WESCO International, Inc.
Q3 2013 Earnings Call Transcript

Published: 24 Oct 2013

[Operator:]

Good morning, and welcome to the WESCO Distribution Third Quarter 2013 Earnings Conference Call. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to Dan Brailer, Vice President, Investor Relations and Corporate Affairs. Please go ahead, sir.

[Daniel A. Brailer:]

Thank you, Danni. Good morning, ladies and gentlemen. Thank you for joining us for WESCO International's conference call to review our third quarter 2013 financial results. Participating in the earnings conference call this morning are the following officers

[John J. Engel:]

Thank you, Dan. Good morning, everyone. We posted record sales and operating profit in the third quarter, and are seeing the positive impact of our One WESCO sales, productivity and LEAN initiatives on our business. We are pleased to see a return to organic growth in the quarter, driven by improvements in Construction and CIG, both in Data Communications and Lighting and continued strength in Utility. Organic sales grew in all 4 end markets versus prior year. We continue to invest in our 8 growth engines and 6 operational excellence initiatives, while maintaining operating cost discipline. In the first half of 2013, we added over 100 personnel in our Global Accounts, Integrated Supply, Utility and safety businesses, as well as our pricing and supply chain management functions. In the third quarter, we added over 75 additional personnel into these areas, while maintaining year-to-date core headcount growth at 1%. These continuing investments position the company for a strong entry into 2014. Meanwhile, we continue to execute our LEAN productivity initiatives and manage an active acquisition integration process and pipeline. Conney Safety grew over 10% in the third quarter, after growing at half that rate in the first 6 months of the year and has been fully integrated into the company. The EECOL integration is also progressing well, and we remain on track to deliver our full year EPS accretion expectation of $1 in 2013. In the third quarter, our market stabilized in Canada, with constant currency sales up 2% versus prior year in both WESCO and EECOL in Canada. In addition, backlog in Canada grew sequentially, as initial recovery and rebuild efforts in Alberta began in the quarter. Operating margins expanded 20 basis points to 6.4 % driven by continued effective cost control, and net income and EPS grew double-digits. Overall, gross margins were flat, but core gross margins took a step down versus prior year, driven by a reduction in supplier volume rebates and the business mix impact of large Utility and Datacom wins. Free cash flow generation remains strong at 90-plus percent of net income in the first 3 quarters and continues to be directed to debt reduction. As a result, leverage is now within our targeted range on a pro forma basis, and we see excellent opportunities to further expand and strengthen our business portfolio over the next year. Our fourth quarter is off to a good start, with month-to-date sales in October at the high end of our Q4 outlook range for both the core and WESCO overall. Backlog is at a record level and our book-to-bill ratio is tracking above 1.0 at this point in October. Now moving to our Industrial performance on Page 4. Sales of our Industrial customers improved in the quarter versus the sales declines experienced in the first half. Channel inventories appear to be in balance with current demand, and third quarter bid activity levels remain strong. Notable customer trends are increased outsourcing, and supplier consolidation are continuing. Our Global Accounts and Integrated Supply pipeline increased to over $2.5 billion, and we remain focused on providing a one-stop shop for our customer supply chain needs. As a result, in the third quarter, we renewed a long-term contract with a large Canadian mining company. The scope of supply includes electrical MRO and project-based materials, with the opportunity to expand the service footprint outside of Canada. Moving to Construction. Nonresidential construction markets remain challenged, but we -- but have begun to show initial improvements in the U.S. and Canada. The continuing strengths of the residential and construction recovery this year is a positive leading indicator for future improvement in the non-resi construction markets later this year and next. Sales to construction customers improved in the quarter, marking the first quarter of growth in construction since Q2 of last year. We experienced another quarter of solid growth in lighting, driven by LED and retrofit applications. Notably, we also saw a return to growth in Data Communications in the third quarter, after experiencing sales declines in the previous 4 quarters, extending back to Q2 of last year. Entering the fourth quarter, backlog remains healthy and is up approximately 8% versus year-end 2012. Bidding activity levels have increased as well, and the non-resi construction market, despite its challenges, remains large, with opportunities for new construction as well as retrofits, renovations and upgrades. Moving on to Utility. We continue to be pleased with the strength of our Utility business in delivering above-market sales growth. Organic sales for Utility customers grew 11% versus last year, following the double-digit growth we experienced in the first half. The third quarter marks the 10th consecutive quarter of year-over-year organic growth, driven by new wins and an expanding scope of supply with our existing Utility customers. Customers are embracing the efficiencies offered by our Integrated Supply capabilities, as they seek to find ways to improve their supply chains. We continue to implement the new customer wins and we're awarded a high-voltage infrastructure project, material supply, logistics and procurement management services with a large IOU in the quarter. The project scope for this effort includes multiple transmission segments, substation upgrades and underground power lines. We are proud of our Utility team and the strong customer relationship that they have built within the last several years. We will be hosting an investor event at PSE&G, a large IOU at the Roseland, New Jersey facility on Monday, November 11. We hope you will consider joining us for this customer visit. If you have any questions, please contact Dan Brailer. Now moving to our CIG performance on Page 7. Sales improved in the quarter, marking the first quarter of growth in CIG since Q2 of 2012. Sales growth was driven by broadband communications and improvements in commercial and institutional, which were partially offset by continued declines in government due to budget constraints and sequestration. Despite the challenges in the overall CIG market, we continue to secure new wins, including the award of a multiyear contract to provide electrical materials and supplies to a large U.S. airport. This customer consolidated their distributor base and selected WESCO as their preferred supplier. With that, I'd now like to hand it off to Ken Parks. Ken will provide the details of our third quarter results and our outlook for the balance of '13. Ken?

