WESCO International's CEO Discusses Q2 2012 Results - Earnings Call Transcript

Jul.19.12 | About: WESCO International, (WCC)

WESCO International, Inc. (NYSE:WCC)

Q2 2012 Earnings Call

July 19, 2012 11:00 am ET

Executives

John J. Engel – Chairman, President and Chief Executive Officer

Kenneth S. Parks – Vice President, Chief Financial Officer

Daniel A. Brailer – Vice President of Investor Relations and Corporate Affairs

Analysts

Jack Stimac – BB&T Capital Markets

Deane Dray – Citi Research

Adam Uhlman – Cleveland Research

Chris Parkinson – Credit Suisse

Ajay Kejriwal – FBR Capital Markets

Steve Tusa – JP Morgan

Tony Kure – KeyBanc

Josh Pokrzywinski – MKM Partners

Sam Darkatsh – Raymond James

David Manthey – Robert W. Baird & Co.

Matt Duncan – Stephens Inc.

Noelle Dilts – Stifel Nicolaus

Steven Fisher – UBS

Ryan Merkel – William Blair

Operator

Good morning, and welcome to the WESCO Second Quarter 2012 Earnings Conference Call. (Operator instructions) After today’s presentation, there will be an opportunity to ask questions. (Operator instructions) Please note this event is being recorded.

I would now like to turn the conference over to John Engel. Please go ahead.

Daniel A. Brailer

Good morning. This is Dan Brailer. Good morning, ladies and gentlemen. Thank you for joining us for WESCO International’s conference call to review our second quarter financial results. Participating in the earnings conference call this morning are the following officers: Mr. John Engel, Chairman, President and Chief Executive Officer; and Mr. Ken Parks, 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.

A supplemental financial presentation has been produced, which provides a summary of our certain financial and end market information to be reviewed in today’s commentary by management. We have filed the supplemental presentation with the Securities and Exchange Commission and posted it on our corporate website.

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.

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

John Engel

Thank you, Dan. Good morning, everyone. Our second quarter results reflect the continued execution of our One WESCO growth strategy. We delivered another quarter of solid sales and earnings growth while generating good momentum in all of our end markets. We have now posted seven consecutive quarters of EPS growth of 15% or greater on a year over year basis.

In the second quarter, organic sales to customers were up double digits in utility and CIG and were up mid to high single digits in construction and industrial. We saw return to growth in the data communications product category with sales up low single digits, a positive change from the declines we had been experiencing since the middle of last year. Sales momentum was consistent across the quarter with sales per workday up high single digits in April, May and June. Backlog declined 2% sequentially in the quarter, but was up 5% versus year-end 2011 and remains at a healthy level.

Our third quarter is off to a solid start with sales up high single digits, which is consistent with our second quarter results. Consistent execution of our LEAN and margin improvement initiatives continues and has translated into improved operating margins and double digit earnings growth in the second quarter. Free cash flow generation was also strong in the quarter and exceeded 80% in net income. Our investments are clearly paying off. Effective execution of our growth strategy continues and we are pleased with our business results in the first two quarters of 2012.

Earlier this month we completed the acquisitions of Trydor Industries and Conney Safety Products. These two acquisitions strengthen our product and service portfolio and support our One WESCO growth strategy of providing our customers with comprehensive supply chain solutions. Trydor, when combined with Brews Supply, which we acquired nine months ago, provides us with a full range of products and services to address the transmission, substation and distribution network needs for utilities, independent power producers and utility contractors in Canada.

Conney Safety expands our MRO supplier base and enables us to bring additional safety products and services to our customers, particularly our global accounts, utility and integrated supply customers. I’m happy to say that we’ve now completed seven acquisitions since mid-2010.

These seven acquired companies have annualized sales of approximately $580 million as of their respective closing dates. With liquidity increasing to a record level of over $640 million and leverage dropping to 1.9 at the end of the second quarter, we have the capacity and financial flexibility to continue to fund our strategy of above-market organic growth plus accretive acquisitions. Our acquisition pipeline remains robust and we see excellent opportunities to further expand and strengthen our portfolio.

In summary, as we reach the midyear point of 2012, we’re operating with a stronger and more diverse business—stronger and more diverse in terms of customers in end markets, products and suppliers and geographies. Our long-term outlook remains unchanged. We expect the economy to continue to recover slowly over the next several years. We expect the industrial and utility end markets to continue to grow this year and construction to continue its move through a bottoming process in the second half and well into next year.

We are continuing to invest in our eight growth engines and our six operational excellence initiatives. We have generated strong momentum across our company over the last few years and are focused on executing our One WESCO growth strategy of providing customers with the supply chain solutions they need to meet their global MRO, OEM and capital project requirements.

Now Ken Parks will provide details on our second quarter results as well as provide our outlook for the third quarter. Ken?

Ken Parks

Okay, thank you, John, and good morning. I’m going to review the quarter results in context of the outlook we provided in April during our first quarter earnings release. At that time, we expected sales including price and foreign exchange to grow between 10% and 12% year over year. As John mentioned, second quarter sales increased 9.7% year over year, which was at the low end of our expected range. This included a 2.2% positive impact from acquisitions and a 0.7% negative impact from foreign exchange.

Organic sales growth was 8.2% including positive pricing of approximately 1%. Sales per workday increased at high single digits rates in all three months of the quarter. Sequentially, sales grew 4.2%.

Acquisition sales growth came from two companies. Brews Supply, with annual sales of approximately $50 million, was acquired on October 3rd, 2011, and RS Electronics, with annual sales of approximately $60 million, which was acquired on January 3rd, 2012. As previously reported, we closed the acquisitions of Trydor Industries, with annual sales of approximately $35 million, on July 5th and Conney Safety Products, with annual sales of approximately $85 million, on July 10th. Together we expect the combined earnings per share from these two acquisitions in the first year of ownership to be accretive by at least $0.15.

Second quarter gross margin of 20.1% was in line with our expectations. We continue to believe that gross margins can expand by an additional 100 to 200 basis points over time, and we’ll provide more information on that in our upcoming Investor Day.

