Wesco International Inc (WCC) 2016 Q2 法說會逐字稿

Good morning, and welcome to the WESCO International second-quarter 2016 earnings conference call.

(Operator Instructions)

Please note this event is being recorded. I would now like to turn the conference over to Mary Ann Bell, Vice President of Investor Relations. Please go ahead.

Thank you, Robert, and good morning, everyone. Thank you for joining us for WESCO International's conference call to review our second-quarter financial results. Participating in today's conference call are John Engel, Chairman, President, and CEO; and Tim Hibbard, Vice President and Corporate Controller and Interim Chief Financial Officer. The conference call today includes 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 includes a discussion of certain non-GAAP financial measures. Information required by regulation G of the Exchange Act with respect to such non-GAAP financial measures can be obtained via WESCO's website at Wesco.com. 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 the next seven days. With that, I would now like to turn the call over to John Engel.

Thank you, Mary Ann. Good morning, everyone, and thanks for joining us today. This morning, we're pleased to report our second-quarter results that are in line with the outlook we provided back in April. Reported sales were flat the prior year reflecting an organic sales decline of 3% in both the US and Canada. Notably, only the industrial end market declined organically this quarter as the construction, utility, and CIG end markets all posted positive organic growth, the first time all three have done so in the last five quarters. Gross margin was flat the prior year, a good performance within a very challenging market environment.

Our operating margin and EPS were within our expected range, and free cash flow generation also remained strong at more than 100% of net income. Let's turn to the market environment. In total, our end markets are performing as we expected when we set our 2016 outlook last December. Although, industrial took another step down in the quarter and was below expectations. As a result of our efforts to diversify our portfolio and customer base, we were able to partially offset this industrial weakness with continued growth in utility and CIG and notably, a return to growth in construction in the quarter.

Let's start on page 4 with our industrial performance. We experienced a 10% organic sales decline in the second quarter, once again driven by oil and gas, metals and mining, and OEM customers. US sales decreased 9% and Canada sales were down 21% in local currency. Direct oil and gas sales declined 25% this quarter on top of a 25% decline in Q1 and a 30% decline in Q2 of last year. As a result of this downturn and our efforts to expand our customer base, direct oil and gas sales are now approximately only 5% to 6% of our total business. A reduced demand outlook, weak global commodity prices, a strong dollar, and global uncertainty continue to weigh on the manufacturing sector.

Business equipment investment is under pressure and companies remain cautious about investing. More than ever, customers in this end market environment must respond to these challenges with supply chain process improvements, cost reductions, and supplier consolidation. We are well-positioned to deliver these solutions and our global accounts and integrated supply opportunity pipeline and bidding activity levels remain strong. Of note, we were recently awarded a multi-year contract to supply MRO supplies from a major US automotive manufacturer in the quarter.

Now moving to page 5 and the construction market. After four quarters of declines, we were very pleased to deliver return to growth in construction in the second quarter. Overall construction sales grew 2% organically with the US up 2% and notably Canada up 4% in local currency. Sales growth to commercial contractors more than offset continued weakness with industrial oriented contractors in both the US and Canada. Outside the industrial sector, our outlook for the nonresidential construction market, commercial education and healthcare in particular, is modestly positive in the overall market is still well below its prior peak. Our latest acquisitions, Hill Country and Needham Electric last year, and AED earlier this year, each grew in the second quarter further expanding our share in the construction end market.

Now moving to page 6. We had another quarters of sales growth in utility with the US flat and Canada up 4% in local currency. We have now achieved 5.5 years of sales growth from scope expansion and value creation with industrial and utilities, public power, and utility contractor customers. This quarter, we awarded a contract to help a large energy developer construct a wind farm in the US. We expect the utility industry to continue to consolidate while benefiting from secular growth in the housing market and a continued demand for renewable energy. We are well-positioned to benefit from these trends and deliver the increasingly complex supply chain needs in this market, including integrated supply solutions for our utility customers.

Finally, turning to CIG on page 7. Sales grew again in the second quarter with the US up 10% and Canada notably up 10% in local currency. US up 2% and Canada up 10% in local currency. Our communications category sales were up mid-single digits following solid growth throughout 2015 and into the first half of this year. We expect continued growth in data and broadband communications driven by data center construction and retrofits and cloud technology projects. Overall, I'm pleased with our performance in the first half of this year and the rough results that we have delivered thus far in a market that has been much more challenging than we expected. With that, I will now turn the call over to Tim Hibbard to provide further details on our second-quarter results. Tim?

Thank you, John, and good morning, everyone. Moving to page 8. We expected second-quarter sales to be down between 1% and 3% when we provided our outlook in April. Actual reported sales were slightly better than this range, down only 3/10 of 1% to prior year. Organic sales declined by 3% while pricing was down 0.5 points. Our acquisitions of Hill Country, Needham Electric, and AED added 4 percentage points to sales while foreign currency translation reduced sales by 1%. Our core backlog increased 4% from year-end 2015 and was down 3% from the second quarter of 2015.

