Wesco International Inc (WCC) 2022 Q4 法說會逐字稿

Hello, and welcome to WESCO's Fourth Quarter and Full Year 2022 Earnings Call. (Operator Instructions) Please note that this event is being recorded. I will now hand the call over to Scott Gaffner, Senior Vice President of Investor Relations. Please begin.

Thank you, and good morning, everyone. Before we get started, I wanted to remind you that certain statements made on this call contain forward-looking information. Forward-looking statements are not guarantees of performance and, by their nature, are subject to inherent uncertainties. Actual results may differ materially. Please see our webcast slides as well as company's SEC filings for additional risk factors and disclosures. Any forward-looking information relayed on this call speaks only as of this date, and the company undertakes no obligation to update the information to reflect the changed circumstances.

Additionally, today, we will use certain non-GAAP financial measures. Required information about these non-GAAP measures is available on our webcast slides and in our press release, both of which are posted on our website at wesco.com. On the call this morning, we've got John Engel, WESCO's Chairman, President and Chief Executive Officer; and Dave Schulz, Executive Vice President and Chief Financial Officer.

And now I'll turn the call over to John.

Thank you, Scott, and good morning, everyone. It's a pleasure to be with you today. WESCO delivered a stellar encore performance in 2022, clearly demonstrating the power of our ongoing transformation and our ability to drive sustained growth and market outperformance. We again set new company records for sales, margin and profitability and reduced leverage to below 3x for the first time since 2019. With this trajectory, we've taken a significant step forward in the achievement of our long-term 10-plus percent EBITDA margin target.

We also delivered record quarterly free cash flow and reduced net working capital in the fourth quarter, notably on the strength of double-digit organic sales growth that exceeded our expectations. We are carrying very strong positive momentum into 2023, and I am confident that this year will be another transformational year, with advances in our digital capabilities, above market growth, continued margin expansion and record free cash flow generation that supports our capital allocation priorities.

Now turning to Page 4. The strength of our business model and the success of our integration efforts over the past 2.5 years have established a track record of superior results for our company. This page highlights our record 2022 results compared to the pro forma pre-pandemic results of legacy WESCO plus legacy Anixter in 2019. As you can see, we have clearly outperformed the market, delivering impressive sales growth and margin expansion, and we achieved record profitability all while rapidly deleveraging our balance sheet. Most importantly, our dedicated team of WESCO associates continues to provide resilient and critical supply chain solutions for our customers around the world, capturing the benefits of our exposure to sustainable secular growth trends that are both deep and drive our future sales and profitability.

Turning to Page 5. This page outlines our noteworthy performance over the last 6 years, and it starts with WESCO's stand-alone results in 2017 and 2018. It's then followed by the WESCO plus Anixter pro forma results in 2019 and 2020. And that is followed by the results of the new WESCO, the result of combining WESCO and Anixter in 2021 and 2022. We delivered an impressive adjusted EBITDA CAGR of 24% from 2019 through 2022. These results would have been truly exceptional under normal circumstances, but they're even more impressive, given the tremendous challenges of combining 2 equal-sized Fortune 500 companies against the backdrop of the pandemic over the last 2.5 years.

Our 3-year post-merger integration plan is coming to a close at the end of 2023. Our digital transformation plan is progressing well, and we're on track to deliver advanced digital capabilities to create superior value for our customers and supplier partners. And this is as we continue our march towards becoming a double-digit EBITDA margin business.

Now moving to Page 6 for a quick update on Rahi Systems, the acquisition we completed on November 1. Rahi's performance in November and December was absolutely outstanding with sales of $112 million, far exceeding our expectation of $65 million to $85 million in sales. For the full year 2022, Rahi generated approximately $480 million in sales, which is substantially higher than their trailing 12-month revenue of $400 million as of the end of September 2022. For 2023, their strong growth is expected to continue with sales up over 20%.

Rahi is an excellent example of the type of acquisition that fits well within our strategy and our capital allocation priorities. It operates in a fast-growing market, is highly complementary to WESCO's product and service capabilities, and it is easily integrated into our operations.

Now shifting to Page 7. As announced in our Investor Day last year, we substantially raised our free cash flow expectations for the new WESCO. This upsized cash generation of $3.5 billion to $4.5 billion through 2026 fully supports investing in our business for above -- continue to above market growth and increasing our capital return to shareholders. For 2023, our capital allocation priorities include initiating a common stock dividend, which we expect to begin paying this quarter, subject to the Board's final review and approval, as well as continuing share repurchases under our current $1 billion share repurchase authorization. This represents our commitment to even higher shareholder returns and our strong confidence in the ongoing strength and future performance of WESCO.

Overall, our stock price has performed well since closing the Anixter acquisition in June 2020, but we're still trading far below our expectations and our intrinsic value. This is especially so, given our series of record-setting results and our overall positive business momentum vector. We look forward with greater confidence than ever to a future of sustained growth and market outperformance.

With that, I will now turn the call over to Dave.