[Kenneth S. Parks:]

Thanks, John, and good morning. On Slide 8, I'm going to review the Q3 results in the context of the outlook we provided during our second quarter earnings call. And as Dan indicated at the beginning of the call, I'll speak to the 2013 results adjusted to exclude the impact of the nonrecurring items. During our Q2 conference call, we estimated third quarter consolidated sales would grow between 17% and 19% year-over-year, and 2% to 4% organic growth. Consolidated sales in the quarter reached $1.93 billion, an increase of 16.6% year-over-year. EECOL sales were $233 million and accounted for 14 percentage points of the overall growth. EECOL sales grew 9% sequentially from the second quarter. On September 30, as previously disclosed, we sold EECOL's Argentina business with a local management team. Annual sales for that business were approximately $7 million. We do expect South America to be a long-term growth platform, with EECOL's business in Chile, Peru and Ecuador as the core. Organic sales increased approximately 3.2% in the third quarter, and foreign exchange was a headwind of 0.7 points of growth. Normalizing for the impact of one additional workday versus last year's third quarter, organic sales grew approximately 1.6%. Organic sales per workday grew 2% holiday adjusted in July, grew 3% in August and were essentially flat in September. Sequentially, third quarter organic sales increased 2.3%. Backlog at the end of September was up 2% versus the end of the third quarter of last year and sequentially from the end of Q2. Year-to-date, backlog has grown approximately 8% since the beginning of the year. Overall pricing was essentially flat in the third quarter. In our July earnings call, we had estimated that third quarter gross margin would be at or above 20.8%. And we're short of that at 20.5% and flat to last year's third quarter, due to lower supplier volume rebates and business mix. We're disappointed that core gross margin declined 90 basis points year-over-year, slightly more than we had anticipated. Two primary factors drove that decline. First was lower supplier volume rebates across WESCO, and particularly, in Canada, where we have ramped up new distribution centers in 2012. The opening of both the Edmonton wire center and the Toronto Hybrid DC required initial stocking of inventory in the prior year. This initial build, combined with the ongoing efforts to reduce inventory and a slower growth environment, have had a larger-than-anticipated negative impact on supplier volume rebates this year. Second, our Data Communications business grew 8% in the quarter, largely driven by -- from direct-ship, large client enterprise network sales, double-digit growth in security products and the initial rollout of the large technology company win that we announced in Q2. Like Utility, which grew approximately 11% this quarter, these Datacom growth drivers have lower gross margins than our average, contributing to the overall gross margin headwind. However, these new customer wins are providing incremental operating profit dollars. We continue to focus on delivering against our 22% gross margin target by executing on our pricing and sourcing initiatives, while delivering solid sales growth. SG&A for the quarter was $255 million, or 13.2% of sales, compared to $226 million or 13.6% of sales in the third quarter of last year. Core SG&A, at $226 million, was flat to the third quarter of last year and declined approximately $6 million from this year's second quarter, even while we continue to invest in the business to support our growth engines and operational excellence initiatives. Core employment was up approximately 1% from last year's third quarter and from the year-end. In addition, this year's company-wide merit increases were affected on July 1. In the second quarter conference call, we expected operating margin to expand to at least 6.2% in the third quarter. Operating profit for the third quarter grew 20% to $124 million, improving operating margin to 6.4% of sales versus 6.2% in Q3 of last year. Sequentially, operating margins expanded 40 basis points, demonstrating the strength of our operating model. With low organic sales growth and gross margin headwind, we were able to more than offset the impacts of headcount investments and merit increases to generate healthy, sequential operating margin expansion. Interest expense in the third quarter increased to $21.3 million versus $12.7 million in the prior year, and that's as a result of the EECOL acquisition-related financing. Our overall weighted average borrowing rate for the quarter declined to 3.9% from 4.4% last year. The third quarter effective tax rate was 27.2%, in line with our expected range of 26% to 27%. Net income increased by approximately 18% to $74.5 million, compared to $63.4 million last year. Now taking a look at Slide 9. Third quarter earnings per diluted share grew 14% to $1.42 from $1.25 in the third quarter of last year. As shown in the chart, the core business was a $0.16 drag on EPS, driven by the soft organic sales growth, gross margin headwind and growth in WESCO shares, which was partially mitigated by effective cost management and control. On the other hand, EECOL contributed approximately $0.33 of EPS accretion in the quarter and did step up from the contribution we saw in Q1 and Q2. Year-to-date, EECOL has contributed $0.74 of EPS accretion to our overall results, and we maintain our outlook that EECOL will be accretive to WESCO earnings per share by approximately $1 in 2013. Taking a look at cash. Over the last 8 quarters, we generated more than $0.5 billion of free cash flow, or approximately 110% of net income over that period. Free cash flow for the third quarter was $72 million, and it's $180 million for the first 3 quarters of 2013. Third quarter operating cash flow included a $21 million contribution to the EECOL pension plan, which was agreed to and funded by the seller as a part of our acquisition of that business. While generally accepted accounting principles require the contribution to be classified as operating cash flow on the face of the cash flow statement, we've excluded it from the calculation of free cash flow because of its nonrecurring nature and its funding by the seller. The acquisition of EECOL increased our leverage ratio above our targeted range of 2 to 3.5x EBITDA. As we stated at the time of the acquisition, we're committed to prioritizing near-term cash redeployment towards debt reduction until we're comfortably back within our target range. At the end of September, our reported leverage ratio was 3.6x EBITDA, which is down from 4.7x at year-end 2012, immediately following the acquisition. More importantly, our pro forma leverage ratio improved to approximately 3.4x EBITDA at the end of the quarter, bringing it back within our targeted range. Pro forma leverage net of cash was 3.2x EBITDA at quarter-end. We expect to continue to delever the company as we move through the balance of the year. In September, we executed an amendment to our accounts receivable securitization facility that increased the commitment to $500 million from $475 million, and reset the maturity to another 3-year term, lowering our borrowing spread and unused fee. At a full utilization level, the amended terms would reduce interest expense by approximately $700,000 annually. Our overall cash redeployment strategy remains unchanged. Over the long term, the first priority for cash redeployment is to invest in our business, with both organic growth initiatives and acquisitions. Liquidity, defined as invested cash plus committed borrowing capacity, was healthy at approximately $546 million at the end of the third quarter, and has increased nicely from $300 million at year-end 2012 and $429 million at the end of the second quarter. ROIC, at the end of September, was approximately 10%. Although the EECOL acquisition has reduced our overall ROIC in the short term, we remain focused on our long-term target of 15%. Now to the Q4 and full year outlook. We continue to experience an economy that is yet to show signs of a meaningful recovery in many of the end markets in which we operate. Our full year outlook provided in July called for mid-teens total sales growth with low single-digit organic growth, reflecting second half sales improvement over the first half. In the fourth quarter, we expect organic sales to grow between 2% and 4%, and total sales to grow 14% to 17%, including EECOL. In light of the sales growth coming in at the low end of our range for the third quarter, full year sales are now expected to grow between 14% and 15%, including acquisitions, a 1-point reduction from the top end of the range provided in July. Organic sales are still expected to be essentially flat to last year. We expect gross margins to be approximately 20.5% in Q4 and approximately 20.7% for the full year, with operating margins approximately 6% in the fourth quarter and 5.9% to 6% for the full year. Our effective tax rate is expected to be between 26% and 28% for the fourth quarter, and 26% and 27% for the full year. Putting all of this together, we now expect full year diluted earnings per share in the range of $5 to $5.20, adjusted for the nonrecurring items that we've discussed today. Reduction from our previous EPS outlook in July of at least $5.15 to $5.35 is driven by the reduction in the top end of the sales range and the resulting impacts on gross and operating margins. As has been our practice, we'll update our full year 2014 outlooks during our Q4 earnings call, which will be in January. With that, I'd now like to open up the conference call for your questions.

