Wesco International Inc (WCC) 2019 Q2 法說會逐字稿

Good day and welcome to the WESCO Second Quarter 2019 Earnings Conference Call. (Operator Instructions) Please note that this event is being recorded.

I would now like to turn the conference over to Will Ruthrauff. Please go ahead.

Thank you, Chuck. Good morning, ladies and gentlemen. Thank you for joining us. Joining on today's call are John Engel, Chairman, President and CEO; and Dave Schulz, Senior Vice President and Chief Financial Officer.

This conference call 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 are 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 7 days.

With that, I'll turn the call over to John.

Thank you, Will. Good morning, everyone, and thank you for joining us for today's call. I'll lead off with a few high-level remarks, and then Dave will take you through our second quarter results and our 2019 outlook before we open the call for questions.

We achieved record sales in the second quarter, and all of our end markets grew on both a year-over-year and sequential basis. However, sales growth came in below our outlook range. Continued strength in Canada, Utility and datacom were partially offset by slower than anticipated overall growth in the U.S. After a slow start in April and May in the United States, our sales growth strengthened in June, but was impacted by slowing momentum and increased uncertainty in our end markets.

Operating margin expanded 30 basis points versus prior year on strong operating profit pull-through, driving our operating profit to its highest level in the past 15 quarters.

Net income grew 10%, a healthy double-digit rate, and EPS grew 19% versus prior year. We also repurchased $150 million of our common stock, which was above our share repurchase forecast for the second quarter.

Finally, as you saw in our release earlier this morning, we have revised our full year outlook for sales growth, operating margin, effective tax rate and EPS to reflect our first half results and our expectation for lower market growth rates in our end markets in the second half.

With that, I will now turn the call over to Dave to provide further details on our second quarter results as well as our third quarter and full year financial outlook. Dave?

Thank you, John, and good morning, everyone. I'll start with an overview beginning on Page 4. As John mentioned, reported sales in the quarter were up 2.2%, below our outlook range of 3% to 6%. On an organic basis, sales were up 1.9% with 6% growth in Canada, 2% growth in U.S. and a decrease of 8% in our international markets.

During our Investor Day on June 13, we indicated that sales were trending to the low end of our outlook range. Relative to our expectation at that time, we missed by about half a day in the back half of June. Pricing provided a favorable impact of approximately 2%. Sales were strong in Canada, where all end markets were up mid- to high-single digits in local currency with the exception of Utility, which was down due to the contract nonrenewals that we discussed previously.

Outside of Canada, our Utility business grew exceptionally well and consolidated sales were up more than 22% on a 2-year stack basis.

Beginning in 2019, we made some changes to our go-to-market team for datacom. Datacom sales were up mid-single digits in the second quarter, following a similar performance in the first quarter. The lower overall sales growth relative to our expectations was primarily due to pockets of weakness that we are seeing in the U.S. with some industrial and OEM customers as well as with industrial-oriented contractors.

Gross margin was 19% in the quarter, flat with the prior year and down 50 basis points sequentially. Relative to the prior year, gross margin this quarter was negatively impacted by mix, which reduced gross margin by approximately 20 basis points. We had significant growth in our utility end market, which, as we discussed at our Investor Day, has a lower-than-line average gross margin rate. Additionally, some of our businesses with short-cycle exposure and high gross margins declined versus the prior year. This impact was offset by the gross margin benefit from the SLS acquisition that closed in March.

Sequentially, gross margin was down 50 basis points. Approximately half of the decrease was driven by mix, as we had significant sequential growth in both our utility and construction end markets. The balance of the decline was driven primarily by the high number of supplier price increases. We are confident we are passing supplier price increases through to our customers, but are experiencing the normal lag between when we receive price increases from suppliers and when we see the impact on our gross margin rate.

SG&A expenses were 1% higher than the prior year on a consolidated basis. The increase in SG&A expense was primarily driven by the SLS acquisition, partially offset by the absence of a $2.5 million bad debt charge incurred in the prior year period and lower variable compensation expenses.

Operating profit in the first (sic) [second] quarter was $97.9 million or 4.6% of sales, within our outlook range for the quarter. The effective tax rate for the quarter was 21.6%, slightly lower than our expected rate of 23% and approximately flat with the prior year.

Moving to the diluted EPS walk on Page 5. We reported diluted earnings per share of $1.45, up 19% from the prior year. This reflected $0.13 from core operations and $0.11 from a lower share count following our repurchase activity in 2018 and 2019.

Foreign exchange rates reduced EPS by $0.02, and the SLS acquisition contributed $0.01 to EPS in the quarter. There was no impact from tax as the effective rate was approximately equal to the prior year.

