billion in sales. And we're a new company. We took this approach and the opportunity to put together 2 equal-sized companies, create a new company so to speak, in the new WESCO, as we call it, as we profiled recently at our Investor Day in September. It's the first Investor Day we had since the global pandemic and the first one since Anixter. Anixter has been a real -- really been a clear catalyst for us in terms of strengthening our market leadership position, increasing our global scale and enabling and supporting our digital transformation. We outlined a 3-year integration period. We're 9 quarters into that. It's going exceptionally well. We've raised our synergy targets numerous times, both the cost and sales synergies. Those targets were set pre-merger close in March 2020, we went out with 3-year integration targets. And as I said, we've raised them several tons. We've produced 9 quarters of results since we came together and they're very strong results with strong momentum. We see ourselves as becoming a real growth company. We're benefiting from a series of secular trends that are very attractive, electrification, automation and IoT, 24/7 connectivity green energy, grid modernization, supply chain consolidation that our customers are driving and near-shoring, reshoring. We've got $1.4 billion of cross-sell synergies that we committed to, true cross-sell synergies as a result of putting these 2 companies together. We originally had committed to 1% of pro forma sales, which would be $170 million, two $8.5 billion a year companies coming together, premerger, that was our target. This has been increased numerous times. It's eightfold what it was. Now $1.4 billion was the target we raised last week in our Q3 earnings call. We expect mid-single-digit plus organic sales growth over the long term. We've outlined our growth algorithm. That's in our Investor Day materials and very excited about our future prospects. Talking about digital transformation. Next, I said Anixter was a catalyst. We've introduced agile development design thinking into our operations and culture. We've established a new digital architecture and tech stack. This is not a monolithic ERP implementation. It's a best-of-breed approach, proprietary architecture. We stitch together these best-of-breed systems. They're all wrapped around 1 world-class data lake that houses our big data. And our big data is comprised of not only our own data, but our customer data and supplier data. And we think really this is going to drive outsized growth over the mid- to long term. Free cash flow generation historically has been strong and resilient. We've historically generated 100% of net income in terms of free cash flow. That's over the long term, it's consistent. That remains our expectation. At our Investor Day, we said we will deliver $4 billion plus of free cash flow through 2026. It was our Investor Day recently where we upsized our cash generation. That's through increased earnings power and improved working capital management and turns. That supports our investment needs in the business. It also supports our capital allocation priorities and plans. We have $1 billion share re-buyback authorization in place, and we announced at our Investor Day 2 months ago that we're going to initiate a common dividend starting in early 2023. Overall, I'll tell you, we're very pleased with the growth and margin trajectory of the business. We've set a long-term goal -- set a long-term goal and maybe not working right now, the deck, I guess, maybe we'll get that working. And you'll see that long-term goal of 10-plus percent operating margins. We just closed out our third quarter earnings, gave those results last week, record third quarter sales, all-time records for gross margin, EBITDA dollars, EBITDA margin and EPS. We've also significantly delevered our business. We did lever up to do this deal in the face of the pandemic. We had a leverage ratio, total debt-to-EBITDA 5.7x when we closed the Anixter acquisition in June of 2020. We've taken 2.5 turns out of our financial leverage in 27 months. The end of Q3, we're at 3.2x. We have a self-imposed leverage range of 2x to 3.5x. We typically like to operate within that. And we're targeting now to be below 3 turns, and that's what we're focused on. With that said, with posting exceptional results 9 quarters in a row an all-time record results. As I said, in terms of profitability in our Q3 results, our stock traded down, very disappointed with that. I'll ask you a couple of things. Remember, we're a leading B2B distribution company that has very strong free cash flow across the cycle. Obviously, we've been investing significantly in our inventory to support all-time record backlog, growing at a much higher rate than sales, and we're very confident in the fundamental cash flow characteristics of the company. We've got an open $1 billion share buyback authorization. I want to emphasize at this stock price, we are buyers of our stock at these levels. So with that, I'll open it up for questions.

