WESCO International, Inc.
Q3 2016 Earnings Call Transcript

Published: 28 Oct 2016

[Operator:]

Good day and welcome to the WESCO International Third Quarter 2016 Earnings Conference Call. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Miss Mary Ann Bell, Vice President of Investor Relations. Please go ahead

[Mary Ann Bell:]

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

[John Engel:]

Thank you, Mary Ann, and good morning, everyone. I’m delighted to welcome Dave Schulz to WESCO. Dave joined us less than two weeks ago and he’s already making a positive impact. He brings a strong finance and operations background, and we look forward to introducing him to investors and analysts. Now turning to the quarter, sales were down 3.6%, below our guidance of flat to down 3%. The shortfall was driven by construction, which was down 5.5% organically after being up 2% in Q2. We saw another significant step down in oil and gas in the quarter and weakness in our construction project business, as customers reacted to the continued economic challenges and uncertainty. Despite lower-than-expected sales, we delivered operating margin in line with our expectations, reflecting the actions taken in the quarter to further improve our cost structure. We again delivered strong free cash flow, which enabled us to reduce our financial leverage to 3.6 times total debt to EBITDA, compared to 3.8 times at the end of the second quarter. We also completed the early redemption of our $345 million of convertible debt, which simplifies our capital structure, reduces our interest expense going forward, and eliminates future EPS dilution associated with these debts instruments. As we previewed during last quarter’s call, we incurred a nonrecurring non-cash charge of $1.70 to redeem our convertible debt. As a result, our reported diluted EPS is a loss of $0.65. Setting aside this charge, our adjusted diluted EPS reflects income of $1.05. Our fourth quarter is off to a solid start, with October month-to-date sales flat to prior year on a consolidated basis. And that’s with just a few days left in the month. Now let’s turn to the market environment. Aside from construction, our end markets generally performed as expected. Starting on Page 4 with our industrial performance, we experienced a 10% organic sales decline in the third quarter driven by oil and gas, metals and mining, and OEM customers. U.S. sales decreased by 7%, and Canada sales were down 20% in local currency. Direct oil and gas sales declined more than 20% this quarter on top of a 30% decline in Q3 of the last year. Direct oil and gas sales are now approximately 5% of our total business, and that’s the result of this protracted downturn as well as our efforts to diversify our customer base. The overall manufacturing sector does remain under pressure, and it continues to struggle as reduced demand outlook, overall weak commodity prices, a strong U.S. dollar, and global uncertainty weigh down industrial production and with companies’ willingness to make capital investments. We’ve been helping our industrial customers respond to these challenges with supply chain process improvements, cost reductions, and supplier consolidation. As a result, our global counts and integrated supply opportunity pipeline is strong and bidding activity levels remain healthy. With our extensive product portfolio, service capabilities, and global footprint, we’re well positioned to deliver a broad range of supply chain solutions to our customers. Now turning to Page 5, construction sales declined by 5.5% in the third quarter, with the U.S. down 6% and Canada down 4% in local currency. Sales to commercial contractors in the U.S. partially offset declines with industrial-oriented contractors whose customers continue to be impacted by the strong U.S. dollar, weak global demand, and slack oil and gas in metals and mining investments. Outside of the industrial sector our outlook for the nonresidential construction market, commercial, education, and health care in particular is modestly positive, and the overall market is still well below its prior peak. Now shifting to utility on Page 6, overall sales were down 2%, with the U.S. down 2% while Canada was up 5% in local currency. Investor-owned utilities in the U.S. are tightly managing their spending, in line with overall electric power demand. We’ve achieved five years of sales growth on an annual basis from scope expansion and value creation with investor-owned utilities, public power customers, and utility contractors. This quarter WESCO renewed a multi-year contract to provide power delivery and generation materials for a large municipal-owned utility. And I am happy to say and especially proud to say the extra effort performance from our WESCO branches and associates in the quarter and in the first part of – the start of this quarter, they worked tirelessly alongside with our utility customers in the Southeast to help restore power to 1 million homes and businesses after Hurricane Matthew. We do expect the utility industry to continue to consolidate, renewable energy to continue to grow, and utility customers to continue to look for operational and supply chain savings. We’re well positioned to benefit from these trends and deliver against increasingly complex supply chain needs in this market, including integrated supply solutions for utility customers. Finally turning to CIG on Page 7, overall sales declined 2%, with the U.S. down 2% and Canada up 9% in local currency. During the quarter a slowdown in government fiscal year-end spending was partially offset by solid growth in broadband. We expect continued market growth in data and broadband communications, driven by data center construction and retrofits, cloud technology projects, and IP security for critical infrastructure protection. With that, I’ll now turn the call over to Dave Schulz to provide further details on our third quarter results and an update on our outlook for 2016. Dave?