SG&A for the quarter was $231 million, or 13.8% of sales. This compares to $214 million, or 14.1% of sales, in the prior year quarter. Approximately $5 million of the year over year SG&A increase in the quarter was related to the recently acquired businesses of Brews Supply and RS Electronics.

In addition, in 2012, WESCO consolidated its merit increase cycle and moved it to April 1st. Previously, annual merit increases were spread throughout the year. The incremental second quarter expense resulting from this change was approximately $4 million. Excluding this, core SG&A grew 4% compared to our organic growth rate of 8%.

Sequentially, second quarter SG&A grew 1%. Employment was higher year over year in the second quarter as we continued to invest in our growth engines, but we held it flat sequentially to the first quarter. We will continue to manage SG&A closely as we balance cost discipline with investing in our growth and productivity initiatives.

In our first quarter earnings call, we estimated operating margin to expand to approximately 6% in the second quarter. Operating profit for the second quarter was $96 million, or 5.7% of sales, and up approximately 13%, or 10 basis points, over last year’s comparable quarter. Sequentially, operating margin improved by 50 basis points with approximately 20 basis points coming from gross margin expansion and 30 basis points coming from operating cost leverage.

In our annual Investor Day meetings over the last two years we’ve outlined our objective to expand operating margin by 40 to 60 basis points annually through a combination of gross margin expansion and operating cost leverage. We continue to make good progress toward that objective and during the first half of 2012 operating margin has expanded 40 basis points over the prior year.

Operating profit pull through, measured by year over year incremental EBIT dollars divided by year over year incremental gross margin dollars is a metric that we use to drive operating margin expansion while investing in the business for growth. Over time, our objective is to consistently generate and operating profit pull through rate of approximately 50%. Our operating profit pull through rate was 38% for the second quarter and 48% for the first half. Operating profit pull through for the core was approximately 4 to 5 points higher.

Interest expense for the second quarter was $11.5 million versus $13.9 million for the prior year reflecting our lower debt balances. Our second quarter effective income tax rate was 30.3%, slightly higher than the 29.4% tax rate in the second quarter of 2011 and consistent with our earlier outlook.

Net income for the second quarter increased 17% year over year to $58.9 million and resulted in IPS of $1.15. This compares to net income of $50.2 million and EPS of $1.00 in the second quarter of 2011. For the first six months of 2012, net income was $111.8 million, up 28% over the comparable 2011 period of $87.5 million. EPS during this same timeframe was $2.18, up 25% versus the $1.74 in 2011.

In the second quarter, capital expenditures were $7.8 million. We continue to evaluate ongoing investment opportunities that we believe are important to drive our growth and profitability objectives. These investments in our people, technology and facilities are made both through capital expenditures and operating expenses.

Free cash flow for the second quarter was $49.1 million, or 83% of net income, compared to a use of cash of $19.6 million in last year’s second quarter. Through the first half of 2012, free cash flow is $103 million, or 92% of net income, well above our ongoing target for free cash flow to net income of at least 80%.

WESCO has historically been a generator of strong free cash flow throughout the entire business cycle. As a first priority, we redeploy cash through organic growth and acquisition initiatives to strengthen and profitably grow our business. Second, we work to maintain a financial leverage ratio between 2 to 3.5 times total par value debt to EBITDA. Our financial leverage ratio at the end of the second quarter was 1.9, which compares favorably to last year’s second quarter ratio of 3.1 and is the second-lowest quarterly leverage ratio since WESCO became a public company in 1999.

Overall average all-in cash borrowing costs for the second quarter, including commitment fees, was approximately 4.9%. Liquidity, defined as invested cash plus committed borrowing capacity, was at an all-time record of $640 million at the end of the second quarter. Net working capital days for the second quarter improved both sequentially and year over year.

I’ll now turn to our third quarter outlook. We expect third quarter consolidated sales growth of approximately 9% to 11% above last year’s third quarter and this sales outlook includes acquisition-related growth of approximately 4%. As a note, the third quarter will have one less work day than both the second quarter of 2012 and the third quarter of 2011.

We continue to believe that the pace of economic recovery will be slow and that we are well positioned to take share and outpace economic activity in this slow growth environment. We are maintaining our full year sales outlook of 7% to 11% including acquisitions.

We expect gross margin to be at or above 20% and operating margin to be at least 6% in the third quarter. We also expect to maintain an operating profit pull through in the range of 50%. Finally, the third quarter’s effective tax rate is expected to be in the range of 30% to 32% for the quarter.

With that, I would like to now open the conference call up to your questions.

Question-and-Answer Session

Operator

We will now begin the question and answer session. (Operator instructions)

In the interest of time, please limit yourself to one question. Our first question comes from David Manthey of Robert W. Baird.

David Manthey – Robert W. Baird & Co.

Thank you. Good morning, guys.

John Engel

Good morning, David.

Ken Parks

Good morning.

David Manthey – Robert W. Baird & Co.

First off, John, in your monologue you mentioned industrial and utilities should continue to grow in the back half of this year and I don’t know by omission if you’re implying that construction may not, and to this point, it seems like you’ve done a good job of taking share and growing in an above market rate in that segment.

Has anything changed or gotten more difficult there? I know it’s in the bottoming process. Are you wrapping up any big projects or anything you have visibility on? Could you help us understand what the trends are there?

John Engel

Yes. I would say the market hasn’t meaningfully changed in terms of what we’re seeing in end market activity, Dave, in terms of challenges. It’s been a darn tough market, quite frankly, when you look at all through 2010, 2011 and the first half of 2012. When you set the clock back a few years ago, our outlook was for this long and protracted recovery. We had thought that the non-resi construction market would have bottomed and started its recovery by now. This was our view a few years ago.

Clearly, that’s kicking out to the right, so I don’t -- We’re not seeing it get more difficult, and that’s --Even though there’s some indicators, I know leading indicators, about what’s happening with project inquiries and you look at the ABI data. That’s not translating into, at least from what we’re seeing, more difficult conditions in the market. They haven’t measurably changed.

