WESCO International, Inc.
Q2 2017 Earnings Call Transcript

Published: 30 Jul 2017

[Operator:]

Good day, and welcome to the WESCO Second Quarter 2017 Earnings Call. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to Mary Ann Bell, please go ahead.

[Mary Ann Bell:]

Thank you, Yoja. Good morning, ladies and gentlemen. Thank you for joining us for WESCO International conference call to review our second quarter financial results. Joining me on today's call is John Engel, Chairman, President and CEO; and Dave Schulz, Senior Vice President and Chief Financial Officer. This conference call includes forward-looking statements, and therefore, actual results may differ materially from expectations. For additional information on WESCO International, please refer to the company's SEC filings, including the risk factors described therein. The following presentation includes a discussion of certain non-GAAP financial measures. Information required by Regulation G of the Exchange Act with respect to such non-GAAP financial measures can be obtained via WESCO's website at wesco.com. Means to access this conference call via webcast was disclosed in the press release and was posted on our corporate website. Replays of this conference call will be archived and available for the next 7 days. I would now like to turn the call over to John Engel.

[John Engel:]

Thank you, Mary Ann. Good morning, everyone, and thank you for joining us today. With positive organic sales growth in the quarter, a strong backlog and favorable book-to-bill performance and encouraging July-to-date sales results, WESCO has returned to growth. We expect this growth to accelerate in the back half of the year, consistent with our full year outlook. Let's turn to Page 3; our second quarter results were in line with the outlook we provided in April. After 8 consecutive quarters of sales declines, we delivered 1% organic growth in the quarter, overcoming unfavorable impact of Easter timing and the large utility contract we did not renew. Sequentially, organic sales grew 8%. Growth was driven by improving business momentum in our Industrial and Construction end markets as well as in our Canadian and international businesses. Our business strengthened as the quarter progressed, with May organic sales flat and June organic sales up 4%. Our positive sales momentum has continued in July, and we're tracking to a mid-single-digit growth with a few days left in the month. Our backlog also strengthened as the quarter progressed and grew sequentially, which is counter to the typical seasonal decline. We ended the quarter in June with our highest monthly backlog since 2012. And our book-to-bill continues to track above 1.0 in July. I'm very pleased with the efforts of the WESCO sales team to diversify our customer base to enable us to win in multiple verticals and end markets. One of the outcomes of this effort is that oil and gas now represents approximately 6% of our sales, which is evenly split between MRO and capital projects. Operating margin was in line with our expectations as well, as we continue to execute our cost management and supply chain initiatives to mitigate the effects of a still challenging and demand-constrained pricing environment. Free cash flow generation in the quarter was impacted by an increase in accounts receivable resulting from our strong June sales. So -- but we do remain on track to deliver full year free cash flow of at least 90% of net income, enabling us to continue to invest in the business, make acquisitions and buy back shares. In the quarter, we repurchased $50 million of shares and remain within our targeted financial leverage band. Now let's turn to our end markets, starting on Page 4 with Industrial. Our Industrial sales were up 6% organically, including 4% growth in the U.S. and 10% growth in Canada in local currency. Also of note, organic sales were up 5% versus the first quarter, reflecting our third consecutive quarter of sequential improvement. Our positive momentum is driven by sequential sales growth in the majority of our industrial end-market verticals, including oil and gas, metals and mining and OEM. Our Global Accounts and Integrated Supply opportunity pipeline remains healthy and our bidding activity levels increased double digits in the quarter, providing a positive setup for the back half of 2017. Our Industrial customers remain focused on tightly managing their cost. While they continue to be cautious with their capital budgets, they remain optimistic about future growth prospects and capital investment plans. With our extensive portfolio of Supply Chain Solutions, we're helping our Industrial customers reduce their costs, operate more efficiently and better plan and manage their projects. Now turning to Page 5; construction sales declined in the second quarter against the prior year period when sales were up 2%. The U.S. was down 6% and Canada declined 4% in local currency. Overall Construction sales were in line with normal seasonality on a sequential basis. In the U.S., sales growth of commercial contractors again partially offset weakness with industrial-oriented contractors whose customers have been deferring capital investments in response to the demand environment and ample capacity. As mentioned earlier, overall backlog grew sequentially and year-over-year and is at its highest level since 2012. This provides a positive setup for the rest of 2017 and entry into 2018. Our outlook for the nonresidential construction market remains modestly positive as forward-looking indicators are supportive and the overall market is still well below its prior peak. Now moving to Page 6; we're very pleased with our performance in the Utility end market this quarter. Excluding the contract that we exited at the end of last year, our Utility business was up 3%, with the U.S. up 5% and Canada down 7% in local currency. Our technical expertise and Supply Chain Solutions have enabled WESCO to become a valued long-term partner to our customers. Through 2016, we achieved five years of sales growth from scope expansion and value creation with Utility customers, including Integrated Supply solutions. This success continued during the second quarter, where we were awarded a contract to provide transmission and distribution materials from an infrastructure upgrade project and investor-owned utility in Alberta, Canada. The utility industry is undergoing continued consolidation. Demand for renewable energy is growing and customers are looking for material cost savings as well as operational efficiency savings. WESCO is well positioned to benefit from these trends. Finally, turning to CIG on Page 7; after three consecutive quarters of sales declines, we delivered 7% organic growth in the quarter, with the U.S. up 2% and Canada up over 30% in local currency. Sequentially, sales were up 14% from the first quarter. Our technical expertise and Supply Chain Solutions are driving positive momentum with our technology customers, that is data centers and cloud technology projects, as evidenced by the new win outlined on this page, as well as supporting growth due to fiber-to-the-x deployments, broadband build-outs and cyber and physical security for critical infrastructure protection. We spent the last two-plus years preparing for growth. We rightsized the organization and are now investing in our technical expertise, capabilities and our service offerings as we grow in the second half, consistent with our original plan. We are confident that these actions will enable us to drive market outperformance, protect and expand operating margins over the long term and increase customer loyalty. With that, I will now turn the call over to Dave Schulz to provide further details on the second quarter results and our outlook for Q3 and the balance of the year. Dave?

