Q3 2022 Wesco International Inc Earnings Call
Okay.
Hello, and welcome to your West Coast Q3, 2022 earnings call.
I would like to remind you that all lines are in a listen only mode throughout the presentation.
If you would like to ask a question. Please.
Please signal for a conference specialist by pressing the star key followed by one on your telephone keypad.
Please note that today's event is being recorded.
I would now like to hand, the call over to Scott Geffner SVP Investor relations to begin.
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 information 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 well 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.
Information about these non-GAAP measures is available on a webcast slide.
And in our press release, both of which are posted on our website at Wesco dotcom.
On the call. This morning, we have John Engel West Coast, Chairman, President and Chief Executive Officer and.
And Dave Schulz, Executive Vice President and Chief Financial Officer.
Now I'll turn the call over to John .
Well, Thank you Scott and good morning, everyone. It's a pleasure to be with you today.
Saw from our earnings release earlier. This morning, we delivered another quarter of outstanding results further demonstrating the substantial value creation capability of the new Wesco. We once again set company records for margin profitability and backlog and further reduced our leverage ratio in the third quarter the power of our increased scale.
<unk> expanded portfolio and industry, leading physicians is clearly evident in our continued strong performance.
Strong demand and operational improvements are driving our record setting performance across our company each of our three strategic business units again delivered strong sales and profit growth in the quarter driven by the breakthrough results of our enterprise wide cross selling and gross margin improvement programs overall, we delivered organic sales growth of 17.
Percent record profitability of eight 6% adjusted EBITDA margin and record adjusted EPS of $4 49 up 64% versus the prior year.
You will recall that we substantially raised our outlook for the year. Following our results in each of the first and second quarters are outstanding results in the third quarter and the continued strong execution across our business support the full year outlook for 2022 that we previously provided we are maintaining our organic.
Sales growth targets, but are adjusting our reported sales range with the change entirely driven by the foreign exchange rates, thus, reflecting the unprecedented strength of the U S dollar throughout 2022.
At the same time, we're increasing our outlook for EBITDA margin and narrowing our range for EPS.
Our increased profitability continues to fuel our investment in advanced digital capabilities that will transform our relationship with both our customers and our supplier partners.
The recent acquisition of rally systems announced earlier this week underscores our strategy to maximize our exposure to these attractive secular growth trends are profitable execution against these sustainable trends and our investment in West Coast digital transformation support a virtuous cycle, which is expected to result.
And in in an even higher level.
Performance operating efficiency and customer loyalty.
Before I hand, it off to Dave I plan to address our transformational results versus pre pandemic levels and our uniquely strong position to capitalize on the secular trends that we talked about in our end markets and that we presented at our recent Investor day.
So, let's turn to page five the demonstrated strength of our business model and the success of our integration efforts over the last nine quarters have established a track record of superior results for our company.
The strength of the new Wesco is best measured by the value. We have created since the merger closed in June 2020.
This page highlights our record year to date 2022 results as compared to our pro forma pre pandemic results for the comparable period in 2019.
As you can clearly see we have outperformed the market delivering impressive sales growth and margin expansion and achieving record profitability all while all while rapidly deleveraging our balance sheet.
Our resilient and critical supply chain solutions combined with our exposure to the sustainable secular trends will drive our future sales and profitability.
As we recently conveyed during our Investor day, we're excited because there's still substantial value embedded in a transformational combination of wesco and anixter.
We look forward with great confidence to a future of sustained growth and market outperformance.
Now, let's move to page six.
Providing our global customers with end to end solutions and that includes the products and supply chain services that make our customers more efficient and more effective is what drives us each and every day, we are executing at a very high level and we are exceptionally well positioned to capitalize on our strong secular growth trends and increasing investments in <unk>.
Public sector infrastructure outlined on this page.
These long term trends are driving secular growth in each of our three strategic business units and across our entire global enterprise I'm pleased to report that we raised our cumulative sales synergy target again this quarter and now stands at $1.4 billion.
Our positive cross selling momentum is fueling our market outperformance and growth.
As I've said before the new Wesco is transforming into a growth company, we have a record backlog and expanding cross sell through appropriate a growing opportunity pipeline and positive momentum overall, but we are only in the early stages of unlocking our dual growth potential.
Now moving to page 10.
The acquisition of <unk> systems closed earlier this week highlights our continued investment in the high growth data Center segment.
And further expands cross sell opportunities across our company.
Well he is a leading global Hyperscale data center solutions provider with over 900 employees in 25 countries and a trailing 12 month sales of approximately $400 million.
Rafi will be integrated will be integrated within our CSS business, then I'll provide complementary global coverage and significantly enhanced our full suite of data center solutions for contractors integrators and end user customers.
With that I will now turn the call over to Dave.
Thanks, John and good morning, everyone I'll start on slide nine with a summary of our third quarter results compared to the prior year.
As John mentioned sales were a third quarter record and cross sell in the quarter again exceeded our expectations are.
Our ability to cross sell Wesco, and anixter products and services contributed $237 million of sales in the quarter.