We've also provided you the reconciliation of our organic and reported sales growth. Foreign exchange was about a 1 percentage point drag to reported sales, but more than offset by the benefits of the SLS acquisition.

Moving to our end market results, beginning on Page 6. Industrial sales were up 1% overall and up 2% and 6% in the U.S. and Canada, respectively. Industrial sales were up 2% sequentially from the first quarter. Overall, momentum with industrial customers improved over Q1 levels, but was not as strong as we expected. Among our Global Account market verticals, petrochemical, metals and mining and food processing were all up from prior year levels and sequentially. The areas where we experienced weakness were technology and OEM, which were down versus the prior year. We continue to expect growth in the industrial end market in 2019. Although moderating, the macroeconomic indicators are still in expansion territory and are supported by strong production levels and capacity utilization rates in the U.S. and Canada. We see continued opportunities to benefit from our customers deploying capital to drive productivity improvements.

During the quarter, we were awarded a new 3-year contract with a medical device manufacturer to provide an integrated supply solution for MRO and OEM materials in their U.S. and Mexican operations with estimated total revenue of $30 million.

Turning to Page 7. Sales in the construction end market were up 3% in the quarter, reflecting sales that were down 1% in the U.S. and up 9% in Canada in local currency. Sales were up 9% sequentially from the first quarter, in line with typical seasonality.

On a 2-year stack basis, construction sales were up 11%, reflecting incremental growth on top of 8% growth in the prior year quarter. Project activity levels remain robust, and many of our customers remain bullish on their outlook for the balance of the year, but we are seeing some project delays with industrial contractors due to budget constraints and uncertainty, partially caused by tariff-driven price increases.

Sales to commercial construction contractors were up mid-single digits in the U.S., but were offset by declines with industrial-oriented contractors. We expect moderate growth for the balance of 2019. The skilled labor shortages that our customers are facing represent opportunities for WESCO project management and construction services that help our customers meet these challenges by reducing supply chain complexity and increasing construction job site productivity.

Backlog in constant currency was down versus prior year and sequentially, reflecting normal seasonality. We ended the quarter with the second-highest Q2 backlog in our history.

As an example of our recent success, this quarter, we were awarded a multimillion-dollar contract to provide electrical equipment and lighting for the construction of a new healthcare manufacturing facility in Canada.

Moving to Page 8. Our utility sales continued to be exceptionally strong. On a global basis, sales were up 3% for the quarter after delivering 19% growth in the prior year. This result was despite a 28% decrease in our Canadian business due to the nonrenewal of a contract at an unacceptable margin that we've discussed previously. We expect one more negative comparison in our Canadian Utility sales to occur next quarter, after which there will be no longer any impact from the absence of this contract. We also expect to begin servicing the new utility alliance customer highlighted on our last call late in the third quarter.

WESCO is benefiting from secular trends in the utility sector, including construction market growth, increased industrial output, grid hardening and reliability projects and higher demand for renewable energy. In addition to these trends, we continued to expand our scope of services with investor-owned utility, public power and utility contractor customers.

After 7 years of growth in Utility, we expect the balance of 2019 to remain strong. Bidding activity levels are high, and we have a robust opportunity pipeline. This quarter, we renewed our contract with a U.S. investor-owned utility to provide electrical and MRO materials for its generation, transmission and distribution operations for 3 years with estimated total revenues of more than $400 million.

Finally, turning to commercial, institutional and government, or CIG, on Page 9. Sales were up 1%, with the U.S. up 1% and Canada up 10% in local currency. Sequentially, sales improved 14%, led by 19% growth in U.S., driven by a bounce-back of government spending following the federal government shutdown that ended in late January as well as certain small and medium project wins.

Sales to datacom and security customers were up high single digits. On a 2-year stack basis, CIG sales were up 11% in the quarter, marking the fifth consecutive quarter in which sales increased by double digits on a 2-year basis. This performance was again driven by our strong capabilities and value-added services in LED lighting renovation, retrofit applications, fiber-to-the-x deployments, broadband buildup in Canada and network and security solutions.

As an example of the continued strength we are seeing in CIG, this quarter, we were awarded a multimillion-dollar order for data communications material in support of a new data center for a large U.S. public university.

Turning to Page 10. Operating cash was an outflow of approximately $38 million in the quarter, which caused year-to-date free cash flow to be negative. This cash usage was primarily attributable to an increase in working capital, driven by an increase in accounts receivable from sales volume in June and slow payment by certain large public companies at the end of the quarter.

The net usage of cash is expected to unwind itself in the coming quarter, and we continue to expect free cash flow of approximately 90% of net income for the full year. We've already seen a bounce back in our cash collections in July.