[David Schulz:]

Thank you, John, and good morning, everyone. Moving to Page 8. Our second quarter outlook called for sales to be down 2% to up 1%. Actual reported sales were flat, with organic sales growth of 1% offset by unfavorable foreign exchange. Our backlog increased 5% from Q1 to Q2, better than typical seasonality as it normally declines during construction season. Backlog was up 7% versus last year on a constant currency basis. Gross margin was 19.2% in the quarter, down 70 basis points versus the prior year and down 50 basis points sequentially. It's important to distinguish two contributors to the decline in gross margin versus prior year. The first is the impact of adjustments that were not directly related to invoicing in the quarter, including the timing of accruals versus prior year. For example, the supplier volume rebate this quarter was lower due to the mix and timing of supplier programs in the prior year. We also accrued for customary reserve increases for higher inventory and accounts receivable balances. Lastly, we recognized a higher-than-normal expense for inventory write-ups in the quarter. In total, these adjustments were unfavorable this year but neutral or favorable last year. These items accounted for about 50 basis points of the 70 basis point decline in gross margin. The second contributor is the billing margin or the day-to-day margin from invoicing. Billing margin was down about 20 basis points from the prior year. This reflects the unfavorable impact of mix, including strong growth in our International business. We are making progress in passing along inflation and have more work to do in the second half. SG&A expenses for the first quarter were $267 million, which was down 3% from last year and flat sequentially. After taking actions to rightsize our organization over the last two years, we continue to be focused on closely managing our costs while making the appropriate investments in key areas. Operating margin was 4.4%, within our outlook range of 4.2% to 4.6% and down 20 basis points from last year. This reflects lower gross margin, partially offset by lower operating cost. The effective tax rate was 25.3% in the quarter, down 200 basis points from the prior year. The favorability was driven by discrete items, most notably the application of the new accounting standard, addressing stock-based awards and a mix of income by country, reflecting relatively stronger performance outside the United States. Moving to the diluted EPS walk on Page 9; we reported earnings of $1.02 versus prior year. Favorable tax expense of $0.03 was fully offset by unfavorable foreign exchange. Moving to Page 10; year-to-date free cash flow was $57 million or 65% of net income. The decrease versus prior year is principally due to increased accounts receivable resulting from higher sales in the month of June. Our debt leverage ratio was 3.5x trailing 12 months EBITDA. Leverage net of cash was 3.3x EBITDA. Liquidity, defined as available cash plus committed borrowing capacity, was $751 million at the end of the quarter. Interest expense in the second quarter was $17 million. And our weighted average borrowing rate for the quarter was 4.3%, consistent with historical averages. We believe our debt is appropriately balanced between fixed rate and variable rate instruments. Capital expenditures were $5 million in the second quarter and $10 million year-to-date. We continue to invest in our people, technology and facilities through both capital expenditures and operating expenses. WESCO has a history of generating strong free cash flow throughout the entire business cycle, and we expect this to continue. Our capital allocation priorities remain consistent. The first priority is to invest cash in organic growth initiatives and accretive acquisitions, to strengthen and profitably grow our business. Second, we target a financial leverage ratio of between 2x to 3.5x EBITDA. Third, we return cash to shareholders through share repurchase. As John mentioned, we completed a $50 million share repurchase in Q2 to offset dilution from management grants and exercises in 2016 and 2017, and currently have $100 million remaining in our existing share buyback authorization. Now let's turn to our outlook for the third quarter and full year 2017 on Slide 11. Remember, that we have one fewer workday this year, which occurs in Q3. Starting with the full year, we are maintaining our expected sales growth at the midpoint up 2%, but narrowing the range to up 1% to up 3% from flat to up 4%, reflects actual results through the first half of the year and our expectations of continued sales momentum in the second half. We are decreasing our EBIT margin range by 30 basis points to 4.1% to 4.3%. This reflects year-to-date performance with the assumption that gross margin percentage in the second half is flat with the first half. We also plan to invest in technical, sales and operational resources as our growth accelerates in the second half. We've adjusted our effective tax rate to approximately 27%, principally to reflect the discrete items recognized in the first half, including the accounting for stock-based awards. Recall the impact of this accounting change was not included in our original outlook for the year and is difficult to estimate. Absent discrete items, our effective tax rate remains approximately 29% to 30% going forward. The result of these adjustments is a $0.10 decrease to the top end of our EPS range to $3.60 to $3.90. Our average shares outstanding remains approximately 49 million shares, and we continue to expect free cash flow of at least 90% of net income. For the third quarter, we expect sales growth of 2% to 5% and operating margin of 4.2% to 4.6%. We expect next quarter's effective tax rate to be approximately 27%. With that, we'll open the call to your questions.