[Operator:]

[Operator Instructions] Our first question comes from David Manthey of Robert W. Baird.

[David J. Manthey:]

First off, could you talk about the growth in the Utility segment on a same-customer basis? Meaning, if you exclude the implementation of customer wins that happened in the last 12 months, I would assume it's growing at a slower rate than 11%. Could you just talk about what that number might be?

[John J. Engel:]

David, good morning, welcome. I don't -- we don't have that number off the top of our head. I'll give you kind of this sense. The overall Utility market has clearly slowed down, and I think we're hearing it across our supplier partner base. And as you know, there's -- some of that market they serve direct, and a piece of it they serve through distribution in which we are one of the partners. And so we've seen a general slowdown in -- clearly, in the transmission portion of the power chain. And distribution has been kind of a bump in the long kind of no growth, a very low single-digit growth. And so that's kind of the backdrop we're facing. We feel that we're doing very well with that tough set of end-market conditions

[David J. Manthey:]

Okay, great. And second on EECOL. How does that 9% sequential growth compare to historical 2Q to 3Q growth rates for them?

[Kenneth S. Parks:]

It is a step up from the typical sequential growth rate that they've seen in Q2 -- from Q2 to Q3 historically. But as you remember, we talked about, on the last call, that the second quarter for EECOL was somewhat held back by the weather patterns that they experienced. So not only did we start to see a little bit of stabilization and recovery in Q3 in their business, but it's also a number that was typically lower in Q2. If it was lower in Q2, then it normally is.

[John J. Engel:]

And David, since you brought it up, I want to give a little more color on this now, because I'm sure there will be a number of questions around EECOL. But we -- when we were here 1 quarter ago, we clearly had some challenges in the second quarter in the Canadian market, particularly in the western provinces due to the late and rainy spring. Alberta floods were the worst in history, and a little more than 1/3 of our sales were kind of out in Alberta in those western provinces. So projects came to a halt and we had expected that, that would start the recovery effort and rebuild efforts to kind of start in Q3 and Q4 in second half of the year. We're encouraged by, first of all, our core performance in Canada. We've been taking share, we believe, consistently for every quarter for a number of years now. But on the WESCO core business, not EECOL, in Canada, it grew 7% sequentially on a Canadian dollar basis, constant currency basis, which is the right way to look at it. And so we feel good there was real nice momentum, and the backlog moved sequentially nicely. So that sets up nicely. Then when you look at EECOL, we're right around, essentially, a double-digit sequential growth. And if you look -- but underneath that, David, and kind of look at the composition, it was really driven by the warehouse sales. Now, again, 3 quarters plus of the sales mix is warehouse space. But that was encouraging for us. And I did mention that our October start is strong, both for the core and for EECOL, and it's at the upper end of our Q4 outlook range. In particular, for EECOL, it's -- that strength that we kind of built through the third quarter has absolutely started, so far, in October.