We feel really good about our execution. I think we’ve built a nice track record here now, really, over the last couple years. We’ve got nine quarters in a row now where we’ve grown our construction business, and inside the quarter, to give you a little insight, we had growth in both the US and Canada for construction and we had growth across most of the US regions. So we would have liked it to be better than 4% growth, but that’s against, I call it, some stiff headwinds that remain.

Our backlog’s down slightly sequentially, but it’s still up 5% year over year. A little insight into our backlog, it’s nice balanced growth across all parts of our business with the exception of government, and when you look at the declines, government’s down a bit, and sequentially, Datacom backlog came down a little bit because we had built some backlog up, as we spoke in the last call. Hopefully, that -- Does that answer your question?

David Manthey – Robert W. Baird & Co.

It does, yes. Maybe if I could sneak one more in here, John, in terms of the utility business, we’ve been hearing that you’ve been battling to win back some of these major account customers that you lost a few years back and that you landed maybe at least one big one. Does the second quarter include any contribution from some of those mega contracts or will that start in the third quarter and beyond?

John Engel

We spiked out in our last earnings call that we won TVA last year in the latter part of the year, and when you win these larger utility alliance programs, it’s kind of like an integrated supply on the industrial side. It ramps slowly over time. It’s not like a big project where it all comes within a quarter or two or three, so we’re seeing the contribution. We spiked out Tennessee Valley Authority in the last call.

We’ve had some other wins, too. I would cite, though, our broad-based utility results as being very positive. We have four quarters in a row now where we have double digit organic sales growth and I would tell you that the growth is fundamentally driven by increasing our scope of supply with our current customers. We’ve had a few new customers we’ve added, but fundamentally it’s increasing our scope of supply with our current customers, which is really our One WESCO strategy.

So, it was a little over a year ago, a year ago plus, we said we thought utility would begin to recover the end markets in the second half of 2011 that would continue. We’re still in the recovery phase.

With that said, the end market, it’s still transmission-led recovery and our outlook for utility end markets, or for that to continue in the second half, that transmission-led recovery where the end markets around transmission are up high single digits, right around maybe double digit range, 10% plus or minus. End market, not WESCO sales, because we don’t forecast that by segment on a future-looking basis, but distribution, the D of TND, is in the very low single digit range in terms of end market growth. It has been in this recovery phase and it’s our view that that continues in the second half.

So, I think the market sets up nicely for us. We’re not getting a lot of tailwind in utility yet because we’re more distribution-biased, but I think we’re getting really nice execution on our growth initiatives.

David Manthey – Robert W. Baird & Co.

Great, thank you.

Operator

Our next question comes from Deane Dray at Citi Research.

Deane Dray – Citi Research

Thank you. Good morning, everyone.

John Engel

Good morning, Deane.

Ken Parks

Good morning, Deane.

Deane Dray – Citi Research

And for Ken, welcome and best of luck in your new role.

Ken Parks

Thank you.

Deane Dray – Citi Research

First question is given the kind of macro angst we’re seeing, especially on volume and demand, can you comment on the progression in the quarter from an organic standpoint?

John Engel

Yes, Deane. I commented briefly, so let me put a fine point on it. We had very consistent growth across the quarter in the high single digit range April, May and June, so when you look at it, we didn’t really see much variation across the quarter, which was encouraging to us.

In our last earnings call, we started out of the gate a little bit slow, but we also had the Easter holiday comparison, which was a challenge at that point right when we did our Q1 earnings call in April, and so far in July that’s continuing. We’re consistent with the second quarter, so we’re off to a solid start.

In addition, I’ll comment -- We don’t typically make this comment, but I’ll share it with you just because backlog was down 2% sequentially in Q2. We do measure book-to-bill ratios, and so far in July our book-to-bill ratio is nicely above 1.0, so that says the orders rate, the bookings rate, is above the sales rate, so I’d say a solid start to the third quarter.

Deane Dray – Citi Research

Good, and can you comment on pricing? This was the one percentage point contribution from pricing is the lowest you’ve had in a number of quarters. Is it tougher to get price in this environment? Is there more that WESCO can be doing in terms of price optimization?

John Engel

Yes, I think pricing somewhat moderated a bit and more normalized in the second quarter versus the first, and clearly versus what we saw last year. Copper is down a bit. We’re very encouraged by the gross margins we posted given some down draft by copper. I think we’ve shown over a long period of time now, not just even a few years, but many, many years. I think we’ve been able to show our resilience against a volatile copper market.

Our view going forward, Deane, into Q3, we get good insight on what the planned supplier price increases are in the second quarter, and again, this is not average for the whole supplier, but for product categories, they were ranging in the 3% to 5% range in Q2 is what they were attempting to get on certain product categories and certain pieces of product categories, and what they’re looking -- and it was a little bit higher in Q1 and clearly higher last year is what they were looking to get, and as we go through Q3, and we have good insight, and they’re planning a range roughly equivalent to the second quarter in the 3% to 5% range on selected categories.

So, I think the pricing, it’s still tough to push it through to customers because I think -- and particularly with a little bit of moderation in end market demand, they’re continuing to look for savings, but I wouldn’t signal any fundamental change up or down.

Deane Dray – Citi Research

Great, and then just last one, a clarification. That was real helpful to call out those changes in SG&A because it looked like there was some other one-timers or adjustments going on there. Just to clarify for third quarter, is there any residual changes on the merit increase, and just in terms of anything you would highlight for third quarter SG&A?

John Engel

No, and I think maybe to put one additional fine point on it, we made the decision some time ago to synchronize and line up all our entire total compensation planning and execution actions, and one of the results of that was to take -- since I’ve been with the company, WESCO’s merit planning, annual merit planning process, we would do it once a year, but they would kick in throughout the year. They were spread across and there wasn’t a common merit increase date.

We made the decision last year in our planning coming into this year that we were going to synch up and do more of a total compensation review, so merit increases, base salary changes, if any, plus, obviously, our annual bonus process and equity, we synch all that up. Now, we had moved the equity planning up from middle of the year to the early part of the year with our board a few years ago, so this synched everything up, and so that drives -- It had a measurable impact in the second quarter, as Ken mentioned in his comments.