[Operator:]

[Operator Instructions] The first question comes from the line of Deane Dray with RBC Capital Markets.

[Deane Dray:]

Maybe we can start with some more specifics around this incremental spending that you highlighted today. Maybe -- you said for sales and operational resources, but really, specifically, what are you targeting this on

[John Engel:]

Yes. No, not to combat -- not at all to combat e-Commerce pressure, Deane. We can -- again, I think we, both at EPG and at Investor Day, kind of laid out to a much greater degree the mix and diversity and strength of our business, and I think we've got tremendous resilience against the commodity pure-play products that are out there transparently on an e-Commerce channel; so absolutely not that. We had originally planned on a two-speed year. So when we put together our original outlook for the year, we expected the second half to be a material step-up versus the first. I'm very pleased that we're seeing that come to fruition. We -- moving through the second quarter, to sequentially grow backlog, that is counter to the typical seasonal decline. That sets up very well for the second half and even into 2018, quite frankly, and we have our highest backlog we've had since 2012 at the end of June. And then stepping up the 4% organic growth in June represented a nice step up. We did expect, again, it would be -- start to occur in the middle of the year and set us up for a much higher second half. And so far in July, we got a few days left and we're at 5% growth in July. Maybe kind of a stitch above it, but call it 5% growth. So -- and all four businesses are growing

[Deane Dray:]

Great. And then just as a follow-up, and this was dynamically talked about at the Analyst Day where the suppliers have begun to put through some of the higher material costs through to you and there's been this lag for -- before WESCO can start to raise pricing. Where do you stand on that dynamic today? And how would that have translated into, let's say, gross margin this quarter?

[John Engel:]

Yes, so I'll make a few comments and then have Dave take you back through it. Because I think, from our perspective, I think clearly from your perspective and all our investors, that's the real question mark, right? What really drove gross margins in the second quarter. The only margins where we have a relative stability, a little bit of a mix effect, as Dave outlined in his earlier comment, but we're talking 20 basis points change. So we've been in the kind of 10 to 20 basis point range or flattish for a number of quarters here in a row. Supplier pricing increases, they continue to try to push them through. It is challenging because the end market demand has not picked up materially yet clearly in the capital project side, but even, I would say, overall. And therefore, pushing the price increases through is somewhat equivalent to pushing a rope through it, until there's pull-through the whole supply chain driven by end-market customer demand. I've taken you through all that before. I will tell you that the second quarter conditions, the pricing challenges, our ability to push them through, it's similar to the first quarter. No change. It did not degrade further. And the measure, that's really our billing margins not our gross margins, so we continue to work hard at that. I think we're getting some push-through, we're not just getting all of them pushed through fast enough, and we continue to work at that. But the gross margin had some specific drivers in the quarter that drove the results, okay? And Dave took you through that earlier, but I'd ask Dave to comment again just so it's very clear to everyone.

[David Schulz:]

Sure. So John mentioned already the impact of the billing margin primarily related to the mix of the results that we saw in Q2 versus the prior year. Unfortunately, we also have a series of other items that impact our gross margin. And generally, we see a series of puts and calls that will impact the overall gross margin. In Q2 of 2017, relative to the prior year, unfortunately all these things went the wrong way and ended up being a drag on our overall gross margin. I mentioned in our prepared remarks the supplier volume rebate, that was primarily the types of programs that were offered in the prior period relative to what's being offered this year. So relative to the range that we discussed about supplier volume rebate as a percent of sales, we were at the higher end of the range in the previous year versus the current year, which I would characterize as more normal. And we still anticipate having a -- the typical supplier volume rebate this year relative to our overall sales growth plan. Unfortunately, the other impact that we had were some issues related to our inventory write-downs. Again, this is part of our normal process where we go through and review our inventory positions. We had a couple of things that we felt was important for us to recognize through the income statement this year. So again, it's a combination of everything just went the wrong way from a gross margin perspective on top of a slight decrease in our billing margin.

[Operator:]

The next question comes from the line of Nigel Coe with Morgan Stanley.

[Jiayan Zhou:]

This is Jiayan Zhou in for Nigel. Actually just to follow up on Deane's question related to gross margin; Dave was talking about the impact of fund, supplier volume rebate and then the inventory accruals. Can you maybe just break that out between the volume rebates versus accruals and assume the impact from accruals would go away starting from 3Q?

[David Schulz:]

So we're not going to break out the specifics on the supplier volume rebate. When you take a look at our 10-K, we provide you with the range of our expectation for supplier volume rebates as a percent of sales. I would say both periods are within the range that we previously disclosed. But obviously, the current year was lower from a dollars basis than in the previous year. And again, on the inventory write-downs, we see variability from quarter-to-quarter on our inventory position and the amount that we recognize in our income statement. Again, we're not going to break out the 50 basis points between those drivers. I think it's safe to say, though, that we don't anticipate that all of these items will continue to be negative going forward.