On an organic basis sales were up 17% driven by a combination of strong price and volume along with share gains largely attributable to our cross sell initiatives.
We estimate pricing added approximately eight points to sales growth in line with the two prior quarters with the benefit primarily in our E S and UBS businesses.
On a reported basis sales were up 15% as differences in foreign exchange rates represented a 170 basis point headwind in the quarter.
Supply chain challenges have continued to impact certain pockets of our business.
We estimate that the lack of availability of certain products reduced sales by approximately 1% to 2% consistent with the first and second quarters.
We continue to strategically invest in inventory in the quarter to address these challenges as well as to support our increased backlog of future sales growth opportunities.
Backlog reached another record level this quarter and was up 5% sequentially from June and up more than 60% from the prior year.
Each business unit posted backlog increases of more than 40%.
We have not experienced any cancellations of projects in the backlog.
Given current supply chain constraints, we are seeing some projects delayed similar to what we saw in the first half of the year.
As we start the fourth quarter demand has continued to be strong.
Preliminary October results are encouraging with sales up approximately 12% year over year, including the impact of a stronger dollar which is expected to negatively impact fourth quarter sales by about 3%.
Gross margin was our highest ever at 22, 1% in the quarter up 80 basis points versus the prior year and up 40 basis points sequentially.
This result was driven by our gross margin improvement program.
The pass through of supplier price increases and the absence of a COVID-19 related PPE inventory write down in the prior year period.
He called the impact of the PPE write down was 10 basis points in the prior year quarter.
Adjusted EBITDA, which excludes merger related and integration costs stock based compensation and other net adjustments was 41% higher than the prior year and represented eight 6% of sales 50 basis points above the record levels set in the second quarter and 160 basis points higher.
Than the prior year.
This result was driven by the combination of increased gross margin.
They'll benefit of higher sales and realized cost synergies from our merger with Anixter I'll walk you through the main drivers of this improvement in a moment.
Adjusted diluted EPS for the quarter was $4 49 also an all time record and up 64% from the prior year.
The primary driver of this increase was core operations that contributed the dollar 92, partially offset by headwinds related to foreign exchange rates interest expense and a higher share count, which collectively reduced adjusted diluted EPS by <unk> 17 cents in the quarter.
The adjusted effective tax rate in the quarter was higher than our fiscal year outlook due to lower benefits from intercompany financing and discrete tax items.
Turning to page 10, this slide bridges, the year over year increase in sales and adjusted EBITDA.
Organic sales increased 17% versus the prior year, including an eight point benefit from price.
Compounding this growth was the impact of the $237 million, we generated in cross sell in the quarter as well as continued share gains.
Adjusted EBITDA increased 41% versus the prior year.
Higher sales and expanded gross margin drove the majority of the $116 million increase in adjusted EBITDA.
We also recognize the benefit of incremental cost synergies of $68 million in the quarter on a run rate basis or $18 million incremental to the prior year quarter.
As you would expect in a strong demand in an inflationary environment, we continued to experience higher volume related operating costs, including shipping and sales commissions as well as expenses for employee benefits and incentive compensation.
Given our strong results, we continue to accrue short term incentive compensation above target.
Finally in accordance with our plan, we incurred higher expenses related to our investment in systems and digital tools.
Overall, we delivered strong operating leverage as we generated a 41% increase in adjusted EBITDA more than two times, our organic sales growth of 17%.
Moving to slide 11.
Sales in our EES segment were up 15% year over year in the third quarter on an organic basis.
This growth reflects continued strong construction sales driven by the ongoing recovery of the nonresidential market.
We also continue to see good momentum in our industrial and OEM businesses supported by broad end market demand.
Strong bidding activity drove a further increase in our EES backlog from its record level in the prior quarter.
We also made progress on our cross sell initiatives and are capturing demand driven by the secular growth trends that John discussed earlier.
Adjusted EBITDA was $226 million a record level for the third quarter for EES and up 30% from the prior year adjusted.
Adjusted EBITDA margin was 10, 1% 130 basis points higher year over year.
This increase reflects the effective price cost pass through strong cost synergy realization and operating cost leverage.
Turning to slide 12.
Sales in our CSS segment were up 10% versus the prior year on an organic basis.
We saw strong growth in both network infrastructure and security solutions operating groups driven by growth with security integrators cloud applications and wireless as well as data center and Hyperscale projects.
While pleased with these results CSS sales growth was not as robust as EES and UBS, primarily due to ongoing supply chain constraints in certain pockets of the industry that we discussed last quarter.
Additionally, pricing in CSS was a low single digit benefit versus the prior year, but improved sequentially.
Profitability was strong with adjusted EBITDA up nine 8% of sales in the quarter 80 basis points higher than the prior year, driven by operating leverage integration cost synergies and the execution of our margin improvement program.
Turning to slide 13 organic.
Organic sales in our UBS segment were exceptionally strong up 29% versus the prior year.
Given the timing there was no material impact to revenue in the quarter from Hurricane Ian.
Utility demand has remained consistently strong as both our investor owned utility public power customers continue to invest in grid hardening and modernization as well as green energy in electrification.