[Dave Schulz:]

Thank you, John, and good morning, everyone. I’m very pleased to be with you today, and I’m looking forward to meeting with many of you in the coming months. Moving to Page 8, we expected third quarter sales to be flat to down 3% when we provided our outlook in July. Actual reported sales were 60 basis points below the bottom of this range. Organic sales declined by 6%, including decreased pricing of about half a point. Our acquisitions of Needham Electric and AED added 3 percentage points to sales, while foreign currency translation provided a slight headwind. Our core backlog increased 2% from year end 2015, and was down 3% from the third quarter of 2015, but was roughly flat sequentially. Gross margin was 19.7% in the quarter, down 10 basis points versus the prior year and down 20 basis points sequentially. However, our billing margin improved sequentially as effective execution of our supply chain management initiatives once again helped offset headwinds from pricing and end market mix. SG&A expenses for the third quarter were $256 million, including acquisitions which added approximately $8 million of incremental SG&A. Excluding acquisitions, core SG&A decreased by $10 million compared to last year. This reflects our cost reduction actions over the last six quarters to eliminate more than 850 positions and exit or consolidate more than 30 branches, along ongoing discretionary spending controls. During the quarter we eliminated more than 250 positions, from which we expect approximately $15 million of savings per year going forward. Operating margin was 5%, within our outlook range of 4.9% to 5.3%. Operating margin was down 50 basis points from the prior year, driven by lower sales but up 40 basis points sequentially from the second quarter due to lower SG&A. The effective tax rate was 28%, up 60 basis points from the prior year but slightly below our expectation of 29%. Turning to Page 9, we reported a net loss of $0.65 per diluted share this quarter including, as John explained earlier, a net loss from redeeming the convertible debt of $1.70 per diluted share. Setting aside this charge, we delivered income of $1.05 per diluted share, compared with $1.28 last year and $1.02 in Q2. Core operations unfavorably impacted EPS by $0.30, driven by lower organic sales partially offset by our actions to reduce operating costs. Acquisitions increased EPS by $0.05. A lower fully diluted share count increased EPS by $0.02. The pretax loss on debt redemption was $2.54, which was reduced by $0.84 from the tax effect. Moving to Page 10, free cash flow in the third quarter was again strong at $73 million, or 140% of adjusted net income. Year-to-date we have generated $204 million of free cash flow, or 150% of adjusted net income. WESCO has historically generated strong free cash flow throughout the entire business cycle. Our capital allocation priorities remain the same. 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 2.0 times to 3.5 times EBITDA. Third, we return cash to shareholders, and currently have $150 million remaining in our existing share buyback authorization to repurchase shares. I’m pleased to highlight that our leverage ratio was reduced to 3.6 times EBITDA, just slightly over our self-imposed target range. We anticipate that continued solid free cash flow generation will enable us to bring this ratio back within our target range by the end of the year. Leveraged on a net debt basis was 3.3 times EBITDA, also slightly below last quarter. Liquidity, defined as available cash plus committed borrowing capacity, is $693 million at the end of the quarter. Interest expense in the third quarter was $20.8 million, roughly flat to prior year, including the incremental cost of carrying both the new senior notes and the convertible debt for most of the quarter. As a result, our weighted average borrowing rate for the quarter was 4.6%, slightly higher than normal. Since the redemption of the 6% convertible debentures in September, our debt is once again appropriately balanced between fixed rate and variable rate instruments. Capital expenditures were $6 million in the quarter. We continue to invest in our people, technology, and facilities through both capital expenditures and operating expenses. Now let’s turn to our outlook for the full year on Page 11. Despite a year of end-market challenges, both our current sales and adjusted EPS outlook are within the original range of the full-year guidance we provided during our 2016 outlook call nearly a year ago. For the full year we expect a decrease in sales of 2% to 3%, reflecting our third quarter actual results and our expectation of current end market challenges continuing in the fourth quarter. We expect operating margin from 4.5% to 4.6%, reflecting lower sales partially offset by the cost savings actions that I just described. We anticipate delivering adjusted diluted EPS of $3.75 to $3.90 on an average share count of approximately 48.5 million shares. We’ve increased our free cash flow outlook to be at least 125% of adjusted net income, which would be our best performance since 2009. For the fourth quarter, our outlook anticipates a decrease in sales from 1% to 4% and an operating margin of 4.5% to 4.8%. This reflects our October actual results to date and our expectation of normal year-end activity levels. We’ll have one fewer work day in Q4 than last year, and we anticipate a fully diluted share count of 49.2 million shares for Q4. Now we’ll open up the call to your questions.

[Operator:]

We will now begin the question-and-answer session. [Operator Instructions] And our first question will come from Deane Dray of RBC. Please go ahead.

[Deane Dray:]

Thank you. Good morning, everyone.

[John Engel:]

Good morning, Deane.

[Deane Dray:]

And Dave, welcome and best of luck in the new role.

[Dave Schulz:]

Thank you very much, Deane.

[Deane Dray:]

Can we start off with construction? John, be interested in hearing your perspective especially since you are so project-oriented. So are these pushouts or outright cancellations? And then in terms of visibility, what’s happened to the backlog and what’s your sense of the non-res cycle here? Is this a blip or is this an actual turn?