Gross margin was 19.9% in the quarter, flat to the prior year and down 10 basis points sequentially. Effective execution of our supply chain management initiatives offset pricing and business mix. SG&A expenses for the second quarter were $275 million, including acquisitions which added approximately $9 million of incremental SG&A. Excluding acquisitions, core SG&A decreased by $10 million compared to last year. This reflects our cost reduction actions over the last six quarters to eliminate approximately 600 positions and eliminate or consolidate more than 30 branches, along with ongoing discretionary spending controls. Operating margin was 4.6%, within our outlook range of 4.5% to 4.9% and down 10 basis points from the prior year but up 70 basis points sequentially from the first quarter.

The effective tax rate was 27.3%, down 200 basis points from the prior year, driven by a shift in the relative proportion of income between the US and Canada. Turning to page 9. Second quarter EPS was $1.02 compared with last year's EPS of $1. Core operations unfavorably impacted EPS by $0.13 while acquisitions increased EPS by $0.05. The foreign exchange impact was favorable by $0.01 as the current year's unfavorable translation impact was more than offset by a favorable change in transaction gains and losses. Tax-related items increased EPS by $0.03 and the lower fully diluted share count increased EPS by $0.06.

On page 10, free cash flow in the second quarter was again strong at $57 million or 113% of net income. Year to date, we have generated $132 million of free cash flow or 156% of net income. WESCO has historically generated strong free cash flow throughout the entire business cycle. Our capital allocation priorities remain the same. As a first priority, we invest cash through organic growth initiatives and accretive acquisitions to strengthen and profitably grow our business. Second, we work to maintain a financial leverage ratio of between 2 to 3.5 times EBITDA. Third, we have $150 million remaining in our existing share buyback authorization to repurchase shares. Following the completion of the Hill Country and Needham Electric acquisitions last year and the AED acquisition in March, our leverage ratio was 3.8 times EBITDA at the end of the first quarter. And remains 3.8 times at the end of the second quarter, slightly above our target range but flat to year-end 2015.

We anticipate that continued solid free cash flow generation will enable us to bring this ratio back within our target range in the near term. Leverage on a net debt basis was 3.4 times EBITDA, slightly below the first quarter. Liquidity, defined as available cash plus committed borrowing capacity, is $997 million at the end of the quarter. This is above our normal liquidity level, largely due to the issuance of the new 5 3/8% senior notes in June with the intention of using the proceeds to redeem the convertible debenture in September. During the quarter, we used the proceeds from the new notes to temporarily pay down short-term debt.

Interest expense in the second quarter was $19.5 million versus $18.6 million in the prior year, including the incremental cost of the new senior notes. Our weighted average borrowing rate for the quarter remains stable at 4%. After the planned redemption of the 6% convertible debentures, we expect that our debt will once again be equally balanced between fixed rate and variable rate instruments. Capital expenditures were $3 million in the quarter. We continue to invest in our people, technology, and facilities through both capital expenditures and operating expenses. Now, I would like to turn the call back to John Engel to discuss our third-quarter and full-year 2016 outlook on page 11.

Thank you, Tim. We expect weakness in commodity driven end markets and foreign exchange headwinds to continue into the second half. As I said earlier, the market environment has been more challenging than we expected this year, especially in industrial. However, we are maintaining our current outlook for 2016 within the original guidance we provided last December. Turning first to our outlook for the third quarter, we expect sales to be down 3% to flat with the same number of workdays as last year. This includes the impact of prior acquisitions and an average Canadian exchange rate assumption of $0.77 to the US dollar. We expect operating margin of between 4.9% to 5.3%, and an effective tax rate of approximately 29%.

We also expect higher interest expense from carrying the new 5.375% senior notes. We're assuming a fully diluted share count of between 48 million and 49 million shares for the quarter. Month to date, July sales are down mid-single digits organically, roughly in line with June. The book-to-bill ratio is positive, above 1.0. We are closely monitoring the current environment and our customer activity levels, and we'll continue to maintain stringent discretionary cost controls while taking additional cost reduction actions in the second half.

Now moving to our full-year outlook. We are narrowing our full-year 2016 outlook range as follows. Sales of down 2% to flat versus prior year. Operating margin of 4.6% to 4.8%. Fully diluted EPS of $3.85 to $4.10. An effective tax rate of approximately 29%, the reduction of which is offset by a higher interest expense, and finally, we are increasing our free cash flow outlook to at least 100% of net income for 2016. Our third-quarter and full-year outlook excludes any impact from the potential redemption of the convertible bonds, which I will discuss next.