[Operator:]

Our next question comes from Deane Dray of Citi Research.

[Deane M. Dray:]

On the guidance, just to get some additional insight here. If you'd take the inputs on the bottom-up guidance that you gave on each one of the metrics, we're getting somewhere around that $1.26 to $1.30 range, if we've got the math right. But if you do the other simple math as to how you put on year-to-date and that goes out and adjusts for the share count and so forth, there's some implied upside on the top end. And I just want to make sure that that's probably -- that's what you're suggesting, is that is additional upside? And if that's the case, what has to go right to see that additional EPS?

[Kenneth S. Parks:]

Sure. I mean, look, you're reading it -- I think you can do the math with the inputs and you kind of come out exactly where I would say my inputs take me. But the opportunity to the upside is truly driven by what happens with the top line. And as John indicated, we're currently running at the high end of our guidance range for the quarter. If that continues, that could deliver upside. But we're early enough in the quarter where we really got to see how we move through.

[Deane M. Dray:]

Great, that's helpful. And then if we can highlight one end market, that looks like there are some changes happening on the positive side, is in Construction. So some additional color in terms of your non-resi outlook. So much of what you do is on the retrofit side, you do not had to wait around for starts and value in place to change from the Dodge numbers. But what are you seeing now in the combined, both retrofits and then the starts, and you highlighted bid activity. So additional color would be helpful.

[John J. Engel:]

And I'll come back to Ken's point about the fourth quarter. We're encouraged by the start in October. And I think what's going to be important is how the fourth quarter unfolds. And we have some sense of what the different parts of WESCO have done historically versus typical seasonality. Sometimes we match our historical seasonality. In fact, we've broken it for a number of years as well. EECOL, this is the first time we will be the owner through the fourth quarter, Deane. Do you think I would comment on that? I think when the freeze comes, the hard freeze, really is the trigger point for -- as the customer spend before the freeze. And so we're encouraged by this kind of initial result so far in October. It's an active pipeline, too. So it's not just the warehouse, it's in kind of small- and midsized projects in both EECOL and WESCO in Canada, which gets to your Construction comment a bit. And typically, if you look at EECOL, at least as they're sharing with us -- and we'll see how this unfolds. October and November are typically stronger and there's -- normal seasonality would suggest as a follow-up in December. But again, that's more weather-driven, the freeze, et cetera. So I think it'll be interesting to see how that unfolds, and I think that'll be a determinant, really, on how Q4 ends, when the flash ball goes up on December 31. In terms of non-resi, we've had some backlog growth sequentially now for a few quarters. And we thought it was setting up, that we'd begin see some improving in sales. We're encouraged that we kind of have a return to growth. I'll give a little more color on this. If you look at -- break WESCO into kind of 3 major regions -- U.S., Canada, and everything else, U.S. and Canada for construction only, there's sequential growth in all 3 pieces. So -- in terms of sales growth. So I think we've got this improving momentum. We're really seeing it more in the small and midsized projects, as opposed to the larger projects by and large. That's not encouraging or discouraging us. That's just kind of what we're seeing. We do see increased bidding activity levels, and particularly for the retrofits renovation upgrades, both for energy efficiency and lighting. We're still seeing some very nice data center growth. We're very encouraged with our step up in Datacom growth. And now, we're -- there is -- we are seeing some of the competitive benchmarks that are out there. So that kind of increases our encouragement a bit. And I'll tell you. As we think -- kind of as we set up and enter next year, non-resi has a very long runway from our perspective. And shale gas development, we think is going to be an increasing opportunity and growth driver, particularly in the U.S. -- but to some degree, in Canada, particularly in the U.S., and we're well positioned to take advantage of that. We've not talked a lot about that, but I think that's a very nice growth trend we're facing into. And the opportunities for that are on site, it's nearby, and it's also upstream, downstream. So does that help?

[Deane M. Dray:]

That's really helpful. But just any color regarding bid activity. How closely is that calibrated?

[John J. Engel:]

Yes. It's picking up. And so, again, in terms of the mix, again, for construction, I'm not addressing industrial bidding activity, which is also very robust. But the bid activity on non-resi construction has ticked up a bit. But again, it's with the smaller and midsized projects.

[Operator:]

Our next question comes from Josh Pokrzywinski of MKM Partners.

[Joshua C. Pokrzywinski:]

So you talked a lot about your big labor Canada here. But I think some of that feedback from your peers and a few other laterals in the space, actually saw a downtick in Canada intra-quarter. Is there anything you can help us with from just the timing of the way your business falls in the sale cycle versus maybe some other peers in distribution or otherwise? Do you guys feel like you're a leading indicator there and that you've already lived through the weakness and they're catching up to that? Or is there a potential that there's a little bit of a sine wave and we have a fresh round of correction coming in 4Q, 1Q?