[John Engel:]

Yes. So let me start out by saying I’m very disappointed with our construction performance and the overall results in the third quarter. It’s not the result of project cancellations. If you take a look at the quarter, overall August was our worst sales month of the year and it was driven by construction. And construction was down double digits organically in the month of August. When you look at how backlog performed across the quarter, backlog actually was flat sequentially across the quarter, it had grown across the month of August, so we entered September and we thought we’d have a very nice pick up in sales. And September did improve, in terms of our sales rate, but we didn’t claw it all back. So at the highest level I would say, let me start here Deane, overall third quarter sales – overall third quarter for the Corporation on a reported basis were down 3% sequentially. That’s not normal seasonality. Normal seasonality is for the third quarter to be equal to or greater than the second quarter. Our backlog was flat sequentially in the quarter from when we entered to when we exited, and typically we’ll eat backlog as we move through the third quarter and progress through the construction season. So if you fast-forward now to October, I mentioned that October is off to a positive start. It’s flat on a consolidated basis. In fact, it’s in the green. We’re slightly positive through month to date on our sales. All-in reported sales, consolidated, it’s driven by a return to growth in construction thus far in October month to date. So it’s not cancellations, is it project timing? There is some of that at play when you look across our regions geographically in the U.S. we still see the declines with the industrial-oriented the contractors. We got growth in commercial construction in the U.S. in the third quarter. When you look at it geographically, we had about half the regions grow, half the geographic regions grow in construction in the third quarter. You will recall the second quarter only one region was down double digits, in Q3 we had a couple regions down double digits. So there’s some isolated unique weakness project activity based in some regions, and that was the composition as we walked through the third quarter. I am very encouraged by the, as I said, by the October start in terms of sales, and again it’s driven by a return to growth in construction. I should also say that book to bill is very healthy well above 1 thus far in the month.

[Deane Dray:]

Okay, that’s helpful. And then maybe touch upon the whole hurricane effort to restore power. We’ve seen this before when you get wind damage on power lines that’s where WESCO is looking important to customers. How many utilities were involved, what was the turnaround, and how might you quantify that benefit in the fourth quarter?

[John Engel:]

From this storm there clearly was damage from wind, but I would – this was not like some of the storms we had many years ago, as you’ll recall, down in the Gulf region and in Florida that were – it was more of an effect of flooding versus wind damage is how to characterize it. With that said, it was a large storm and it impacted a number of different states. We have a very strong set of utility customer relationships in the southeastern portion of the United States, so we dispatched WESCO personnel and repositioned inventory as our utilities are a first line responder. In these types of situations we work hand in hand with them to try to get power restored. The impact in the third quarter was very minimal in terms of incremental sales, a couple million dollars, and it was offset by disruption with our branches because of flooding and such. We had numerous branches that ended up short shifting and then actually being closed for a period of time. So net-net the Q3 impact was essentially a wash. Thus far in Q4 it’s not a material driver yet. I think, Deane, this will play out over time as now that waters have receded damage is assessed, and then based on water damage those sales that potentially could kick in don’t happen immediately. They happen out, metered out over a different period of time. So we’ll have a better sense of that when we finish the fourth quarter. We will call out if it’s notable. At this point we are not seeing anything that’s notable thus far in October.

[Deane Dray:]

Okay. And then just one last quick question from me, just a clarification. On Slide 3 at the bottom when you talk about the forward month, you typically give that in an organic sales basis. And it looks like this month, you’re talking about October on a reported all-in basis. Why that change and how meaningful is that and what would the organic be?

[John Engel:]

There wasn’t an intent to change anything. Basically organic delta is essentially 3 points. I’ll round up

[Deane Dray:]

Okay. Thank you.

[John Engel:]

So I said we’re flat consolidated, Deane. I actually said we’re in the positive and green as of our latest daily sales report. And then it’s a 3-point adjustment for organic. So the way I would think about that, there’s no doubt that August was our worst month of the year on an organic year-over-year basis. The worst month of the year, we didn’t see it coming. We thought we’d have a nice spring back in September, we saw some of it not all of it. But October thus far, and it’s not over, October thus far, we’ve got a couple days left, organically it’s the best sales month of the year.

[Deane Dray:]

Good, that’s helpful. Thank you.

[Operator:]

Our next question will come from Joshua Pokrzywinski of Buckingham Research. Please go ahead.

[Joshua Pokrzywinski:]

Hi, good morning, guys.

[John Engel:]

Good morning, Josh.

[Joshua Pokrzywinski:]

Maybe just to follow up on Deane’s question on non-res, according to your exposure to non-res as in traditional, commercial, and institutional bias, there’s a big chunk of industrial in there. And John, I’m hearing what you’re saying on still seeing incremental weakness on oil and gas and some of the heavier industry markets, but I think you’re seeing, maybe this is too bold of a word, green shoots from other folks who participated in that space, whether or not they are focusing on rig count or seeing some MROs start to come back. What are you hearing from your customers, maybe not current quarter, because clearly things are still weak, but prospectively on what it’s going to take for some of these to pick up or what kind of lag they would typically expect to see versus some other indicators? I guess what I’m trying to say is at what point do you feel comfortable calling a trough in some of the really big ugly end markets?