Thanks, John, and good morning, everyone. Thank you for joining our call. I'll start on Slide 8 with a summary of our fourth quarter results compared to the prior year. As John mentioned, sales were an all-time fourth quarter record and cross-sell again exceeded our expectations. Our ability to cross-sell WESCO and Anixter products and services contributed more than $260 million of sales in the quarter. I'll provide more details on cross-sell synergies in a moment, including an increase to our expectations for 2023.

On an organic basis, sales were up 14% in the quarter, driven by a combination of strong price and volume, along with share gains largely attributable to our cross-sell initiatives. We estimate pricing added approximately 6 points to sales growth, with the benefit primarily in our UBS and EES businesses. On a reported basis, sales were up 15% as additional sales from Rahi were partially offset by a headwind due to differences in foreign exchange rates in the quarter.

Supply chain challenges have continued to impact our business, although we are seeing signs of supply chain pressures easing in certain product categories. We continue to strategically invest in inventory to ensure we provide continuity of supply for our customers. Backlog continues to be at historically high levels. In total, backlog was up 44% year-over-year and was down approximately 1% sequentially from the end of September. The sequential change in backlog was primarily driven by increased availability of security products within our CSS business that allowed us to ship certain customer projects.

As we start the first quarter, demand has continued to be strong. Preliminary reported January results are encouraging, with sales up approximately 17% year-over-year, including the impact of a stronger dollar, which is expected to negatively impact first quarter sales growth by about 2 points and the Rahi acquisition providing about a 3-point benefit. Note that January is the easiest comparable of the first quarter as February and March were the primary drivers of last year's 21% organic sales growth in Q1 of 2022.

Gross margin was a fourth quarter record at 21.9%, up 110 basis points versus the prior year and down 20 basis points sequentially. This result was driven by our gross margin improvement program, a 40-basis point benefit of higher supplier volume rebates in the quarter, the effective pass-through of supplier price increases and the absence of a COVID-related PPE inventory write-down in the prior year period. Adjusted EBITDA, which excludes merger-related and integration costs, stock-based compensation and other net adjustments was another fourth quarter record and 41% higher than the prior year.

Adjusted EBITDA margin was 8.1% of sales or 150 basis points above the prior year. This result was driven by the combination of increased gross margin, a scale benefit of higher sales and realized cost synergies from our merger with Anixter. Adjusted diluted EPS for the quarter was $4.13, also a fourth quarter record and up 30% from the prior year. The primary driver of this increase was core operations as we recognized higher interest expense and a higher effective tax rate versus the prior year. Additionally, Rahi was accretive to EPS in the quarter with just 2 months of results.

Turning to Page 9. This slide bridges the year-over-year increase in sales and adjusted EBITDA. Organic sales increased 14% versus the prior year, including a 6% benefit from price in the quarter, along with volume growth in our markets. The contribution from price moderated in the quarter relative to the first 9 months of the year, as there were fewer supplier price increases, while the year-over-year magnitude of these increases remained relatively unchanged. Compounding this growth was the impact of the $262 million we generated in cross-sell in the quarter as well as continued share gains.

Adjusted EBITDA increased 41% versus the prior year. Higher sales and expanded gross margin drove the majority of the increase, along with the realization of cost synergies in the quarter. Consistent with the first 3 quarters of the year, we continue to experience higher volume-related operating costs, including shipping and sales commissions as well as higher expenses for employee benefits and incentive compensation. Finally, in accordance with our plan, we continued our strategic investments in systems and digital tools. Overall, we delivered strong operating leverage as we generated a 41% increase in adjusted EBITDA, almost 3x our organic sales growth of 14%.

Turning to Page 10. This table compares our full year 2022 adjusted results to the prior year. For the full year, sales reached a record $21.4 billion or up 18% organically compared to 2021, including double-digit growth in each of our strategic business units. Gross margin was 21.8%, a new record for the company and 100 basis points higher than the prior year. Adjusted EBITDA was $1.726 billion, also a record level and 47% higher than 2021. As a percentage of sales, adjusted EBITDA was a record 8.1%, representing an increase of 160 basis points compared to 2021 and an increase of almost 300 basis points compared to 2019. Relative to the outlook we provided in early November, we came in at the high end of our organic sales range and slightly better on adjusted EBITDA margin. The operating beat also resulted in EPS above the high end of the outlook range.

Turning to Page 11. This slide provides the same sales and EBITDA bridges that we reviewed a moment ago but for the full year 2022 results. Organic sales increased 18% versus the prior year, including an 8% benefit from price, along with growth in our markets. Compounding this growth was the impact of more than $850 million we generated in cross-sell, $500 million more than in 2021 as well as continued share gains. Adjusted EBITDA increased 47% versus the prior year to a record 8.1% of sales. Higher sales and expanded gross margin drove the majority of the $550 million increase in adjusted EBITDA.

We also recognized the benefit of $270 million of cumulative cost synergies. As you'd expect, in a strong demand and inflationary environment, we continued to experience higher volume-related operating costs, including shipping and sales commissions as well as higher expenses for employee benefits and incentive compensation.

