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Executives

Daniel Brailer – Vice President and Treasurer

Steve Van Oss – Senior Vice President and Chief Operating Officer

John Engel – President and Chief Executive Officer

Richard Heyse – Vice President and Chief Financial Officer

Analysts

Deane Dray – FBR Capital Markets & Co.

Hamzah Mazari – Credit Suisse

Sam Darkatsh – Raymond James

Matt Duncan – Stephens Incorporated

Shannon O'Callaghan – Barclays Capital

David Manthey – Robert W. Baird & Co.

John Baliotti – FTN Equity Capital Markets

[Steve Gambuza] – Longbow Capital

Daniel Whang – B. Riley & Company, Inc.

[Matt Biteriso] – Barclays Capital

WESCO International Inc. (WCC) Q3 2009 Earnings Call October 22, 2009 11:00 AM ET

Operator

Welcome to WESCO International Earnings Conference. (Operator Instructions). I would like to turn the conference over to Dan Brailer.

Daniel Brailer

Thank you for joining us for WESCO International's conference call to review the third quarter 2009 financial results. During the quarter, WESCO completed the previously announced executive management transition related to the company's management succession plan.

Effective September 1, Roy Haley is Executive Chairman of the Board, John Engel became President and Chief Executive Officer and Steve Van Oss assumed the role of Senior Vice President and Chief Operating Officer.

Participating in the earnings conference call this morning are the following officers, Mr. John Engel, President and CEO, Mr. Steve Van Oss, Senior Vice President and Chief Operating Officer and Mr. Richard Heyse, Vice President and Chief Financial Officer.

Means to access this conference call via Webcast was disclosed in the press release and was posted on our corporate Website. Replays of this conference call will be archived and available for seven days. Following the conclusion of this conference call, we will post on our Website a supplemental financial data presentation that provides a summary of certain financial and end market information provided in today's commentary by management.

This conference call may include forward-looking statements and therefore actual results may differ materially from expectations. For additional information on WESCO International, please refer to the company's SEC filings, including the risk factors described therein. The following presentation may also include a discussion of certain non-GAAP financial measures. Information required by Regulation G with respect to such non-GAAP financial measures can be obtained via WESCO's Website at www.wesco.com.

I would now like to turn the conference call over to John Engel.

John Engel

The final chapter of this economic downturn is not yet written, but it appears that a bottom is forming. Our current outlook is for the overall economy to recover slowly with continued contraction in non-residential construction in 2010. With that said, we see excellent potential for value creation. Our customers and our suppliers are increasingly concerned about the integrity of their supply chains and are looking to do business with a smaller number of larger partners, which bodes well for us.

The challenging market conditions and the expected duration of this downturn provide opportunities for share gain and additional acquisitions by stronger well capitalized companies like WESCO. Our company is larger, more diverse, more profitable and financially stronger than during the last downturn in 2001 to 2003, and as a result well positioned to gain ground during this period.

In the third quarter, we delivered stable sales and margin in the face of continued weakness and highly competitive conditions in our end market. As you'll recall, we experienced the initial effects of the economic downturn and a decline in our daily sales rates in mid-November 2008.

We responded quickly and took actions to protect profitability over the last four quarters while continuing to invest in our growth initiative. Specifically, we've maintained our 100% contract renewal rate with our national account customers and have secured over 60 new wins since the beginning of 2008, while increasing our opportunity pipeline to an all time record level.

We've strengthened our international operations by establishing several new foreign subsidiaries over the last 12 months. This geographic expansion strategy supports an evolution of our nation accounts program to a global accounts management approach directly in response to our customers increasing requests to address their needs outside of North America.

We've opened nine new communications supply operations within WESCO branches over the last year to geographically expand our data communications and security products footprint. These branches are taking share in their local markets.

We've established dedicated government and stimulus teams supported by a centralized lead generation and qualification group to target both government customers and stimulus funded projects through proactive selling efforts earlier in the construction project cycle.

We've conducted six green/sustainability summits with large customer audiences in major cities across the U.S. this year to provide education on the opportunities and benefits of energy efficient buildings and data centers. This is helping to position our company as a trusted business advisor and solutions provider for our customers as they work to cost effectively meet their energy efficiency requirements and sustainability goals.

And finally, we are investing in local/regional markets which offer attractive share gain potential, such as in Edmonton, Canada where we opened a new distribution center serving the Prairies region and in Houston, Texas where we opened a new facility which houses our industrial, construction, data communications, integrated supply and international personnel. This is in support of a one WESCO saturation strategy that targets the Gulf Coast region.

Now shifting to our productivity initiatives, we are on track to deliver over $140 million of cost reductions for 2009 and are maintaining our industry leading cost structure and sales per employee performance.

We are continuing to execute a series of comprehensive lien programs focused on improving the efficiency and effectiveness of pricing, purchasing, transportation, operations and customer sales and service. We are now in year six of our lien journey and see more opportunities to improve our business than the day we started. As a result of our margin costs and productivity initiative, we are projecting profitability.

Our operating margins are holding up well with 4% EBIT delivered in the third quarter versus 3.9% in the first half of this year. In late August, we completed the exchange of outstanding convertible debentures with a new issue having a 2029 maturity. This very effective financing provides significant long-term funding flexibility with attractive after-tax interest rates. Richard will provide more detail on this transaction in his commentary.

Strong working capital management contributed to record free cash flow enabling us to further reduce our debt and increase our liquidity position to a record level. Now that the AR securitization and convertible debenture exchange have been successfully completed, we enter the fourth quarter with a strength and capital structure which provides the financial flexibility required to support our growth strategy of organic growth above market, plus the creative acquisitions.

