WESCO International, Inc. (NYSE:WCC) Q1 2023 Earnings Call Transcript

WESCO International, Inc. (NYSE:WCC) Q1 2023 Earnings Call Transcript May 4, 2023

Operator: Hello and welcome to Wesco’s First Quarter 2023 Earnings Call. I would like to remind you that all lines are in a listen-only mode throughout the presentation. Please note that this event is being recorded. I will now hand the call over to Scott Gaffner, SVP, Investor Relations, to begin.

Scott Gaffner: Thank you and good morning, everyone. Before we get started, I want to remind you that certain statements made on this call contain forward-looking information. Forward-looking statements are not guarantees of performance and, by their nature, are subject to inherent uncertainties. Actual results may differ materially. Please see our webcast slides as the company’s SEC filings for additional risk factors and disclosures. Any forward-looking information relayed on this call speaks only as of this date, and the company undertakes no obligation to update the information to reflect the changed circumstances. Additionally, today, we will use certain non-GAAP financial measures. Required information about these non-GAAP measures is available on our webcast slides and in our press release, both of which are posted on our website at wesco.com.

On this call — on the call this morning, we have John Engel, Wesco’s Chairman, President and Chief Executive Officer; and Dave Schulz, Executive Vice President and Chief Financial Officer. And now I’ll turn the call over to John.

John Engel: Thank you, Scott, and good morning, everyone. It’s a pleasure to be with you today. We’re off to a strong start this year and set a new first quarter company record for sales, backlog, margin and profitability. The power of our increased scale, our industry leading positions and our expanded portfolio of product, services and complete solutions is evident in our continued strong performance. We delivered double-digit organic sales growth driven by secular demand trends, share gains and ongoing improvements in the supply chain. All three of our business units set new records for first quarter sales as well as gross margin. And we delivered another impressive quarter of cross-sell results, which continue to exceed our expectations.

We’re confident that 2023 will be another transformational year for Wesco. We’re making excellent progress on our digital transformation and expect our strong sales growth and margin expansion to continue. As you saw in our release earlier this morning, we reaffirmed our full year outlook, and we expect to generate significant free cash flow in 2023. As Dave will discuss in more detail later in the call, we are focusing our cash generation on debt reduction in the near-term. As a result, we expect to reduce our leverage below 2.75 times, which is the midpoint of our target range by year-end. And that creates increased capital allocation optionality for us in the second half and entering next year. Now turning to page 4. The strength of our business model and the success of our integration efforts since closing the Anixter acquisition in mid-2020 have established a track record of superior results for our company.

This page highlights our first quarter record results compared to the pro forma pre-pandemic results of legacy Wesco, plus legacy Anixter in the first quarter of 2019. As you can see, we have clearly outperformed the market, delivering impressive sales growth and margin expansion, and we’ve achieved record profitability, all while rapidly deleveraging our balance sheet. Most importantly, our dedicated team of Wesco associates continues to provide resilient and critical supply chain solutions for our customers around the world, capturing the benefits of our deep exposure to sustainable secular growth trends that drive our future sales and profitability. So with that, I’ll now turn the call over to Dave.

Dave Schulz: Thanks, John, and good morning, everyone. I’ll start on slide 5 with a summary of our first quarter results compared to the prior year. As John mentioned, we delivered first quarter record sales, gross margin, adjusted EBITDA margin and adjusted EPS. Our cross-sell program again exceeded our expectations. Our ability to cross-sell Wesco and Anixter products and services contributed approximately $220 million of sales in the quarter. On an organic basis, sales were up 11% in the quarter driven by a combination of price and volume, along with share gains. We estimate pricing added approximately five points to sales growth with the benefit primarily in our UBS and EES segments. On a reported basis, sales were up 12% as additional sales from Rahi were partially offset by a headwind due to foreign exchange rates in the quarter.