Turning to Slide 12. Sales in our EES segment were up 11% year-over-year in the fourth quarter on an organic basis. Of note is the sequential organic growth of 1% for the segment versus a normal seasonal sequential decline of low to mid-single digits. The sequential and year-over-year growth reflects continued strong construction sales driven by the ongoing recovery of the nonresidential market as well as momentum in our industrial and OEM end markets. Backlog was a record in the quarter, 41% higher than the prior year and up 4% sequentially at the end of the quarter.

Adjusted EBITDA was $198 million for EES, up 31% from the prior year. Adjusted EBITDA margin was 9.1%, 160 basis points higher year-over-year. The increase reflects continued gross margin expansion, strong cost synergy realization and operating cost leverage. Full year sales were a new record, up 17% with record adjusted EBITDA that was 41% higher than prior year. As a percentage of sales, adjusted EBITDA was 9.6% for the year, also a record and representing an increase of 170 basis points.

Turning to Slide 13. Sales in our CSS segment were a quarterly record and up 12% versus the prior year on an organic basis. Of critical importance was the building momentum that CSS experienced in Q4 as year-over-year organic sales growth accelerated in each months of the quarter. We saw stronger growth in network infrastructure driven by data center and hyperscale projects as well as continued investments in cloud-based applications, professional audio-visual installations and security solutions. Backlog was up 9% over the prior year and decreased 15% sequentially as we were able to release more projects from backlog due to improved availability of product and reduction in certain product category lead times.

2023 is off to a great start. Book-to-bill in January was significantly above 1.0 as demand for our products and services remains robust. Profitability was also strong with record adjusted EBITDA and adjusted EBITDA margin of 9.6%, 130 basis points higher than the prior year driven by operating leverage, integration cost synergies and the execution of our margin improvement initiatives. For the full year, CSS sales were a record and up 12% from the prior year. Adjusted EBITDA was up 25% with adjusted EBITDA margin of 9.4%, a segment record and a 100-basis point increase over the prior year.

Turning to Slide 14. Record sales in our UBS segment were up 22% versus the prior year on an organic basis in the quarter, marking the fifth consecutive quarter of organic growth above 20%. All operating groups grew again in the quarter over the prior year, led by utility sales, which were up more than the segment average. Backlog was a record in the quarter, up 86% over the prior year and up approximately 1% sequentially. Profitability was also strong with an adjusted EBITDA margin of 11.4%, 180 basis points higher than the prior year driven by our gross margin improvement initiatives, operating leverage and integration cost synergies. Full year sales were a new record, up 27%, with record adjusted EBITDA that was 58% higher than prior year. As a percentage of sales, adjusted EBITDA was 10.9% for the year, also a record and representing an increase of 210 basis points.

Now moving to Page 15. The size of the cross-sell opportunity of combining WESCO and Anixter continue to exceed our expectations. In Q4, we recognized $262 million of cross-sell revenue, bringing the cumulative total to more than $850 million for the year and over $1.2 billion since the beginning of the program. Our pipeline of sales opportunities remains healthy, and our cross-sell initiatives continue to deliver. We are capitalizing on the complementary portfolio of products and services as well as the minimal overlap between legacy WESCO and legacy Anixter customers. As we look at the remaining 12 months of the program in 2023, we are increasing our expected cumulative total to $1.6 billion or 9x greater than the original target we set when the Anixter merger closed.

Turning to Slide 16. This is a slide we've shown throughout the integration, with the realized cumulative run rate cost synergies of $188 million in 2021 and $270 million in 2022. We remain on track to meet our expected target of $315 million by the end of 2023. The largest remaining synergies are those that take longer to execute, including those related to supply chain and field operations.

Turning to Page 17. On this page, you can see a free cash flow bridge for both the fourth quarter and full year. Note that the impact of the Rahi acquisition is included in these free cash flow reconciliations. We delivered record quarterly free cash flow of almost $400 million in the quarter, with significant improvement in all 3 working capital accounts of $190 million. Also, as we discussed last quarter, we expected to deliver substantial free cash flow in the fourth quarter based on a seasonal decline in revenue and reducing levels of working capital. This seasonal decline did not occur as we delivered sequential sales growth but still reduced net working capital.

Furthermore, Rahi's exceptional fourth quarter growth increased net working capital by approximately $57 million for both the fourth quarter and full year. Excluding this impact, free cash flow for WESCO would have been approximately $456 million in Q4 and up $36 million in fiscal year 2022. For the full year, you can see that working capital was a use of cash in 2022, driven by our strategic investment in inventory in response to global supply chain shortages and increases in receivables due to our exceptionally high level of sales growth.

You can see that the CapEx and IT spend, which reflects the investment related to our ongoing digital transformation and supply chain optimization. This amount increased in the second half of the year as we accelerated several digital projects and operational investments to drive the efficiency of our facilities. For the full year, this spend totaled $165 million, which was above our expectations provided last quarter. The increase was largely driven by the acceleration of high-return projects that are supporting our supply chain optimization and IT transformation, enabling growth ahead of historical levels.