Sales growth in our broadband business was also strong again this quarter driven by continued demand for data and high speed connectivity, including Repot requirements for fiber to the X applications.
We continue to benefit from sales activity related to the federal government's rural digital opportunity fund.
Adjusted EBITDA in the quarter was up 62% for UBS and adjusted EBITDA margin expanded 250 basis points to 11, 6% of sales.
This outsized growth was driven by the scale benefit of sales and gross margin expansion.
Now moving to page 14.
The size of the cross sell opportunity of combining wesco and anixter continues to exceed our expectations.
In Q3, we recognized $237 million of cross sell revenue our largest quarter to date.
Our pipeline of sales opportunities continues to expand and our cross sell initiatives continued to deliver.
Capitalizing on the complementary portfolio of products and services as well as the minimal overlap between legacy Wesco and legacy anixter customers.
The size of this opportunity has turned out to be one of the most significant value drivers of the combination of Westfield plus anixter as you can see from the steady increase in our expected target.
Recall that two quarters ago, we increased our cumulative cross sell target to $850 million and last quarter, we increased it again to $1 2 billion due.
Due to the continued growth of the pipeline, we are raising our cumulative cross sell target to $1 4 billion by the end of 2023 to date, we have generated $966 million of that target.
Yes.
Turning to slide 15.
On the left side of the slide you can see in the gray boxes that we realized cumulative run rate cost synergies of $188 million through 2021.
Due to continued progress we are increasing our 2022 targets slightly from 265 million to $270 million of cost synergies and we remain on track to meet our expected target of $315 million by the end of 2023.
Recall that these savings are relative to the 2019 pro forma base.
On the right side of the slide we've outlined to $315 million of cost savings target by synergy type and in the chart you get a sense for the synergies that have been realized to date in each category. For example, the estimated $45 million in corporate overhead savings have now been fully realized the largest remaining synergies are those that take.
Longer to execute including those related to supply chain and field operations.
Turning to page 16.
On this page, you'll see a year to date bridge of our free cash flow.
Starting with adjusted net income and moving right the $139 million source of cash primarily reflects a combination of DNA interest and income taxes.
In total working capital has been a $1 $1 billion use of cash to date driven by increases in receivables and inventory.
In response to the exceptionally high level of sales growth. We have experienced this year, we invested in inventory to ensure we maintain best in class service levels and continuity of supply for our customers.
The unprecedented backlog up for the seventh consecutive quarter supports this increase.
Lastly, the Capex and it spend reflects the investments related to our ongoing digital transformation and is consistent with our plan. In addition, a key driver of the increase Capex year to date is related to our supply chain network optimization strategy.
Moving to slide 17.
Reducing our leverage has been a top priority since we announced the acquisition of anixter.
In the third quarter, we reduced leverage by 0.2 times trailing 12 month adjusted EBITDA.
And brought our leverage ratio down to three two times.
This represents a decrease of 2.5 leverage turned since closing the acquisition in June of 2020.
We are now well within our target range of two to three five times, which represents a significantly faster pace of deleveraging than the target then provided prior to the closing of the anixter merger.
Moving to page 18, we are updating our full year outlook based on this quarter's results.
As John mentioned at the top of the call our expectation for full year organic sales growth remains unchanged. We are revising our outlook for reported sales growth to 15% to 17% to reflect a larger headwind due to foreign exchange rates.
This headwind is now expected to negatively impact full year revenue by 2% versus our prior expectation of 1%.
The rest of our sales growth assumptions remain unchanged, we continue to expect market growth of 12% to 14%, including a benefit of eight points due to price, 5% from cross sell and share gain and the benefit of an extra workday in 2022.
We expect the demand environment for our products services and solutions to continue to be strong. However, we recognize that supply chain constraints and the pace of inflation presents some uncertainties for the fourth quarter of the year.
With regard to our business units, we expect that UBS will be above the upper end of our sales range EES to be within the range and CSS to benefit.
Below the lower end of the range due to their experiencing less of a benefit from price as well as the larger impact of sales from supply chain disruptions.
Also recall that included in our outlook is a contract with a utility customer that will shift from a full revenue model to a service fee model, which will negatively impact sales by approximately half a point with no impact to EBITDA.
I'd like to point out that this outlook does not include sales from the acquisition of Rockies systems, which we expect will contribute $65 million to $80 million of sales in the final two months of the year.
For adjusted EBITDA margin, we are increasing the midpoint and narrowing the range of our outlook to seven 9% to 8% of sales at the upper end of our prior range, primarily reflecting continued benefit from our gross margin improvement program.
At the midpoint of the sales and the EBITDA margin range, our full year outlook for adjusted EBITDA remains unchanged at 1.68 billion.
We are maintaining the midpoint and narrowing the range for our adjusted EPS outlook.
$15 80 to $16 20.
Which represents growth versus the prior year of approximately 58% to 62%.
Lastly, we are adjusting our expectation for free cash flow to approximately 10% of adjusted net income.
As noted earlier the primary drivers of our net working capital increase our accounts receivable and inventory.
We are adjusting our free cash flow forecast to reflect balances as of September 30th and increased inventory to support growth to the backlog.