Backlog continues to be at historically high levels. In total, backlog was up 21% year-over-year and flat sequentially from the end of December, including backlog associated with the Rahi acquisition. Supply chains have started to heal and, in some instances, have returned to normal. However, we are still experiencing extended lead times in our EES and UBS segments for critical components such as switchgear, breakers and transformers. While an improving supply chain is a positive for Wesco, our customers and suppliers, it has created some near-term timing issues around inventory. Specifically, we are adjusting our order patterns to reflect shorter lead times versus last year. Our current inventory levels support our record backlog and our expectation to deliver 6% to 9% revenue growth in 2023.

As we start the second quarter, demand has continued to be resilient on top of a tough base period comparison. In the month of April, growth continues to be led by CSS and UBS, which were both up low double digits. Preliminary workday adjusted April sales were up approximately 6% year-over-year, including the impact of a stronger dollar and the Rahi acquisition. On a preliminary workday adjusted two-year stack basis, sales were up 28% in April. Recall that comparables in the first half of the year are particularly challenging. Gross margin was a first quarter record at 21.9%, up 60 basis points versus the prior year and in line with the fourth quarter of 2022. This result was again driven by our margin improvement program and the effective pass-through of supplier price increases.

Adjusted EBITDA, which excludes merger-related integration costs, stock-based compensation and other net adjustments was a Q1 record and 16% higher than the prior year. Adjusted EBITDA margin was also a Q1 record at 7.6% of sales or 20 basis points above the prior year. Adjusted diluted EPS for the quarter was $3.75, another Q1 record, and $0.12 above the prior year. The primary driver of this increase was core operations as we recognized higher below the line items related to interest and other expenses. Turning to page 6. This slide bridges the year-over-year increase in sales and adjusted EBITDA. Organic sales increased 11% versus the prior year, including a 5% benefit from price in the quarter, along with volume growth in our markets. As expected, the contribution from price moderated in the quarter relative to 2022 as there have been fewer supplier price increases, and the magnitude of these increases has moderated.

Adding to this growth was the impact of the $220 million we generated in cross-sell in the quarter as well as continued share gains. Adjusted EBITDA increased 16% versus the prior year. Higher sales and expanded gross margin drove the majority of the increase, along with the realization of cost synergies in the quarter. Consistent with 2022, we continue to experience higher volume related operating costs, including shipping and sales commissions. We also recognized higher expenses for employee compensation and benefits due to inflation and higher headcount as well as cost increases related to the operation of our facilities. SG&A came in above expectations, with the majority of the increase incurred in our EES business unit. Finally, in accordance with our plan, we continued our strategic investments in systems and digital tools.

These cost increases partially offset by the realization of integration cost synergies and lower incentive compensation expense. Turning to slide 7. Organic sales in our EES business were up 4% year-over-year and a first quarter record. Recall that beginning in Q1, we transferred certain businesses from EES to CSS and UBS to better align our sales management of certain customer accounts. Excluding the impact of this transfer, EES organic sales would have been 6% above prior year. The year-over-year growth primarily reflects continued double-digit sales growth momentum in our industrial markets, and solid construction sales up mid-single digits. OEM sales were down low single digits driven primarily by lower specialty vehicle and manufactured structures demand.

Backlog was flat with the record December level and 14% higher than the prior year. In the first quarter, adjusted EBITDA was $183 million for EES, down approximately 5% from the prior year. Adjusted EBITDA margin was 8.6%, 60 basis points lower year-over-year. Segment gross margins were up over prior year. However, higher SG&A costs in the quarter, specifically related to higher headcount and transportation and logistics costs drove the decline in EBITDA. We expect EES profitability to improve in the second and third quarters driven by operating leverage on seasonally higher sales. SG&A reductions initiated in the second quarter will take effect in the second half of the year. Turning to slide 8. Sales in our CSS business were a Q1 record and up 13% versus the prior year on an organic basis.

Excluding the impact of the inter-segment business transfer I mentioned a moment ago, CSS organic growth would have been 11%. Of critical importance was the strong sales growth in February and March, the two toughest comparables of the quarter. We saw solid growth in network infrastructure, up mid-single digits, driven by data center and cloud applications, as well as very strong growth in security, which was up low double digits, and professional audio visual installations, which was up more than 30% from prior year. Backlog, including Rahi, was up 10% over the prior year and decreased 2% sequentially as we were able again to release more projects from backlog due to improved availability of product and a return to more normal lead times across most product categories.