Moving to Slide 18. Reducing our leverage has been a top priority since we announced the acquisition of Anixter. In the fourth quarter, we reduced leverage 0.3x trailing 12-month adjusted EBITDA and brought our leverage ratio down to 2.9x, approaching the midpoint of our target range of 2 to 3.5x. Note that this decrease includes the $217 million purchase of Rahi Systems and reflects a net debt reduction of $142 million sequentially. This represents a decrease of 2.8 leverage turns since closing the acquisition in June 2020.

Now moving to Page 19. This slide shows the uniquely strong position of our company to drive growth and profitability in the years ahead. The end-to-end solutions that we provide to our global customer base are directly aligned with the 6 secular growth trends shown on the left side of this page. Our participation in these trends, coupled with increasing public sector investments in infrastructure, broadband and partnerships with the private sector make WESCO positioned exceptionally well. As we outlined at our Investor Day last year, we expect to grow 2% to 4% above the market due to the combined benefit of secular trend growth and increasing share. In short, WESCO is transforming into a secular growth company.

Moving to Page 20, you can see our 2023 outlook. We are encouraged by the demand trends and positive business momentum as we closed out 2022. In 2023, market growth is expected to contribute approximately 4% to 6% to the top line, which is a combination of volume and price. We expect U.S. GDP to be flat in 2023, with our secular tailwinds providing 1 to 2 points of volume growth. Price carryover in 2023 will be 3 to 4 points based on rollover pricing from 2022 actions. Recall that our guidance does not incorporate any additional future impact from price.

In addition to market growth, we believe our scale and continued cross-selling efforts will contribute an additional 1% to 2% above the market, driving total organic growth of 5% to 8%. After factoring in the additional revenue from Rahi and the impact of working days and foreign exchange, we estimate our reported sales growth will be in the range of 6% to 9%.

For our strategic business units, we expect EES reported sales to increase by mid-single digits versus 2022, with both CSS and UBS up high single digits. Please note that in the appendix, we have highlighted some account transfers from EES to CSS and UBS that will take effect in 2023. In 2022, these accounts represented approximately $200 million of sales with approximately 85% moving to CSS and 15% moving to UBS. For adjusted EBITDA margin, our outlook is for a range of 8.1% to 8.4%, which represents approximately 20 basis points of expansion at the midpoint. We expect adjusted earnings per share between $16.80 to $18.30 and free cash flow of between $600 million and $800 million. This free cash flow outlook of $700 million at the midpoint would represent the highest free cash flow in our history.

Through the cycle, we still expect the company will deliver free cash flow equivalent to net income. In 2023, we expect to continue to make selective investments in inventory as supply chains heal and order lead times return to historical levels. Consistent with the expectations we outlined during our Investor Day in September, we expect to generate $3.5 billion to $4.5 billion of operating cash flow during the period of 2022 through 2026. To note, we expect free cash flow in Q1 to be a use of cash as we will make the 2022 incentive compensation payment in March.

This outlook reflects a handful of assumptions that I'd like to walk you through. Our short-term compensation structure is reflected in our margin outlook as a target payout. This is a tailwind of approximately 20 basis points compared to 2022, which incurred higher short-term compensation costs due to outperformance of EBITDA. This tailwind is slightly lower than what you originally anticipated as we didn't pay out on our free cash flow objective for the year. We expect transportation and logistics costs will be an incremental headwind to margin in 2023 of approximately 20 basis points. We expect depreciation and amortization will be in line or slightly below the 2022 level.

Interest expense is expected to be in the range of $330 million to $370 million due to higher variable interest rates and timing of debt paydown in 2023. This outlook reflects an effective tax rate of about 27%. This is slightly above our ETR of the past few years, primarily due to the implementation of certain rules in our Canadian business related to hybrid debt instruments. 2022 also benefited from certain onetime discrete items, primarily related to a change to U.S. tax law regarding the valuation allowance on certain foreign tax credits and onetime discrete benefits in Canada.

In 2023, we expect to spend approximately $100 million on capital expenditures and an additional $40 million on capitalized cloud-based computing arrangements related to our digital transformation. On the statement of cash flows, $100 million will flow through capital expenditures, and approximately $40 million will flow through changes in other assets. Our outlook assumes an average diluted share count of 52 million to 53 million shares for the year. This outlook reflects our expectation that 2023 will be the third consecutive year of record results, with record sales, gross and EBITDA margins and record free cash flow and is consistent with the long-term financial framework we presented at our Investor Day in September of last year. We will complete our integration with Anixter at the end of the year and expect the results in 2023 to substantially outperform the expectations we set at the time the transaction closed. As it relates to the first quarter, preliminary reported January sales were up 17%. Recall that sales grew 21% organically in Q1 of 2022 as February and March were exceptionally strong.