We expect fourth quarter sales to be down sequentially, releasing net working capital and generating positive free cash flow.
There is no change to the long term free cash flow conversion capability of the company and we continue to expect to generate 100% of net income through the cycle.
This outlook reflects a handful of assumptions that I would like to remind you of first based on our year to date results and outlook for the year. Our short term compensation structure is reflected in our margin outlook at an above target payout we.
We have also included the impact of an increase in transportation and logistics costs that we mentioned last quarter.
On cash flow, we now expect to spend approximately $130 million in combined capital expenditures and digital investments.
On the statement of cash flows approximately $75 million will flow through capex and approximately $55 million will flow through changes in other assets.
We expect depreciation and amortization of between $175 million and $180 million for the full year were $40 to $45 million for the fourth quarter.
We expect interest expense to be approximately $285 million to $290 million for the year or $80 million to $85 million for the fourth quarter.
This outlook incorporates the potential effects of higher short term interest rates.
Our outlook assumes an average diluted share count of approximately 52 to 53 million shares for the year and lastly, this outlook does not reflect any potential changes to applicable tax laws.
As it relates to the fourth quarter preliminary October sales were up 12% against a very difficult comparison versus October 2021.
We anticipate sales remained strong in the fourth quarter, but more normal seasonality, depending on supply chains and the ability for us to continue to supply products to our customers.
Moving to slide 19.
Before opening the call for questions. Let me provide a brief summary of what we covered this morning.
This has been an exceptional three quarters and we have strong momentum across our business we.
We delivered very strong financial results across the board, including record third quarter sales, an all time record operating profit adjusted EBITDA adjusted EPS and the strongest quarter since the anixter transaction closed in June of 2020.
Every segment of our business grew versus the prior year and sequentially in the quarter as well as compared to 2019 levels.
We delivered adjusted EBITDA margin expansion of 160 basis points over the prior year driven by our value based pricing execution accelerated cross sell and continued cost synergy generation.
Our pace of deleveraging has exceeded our expectations and we are now back within our target leverage range just nine quarters. After closing the acquisition of anixter.
And lastly, we're making excellent progress on our it and digital roadmap and are exceptionally well positioned to benefit from the secular growth trends and increasing public sector investments that John discussed earlier.
With that let's open the call to your questions.
We will now begin the question and answer session. If he would like to ask a question. Please press star followed by one on your telephone keypad.
As a reminder, please limit your questions to one question and one follow up.
At this time, we will pause momentarily to assemble IRA.
Today's first question comes from Deane Dray with RBC capital markets. Please proceed.
Thank you and good morning, everyone.
Good morning Deane.
Hey, can we start with the cadence of demand since the New York Analyst meeting.
We've got the look into October against the tough comps, but John any context daily stock and flow bid activity any kind of color taking us through October would be real helpful.
Yeah.
I'd characterize as the beat goes on being.
The strongest growth from UBS.
But all but all three businesses grew.
And we're very pleased with the momentum we have.
The backlog growth that we had that was 5%.
At the end of Q3 sequentially versus the end of Q2 as another exceptional.
Much better than historical seasonality growth then we continued in October with a book to bill ratio above a one point.
Which is which is also not typical because typically we eat into backlog I think as you know as we go through the fourth quarter. So.
There's a there's a bit of color.
Bottom line is the beat goes on the demand environment, but I would tell you that it's.
It's really the opportunities that are coming to us and that we're also generating that are captured in an expanding opportunity sales pipeline of which the cross sell execution and momentum again, just continues to increase and I couldnt be more pleased with that.
That's great to hear and that's consistent what we've heard from your key suppliers.
And my follow up questions for Dave on the free cash flow guidance. How do you expect this you know kind of when and where does it normalize.
I appreciate you're saying you still expect 100% free cash flow conversion over the course of the cycle you all have the ability to flex up and down.
Working capital as needed throughout the cycle, so I've seen that for years.
And then just add it does this in any way a cramp your capital allocation Optionality.
With the 22.
Free cash flow guidance, having been cut.
Yeah, Deane. So again, we have demonstrated through cycles that we're able to generate above 100% of free cash flow on average we're very confident that the model is still intact and as represented by our expectation for fourth quarter cash flow generation. So if you take a look at R. R.
Our implied guide for the year Youll see a sequential step down in sales that will release working capital and will create significant free cash flow in the fourth quarter based on our current expectation for the demand profile and so we're very comfortable that our free cash flow model is intact. Obviously when sales are growing as strong as they had been.
All throughout 2022, we have been investing in networking capital is that sales growth normalizes more to our midterm or I'm, sorry, more to our long term growth algorithm than you would expect us to continue to deliver that 100% free cash flow on our capital allocation. Yeah, we have not changed how we view capital allocation.
We have been consistently focused on driving down our leverage.
And as you can see we have begun to invest again and some of the secular growth trends with the recently announced acquisition of right.
The only thing I would add Dave Thanks for that Dean is that with.
With our recent Investor day, which was the first one we had since the bringing together of Wesco and Anixter. We were we provided a very set of critical updates I would call that in terms of the long term view investor thesis with regards to cash generation, you'll recall, we significantly raised our cash generation.