[John Engel:]

Yes, I think I mentioned last quarter that we weren’t calling the bottom yet, but we thought we might be entering a bottoming process. That remains our view at this point, Josh. We’re still not calling the bottom yet, and I’ll amplify why that is the case. I think we’re seeing signs of the bottoming process, and so specifically I’ll say there is still a number of our oil and gas customers that are planning further cost reduction activities. So until that is done, I would say that all in we’re not really in the bottoming – we haven’t really bottomed. Now, the number of customers and the degree to which they are making these additional cost reductions, is not the same magnitude and it’s not the same number of customers, but there’s still some that are doing it and plan to do it. So I think that speaks to our view of have we bottomed yet or not, I think we are in the bottoming process, but I don’t think we have bottomed yet and we are not calling the bottom. Your reference of some other leading indicators going – having positive momentum, yes we see that too. Our oil and gas customers see that as well, and that’s encouraging. So that’s not going to impact Q4. So the question is going to be when does that kick in 2017? But that’s a good leading indicator for 2017. The other comment I would make is I did mention last quarter that, which was a positive development, that there were a couple of very large I’ll call them capital construction projects that went through final investment decision and proceeded, essentially got launched. We saw activity like that again in the third quarter. It’s not a large number, but we’re seeing that start. And not primary activity we’re seeing as in the petrochem market, but nevertheless it’s large capital projects. So I think that we are in the bottoming process for overall industrial for us. I mean the way to look at Q3 is similar to Q2. We’re in the bottoming, there is strong bid activity levels, however, and we are adding customers. Not in oil and gas because we are working really to take share of a lower spend with our oil and gas metal mining customers, but we had six new global account wins in the quarter, which is a positive. The pipeline is still strong. I would say that overall industrial remains challenging, but I think we’re beginning to get positioned where if things can bottom and start turning to the positive, I think we’re exceptionally well positioned in 2017 with the structural cost reductions we’ve taken thus far in the year and we’re completing some in Q4, to get very good pull through on industrial – incremental industrial improvement in 2017. And as you know, we’ve got a 2017 outlook call plan in December where we’ll take you through all our outlook in great detail.

[Joshua Pokrzywinski:]

Maybe to pull that thread a little bit more though on the – some of the cost reductions you’ve made and how that layers into 2017, do you feel like there’s some temporary stuff that needs to come back, or is that 50% GP pull through still a fair way to think about out years?

[John Engel:]

Yes, 50% up we call it operating margin, pull through, incremental gross profit dollar growth, it would be 50% of that to be pulled through to EBIT dollar growth. That’s still our operating construct and framework, absolutely. And when we get strong top line organic growth, we obviously have exceeded that handsomely. And those periods of times when we’re flat or when we’re declining its – we end up getting negative pull through unless we can take out structural costs. You can’t take them out fast enough. So I mean you understand how the equation works. So our focus is really on let’s get a return to growth, that still is our framework, it remains unchanged, that’s our operating framework. And I think again as we go through the fourth quarter we’ll have our outlook call, we’ll have a much better sense of where things end up. I would tell you that industrial – the way I look at industrial in the third quarter, it didn’t get a lot better but it didn’t get worse. And we’ve got some new wins in global accounts, and there’s some big capital projects that have kicked in. So in terms of cost we took substantial cost out, substantial cost out in the third quarter. If you look at what we took out – and we had planned to do it, but as we moved through the quarter and we saw sales softening, getting in the middle part of the quarter latter part of the quarter, we stepped up those cost take-out efforts. And there are some that we’re concluding here in the fourth quarter. So I think we’re going to be very well positioned with our cost structure entering 2017.

[Joshua Pokrzywinski:]

Perfect. Thanks for the color, John.

[Operator:]

Our next question will come from David Manthey of Baird. Please go ahead.

[David Manthey:]

Hello, good morning John and Mary Ann. Welcome Dave.

[John Engel:]

Good morning, Dave.

[David Manthey:]

Just to clarify a couple of data points here, the number of days in the fourth quarter, is it 62 this year versus 63 last year?

[John Engel:]

Yes, so we have one less day and that should be in the webcast document, Dave, on the last page it’s in the appendix that lays out. And you had it right, we have 62 days in fourth quarter of this year, we had 63 in the fourth quarter of last year.

[David Manthey:]

Okay, great. And then on pricing, Dave, you mentioned down 50 basis points. Was that more heavily weighted in one segment or another?

[John Engel:]

I’ll take that one, Dave. We had run many quarters in a row where we had flat pricing, and we had a 0.5 point of pricing impact in Q2, and another 0.5 point in Q3. So that tougher pricing environment that we signaled in the second quarter continued in the third. So I would characterize the pricing environment in the third quarter as very similar to the second and very challenging. I did mention in the last earnings call that there were some suppliers that had planned price increases that were slightly above specific categories, or subcategories let’s call it, above what they had historically planned. They did try to push those through, they had some success in some cases, in other cases not. Right now my view of what the planned supplier price increases are for the fourth quarter are more consistent with normal and historical range. So again, certain subcategories and certain supply – in certain product aggregate we’re looking more the range of 1% to 5%. It’s not broad-based across all categories, but it’s in that range. So we don’t see some of these higher increases trying to be pushed at the present moment for the fourth quarter. We have pretty good insight into what’s preplanned with an advanced look. So that gives you a little sense of the composition, if that’s helpful.

[David Manthey:]

Yes, so you’re saying continuation of no inflation environment going forward, but as you look at the impact on the current quarter, was it more heavily weighted towards industrial say than utility, or where was the most – the majority of the impact?