Now Richard Heyse, our CFO, will provide details on the third quarter and provide an outlook for the balance of the year. He'll be followed by Steve Van Oss, our Chief Operating Officer and Steve will then give you an update on our major end markets and various growth initiatives before we go to the Q&A section.

With that, Richard.

Richard Heyse

During the third quarter, we continued to invest our resources on a series of growth initiatives targeting end markets with immediate and long-term growth potential, continue to execute on our cost reduction and working capital management efforts, and successfully completed a refinancing of the majority of our convertible debentures.

As John mentioned, our third quarter daily sales rates were stable, which is a positive indicator that we have entered a bottoming process. Our industrial end markets had slight sequential sales growth while sales to our construction customers were down slightly.

Adjusting for the negative impact of foreign exchange, consolidated sales and $1.15 billion, decreased 28.5% versus the third quarter of 2008. Reductions in product prices reduced current quarter revenue by approximately $35 million in comparison to the third quarter of 2008.

Backlog, which consists of firm construction orders for future delivery, ended the quarter down 8% from year-end and 1% from the second quarter. Product margins showed slight improvement on both the comparables and sequential basis despite very competitive market conditions throughout the quarter.

Gross margins of 19.2% were down 20 basis points versus last year due to cost associated with our inventory reduction efforts and lower supplier rebate rates. Sequentially, gross margins declined 10 basis points primarily due to expenses related to our inventory management efforts, offsetting other positive factors.

Our overall mix of business was consistent with the third quarter of 2008 and had minimal impact on gross margins. In the last year we've reduced nearly 1,100 position or approximately 15% of our employee base as part of our cost reduction efforts. As a result of this and other initiatives, third quarter 2009 SG&A costs were reduced $43 million or 20% versus last year.

We were on track to deliver over $140 million of operating expense reduction in 2009. Approximately $70 million of the $140 million reduction is related to lower headcount, branch closures and other permanent actions. Approximately $45 million are related to incentives and freight costs that vary with business activity.

The balance or roughly $25 million is related to the temporary suspension of benefits and mandatory unpaid leaves of absence. We do not anticipate continuing mandatory unpaid leaves of absence and benefit suspensions in 2010. Our actions to protect profitability are reflected in the third quarters operating margin of 4.0% of sales.

In the third quarter, our all-in cash borrowing rate on total PAR debt value remained low at approximately 3.8%. This rate is higher than the 3.3% experienced in the second quarter in part due to the higher coupon rate on our new debentures. Exiting the quarter our all-in cash borrowing rate was 4.8%.

The effective income rate for the quarter was 15.8% versus last year's second quarter rate of 25.2%. Without the convertible debenture exchange our effective tax rate would have been 20.3%. This lower than expected rate was driven by the effectiveness of our tax planning initiatives.

Net income for the quarter was $33.6 million and resulted in an EPS of $0.79 per share versus net income of $63.7 million and an APS of $1.48 per share last year. The pre-tax earnings gain of $6 million net of expenses and the associated tax rate impact in the convertible debenture exchange had a favorable impact of $0.16 per share.

During the third quarter, we successfully exchanged $357 million of our outstanding $450 million of convertible debentures. These new debentures are a long-term foundational piece of our capital structure. The new debentures have a 20-year term and are callable by WESCO after seven years and have no put rights for the debenture holders.

Essentially all of our 2026 debentures, which total $300 million, and $58 million of our 2025 debentures were exchanged for $345 million of the new 2029 debentures, $92 million of our 2025 debentures remain and we expect those to be put to the company in October 2010.

The combination of stable gross margins, operating cost reductions, and working capital management drove strong free cash flow for the quarter. Year-to-date we have generated $280 million of free cash flow a record for the company. This free cash flow has been used to reduce debt levels and improve our liquidity position.

Our successful debenture exchange, the second quarter renewal of our accounts receivable secured debt securitization, and record year-to-date cash flow generation has significantly improved WESCO's financial flexibility. At the end of the third quarter, liquidity at $439 million is at an all time record level for the company. We are, therefore, confident that WESCO has ample capacity to handle anticipated future funding requirements.

Now I'd like to turn to or outlook for the fourth quarter. In the fourth quarter, we anticipate a positive impact from our sales initiative, strengthening in our industrial end markets, and contraction in our non-residential construction end markets.

When these factors are combined with traditional fourth quarter market seasonality, we anticipate a 4% to 6% sequential decline in quarterly sales. Month-to-date October daily sales rates are stable and consistent with third quarter rates.

Despite competitive pressures, we expect to maintain fourth quarter gross margins at the levels experienced in the second and third quarter. While we will not reduce our focus on cost controls in the fourth quarter, we will experience some negative operating expenses leverage due to lower sales.

Finally, our fourth quarter interest expense will reflect the full quarter impact of our new debentures. We expect our affective tax rate will trend up to 30% over the next several quarters with the fourth quarter tax rate expected to be approximately 24%.

Our financial priorities remain unchanged. To generate sales performances better than the market, to manage and improve marketing margins, to deliver upper core tell return on invested capital, to generate strong pre cash flow and to maintain a strong capital structure.

At this point I'd like to turn the call over next to Steve Van Oss. Steve will provide additional commentary on our end market and growth initiative.

Steve Van Oss

I'll be providing some insight on the activity levels for each of our major end markets and our actions relative to those markets. Sales to our construction, industrial and OEM and utility customers were down 29% in the third quarter versus last year and were down slightly sequentially. The sales declines were broad-based across our end markets and have continued at a similar rate into mid-October.