Right. Thanks very much, John. Let's drill into that a little bit more here because it's the question that I've been getting repeatedly over the last week or so regarding free cash flow. First of all, you took your guidance of free cash flow to net income from 50% to 10%. And first off, could you just explain why that was? I think Dave, you and I had that conversation. I think there's a pretty logical reason why, but if you could explain why that was.

David, why don't you start with that.

Yes. So as John mentioned, I mean, we've had sizable sales growth this year. We've also been seeing sizable increases to our backlog. And as our backlog increased 5% sequentially in the third quarter, up over 60% versus the prior year. We have increased our inventory position to support those firm orders. And so essentially, the inventory increase is all driven by not only our sales growth but also by the strong backlog, both sequentially and versus the prior year.

And that 5% relative to normal seasonality would be what?

Normally, we're eating into the backlog during the third quarter. So that's in a typical year. We haven't, of course, had a typical year in the last 2 years, both coming out of COVID in 2021 and then also here in 2022. But typically, we grow our backlog through the end of the second quarter, then we begin eating into the backlog in the back half of the year. As we eat into that backlog and we see a sequential decline in sales Q3 to Q4, we generally release net working capital, that's what drives the free cash flow outlook that we have for this year.

I think it's important to emphasize that this is not inventory that's added based on speculation. You can think about our business as having 2 models in it. There's a stock and flow business that supports real-time demand and then there's the project-based business. The stock and flow business turns -- we turn that inventory, the inventory to support that 6x to 7x a year. Those inventory -- those days, those inventory days are being held constant. So that's in very good shape. The inventory growth has been driven exclusively by our growth in project business. and that's represented by our backlog growth, which is up 60% year-over-year, well in excess of our out-the-door sales growth rate. So yes, we're disappointed. We had to take the cash flow guide for the year down, but this is a very high-quality problem. I would call the highest quality problem because that's sitting in the form of inventory to support the backlog where we have firm orders on the books with customer POs, pricing and terms that will ship, it will convert to AR, we'll collect it and get the cash. Just a timing issue.

Got it. I wanted to ask about that, too, that backlog, like you say, those are firm orders. It's not cancelable backlog?

Firm orders, if they cancel it, there's terms and conditions that wrapped around the cancellations. And we've seen no cancellations of our backlog to date -- in 2022.

Okay. The final piece I wanted to touch on. There's been some supply chain issues and maybe some of the projects you could have otherwise shipped, you may not be able to because it's not complete. And I think, Dave, when we talked, you said that you looked out at your supply chain and you said we have this backlog. We have some availability of some product that we know we're going to need and that was part of this as well. Can you talk about the supply chain as well?

Well, let me precisely address that, Dave, because where we have the customer PO, in many cases, we're providing a complete solution. It will include different types of equipment, subsystems. We put it together. We wrap services around it. And sometimes the customer wants that delivered in stages, sometimes they want the full solution delivered. So we'll kit stage and store various elements of the full package and if it's required to deliver the full system. So once we get the order on the books, it goes in the backlog, we'll drive the supply chain to fulfill all the pieces of that. And then in many, many cases, that's required shipments from numerous suppliers on different product types. And they'll come in at various stages. What has happened throughout the pandemic is lead times have extended in the supplier base and what they're quoting us and others. And the pandemic has caused tremendous disruption in the supply chain. So in some cases, we're waiting for certain components that come in to provide the complete solution to provide it to the customer into their operations or on the job site. So -- but in all cases, what's in backlog is backed up by firm orders. So Dave, to your point, there is some timing of the backlog shipping that's impacted by the supply chains that are not fully healed yet, to your point.

Okay. Last question on this, and then we'll move on to other things. That the release of free cash flow between now and year-end, it looks like a big number. But there's a seasonality to that. There's a tone of business to that. Could you talk about your confidence in your ability to release just to get to the 10% relative to what we've seen year-to-date in terms of cash flow.