Moving to Slide 21 and before opening the call for questions, let me provide a brief summary of what we covered this morning. 2022 was an exceptionally strong year of growth and profitability. We had record sales in all 3 of our business units, along with record gross margin, operating profit, adjusted EBITDA and adjusted EBITDA margin. WESCO's EBITDA margin expanded 160 basis points over the prior year to 8.1%. We took share through sales execution and our cross-sell program, and we are again increasing our revenue synergies outlook for 2023.

WESCO delivered a quarterly record of approximately $400 million of free cash flow in the fourth quarter, reflecting the power and inherent cash generation characteristics of our business model. Our pace of deleveraging has exceeded our expectations. We are now approaching the midpoint of our target leverage range just 2.5 years after closing the acquisition of Anixter, well ahead of expectations.

Lastly, we're making excellent progress on our IT and digital road map and are exceptionally well positioned to benefit from the secular growth trends and increasing public sector investments that John discussed earlier.

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

(Operator Instructions)

Our first question today comes from Deane Dray with RBC Capital Markets.

I was hoping to start with some what would be real-time color on the demand outlook, so daily stock and flow, build activity, product availability. And John, as you take us through this, we're all trying to gauge what does normalization look like? There's some references to the supply chain getting better, but you're still -- it sounds like you're adding some buffer inventory in some places. So just kind of take us through the real-time update and then kind of frame for us about normalization to any degree in '23.

Yes. Good question, Deane. I'd, first of all, start with January because that's in the record books. Very strong start to the year. After delivering an encore performance last year, we turned the calendar page. In January, I'd say the beat goes on and just a very strong start with 14% growth plus the additional incremental contribution of Rahi. So as we look through the balance of the first quarter, the comps are a little bit more challenging, but I'll tell you that momentum vector that we had in January is continuing so far in February. So I'll also say that margins are holding up very, very well. So it's just -- it's an excellent start, sales and margin-wise so far.

I would say our outlook for the year and what does normalization look like, I think it's going to be a multi-speed economy. You look at our end markets, there's parts of the end market that will experience some significant pressure. But the good news is that's not lined up with our portfolio. Residential construction faces some headwinds but we don't serve into that market. When you look at our EES business, nonresi is -- got record backlog entering the year, strong momentum vector and performed sequentially stronger in Q4 versus Q3 versus normal seasonality. Industrial end markets holding up very well and strong.

You move to CSS. And that, that business was particularly supply chain constrained, Deane, as we talked about all through last year. Those constraints started to heal in Q4. Not fully healed yet but I think we'll see that healing as we move through 2023. And you saw the significant step-up in momentum vector of CSS in Q4, and that's continued as we started 2023.

And then UBS, just an absolute breakout year of growth, tremendously strong results. As Dave mentioned in his commentary, utilities actually leading the pack with broadband being right there as a very strong double-digit growth driver. So our momentum vector is very strong. I think the economic cycle, we'll see some parts of the economy will be up, parts will be down. We think inflation continues this year, albeit not at the same rates that they were last year, but we think inflation continues through all of 2023, quite frankly.

And we'll see that in labor and wages and benefits and transportation costs. The commodities will move around a bit. But in general, demand is still outstripping supply from our perspective. Our book-to-bill ratio in January was above 1. And so we're off to an excellent start, I think. When you look at what we've guided for the year, it would be another transformational year and another year of record-setting results.

So we're not -- I think the normalization -- the short answer to the normalization question is you'll see that as we move through the year. But I think what you'll see and what is outlined in our outlook fundamentally is strong market outperformance, and it's driven by the execution of our initiatives, the tremendous cross-sell, which we've taken up again, and these secular growth trends that we think fundamentally have shifted the company to a secular growth company.

Again, we've said that as we moved through this last 2.5 years of post Anixter-WESCO coming together, we think we've fundamentally mix shifted the company in the higher growth markets. I think we've clearly seen that over the last 10 quarters. But given where we are in the economic cycle and given kind of a multi-speed economy, I think you'll see that outperformance to an even greater degree as we separate ourselves even further from the pack in 2023.

All right. That's comprehensive. Really appreciate all the color. And just as a follow-up, like to put the spotlight on free cash flow, if we could, and this was an exceptionally strong quarter by our estimates, like 2x your seasonal free cash flow conversion. So Dave, can you just take us through expectations on the cadence of free cash flow for the year?

You said first quarter would be a use. You called that out on stock comp. Maybe some color on buffer inventory because the extent to which you start peeling that out, that should have a positive impact on free cash flow. And are we kind of stuck with this hockey stick fourth quarter? Just kind of gauging what that cadence is through the year.

Yes, certainly. So let me start by providing the historical context of, generally in a normal demand environment, we would see our free cash flow generation split 30% first half, 70% the second half. 40% of that free cash flow generation in a year typically occurred in the fourth quarter primarily because we would see the sequential decline in sales. We would then release both accounts receivable and inventory.