[Jiayan Zhou:]

Okay, got it. Cool. And then just on the investment, that was very good color John was providing relative to this high value investment you are going to make. Can you maybe just -- maybe give us a little bit color, maybe try to quantify the investment that you're planning to make? And is that mainly going to happen in the second half of '17? Or that will also go into 2018?

[John Engel:]

Oh, yes. So look, I already made the statement that -- and our original plan, in response to Deane's comments and questions, our original plan was as our growth returned in the second half, we were going to begin to add some technical resources, both technical support resources that support our technical selling effort and service category development as well as sales resources. So we had not -- we did not start that though, however, in June. We have not started in July. So I think our second half outlook and guidance does presume a continued strong top line momentum, and we'll start to incrementally release that. We've got pent-up demand. I can tell you, our organization is excited about the return to growth. And I've got a number of requests across the organization to add incremental resources in some areas that we've got high confidence will help resolve an even acceleration of our growth rate, and that's exciting. And that's -- so but I've been holding off on those. We've come out of 2.5 years where we've done the opposite. Not only have we been very diligent about any incremental additions, in certain areas we've done some of that, but we have not taken our overall headcount down. And Dave mentioned in his comments, the overall headcount in the quarter was down year-over-year. So we're continuing to see the benefits of what we've done over the last couple of years in our SG&A. So I'm not going to foreshadow exactly what the ramp rate is, it's going to be completely a function of what the sales ramp is and can we afford that. And we'll only do it where we think that it will provide significant strong incremental growth. This is all about -- now we're getting a return to growth, I want to put the accelerator down and make sure we support that growth. And with that, the operating model is intact. We'll get strong pull-through. That's our operating model and commitment.

[Jiayan Zhou:]

Okay, got it. If I can throw in one last one quickly. Dave, can you just talk about what product category was related to the inventory write-down?

[David Schulz:]

We're not going to provide you with -- distinguish between the product categories. Again, I think the primary driver of the mix erosion was related to International. And again, from a billing margin perspective, it was a modest decline year-over-year, primarily driven by the strong growth in our International business.

[Operator:]

The next question comes from the line of Matt Duncan with Stephens.

[Charles Duncan:]

Sorry to beleaguer the point on gross margin, but there's I think a couple of things that people are struggling with, and I want to make sure this is very well understood. So when we think about the mix in your business, Industrial is typically better margin, Construction is lower, rest of world is lower, because that's direct shut business as opposed to other stuff. But I know within Industrial, you've got things like integrated supply and national accounts that can carry a lower gross margin. It doesn't necessarily translate to a lower operating margin to be clear. But can you help us think through how you're not getting some benefit from mix with Industrial growing so much faster than what's happening with Construction?

[David Schulz:]

So Matt, it's Dave Schultz. So from our perspective, what we saw in terms of growth in industrial generally does lead to higher margins. We did have, as you mentioned, we had varying mix impacts by the type of customer we sell to and the business model that we sell with, including our Integrated Supply business. Again, primarily the mix impact was driven by the strong growth in International, and a lot of that International growth was in our Industrial end market. So from the perspective of -- as we analyze the gross margin impact, we look at it from not only our geographical mix, we look at it from our end market mix. The end market mix essentially became neutral relative to the growth that we saw on the geographical mix perspective. So they basically offset each other. The other thing that we look at is that we look at shipment type. And shipment type did not have a significant impact on gross margins versus the prior year.

[John Engel:]

So Matt, I think the way to think about it is our billing margins is where we see that really, let's say, the range of the margins vary based on some business model. When you get into the elements between billing and gross margin, we may have an individual product category that serves customers in Industrial and CIG and Utility. And when you think about the structure of the supplier volume rebate programs, we get paid rebates based upon products irrespective of what end market they're sold in. So that's the way you should think about them. I mean, again, think about the quarter, the billing margins, a little bit of pressure its mix driven. There's still relative stability over the last four to five quarters in billing margins versus what some others are facing. We do have this lag of the ability to push all the price increases through, so I think the conditions are the same in Q2 as 1. These elements between billing and gross margin in that spread, think of it between billing and gross margin, those are the -- what Dave has taken us through already. Again, those kinds of all went the wrong direction this quarter. That is not typical, and we don't see those as repeating.

[Charles Duncan:]

Okay. Thank you for all the clarity.

[John Engel:]

Is that helpful?

[Charles Duncan:]

It is. And so secondly on the Construction business, you've been seeing improvement in backlog for a few quarters now. We're still seeing declines year-over-year in revenue. I know you sort of said you expect modest improvement in that business through the year. Do you expect it to get back to revenue growth during 2017? Or is the duration of the backlog maybe stretching out and it's really more of an '18 story when that business starts growing again?