If you were to adjust for that, we were very nicely at a 50% pull through, and on a first half basis, which normalizes the effect for the second quarter because those increases that were planned in Q1 we held off until Q2, and on a first half basis we’re at 50% pull through, so I think we had a really solid quarter.

It puts the cost question, if there was any, it hopefully brings it to clarity for everyone because I think that was a question from some of you. When you looked at our results, that didn’t make sense.

Deane Dray – Citi Research

That’s real helpful. Thank you.

Operator

Our next question comes from Adam Uhlman at Cleveland Research.

Adam Uhlman – Cleveland Research

Hi, guys. Good morning and welcome to --

John Engel

Good morning, Adam.

Adam Uhlman – Cleveland Research

Just to clarify that, the comp plan change was not in the guidance that you provided for the second quarter?

John Engel

Well, no, but I think what I would say is we had a 10% to 12% top line sales guidance. We came just below the low end of the range. We’re at 9.7 and so coming out of the first quarter, we had very good momentum consistent with how we provided outlooks in the past. We were driving for that 10 to 12 range and we were hopeful that, honestly, that we’d be at the high end of that range, which is the track record we had been posting for many, many quarters in a row, and we saw a slowdown in the end market demand that happened as we progressed through the quarter.

We still feel really good about our execution, but if we had another 2 points of sales growth, the quarter would have been that much better. We still think it was a solid quarter, but with an additional 2 points of sales growth and the pull through that you get on that, because our cost structure was set in place, it would have been terrific.

It think that’s -- From our perspective, that’s really the story. We had hoped and were driving for coming in the upper end of our sales outlook range. We came in at the low end and that really was the -- Gross margins were solid and cost was -- We knew what we had with the cost perspective, but with additional 2 points of sales growth, it wouldn’t -- We still improved SG&A leverage 30 basis points year over year, quarter two versus prior year.

Ken Parks

And I think it’s an important point to note that, and I made it in the comments, we continue to invest in our workforce for the growth engines. We did, as we saw some of the growth start to moderate in some of our end markets as we moved through the quarter, we did actually start to look at each individual position very, very closely and actually worked to hold our head count flat year over -- to the end of the first quarter. Head count had been up a little more than 3% at the end of the first quarter and by holding it flat we still saw growth.

John Engel

Sequentially.

Ken Parks

Sequentially, but we still saw growth year over year in the second quarter, but more at the 2% range.

Adam Uhlman – Cleveland Research

Okay. The $4 million, though, was in the 6% EBIT margin target?

Ken Parks

I think it’s fair to say yes. Again, as John said, 2 more points of top line growth, everything would have flowed through exactly as the guidance laid out.

Adam Uhlman – Cleveland Research

Okay, got it, and then shifting gears a little bit, the Conney acquisition was a little bit different for you folks, a catalog type business, and I’m just wondering how you’re thinking about acquisitions going forward with the leverage ratios pretty low. Are we going to be doing more different acquisitions or are we going to be seeing a move back to the prior history of more electrical type acquisitions? Can you just flush that out a little bit more, please?

John Engel

Well, first of all, and I think Ken mentioned this in his comments, we feel really good about our capital structure and our balance sheet as we enter the third quarter. With a leverage ratio of 1.9 at the end of the quarter, it’s the second-lowest leverage ratio we’ve had at the end of a quarter since we’ve been a public company in 1999. The next lowest leverage ratio was 1.8 and that was in the quarter right before we acquired CSC, so we feel really good about, again, our position entering the third quarter. We did close Conney and Trydor in July and so they’re not in the 1.9, but they’re not large acquisitions, so that’s the first comment I wanted to make.

Second would be that if you look at a few years ago when we did our first-ever Investor Day, we had a page on our acquisition strategy, and I think you’ll recall, and we’ve been using it consistently since. We have an acquisition; you have that MRO ski slope with all the various product categories. We had highlighted several years ago categories outside of core electrical. We had four different categories highlighted. Electrical was highlighted, but so was industrial and so was safety and so was one additional category, so it’s been in our sights and we think our business model extends horizontally to other product categories that we can sell to our existing customers to service their MRO, OEM and capital project needs.

We’re really excited about the Conney acquisition, and as we mentioned in our press release, it’s a terrific addition to our portfolio. They’re a premier player in terms of MRO safety products and it also does a nice job in terms of giving us -- helping gross margins and operating margins, so we’re really looking for to. They’re on board now. Initial reaction from customers is very favorable, and from suppliers, and we look forward to the contributions they’ll deliver, as well as Trydor coupled with Brews for utility for a more aggressive utility play in Canada.

I would tell you that going forward you should expect to see those same types of acquisitions. You should not expect to see just classic pure play electrical distribution house where we’re just trying to capture and roll up. We’d rather take share organically but then supplement and strengthen the portfolio with these acquisitions that broaden our product and services.

Adam Uhlman – Cleveland Research

Great, thank you.

Operator

Our next question comes from Tony Kure of KeyBanc.

Tony Kure – KeyBanc

Thanks for taking my questions. Just wanted to clear a question on the sales force additions in the first quarter. I think you said last quarter you added about 5% to the sales force, so given the somewhat deceleration on the growth side, the slight deceleration and maybe a push out in the construction recovery, has that changed, do you think, the pace maybe by which you’re going to invest in the sales force or is that still on track for the prior periods?

John Engel

Good morning, Tony. It’s a great question. You’ll see us spotlight this in the Investor Day, as well. Let me take 30 seconds and just put it in historical context. I’ve been with the company since the middle of 2004. 2004, 2005, 2006, 2007, going into 2008, our average head count growth for the core business for WESCO, ex acquisitions—without acquisitions—our average organic head count growth was 1% a year.

You’ll recall that prior to 2004 we had never been above 3.x% EBIT. We launched LEAN and so we really focused on getting additional capacity and capability and productivity out of what we had, so we were able -- and then we supplemented that with acquisitions, but our core head count growth was 1%.