Debt leverage, net of cash, was 3.2x trailing 12 months EBITDA, up from the prior quarter, driven by borrowings to support our share repurchase program. Leverage is within our target range of 2 to 3.5x trailing 12-month EBITDA. As a result of adopting the new lease accounting standard at the beginning of the year, our balance sheet at the end of the period includes operating lease assets and liabilities of approximately $230 million. The adoption of the lease accounting standard did not have a material impact on the income statement or the statement of cash flow.

We maintained strong liquidity, defined as available cash plus committed borrowing capacity, of $587 million at the end of the quarter. Our weighted average borrowing rate was 4.5% for the quarter. Fixed rate debt is approximately 59% of total debt, consistent with historical averages.

Capital expenditures were $11 million in the quarter, in line with the first quarter, reflecting investment to digitize our business, including information technology tools, digital applications and facilities.

As we mentioned at our Investor Day, we entered into an accelerated share repurchase transaction in May for $150 million. When this program settles later this year, we will have completed $275 million of the $400 million share buyback authorization that expires at the end of 2020. WESCO has a history of generating strong free cash flow throughout the entire business cycle, and we expect this to continue.

Our capital allocation priorities remain consistent. The first priority is to invest in organic growth initiatives and accretive acquisitions, including large core electrical distributors that consolidate the market or transactions that provide a new strategic capability. Second, we seek to maintain a target financial leverage ratio of between 2 to 3.5x EBITDA. Third, we return cash to shareholders through share repurchase under our 3-year, $400 million share buyback authorization. As we said at our Investor Day, we expect to initiate a dividend at some point over the next several years and we'll analyze that option as we complete the current repurchase authorization.

Now let's turn to our outlook for the third quarter and full year on Slide 11. For the third quarter, we are projecting sales growth to be in the range of 3% to 5% and operating margin to be 4.3% to 4.7%. We are expecting an effective tax rate of approximately 22% in the third quarter, in line with the expectation for the full year. Preliminary July sales are up mid-single digit, with continuation of the strong sales momentum that we experienced in June.

For the full year, we are lowering the midpoint of our outlook to reflect the impact of weakness in certain markets in the first half as well as economic data that now point to slower end market growth in the second half of the year. We expect our industrial, construction and CIG end markets to be up low-single digits for the full year and our utility end market to be up low- to mid-single digits. We expect the U.S. to be up low-single digits and sales in Canada to be up low- to mid-single-digits for the year.

On a consolidated basis, our outlook is for sales growth of 1% to 4%, operating margin of 4.2% to 4.5%, an effective tax rate of 21% to 23% and diluted EPS of $5 to $5.60. At the midpoint, the outlook for operating profit would represent the highest operating profit in 4 years and the highest earnings per share in WESCO history. We still expect to generate free cash flow of approximately 90% of net income, as the increase in accounts receivable that impacted the first half will be converted to cash in the next few quarters.

With that, let's open the call to your questions.

(Operator Instructions) The first question comes from Deane Dray with RBC Capital Markets.

Let's start with the macro, because we are seeing multiple headwinds across the industrials this quarter and you hit every one of these air pockets, it seems, on industrial short cycle slowing as well as some projects pushouts and delays. So John, you always give really good end market color on the pulse of what the customers are doing and thinking. So take us through those 2 primary headwinds. And with July having an uptick, how much do you think that improves in the third quarter? And if you could take us through that, I would appreciate it.

Thanks, Dean. Yes, the slowing momentum in, and you used the term short cycle, but I'll say kind of daily activity, the MRO. We're seeing that in terms of directional pressure, and I'm using those words purposely. And in the projects for industrial end markets and customer applications, we're seeing some selected pushouts as well as a reluctance to kind of initiate or move those along versus what we had originally expected at -- kind of going through Q2 and at the midpoint this year. So I will say overall, given our exposure, our mix, our customer base, we're seeing the slowing momentum vector in terms of end market customer activity levels. It is all tied around the slowing global economic growth, uncertainty around the trade situation, primarily. And that's giving pause to the CFOs in our company in terms of capital spending. We had expected that would step up as we move through this year. So I would say that's the primary difference.

When you look at our results in Q2, we did improve in industrial. So we did grow sequentially. Remember, the U.S. didn't grow in the first quarter, neither did Canada. And in the second quarter, the U.S. grew 2%. I mean, not a strong number, but it's still growth. And Canada grew 6%. International was down double digits after being down very low single digits in Q1. And that international industrial decline is specifically around capital projects in oil and gas. So -- and I'll just spend a moment on that. Oil and gas for us, in the first half, it was roughly flattish in Q1 and it was down 1 percentage point in Q2. In oil and gas, we're getting -- we're seeing low growth, but it is growth, in Canada and the U.S. and the declines are in international, and again, around this project activity. So clearly, the markets have some slowing momentum, and there is a pause and -- in terms of capital spending and such. Our momentum vector against that backdrop, I actually am encouraged that we began to step it up in Q2 versus Q1, and then the momentum vector inside the quarter showed a nice step up in June. It did come in a little bit below where we thought, but we're not -- as Dave mentioned, we're talking about half a day of sales from the low end. And July, to your point, Deane, is in that -- we haven't -- we got a flash report, we haven't closed July fully yet. So it's in the mid-single digit growth range though. And that's encouraging because it's not like there is a lot of pull-forward, right, from July into June.