I mentioned that we do anticipate that our first quarter will be a draw. That's primarily because we're going to be making the incentive compensation payment in March. But after that, we should expect to see things begin to normalize from a free cash flow perspective. As you mentioned, Deane, supply chains haven't healed yet, so we would anticipate that we would begin to see inventory releasing in the second half of the year as those supply chains heal.

The next question comes from Sam Darkatsh with Raymond James.

Two questions. First, John, you mentioned in your prepared remarks that you see WESCO shares as trading far below in trade out, I guess is that's due to a concern around the sustainability of gross margins. I mean, they're up a couple of hundred basis points over the past 2, 3 years. If we could just unpack gross margins a little bit (inaudible) over the past couple of years?

Sam, I think we lost you. Would you mind repeating? After unpacked gross margins, I think we lost you.

Sure. I'm sorry. Can you hear me now, John?

Yes, Sam.

Okay, sorry about that. Just trying to get a sense, how much of the gross margin expansion is specifically price/cost benefit on stock and flow inventory?

So let me answer the question this way. The enterprise-wide gross margin improvement program that we put in across the enterprise that we now are multiyear -- several years into execute, has great momentum. It's not focused on stock and flow versus ship and debit versus -- it's looking at all categories of our all fulfillment method types. It's really focused on, at the core level of pricing and the value of our supply chain solutions and services.

So we have seen improvement in margins both for stock and flow and our DS business, our direct ship business. So -- and we are focused on continuing to drive gross margin expansion across all our business models. I think there's tremendous legs left in our gross margin expansion program. And look, we've set a mark of 10-plus percent EBITDA margins for the enterprise. We've got north of 8%, a huge mark for us, all-time record results in 2022 to eclipse the 8% adjusted EBITDA margin level.

And we're looking at, going forward here, having a strong contribution of both gross margin expansion plus operating cost leverage, those 2 both being additive to contributing to overall operating margin expansion. So I understand your question. I can tell you that the bottom line is, we've seen contributions, since we put the 2 companies together, including in 2022, improvement in gross margins for both stock and flow and DS.

And again, it's because of the nature of our gross margin improvement program and the way we're going about pricing value. I know this is the question. I think the bigger question is, how does the new WESCO perform against an economic backdrop that has some recessionary pressures? Well, look at the guide we just put out there for 2023. And we are highly confident in the guide that we've outlined. And so that should speak volumes about our confidence in the new WESCO and our ability to generate profitable sales growth across all phases of the economic cycle.

My second question, assuming my phone is still working. So the -- what expectations do you have, Dave, for year-on-year backlogs by the end of the fiscal year '23 that informs your free cash flow guide for the year?

Yes. So Sam, I would say that our free cash flow guide is less tied to the backlog. It's more tied to the supply chain's healing. And one of the ways that I would ask you to think about this is, through the first half of the year, we're expecting some product categories will still be facing severe supply chain constraints. Some product categories, we're starting to see some improvement. But right now, our expectation is that it will be the back half before we get more to a normal lead time in order to support our customers.

The way that I would encourage you to think about this and how we think about it internally is that we expect that in order to support our sales growth, our net working capital will grow half the rate of sales, and that includes that we have elevated our days of inventory outstanding. So our financial days outstanding, you can take a look at that. It's up substantially because of the supply chain lead times and our need to service the customers. We expect to make some progress against our [DIO] metric in 2023. That's what's informing our free cash flow. And we're assuming that we'll have a typical seasonal pattern to sales, meaning fourth quarter sales will be down sequentially from the third quarter to release working capital.

The next question comes from Nigel Coe with Wolfe Research.

So I wanted talk a little bit -- just want to switch gears to Rahi. Really exceptional performance as you pointed out. So where did the upside come from? The [110], I think it was in the quarter versus [60 to 80] in the guide. If I've got this wrong, please correct me. But where did that strength come from and how much visibility do you have in that 20% growth in 2023?

What was the second part of that, Nigel? How much -- what did you say...

Yes, the visibility on the 20% growth.

Visibility. Okay. Thank you. Yes. Well, we -- when we closed on Rahi, we had been giving updates and you see that's in our public materials, about what their trailing 12-month sales were. So you saw what it was when we initially announced the deal and you saw what it was when we did our Q3 earnings. So that number is -- and they came in substantially stronger. We then gave an outlook for the stub period in Q4.

It was the result of releasing some projects and delivering projects that were in backlog. With that said, they grew their backlog. So the momentum vector there is exceptionally strong. And we're getting to learn that business. Now we've got a good sense with parts of the Anixter CSS business, and that now has been absorbed and integrated. And the leader of Rahi is running "WESCO data solution, data center solutions." So we've taken the Rahi assets and combined them with Anixter's legacy data center capability and assets globally, and the leader of Rahi is running that as part of Bill Geary's business.

But the short answer to your question, Nigel, is it's the -- it was releasing out of backlog booked orders that were there. But the backlog grew. And coming into 2023, we've got a very clear view of what the operating plan commitments are, that, that leader who started the business committed to. He's been over-delivering against those expectations.