[John Engel:]

Yes, excellent question. I'm glad you raised that because I think that's important for me to kind of share our views on this. I think if you think about the first half, it's developed kind of overall as we expected and we're seeing the return to growth overall, but the mix is different. So Industrial is really contributing nicely as we said. Now CIG is contributing nicely. And by the way, we expected CIG to be low single-digit to mid-single-digit growth in our original outlook. And Utility is contributing very nicely ex the contract we chose not to renew. So I would tell you, CIG, Utility, Industrial are better than what our original guide presumed when we put together our 2017 outlook and articulated it in December. Because at that point, we said Industrial was down low single digits to up low single digits and we're seeing that strengthen. Utility we said was flat to low single digits. And now, post this contract, we're seeing that thing strengthen. And CIG obviously is looking a little stronger than low single digits now. So those three are stronger, Construction is weaker. And so I would tell you it's -- I'll tell you, what drove us in Q1, the same conditions are occurring in Q2. When you get underneath and decompose the projects into industrial-oriented contractors, those longer-cycle projects, the bigger CapEx spend, that's where we're still seeing significant declines. And it's being partially offset by growth with commercial construction. So I would tell you though our leading indicator is backlog. So I'm very encouraged by the setup as we enter the second half. Again, this is not normal seasonality. I'll make the other point. We had sequential growth in our backlog every month this year. So again, I think it's a nice building-momentum vector. With all that said, given the first half results, Construction's underperforming versus our original outlook, and still will be when you think about the composition of our new guide. One other point, there's been a lot of talk about oil and gas and where oil pricing has gone. It's now only 6% of our business. It returned to growth in the second quarter for us. So I want to make this point. And that's driven by MRO and some small projects. So we actually grew double digits in oil and gas, all in, both in the U.S. and Canada, which is very interesting given maybe what the market looks like. And that doesn't have the contribution yet of the -- kind of the midsized to larger projects which continue to be shifted to the right. So -- and fundamentally, the last point I would make is in the big industrial customer base we have, there's still very tight controls on capital spending. Some of them have planned on increased capital this year, but it hasn't been released in the first half. So again, I think that we're set up well for when that capital spending does increase. You can only defer it so long. I think they want to see -- have a greater confidence in their end market sales and the demand streams that they're serving before they release that. But when that kicks in, that represents another incremental growth driver. And I think how much of that happens in second half versus 2018, I'm not sure of the timing necessarily. But clearly, it's a future positive incremental growth driver.

[Operator:]

The next question comes from the line of Andrew Buscaglia with Credit Suisse.

[Andrew Buscaglia:]

Just a question; when we -- if you go back to June at the Analyst Day, I'm trying to figure out what changed over the course of a month that would prompt the new guide as -- did you see some of this stuff transpiring in June? Or is this sort of a surprise in the last 30 days?

[David Schulz:]

Andrew, its Dave Schulz. So as we mentioned during the Investor Day, our billing margins through -- that period in early June, we had visibility too in May, were about flat. And so we did see -- essentially the adjustments that we had to gross margin as we closed our quarter is what's really new. And the adjustments that we made relative to the inventory, the changes in the supplier volume rebates, that's really what changed relative to what we discussed back during our Investor Day in early June. And we did not have visibly to that at the time.

[Andrew Buscaglia:]

Okay. Okay. And then, I guess within those gross margin puts and takes, it sounds like everything just kind of didn't go your way. But how much of this -- I guess we're trying to figure out what -- how much of this is going to continue or could be a more secular issue versus just cyclical improvements that we're going to see going forward?

[David Schulz:]

Right. So as it relates to the supply volume rebate, we still anticipate that our year-over-year benefit to gross margin from supplier volume rebates will be consistent. So we don't see this as a decline in our total year outlook for supplier volume rebate. We see this is as more of timing issue. So we do anticipate that it'll normalize over the course of the full year. That's essentially how we do our estimate. The other items related to some of these write-downs, we don't anticipate that they will all continue at this magnitude. Again, we go through this every close during the month. Unfortunately, as we closed the quarter, we had more inventory write-downs that we had to recognize in the second quarter.

[Operator:]

The next question comes from the line of Hamzah Mazari with Macquarie Capital.

[Hamzah Mazari:]

John, you touched on pent-up demand. I was hoping you could add a little more color there. Is that mostly on the Industrial side on deferred project and maintenance spend? Curious what you meant there.

[John Engel:]

No, I -- well, I -- the -- it's broad-based, Hamza. Because again, I think, think about -- we don't parse our backlog out by end market per se. We've never done that. But our backlog is broad based. It does represent Construction end markets or sales to contractors, whether they're local, regional, national contractors or large global EPCs, that's in our backlog and would manifest itself as Construction sales. It also represents projects we do direct with end users. So if it's an Industrial, there's direct end-user sales for projects to -- which show up in Industrial sales. If we're selling direct to a Utility, that project sale would show up as a Utility sale. So I think, we haven't parsed the backlog, never have. I can tell you, it's somewhat broad based, right? The overall leading indicator for backlog is very, very positive, and that is a good precursor for what overall project business will look like in the coming quarters. I did make the comment around oil and gas. And there it is we returned to growth in the quarter, and that's being driven by MRO and smaller projects. So if I were -- I will make this comment that, by and large, we're seeing the MRO and OEM -- the demand streams we serving -- we serve three demand streams, MRO, OEM, capital projects, we're seeing MRO and OEM demand stream's growing very strongly both year-over-year and sequentially. That's what's supporting the Industrial momentum build. We're not seeing the capital projects per se. And so I think that does represent future opportunity when there's a meaningful release and step-up in capital spending from our Industrial customers.

[Hamzah Mazari:]

That's very helpful. Just to follow up, I'll turn it over. Your inventory levels have stepped-up, and I realize you return to growth and you mentioned pushing the accelerator. Could you just frame for us -- does inventory move up from here? Or how should we think about your inventory levels given sort of your outlook on demand?