The guide that we've given for the balance of the year does reflect, and Dave shared this, kind of a more historical seasonality first half, second half. We got 49% of our sales roughly in the first half, 51% in the second half. So what does that imply? That implies that we continue our relatively positive sequential performance versus the market. It's a little bit tougher. I think the wildcard is going to be how does the market shape up as we move,

and particularly industrial, as we move through Q3 and into Q4? And I will just say this, I think business spending could be a real stabilizing factor, if the trade uncertainty gets better resolved or begins to get resolved, and that's really the way we're looking at it. And that's what we're hearing from our customers. So to the extent that happens, the capital starts getting spent again. Production levels in the industrial manufacturing space is still relatively high. Capital utilization still healthy, but it really is around the confidence on spending the capital. Does that help?

It really does. And just a follow-up on the guidance. And so we have an implied 4Q guide here as well. And if we take third quarter midpoint and see where that puts us in 4Q, it really does look like the implied guidance is well above consensus. Are you baking in this the trade resolution rebound? Or just -- it does look like it inflects stronger in 4Q. So what seasonal and are there any macro assumptions there?

Yes. Great question. I think what -- the way we look at it, first, as I go back to kind of first half, second half, we look more in line with kind of typical seasonality with the 49-51. The other thing that is definitely different in 3 versus 4 is our year-over-year comparable. So as we mentioned earlier, our first half comparables were really challenging because we delivered double-digit growth in Q1 and Q2, really through the whole first half of last year. And then when you get to Q3, those comparables are stronger than Q4. So I would say that's the way to think about it. Q3, we've given the guide. I would say the July start is a supportive and an encouraging start too and does support the guide. The implied 4Q guide has a wider range, kind of by definition. So what we're trying to do, Deane, as we move through Q3, is build off the momentum relative to market that we think we built in Q2 and continue to sell the value proposition and kind of outtake -- kind of outperform the market. And again, I'm going to come back to this, because this, I think, is the key issue, that business spending is the potential stabilizing factor and potential growth catalyst. And to the extent that -- the conditions in the global economy and the trade uncertainty is resolved, that would represent a nice positive catalyst.

The next question comes from David Manthey with Baird.

John, you just went through a lot of this stuff, but I'm still sensing a disconnect here. I'll take you back to mid-June, when you said you we're tracking the low end of the 3% to 6%, then you came in at 2% after reporting what looks like a really strong June. And now you're sort of guiding the third quarter and the full year lower on uncertainty and slowing momentum, but your growth just went from 1% to mid-single digit. Could you help me justify those things?

Yes. I mean, again, I think it's the same commentary that I just shared with Deane in respect to overall first half, second half. The only thing I'll add to that is that we're really focusing on industrial. I'll make -- I didn't talk about the other end markets explicitly, so let me hit them quickly and then Dave, you may want to tag onto this.

If we look at Utility, also our comparables there get measurably easier as we go through the second half due to the nonrenewal that we walked away from in Canada previously disclosed. So overall, Utility gets easier comps. And then we begin -- as Dave mentioned in his prepared remarks, we begin to see the contribution of those -- of the previously announced Utility win. So we think we have really strong momentum, Dave, in Utility versus underlying end markets. All 3 portions of Utility grew in the quarter. IOUs is a big piece of our sales, direct to them, that was up, that was actually up really strongly. Public power also grew and utility contractors. So -- and that's all more double-clicking into the U.S. So U.S. was really -- we think really strong number at the plus 6%. And Canada down over 20% is really due to that nonrenewal. So -- but that comparable gets measurably easier as we go through the second half of this year and Q4.

If you go into CIG, and this is really important, and I don't think we made this point in our Q1 results, which is why we wanted to amplify it a bit here. We made some changes in how we kind of manage the front end of our datacom business. We did that the latter part of last year. We weren't pleased with the execution that we were getting, and we've got terrific supplier support. I feel really good about our datacom and security in the first half. We're up very high single-digits, close to a double-digit rate, really nice results. We see that momentum building, and that's not consistent with market. I think we're outperforming market. So we think that continues as well, as we go into the second half and those comparables on a datacom category basis are easier.