Looking at construction, sales to construction customers were down versus last year in all geographic regions. Sequentially sales were down slightly at 2%. Backlog, which includes construction oriented firm orders, declined slightingly in the third quarter at a rate comparable to sales.

While the architect building index has continued to reflect rapid declining levels of activity, recent forecast from Dodge indicates that starts for the primary non-residential construction market segments of commercial, institutional and manufacturing buildings are forecasted to be down $3 billion or less than 2% in 2010.

Construction expenditures, however, are forecasted to be down in the mid-teens. Our construction sales and service initiatives continue to be focused on large regional and national contractors, particularly those involved in health care, educational facilities, data centers, energy and government, infrastructure related projects where we expect to see the most activity over the next four to six quarters.

We have a series of major initiatives and opportunities with our utility, industrial and contractor customers in the $2.5 billion outdoor and area lighting market as innovation, such as LED technology and stimulus funding, provides catalyst for increased spending.

Data communication projects activity and our opportunity pipeline in enterprise cabling and security remains healthy as our sales and marketing initiatives are continuing to yield positive results. Key wins during the quarter were posted in the government, education and health care sectors with seven project awards in excess of $1 million each.

Our data communications geographic expansion program utilizing existing WESCO facilities has resulted in the opening of nine communications supply locations since this program started in 2008. We are planning on significant further expansion of this program in 2010. This branch within a branch expansion strategy increases cross-selling and service opportunities into our blue chip customer base.

Our long-term outlook is for increasing bandwidth demand as customers will continue to use information technology to drive productivity improvement, invest in data centers, improve the security of their facility and IT networks and seek green solutions that are cost effective and reduce power consumption.

We've increased our American Recovery and Reinvestment Act of 2009 stimulus efforts as discussed last quarter due to project timing considerations it's unlikely that the industry will see significant benefits from the stimulus plan investments in 2009. And in fact in the near-term the stimulus plan may be delaying projects if customers wait for qualifications of projects for stimulus funding. Our efforts around stimulus funded projects are supported by a full-time leader and team of over 30 personnel across our operations.

Late last quarter we launched an online WESCO stimulus clearinghouse, which provides our branch personnel with a centralized depository of qualified project opportunities in their local geographic markets. This target list of stimulus related projects increased significantly in the third quarter, as have early sales cycle activity levels resolving in an active pipeline and new orders. We have an increased level of confidence that stimulus related opportunities will arise at an increasing rate into 2010 and 2011.

In additional, we're encouraged with the overall results we're seeing in our targeted government market efforts, which resulted in government sales increasing in third quarter 15% versus last year. Also we are seeing contractors put more emphasis on the financial health and stability of their potential distributors and their supplier selection and project award criteria. With our strong balance sheet, this is a positive trend for WESCO.

Moving to industrial, build to our national accounts customers declined in the quarter driven by reduced MRO demand associated with low capacity utilization and tight purchasing controls. Our integrated supply and OEM customers, most of whom are diversified manufacturers, reflected the overall weakness in the industrial market and declined more than 30% as destocking pressures continued through the quarter.

National account bid activity levels were high in the quarter and our national account opportunity pipeline expanded to another successive all time record level. The purchasing managers index indicates a moderate improvement and sentiment by purchase executives, as they commented in this month's report that quote, "It appears the fundamentals for continuing recovery are still at work as inventories and sales are gaining balance."

Purchasing executives and our customers continue to be concerned about supply chain integrity and are looking for large, financially strong companies to mitigate their risks. We believe our increased activity levels reflect their heightened concerns and overall favorable assessment of WESCO.

Our customer facing initiatives continue to be focused on providing value-added services in selling the complete WESCO portfolio product to serve our global customers needs in MRO, capital projects and direct materials in value-added assemblies.

We are encouraged with our national account customer wins in the third quarter where we added a total of six new customers across the four different industries. We maintained our 100% renewal rate for the 13th quarter in a row renewing eight customers, and currently have a majority of the Fortune 500 companies as our customers.

Looking at utility, as a result of the economic downturn industrial demand for power is reported to be an eight-year low and residential demand has declined at an unprecedented rate, resulting in our utility customers addressing primarily the required maintenance activities.

Transmission related and alternative energy projects remain a priority for our customers over the mid to long-term. Our response is twofold, expanding the scope of our existing alliance business models to include high-voltage product categories, and combining our integrated supply and project management service models to increase our scope of supply on large scale transmissions, generation and alternative energy construction projects, which are now receiving a disproportionate share of utility capital spending.

Additionally, we continue to see an increasing number of investor owned utilities and public power customers apply for Federal grant money under provisions of the American Recovery and Reinvestment Act, specifically targeting energy-efficient lighting, system upgrades and smart grid programs which will require products sourced through the distribution channel.

The market remains active with bid request and interest in our LEAN Customer Value Creation programs and integrated supply capabilities remain high. We are actively involved in new customer presentations and remain well positioned as utilities look to rationalize their supply chains, improve their inventory management process.

Our Canadian markets have faired better during the economic downturn and based on published data for the first half of the year, we have outperformed the markets significantly. While sales on the Canadian dollar basis were down modestly, our backlog in Canada has grown throughout the year. And at over 10% growth versus last year, is at record levels. We believe we will see top line growth in Canada in 2010.

At this point, I will open the call for the question and answer session.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Deane Dray – FBR Capital Markets.

Deane Dray – FBR Capital Markets & Co.

I'm not sure who would want to take this question, but just the phenomenon of the past couple of quarters has been all about destocking and it didn't sound as though that was called out as a factor. Is that over and you're seeing that tide shift the other way yet?