So, let's turn to page 12. As I mentioned earlier, last month we issued new 5.375% senior notes and announced that we intend to use those proceeds to redeem our 6% convertible debt on or after the first call date of September 15. Redeeming our convertible bond simplifies our capital structure and eliminates future EPS dilution associated with those debt instruments. We also expect an ongoing benefit from reduced interest expense is a result of replacing the 2029 debentures with lower cost debt. Upon redemption of the convertible debt, we expect to record a non-recurring non-cash charge.

The decision to redeem the amount of the charge and the final share count will be based upon prevailing debt market conditions later in the third quarter. Assuming conditions similar to those as of June 30, 2016, the estimated charge will be approximately $120 million on a pre-tax basis or about $1.70 reduction to EPS. We expect that this transaction will have no impact on our fully diluted share count or our debt ratios. With that, I would now like to open up the call to your questions.

(Operator Instructions)

Deane Dray of RBC.

Thank you. Good morning, everyone. I would like to start on the good news in gross margins. Maybe you could provide some color in terms of some of the dynamics across mix and pricing. You said supply chain was an offset, and it really has not come through in your pull through numbers yet and maybe your expectations there.

Yes. Thanks, Deane. Good question. I am very pleased with the margin performance in the second quarter. It is a very challenging pricing environment. I would say it's even a -- it's been a challenging pricing environment since we've been in this lackluster economic recovery period. With that said, I would say it's a bit tougher pricing environment this quarter. As Tim outlined in his comments, we had approximately 0.5 percentage points of price impact negative in the quarter. And so I think what we have begun to see is the initial positive impact of our wide array of supply chain initiatives, pricing, sourcing, et cetera, that Hemant took all of you through at our investor day.

We continue to work the front end of our business very hard as well. I am particularly pleased I think with what we are able to do with margins in the quarter relative to the overall market environment. I think as I've seen other companies presenting their results, there is no doubt that there's a tremendous amount of margin headwinds in the environment today in the competitive environment. In terms of the pull through versus Q3 last year, I think that we have done an excellent job of resizing our cost structure. We've had stringent cost controls in place really throughout last year and the first half of this year and we've consistently been continuing to squeezing out productivity improvements in making structural cost reductions and organizational streamlining moves in the Company.

As Tim outlined, we have taken our headcount down by over 600 positions over the last six quarters, five to six quarters, really starting in earnest Q2 of last year. We've closed or consolidated 30 branches. In the first half this year, of that 600, 150 personnel reductions were executed and 10 of those 30 branches. I think we're taking the right actions. The pull through, we're well positioned with our cost structure, Deane, and when the sales growth kicks back into positive organic growth, we will have very strong operating cost leverage and good pull through, positive pull through to EBIT, and we've shown that historically across prior cycles.

That's good color. Second question was on the free cash flow guidance. I really do like seeing that plus 100%, and you and I have talked about this before. I think you all have had this penchant to under promise and over deliver. There used to be a plus 80% or better. Then there was a plus 90% or better. You have always had good cash flow conversion capability, but now we are at that 100% level. What is driving this confidence? Any specific changes in working capital? Is there anything that Tim is doing here in the background? What is the significance of now -- to that 100%.

I appreciate the question. I think we have -- if I were to take an objective look at our Company and it is really a function of, I think, inherently our business model and how we run our distribution business model and the strong execution team. We have been a very, very strong free cash flow performer across all phases of the economic cycle. To your point, Deane, to be fair, we had an 80% mark out there that was a low bar and we were consistently beating that. We took it to 90% entering this year. I think that was appropriate. As we move through the first half, I would say we continue have great controls in place. The team is focused. We all know what we're doing in terms of driving the performance there and the fact that we are not in positive organic sales growth territory does result in a little better free cash flow generation. We're not doing anything unnatural to our inventories.

We are very focused with our inventory levels on two metrics, availability for our key SKUs and then the ability to provide and service our flow rate, our commitments to our customers. The one word I would always use I think -- this has been very consistent I think in my 10 years with the Company. The team does a great job -- is execution. That's the word I'd apply to free cash flow. Tim has been here the better part of a decade. I don't think that you and the investor community have had a chance to meet him. He was a very strong number two in finance, very seasoned operator. I call him operating oriented finance business partner to myself and the business leaders. Quite frankly, having Tim here is one of the reasons we did such a great job in ramping Ken up. When we hired Ken four years ago, Ken had never been in the full CFO seat, let's say, and he -- Ken did a terrific job for us but having -- Tim, I think it's just a testament to the strength of the organization and the team that Tim has built.

Good to hear. Thank you.

David Manthey of Robert W. Baird.

Good morning, guys.

Good morning.

Looking at the third-quarter guidance here, John, where second-quarter sales were flat year to year and then we look across the comparisons, in every segment they get easier and I'm just trying to understand the flat to down 3% sort rather than sort of a midpoint around flat or even better than that based on the trend and sort of what things look like here. Then second and related I guess is, do you think there was any kind of pull forward in your outdoor sports construction or utility business that would distort that sequential pattern into the third quarter?