And in Canada, the strength of Canada, in general, we think, is, the Canadian economy turned out to be incrementally a bit stronger, but I think our own performance against it continues to be a positive, a real bright spot, really proud of our Canadian team, our execution.

Then the final segment would be -- end market category would be construction. And we got our second-highest backlog ever at the end of Q2. And when you double-click into construction, really good results in Canada, obviously. So I think we're really performing well above market there. But when you look at the U.S., as Dave mentioned again in his prepared remarks, you can -- commercial construction piece of construction, the sales to contractors for commercial projects was mid-single digit growth. And it really is the industrial projects, I think, that they were down and offset effectively, slightly more than offset the growth we're seeing in for commercial project in construction. So if you kind of add that all up, it's the comments that I made in response to Deane's question plus I wanted to take you through the other end markets and in Canada overall. Hopefully that's helpful. Dave, you may want to add on exactly -- Investor Day commentary and then relative to how we closed out.

Sure. So clearly, what we said during the Investor Day was we were trending towards the low end of our range. That was after on an organic basis putting up a plus 1% in May against a difficult base period comparison. As we mentioned in prepared remarks, relative to what we thought, which was based on the 11th of June at the time, the data that we had, we missed by -- sales by about half a day. As we've taken a look at our backlog, at the contracts that we have signed that we know are going to begin generating revenue in the back half, we put together what we believe is the appropriate outlook by quarter. Obviously, you can imply what the fourth quarter looks like based on the full year. But one of the keys for us is, last year, on a reported sales basis, we're comparing against the plus 2%. In the first half of 2018, we did a plus 11%. So the comparisons are getting easier. We've included that in how we think about our front half, black half split. And from a 49-51 split, front half, back half revenue, that includes the SLS acquisition in the back half, we'll have the full benefit in all 6 months. So again, we feel that this is the right outlook, given the macroeconomic indicators and then some of the things that we can see internally relative to backlog in contracts that we expect to continue and contracts that we have that will start generating revenue in the back half of the year.

Okay. And just as a follow-up on, maybe there's some commentary in there that relates to gross margin. I think the drop from 19.5% to 19% sequentially was a bit of a surprise for us, but you mentioned in the monologue and answers to the questions that Utility is growing well and industrial is seeing some slowing. Is that part of what's going on here, too, is that maybe there is a little bit more downward pressure on gross margin than you previously expected?

So I would -- Dave, you may want to add to this, too. I would say that the mix piece, as you just outlined, yes, which, again, Dave shared in his prepared comments, is clearly a factor. I think the other factor, let me expand on, was, and Hemant spoke to this at our Investor Day, our recent Investor Day, that the first half we've seen a record number of price increases over prior year. And you'll recall as we closed out '18, we shared that those increases in '18 were more than the previous several years combined. So now '19 first half is above '18, which was you're kind of at a very much elevated level. The other thing we're hearing from our suppliers in those announcements that have occurred throughout the first half, but particularly in Q2, is tariffs are being mentioned as kind of the driver or the cause of the trigger in approximately 2/3 of the announcements that went into effect in Q2. That's across our whole supply base. So -- and the magnitude of these price increases are in the double-digit range. We're seeing 15s, 18s and the like for some SKUs, for some of our suppliers' category. So we're actually kind of caught in that same time lag, Dave, that we do experience, I think, maybe disproportionately at a higher level than others because of our percent of our businesses is Global Accounts, integrated supply and utility alliances. So we can't -- there's always a time lag when we get the price increase. Obviously, any price increase we try to put a bump on it. If we only pass it through on a strict percentage basis, we have contracting margin. So we try to put the bump on it, but it takes time to work it through as opposed to just normal spot business that we're quoting in a day. That can be worked through instantaneously, virtually instantaneously. We change the pricing system, that's exposed to the branches real-time every day. So that's part of the factor as well. So I -- the way I look at it -- we were pleased with the 19.5% in Q1. I thought we'd have some pressure sequentially. We don't guide the gross margin, as you know, now. We guide to EBIT margin. In Q1 to Q2 sequentially, the fact that it's still flattish versus prior year, given the supplier price increase impact and the lag, actually, I'm still feeling that the margin momentum, foundation is still stable and in place. And obviously, we're going to -- we're applying all our efforts continuing those initiatives to try to step those up sequentially as we move through the second half.

The next question comes from Sam Darkatsh with Raymond James.

Just wanted to follow up on Dave Manthey's last question here. So -- and I apologize if I'm putting words in your mouth. But because of the time lag, should we then assume that pricing in the second half goes higher than the plus 2% that you saw in the first half? And if so, is that enough to offset the 20 to 30 basis points of billing margin pressure that you saw sequentially in the second quarter? I just want to make sure I'm understanding the dynamics.