As long as we talked to Rahi, which was many, many, many months, he kept beating and raising "his performance" against his plan. So we locked in his plan. But when I look at the backlog growth and the momentum vector of the business, we're just -- we're set up for just an outstanding year. I think it comes down to, Nigel, fundamentally, the core value proposition of Rahi and combined with the secular growth that's associated with data centers and how we -- where we play in the value chain and the combination with Anixter's CSS business is exceptional. This is just a terrific acquisition and we're thrilled with the start.

Another question. That's -- congratulations on the acquisition. Maybe just talk about the kind of the free cash deployments in '23. So after dividends, both preferred and equity dividends, you're going to have about [$550 million] of cash flow to deploy. Just wondering how you're seeing that sharing that between debt paydown versus share buybacks versus maybe M&A. Maybe just some thoughts on that. And then just on top of that, I think if you just take your EBITDA plan, you're going to be down to about 2.6x leverage just on EBITDA growth. So curious how much further you want to take down leverage this year.

Nigel, thanks for the question. We're going to be balanced with how we deploy the available cash. We are working through with our Board to get the approval for the common stock dividend, so that will be happening here shortly. We also are committed to the $1 billion buyback, and we will be focused on leveraging available cash as part of that buyback program.

But from our perspective, right now, the primary concern is, we want to operate within the middle of our range on leverage. We're getting closer to that, but that does provide us with significant optionality, which will include providing capital back to shareholders, plus we'll continue to take a look at M&A activity and see what may make sense for our company. But again, I think the common stock dividend and the buyback is something that we will be initiating here in 2023.

The next question comes from David Manthey with Baird.

I'd like to circle back on the gross margin. Dave mentioned that you're expecting record gross margins in 2023. And you clearly have a lot of company-specific factors that are driving it higher, but what would need to happen to drive 2023 gross margin below what you just reported here in '22?

Yes, Dave, I think we would have to see a considerable amount of pressure on our top line. And if we see that considerable pressure on the top line, we would see our supplier volume rebates would fall to the lower end of the historical range. And just to put that into perspective, as we outlined, we did get the benefit of higher supplier volume rebates versus the prior year. So that will be a headwind going into the more normalized period in 2023.

But if you start to see demands from, I think I'll call it, a deep recession, then that would mean that our supplier volume rebates would tend to the lower end of the historical range. That would put pressure on gross margin. We have been very clear about our margin improvement program and our focus on passing through costs to our customers. We have been positive on that throughout the full period of 2022. It will be incredibly important that we're able to sustain that momentum into 2023. We believe that we have provided our sales force with the right tools and techniques in order to do that. But clearly, if we saw significant demand destruction, that would put pressure on gross margin.

Okay, that's helpful. And related to that, you're seeing 17% growth in January. You're guiding full year to 6% to 9%. It clearly implies some sort of slowdown overall. And notwithstanding the growth driver overlays you have, what is your core assumption for the economy, industrial production, when you're thinking about formulating that top line guidance?

Got it. And as we mentioned, we think that GDP here in the U.S. is going to be essentially flat. We do think that there are pockets of the end markets that we serve that will still be very positive, including non-res construction, the industrial markets, data center growth. We're still expecting that to be. And so that's where we're still assuming that we have a volume opportunity as well as the pricing carryover, that's going to move our sales up in 2023.

So we're taking a look at all the same economic data that you are. We're also talking to our customers. That's informing how we've positioned our outlook for 2023.

The next question comes from Ken Newman with KeyBanc Capital Markets.

First question for me. Sorry if I missed this, but obviously, you've increased the synergy target here. But I know when you first introduced Rahi, there were no identifiable synergies yet as the deal was just closing. Given all the opportunities that you've had to look into that business and obviously, the demand is improving, any way you can kind of parse out just what the identifiable synergies are for Rahi specifically?

So I'll just tell you, I think that the way to think about that business is it's going to -- it's a major growth engine, and it's got a tremendously positive business momentum vector. And the synergies will be cross-sell. But we haven't put a specific target on that. Again, we did that when we put 2 equal-sized Fortune 500 companies together back and which was actually announced prepandemic, closed at the beginning of the pandemic.

We're not going to break out a separate synergy target, cross-sell synergy target for Rahi, but that's how to think about it, Ken. The discipline and the process we put in place across -- as a result of the combination of Anixter and WESCO, is still in place. I've said -- made the statement before. It's turning out to be the single largest, most sustainable value creation lever of putting these 2 companies together. I think it's a demonstration of the combined market leadership position, the superior value proposition, the global scale. And we've just raised that combined synergy target again.

And we think we've got tremendous legs to that as we have tremendous legs to our gross margin improvement program. But Rahi now will draft off of that process. So think about it as taking Rahi's services -- products, really services and solutions because they're much more service-oriented and just literally adding that to our cross-sell program. And so that will be leveraged inside Anixter, Anixter's prior CSS business, which is Bill Geary's CSS business as well as across the SBUs.