Let me address the second one first. I don't think, Dave, that there was any pull forward from Q3 to Q4 in the segments you are outlining. I will say, because we didn't address this in the prepared commentary, I will say that with certain of our industrial customers, we did experience some reduced hours, some adjustments to their schedules let's say in the latter part of Q2 entering Q3. It wasn't significant and it wasn't broad based but I would say that's the only dynamic that we've seen thus far kind of that there was a little different. It was not consistent across the quarter, more wrapped around the Fourth of July holiday. It seems like there were some customers where they are taking extended holidays durations around the Fourth. We saw little bit of that.

I think, Dave, we have tried to set -- we took a very hard look at our outlook for the second half and full year based upon what we saw in the first half. I want to kind of make sure I frame it for all of you properly. As I reflect upon 2016 versus the outlook that we provided in December of last year, I think industrial has turned out to be tougher than we thought, and we've got prolonged weakness, lingering weakness. We had expected industrial would improve as we moved through the year, particularly in the second half. we're clearly not seeing that because Q2, our industrial market, our largest end market was down 10%. So our outlook in last December for industrial was for it to be down mid to high-single digits you'll recall for the year. And now we're looking at much more high-single digits to low-double digits. So that is part of what informs our second half look, Dave.

Secondly, construction, if you recall when we set our outlook for 2016, we said that would be down low-single digits to up low-single digits. Based upon some improving momentum and I think to a large part, a large degree, our execution in the second quarter in construction, we have revised our full-year outlook to be flat to up low-single digits for construction. Utility and CIG are operating as we anticipated, as we expected last December. We said flat to low-single digits on each and we are maintaining those. I think it is just taking a look at Q3, Q4, the industrial headwinds continuing, still foreign exchange headwinds there. Hopefully -- I am pleased with the return to growth in construction. We are only part way through the construction season, and that is how we reflected it in our updated outlook for the full year, it spread it Q3 to Q4.

Okay. Just one follow on here, John, as it relates to the outlook for the full year. My biggest concern has always been the second half SG&A required to get there. When you look at the guidance, even if you assume sort of a 20% gross margin SG&A, run rate would have to decline by about $10 million versus the second quarter level by the end of the year to get you there. When I look at the restructuring, the headcount reductions, by my calculations, you did maybe 50 of the 600 in the second quarter. I am trying to understand how you drive absolute SG&A dollars down especially in the third quarter when revenue is going to be sequentially rough to flat.

Yes, Dave. I think you had some discussions with Ken and Mary Ann after the first quarter. So let me frame it for you. If you look at what we did last year, and we do break out as we go quarter to quarter what the core is, i.e, ex acquisitions versus the acquisitions' contributions to SG&A. We had a significant step down in our costs second half to first last year. Now, we took a series of actions. They were large in magnitude. So, if you look at -- if you were to do kind of a first half to second half walk this year, I am going to give you a number of factors. I am not going to size each piece but at least give you a sense directionally of how I'd suggest you look at it. We rolled up higher sales in the second half. That does give us some operating cost leverage on our cost base. That doesn't reduce SG&A dollars, but at least it gives us some higher leverage through to op margin.

Employee benefits costs are always substantially higher in the first part of the year versus the second. We have continued discretionary cost controls, and there are some specific items we have identified that will be non-repeating costs in the second half that we had in the first half under our, I will call it, the category of discretionary cost controls. I'll hit variable compensation last. And then we did take action across the first half, Q1 and Q2, so you have that in the full run rate in terms of structural cost takeout. As we go through the second half, we do not ever take restructuring charges. We never do that. We have never done that since I have been here, so any cost required to execute the cost takeout rolls right through our P&L. We expense it in the current period. So when you look at how the first half rolled out, what we did, and the run rate in the second half, we get some sequential benefit from that.

We have a policy in place now where there is no automatic replacements, so we are highly scrutinizing any replacement headcount and we run a -- our turnover rates, our attrition rates are relatively consistent. So that gives us some additional leverage, and then we have some additional cost takeout that is being executed for the second half. Then I would say finally, variable compensation, which was a very large factor last year. I know that we have taken you through that. Ken has taken you through that previously. It is another factor as we go through the second half. We as a matter of practice build our internal plans above the external outlook that we committed to. That was true last December when we provided our 2016 outlook. It is true as we provided our revised outlook.

But the point I did want to make was our compensation, our variable compensation is tied to our internal plans which are higher than our external outlook and that -- the delta which forms our contingency. And depending on the mix of that performance by business, by function, and such, than can have a pretty dramatic effect. That is what we saw last year where we missed our internal plans and had to revise our external outlook. When you factor all those together, we are driving to some internal targets that are above our outlook in the second half. We are still running with some contingency and you factor in all of the other items I said, that is what speaks to the second half outlook, Dave. Hopefully that helps.

Thank you.

Andrew Buscaglia of Credit Suisse.