[John Engel:]

No I would say it was, again, it was pretty broad-based. So I wouldn’t signal the pricing pressure other than the two verticals in industrial that are still facing the most significant challenges, which is oil and gas and metals and mining. Now in those verticals the customers have been really challenging their supply chain partners to help them drive cost – fundamental cost reduction down to supply chain and productivity. So putting that aside, I would say it’s more broad-based. And we don’t forecast price, but my view is that Q4 will be a repeat of Q3. It’s a challenging pricing environment. And yes, our view remains unchanged. It’s a little to no growth low inflation environment. Through the balance of the year I think we’ll have to see how things set up for next year. We will give an outlook in our December call, does the Fed make a move, given the election results what will be planned in terms of any fiscal stimulus, and then how does that result in what the outlook is for growth in 2017. So I think we have some questions that need to be answered still before we have a definitive view on 2017, but for the balance of 2016 it’s going to be more of the same.

[David Manthey:]

Okay, and then finally I just want to drill in on SG&A again as usual here. When you look at the progression from third quarter to fourth quarter in the last couple of years, OpEx has been flat to down and sequential revenues have declined. Given that you’re guiding revenues this fourth quarter down slightly to peers, you’re pretty confident that SG&A dollars can be flat to lower in the fourth quarter based on these headcount reductions and so forth?

[John Engel:]

Yes, I would say the way to think of the business is how we ended up managing the business as we went through the back half of last year, we’re in that same mode this year, Dave. So that’s the bottom line. When you take a look at our SG&A in Q3 versus Q2 sequentially, we had some one-time costs in Q3 as a result of structural cost take-out, we took – and discretionary spend controls and pulled and work off some variable compensation levers as well. Q4 will be flattish to down, but again we have some additional actions we’re taking in the fourth quarter.

[David Manthey:]

And then final question, I’m sorry, on the SG&A to the first quarter last year you had some discretionary spending controls and then things pop up again in the first quarter, some of that seasonal some of that I don’t know if that was a rebound…

[John Engel:]

Yes, we will have that again, Dave, and as has been our practice we’ll outline that for you and frame it up and give you the sizing of that when we do the outlook call, because it’s going to be a function of we’re still taking cost out as we move through Q4. And some other actions to complete, let me say that we’re executing. So we really got to get a sense of how do we end the year in Q4, what’s that run rate, and then on a full-year basis. Then we’ll frame that in the outlook call for 2017. But I would tell you the answer to your question is yes, that same phenomenon will occur in Q1 of 2017

[David Manthey:]

Okay. Thanks a lot, John.

[Operator:]

Our next question will come from Shannon O’Callaghan of UBS. Please go ahead.

[Shannon O’Callaghan:]

Good morning.

[John Engel:]

Good morning, Shannon.

[Shannon O’Callaghan:]

Maybe just to clarify on that last point if you haven’t, so in terms of all the cost actions what was the total realized benefit this year, and how much incremental will you get next year?

[John Engel:]

Again, I think what I’d like to do, Shannon, is let’s do that when we do the outlook call because we have some additional actions planned in the fourth quarter and if I give you a number now it won’t be the final number. I think what’s important is to put the whole year in context, what we did across Q2, Q3, Q4, what’s our exit run rate on costs, then what we need to do which is what we’ve done in the past. We’ll take out the one-time costs to execute the structural actions and then there is going to be some add back in terms of variable compensation and some other elements as I went through with Dave. So let us walk you through that if it’s okay back in the December outlook call. But specifically though in Q3 I would say it’s approximately, but again you can’t run with this number because it doesn’t represent what we are doing with Q4 and the whole – it’s upwards of $15 million on an annualized basis going forward is the cost we took out. And it costs us several million dollars to execute that. If that’s helpful

[Shannon O’Callaghan:]

Okay, great. And then on this August dynamic I mean have you ever seen a dynamic like this in prior years where you have a really bad August, or was this a real extreme outlier on that respect?

[John Engel:]

Look, I’ll tell you it’s an outlier. I’ve been with the Company 12 years, the indications were as we entered August we didn’t expect any step down. We’re starting through August, but as August – as we got to the latter parts of August we weren’t getting the normal pick up near end of month. We’re not linear. Our average daily sales rate is not linear through the month, we’ve taken you through that a little bit in the past. Because project business can be lumpy, and there’s always – there is some backend loading with some customers in certain end markets. So we didn’t see that pick up. The only thing I will say is that backlog grew sequentially in August. So as we exited August we said wait a minute, what the heck happened. And we had expected some improvement in September, which we saw, but we didn’t get it all back. But encouragingly as it moves, and we now moved into October, you see even a much, much stronger start. And again, it’s our strongest month of the year, and it’s driven by a return to growth in construction.

[Shannon O’Callaghan:]

And the oil and gas down over 20% on the 30% comp, you talked about customers taking some additional cost action. Do you have a sense of in talking to them when those cost actions that they are taking run their course?