’08 moving into ’09 we dealt with the global recession. We obviously had some significant head count or employment reductions. As we moved into 2011, or 2010 and ’11, we went through a succession, we refreshed our strategy, we had our first ever Investor Day, we made some other management changes, we launched our growth engines and we used the term “playing offense.”

“Playing offense” was increased investment in our business. We’ve gone through this at length, but let me put numbers to it. Our average in employment growth for the core business in 2010 and 2011 was 5% each year total head count growth and we tried to disproportionately add more sales than non-sales.

As we move into 2012 in the first quarter, Ken mentioned 3+% total head count growth in Q1, of which 5%, roughly, was our sales growth, so non-sales was lower than 3%. In Q2 it was 2% growth, which is still twice the average of what we did from ’04 to ’07, but we did moderate it a bit, and we did that because as we began to see slowing in the end markets, we wanted to be more judicious in terms of new additions to WESCO plus replacements.

But it’s our plan to continue to invest in the business. We do not want to go back to the 1% core head count growth that we had ’04 to ’07, ’08. That’s not playing offense, and we’ll size and moderate or modulate that addition based upon what we’re seeing. We are quick reaction, quick response. We showed that in 2008 going into ’09 in how we reacted when we saw the downturn, but our view is not that we’re facing that. Our view is a long protracted recovery. We had a little bit of end market slowdown in Q2. We think very solid results and we’ve got our growth engines identified. We’re still investing. We’re going to plow forward.

Ken Parks

I think that’s exactly the point, which is the long-term strategy stays exactly what it is. We have an obligation to watch and moderate as we see the markets moderate and that’s what we did in the second quarter, but I think there’s a full intent to continue to invest in this, specifically, sales force or all of the initiatives because we see the opportunity to continue this out-of-pattern organic growth rate compared to the market.

John Engel

One final point, when we use the term “investment” it is -- there’s two pillars to that investment, we think, two legs to our shareholder value creation strategy. One is organic so it’s adding additional sales resources, opening up new locations as branch within a branch, et cetera.

Secondly, it’s acquisitions, and so I think we’ve got very nice momentum there. Our pipeline’s in terrific shape, and as we mentioned earlier, with the shape of our capital structure and balance sheet entering a third quarter, we’re extraordinarily well positioned to continue to work the acquisition opportunities.

Tony Kure – KeyBanc

Great. That context is helpful. I just want to sneak another one in on Datacom Products sales trends. You mentioned the recovery here in the second quarter. Just wondering, we’ve heard some caution out of the more tech-related enterprise type companies as move forward in the second half, some cautious end customers. Just wondering what your visibility is there in the second half and what gives you confidence in your ability to continue to outperform if the market gets more sluggish.

John Engel

Well, I’ll tell you, our feedback from our suppliers, our customers and other sources clearly confirm that we had weaker demand—end market demand—than expected for Datacom in the whole first half both Q1 and Q2. I think there was some belief by some that the second half would represent some marked recovery and we made some comments to that effect in the last earnings call.

I think the market’s going to continue to remain challenging as we go through the third and fourth quarter. With that said, we’re really encouraged that our Datacom sales returned to growth in the second quarter, and by the way, just to give a little color on that, we had growth across all regions geographically that was offset by a decline in government sales, but net we grew. We think Data Center continues to grow, but I think there’s going to be fewer Greenfield projects and more retrofits and [colos] as we move through the third and fourth quarter.

IP and physical security markets are growing. WESCO Security sales--and we’ll talk about this at Investor Day--were up double digits, grew double digits versus prior year in Q1 and Q2 and our broadband communications TBC acquisition performed very well growing mid-single digits in the quarter, so I think that we’re generating good results.

Maybe one more piece of data, remember our Datacom and broadband communication sales, if they’re sold directly to a contractor, they show up in construction. If they’re sold directly to an end user, and that’s an institution, a federal, a financial institution or a governmental agency or a hospital or et cetera or a property management firm, it would be in CIG, and our Datacom and broadband communication growth in CIG—into CIG, not through the contractor channel—was up double digits in Q2, which was very encouraging for us.

Tony Kure – KeyBanc

Great. Thank you so much for the color.

John Engel

Thank you.

Operator

Our next question comes from Sam Darkatsh at Raymond James.

Sam Darkatsh – Raymond James

Good morning, John, and Ken, again, welcome to the party.

Ken Parks

Thank you.

Sam Darkatsh – Raymond James

My question, I wanted to piggyback on a prior question as it related to Conney. It’s an MRO distributor of safety products that sells largely, as I understand it, to national accounts, and as a result you’d think that you’d be getting to be encroaching now on some of the sweet spots of some of the larger MRO players by looking at a company like this, and so I have two questions as it relates to that.

First off, as you -- with your M&A activities, as you move away from electrical, are you finding you have to pay up more when you’re looking at these types of businesses? And then secondly, are there additional challenges that you’re finding in these nonelectrical markets where you have to try and differentiate yourselves against some folks that are perhaps a little more entrenched?

John Engel

I’d answer it this way. As large and fragmented that core electrical markets are, what we’re finding is the industrial distribution markets are even larger and even more fragmented. I’d answer it that simply, and so I think there is outstanding opportunity, not just for WESCO, but for each of the larger players individually and in the aggregate to do very well in that large fragmented space and support the customer trends of which we are seeing.

They existed and they’re accelerating, particularly on behalf of these industrial kind of increased outsourcing and looking for more supply chain savings and higher supply chain integrity, so there’s this significant opportunity for the larger, stronger players, I think, to take share organically and, quote, unquote, “help consolidate the market” by outperforming versus the smaller players. That’s our view.

The more we get into -- And we have substantial amount of industrial products and services in our current portfolio. We’ve been diversifying our portfolio for years now, so I think this is just another step in that evolution, but we’re bullish on that. We’ll get into that in some more detail, Sam, when we get into Investor Day because I think we’ll give some more insight into how we’re looking at accelerating in that.