Hello, guys. Thanks for taking my question. Can you just talk -- I am just looking at the guidance as well. You guys laid out a little bit of a contingency in the past or in the last couple quarters about 1% to 2%. Can you talk about how have we worked through some of that year to date or how much is left in that?

I am not going to quantify what is left, Andrew, but we did use up some in the first half and we do have some in the second half but the methodology is one I just outlined in my comments to Dave's question. We are continuing to drive the organization, the targets that are a bit above that. We are not pulling back the reins on sales one iota. Maybe to give a little more insight in that, we talked about seeing some of the positive effects of the supply chain initiatives in this quarter's gross margin results. You will recall at investor day, David Bemoras went through all of our front end sales and marketing initiatives, and we are building momentum there.

I think that did help us speak to and was a driver of what we are doing with our salesforce of outperforming our sales outlook range for Q2. So we are driving that very, very hard. So hopefully, the key thing is we see headwinds persisting in the environment. We are continuing to focus on improving our execution. We think we have been improving our execution, and if our assumptions prove to be overly optimistic, we will be working to capture the upside.

Okay. That is helpful. Then can you just talk about the -- Canada just seemed to tick up multiple segments this quarter. Was there anything specific that you guys noticed that you can talk to and how you think of Canada going forward? Is this sustainable here?

Yes. I am very, very pleased and proud of our Canadian team. The on-the-ground conditions are very challenging. It didn't get easier. It didn't get better in the second quarter versus the first, versus what we are facing the second half of last year. We are not calling the bottom yet, but I am very pleased with the team's performance and execution. To have overall Canadian sales down 3% organic and to have growth in construction and utility and CIG, all three of our four end market segments in Canada organically in the quarter, with CIG at 10%, I think is very notable.

When you look at by geographic region, the prairies are down double digits as expected, and the on-the-ground conditions are -- it didn't get better. There are parts of those geographies where it was worse in Q2 than Q1, the worst we've seen. British Columbia we grew double digits, very notable, and when you match our performance against the market, I think we are performing well. I think we continue to strengthen our position in the market. We are gaining ground. Than as you move west to east, the economy remains a bifurcated economy as we've talked in the past with the oil producing provinces facing the challenges and the oil consuming provinces starting to see pickup, so as you get into Manitoba, Ontario, et cetera, you start moving into the east, overall GTA area, Quebec, those market conditions are a little more accommodative and we are seeing positive results.

So, I think when you integrate all of that, I actually could not be more pleased. It was a positive surprise in the quarter. It was the factor along with utility, I will come back to that, because utility in Canada, too, that helped drive us to outperform our sales outlook range. The only other thing I would note is and that was with facing fires in Fort McMurray that as we've said before, less than 5% of our sales, we have two branches there, one EESCO, one EECOL, we were down, very high double-digit sales were down, double-digit declines as a result of the fire. The operations are back up and running our customers operations but they are not back to quote-unquote rate production and the rebuild has not started yet in earnest.

So, we said that might be second half. If anything it may be late. It may be Q4/2017. I think we have also worked hard as part of that cleanup of the fire, the remediation, that Hazmasters acquisition we did in Canada. We are actually driving some very nice safety growth to support the cleanup after the fire. So look, we are working hard. When you really calibrate the performance versus the market, I could not be more pleased. Thank you for that question.

Yes. Great color. Thank you.

Christopher Glynn of Oppenheimer.

Thanks. Good morning.

Hello, Chris. Good morning.

Hello, John. I just want to go into a little more detail what change in the margin guide. You kind of wiped out the lower half of the revenue guidance range, narrowed it into the top half and then maybe a little detail on what trimmed to the margins.

It's really this easy. Look at our first half op margin versus last year. So what we have been facing as a business, mixed pressure and challenges in the competitive environment. I think that's -- it just reflects that. I think our op margin was solid in Q2. Our op margin wasn't as strong versus prior year in Q1. You take a look at the first half. It is kind of flowing that through to the second half.

Okay. Then taking another crack at the conservative looking 3Q revenue guide, I think FX should flatten out. What did July do qualitatively or quantitatively if you adjust for the July 4 week?

I did not do that math and so remember, when I give you July, when I say July is mid-single digits roughly in line with June, that is Fourth of July is in both periods. So the only thing I would say that we experienced and I have seen some commentary from other companies in our supply chain, let's say that has spoken to maybe more significant manufacturing and factory shutdowns, slowdowns, and such, we did not see anywhere near to that degree. There are some select customers that had kind of extended holidays over the Fourth and it didn't seem like that was preplanned as they entered the second quarter. It wasn't pervasive, and I only call that out as a kind of a fine point. It wasn't really material. So the July number represents July to July, both the Fourth of Julys.

It seemed like the holiday timing was a little bit of a headwind this year. Then the implied lack of seasonality into 3Q, are you maybe suggesting that Canada had a little bit of an off trend breather from the headwinds in the second quarter?