[John Engel:]

Yes, here’s how I’d characterize it. Let me give you a little finer tuned number. We were down 25% in Q2, we’re – and then when we said over 20%, but we’re actually closer to down 25% than down 20%. It’s over 20%, it’s less than 25% but it’s closer to 25%. So that’s another big step down in Q3. When I say they are taking additional actions, it’s not clear that these actions are going to extend into 2017. We don’t have information on that yet, but the ones I’m alluding to is it’s happening as we speak in Q3 and Q4. And the only point I was making is in overall until that’s effectively done, it just speaks to how they are managing their business. Until that’s effectively done I don’t think we’ve hit the bottom.

[Shannon O’Callaghan:]

Okay, great, thanks a lot.

[Operator:]

Our next question will come from Andrew Buscaglia of Credit Suisse. Please go ahead.

[Andrew Buscaglia:]

Hey, guys. Thanks for taking my question. So when we look into when you’re going to give your outlook in 2017, I know you don’t want to talk about this too much, but just given how bad things continue to trend, I mean how bad – you’ve taken a ton of costs out, how bad do you think it would have to be for earnings to be flat or down in 2017? Are you confident even in a slightly down environment you can still grow earnings?

[John Engel:]

So I think a couple of comments I will make. And again, I don’t – I’m not going to, we’re not going to scoop ourselves by laying out a 2017 framework in this call. Because again, we will do that in December and that’s our process. With that said, as I reflect upon 2016 thus far, and let’s call it through three quarters and the majority of October is in the record books at this point, what’s happened industrial underperformed what we expected a year ago. All in. Margins have remained relatively stable, both at a billing margin and gross margin line, off a little bit, but relatively stable. And we took a much more significant cost – structural cost reduction actions than we had planned because industrial was off much worse than we thought. That’s the story thus far through the three quarters plus almost another full month. The cash generation aspects of the business model are still intact, they’re very strong. The fact that our sales are off, we’re going to generate a little stronger cash, much stronger cash. As Dave mentioned in his commentary, we’re on track to have the strongest cash year since 2009. So I think that’s all working well, we cleaned up our capital structure by getting the convert redeemed. So I think we’ve taken all the right actions. Our focus now really is on driving the incremental growth and scraping and clawing and creating the value with customers on the growth front. And we outlined eight growth engines in our investor day. And our view of those is unchanged. It’s a very bullish view, these are – these eight areas that we outlined on investor day fundamentally inherently have very strong growth characteristics we think over the next five to 10 years, and that’s in any economic environment. So that’s where we’re focusing our investments and our execution. And so that’s our view, just to give you the overall view. We’ve taken the cost actions, we’ve positioned the structure right, margins are effectively stable, it’s all about driving incremental growth. We get very good pull through on the growth. We’ve been here before, I’ve done this multiple times before WESCO, and so we’re back in that mode and that’s – we’re myopically focused on driving that growth and we’re focused on those growth engines to deliver the superior results. So that’s really the way we think about 2016 unfolding and then ultimately 2017. And then the only other thing I would say is we did revise our full-year outlook, we didn’t do it in Q1, we had a solid Q1 versus expectations. We had a solid Q2. We refined our full-year outlook in Q2 and we exceeded our expectations I think on the top line, and that gave us some confidence. Q3 was a challenge on sales, particularly because of August. It’s encouraging have October come back even with this next set of revisions for the full year, we’re still contained within the outlook range we put in place last December on both the top line and bottom line EPS. So I think that does give us some confidence that we’ve got a good handle on the business, we’re executing, and we’ll take the actions necessary when required. Again, sales didn’t manifest like we thought, we took the cost actions, now we’re positioned for the good pull through when we get a return to growth.

[Andrew Buscaglia:]

Yes, that’s helpful. You talk a little bit about generating a lot more cash than you initially expected this year, any update with the uses of that cash? I know you have an outstanding repurchase available, and then you were talking about M&A at your analyst day last year. Anything striking your interest now?

[John Engel:]