Expectations for the new Wesco to three five to $4 $5 billion of cash generation over the next five years that supports our $1 billion buyback program and also supports.
Initiating our common dividend, which we expect to initiate in early 2023. So we.
We have great confidence in the cash generation characteristics.
When this when this year is done and we look at it.
And we've said this as we move through the year the exceptional growth.
In terms of backlog growth, which is a result of winning this new business and we're getting good conversion to sales.
In terms of sales generation, but we made a conscious decision to support that backlog growth with the investment in inventory and you look at the amount of inventory growth in a our growth in the calendar year. It is substantial.
Quality of our inventory the quality of a R. E. R is consistent with what we've had over the long term through high quality that a or will get collected that inventory will convert the sales because it's backed by orders that are at our order book and firm backlog and then consequently that will convert to cash so very very <unk>.
<unk> confidence in the inherent and fundamentally stronger now cash flow characteristics of the combined company.
Oh, that's great to hear and just one quick clarification because of the size of the inventory investment you've made and I think it'd be helpful. Just to clarify that this inventory is not speculative.
Just hoping the customers show up and buy it but they are tied to projects and just explain the customer the obligation contractual obligation for these project inventory investments that you've made.
Yes, Dana it's Dave again, so just one thing to point out is our stock and flow of inventory has been relatively unchanged throughout 2022.
Our inventory increase is really being driven by our project backlog those are firm orders that we bring the inventory in given the supply chain constraints in the current economic environment, we have had to bring in inventory when available and in some cases, making sure that we have.
As committed on that order to the customer and so it is hanging in in our inventory longer than we would typically see.
But given the supply chain constraints, we're making sure that we can service the customer that is inventory that will be released as part of the sales order and we're confident that we'll silica I mean, very very important point and thanks for raising that data in the way we look at it internally we have a strong view on this.
How we're performing versus market is a function of.
The growth in our firm backlog that's orders on the books supported with customer P O's and Ts and CS.
In conjunction with plus our out the door sales growth.
And if you look at the backlog growth that we've been generating since we put these two companies together and particularly over the last.
For four to six quarters, it's absolutely exceptional it's well above our out the door sales growth rate and that is the driver of our inventory build.
Thank you.
The next question comes from David Manthey with Baird.
Thank you yeah. Good morning, I was wondering if you can share with us what you're hearing from your suppliers relative to list prices for 2023 any directional thoughts there.
Hey, good morning. Thanks for thanks for the question of pricing I would tell you pricing in the quarter and our current look on pricing.
But I do expect as we go through this quarter.
We will get a let's call it a much more robust view of 2023 pricing for our suppliers, but at the present moment. When you look at where pricing is landing and what they are anticipating.
The price increases on average are relatively consistent with what we've had across leased.
At least the last two quarters Q2, and Q3 of 2022.
That is the case for 2024, and I would say as we look into 2023.
At least the front end of it it's starting to look like and what well have much better sense of that once we.
Once we go through the next four to six week period, because they're all working that in earnest now and.
There may be some revisions here or there, but the key the key messages and the answer is yeah. Yeah, you know what the average price increase.
It's holding relatively steady in Q4 versus Q3 in Q2.
It appears that what it looks like as we enter 2023 now the number of price increases.
On individual skus.
In terms of being impacted is less in Q4 than Q3 or two but that's typical.
Right, Okay, and just to clarify that when you say that it's holding that you're referring to a price level, then and so as we come up against Friday lateral close.
Yeah, that'll sort of stayed correct okay.
Alright, and then again as we're looking into 2023 without pinning down specifics here, you've outlined things like incentive comp and the anixter synergies of course are there any other sort of unusual cost or benefit factors. We should consider as we look into 2023 relative to 'twenty two I mean like higher did.
Little roadmap expenses are lower rebates or anything that that you can talk about today that might influence that delta.
Dave just to.
To add to that the one area that we're experiencing like every company is the inflation on labor costs and so while you are correct that we will have a tailwind from lower incentive compensation returning back to target. We are seeing some higher market rates as we look to the plan.
For Merit increases for 2023, I think everything else that you've captured there is is correct. I mean, we are also seeing some variability in our logistics costs, primarily the cost of warehousing and we are going through a supply chain network design. That's part of our synergy drive so that is coming in at a higher rate than we.
We had initially anticipated.
Great. Thanks, Dave Thanks, Joan.
Thanks, Dave.
The next question comes from Santa Dark cash with Raymond James.
Good morning, John Dave how are you.
Good morning, good morning.
Two questions. The first directionally as it relates to 2023 gross margin.
I know you indicated rebates will be a little bit of a headwind, although I'm guessing purchasing synergies.
It might offset much of that so.
Outside of continued outsized growth in UBS, which would hurt mix.
What would have to happen for 23 gross margins to be down.
And how likely is that to occur.
Based on what you can see right now.
So Sam.
I'll answer it this way because you know we haven't provided guidance for 2023 and when we do we won't guide at the gross margin line as you know well guide at the EBITDA margin line as well as sales and EPS and cash flow.