I understand. Good, good question. We are still net-net looking at sales higher in the second half than the first. that seasonality is preserved. I am -- Canada really performed I think strongly given the end markets conditions in the second quarter, and so it is our intent to continue to drive that performance. But we tried to factor in all of the conditions that we are facing and outlook of what we're hearing from customers, how our backlog, quality of our backlog, the nature of our backlog, and so that is what we have built into the outlook. There is not much more I can really say on that.

Net-net though, we do have a second half that is higher than the first all-in on a sales level basis. When you look at it, how we have shaped it, it is a little bit more balanced Q3 versus Q4, and the only thing I will cite and I know you will recall this was, we were facing a lot of end market downturns as we -- progressively, as we went through the second half of last year in particular, but Q4 you may recall which typically is up, EECOL has a strong contribution to our fourth-quarter results. It was a particularly mild winter, and the winter effects in Q4 of last year were not equivalent to what they had been the prior couple of years. Do we expect this to be more normal, we will see but I think that would result in maybe a different balancing between Q3 versus Q4.

Okay. Got it. Thanks.

Shannon O'Callaghan of UBS.

Good morning.

Good morning, Shannon.

Hello, John. On industrial, still down even though the comps are getting easy. What do you think it's going to take for that to sort of join the growth club of the other segments here? Can you break it out at all between how much of the continuing pressure there you think is commodity related versus other things?

Let me give you this color. We're still seeing pervasive challenges across industrial, I think. Business investment is being controlled tightly. You are not seeing a big uptick in really capital spending. As we look across our global accounts and integrated supply customer base, we're growing with some customers. We're declining with others. Where we are growing, we're increasing scope of supply by and large. It's not because they are increasing their spend. If you look at global accounts in particular, we are seeing a tremendous challenge continually in oil, gas, metals, and mining, with selective OEM customers as well.

We are getting growth, however, in technology, with technology customers, our global accounts technology customers, aerospace, and automotive. So it is broad based, and I think when it does kind of flatten out and turn, we have such a terrific set of value -- our value proposition or solutions are strong, we will get really good leverage on the upside. But, when we originally set our outlook for 2016, we did not expect the degree of industrial challenges we faced in the first half. In fact, we did absolutely expect that it would improve in the second half versus the first, and we're not seeing that. So I think ultimately, it requires confidence on the part of the CFOs and the executive teams and our customers to go back into investment mode, quite frankly.

Now in terms of MRO spending, if that customer is facing real challenges in the end market, they are also tightly controlling the MRO spending. You can only do that so long and so far. Ultimately it kicks in but industrial is tough. Let's make no mistake about it, and there are certain customers, certain verticals we are doing exceptionally well in, but the challenge is pretty pervasive.

Great. That is helpful. Thanks. Then on this variable comp issue, I mean, it's a benefit this year. As you kind of reset assuming that you have better dynamics with some of your businesses improving here, better dynamics than in next year, how do we think about that kind of resetting and representing an increase in a better environment?

That was a significant contributor last year. I know Ken had previously taken you through that and then we -- when we lay out our outlook for the current year, that resets and so that was a reset as we entered 2016, but we are not on our internal plan, make no mistake about it because we essentially used some of the contingent. I will just share that with you. So, we won't know really the full impact/contributions/reset impact until we get through the fourth quarter. As we move through because it is going to be a function of how we finish up Q3, Q4 and the mix of that. So as we do that, we will talk to that relative to what is in our SG&A and how to think about that, Shannon.

Okay. Great, thanks.

Thank you.

Ryan Merkel of William Blair.

Thanks. Good morning, everyone.

Good morning, Ryan.

Good morning.

I noticed that construction core backlog was down 3% year over year. Is there anything that you could call out that is driving that? And then does that not temper your expectations for the second half even a little bit?

Well, I think our performance in construction was the best we have seen in five quarters because we have gotten some growth and again, backlog is one of the data points that we use along with a variety of other data points and how we look at the second half and revise our second-half full-year outlook and our Q3 outlook so it's factored in.

Okay. Then back in construction which was better this quarter, is there anything else you would call out? You mentioned execution, but was there one or two big jobs that hit or was commercial better than you thought? Is there anything else that you could sort of unpack there?

Let me unpack it. I think I gave you a sense of how Canada performed. Let me start with Canada and move to the US. I gave you a sense of how Canada performed and that was all in across all end markets by region, but that was also true in construction. So the strong double-digit growth in British Columbia, across British Columbia was heavily construction driven, and the growth as we got east of the -- got into the eastern provinces, GTA and plus, we are seeing growth in construction and CIG. I think that is important to understand. It is not just all in those regions.