[John Engel:]

No, I think we've talked about this over the years. And from -- our focus on how we manage our inventory is availability and fill rate. Most of our branches don't have counters. So we're not -- we don't have that model that some of our competitors have, serving the unforecasted walk-up customer demand. We don't -- a variation of retail. We don't have that business model. So this inventory that's been laid in is a function of -- the inventory increases is a function of specific bona fide opportunities we're working and orders that we actually have on the books. The backlog stepping up in and of itself is driving some increase in inventory. So what -- we position the inventory for this return to growth and step-up, we don't want that to be the gating item, Hamzah. So that leads -- that was leading the return to growth. We only did it as we started to see the return to growth. And going forward, I think we'll continue to manage inventory as we always have. Once we're in a more consistent growth state, we have -- our inventory controls are excellent and we don't -- we have good -- we manage the days well. If the days somewhat stay flat, we try to incrementally improve those over time. So that's how we manage it, and we've done that through all phases of the economic cycle that way. I would say this is just a timing issue, where it's a 2-speed year. We now are stepping up, and as Dave mentioned, and some inventory lay-ins to support that. With that comes some higher inventory reserves associated with the higher balances and then the timing for AR because of the strong June sales growth, we have a big AR balance, obviously, exiting the quarter. Again, that's timing. So...

[Operator:]

The next question comes from the line of Christopher Glynn with Oppenheimer.

[Christopher Glynn:]

So as we look at the 3Q margin guidance at the midpoint indicates about flat sequentially, usually you have a seasonal uptick. So just want to tease that out. I think, gross margin, you're improving off the second quarter level. So counter to the seasonality in recent years, you're definitely forecasting SG&A dollars to grow sequentially?

[John Engel:]

Well, last year, we were pulling all kinds of cost levers too. So I think that's -- when you start looking at the year-over-year, Chris, both in -- while we -- we've been in that mode for 2-plus years running. But clearly, as we moved through last year, inclusive of Q3 and Q4, we were still taking out incremental headcount, right, as well as pulling discretionary cost control levers very aggressively and variable compensation levers. So again, I think, what we've done with the outlook, as Dave has tried to take you through in some detail, is we got a second half where gross margins all in are equal to first half, which does represent a step-up from Q2. And that's really -- not seeing some of those spread items between billing and gross margin, they're not going to repeat. But it basically says that billing margins are flattish. And so we're going to do everything we can to start getting some margin expansion, but we do anticipate that until the demand environment meaningfully picks up, we're going to -- it's going to continue to be challenging to work the price cost equation. With that said, I think we're making progress. And I said, as we grow, we'll look at releasing some incremental investments. Haven't done it yet. But again, I've got a long list that's lined up in the queue that is frozen until we agree to release them.

[Christopher Glynn:]

Okay. And then on gross margin, I know you need a base case for guidance. But what's the conviction level on the second half gross margin in total being sort of parallel with the first half?

[David Schulz:]

Chris, it's Dave Schulz. So as we take a look at particularly the items that impacted Q2, we looked at this historically and we looked at what normally goes favorable versus unfavorable. And as we think about this in an environment where, as John mentioned, we expect billing margin to retain essentially stable, we would anticipate that not all of these gross margin adjustments would be negative, and that's what give us the conviction. I mean, the history is on our side there.

[Operator:]

The next question comes from the line of David Manthey with Baird.

[David Manthey:]

It's Dave Manthey with Baird. Dave, I believe you implied that the second half gross margin will be flat with the first, I think you just mentioned that a second ago. And that would also translate to flat or slightly down versus the second half last year. I'm just wondering if you can help us understand with trends, sales trends right now accelerating into the second half of '17 versus deceleration in the second half of '16, why would you expect gross margins to be flat-ish in the second half.

[David Schulz:]

Dave, as John mentioned, we anticipate right now that our billing margins will stay essentially flat on a sequential basis. This is, again, against a competitive environment that has not changed significantly from Q1 to Q2. And so while we're optimistic that we will continue to drive recovery of inflation through our sales, right now what we have assumed is that billing margins stay essentially flat and that we recover some of the gross margin issues that occurred in Q2 going forward.

[David Manthey:]

Okay. And then based on your guidance, it looks like you're not going to get to the pull-through margins you expect in the second half of 2017 as gross margin stabilizes and you make these investments. Can you tell us approximately when? So as we look into '18, should we be thinking first half '18, second half '18, when we should start to see a move toward those -- the 50% goal that you have?

[John Engel:]

That absolutely is our goal. We've not provided 2018 guide yet. I think it's -- based on everything we see right now, Dave, it's -- here's our view, right, that we expected it to be a 2-speed year, it's occurring. That's the good news. Backlog is very supportive. So we're going to do everything we can in the second half of taking advantage of and leverage this inflection. What's the inflection? The inflection is from several years of declining forward sales on an organic basis to flattish kind of in the first half, to now inflecting the growth. So we want to prime the pump here in the front end, that's what we did with inventory, we'll do that with some selective resources. And then, hopefully, we're back off to the races here with our growth. That is our intent. We've been here before, managing through this cycle. So it's our intent to manage it that well -- that way again. We'll provide our 2018 outlook as we typically do later this year. That will be our standard practice. And again, the 15% -- 50% operating profit pull-through is still our optimizing variable. When we get back into a growth mode, that is what we'll try to operate to and optimize to. And hopefully, we'll get the pump primed here as we finish second half, enter next year with a great momentum vector and support the backlog and I think we're off. And then I think we'll be able to provide a point of view then of what the investment picture looks like relative to top line growth and be more precise in the form of our outlook, which is our normal process in December.