With that said.
We feel we have outstanding momentum in our enterprise wide gross margin improvement program.
There's no doubt that the inflationary environment.
Affected everyone in about up and down the value chain.
But we are we are laser focused myopically focused on selling the value of our I'll call. It the industry, leading value proposition around our complete supply chain solutions and that enterprise wide margin improvement program, we put in place we're seeing tremendous benefit on in that.
Is completely focused on and incentivize as everyone in the front end of our business.
Including our all our account managers and sales reps, both inside and outside sales reps to expand margin and expand margin.
This is <unk>.
Sequentially and year over year, and we are paying them for that.
Anixter as you know had a program in place.
Two years plus prior to the close of Anixter, and Wesco and they were enjoying very good gains from that and we revise that and drove it enterprise wide post close.
We think theres a lot of legs left to our gross margin improvement, we don't control the external market I've told you I got a strong view of this I've said this the last two quarters and at Investor Day, I think we're in an inflationary cycle.
That continues in 2023, but given that backdrop.
What we're focused on is what we can control and that gross margin program.
We feel good about it's enterprise wide and we're going to keep the pedal to the metal on that.
Second question Rick.
Regarding the CSS backlogs.
I think there is sequentially flat.
Despite the supply chain constraints, continuing I'm trying to get a sense is that like a decent leading indicator or is it something one off happening in CSS that would lead that to perhaps show different backlog trends than what would be seen in the other two.
Segments in that Holistically for the enterprise as a whole.
No not a leading indicator.
I would.
We remain.
Very bullish on the short mid and long term growth prospects of the CSS business.
Given the secular trends that face that business the backlog as it is at an exceptionally high level and so you know when you go quarter to quarter, if it's up if it's flattish.
That's not something that's that's not out of the norm when you look at it over years.
<unk> historical seasonality over numerous years over over the cycle, Sam So no leading indicator there whatsoever.
We feel really good about the momentum in CSS I think Dave mentioned this that you know what.
It's a little bit better price pass through there.
So the trend on that is positive and that's a good sign.
When you look up and down the value chain, starting with our supplier partners.
In addition.
Very nice growth rate on CSS comparably speaking versus what we did in Q1 and Q2.
That's on a year over year basis. So.
Feel terrific about that business.
The final validation point, which should speak volumes is the fact that we went out and acquired raw E systems.
Should be a strong statement to everyone that we're investing in these secular growth trends that is going to be an exceptional addition to.
Through our CSS portfolio.
And we expect this.
To realize significant cross sell synergies globally with our data center customers.
So to paraphrase so EES despite no there's some secular trends there, but that that's still the most economically sensitive business and so that would be more instructive for us to look at the backlog trends there to get a sense of how the macro might affect you going forward.
Yeah, Yeah, so if a pivot to the other two.
You know I would say the UBS business now.
Characteristics of the end market.
Full value chain are fundamentally different than five or 10 years ago I'll start there and then get to go to EES. Sam We believe what is what has been basically utilities had been a GDP business. When you look at it over multiple decades no longer we.
We believe fundamentally utilities, a secular growth business.
Second because the industry secular growth fundamentally.
Secondly, broadband is facing into some very strong and will leverage very strong secular growth trends. So that business has completely shifted and so are we.
You've seen our commentary and the results are backing it up just got exceptional momentum there and we have very strong results and we're very bullish on that when you look at EES, we've been enjoying terrific results as well.
Now that has a mix of businesses stand, which is where your question why is there a good good good our industrial end market exposures in that business.
For MRO supplies as well as industrial capital driven projects as well as OEM solutions, and then and that's where our construction exposure is as well.
Just to remind everyone very little residential construction exposure.
Derivative basis, where non res broad and deep across non resi and so typically to answer your questions distinctly sand EES give a look into the portion of the business. That's construction driven it'll give a look into that cycle.
Or and as well as the industrial cycle.
With that said, we've got very strong demand for both industrial construction portion of that business and I must say that the various bills that are passed through Congress, we're not seeing any of that in our results yet, but when you look at 2023 and 2020 for 2025 and beyond that's going to represent a sick.
Mifid can step up in demand that will benefit EES as well as U S. S. T E C S S for that matter.
Very helpful. Thank you both.
Our next question is from Nigel Coe with Wolfe research.
Thanks, Good morning, everyone. Thanks for the question.
Maybe good morning, David.
Good morning Ghansham.
Just on the pricing I think you mentioned, 8% price.
Carrying forward, just maybe clarify that I'm, assuming that's not a 2023.
Comment I think you'd probably just meant prices at these levels kind of cool, but can you just maybe clarify that.
And then my question really is around you know going back to the cash flow your fourth quarter implied free cash is roughly $400 million.
Demand remains very strong and supply chain remain pretty tight so I'm just wondering the degree of confidence in and that generation in the fourth quarter.
Sure Nigel let me address first pricing so we.
Provided you some some insight that we estimate 8% price benefit in the third quarter, that's consistent with what we saw in the second quarter.
So we really haven't seen a material change sequentially in the price benefit to our topline.