So look, we have been and will remain acquisitive. Again, we see this opportunity to play a consolidation role in our markets and we think the overall framework is the markets are evolving and we think the big are going to get bigger faster, and we see ourselves taken a leadership role in that. We have been, that will remain consistent. You are right, we have a $300 million share buyback authorization that was approved at the end of 2014. We had foreshadowed that we would do $100 million of buyback, up to $100 million over the next three-year period. We did $150 million of buybacks last year, which exhausted about half of the current authorization. We haven’t done any this year, but our leverage ratio has been above the high end of our self-imposed financial leverage band of 2.0 to 3.5 total debt to EBITDA. We were running at 3.8 at the end of Q1 at the end of Q2, and that’s including doing the buybacks last year obviously and then continuing to do acquisitions, Needham and AED in particular in the last three quarters. So we haven’t done any, obviously we didn’t do any in Q3, it would bring our leverage ratio down to 3.6. We delever very quickly, you can look at our historical results on this. As Dave mentioned in his commentary, our current view is that we’ll delever back within our self-imposed band of 2 to 3.5 exiting the fourth quarter. That’s barring doing any acquisition or buyback. But so that’s where we are. How do we think about it? Our priorities remain the same. First, the bias is I want to get back within the range. So we’re going to get back within the 2 to 3.5 first and foremost, and we are on track to do that. Secondly, it’s investing in our core business, our organic initiatives plus M&A, consistent with our M&A strategy in prior years. And third, it’s being more thoughtful and preplanned with stock buybacks, and we’ll share that framework in the future. We have the authorization in place, we’ll be coming to you and giving you a little better framework that you can look to and have a – so you can do a little better planning around it in terms of how we think about that. At a minimum we want to offset the dilution associated with the annual management equity grants, and then we’ll have another set of framework variables that we tee up to you. The cash flow generation performance for this Company is very strong, it has been through all phases of the economic cycle, and I think we’re going to be entering 2017 with continued strong free cash flow generation which gives us additional optionality as we move through 2017. In terms of the M&A environment, M&A pipeline, nothing has changed in that regard with respect to how we manage it and approach it. It’s not an event, it’s a process. We have a phase-gated process, we’re managing targets in that process. Presently we have many companies under NDA where we’re looking at potential opportunities. That’s a standard course of business, and we can’t control the timing of these deals. The majority of these have been private companies. We don’t control the governance transition event. Some put it into play and we decide whether we want to participate, others we drive them into play. But we need to be positioned when it goes into play that whether want do the deal to make the decision. I’ve said previously I’m comfortable being above the high end of our self-imposed band. We’ve been running at that in the first half and we remain comfortable with that, given the right acquisition. So we’ll continue to work the M&A process, I think it’s an important value creation lever for the Company going forward. Nothing has changed on that front.

[Andrew Buscaglia:]

Got it, thanks.

[Operator:]

Our next question will come from Nigel Coe of Morgan Stanley. Please go ahead.

[Nigel Coe:]

Thanks, good morning.

[John Engel:]

Good morning, Nigel.

[Nigel Coe:]

Hello, John. So obviously gross margin is fairly flat year over year, so just broadly to make sure I understand, you’ve got prior cessation, about 50 bps, you’re getting basically some inflation from supplies, I’m not sure if you’re getting some deflation or some inflation, but you’re getting a little bit of squeeze on that spread offset by cost reductions. Is that way to think about it?

[John Engel:]

Yes, I think that’s a good way to think about it. Again, we look at billing margin, which is selling price minus purchase acquisition cost, call it. They’ve been relatively stable. When I say stable I’m talking – if we’re within 5, 10, 15, 20 basis points plus or minus to me that’s relative stability in this – the most challenging pricing environment I’ve seen at my time at WESCO is now. And then what are the other levers that go between billing and gross margin? The biggest one is higher volume rebates and then there’s inventory adjustments, and a few other factors that are nowhere near the same magnitude. So when you look at gross margins year over year and the fact that our organic sales have declined, that puts challenges into the SVR, supply volume rebates. That really is the high line. I think at the highest level is the way to think about it. As we go through each quarter of year, we true up SVR based on our year-end outlook. And as we go through the fourth quarter, that final number is determined, that’s based upon how Q4 ends up unfolding and closing out, and mix is a factor too. That’s the only other factor when you look at mix year over year, we’re somewhat agnostic, Nigel, at the operating margin line, but at the gross margin line we have different gross margins by end market segment, by product category. Even the better way to think about it is we have significantly different gross margins based upon if the fulfillment method is out of our warehouse, out of stock that is, or if it’s a direct ship business to support a project. When you factor in mix, mix is a little – the way I think about it is pricing is a bit of a headwind. Our business mix is a bit of a headwind, our sales are down which creates a little SVR headwind, and all the initiatives we talked about at our investor day that Hermant took you through, the supply chain initiatives, it’s a pressure curve. We’re trying to offset all those initiatives, we’d like to expand margins, tough environment. I think we’re holding our own pretty darn well when I calibrate how we’re doing versus others.

[Nigel Coe:]

I agree. So then thinking about inventory, and I understand there’s a couple of small deals which muddies the waters, but if I just look at the inventory compared to sales, turns have been declining. I’m just wondering are you happy with where inventories are today, or do you think that some action needs to take to think about that?

[John Engel:]

That’s a great question. Thank you for asking this because we normally don’t get into this part of the business. I think it’s important that again, just the way we think about it. Look at our strong free cash flow generation. So number one priority for me when I think through working capital let’s focus on inventory, it’s inventory availability and fill rate. Those are the two measures that we want to make absolutely sure we keep performing consistent with how we want to run the business. We want high inventory availability of the items based upon our view of demand by product with our customers, and those that are particularly difficult to forecast at a SKU level, we want to maintain a high inventory availability for those and then fill rate is imperative. I will tell you back in the global recession in 2009, we took total inventory dollars down, but it wasn’t commensurate with sales because we wanted to maintain high availability and fill rate. So our sales have obviously declined Q3 year to date, but it’s very important we maintain appropriate inventory levels to support our customer service and satisfaction levels. And with that said, we are able to do that and still generate a very strong free cash flow, which I think is really important. I only think about doing something special and draconian on inventory that only occurs if we are in a true overall recessionary environment, and then we would size accordingly. So I thank you for that question, that’s how we think about it. With that said, we’re trying to improve our inventory – we are working inventory improvement programs, applying lean, all that stuff, but the optimizing measure is availability fill rate.