John Engel

We definitely would say that we have not seen the destocking come to an end. As we mentioned, we saw a sequential uptick in our industrial end markets, but I think you can take a look at that and think of that as destocking is still occurring with us gaining some momentum. We had been adding new accounts and we had been increasingly trying to sell all our products and services to each and every customer.

Deane Dray – FBR Capital Markets & Co.

With regard to pricing, can you give us a sense of the impact of pricing on the quarter and then specifically address the issue whether you're seeing any big project re-bidding or coming back, customers re-pricing?

John Engel

I'll hand it to Richard to talk through pricing and then I'll follow-on with kind of the dynamic we're seeing in the markets.

Richard Heyse

Just on a year-over-year basis, pricing had about a $35 million impact on the quarter, roughly $20 million of that was related to the impact on commodity prices. I think that's fairly consistent with what we've been seeing the last in the second quarter and first quarter of this year. So really no big change there.

John Engel

And I'd say if I were to characterize the pricing environment, Deane, which is the heart of your question, it is very competitive. We're seeing a similar dynamic in the third quarter as we saw in the second. That is, there are many more I'll call it contractors bidding for new projects. And those projects that are underway really increased pressure to look at price reduction and/or additional re-bids.

So if you step back and take a look at it, a lot of capacity came out of the industrial market, the destocking been occurring it's not quite finished on the construction side. We still have – the large number of competitors are still in the market competing for a smaller number of opportunities. And the pricing dynamic, I'd say in the third quarter is very much similar in the second, which is highly competitive.

Deane Dray – FBR Capital Markets & Co.

Just last question from me related to pricing is, how do you reconcile the dynamics with copper price that's now expected to escalate in the face of broad customer pushback on getting prices through?

Richard Heyse

Deane, on the copper front, we've seen some real nice movement in this year, it's still below where it was last year. And I would say WESCO specifically and the industry in general is pretty efficient on the commodity side where it relates to copper content or steel conduit of getting that push through the marketplace. There's a little bit of lead lag on that.

As you know when we stopped many times that we addressed that by maintaining a tight inventory supply. Where we do have annual or multi-year agreements, and we have specific breakouts in those contracts were commodity movement. So I agree that there's a sentiment out there, but I think the industry is relatively efficient at dealing with that phenomenon because it has been really volatile since starting in mid-2004.

Operator

Your next question comes from Hamzah Mazari – Credit Suisse.

Hamzah Mazari – Credit Suisse

Could you speak a little bit about your own inventory levels and where they need to be right now, given what you're seeing in your end market? You spoke last quarter of them having to come down some more. How should we think about that?

John Engel

We feel very good about our current inventory levels as we exit the third quarter and enter the fourth. As we've mentioned in the past, we're very much focused on our customer service metrics. We look at fill rate. We look at inventory availability for our high velocity items.

So we want to make we have in stock those items that our customers are going to need. We [master] that, and keep in mind we have a distribution center network that feeds the branches and provides daily replenishments to our branches.

So if you look at entire system, we've got a high degree of sophistication in terms of how we set our inventory stocking levels, not to mention, we are for most of our suppliers their largest customer, which gives us opportunity to command, let's say if we're short in a particular product area, we can work that supplier to get that product.

So I would say we're in good shape. And just to bring a point to that, we have reduced inventory significantly over the last year. And it included some additional reductions in the third quarter, as we mentioned we would have in our last release. Presently, we feel good about the levels.

Hamzah Mazari – Credit Suisse

Then is it fair to say that your business is more mid-to-late cycle because of your exposure to CapEx spend and projects and so your top line is going to lag some of the lead economic indicators getting better by say six months?

And assuming that non-resi doesn't take another huge leg from here and sort of deteriorate a little bit, that implies that we should start seeing a stronger sequential growth in your top line sometime in the first half 2010. Is that a fair way to think about your business? I'm not asking for guidance, but just some color around that.

John Engel

We are relatively balanced across the cycle. I'd say we're more balanced if you were to look at us over a 15-year time horizon since we spun out of Westinghouse if you look at the acquisitions we've done. It created more balance, but I'd say we're more biased towards a mid-to-late cycle. Here's how we're thinking about it, and just to be very direct, we're presently going through our 2010 operating planning process, so we've not established how we're dialing up next year as of yet.

But, the way we think about it is we're seeing positive indicators on the industrial end markets. So, in terms of our industrial and our OEM valued-added assembly, we're seeing potential for sequential positive momentum i.e. a tailwind. On the institution and government segments, the ING of C&G, we absolutely given our initiatives and the market and stimulus funding as a positive contributor, see that as a potential for sequential positive momentum, i.e. a tailwind.

Utility, I'd say it's a mixed bag. As Steve mentioned, power demand is down for the first time in essentially a decade. So, distribution the D of T&D should have some headwind in 2010. Transmission through the substation will have some relative tailwind, we wouldn't say a lot. How does that integrate? We're sorting through those, as we speak. And then, finally, as you suggested, Hamzah, the non-resi clearly is going to be a headwind.

You look at the starts this year down over 30% and McGraw Hill now says starts next year will be down low single-digit, but it's the time lag factor of a relatively long cycle industry. And so, the put in place effect we're going to feel the starts being down in 2010. That clearly represents a headwind. So, that's how we're thinking about it from an end market dynamic perspective.

And then obviously, we're going through a process now of working all our growth initiative. We gave some deeper insight in this call about what we're doing and how do we integrate that against the end market. So, as we've done in prior years, we'll give very detailed color on that in our next earnings call.

Operator

Your next question comes from Sam Darkatsh – Raymond James.