Our comments were not intended to imply anything related to 2023.
The free cash flow, you're absolutely correct. It does indicate our free cash flow guide at 10% of adjusted net income.
Indicates a substantial cash flow generation in the fourth quarter and as I said earlier I really believe that this is driven by our expectation for demand by month within the fourth quarter it'll be very different than what we saw last year last year. We saw continued strength in the fourth quarter was up 6% sequentially on a work.
Day adjusted basis versus the third quarter of 2021, so we're against the tough comp we do expect that sequentially in the implied outlook. We provided you today sequentially fourth quarter sales will come down that will lead to a substantial a release of the networking capital along with our earnings that's what.
Gives us the confidence that we can generate positive free cash flow for the full year 2022.
And it appears that our questioner has dropped his line. So we will move on to the next questioner, which comes from Christopher Glynn with Oppenheimer.
Thanks, Good morning, guys.
Good morning, Chris.
Hey, so.
Little bit on the free.
Free cash flow harkening to the.
Reiteration of 100% through the cycle.
Given the working capital investment this year is 23, where they come in a bit more normalized mid single digit top line would you expect to overshoot on free cash flow in that type of environment.
Yeah, Hey, Chris So it would really be dependent upon the environment with supplier constraints and making sure that we still have the right inventory, but based on what we currently are working through with our suppliers given that we are within you know if we're back over the long term.
Two way.
More.
<unk> sales growth rate again over the long term, we're not guiding 2023, but over the long term. That's why we have confidence that our model has not changed and we will be exiting 2022 with with.
With cash flow generation that will demonstrate again the validity of our model. So we're confident that the model is intact.
We do see sales over the longer term moderate back to where you know that long term growth algorithm of mid single digit plus.
We're very confident that we'll be able to manage our inventory appropriately given the current supply constraints, we're still going to have to take a look at what 2023. It looks like we will provide you more details at the end of our fourth quarter call.
Okay.
Leverage reduction ahead of pace.
Absolutely.
Balances up just a touch from when you close the deal and the EBIT growth has been.
The terrific debt reduction lever would you anticipate.
Actual gross debt reduction.
And some aggressive measure.
When cash flow kind of kicked into gear.
We would and again.
Consistent with our our communication of our capital allocation. The gross debt number is up through the third quarter, primarily because we've been borrowing against our facilities for networking capital.
We just increased the capacity under our existing facilities, partly to support the acquisition of raw heat.
But as we think about capital deployment going forward, we want to make sure that we are maintaining a reasonable leverage around the midpoint of our range. We also want to support.
Our aspiration is to continue to acquire capabilities and then of course, we've got our share buyback and the dividend that we announced that would commence in 2023.
Okay, Great last one from me is rohit profitability EBIT.
Operating margins consistent with the CSS segment.
Yes, it's consistent with our total company and again, we just closed so we've got to do some work and really understand what the synergies will look like.
That perspective, but you know we're really excited to have wrought he part of the wesco team and they will bring a fantastic capability in that data center space again, there they have grown rapidly.
So we're very much looking forward to getting in there and I know I'll be spending some time out there next week with the management team and we will provide you more details as we learn more ourselves.
Sounds great. Thanks, guys.
Yeah.
Our next question comes from Tommy Moll with.
Steven.
Good morning, and thanks for taking my questions.
Good morning, Tommy.
I wanted to start on fourth quarter sales. So October of 12% I think you said and then the implied full year guide or rather the full year guide implies November and December would be lower than that.
You've called out some of the comps issues from last year FX.
It has an impact in the quarter that you also called out I just want to make sure is there any conservatism baked in here is there any deterioration in underlying demand baked in.
Or is there any other factor that you would want to call out as to that implied step down in the comps as you go through the quarter.
So no degradation.
Dave Dave cited this I want to.
Kind of an exclamation point on it last year's fourth quarter was truly unprecedented to sequentially be up 6%.
Versus the end of Q4 versus the end of Q3, our typical seasonality is flat to down two points I was it was exceptional so.
What you summarized there Tommy is correct.
It's that it's that challenging comparable plus the additional FX impact in the quarter that speaks to it the underlying demand is exceptionally strong our backlog grew sequentially entering this quarter, we've got great momentum.
Three businesses overall, and then you look at it on a two year stacked basis very exceptionally strong so we feel very good at it.
No degradation.
Thank you for clarifying.
To follow up Dave we don't often talk about it.
Triste rates or interest expense on these calls, but I did note that your revised guidance there implies a significant step up in Q4, you called out that there is some floating rate sensitivity to that expense line and just playing it forward for a quarter from now when we'll have an EPS guide that may embed us significantly.
Interest expense run rate can you frame for us. This Q4 reflect today's rate environment fully is there some lag there.
Is there any way you would just frame the sensitivity to rates.
Yes, Tommy we've included in the outlook that we provided you some additional detail about the interest expense given the unprecedented increases to the rates that we've been seeing all year. So we provided you with our best view of what those rates are going to look like and the impact on our interest expense in the fourth quarter. The one thing that I'll highlight.