Yes, certainly. So the outlook that we provided during our earnings call it implies that we're going to see a sequential step down in sales from Q3 to Q4. So we'll see a reduction in our accounts receivable. We'll see a reduction in our inventory as we ship that backlog. So that's what's really driving our confidence in the free cash flow generation in Q4.

And that assumes more typical seasonality. And if you were to look at us over the long term, we typically Q4 sales would be down 1% to 3% versus Q3. Last year was unique in that we grew our Q4 sales 6% and sequentially versus Q3. So that was a tremendously strong close to the year, but that's what -- that's the underpinning assumptions Dave, for that the sequential sales decline will be kind of a release of working capital in the form of cash.

Okay. All right. Maybe let's talk about the business and growth and some of these secular drivers, which I think are really very interesting. But as it relates to the cycle, I think there's an expectation from most that we're going to see recession next year of some form, and they're all different, of course. But KPMG did a survey, 95% of the CEOs they surveyed thought would be in recession in 2023. When you look back, I think you mentioned this on a conference call, John, where you talked about the change in the complexion of this business going from sort of 2000, 2001 through the GFC, even 2015, 2016, into today, relative to the cyclical components of the business. I know when I started covering WESCO was mostly commercial construction. That was sort of how I thought about the company. Can you talk about that evolution and then where you stand today relative to a garden variety industrial production down 5%, let's say, or consumer-driven recession?

So we've not given guidance yet for 2023. However, we do -- we have said that we will grow next year, and we will grow sales and we will grow profit. So we have made that statement. We typically will give our guide as part of our Q4 results, and we will do that. So -- but I do want to at least put that marker in and that does presume that we have a challenging economic backdrop. I mean one can argue we're in a recession now. I also get surveyed as part of the CEO surveys. And so I'm part of the 95%, David. I think we're facing into an economic cycle, and I think Europe will have more challenges than the U.S. and Canada. But given that belief, I think we are positioned to grow our top line and bottom line next year if it's a garden-variety recession. Now let me address your question directly. We believe strongly we've mix shifted the company up into fundamentally higher growth markets with some more attractive margin structures. Our mix -- our portfolio mix as a result of Anixter and WESCO coming together has over 50% of the portfolio is exposed to a much higher growth secular trends, and we're excited about that. We've got 3 business units. We're 3 segment reporting. Let me start with UBS first, utility and broadband solutions and services, our UBS business. I believe strongly at utility, which was traditionally a GDP business, if you look at the last 5 decades, it has become a secular growth industry fundamentally. And it's the amount of investment that's required across the entire power transmission, generation through transmission, distribution chain. So the view of UBS, we think, has secular growth. We've been enjoying tremendously strong top line growth as well as backlog growth. It's those future sales in that business. The broadband portion of that business is outside plant fiber connectivity, fiber-to-the-X solutions. That is absolutely facing very attractive secular growth, of which the biggest one we all read about is the 5G build-out, broadband build out, both in the U.S. and Canada. So we're exceptionally well positioned to participate very well in that and have an array of solutions that's driving our growth. So our UBS business has been growing at very high rates. Backlog has been exceeding the sales growth. and backlog, and it grew 29% in the third quarter. And I think fundamentally, utility and broadband together, it is secular. Second business is communications and security solutions and services. That's the legacy Anixter business. They called it NSS. That's data communications, IP security. They were the global leader, absolutely facing secular trends. It's the demand for bandwidth, it's 24/7 connectivity. It's a demand for more AV and security solutions, experiencing very strong growth in that business. That has been supply chain constraint. Of the 3 businesses that has had the most acute supply chain constraints on growth. Backlogs at a record level, it grew 10% in the third quarter. And we expect that, that business will face a very strong set of continuing demand curve. And that -- the inherent nature of that is one that is also secular growth. And if you look at how that's performed through the cycle historically, it had nowhere near the peak to trough swing that more secular construction-driven industry has had. And the final business unit is EES, Electrical and Electronic Systems. And I would say historically, that's been the more cyclical portion of our portfolio. It's a much smaller percentage of the portfolio now. With that said, that includes industrial, both MRO supplies, industrial capital projects and OEM solutions and it includes construction, nonresidential construction, everything other than resi. And right now, we exited the third quarter with record backlog in EES, strong growth at 15% and I think that for the first time in my career in WESCO, I joined in 2004, the electrical industry is facing some secular growth drivers now. So there still will be cyclicality associated with the construction cycle and the industrial cycle. But right now, all our activity levels are very strong, record backlog and setting us up very well. I do think it will behave differently through the cycle day this time because of the underlying secular trends of automation and IoT and electrification coupled with electrical requiring to support green energy. And so I just fundamentally different company we have, it is the new WESCO. A big part of it is the complementary combination of the portfolio and our own self-help and the execution, but the end markets we're facing and fundamentally have secular growth, and we've mix shifted this company to a higher growth level.