Sam Darkatsh – Raymond James

So you didn’t find that the multiples are beginning to pay on some of the nonelectrical players are starting to rise a little bit because you’re going up against more well-capitalized folks that are also bidding on them?

John Engel

Look, I’m not going to comment on a specific multiple except to say that I think that overall what we have found, we’ve been very disciplined as a company in terms of the prices we pay and we’ve been as well, if not even more disciplined in terms of our integration and execution of the acquisition to ensure that we deliver the synergies and the accretion. We’ve got a very good track record there and we’re building on that track record.

The only thing I would say is I think that we’re getting much -- we have a very good track record of being good for some period of time. We’re getting much stronger in that. The strength of our management team, the additional dedicated resources we put into the function centralized working the pipeline, working the deal structures, the negotiation, the front end, and then once we execute the [hundred]-day integration plan, how we move through that, we continue to try to improve that, but we’re the best we’ve been.

Now, our expectation is we’ll even get better, but I think you have something very good about the capability there.

Ken Parks

I think, just to add on one short comment, the variance in pricing, which, again, we don’t talk about multiples specifically, but I think the variance in pricing in this very fragmented market where there are many opportunities and properties out there to look at is much more driven by the variance in profitability and positioning of the businesses than it is in multiple variances across the parts of the business that we’re looking at.

John Engel

The only final point I’d make is we are a strategic buyer. We’re not a financial buyer, so when we acquire one of these operations, we have a long-standing history of the way that we integrate, the way that we assimilate and combine it with our WESCO, other operations and our culture and taking the strong management team we’re acquiring.

We have not bought a turnaround. We are buying well-run companies and we’re providing the opportunity for the management teams of these companies to further their career and develop and grow and do greater things inside a larger enterprise. We have a very strong track record on that.

You look at the top operating leaders of our company, some of which we showcased over the last two years, and a number of them have come via acquisition, and so I think that speaks volumes in terms of the strategic buyer and the ability to -- that synergy, that value is on our side of the ledger when we negotiate price.

Sam Darkatsh – Raymond James

Thank you. Very helpful, gentlemen.

John Engel

Thank you.

Operator

Our next question comes from Matt Duncan at Stephens Inc.

Matt Duncan – Stephens Inc.

Good morning, guys.

John Engel

Good morning.

Ken Parks

Good morning, Matt.

Matt Duncan – Stephens Inc.

Just sticking with Conney for a second, to better maybe understand the strategy there, my understanding is that is a business that had a fairly limited footprint, yet a much broader product portfolio in safety than you yourselves did, so can you talk about the opportunity to cross sell those products across your footprint and turn $85 million revenue into something much greater?

John Engel

Okay. All I can say is, “Bull’s-eye.” That’s one of the opportunities and there’s a number of other ones, but that is one of the top opportunities. We’ll give you some more insight at Investor Day. They have a limited geographic footprint, but they have this very interesting integrated centralized operating model, I’ll call it, business model, and so you look at WESCO’s blue chip customer base and the ability to take those product services, leverage Conney’s specialized safety sales resources that are focused on safety applications and the additional supply relationships that they bring to the table. We’re very, very excited about it. Bull’s-eye.

Matt Duncan – Stephens Inc.

Okay. I just wanted to make sure, and then lastly, just a clarification on SG&A, and I appreciate the help you gave us understanding some of the extra costs that flowed through there, was there any maybe above-normal due diligence expense associated with the fact you announced two acquisitions in the quarter? Was there any of that going on in that line as well?

Ken Parks

We’ve been in an inquisitive mode for a while and I would say the run rate of related expenses is not significantly different.

Matt Duncan – Stephens Inc.

Okay, thanks, Ken.

Operator

Our next question comes from Matt McCall, BB&T Capital Markets.

Jack Stimac – BB&T Capital Markets

Good morning, guys. This is actually Jack Stimac in for Matt today. I just wanted to get a -- based on the recent PMI and maybe some comments from some of your suppliers. They’ve reported results. Has your outlook for the industrial market changed much? I know you still expect -- you gave us your outlook for construction utility. I was wondering if you could give us a little more color on if that’s changed at all or what you’re thinking for the end market growth there?

John Engel

We think industrial still grows, but we don’t get -- as you know, it’s never been our practice to get precise by end market segment and say, “Here’s the end market growth on a forward-looking basis.” Look, our -- all our belief and all our assumptions and our outlook is reflected in our third quarter outlook, which Ken went through, and we’ve given the end market commentary. We think industrial still grows. We’re not going to size the growth of the end market, but we think industrial still grows.

We think we had very solid results in Q2 at 8% growth, and others have gone and posted results. I know Grainger’s out there with what their growth rate was in the US. You can see that in terms of the industrial market. We think we fared very well in terms of the industrial performance in Q2, so that’s all I’d say.

Jack Stimac – BB&T Capital Markets

And then maybe a follow up, just looking at the growth you did during the quarter versus your previous guidance, other than Datacom, were there any other specific industries where you fell a little short of expectations?

John Engel

Again, I wouldn’t say Datacom fell short of expectations. We’re encouraged Datacom returned to growth. We had solid results through the quarter. It’s a solid quarter. There’s a general overall end market slowdown. We’re not seeing it in any one end market. This is -- it’s somewhat broad based. There’s some slowing in the industrial end markets.

Utility, we think, we’re performing very well. Still in a recovery phase, but core, the [DMTND] is growing low single digits end market, so we’re performing exceptionally well against that. Construction continues to represent some headwind and we’re performing well.

Our CIG growth was particularly nice in the quarter, so I don't -- You said that Datacom was below expectation. Datacom’s not below expectation. We’ve been working hard to get Datacom back into a growth mode and we got back into a growth mode in Q2. We’re very encouraged by that.

Ken Parks

And I think I would just say that we expect 10% to 12%. We ended at 10. Everything -- it was movements among the pieces in general, but they all fell within the range.

Jack Stimac – BB&T Capital Markets

Okay, great. Thank you.

Operator

Our next question comes from Ajay Kejriwal at FBR Capital Markets.