Profitability was also strong with record Q1 adjusted EBITDA and adjusted EBITDA margin of 9%, 40 basis points higher than the prior year, driven by operating leverage, integration cost synergies and the continued successful execution of our margin improvement initiatives. Turning to slide 9. Record sales in our UBS business were up 18% versus the prior year on an organic basis in the quarter, marking the sixth consecutive quarter of organic growth above 15%. We experienced broad-based growth in our utility and integrated supply business with sales up over 20% and up low double digits, respectively. Broadband sales were down low double digits as certain customers work through higher levels of inventory that were built last year. Backlog was another record in the quarter, up 46% over the prior year and up approximately 1% sequentially.

Profitability was exceptionally strong with an adjusted EBITDA margin of 11.3%, up 160 basis points versus the prior year, driven by operating leverage on higher sales, our margin improvement initiatives and integration synergies. This was the fourth consecutive quarter of adjusted EBITDA margins above 10%. Now moving to page 10. The size of the cross-sell opportunity of combining Wesco and Anixter continues to exceed our expectations. In Q1, we recognized $220 million of cross-sell revenue, bringing the cumulative total to $1.45 billion since the beginning of the program. Our pipeline of sales opportunities remains healthy and expanded again in the quarter. We are capitalizing on the complementary portfolio of products and services, as well as the minimal overlap between legacy Wesco and legacy Anixter customers.

As we look at the remaining nine months of the program in 2023, we are increasing our expected cumulative total to $1.8 billion, reflecting the strength of our value proposition against the backdrop of accelerating secular trends. Turning to slide 11. This is a slide that we’ve shown throughout the integration with the realized cumulative run rate cost synergies of $188 million in 2021 and $270 million in 2022. We remain on track to meet our expected target of $315 million by the end of 2023. Our focus through the balance of the year is on our supply chain network design and field operations to drive cost synergies. Turning to page 12. On this page, you can see a bridge of free cash flow in the first quarter, which was a draw of $266 million.

The primary driver was working capital, which more than offset net income. Receivables increased sequentially in Q1 as some customers delayed payments from March into April. However, accounts receivable reserves and bad debt write-offs are at normal levels. The increase in inventory in the quarter was due to a few factors. As we continue to see supply chains normalize, certain suppliers are accelerating their pace of shipments to us. While the improved availability of product is a positive for our customers, recall that we do not typically ship product to our customers until their entire order is available. As we make progress shipping the backlog of projects, we expect to see a normalization of inventory levels, which will drive cash generation through the rest of the year.

Payables were an $87 million use of cash following the $70 million cash generation in the fourth quarter, driven by the timing of purchases in Q1 and normal seasonal cash payments based on prior year accruals. Capital expenditures was approximately $14 million in the quarter, and other sources and uses of cash were collectively an $18 million use of cash in the quarter. Moving to Slide 13. Reducing our leverage has been a top priority since we announced the acquisition of Anixter. While leverage decreased for eight consecutive quarters through the end of last year, our leverage increased one-tenth of a turn in Q1 driven by the use of cash in the quarter. Leverage remains well within our targeted range of 2 to 3.5 turns, and we expect to generate full year free cash flow of $600 million to $800 million.

Given our current debt levels and the interest rate environment, our near-term capital allocation priority will be to pay down debt until we reach the midpoint of our target leverage range, which we expect will occur in the second half of the year. Now moving to page 14. This slide shows the uniquely strong position of our company to drive growth and profitability in the years ahead. The end-to-end solutions that we provide to our global customer base are directly aligned with the six secular growth trends shown on the left side of this page. Our participation in these trends, coupled with increasing public sector investments in infrastructure, broadband and partnerships with the private sector, make Wesco positioned exceptionally well. As we outlined at our Investor Day last year, we expect to grow 2% to 4% above the market due to the combined benefit of secular trend growth and increasing share.