It was -- construction was a key factor and utility was a key driver, and CIG was a factor. As you go into the US, I think I gave a little more color on that last time, and I will give you similar color. As you look across all our regions in the US, where approximately half of our regions grew in construction in Q2 and two of them were up double digits. None were down double digits, okay, versus Q2 of last year. That complexion, that mix is a nice improvement versus Q1. If you recall, I gave a little insight on that in Q1, and we did not have that level of performance. It was spottier. And all in, we didn't grow. So that was encouraging because it was a -- I'm not going to say it was broad based. It is not like 90% of the regions grew but more regions grew than not and having a couple up double digits was encouraging.

The other thing I will mention is, our last three acquisitions, Hill Country, Needham Electric, and AED, all three grew in the quarter organically. Two were up double digits. One was up single digits, and they are very construction -- the majority of their sales are construction oriented. And recall where they are positioned, right, Texas, Metro Atlanta, and New England. Three very different markets in terms of dynamics yet we are growing in all three. So again, as I said earlier, I am pleased with our construction results in the second quarter. The industrial oriented contractors are still down. Those that are impacted by oil and gas, metals, mining, but healthcare, education, commercial is where we are seeing some of the projects.

Okay. That is helpful. Lastly, just quick on oil and gas. I know it's a smaller percent of sales now, but what are you hearing out there? And then as part of the guide, are you expecting in oil and gas to stable in the second half versus where you are in Q2 or you are you expecting it a little worse?

I'll tell you. We have not called the bottom yet. We did not forecast, necessarily quarter by quarter what we thought it would be, but at this point, I thought -- I was hopeful that it would stabilize. The fact that we lagged down another 25% in the quarter on top of what we did last year in the first, it is just -- we're still kind of bouncing along there. It's tough. The only thing I would say is, and I don't know if I would -- I'm not using -- I won't use the term green shoot but this is a positive. This is a positive. With three of our global account customers that are in more of the longer cycle infrastructure oriented industries, with three different ones, they reached positive FID decisions in Q2 on large capital projects.

So, that's final investment decision. FID is final investment decision. So I don't know if that is the start of a trend, is that indicative of some incremental confidence. But, what has happened throughout 2015, in the first half of 2016, make no mistake about it, projects that were underway we are continuing. Some were kind of trimmed back. New projects weren't being started. So you go through the whole construction cycle. FID decisions were kind of frozen and weren't being made.

The fact that we -- I'm not speaking to the whole market but I'm speaking to at least three of our global account customers. The fact that three were reached in Q2, that is an incremental positive indicator. Now these are longer cycle projects and they are not sales in the second half, last year, but it is a data point. So, it is something that we look at. Again, this is just all part of -- we look at our business in great detail and that is what we try to factor into our outlook.

Very good. Thank you.

Matt Duncan of Stephens.

Good morning, guys. A nice job this quarter.

Thank you, Matt. Good morning.

John, I want to go back to the conversation on July for a second. I do not know if you have got the data or even just a feel for how different July has been since those days on either side of the Fourth of July, but if the month is tracking call it similar to June, does that imply that it is a little better than that once you kind of got past the July 4 hangover?

I'm not -- I'd just say it's roughly in line. I am not going to say it's better or worse. It is within a rounding error right now, and so we are nonlinear in the month as you know, and we are down to the last couple of days, our last couple of days. Our last couple days are -- the last several days are always bigger sales versus what our average sales are across the month. We will see where we finish. Again, I would just tell you that -- here is what I would leave you with, and I didn't make this comment yet.

If you were to look across the second quarter, if you adjust April for Easter, we were down 5, we were down 3 in May, we were down 4 in June. It was basically down -- it was flattish. We did not see a lot of puts and takes. We did get a little bit of -- it was these kind of -- with some select customers in industrial with some kind of extended holidays, latter part of Q2, early part of -- it was latter part of June and early part of July, and July is roughly running in line with June. That just gives you a sense of how it started. We'll see.

We are in the construction season. Industrial headwinds continue to exist. I think utility, I did not comment on. I continue to be very confident and pleased with our utility business and given a recent public data point from another company, I'm particularly pleased with our utility performance. So I think it helps to really put that into context. And also some data points from our supplier community on the challenges in utility. That is where -- the mix in July is no different than what we really have been experiencing. That's the only other color I will share.

I want to go back to Canada as well because you guys are clearly doing better in Canada than other distributors are right now. I just want to point that out. Do you think you are taking share in Canada? Sort of what is your view on the Canadian market in general?

I will tell you absolutely. I think we are outperforming the market. I really believe strongly that when -- and I have said this before. It is part of our fundamental thesis that where we have a stronger market position in the form of the breadth of our solutions and a higher market share, we have a stronger role in the value chain, we are more important to customers, we're better partners with suppliers. So when a market goes through a cycle and there's contraction, we are even better positioned to super serve those customers.