Ajay Kejriwal – FBR Capital Markets

Thank you. Good morning.

John Engel

Good morning, Ajay.

Ajay Kejriwal – FBR Capital Markets

Just maybe on the [pre-Q] guide, a little bit moderation on the organic, but then margins improving sequentially. Maybe a little bit of color on that. Is that seasonality? Is that change in mix? Is there anything else going on and what’s the confidence level in that margin?

John Engel

And your comment’s with respect -- We said growth margins would be 20% or greater. You comment is on -

Ajay Kejriwal – FBR Capital Markets

Is more on operating margin.

John Engel

Oh, operating margin? Yes. Well, look, at 9, 11% growth year over year, but you look at sequential growth, we’re in essential in a 3% range when you look at the base business is what we have laid in in the focus. We should -- and if you look at what we’ve done historically in terms of Q3 margins versus Q2, it’s -- what we tried to reflect into our Q3 outlook is really fundamentally we took what we saw in Q2 in terms of the end markets, our performance against it, and our outlook for Q3 reflects this slowing in the end markets, as well as our continued strong execution against that.

We had the cost delta, as we talked about, in Q2, which really spoke to the delta in the pull through versus the 50%. You adjust for that, we’re right at 50. We’re at 50 on a first half basis, Ajay, so I think it’s very solid. It’s consistent with that top line range.

Ken Parks

And I think you know this as well as I do, but the third quarter is the strongest quarter on volume so you get incrementally some operating cost leverage in the third quarter, even though the margin rates will stay essentially the same from our outlook, so that’s where we see the additional operating margin expansion come from.

Ajay Kejriwal – FBR Capital Markets

Got it. That’s very helpful, and then just on that comment on the merit increases and adjustments to SG&A, help me understand, is that one time or is that something that continues and it was just an event that happened on first April so you say that --

John Engel

No, we synched it up to first April this year, so going forward, it will be annual. It’ll be in April and it’ll -- it’s part of a total compensation look for the entire enterprise.

Ken Parks

But I think the increased expense impact will be more of a one-time look because now we’ll just be on a common pattern throughout the year once we kind of, for lack of a better term, caught everyone up to an April first date.

Ajay Kejriwal – FBR Capital Markets

Very helpful, thank you.

Operator

Our next question comes from Steven Fisher at UBS.

Steven Fisher – UBS

Hi. Good morning.

John Engel

Good morning.

Steven Fisher – UBS

The book-to-bill was positive in July so far. I’m just wondering if you had any thoughts on how the backlog can shape up in the back half of the year in general and I’m wondering if there’s any bit potential swing factors there like some of the project opportunities up in Canada?

John Engel

I think the way I’d speak to that, Steve, is we have an outstanding opportunity pipeline. I may not have mentioned this as of yet today. As I recall, I don't think that I have. Our opportunity pipeline for global accounts, integrated supply, et cetera, is at $2.2 billion plus, so we’re managing our pipeline of customer opportunities for both MRO, OEM expansion and also capital projects. So we’re really encouraged with that strong pipeline and now it’s in -- what’s our ability to convert pipeline execution into backlog and into sales, so that’s the process we’re working.

That overall process, by the way, is something we’ve spent a lot of time and energy on over the last several years when we lined up these eight growth initiatives and we added additional resources and really focused on managing that, so that’s about all I’d say about the second half of the year. We get our overall view of the macros and it’s going to be a function of what the macros do plus our ability to convert opportunity pipeline to backlog.

Steven Fisher – UBS

Okay, fair enough, and just one quick clarification. The interest expense was up sequentially, but the debt was down. Can you just clarify that?

John Engel

Dan, why don’t you get back to him?

Daniel Brailer

Yes, Steve, I’ll follow through offline.

Steven Fisher – UBS

Okay, thanks.

Operator

Our next question comes from Josh Pokrzywinski at MKM Partners.

Josh Pokrzywinski – MKM Partners

Hi. Good morning, guys.

John Engel

Good morning, Josh.

Josh Pokrzywinski – MKM Partners

Just to ask one follow up on the SG&A. I know you’ve covered it from a couple different angles now, but what impact has the softer pricing, not sequentially on a growth basis, but a downtick from the pricing growth rate of 2011 and even in the first quarter, has that had a negative impact on SG&A and with something higher than that built in to the model?

John Engel

No.

Josh Pokrzywinski – MKM Partners

No, it didn’t have a negative impact, or --

John Engel

No, I don’t think that effect would manifest itself in SG&A in a measurable way.

Ken Parks

No.

Josh Pokrzywinski – MKM Partners

Okay, thanks for taking the question.

Operator

Our next question comes from Ryan Merkel at William Blair.

Ryan Merkel – William Blair

Great. Thanks for fitting me in. Just one question. I’m hoping you could provide a little more color on a comment that channel inventory within industrial is in balance with demand, so I guess have you seen customers work down inventories in response to slowing orders?

John Engel

We have seen selected customers do that, Ryan, so I think what the real question becomes now is what’s the inventory level at a specific customer relative to the true demand stream that they’re facing into, ultimately through the value chain, and so we’re so -- we have such a diversity of customers. I know a few years ago we took our total global accounts customer base in industrial and broke it into 16 end market segments and we’ve given insight into that over time, so I would -- our comment is more in the aggregate level.

They appear to be effectively or relatively in balance as we move through the quarter and exit the quarter, but there’s clearly some customers that have worked them down and it’s an anticipation of what their demand profile looks like. Other customers, it’s worked up a bit, so our comment’s at the overall level.

Ryan Merkel – William Blair

Got you. Thanks for taking the question.

John Engel

Thank you.

Operator

Our next question comes from Noelle Dilts at Stifel Nicolaus.

Noelle Dilts – Stifel Nicolaus

Hi. Good morning.

John Engel

Good morning, Noelle.

Ken Parks

Good morning, Noelle.

Noelle Dilts – Stifel Nicolaus

I was wondering if you could just comment on, in terms of your third quarter guidance, specifically on the construction side, what you’re incorporating into your guidance in terms of seasonality and how that compares to what you view as typical seasonality in that business after adjusting for the one less sales day in the quarter?