Sam Darkatsh – Raymond James

Three questions, if I might. The first one, looking at the sequential gross margin guidance, Richard, you were mentioning you thought it might be flat sequentially. I'm guessing, do the inventory reduction efforts then continue into Q4 and then, therefore, you're going to have negative pressure there, or? I would think that that would begin to moderate as well as you might be getting some sequential benefit from copper. So, I'm curious as to why the sequential flatness in gross margins?

Richard Heyse

I think to answer your first question, yes, that we're going to keep focused on inventory management, effective use of capital is clearly a priority for us. I would expect we're targeting about the similar reductions in inventory in the fourth quarter as we had in the third quarter, and so the costs associated with that should be about the same.

Beyond that, as John said, it is a very competitive landscape, but from a pricing point of view, but we've been doing a good job on that front. So, overall our expectations that gross margins should be similar to second and third quarter level.

Steve Van Oss

Sam, we've been doing a lot of work on the product side of that and even in the second quarter with the gross margin being relatively flat, we've got our product margins up a bit and the offset was related around the inventory areas. Also, as you know, tied to that is the rebates from suppliers and with the growth program buys, you have to have growth in the programs to maintain parody on a percent of cost of sales.

So, obviously with sales being down we lost some, so that's been a major headwind on that. But the exciting part or the promising part even in this competitive environment is we've been able to have some success in our product margins across the board.

Sam Darkatsh – Raymond James

The second question, your incremental cost savings in 2010 versus 2009, how would you quantify that generally speaking? I know you're going to have some of the discretionary spending cuts in 2009 returned in 2010, or at least the spending come back in 2010. So, how should we look at incremental cost saves next year?

John Engel

Yes, the one-time discretionary benefits that we got this year as a result of limiting those programs, we're going to reinstate those for 2010. That's our current plan in construct. As we mentioned before, we had a $160 million of total cost savings targeted that we're executing against and we're going to deliver over $140 million of that in 2009 so the residual of that rolls into next year.

But the bottom line answer on it is, it is a function of ultimately how we size our 2010 plan because that's the process we're going through now. So, it's a question of our growth initiatives, the level of investment in those growth initiatives. And once we have the 2010 plan solidified, that'll speak to how much costs moves year-over-year. Richard, you may want to add some additional commentary.

Richard Heyse

No, I think you pretty much covered it all. We would expect to get the full year benefit in 2010 of our permanent reductions that we made in 2009.

Sam Darkatsh – Raymond James

So, you've got $20 million of overflow and then $25 million of discretionary spend coming back, so they net against each other. So, how should we look at productivity then next year if cost saves net against each other?

Richard Heyse

Correct. The full year impact of the permanent reduction is approximately $90 million. We know we'll see about $70 million this year. And given the planning construct John mentioned, we expect to restore the temporary benefits suspensions next year. But again, we have to go through our planning cycle and we'll give more color to that in our next conference call.

Sam Darkatsh – Raymond James

Last quick question and then I'll defer to others. John, in your answer to the prior question, you mentioned that you don't think you'll be stocking from your customers have come to an end. Some other peers, distributor peers have mentioned that destocking, at least with their customers, they think has come to an end.

Is that an issue of electrical versus other end market categories or a mix of your customer base or a share situation? How would you – I know I'm asking you to put words in other people's mouths perhaps, but how would you reconcile that?

John Engel

This is not a West Coast specific issue. I think we serve so many different end markets, it depends. Example, our steel customers. Our steel customers began to bring factories back online in the third quarter and add back recall people that they had taken out and production levels are up. So, if you were to say what's happened, at least in terms of at least our view into the service industry and those that we serve, destocking is over and you begin to see some uptick in sequential demand.

So I think that's where our statement, we're very clear on, overall you're looking at all the various sub segments of the industrial end markets that we serve. We're stating very clearly that destocking has not stopped across the board. It's end market dependant. Overall, we still saw that in the quarter, Sam, but I think the indicators are positive, but we still saw that occur in the quarter.

Operator

Your next question comes from Matt Duncan – Stephens Incorporated.

Matt Duncan – Stephens Incorporated

Getting back to the gross margin for just a second, did you guys have any [inaudible] this quarter?

John Engel

We missed that. You cut out the end of that question. Could you repeat it?

Matt Duncan – Stephens Incorporated

Yes, did you have any LIFO layer liquidations this quarter that impacted gross margins?

Richard Heyse

No, no we don't use LIFO, so we're on a non-LIFO basis for accounting.

Matt Duncan – Stephens Incorporated

And then when you look at supplier rebate levels, I would assume that they're down versus 2008. Are you trying in essence to accrue for that evenly throughout the year or is there some chance that there may be an impact there in the fourth quarter?

Richard Heyse

We attempt to accrue at an even rate and the year-over-year rates of accrual are somewhat down.

Matt Duncan – Stephens Incorporated

And then when you look at the expectations for a slow recovery in industrial, I'm wondering if you can give us some color around that. And typically I would assume that you would be hearing positive chatter from your customers. Your order patterns might be changing a bit.

And industrial was up under 1% sequentially. Is that kind of activity starting? Are you beginning to see those early signs or are you referring more to sort of what you're seeing in the economic data when you're talking about a slow recovery there?

Steve Van Oss

I think you're seeing it both. You're obviously seeing it in the economic data. The utilization rates are starting to trend back up, the purchasing managed index is in positive territory, the backlog of orders is in the right direction. The one that hasn't really turned positive yet and probably won't for some period of time is in the manufacturing employment area. That tends to lag as people are going to bring on full shifts or work some overtime before they commit to full-time employment.