And so I believe strongly, always have. It is part of our thesis. It is part of what we are driving the business to do. It's why we're doing acquisitions in conjunction with our organic initiatives, is to increase our scale and scope in all our served markets as we do that. I believe benefits accrue to the strongest players in all markets. Clearly for distribution that is true, and when the market goes through a cycle it is even more so. I think we're seeing it. With all that said, I expected some outperformance, but it was a very positive surprise for us in Q2. Because the market conditions are better, all in. Particularly in the prairies, but as I said, you get into the oil consuming provinces and there is some positives that we are taking advantage of. Hopefully that helps.

And then last thing, let's bring Tim in on this conversation. Gross margin, what are we thinking on gross margin going forward? And then just help us to make sure we get interest expense right here. 3Q, what should all in interest expense be and then how much does it go down by once you redeem the 6% notes?

I'll take the interest expense first. Our guidance does not contemplate calling the convert and so we intend or we think the interest expense will continue as though we were carrying that note for the full quarter. I think you have to look more for it to be like that. In terms of the gross margin, our gross margins we feel have stabilized over the last few quarters, as we said. We will continue to work hard on our supply chain initiatives and continue to execute on those, be opportunistic as we can, and we intend for them to be stable going forward.

I think the margin environment is -- if you look at all the other public data, it is challenging. I would leave it saying the headwinds are a bit stiffer in the general -- throughout the gross margins. So it requires continued strong execution.

All right. Thanks, guys. I appreciate the color.

Robert Barry of Susquehanna.

Hello, guys. Good morning. Thanks for fitting me in. I actually just did want to follow up on that, and you kind of touched on it a little, John, with the pricing looking a little weaker and weaker industrial, stronger construction. I think all those things are kind of headwinds for gross margin. You took your op margin guidance down. So maybe to put a finer point on the commentary around what the back half outlook includes for gross margin.

I'm not going to give you that, Robert, because what we really want to focus on which is we have moved to that is sales, operating margin, tax through EPS. So, I think clearly you have seen and you are seeing from others and not everyone has reported yet. There are some others to report but as evidenced by -- across the companies in our supply chain, right, in our competitive space, whether it's other distributors or manufacturers, there is a lot of pressure on margins in this environment and it's around the pricing and the competitive dynamic.

And it's because we have this lackluster economic recovery, industrial is challenged, construction is at least getting some growth but there are also some bits and starts from an end market perspective there. Utility overall, we're not seeing a lot of end market growth. The only way you grow there is by taking share. So it is just this tough environment. The competitive intensity is stoked up. There's no doubt about it. I am particularly pleased again with what we did with gross margin relative to us. When you look -- the fact that we are flat year over year, and the fact that we're down only 10 basis points sequentially I think is notable.

Given the market environment we are in and some of the mix challenges we have been facing and it's still in our -- expectedly is in our results. We have seen this mix shift. It is our intent, Robert, as we outlined at investor day, to continue to grind away in execution. I would leave you with this, again, we said this, this is not hitting a couple home runs in the margin initiative front. This is a lot of singles, and we want to have a good batting average. So I think that is what you are seeing. It is not one or two things we did in the second quarter. It's is a whole number of things that we're just grinding away on to try to maintain margin and hopefully at some point get some improvement.

The only other thing I will say is that supplier price increases, at least what there -- we have a view at all times of what suppliers have published and what they are intending to publish. So if you look at supplier price increases that suppliers would like to do in the third quarter, some of them are desiring to have a little higher price push through the value chain. So that will be interesting to see how that ultimately -- does that flow through or not, will the market absorb that. So it's not by a large degree. I would normally comment on this. The last couple of quarters have been relatively consistent. When you look at what the level of price increases were kind of the range by category that our suppliers try to push through. That is a consistent process in our industry.

Here, there are a few categories with a few suppliers that are trying to edge that up a bit. I think part of that is probably a reflection of the rising steel prices in particular. Steel is really the only commodity that has spiked up significantly as we have moved through the first half. When you look at copper, copper has not really moved much. There is a little bit of downward pressure. Aluminum really hasn't moved much. Zinc, zinc has moved up a bit, but it is steel so hopefully that is some additional color.

Yes. I appreciate it. Quickly, in the outlook for the revenue since you give the total growth expectation, what is the assumption now for M&A and currency in there?

So there is no incremental M&A assumed. For currency, we assume $0.77 on the US dollar for the second half of Q3 and Q4.

Yes. I think since you outdated the outlook, the M&A was expected to add 2 points so maybe now it is 3.

It is a little bit higher than 2.

The currency I think had been a headwind of 2 to 3, but I think now it would be much lower than that.

Yes, it will be a little bit lower but again, given your assumption of $0.77 on the US dollar so that is our assumption right now for Q3 and Q4.

Right. Right. Okay. Thank you.

This concludes our question-and-answer session. I would like to turn the conference back over to Mr. John Engel for any closing remarks.

Thank you all again for your time this morning and your continued support. I know Mary Ann has a lot of scheduled calls already and she is around and we are around to take any further questions. Have a great day.

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