So I want to be very clear. I'm giving you kind of the general trends. We do not -- we don't guide, and I'm not going to start guiding in the call via question-and-answer, Sam, that pricing as well as -- and we're not guiding -- we don't guide gross margins, right? So we guide operating margin. I just wanted to give you a sense of kind of the headwind, tailwind in aggregate that we experienced. Dave in his prepared commentary kind of took you through the walk year-over-year and sequentially and mix was a factor, right? And then all that I wanted to speak to, again, was we see the tariffs in the headlines every day. We -- our suppliers are trying to work those through and using that as an opportunity to work through price increases because they're experiencing that on the input side of the cost equation, right? And so we -- look, normal process. We work that aggressively, but when we get that announced price increase and then we proceed to try to drive it across into our customer base, so that again, the spot market activity, we're factoring that in to how we're bidding, effectively real-time, but where we have the Global Accounts relationships, those multi-year contracts or utility alliances, integrated supply contracts, where we have construction projects that are already bid and there may be some dynamic there with what contractors try to do. So it's those kinds of things that there is a normal time lag, we've experienced it historically. I think those of you that we had this discussion over the years, and we're feeling that. So we saw that in Q2.

So does it -- so the short answer though to your question is, does that manifest itself in terms of improved gross margins in the second half? We're not going to guide that, but that also would be a function of what are all the headwinds, tailwinds and the pricing environment and where the mix ends up. We clearly guide operating margins. And when you step back and think about how the first half ended up, bottom line is this. Sales came in lower than expected, gross margins are higher than last year's first half and that's in the face of a tougher supplier price increase environment, right? And we continue to have very good, effective cost management. We're getting good pull-through, very good pull-through, as demonstrated in Q2. And so I think we've got the cost structure, it's always been well under control. Now the effort and all the efforts are focused on margin improvement initiatives and getting that sales top line, given we see some stiffer headwinds and uncertainties in the end markets in the second half. That's where we are at the midyear point.

And then my second question -- my second question, Dave, at least by my math, it looks like in order to get your free cash flow guidance, you'll have to take about $100 million out of working capital in the back half, and you mentioned it was receivables. A number of your vendors have noted that they're expecting inventory drawdowns in the channel at distribution. It doesn't sound like that's what you're anticipating or expecting, that you're going to be keeping inventory levels fairly static. Is that strategic in terms of picking up some market share and/or to make sure that your rebates are going to be at a level that you originally projected? Or how should I read the lack of an inventory drawdown from you folks strategically?

Certainly. So clearly, our inventory levels are much higher than we experienced in the prior year. There's a couple of factors driving that. One, the SLS acquisition added inventory versus the prior year. Second, as we said during Investor Day, and I know some of you are well aware of this, we opened up a new distribution center. So we've been building inventory for that. The combination of those 2 factors, Sam, we would anticipate continued focus on managing our inventory levels. And I would anticipate that our inventory levels would come down in the back half of the year because of those 2 factors. We're still going to make sure we have the right inventory to service our customers. The real driver of our 90% free cash flow of net income is going to be accounts receivable. We saw a significant uptick in our accounts receivable balance at the latter half of the second quarter. We anticipate that we'll get that back under control. As we were walking in here, we looked at collections. Our collections are well above our run rate for July. So we know that we had some receivables due in June that were held, and we've already received them. So that will unwind here as we go through the balance of the year.

Sam, the only thing I would add is, we always look at availability and fill rates being able to serve customer demand. Both the demand that we understand and are planning for via Global Accounts, utility alliance relationships, new contracts that we won, ramp-up of those new wins, but as well as kind of the walk-in business. We're in really good shape in terms of availability and fill rates coming out of the first half. And that's -- those are the key metrics that we kind of watch and manage very carefully. We had laid in some inventory, though. In addition to what Dave said, we have laid in some inventory originally in support of what we thought would be higher sales and some new wins in the first half. So we've got that dialed in pretty tightly. And if the demand is not manifesting, the inventories are going to get trued up a bit and, as Dave mentioned, there will be some downward trend there.

The next question comes from Robert Barry with Buckingham Research.

Curious to understand better what was going on with SG&A. Did you give or could you give a kind of same-store basis SG&A number or performance, I guess you have some SLS SG&A in there?

Rob, that's correct. So our SG&A versus the prior year was up 1%. So when you take a look at it on a consolidated basis, we're up roughly $3 million. Couple of factors that drove that. The first is in the base period, we had that bad debt charge. We didn't have that same level of bad debt expense in the current year. Obviously, SLS has a much higher SG&A as a percentage of sales. And so that was a negative impact to profitability year-over-year. And we've had the typical inflation on wages and other expenses, but these were offset by cost controls. So as we saw some of the decline in our Q2 results, we began a series of cost controls. The other factor, quite frankly, is that -- was our variable compensation. So we are below our expectations relative to our fiscal year operating plan, and we reduced the accruals for our variable compensation.