[Operator:]

The next question comes from the line of Steve Tusa with JPMorgan.

[Charles Tusa:]

Can you just talk about what you're seeing on the Utility side and what you're -- and any kind of changes in customer behavior in this kind of dynamic environment where renewables are coming on maybe a little bit faster than expected and centralized generation is maybe being a little more de-emphasized over time? Anything you're seeing there from your customers on that front?

[John Engel:]

So what you described in terms of the trend is occurring clearly. A strong push in renewables. A shift from -- a shift on the generation side to natural gas. So clearly, what you've outlined is the trend. We're very pleased with our Utility business. Again, adjusting for that $100 million contract we didn't renew, we were growing. We grew in Q1. We grew in Q2 ex that contract. In Q2, we grew both investor-owned utility. Again, adjusting for that contract, we grew investor-owned utility a nice -- mid to upper single-digit range. And we grew public power double digits in the U.S. public power, double digit plus. So I think we're seeing good execution of our initiatives. We have a terrific value proposition. We don't talk a lot about our renewables business. We do support the solar industry. And we've had very strong growth in the first quarter and the second quarter this year on top of last year. It started very small a number of years ago. And it's still not very large, but it's growing double digits. It grew double digits again in the quarter. So I think the dynamic you described is what we're seeing. And utilities are -- they all have different strategies and they're managing based upon their mix of generation assets. So some are emphasizing renewables to a greater degree than others but overall, that trend is clear. I would say there's been also an incremental uptick in kind of outlook for the market this year in Utility. So I'd say our results are a little bit of incremental improvement in the market plus our own execution. In the utility contractor part of our business, we've got -- our quoted project values are up double digits there too. So -- and that speaks to Steve, the project specifically with respect to the utility power chain, from generation through transmission, substation and then distribution. So in that case, what our quoting activities for that -- for those contractors that serve that business is up over double digits. So again, as I mentioned earlier, more -- an incremental positive from our original outlook this year.

[Charles Tusa:]

And when you talk about the contract you walked away from, I mean, what's kind of the flavor of that kind of that seems like a big contract? What typically occurs? What's the reasoning behind the...

[John Engel:]

Yes. Well, we went through that. But I think that was very customer-specific, where the customer changed their supply chain model and they inserted someone else in the middle of the supply chain. And we had that business. And we were unwilling to go to the margin levels required for that, that new model. That's back to our margin discipline. And so that's a decision we made, and I'd make it again today if I had to. So with that said, we have, through the first half of this year, every renewal that's come up, we've won in Utility.

[Operator:]

The next question comes from Josh Pokrzywinski with Wolfe Research.

[Joshua Pokrzywinski:]

John, can we just take a step back on that comment about still targeting a 50% gross profit pull-through and we're through the first phase of this investment, and whether or not that's all done in the second half of '17, I guess, is less the point. But just given how bad decrementals have been on the way down, you're seeing at some point inflation that should hit your system, maybe it's on a lag, but in theory, that shouldn't continue forever. You're seeing the Canadian dollar start to come back into your favor. Wouldn't a 50% pull-through off of these levels still feel pretty terrible? I mean, I guess the takeaway from that is that cycle-to-cycle margin is getting lower?

[John Engel:]

Not to interrupt you, you're spot on. When the inflation starts to get pushed through, we have a sustained return to growth and if exchange rate moves in our favor, we will have the ability to deliver above 50% pull-through. No doubt about it. You are spot on. And if you look at our history, there has been times in the cycle where we've done that. I did very clearly when we -- when I shifted from COO to CEO back in 2009, signaled that when we get to a 50% pull-through, I would -- the operating contract I'm running with is anything kind of above that, as long as I can be assured and I have confidence in good return on those incremental technical sales and services kind of investments, I'm going to make them to feed the growth engine because ultimately, scale and scope and concentration matter in distribution. And so that's the operating model. You're right though. When all that kicks back in, we'll be in a position if we're not adding incremental resources. You're absolutely right that the pull-through will go well above the 50%, can and has -- it has in the past.

[Joshua Pokrzywinski:]

So I guess just to keep pulling on that thread a little bit more -- and I apologize, John, I'm going to put a few words in your mouth, but you can correct me. So if I look back to 2015, operating margins were about 5%, similar Canadian dollar rate, CapEx was in a tough environment but obviously not as bad as it is today. So if Industrial leads the way out and inflation hits your system, is that conceptually a real target? Or does that require an awful lot more volume versus what you could put up in one year?