[John J. Engel:]

Josh, I'm glad you asked this because I think we should parse our comments a bit. I want to be very specific. I -- we've stated before, and I think we've really shined a spotlight on this and this is before we acquired EECOL, that we felt very strongly that we've -- our Canadian business has performed well to exceptionally well, at times, over the last 3.5 to 4 years. We have much better market data in Canada than we do in the U.S. And so we can say, definitively, we were taking share over the last 3 to 4 years from a WESCO Canada side. Obviously, we worked that EECOL acquisition for a long time, and as we got inside their numbers and looked at it, and they shared them with us before the acquired them, all historical financials, it's very clear they were taking share, too. So we put 2 very strong companies together. I would say that's it. I think that's what we're seeing in Q3. I'm not -- It's hard to really determine and parse, which I understand your question is, how much of it is our performance, outperformance versus the core market. And -- but I do believe strongly that we're outperforming the market. And we did see some improvement in the market. And, again, it was -- Q2 had set up such that there was -- because of the weather and the flooding, it was set up to have an improvement sequentially, clearly. But I think we're particularly pleased with the level of sequential improvement. To be at 7% for WESCO in Canada held to core and then to be literally kind of at the double-digit level on a Canadian dollar basis for EECOL is what we're sort of driving for, but we're very encouraged to see it.

[Joshua C. Pokrzywinski:]

Got you. So it sounds like some of the, perhaps, contingency or opportunity on the high end of your guidance, if I'm understanding some of the earlier comments correctly, is you've had some project deferrals to the extent that those come through in the fourth quarter here -- and maybe you'll know more in the next 4 or 5 weeks, that that's kind of the upside. If not, you have good visibility. Otherwise, that things are stable.

[John J. Engel:]

Well, that is a factor, what you described. And the other factor, as I described earlier, really, weather. So I think -- and again, what we don't know and don't have a good feel for, just to be very specific about it -- because EECOL is essentially 3 quarters plus base warehouse-driven sales versus Direct Ship, what -- and what is the effect when the freeze comes and how does it impact that versus DS, or Direct Ship, and projects? All that we know is what they tell us, and we're engaged in the business and what we've seen historically. So we're -- it'll be -- we'll have a much better feel as we get through the quarter. But I think that represents kind of a factor, it could be a plus or a minus.

[Joshua C. Pokrzywinski:]

Got you. And then if I could just squeeze one more follow-up for Ken. Does the comp -- and I appreciate the color on October, do the comps get easier or harder or about the same as we go through here? I know it's putting a fine point on it. Just anything to kind of help us with the top line would be helpful.

[Kenneth S. Parks:]

I would say, the comps are probably, overall, about the same in the mix business as you move through the quarter. One thing we should spike out is that, you'll recall, we closed EECOL in the middle of December last year. So essentially, when we get to December and then we close the quarter, we -- EECOL becomes part of our core, that's our custom, halfway through December. It doesn't affect our consolidated quarter results, but I just -- as we get through and report out Q4 results and we parse core versus consolidated. One other discontinuity point year-to-year, and we did address it last year and it was not insignificant, was Hurricane Sandy and the effects. And so I think you'll recall that Hurricane Sandy was, as I recall it, in the kind of a $12 million to $14 million or $15 million range is what, I recall, we said in Q4 of last year as a positive benefit to our Utility business. And we don't have -- to this point, there's been no significant storm that sets up that. That just becomes a more challenging comparable just for that quarter.

[Operator:]

Our next question comes from John Baliotti of Janney Capital Markets.

[John Anthony Baliotti:]

John, it seemed like this was the first quarter where all 4 of the end markets -- the major end markets, were positive. I mean, I know to various degrees. But if I go back, it seems like the third quarter of last year was the first quarter -- was the last quarter where all 4 them had positive growth. And I'm just wondering, sort of collectively -- I know you gave us some plus or minuses on Utility and so on. But any change you're sensing, whether internally or with customers in terms of their visibility or their feelings about the, let's say, the next 6 to 12 months?

[John J. Engel:]

Yes. I -- Actually, as we -- from our accounting, we were -- we had such a nice growth kind of 2010 into '11. And the first part of 2012, we had very much growth momentum. And we kind of -- last year became a 2-speed year. So we didn't grow at all 4 segments, end market segments, since Q2 of last year. We grew a little bit in Q3, but we didn't have all 4 growing, the same Q4, Q1, Q2. And it's been extremely disappointing to us, and we were ticked off up about it, quite frankly, and we've talked about that. So we've been pushing really hard to improve our execution, and that's been a focus across the entire organization. I don't sense any major change in customer sentiment or buying behavior in Industrial. I still think that there's a significant opportunity for a step-up in Industrial, if and when kind of GDP picks up and there's confidence that the economic recovery portion of that cycle we're in is pretty stable and it's ticking up. There are capital expenditures that can be released. We're not seeing that in a meaningful way. Now, there are different segments there. Mining is down a bit, et cetera. But fundamentally, we aren't seeing a pickup or a release of CapEx here, I think that represents a positive potential as we move into next year. We are seeing -- that we are stating this quarter, "This is different." The non-resi is beginning to start the recovery. I think what's going to be important is, honestly, it's a long runway for the recovery, but what's going to be the shape of the recovery? And I think that's the -- really, the key question. Once the recovery starts in our -- because the resi recovery has been underway now for some time, it's been strong double-digit. But if you look at the nature of the resi recovery, it's not necessarily feeding a double-digit non-resi recovery. So I think the amplitude or the shape of that recovery is going to be important. Utility is setting up to be a more -- still a challenging market. I mean, we're doing well because I think we're executing, but there's a depressed outlook for low growth. There's been a decline in power demand. And -- which is surprising, when you step back and think about it, in 2013. And there's continued regulatory pressure, there's rate case battles. There's a lot of pressure by utilities that they're placing cost reduction and productivity improvements, and that actually turns into opportunities for us, because of what we can provide them. There is increasing investment in distribution automation and demand response, along with gas plants. But our view for utilities as we kind of go through this quarter and set up for 2014 is, the distribution part of T&D is very low single-digit growth for the market. I'm not speaking of WESCO's performance. But for the market, very low single-digit. And transmission, we think, it's going to be down mid single digits. And again -- for the market. And so a tougher backdrop. Again, we feel real good about our position and our capabilities. CIG, we still see a downdraft, or what's called a headwind, from government. Our government sales were down in the mid single digits in the quarter. But CIG returned to growth. And it was driven by broadband communications, we had very nice growth there. Plus some nice wins and some uptick in some -- selectively, in commercial and institutional. So that's kind of the overall outlook. I don't -- we're not -- fundamental, the short answer -- and I gave a lot of color, right, by segment. But the short answer, we are not seeing increasing tailwinds at this moment. If anything, I would say, the headwinds have picked up a little bit in Utility. Industrial is about the same in our outlook. And hopefully, a tailwind is going to start here in non-resi. Does that help?