[Nigel Coe:]

That’s great. And then just one more for me, quite a few of your industrial peers and even some of the distributors have thought about exec comp next year as being a headwind. Do you think that’s weighted today? Do you think that’s going to be a material headwind next year?

[John Engel:]

Yes, and I won’t use the word exec comp, because for us its overall variable comp. I want be very precise with this, it’s not quote/unquote exec comp. It’s not like it’s a small percentage. If you look at our structure, we have a variable component for all the various leaders in our Company, and that’s based upon them hitting their plans. We set the plans at the end of the year in December, and as I’ve said before, those plans are set higher to what we set our external commitments to, but now they’re compensated based on hitting those higher targets. And so this was the question Dave Manthey had earlier in the call, Nigel, that there will be a headwind for that that starts to manifest. It shows up in Q1 and we’ll take you through that in the outlook call.

[Nigel Coe:]

Okay, thanks a lot.

[Operator:]

Our next question will come from Ryan Merkel of William Blair. Please go ahead.

[Ryan Merkel:]

Hello, thanks for fitting me in.

[John Engel:]

Good morning, Ryan.

[Ryan Merkel:]

So back to non-res I had two questions. First, could you break out the growth rates for industrial versus commercial? And then if you could even residential?

[John Engel:]

So we grew low single digits in commercial, industrial was down more than that obviously because overall we are down. And residential as we’ve said before, residential as a direct end market segment is de minimus. Now residential construction impacts us on a second derivative basis for our utility business. Because there’s residential construction, either single-family home, multifamily homes, as those – as they are put in place new meters are put in the ground and that drives utility growth ultimately. And it also is a second derivative benefit with overall commercial construction, which lags resi. But we stepped about as far as I’ll go, Ryan, we don’t put numbers on the individual pieces, I think we just give you directionally what’s occurred.

[Ryan Merkel:]

Got it, okay. And then secondly Dodge came out, and I think their forecast for next year is 5% growth for starts. I think that’s a little better than most of us were thinking. So does that pass the smell test for you? And then secondly is the biggest wild card going to be the oil and gas spend? Thank you.

[John Engel:]

Yes, that’s a very good question. I’ll make two comments with respect to Dodge. One is I would just encourage anyone to go back and look at forecast accuracy and integrity over time. I’ll leave it at that. I mean, and that’s even true for a lot of the economists that predicted what GDP growth rate for the U.S. this year, and where are we Q3 year to date. So I think I’ll leave that where that is. That’s number one, number two, I think oil, gas, metals, and mining is a factor, but it’s only one factor. I think the real question is going to be remember residential construction has been growing several years in a row. If residential construction continues to grow, there’s a lag effect for non-resi. And I’m telling you non-resi is all the various verticals, putting aside those that have unique and acute challenges like oil, gas, metals, and mining. So I maintain the view that non-resi lags resi, and that’s a positive – that portends non-resi growth. So that’s the second point. Third point would be you’ve got to see growth in starts before you see growth in put in place. It starts there. So let’s see where the growth and starts end up, and then there’s some time lag we’ll put in place. So we’ll give our view again in the December outlook call, but I think we’re still positioned for non-resi growth. I know this is a big question out there, is non-resi rolling over? My simple way to give you the framework, resi hasn’t rolled over.

[Ryan Merkel:]

Right

[John Engel:]

So why would non-resi roll over? And typically the non-resi cycle is time phased after resi, and it’s not just by a year. One other point I think I would make, I didn’t get a question on Canada because I know we’re going to run out of time, I at least want to get this out there and give a little more color, because I’m sure this will come up in additional Q&A with Mary Ann. Let me just give a little more color on Canada in particular. We still remain very confident in the strength and execution of our Canadian business, relative to the market. There is a bit of a – the results are a bit weaker than we had in Q2, but I still feel very good about our Canadian team and our results versus the economic and market backdrop. The Canadian economy still remains bifurcated between the oil-producing provinces and the oil-consuming provinces, and the challenges in the prairies continue, they’re very significant. We were down double digits in the prairies again. We still think we’re holding share, even gaining share with some customers in the prairies. Given this bifurcated economy, the oil-consuming provinces are doing better as an overall market. We also had double-digit growth in BC. We had that in Q2, we had it again in Q3, and that’s encouraging to see. The housing market in BC remains strong, although a foreign buyer tax credit which was implemented in August, but still it’s a fairly robust market. Infrastructure spending is occurring in Ontario, including condos. So I mean there’s some positive development in the Canadian market, and in terms of outlook, again we’ll give outlook in December, but remember we had a new government in place in Canada, they were elected in October of last year, their platform was to raise taxes and spend – and invest in infrastructure. They’re planning to spend CAD120 billion plus over the next decade on infrastructure projects first, focusing on public transit, water, wastewater, waste management, and then housing infrastructure. That’s a positive indicator. That’s not showing up in the Canadian market spend numbers, GDP numbers yet. We’ll see to what degree that manifests itself, but that can be a positive indicator.

[John Engel:]

With that, I know we had a few more of you in the queue. I’m going to bring this to a wrap, I know Mary Ann and Dave will be taken your calls later and following up. Let me end by saying thank you very much for your time and your continued support, and have a great day

[Operator:]

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