Got it. I was going to follow up with that. I mean, so what's a good expectation? I mean, do you think on, like, the same-store basis, you can keep SG&A growth in the back half at around 1% or is that what's in the plan?

I think the 1% would be tougher relative to the prior year. Again, we want to make sure that we are continuing to invest in the right areas of our business. We've also got a couple of onetime events in the back half of last year, including a property sale that reduced our SG&A in Q3. So I think if you take a look at our Q2 results, I think that, that would be a good starting point for overall SG&A, but I wouldn't call that just a 1%, given we had a couple of items in the base period that we wouldn't expect to repeat.

Got it. Got it. I guess, just lastly, on mix. I mean, big picture directionally, given it sounds like you're expecting a lot of growth improvement in back half in addition to comp to come from Utility and construction. Does mix -- does this mix headwind probably get worse in the back half?

We're -- we obviously have laid out what our full year expectations are for those end markets. We do expect a higher growth rate opportunity in Utility, and we would anticipate that construction would continue to be a key driver of our sales growth sequentially. I think the way that I would suggest that you take a look at this is, even if there is an impact on the gross margins because of that mix, generally that is agnostic at the operating margin level.

Right. Fair enough. Just lastly, a housekeeping item. What would the share count be now in the guide, given you've done more on the repos, I think it was 45?

Sure. So you've seen the numbers that we reported for the second quarter. I would say that we're still executing against our $150 million share repurchase. I think for Q3, you should expect about 43 million shares outstanding on a diluted basis.

Okay. And for the year, maybe 42 million or 43 million?

Right now, I would anticipate the fourth quarter to be similar to the third quarter. So you're probably in that $43.5 million to $44 million (sic) [43.5 million to 44 million] diluted share count for the full year share count.

The next question comes from Steve Barger with KeyBanc Capital Markets.

This is Ryan Mills on for Steve. I just want to focus in on the guide. Back half's implying more top line growth than the first half, but at the same time, guidance implies EBIT margins flat to down slightly year-over-year and weaker incrementals compared to the 14% you put up in this quarter. So could you just help me wrap my head around what's driving that? I know, Dave, you talked about some of the onetime items in the back half of last year that might be affecting it, but is there anything else that we should be thinking about?

Sure. So relative to the prior year back half, the one thing to keep in mind is that SLS has -- we had $28 million of SLS sales in the second quarter. That's about the run rate that we've been describing for SLS on an annualized basis. And remember that we said that, that basically comes with no profit. And so that SLS acquisition on the total company is going to be roughly a 10 basis point drag at the operating margin line. So when you're comparing back half of '18 versus back half of '19, that's one factor to keep in mind. Clearly, there are other investments that we talked about back in June with our Investor Day. We want to continue to invest in those strategies, particularly the digital play and some of the digital initiatives that we shared with investors. And so that is some incremental cost relative to the prior year.

Okay. And then just sticking with the guide, your updated top line guidance and your updated end market outlook. When I think about that and also considering your SLS acquisition, to me, it kind of implies that your market outperformance expectation of 1% to 2%, the updated outlook kind of implies you're tracking at the low end or maybe below. Is that a right assumption? And if so, what's driving the lower market outperformance expectation?

So Ryan, as we take a look at it, clearly, there's been some pressure in the first half on our sales rate, but we're still comfortable that we are growing share. I mean, we obviously are looking at that very closely. We've looked at what some of the competitors have put out. As we mentioned, there has been some pressure on our business, specifically in certain pockets of our U.S., but overall, we still are confident that we're going to be able to grow share relative to competition during the full year.

Yes. I mean, what I would add is, I think where -- what has occurred, the end market growth rate we are expecting, I mean, that they are materially lower in the second half. I mean, that -- there is some -- that's the pressure that is going to ripple through our outlook, et cetera. Now our performance versus them, I don't see it as degrading, I see that kind of maintaining/improving. And we've got, again, I kind of took you through earlier in this call each of the segments and kind of gave you a sense on how we think we're performing, what some of the headwinds were. And the wildcard is going to be, I think, again, as I answered in response to Deane's question and Dave Manthey's question, what do the end market -- how do the end markets develop as we move through Q3 and Q4, principally around industrial CapEx spending.

And then just one last one for me. Can you talk about your capital allocation priorities? I know a good focus has been on share buybacks, but with leverage creeping up to the high end of your targeted range, will you start to focus more on debt reduction?