Yes, it's definitely interesting. And even within that EES group, where you say there's more cyclicality, if you line up some of those trends that you talked about, the automation and the electrification you could make a case that there's some tailwinds that would exist there even in the midst of manufacturing slowing 5% or so.

And that's our view, Dave. I will say we're also not bias to residential construction on a first derivative basis. Most of our branches don't have counters. We don't really serve the residential market in any meaningful way. It's a single-digit percent of our business. If you look at what residential construction did through the pandemic, grew through the pandemic grew strongly. You adjust our mix for not having resi. It just puts our performance in an even stronger light. But the more important point that I wanted to make is the residential construction market has clearly rolled over. And so there's no argument that that's going to go -- that's going through the front end of the cycle. We'll see how deep it goes and how long it lasts. I do think, and this is our belief, is yet to be proven, that the relationship of nonresi to resi, where typically nonresi was a time lag to resi. And if resi cycled, non-resi would cycle, I think it's not going to be -- past is not prologue. And I think the difference will be -- the 2 major bills passed in Congress that will represent substantial infrastructure investment. We haven't even begun bidding those yet. We'll start to bid those in 2023. But they will represent significant upticks in demand in 2024, 2025 and beyond, that demand is not in our value in the economy. And so that is going to drive the nonresi cycle over the mid- to long term. It's also going to stoke inflation because the biggest shortage is around labor and the skilled trades. And so I know everyone's working hard on inflation and trying to get it down, but we think we're in an inflation part of the cycle that extends well into 2023 and don't underestimate the impact of wage and benefit inflation. And so look, again, I'm not arguing that there isn't cyclicality there. There's inherent cyclicality, but we don't have the residential exposure and the non-resi, the nature of it, it's at least our view today that it's going to behave a bit differently. So again, speaks to a different company, David.

That's a good point. What I think nonres, I often think office building, restaurant, but you're thinking airport and other infrastructure.

You look at 50% of the bills that were -- of those 2 bills that were passed addresses our addressable end markets in some former fashion. I mean we don't do concrete. We don't do the moving dirt. But everything else with the infrastructure, the electrical package, power gen, broadband, communications and security, that's our wheelhouse.

Okay. Let me get to the questions from the audience here. The first one is what are the most important levers and largest opportunities to reach the 10% margin target?

Well, the last 2 quarters, sequentially, we posted record EBITDA margins. We've got north of 8% for the first time ever in Q2 at 8.2%, 8.1%. It's north of 8%. And we just posted at 8.6% in Q3. And so I think, look, we're well on our way of heading towards the 10%, having posted back-to-back record margins. We're seeing very strong contribution from our gross margin expansion program, it's enterprise-wide as well as getting operating cost leverage on our sales growth because we're not adding costs. We're adding costs at a fraction of the rate that the sales are growing. Furthermore, we have additional synergies to capture. So we have the remaining part of the cost synergies for year 3 of the integration, and we just upsized again our sales synergy substantially. So I think the drivers are all 3 businesses are growing. All 3 grew double digits. All 3 have record backlog. All 3 have backlog growth that was well in excess of their sales growth in Q3. So we got great momentum vector, we think we're executing well. That's why we're confident we'll grow next year, top and bottom line. And I think we keep at it. I think we got the right initiative. It's just continuing the execution.