But we have a fair amount of business to we work with our OEM's on a direct material where we're getting future forecasts, and they're starting to show some signs of strengthening. Certainly not back to the '07, '08 levels but better than what we've seen through most of 2009. So I'd say it's both where we're seeing it in specific customers and their activity level on the maintenance and repair and in their forecast for the direct material where we work with that.

Matt Duncan – Stephens Incorporated

The last thing here and I'll jump in queue. On the convert exchange and then also on your tax rate, Richard, can you just give us a rough guesstimate as to what annual interest expense ought to look like on a go-forward basis? And then on the commentary that you'll start at 24% in the fourth quarter slowly ramp to a 30% tax rate, how long do we need to think about that process taking?

Richard Heyse

Your first question, as I mentioned in the script, we exited the quarter at about a 4.8% cash interest rate and that's on total par debt value, and that fully reflects the impact of the convert. So I think roughly it's about $13 million to $14 million year-over- year in cash interest rates due to the convert.

Matt Duncan – Stephens Incorporated

What about for reporting purposes, I guess, is what I'm getting at? What are you going to have to report through the P&L?

Richard Heyse

It gets, again, fairly complicated as far as the debt discounts, so I think overall it's a modest difference but the main effect is on the cash interest rate.

Matt Duncan – Stephens Incorporated

Yes, I understand that. I just want to make sure we kind of model it right so it doesn't goof up [inaudible]. And then on the tax rate?

Richard Heyse

On the tax rate, there again, the 24% rate was our effective year-to-date rate when we remove the impact of the convert exchange, and that's a good number for the fourth quarter. And in 2010 we expect that there's going to be some tax law changes and some changes in some of our international structure that will move our effective rate up to approximately 30% next year.

Matt Duncan – Stephens Incorporated

For the full year then?

Richard Heyse

Yes, for the full year and that should be pretty much in place we would estimate by the second quarter.

Operator

Your next question comes from Shannon O'Callaghan – Barclays Capital.

Shannon O'Callaghan - Barclays Capital

Do you have a sense, I mean, can you quantify the impact this year on gross margins of your inventory management efforts, the volume rebates, anything else that was flowing through there that you think is going to go away?

Richard Heyse

Yes, I would say approximately about 30 basis points if you look at the inventory managed we recalled this quarter is about 20 basis points. There's another miscellaneous 10 basis points of other factors related to rebates, etc., and I think that's a pretty good number overall.

Shannon O'Callaghan - Barclays Capital

And that was basically for the quarter and for the whole year?

Richard Heyse

Yes, I think for both on the year. As we mention on the rebates we attempt to true that up and keep that at a full-year estimate rate. So that's for a full-year basis, those are the two main impacts that affected both the quarter and year-to-date.

Shannon O'Callaghan - Barclays Capital

Then in terms of the commodity impact on the pricing, I mean you mentioned keeping lean inventories there, so when would we expect that to turn positive? I mean, is it going to track pretty closely with a copper price chart we might see, or when do you expect that to go from a negative to a positive?

John Van Oss

We generally see on the copper point with two components there, if you look at it year-over-year definitely had an impact on the top line. As Richard mentioned, we've already worked through it for the most part, so the margin percents were pretty good year-over-year and sequentially, but it usually takes a period of time, maybe a quarter or so, for it to go through.

And it depends on the how fast it goes up and how much it goes up because there's a lot – what happens with the numbers you'll see on [Commix] that's more on the speculative side, and in the near run we can see from our suppliers on the price sheets, sometimes they can go counter where [Commix] is going. But generally it tracks it over time. They want to make sure that it's going to hold as they try to push prices through. And we have a bias to help the suppliers push that price through the channel as quickly as we can because it helps everybody. So a couple of month's lag typically on that for us.

John Engel

And if you were look at the supplier price sheets, they're constantly updating those. They strategically have – each one of those suppliers to us have their own strategy on how they try to work price in. In general they've been trying to push prices through and get the price sheets up, but the environment is very difficult. So what we've been seeing is the price sheets have not been sticking.

Shannon O'Callaghan - Barclays Capital

Just a last quick one. Did you guys mention what severance charges were this quarter or next quarter?

John Engel

No, we haven't and we did have severance charges but they weren't material enough for us to call them out.

Operator

Your next question comes from David Manthey – Robert W. Baird.

David Manthey - Robert W. Baird & Co.

You mentioned that industrial was up about 1% and construction down about 2% sequentially. Can you tell us what normal seasonality from 2Q to 3Q would be in those two segments? And then just one minor question beyond that is, Data COM, could you hang a number on what it was year-over-year in the quarter?

Steve Van Oss

Dave, normally our typical seasonality is the second and third quarter kind of aggregate sales would be flat. What we've been experiencing for the last almost a year and a half or so has been a bit stronger in the commercial construction side, so it has been showing growth. And if you look at it for all of 2009, it's relatively flat for the year when it typically would have been down in first quarter and then grown a lot in the second in the third quarter.

So it has shifted, I think it talks to what we talked about the economic environment with the industrial looking like it wants to, maybe it's found it's bottom and is looking to improve. We'll see what happens going forward. It's a huge market. We've got, I think, absolutely the best program in place to take advantage of what's happening with the stimulus fund, and a lot of that is construction project related. And a lot of that's going to be related in the energy efficient lightening, as well as Data COM.

Data COM versus last year is down but it's down roughly half the rate of what we're seeing in our overall business and it's doing pretty good. It actually grew sequentially third quarter versus second quarter. We talked about opening up facilities within a facility. We talked about doing nine of those so far.