Ryan, as we think about the priorities, they're not changed. So we're investing in the business. We are still actively looking for the acquisitions, the ones that we specifically talked about being large, transformational acquisitions and then the strategic capabilities that we can acquire. We want to make sure that we're managing our debt leverage, but we'll continue to be opportunistic on share repurchase. We have the program available. So we will continue to focus on those priorities going forward.

The next question comes from Nigel Coe with Wolfe Research.

Just wanted to go back to the industrial momentum and you called out metals, called out petrochem. These are obviously CapEx-focused projects. But then you referred to some of the projects getting pushed to the right. So I'm just -- kind of just wanted to dig into that a little bit more, in terms of are we seeing, obviously, the projects in place, work in progress getting done and that's a source of strength, but we are seeing some of the new projects getting pushed, and therefore, we might see a bit of an air pocket in CapEx towards the back half of the year. Is that a risk, number one? And then the second part would be, you called out OEM weakness. Is that construction-focused, is it just manufacturing in general? How do you define OEM?

Great question, Nigel, because I want to come back and it's really important that we -- that it's clear in terms of what we're seeing in what parts of our business. So I'm glad you raised this. In Dave's commentary, when he talked about what pieces of industrial we're growing, he was looking at it from Global Accounts relationship standpoint. Now remember, with a Global Account customer, the foundation of that relationship is principally MRO and then where we do capital projects directly with that Global Account end-user customer, it would show up in those sales. If we're selling through a big contractor with a large construction project through an EPC, it would be categorized as construction. And it also can include some selective OEMs. So when Dave commented about petrochem overall, metals and mining and food processing as being 3 of the areas in Global Accounts where we have strength, you can think about that as being a combination of MRO, okay, plus projects that are direct with those customers, end users in those verticals. And by very definition, those projects are more small to midsize because when they get larger, they typically are managed through the construction value chain upwards to a big EPC at times, okay? So hopefully that's helpful.

Then Dave talked about some of the -- the 2 verticals that we had headwinds in, in Global Accounts and one was OEM. And so you will remember that we bought a business back in 2005, Carlton-Bates, and then we made a few other acquisitions along the way, RS Electronics, AA Electric, so we got a terrific OEM business model and platform. And so that selling, value-added assemblies, kitted parts and value-added assemblies, that get incorporated into our customers' products, truly feed into the manufacturing process flow because it's true OEM. We're seeing some -- that's where we're seeing the slowdown with select OEM customers. So that's more customer by customer. And also with the broader -- I'd say, broader customers across Global Accounts in that vertical.

And for technology, we serve a number of tech companies directly through a Global Accounts relationship and that's typically, not exclusively, but typically, has a higher datacom content because it's wrapped around, in most cases, their enterprise-class data centers. And we did call out as a comparable -- challenging comparable in Q2 of last year, we had significant growth with those tech companies supporting a several of them, one in particular, with global expansion of their enterprise captive data centers to run their business. So thank you for that question. It was important to kind of raise that.

Back to the air pocket question, we're not saying that we're forecasting an air pocket. Again, the way to think about project activity overall is, what's our -- what I would ask you to look -- to think about is, where is our overall backlog level? We're at the second-highest, Q2-ending backlog level ever, and we're starting out Q3 with a really solid July and we've got a first half, second half guide that is somewhat -- is consistent with historical seasonality, 49% of sales in the first half, 51% in the second. So we're not foreshadowing or forecasting an air pocket. The question on is there further headwind for capital spending or if some of the uncertainties are kind of resolved, that business spending becomes this stabilizing factor and catalyst, that remains to be seen. But we're delivering solid performance and not seeing an air pocket per se yet, even given those challenges. Hopefully that helps, Nigel. Does that get to your question?

Yes, kind of. John, it really does. I do have a quick follow-on this time for Dave on cash flow, and it sounds like obviously, accounts receivable is the biggest driver of second half cash improvement in the back half of the year. Would you expect the AR -- I guess, the DSOs get back to where they were at year-end '18 by year-end? And then on the inventory, you talked about some work done in the back half of the year. Normally we do see Q4 lower than Q2, roughly 5%, 10%. Is that the sort of magnitude of inventory decline you would expect to see?

That's correct. So again, our key driver and our lever will be the accounts receivable and getting back to a reasonable DSO. And then we do have opportunities on inventory, basic seasonality, but also some of the investments we made in the front half to set up that Chicago DC. So we do anticipate an inventory balance sheet decline through the balance of the year.

And then DSOs, Dave?

DSO, we would get back to our typical historical range at a minimum.

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

Thank you all again for your time this morning. We really appreciate it. Brian and Will are available to take your questions. And we look forward to seeing many of you at one of our investor marketing events that we will be participating in during the third quarter. Thanks, again. Have a great day.

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