As you know we did call out that we expect $80 million to $85 million of interest expense in Q4 that does not include the impact of the borrowings for Rocky. So again, you know given the timing of that close that would probably add another $2 million to our interest expense that is not reflected in the outlook today.
But again, we've tried to get you know our view of where the rates are going to be we had been seeing substantial increases of course.
Given our exposure to our facilities in the amount of money that we had been borrowing against those facilities.
So again, the $80 million to $85 million does not include raw here that would be about another $2 million in the fourth quarter.
And that 2 million David Am I right.
When you have a full quarter starting in 2023.
$2 million would actually be a number higher than that.
You know I'm not going to speculate at this point because again, we increased our facilities for the acquisition of raw heat to fund that deal and our expectation and again, we're not guiding 2023, but our expectation is that we're going to generate free cash flow in the fourth quarter and we will continue to generate free.
Cash flow through the cycle at 100% of adjusted net income that will provide us with available cash to pay down the facilities that will obviously impact the interest expense guide for 2023 will provide you more details on that at the end of the fourth quarter.
Great. That's helpful context, Thank you and I'll turn it back.
Yeah.
The next question comes from Ken Newman with Keybanc capital markets.
Hey, good morning, guys. Thanks for taking the question.
Good morning, Ken.
So I know you werent ready to go into 2023, yet, but just given how strong the backlog is I'm curious if you have any color of just how much. The current backlog is for 'twenty three delivery at this point and as a follow on to that maybe any color on.
One of the orders, you're taking into backlog today or at or above margins that you posted in the third quarter.
I'll answer the second part, but we're not going to guide the guide so we're pre got it got it let's say.
The margin rate in the backlog.
Strong.
If you were to look at it over time, we've had a we've.
We've had a.
A rising trend.
What the margins were in the backlog, which has been very encouraging so im giving you kind of the the nine quarter views post.
Nextera and western coming together when you look in general when you look at the margin in our backlog had a rising trend, which is terrific and thats really reflecting the positive results I mentioned this to Sam Sam's question earlier in response to his question the gross enterprise wide gross margin.
Kind of an improvement program that we have we're incentivizing the sales force.
Youre going to see the margin rate in the backlog go up first before you see it in the out the door sales for those those projects that are in backlog. So that I will answer that part of it and that gives us again confidence in the margin generation characteristics of the business entering 2023, but I'm not.
Pre guide the year, the only thing I will say is last quarter.
I've made a strong statement with conviction and Dave Dave as well did that we're going to grow in 2023.
We talked about that at our Investor day, which which occurred between the Q2 earnings release in this release.
And we gave you some additional support for that as I sit here today I can tell you I've got even greater confidence in the underlying growth characteristics of the business and the margin generation characteristics of the business and inherently the cash flow generation characteristics of the business.
Even greater confidence of that and greater confidence that with respect to 2023.
Given the guide.
That's helpful color.
For my follow up here.
I wanted to clarify on the inventory growth questions from earlier.
But is there any way to quantify just how much of that inventory growth is really driven by backlog growth versus true supply chain issues with some of your suppliers.
Just trying to get a better sense of how much as a pull forward in that spend because of the visibility that you see rather than just purely the orders being so much stronger than you anticipated.
It's eight theres no way to precisely quantify that with a number but it's more it's.
Disproportionately driven by the latter point that you made.
Dave mentioned on our stock and flow business, our stock and flow business.
We've got we've been maintaining our days.
And so think about that as the business that is in and out.
As in and out were quoting it and can we have the inventory was filled the water. So we're you know we're shipping.
Relatively short order after taking the order, that's our stock and flow business and so our days there. It's been held constant relatively constant it's being maintained and.
And that's deemed question earlier, we are we didn't do any speculative buys it would take up the days supply for stock and flow and.
And that machine is working very well.
It has driven the inventory increase.
Is it is a product of the backlog growth.
Tremendous growth in orders.
Security order, we get pricing, we get terms that protected we loaded into our order book and then we go and work our supplier base and the entire supply chain to ensure we got the full solution all in order to support the committed dates we committed to.
And that process is an intricate process that we're managing that in many cases, we're shipping multiple sub systems that.
In aggregate form a system solution.
With numerous suppliers. So we've got to work all those respective dates and in some cases, we're bringing that inventory and kits kitting and staging it storing it as we get the full solution together to meet the customers' committed date that we committed to so that's what gives us great confidence CAD around the.
The quality of the backlog it ultimately shifting shipping and converting the sales. It's batch so growth is backed up by our order book.
Which is in backlog.
Very good thank you.
This concludes our question and answer session I would now like to turn the conference back over to John Engel for any closing remarks.
Well.
We are at the top of the hour. So I just wanted to thank you all for your support it's very much appreciated and we look forward to speaking with many of you in the coming days, we've got a robust list of call scheduled and we look forward to that in the next several days will also be participating in the Baird Global Industrials Conference next week.
And that's Stephen's annual investment conference.
So we look forward to engaging with you.
Again, thank you for your support and.
We'll talk to you soon.
The conference has now concluded. Thank you for attending today's presentation and you may now disconnect.
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