To put that into perspective, when we bought CSE they only had 32 locations so that's a significant number and we look to really expand that. So we're pretty bullish on that. It's a lot of taking share and a lot of taking opportunity of the stimulus spending.

David Manthey - Robert W. Baird & Co.

Steve, just so I'm clear on what you said here. At normal seasonality it sounds like industrial would normally pick up a little bit second quarter to third quarter, which is what it did. Non-res probably would pick up a little bit as well but it didn't. Is that how I'm reading you?

Steve Van Oss

I'd said that we would typically see second and third quarter activity levels in both of those being similar with generally a bigger pick up in construction second quarter versus first quarter, a lot related to weather. What we had been seeing was our construction business had been stronger in relative basis didn't fall off as much originally or as quickly and we talked earlier about a little bit of the lag mid-to-late cycle kind of feel to the business.

Operator

Your next question comes from John Baliotti – FTN Equity Capital Markets.

John Baliotti - FTN Equity Capital Markets.

John, I had a question. If you think about it you guys have been pretty realistic about visibility when markets are going to come back. And I was just thinking, do you ever feel, or as you think about 2010 or as you think about just the upcoming months.

If you think about inventory levels before customers started shutting facilities and becoming more efficient, rationalizing locations, do you have a sense of where you think if you index that at one, where with respect to that, do you expect inventory levels to get? If customers after your facilities I wouldn't expect them to put as much stuff in, because now they have fewer locations to put them. Do you have any feel for that?

Richard Heyse

I'll just give you kind of a general sense we have based upon talking to a bit of our customers and our suppliers. And keep in mind, our suppliers have the same challenge, right, where they have [inaudible]. Kind of step back and put it in context. Set the clock back a year ago. Look at how much capacity's been taken out of the system over the last four quarters.

Significant headcount reductions, factories being shutdown, furloughing parts of workforces, etc., etc. You could pick any end market submarket as far as industrial, and you see that to a large degree. So we've been facing that. I think quite frankly that a number of our leading industrial companies and even our supply community.

As the end-market demand begins to come back you're not going to see a rapid rebuild in terms of adding people back in and inventory back in, releasing the controls on purchasing, releasing the controls on capital, because the leaders of these companies in essence have the opportunity to drive significant productivity. As that market demand comes back and pulls through the value chain, they'll kind of add back not at the rate that the demand is pulling. I think that speaks to fundamentally, this is going to be a long, slow recovery. And that's our planning construct.

John Baliotti - FTN Equity Capital Markets.

Right, but that can also be a good thing for you.

Richard Heyse

We think it's a very good thing for us from an industries perspective. The longer the downturn is, if you take out a long-term view, it's a large market highly fragmented, many small players. The longer this downturn occurs at these kind of levels, there's some sequential uptick, the more opportunity for it to begin to squeeze out the weaker players over time. The fact that this cycle's longer is different than prior cycles.

John Baliotti - FTN Equity Capital Markets.

It's fair to characterize that you're being realistic about the pace of inventory coming back, but if it does come back quicker, you're positioned for that as well?

Richard Heyse

Yes, that's our planned concept. We know we can react very quickly. We did it on the downturn, which no one forecasted this level of decline. We're absolutely, extremely well positioned to do it on the upturn. And if you recall from the 2004 through 2007 timeframe, we had double-digit organic growth through 11 quarters. We had tight controls on our headcount, and we got great operating leverage. So we know how to deal with a spike in the top line and we know how to manage that thoughtfully.

Operator

Your next question comes from [Steve Gambuza] – Longbow Capital.

[Steve Gambuza] – Longbow Capital

I just wanted to make sure I understood the comment on the impact of inventory reductions on margins in the third quarter. Was that 20 basis points of a sequential headwind from the inventory reductions?

Richard Heyse

Correct.

[Steve Gambuza] – Longbow Capital

Okay, and it seems like cash flow was stronger in the third quarter than perhaps you expected at the end of the second quarter. Is that generally from greater than expected inventory reductions?

Richard Heyse

I think cash flow was a little bit stronger than what we expected, but I think we were pretty clear on our inventory targets. We met them in the quarter, so overall, that's a high priority for us being a strong generator of free cash flow, and we're pretty satisfied with the results of the quarter.

[Steve Gambuza] – Longbow Capital

And you expect an additional or a similar dollar amount of inventory reduction in the fourth quarter, with a similar P&L impact? Is that correct?

Richard Heyse

As John mentioned, we focus on managing our inventories in a focused fashion. We are targeting to reduce inventories, but as far as specific we'll be selective in what we reduce because we want to make sure we maintain service levels.

If you were to take kind of a four quarter view, our inventories peaked in the third quarter of last year. We brought them down successively each quarter, Q4, Q1, Q2. The amount of drop from Q1 to Q2 and then Q2 to Q, each successive quarter it was less, and so Q4 may come down slightly.

We're going to focus on customer-service levels, but we feel very good right now, as I stated earlier, about our current inventory position to satisfy customers. And then we're very much poised as we see any sequential pickup to begin to add to our inventories appropriately. So we don't want to signal that there's any significant further movement in inventories in the current quarter.

Operator

Your next question comes from Dan Whang – B. Riley & Company.

Daniel Whang – B. Riley & Company, Inc.

First question was, I guess about free cash flow. Is free cash flow performance probably better than what we all expected, and what are the opportunities going forward on [inaudible] or managing the working capital?

And I guess kind of related to that, I think I heard additional mention of acquisitions and probably more so than the last couple quarters conference call, and sounds like you're more actively looking there and what type of potential deals are you pursuing? And is that something we could hear more about in the next couple quarters or a little bit beyond that?