[John Engel:]

Yes, we have not time-phased that walk yet, but we did lay out a framework on our Investor Day, right? And so that's what I'd point you back to. And so nothing's changed from that in that regard. And so that's the framework we're running with a multiyear lookout right now. I think what I was just addressing more was your initial question, which is, which I agree with, your point, which is we can drive incremental pull-through above 50%. I just -- again, I've got a very long-term view on the -- in terms of how the company is being managed. And I'll go back to what I've said many times before, we're still in a fragmented market and consolidation is occurring across our value chain, both in our supplier base and in the distributor portion of the value chain. We need to continue to be a leader in that consolidation. We're doing that through organic growth. Obviously, we want to grow above market, that helps to do that, as well as that accretive acquisitions because ultimately, scale matters in distribution and the economic power that comes with that is very important for distribution. So anyway, again, that's how we run it. That's how we optimize it. And we haven't laid out a precise by-quarter walk on that margin expansion. But we did give an overall framework in our Investor Day, and that's intact. Okay. I think this is the last question.

[Operator:]

So this concludes our question-and-answer session.

[John Engel:]

No, one more question, please...

[Mary Ann Bell:]

One more.

[John Engel:]

The next question comes from the line of Ryan Cieslak with Northcoast Research.

[Ryan Cieslak:]

Yes, I guess, the first question, John, I had is when you think about the way billing margins are trending right now at this part of the cycle and you think about past cycles, is there something that's different this time around? Or is there anything unusual? Or is this typically what you would think with regards to how billing margins have been in the last couple of quarters?

[John Engel:]

If you think about this versus you take a longer-term view and not just a multiyear view, but a multicycle view, yes. I think the difference this time in is that we're "in a recovery period," but it doesn't feel like a recovery. I mean, it's been a lackluster recovery. And so I think that's the difference here, that inflation is trying to rise and, again, my push the rope analogy. Suppliers are feeling on the raw material side of their business, the input side of their equation, they're trying to deal with that, they like to pass it to us through us to customers. But until customers see demand meaningfully pick up and be sustained, their focused on -- they are not preoccupied with capacity expansion, driving up utilization rates to their current capacity. They're still very focused on cost reduction both inside their four walls and down to supply chain. And that's what I think is a bit different, Ryan. It's just it's been a very challenging pricing environment, and it's really the supply-demand equation driven by supply is there, but not enough demand versus other cycles.

[Ryan Cieslak:]

And John, where do you -- what do we need to see to -- in terms of overall top line trends or demands trends, to really get you more comfortable that we can finally see the billing margins inflect higher? And it seems like everything are going in the right direction with backlog and sales ramping, but is there a level, is there a bogey that we should be thinking about that is sort of -- would really sort of turn it on I guess?

[John Engel:]

Yes, that's a great question. Again, we just returned to growth in the quarter, let's say, slight growth overall for the quarter, and it was driven by June. So we're at the front end of this return to growth. But I -- even at these levels, I think, we're in a better position as we move forward to begin to manage price, there's no doubt about it, right? So -- and push through a bit. So we're working very aggressively on our all margin initiatives, both that affect billing and gross margin. Again, I want to be very clear that billing margins have been -- they're slightly down and have been slightly down and that's the year-over-year delta, too, quite frankly. We've been in the 10 to 20 basis points range. If we weren't pushing any price increases through, those billing margins would be contracting, in all likelihood, 40 or 50, right? So we're pushing some through and we're working it very hard and we're trying to continue to sell our value proposition. And I feel really good about the momentum vector of sales and what -- and the precursor of what backlog portends. And we -- what we attempted to do at the Investor Day this year is really kind of outline our full range of products, services and solutions. And to me, that's the differentiation of our business model and value prop. We did outline -- and I was very clear about this, we are not doing a good job of pricing our value yet and our total service value proposition. We're in the very early days of that, quite frankly. So I would envision that being a nice driver, and I don't say in the next quarter, even the next year and the years to come. So -- but to answer your question directly, this mid-single-digit growth range where in our business we start getting a pull-through, we got the leverage, we're able to -- and ultimately, the customers got to be confident enough in the demand on their end of the -- on their outside -- sale side of their business to allow us to kind of push it through as we work our service value proposition and try to improve the pricing we're getting on the value we're delivering. So it's -- we're working it very aggressively. I think the sales and growth and the backlog portend that the future growth leads the ability, obviously, to work the margins and get the pull-through.

[Ryan Cieslak:]

Okay, great. And then my next follow-up question, Dave, when you look at the top line guidance for the third quarter of up two to five, you mentioned July was up mid-single-digits, I think the comps get easier and FX maybe is now turning a little bit positive for you guys, what's -- is there something else going on where you wouldn't see maybe closer to the -- obviously, to the high end of that guidance versus the low end? And -- or is it just some conservatism you're baking in there?

[David Schulz:]

Well, Ryan, one thing to keep in mind is that we do have one less work day in the quarter. So obviously, we've incorporated that into how we think about the range. And again, we are seeing sequential growth in our backlog. We're seeing sequential strength across many of our business units. But right now, I mean, obviously we just had one month of mid-single-digit growth. And so obviously, we're taking into context how we see the markets developing through the balance of the year and how that will impact our Q3, which is incorporated into our guide.

[Operator:]

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

[John Engel:]

Thank you, everyone. We do have a few additional callers in the queue, we do apologize for not being able to get to you, but Dave and Mary Ann are available. And I know their schedule is being -- is getting filled up in terms of additional calls today and tomorrow, so thank you for that. And thank you for your time this morning and your continued support. Have a great day.

[Operator:]

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