In short, we view Wesco as a secular growth company. Moving to page 15. We are reaffirming our 2023 outlook today based on the demand trends and record results in the first quarter. In 2023, market growth is expected to contribute approximately 4% to 6% to the top line, which is a combination of volume and price. We expect US GDP to be flat in 2023 with our secular tailwinds providing one to two points of volume growth. Price carryover in 2023 will be three to four points based primarily on pricing actions in 2022. Recall that our guidance does not incorporate any impact of future pricing actions. In addition to market growth, we believe our scale and continued cross-selling efforts will contribute an additional one to two percentage points above the market, driving total organic growth of 5% to 8%.

After factoring in the additional revenue from Rahi and the impact of working days and foreign exchange, we estimate our reported sales growth will be in the range of 6% to 9%. For our strategic business units, we expect EES reported sales increased by mid-single digits versus 2022, with both CSS and UBS up high single to low double digits. Please note that in the appendix, we have highlighted the account transfers from EES to CSS and UBS we discussed earlier and that began taking effect in Q1. In 2022, these accounts represented approximately $200 million of sales with 85% moving to CSS and 15% moving to UBS. For adjusted EBITDA margin, our outlook is for a range of 8.1% to 8.4%, which represents approximately 20 basis points of expansion at the midpoint.

We expect adjusted earnings per share between $16.80 to $18.30 and free cash flow of between $600 million and $800 million. This free cash flow outlook of $700 million at the midpoint would represent the highest free cash flow in our history. Through the cycle, we still expect the company will deliver free cash flow equivalent to net income. Consistent with the expectations we outlined during our Investor Day in September, we expect to generate $3.5 billion to $4.5 billion of operating cash flow during the period of 2022 through 2026. To note, we expect positive free cash flow in Q2 to return to us net neutral cash generation for the first half and to deliver the rest of our targeted $600 million to $800 million of free cash flow in the second half of the year.

We increased our expectation for interest expense for the year from a range of $330 million to $370 million to a range of $350 million to $390 million, primarily driven by higher variable rates and the timing of debt paydown in 2023. We have detailed our expectation for other expense, which captures certain non-operating expenses, primarily related to the impact of pensions and foreign exchange. In the first quarter, these expenses were approximately $10 million, and we expect $30 million to $40 million for the full year. This expense reflects the recent devaluation of certain foreign currencies, along with slightly higher pension expense. This outlook reflects a revised effective tax rate of about 25% to 26% for the year, lower than our prior expectation due to the benefit of certain discrete items in the first quarter.

We still expect an effective tax rate of approximately 27% for the remaining three quarters of the year. This is slightly above our ETR over the past few years, primarily due to the implementation of certain rules in our Canadian business related to hybrid debt instruments. 2022 also benefited from certain one-time discrete items, primarily related to a change in US tax law regarding the valuation allowance on certain foreign tax credits and one-time discrete benefits in Canada. In 2023, we continue to expect to spend approximately $100 million on capital, an additional $40 million on capitalized cloud-based computing arrangements related to our digital transformation. On the statement of cash flows, approximately $100 million will flow through capital expenditures and approximately $40 million will flow through changes in other assets.

For the year, the lower tax rate that we experienced in Q1 will be more than offset by higher interest and other expenses, but we continue to expect adjusted EPS will be within the outlook range. Our outlook assumes an average diluted share count of 52 million to 53 million shares for the year. This outlook reflects our expectation that 2023 will be the third consecutive year of record results, record sales, gross and EBITDA margins, EPS and a record free cash flow and is consistent with the long-term financial framework we presented at our Investor Day in September of last year. We will complete our integration with Anixter at the end of the year and expect the results in 2023 to substantially outperform the expectations we set and raised since the time of the transaction closed.