John Engel

Richard, why don't you address the cash flow and hand it back to me for the acquisitions.

Richard Heyse

Again, we've touched on here clearly we're going to stay focused on being an efficient user of working capital. That won't change. And as far as use of free cash flow, recently our focus has been on improving our liquidity position, and clearly you can see with our record's liquidity as far as this quarter, that's been successful. I think on the M&A side I'll let John touch on that.

John Engel

Again, if you take a four-quarter look at free cash flow, we're north of $300 million. It's been very strong. And if you step back and think, how should you think about that, it's us managing our working capital effectively and responding to this precipitous decline in market activity. We did the same thing with our cost structure, but as we look forward we'll be thoughtful in terms about the appropriate investment in working capital to support sequential uptick in demand as we see it across our end market segments.

And we tried to share a little more in detail this time in terms of where our investments are. So let's come to the second part of your question, which is acquisitions. Look, they've been an integral part of our growth and value creation strategy, having done over 30 since 1994 when we spun out of Westinghouse. We see ourselves as a good acquirer. We have a pretty stringent process in terms of how we identify acquisitions. We have a very healthy pipeline.

Look at the capital structure transactions we did this year. It would position us to continue to be positioned to take advantage of outstanding acquisition opportunities. And as we mentioned, we think the challenging market conditions and this expected duration of the downturn is going to give us opportunities to continue to do acquisitions that are very powerful additions to our portfolio and our accretive. So the takeaway should be we're well positioned to do it and it's a matter of right deal, right time, right place. We have a rigorous process.

Steve Van Oss

I just would add to that, Dan, is there's two ways to do the acquisition, one is kind of a formal process by the company, and the other way, which we don't talk about that much, which this economic backdrop is giving us a tremendous amount of ability is to pick up the pieces of a weak competitor. As you know, there's a lot of capacity in the market. We'd like to see some of that taken out.

So we're also, while we're looking at good, solid companies for product expansion or geographic market saturation, we're also looking at the weaker competitors and how we can kind of acquire a business by being aggressive on the customer front, as well as the employee acquisition front.

Daniel Whang – B. Riley & Company, Inc.

I think just coming out of the last downturn, you probably steered away from acquisitions or weren't as active coming out of it, maybe waited a little bit more as the markets recovered.

Steve Van Oss

That is really two-fold. One was the balance sheet, the financial strength, the size of the companies. They're significantly better today than it was before, and we're in position now to do it more real-time as the opportunities provide themselves to us.

Daniel Whang – B. Riley & Company, Inc.

So probably continue to target good opportunities perhaps on the OEM and the attractive parts of the business that you've historically focused on?

John Engel

In terms of that, if you look at the acquisitions we've done and we've been clear about, they've been very, very much, I'll call it product category and portfolio strengthening moves. We haven't just bought geographic position. You look at a CSC, you look at a Carlton-Bates, you look at a Fastec, we could go on and on, so those that were done in the recent four to five years.

So we seek increasing opportunities to continue down that path. As we get additional products and services and we add them to our portfolio, we expand, we can plow through our national accounts business model, integrated supply models.

Steve Van Oss

We have time for one more quick question.

Operator

Your final question comes from [Matt Biteriso] – Barclays Capital.

[Matt Biteriso] – Barclays Capital

I'll just pile in on the back of that question. Is there any sort of target leverage or max leverage that you'll kind of manage to as you think about getting back into the M&A game? And then if you could just maybe prioritize as things stabilize and you have such strong liquidity, is M&A at the top of that cash deployment strategy, or are there other things which you look to pay down debt as well?

Steve Van Oss

In the near-term we'll be cautious with the leverage. The company's in great shape, but we are looking at the end markets and when they're going to recover in that regards. But if you think about it, for a distribution company and the way we structured our ability to grow the company, the acquired assets become part of our borrowing base.

The earnings come into that and it helps us kind of keep the leverage in check as we go up. But our bias in the near-term would be to maintain lots of flexibility in the capital structure but take advantage, if it's a strategic acquisition, we'd certainly look at the right way to fund that

John Engel

Our bias has been over the recent quarters to pay down debt. We've been doing that. And the capital structure transaction we did this year provide the flexibility to continue to invest in the business organically, as well as through acquisitions. We do feel good. We don't think about a leverage ratio as an explicit target. It's kind of the outcome of our strategy.

If you look at the other acquisitions we did, leverage would go up when we did the transaction, but we always had a target one year out, and it had to be accretive and get leverage back in a reasonable target range. The only other point I'd make is in the last downturn our leverage ratio started with a 7, now we're sitting here with a 3. We feel very good about the strength of the company going forward.

[Matt Biteriso] – Barclays Capital

Do you guys have the debt balances real quickly or maybe I can get that offline, but just curious what your revolver balance and AR securitization balances were at the end of the quarter.

Richard Heyse

[Matt], that's on the supplemental, and I can talk to you offline about that.

John Engel

Okay, I'd like to wrap now. Thank you all for attending today's call and we appreciate your interest and support of WESCO. We're successfully managing our way through these challenging times. We see these challenges, however, as an opportunity to strengthen the company and build on and extend our market leadership positions.

In the spirit of our lean culture, we're continuously focused on providing superior customer satisfaction, maintaining our cost leadership position, strengthening our team, and delivering improved shareholder returns. We strengthen our organization and talent base and have the strongest team we've ever had. Our extra effort people are our differentiator. With that, we're committed and remain confident in our ability to exit this downturn a stronger company. Thank you, and have a good day.

Operator

That does conclude today's conference. You may now disconnect your line.

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Source: WESCO International Inc. Q3 2009 Earnings Call Transcript
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