I think one of the key questions around that, though, is that when I think of all of distribution, everyone has contribution margins at record levels right now because of the contribution from price, which obviously gives you great leverage. Is -- I don't mean the 10% target, but as you're thinking about 2023, and I know you haven't given guidance. But is it possible that if pricing stabilizes or even comes in a little bit that you can take a step back before you take a step forward just based on some of the commodity products that you sell, retrenching more than average?

I'll make a comment, Dave, I'll ask you to tag on. So I think -- we typically give visibility in the formally planned price increases from our suppliers. We'll get a 90- to 120-day lookout, by and large, sometimes a little longer, sometimes not as long, but that's what it averages. What we are seeing right now, which would be price increases that suppliers have already planned that will go into effect, they are going to be executed for Q4 in the parts of Q1. The average price increase on a per SKU basis is consistent with Q3 and 2. So the inflation rate, the price increase amount has not dropped, first point. Second point is, as we go through November and December, it's when we typically get a barrage and I say barrage from our suppliers in terms of what their planned price increases are for Q1. In a normal cycle, if you go back and look at decades, multiple decades, they would plan a big set of price increases in Q1 to start the year and sometimes they come back midyear point and do some other adjustments. We've gotten into the mode the last couple of years where they're doing price increases every month or every other month. So we expect to see a lot more what the planned price increases are in the coming 6 to 8 weeks. But so far, for our look in the early look into 2023 is the price increase levels are holding up at the Q2, Q3 levels. I think we're still in this inflation cycle. Suppliers are challenging themselves to get back -- get the price cost gap back. And remember the labor component and transportation components. So they're endeavoring to push price. Supply chains are not rebuilt yet. We still -- they are not fully back to pre-pandemic levels. We still have demand greater than supply. I think it speaks to an inflationary environment, which is why we're confident we'll grow top and bottom line. Dave, you may want to talk about the other potential to that.

Yes, certainly. The -- in our Investor Day materials from back in September, we talked about a mid-single-digit plus organic growth rate over the long term. We also talked about a 14% incremental margin supported by that top line. We've clearly been getting better incremental margins here in 2022 because we've been growing 18% year-to-date. So we have gotten some benefit because of the high sales growth. We're a distributor. We know how to manage our costs appropriately to get to that right incremental margin going forward. But I would think about it more longer term mid-single-digit plus sales, 14% incrementals.

One last point I forgot to make. The true commodity products that we kind of pass through and don't add value to copper wire, aluminum wire and so a single-digit percent of our sales. Our stock and flow business I told you days have been maintained. We turn that 6 to 7 times a year. The commodity prices have already rolled over. I mean there's many that said you're going to start seeing margin pressure in 2022 in Q2 or Q3. We've seen the opposite, right? We've seen -- we've expanded gross margin sequentially every quarter this year. We have an enterprise-wide gross margin expansion program underway. We think that has a lot of legs left in it. We really do. Anixter started 2 years before merger closed, they were publicly traded and take a look. Those -- this is 2018 into '19. They expanded gross margins 7 quarters in a row before we acquired them. Where all the other distributors we had flat to declining margins. We've taken that and driven an enterprise-wide starting early 2021. We think we got a lot of legs left in that. So we're pushing on gross margins hard. And I do think part of it is the value selling of the combined portfolio.

Before I let you go, I want to clarify, when you're talking about the inflation rate you're seeing, you're talking about the rate of change year-over-year because your comparisons don't get that much more difficult as we move forward. So if you're saying whatever it was, 6% in the third?

I'll be precise. Like supplier price increases were averaging 8% to 9% in Q2 and Q3. Those price increases they give to us and our competitors that they try to pass on. That's what we're seeing as an average price increase, Dave, in Q4 and what we're seeing for Q1 thus far.

Okay. Fair enough.

It's in the 8% to 9% range.

All right. John, Dave, thank you very much. Thank you being with us.

Thank you.

Thanks for having us.