Moving to slide 16 and before opening the call for questions, let me provide a brief summary of what we covered this morning. The first quarter was a great start to the year. We had record first quarter sales in all three of our business units, along with record gross margin, operating profit, adjusted EBITDA and adjusted EBITDA margin. We again took share through sales execution in our cross-sell program, and we are again increasing our cross-sell synergies outlook for 2023. Profitability was also strong in the quarter as gross margin and EBITDA margin both expanded versus the prior year. We continue to expect 2023 will be a transformational year with continued execution of our digital initiatives, strong sales growth and continued margin expansion.

Lastly, we remain on track to deliver record free cash flow of $600 million to $800 million to support our capital allocation priorities. With that, we’ll open the call to your questions.

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Q&A Session

Operator: We will now begin the question-and-answer session. Our first question today comes from Deane Dray with RBC Capital Markets. Please go ahead.

Deane Dray: Thank you. Good morning, everyone.

John Engel: Good morning Deane.

Deane Dray: We’re hearing lots of consternation about channel inventory and customer inventories and whether there’s destocking going on. And I was hoping you could just take us through from your perspective, supply chain normalization is allowing companies and customers to be able to release buffer inventory. They’re all talking about that. But anytime you see or hear about destocking, it raises concerns, is that the early sign of a slowdown? So look, you’re right in the ground zero of all of this because you’re getting inventory from the suppliers, taking that in, you’re seeing the pace with the customers as well. So please share with us what you’re seeing with regard to that question. Thanks.

John Engel: Yeah. Deane, very good question. I — look, I think we had a very strong quarter. We built a plan for the year. We essentially delivered our plan. The mix was a little different than what we thought. UBS and CSS a bit stronger than an EES, a little bit of headwinds there, but still grew in the quarter. So overall, we’re seeing very strong demand levels still. Backlog was held flat in the quarter. We do expect because our backlog is running at over two times a normalized rate, and that was built over the last couple of years, and we’re running with elevated inventories as well. We expect backlog to start to go down. That’s working our business back to a more normalized state, but we did not see that yet in Q1, even with the 12% reported — 11% organic growth.

And that’s a reflection of very strong demand levels. Bid activity levels remained at a record high. Our opportunity pipeline continues to grow. The cross-sell synergies we took up meaningfully, again, had terrific cross-sell results in the quarter. So this is really a strong quarter. In terms of the destocking, the only area where we’re seeing material destocking at the customer level is in broadband. And I think if you look at some companies that are heavily exposed to broadband value chain, you’ll see that in their results, the other publicly traded companies. There was very strong growth last year. And what customers did was run with higher levels of inventory knowing that the secular growth trends are there, but also concerns about the overall supply chain, which was very constrained through the pandemic.

So they’re working through that a bit. This is for broadband. It’s our anticipation — it will take one to two quarters for customers to work down those inventory levels, and we expect broadband to return to growth in the second half. I remain very bullish on broadband over the mid to long-term driven by strong secular growth trends, 24/7 connectivity, automation, IoT applications, as well as government spending in both US and Canada, RDOF and ND , to name two drivers of that. So that’s really the only other area, Deane. I think the other point I will make, which is incredibly important, I think, many folks are missing, remember that our purchases are our suppliers’ sales. Our purchases are our suppliers’ sales. We grew our inventories over 30% in Q1 2023 versus Q1 2022.

And that’s because our suppliers have been recovering quickly. Their production rates have been coming up. Their past dues have been coming down, and their shipments to us accelerated. But I think that’s incredibly important to understand, because their shipments to us, which reflect — is reflected in our inventory growth, is their out-the-door sales. And with that, our out-the-door sales had strong double-digit growth, and we’ve got, again, maintaining this record backlog. So very highly, highly confident as we look through the second half — through the second quarter, through the second half of this year, and that’s why we reaffirm the guide. Hopefully, that gives you the color.

Deane Dray: It’s really helpful. I appreciate you taking us through all of that. And just if we could drill down a bit on EES, and I like hearing the expectations that second quarter and third quarter are projected to be better. We don’t often hear about specialty vehicle and manufactured housing as verticals. But take us through to the extent that, that’s meaningful, but more importantly, what you’re seeing in the construction markets. Thanks.