[John Anthony Baliotti:]

Yes, that's great. How about, if you could just strip out government from CIG, any idea of -- so how are you feeling about how that grew, if you strip that out? Because, obviously, it's been a headwind for number of distributors and other companies.

[John J. Engel:]

Yes. Well, our government was down in the -- actually, in the low single digit. So the decline we experienced in government, because it was double-digit declines in the Q1 and Q2, actually was not as big -- it was only down low-single digits for government, and that's embedded in that number. And so I -- we're still -- we're hopeful, but let's see if that's the real trend. Because that market is tough, right? It's tough. And so, we did -- we have pretty good execution, though, in government. So I think that's part of it. So -- but obviously, if you strip government out, I'm not going to give you an exact number, but we're above the 5% because the government was a downdraft.

[John Anthony Baliotti:]

Just a quick question for Ken. Ken, you guys did a nice job. You talked about the mix and how you got to the operating margin being above expectation. You did a nice job on the SG&A efficiency. I'm just wondering, you gave us some color, but is there anything more, on secular basis, that you guys are working on that is pushing that efficiency, let's say, going forward?

[Kenneth S. Parks:]

Really, the main thing that has driven a sequential decline is just -- we talked about it early in the year. As we came into the year and we're looking at a flattish first half from a top line with a step up in the second. But as a moved into and through the second quarter, we were becoming more and more confident we weren't going to see that second-half step-up. We have a large amount of cost that I will not describe as discretionary, because everything is ultimately discretionary to some degree, but more readily controllable. So we have actively gone out with all of our operating group leaders and finance leaders and worked to manage those controllable costs out of the business in the second half as much as possible, without harming the business. And there's a lot of those that can be managed and moved around in order to benefit the bottom line. So that is the biggest thing that we're doing, because we are a people-oriented business. So when you talk about secular movement, it's really about managing what our people spend. I will also tell you, not surprisingly, as we set our guidance for the year, we're clearly coming in at a lesser amount than we were when we started the year because of the second half outlook. So our compensation as a performance-based organization is tied to our performance against plan. So during the third quarter, we did take a bit of adjustment in our variable compensation in order to get it aligned to our performance versus plan. But the biggest chunk in positive performance was in managing the controllable cost, not just here in Pittsburgh, but across the organization.

[John J. Engel:]

The only thing I'll add, John, is that -- and we're -- this is hard work and hard to do, and we're proud of it, is we are still -- stepping up our investments in our growth -- selected growth engines and also the pricing and sourcing functions. So as I stated earlier, we added 100 people, net-net, sequentially, from December 31 through the middle of the year, through June. So averaging 50 per quarter, we added 75 in Q3. So I think it's incredibly important for us -- and the whole team is aligned, that we want to continue to step up the investment and those areas are going to drive better growth, more profitable growth for us. And yet to do that and hold our overall headcount basically within 1% growth, because we're really driving productivity in a number of other function, and that's LEAN. LEAN is still alive and well. We're driving and executing our LEAN productivity initiatives. And as I've stated continuously, that will always be here. It's continuous, it will never stop.

[Operator:]

Our next question comes from Shawn Harrison of Longbow Research.

[Shawn M. Harrison:]

I just want to touch on the rebate issue first. I want to make sure that it's not kind of a secular issue as we would head into '14, that you would see continued pressure, but more just the dynamics you described in 2012 with opening the other sites.

[John J. Engel:]

Absolutely. It's not a secular issue. It's not a change, necessarily, in how the programs are built. It's really about how the volume is coming out in the year.

[Shawn M. Harrison:]

Okay. This is my follow-up. What if we just, I guess, dig in a little bit deeper into the Datacom market, the strong performance side of this quarter. I think it was maybe alluded to earlier that you're taking share. But if you could just elaborate kind of -- about the strength you're seeing. How much of that is maybe market coming back, because it seems a bit choppy versus share gains you're taking in the market?