John Engel

I think in general the construction markets are clearly stronger in the middle two quarters of the year, the second and third quarter, and so we’re reflecting what we would say is a more historical seasonality as our current view, and the reason we’re doing that is we do believe the end markets will remain challenging, but they have been for several years and we’ve been executing, we think, very well against those end markets and our view is that’s not going to change. We’ve got a lot of energy, resources, initiatives and execution priorities and processes wrapped around that, so what could be a potential delta, which we do not predict and we don’t put that into a forecast, is the impact of storms.

So to the extent this becomes a significant storm season, i.e. hurricane, there’s a hurricane impact, that could end up being a positive kicker to both utility and construction depending on if it happens in the quarter. What we’ve done historically there if we see that kind of effect -- and where would that effect occur? It would occur in the third quarter, sometimes very early fourth, but typically it’s the third quarter, and if that happens, we spike that out like what we’ve done historically like we did years ago when we faced -- when the US faced Katrina, Rita, et cetera.

Noelle Dilts – Stifel Nicolaus

Okay, great, and then just one quick additional question. In the past you’ve talked about your percentage of sales that you view as tied to copper or copper-driven. Now with the acquisition of TVC to you have an updated estimate for the percentage of your sales that are tied to commodities?

John Engel

No change. No change. You look at how the portfolio’s evolved, and I know we went through that in pretty excruciating detail in the latter part of last year, third and fourth quarter. No change.

Noelle Dilts – Stifel Nicolaus

Okay, thanks.

Operator

Our next question comes from Hamzah Mazari at Credit Suisse.

Chris Parkinson – Credit Suisse

Good morning, guys. This is Chris Parkinson on behalf of Hamzah. Most of my questions have been answered. Do you guys have any quick commentary on how to think about your gross margin pull through over the intermediate or long term as your growth initiatives and your cross-selling efforts materialize?

John Engel

Yes. It’s really an important point. I’m glad you brought this question up. We, at times, have, when we had very strong top line growth in an individual quarter we’ve had pull through rates in the 60%, 60+%. Our long-run objective is to have pull through be in the 50% range. Now, it could be 45% in a given quarter, it could be 55% in a given quarter, but in general we’re looking at 50% operating profit pull through.

That’s defined as for an incremental dollar of gross margin growth at least $0.50 gets pulled through EBIT, and so that’s kind of a control or optimizing variable on how we try to run the company, and so when you think about stepping up investments in SG&A and in salespeople, et cetera, organically in the quarter, like what I went through earlier when we’ve been raising our head count increases in growth, what we’ve done in 2010, 2011, we now need to drive the higher top line and get the gross margin through the pull through to work.

That equation has worked very well in 2010, 2011 and so far in the first half of 2012 we’re right at 50%, so that 50% remains intact as the target. Again, it won’t always be exactly that in the quarter because the way it manifests itself is you make decisions on cost and then you’re executing to deliver sales and there’s a time lag on what you do with costs versus what sales end up doing either direction, but that’s our control variable. That’s how we think about that.

Ken Parks

And I think you were also asking a bit about the margin rate itself and the opportunity and my comments, and I think it’s consistent with what we said before. We believe there’s 100 to 200 basis points of additional margin that we believe we can pull in at the gross margin line. We’re going to talk to you a bit about more of that at the Investor Day that’s coming up and where the pieces of that come from.

Chris Parkinson – Credit Suisse

Perfect. Thank you very much for the clarification and have a good day.

John Engel

Thank you.

Operator

Our next question comes from Steve Tusa at JP Morgan.

Steve Tusa – JP Morgan

Hi. Good morning.

John Engel

Good morning.

Ken Parks

Good morning, Steve.

Steve Tusa – JP Morgan

On the industrial side, I know you talked about customer inventory. It doesn’t sound like there’s been enough of a step down in the growth rate for you guys to adjust your own inventories, right? You guys are pretty comfortable where you are with the various suppliers?

John Engel

We’re very comfortable. I’m not sure -- As I recall, I don’t think, Ken, you mentioned it in your opening comments, but if you look at our working capital performance in the quarter on inventory payables, but particularly for inventory, on a day’s basis we got nice improvement year over year and sequentially, so historically we’ve had very good working capital performance. That part of the business has to run, be well run, be disciplined, be consistent. We don’t talk about it a lot because, frankly, it’s admitting control, it stays in control.

If we need to adjust, we’ll adjust, but even with the precipitous downturn we’ve faced in 2009 as a result of global recession, we made significant adjustments to our staffing levels and head count. We took $100 million of inventory out. We challenged ourselves and said, “Let’s take out -- We need to take some out,” but we didn’t want to take out too much because we wanted to serve customers. We’re very focused on availability and fill rate. Availability and fill rate, not just fill rate. We have sophisticated processes around that and so very good performance in the quarter in terms of working capital results, we feel. Again, consistent with how we’ve operated and we feel we’re sized appropriately.

Steve Tusa – JP Morgan

Right, so basically industrial going from up 12 to up 8 or flat sequentially doesn’t cause you guys to stop ordering incrementally from your suppliers?

John Engel

No. Again, our view is for working capital days to be flat to improving as we move forward to every quarter. We want to get that improvement in asset management terms consistently over time. A well-run distribution and supply chain company should do that.

Ken Parks

And specifically, that holds not only true for working capital, but inventory days themselves have declined consistently through the first six months of the year.

John Engel

Thanks a lot.

Steve Tusa – JP Morgan

Okay, great. Thank you.

John Engel

I think we’ve gotten through all the questions. We went a few minutes over. We very much appreciate the questions today.

I’ll make a few closing comments. Thank you for your time and your continued support. We’re encouraged by our positive momentum and the results in the first half of the year. We think we’ve had a strong start to the year. We’re continuing to invest in our people and in our business and we remain focused on producing improved shareholder returns. Thanks a lot and have a great day.

Operator

The conference is now concluded. Thank you for attending today’s event. You may now disconnect.

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