[John J. Engel:]

Short answer is, market is not growing. Not growing in Q3, it's been challenged in Q1, Q2, Q3. We did not -- we grew this quarter, and we grew nicely. It wasn't 1% or 2%, as we outlined, it was 8% growth, right? And so we feel really good about that. We have not grown in Datacom since Q2 of last year. So -- and the pricing environment is very difficult. It's very difficult and it has not gotten better, it's gotten worse over the last couple of quarters. That doesn't mean I think it's going to continue to that degree. But we think if Q4 sets up as challenging from an end-market perspective, and we're hopeful as we get into the next year that the market starts to improve and heal and get a little bit better in Datacom. But our execution, clearly, has performed against that backdrop.

[Shawn M. Harrison:]

Okay. And I guess from that comment, it sounds as if you don't see any green sheets yet of Datacom starting a term for 2014?

[John J. Engel:]

I think it's -- we're going to have to really monitor that as a go through Q4. And -- but we did not see that in Q3. The market is still tough.

[Operator:]

Now our next question comes from Ryan Merkel of William Blair.

[Ryan Merkel:]

But I want to start with EECOL, and a question on the guidance, just to make sure I have this right. So the guidance seems to imply EECOL sales of kind of 2 10, 2 20 in the fourth quarter. And if add back the stub periods from last year, that would put down about, what, 3% year-over-year, is that about right?

[Kenneth S. Parks:]

And you also got to consider the fact that we know that FX will be a bit of a headwind in the fourth quarter on that number. That's a few percentage points as well. Effectively, the takeaway is what we've got in the fourth quarter outlook for EECOL is essentially the same kind of volume that you saw on the third on a constant currency basis.

[Shawn M. Harrison:]

Okay. But it looks like, sequentially, the 2 10 and 2 20 implied by the guidance is down sequentially. And I thought the fourth quarter was a seasonally strong period, because people are buttoning up for the winter. So what kind of reconciles that?

[Kenneth S. Parks:]

Well, like I said, we've got the fourth quarter kind of running at where we had in the third. We, as John mentioned earlier, we're going through the fourth quarter for the first time with them. We know that it is typically a bit of a step-up, and we are going to see how that plays out. So right now, we have the guidance set at consistent with third quarter.

[Ryan Merkel:]

Okay. Then just for my follow-up. October is running kind of 4% organic growth. Is that broad-based or is that weighted to Utility and Datacom?

[Kenneth S. Parks:]

It's broad-based. And, again, when I say broad-based, U.S., Canada, international, at that kind of level. I mean, I'm not -- and so, it's kind of an extension of how we kind of went through finish Q3 into Q4.

[Ryan Merkel:]

So is that -- you don't have the end-market color there, you're just talking geographically? Or do you have the end market and...

[Kenneth S. Parks:]

Yes, we have the end market been color. It's consistent. It's consistent. And how we kind of finished Q3, that momentum carrying into Q4 so far, in October so far.

[Operator:]

Our next question comes from Matt Duncan of Stephens.

[Matt Duncan:]

Back on SG&A, Ken, real quick, to make sure we know how much sort of actual discretionary cost pull-down versus an adjustment to the variable comp. Can you give us a little help there on the $10 million sequential drop in SG&A cost? How much of that is sustainable if you continue to take a lid on the discretionary cost versus how much of it maybe comes back into the 4Q now that you're going to be running, again, on the variable comp?

[Kenneth S. Parks:]

I would say what we've taken out on the discretionary controllable fees, you should anticipate, we can manage that consistently at the forecasted sales level to carry through to the fourth quarter. I'll also tell you that the variable comp adjustment, if that helps you to size it, is somewhere between $2 million and $3 million in the quarter.

[Matt Duncan:]

Okay, that's helpful. So then if you get a little bit of a sequential drop in revenue, which is seasonal norm, the net-net SG&A cost are up a little bit, not a lot, because that $2 million to $3 million comes back.

[Kenneth S. Parks:]

It's always what we target.

[Matt Duncan:]

Okay. And then just in terms of the Industrial market, it seems like things have still been pretty flat out there in industrial world. You guys obviously have a pretty good view on sort of what's going on more broadly, just especially through the old broader Integrated Supply business. I'm curious, the better PMI data, the ISM has been a lot better for 3 months in a row, are you seeing that show up at all in your Industrial business? Are you picking up on any kind of change in tone from customer conversations? Are there any reasons to believe that maybe things could turn there?

[John J. Engel:]

It's not showing up in our sales yet. But it is showing up in increased bid activity levels. And our pipeline actually grew a bit this quarter, and we spike that up for you every quarter. And so of our -- I think as we've shared in the past, we've got roughly 16 different verticals under industrial that the measure our performance against. And I'll just give you a sense that 10 of the 16 were up in the third quarter.

[Matt Duncan:]

Okay, John, that's very helpful color. And then last thing...

[John J. Engel:]

Six of them -- and 1, and 6 of them grew double-digits. So I just -- I would tell you that if the PMI perception index says that things are going to get better, it's not showing up in sales yet. Clearly in the bid activity levels, and in our opportunity pipeline, it is. We are seeing continued trend of this outsourcing supply chain consolidation boding well for us. There's still this CapEx that's locked up that would be released, quite frankly. If there was confidence on the behalf of the CFOs of these industrial companies, that we are truly in a recovery. And there is -- and some of this uncertainty could be lifted that -- which some of it is self-imposed with the government and other drivers. Let's say it that way. So we're hopeful that as we move into 2014 that, that CapEx release kind of starts and there's just a general pickup in Industrial production levels.

[Matt Duncan:]

Okay, that helps. And then last thing, Ken, as we look out to next year, should we still view the $5.70 to $6.10 EPS guide as valid today?

[Kenneth S. Parks:]

I think the way you're going to look at that is what we always do in this part of the year, we don't update anything on the next year until we get into January. And Matt, I think, by the way, I was just blamed for the economic recovery. But John and I will talk about that later, as CFOs of industrial business.

[John J. Engel:]

We did the same thing, Ken. Look at how we ratcheted down our expenses and cost controls, right? So we understand the motivations.

[Operator:]

Our next question comes from some Sam Darkatsh of Raymond James.

[Sam Darkatsh:]

What do you attribute the Conney sequential strength to? And might that be an additional tail, or is that something that's just being helped by the improved integration and everybody rolling in the right direction?

[Kenneth S. Parks:]

We are -- and I'm going to use the word, we're thrilled with Conney. That was a step out for us, Sam, as you know, right, the type of distributor it is. We grew 4% to 5% mid-single digits in the first half. We're double-digit, we're above 10% in Q3. And they had their best month ever in history in September. I'll give you a little more color. This is the result of -- we're getting synergies. It's really hard to get sales synergies, we're getting sales synergies, which are the most difficult thing to do in an acquisition. In addition, they have a centralized model of sales and applications specialist resources, and we have built that out from less than 1 dozen folks in the fourth quarter of last year, and it's now at 50. 50 people, as we enter the fourth quarter in October. This was part of our strategic plan for Conney. This was not like some of the other acquisitions where we said we have all those cost synergy, we're going to wring that out in year 1 and year 2. We're going to invest in the growth platform for the company as part of our MRO leg, along with OEM and Capital projects, the 3 legs of growth for the company on our platform. And we are absolutely thrilled with kind of the execution there and the growth we're seeing.

[Sam Darkatsh:]

You anticipate that double-digit growth continues, John, into Q4. And since it's safety equipment, that implies manufacturing, which again, getting back to Matt's question, might that also suggest better things broadly industrially?

[John J. Engel:]

Yes. I wouldn't make that leap yet because the growth, quite frankly, is -- we have invested, we're getting real good ROI on that investment, and it's working what we outlined, which is opening up our Global Account and Integrated Supply customer relationships, where we were not able to bring the safety category to them previously in a meaningful way, and now we are. So think of that as really One WESCO sales synergies that Conney is enabling. So I wouldn't deduce from that, but it's the end markets ramping up.

[Operator:]

And our last question comes from Hamzah Mazari of Crédit Suisse.

[Hamzah Mazari:]

It's just a 2-part question. First one, do you guys feel comfortable getting back into the M&A market? I know the leverage is within target, but close to the high end. And then second part, for John maybe. How do you think about getting bigger on the nonelectrical side? Post EECOL, that business seems to be higher gross margin that the electrical side. You do have a pretty good network and PC network and branches. How do you think about that?

[John J. Engel:]

Hamzah, thanks. Great questions. Still have a very active pipeline on M&A. We never turned it off, right? So it's a continuous process. And I think -- and EECOL, it's very indicative of. We worked that deal for over 5 years. We were constantly working relationships with different targets that are in our pipeline and we want to be positioned when there's a governance event. And if we've been positioned and built the relationship, we need to be able to execute at that point. So we continue to actively manage this pipeline. At any given time, we have 1 dozen to 2 dozens non-disclosed agreements, confidentiality agreements in place, where we're evaluating companies and running them our models and such. And I've said that before. That has not stopped. It is one of the 2 value creation legs for the company. First being -- first and foremost, organic. Organic growth with our pull-through and getting the value creation there. Secondly, acquisitions. We see excellent opportunities, Hamzah, to continue to further expand and strengthen the portfolio as we close out this year and enter next. And we really feel good about our leverage ratio, the cash generation of the company, and that whole model continues to work well. So it remains just a great value creation lever and very high priority for us. Your second part of your question?

[Hamzah Mazari:]

Yes. I was just saying, do you wait for leverage to come down a little more before you get more aggressive on M&A or this is fine?

[John J. Engel:]

Yes, that's why I thought. So I think, on that point, is we are not going to -- EECOL ticked us above 3.5, but it was temporary, right? We said we're going to get back inside 3.5 as soon as we could, and we've done -- I think we've done a very nice job. We called EECOL our biggest acquisition in history, over 40 acquisitions we've done. We closed it in December of last year, and look at where we are 3 quarters later, right? We're north of 4 and now we're inside the 3.5. So we're not going to allow where we sit to be at the turn to doing the right deal, and we are constantly working it. So does that help now on the portfolio? On the portfolio, you'll see more of what these last 8 deals look like. If you look at these, they include a Conney Safety, they include a Brews and Trydor. They included AuRico, a Potelcom. They included a TVC Communications, and they include a major strategic acquisition that gave us, actually, South American exposure, as well, on EECOL. These are not just rolling up little electrical distributors and adding to our core -- core of the Electrical category, or that category for us. So I think in the company -- and we've been clear about this, we got 3 legs, Industrial MRO, nonelectrical; Industrial, inclusive of electrical, OEM and direct materials and value-added assemblies and services; and Capital projects. And increasingly, I think these acquisitions will support all 3 legs, but in particular, MRO. Thank you. That was our last question. We really thank you for your time today and your continued support. And I'll close with just a brief comment. We're encouraged with the accelerating momentum of our One WESCO initiative, and we're continuing to make investments in our people, our processes and our business. Have a great day.

[Operator:]

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