I'll just highlight that right now, we are not going to separate out any of the merger integration-related costs for Rahi. It's not material, the way that the Anixter merger was. So what you see on Rahi will be its fully reported results in our adjusted results. We won't be breaking out any synergies for you as we go forward in 2023.

We'll call out the top line growth so you'll see reported versus organic sales. So you'll see that until we lap -- till we lap the acquisition at the 12-month point, post close.

Understood. For my follow-up here, I really wanted to clarify the CSS guidance for the year. I think if I -- after the re-segment and backing out the acquisitions, I think the guide implies organic growth for that segment being in the low to maybe mid-single digits in 2023. One, I just want to see, is that right? And if so, that seems a bit slower than I would have anticipated just after all the positive commentary on the backlog that you guys mentioned in the prepared remarks.

Yes, Ken. So we expect our CSS business reported sales will be high single digits. And that does include about the benefit that we'll get for both Rahi. And remember, though, that the CSS business doesn't have the same pricing carryover as the other 2 SBUs. The pricing in CSS has been low single digits throughout 2022. We don't get that same carryover benefit that we get with EES and with UBS.

(inaudible) comment on EES. Ken, was your question EES?

No, it was CSS specifically on organic growth, but I'll definitely welcome any comments you have on EES as well.

No, no, no. And Dave gave that guide, too. I mean, he said EES' outlook is mid-single digits. UBS and CSS are high single digits as part of the construct and the guide for 2023. Just we talked about, throughout 2022, about the supply chain constraints as it started to heal and there's some recovery and it was different by product category and supplier obviously.

Then CSS was still feeling severe impacts throughout -- the majority of 2022. Started to heal late in the year, and you saw the improved results in 2020 -- in the fourth quarter. And that's continued to start this year. So that's what serves the basis of the guide for CSS stepping up its growth rates in 2023 versus 2022.

The next question comes from Christopher Glynn with Oppenheimer.

I was curious, for CSS, how are you thinking about prospects or market backdrop for sort of price reclamation on a deferred basis as the supply chains normalize? I know it's not in your guide.

So I think Dave mentioned that briefly, Chris, but we started -- we saw an improved contribution from price in CSS in the fourth quarter. I mean, it goes hand-in-hand and in concert with the supply chain's healing as well. And we do expect that we'll have a -- that kind of sets us up well for the beginning of '23. Dave, I don't know if you want to add to that commentary.

Right. I mean, we're still monitoring what the suppliers, particularly those that service our CSS business, we're in conversations with them, how are they thinking about capturing price/cost. Obviously, we've not included that in our outlook at this time for 2023. But again just to reiterate, we haven't seen the same frequency and magnitude of supply price increases from our suppliers in the CSS category. That's been low single digit throughout 2022, and we would not anticipate at this point any incremental price increase activity. But again, we'll continue to monitor that with our suppliers.

I mean, the backdrop is there's strong secular demand, secular growth. And if you look at our Rahi results, which shines a spotlight on our global data center solution, that's very encouraging. So look, we'll -- we're pricing value as part of our gross margin improvement program. We'll -- and the sales force is very focused on optimizing that.

As we said, I want to reinforce, that program has tremendous legs left in it. And we're incentivizing the sales force for incremental gross margin improvement. That's where they get the increased compensation in the kickers. So it sets us a floor, as a starting point, what we did last year. And so again, there's tremendous incentive in place to sell our full value proposition to customers.

Appreciate that filling color. And then digital transformation, a lot of mention of acceleration of the deployment and yields on that. Curious if any metrics you could share around operating efficiencies or service levels that you're seeing more or less directly tied to your big data utilization ramp.

Chris, great question. We have that on our road map to begin -- to start disclosing that. We have not done that yet, so let's put a pin on that and say that's something we're going to get to. I won't foreshadow, is it 1 or 2 quarters out or at what point. But clearly on our road map to start to provide that.

I will say that, and we've mentioned that we got a new digital -- digital's impacted a series of applications across our company. I've cited those before our Investor Day last year. We put a finer spotlight on that at our Investor Day. And they include what we're seeing tremendous benefits from thus far, our AI-enabled product search, our intelligent pricing application and something we call unified sales desk, which is brand new and kind of knits together all the applications and the behind-the-scenes work we've done on our big data in 1 master data lake and making that -- turning that into more valuable information that we can use as we -- as the sales force engages with customers in developing their solutions.

It also includes products that are -- that included as-a-service capability like that AV-as-a-service that we highlighted a year ago. And so we're getting very nice momentum with those as we continue to also build out the tech stack that we took you through at Investor Day, where we've got a new finance app implementation, a new human capital implementation. They're in place and continue to be expanded, and we've started with our WMS, TMS rollout. So taking this digital transformation, it's a great question as a continuum.

When we put these 2 companies together, I'll remind everyone, that was one of the major strategic rationales for putting these companies together. None of us in the distribution portion of the value chain could invest in digital fast enough. We put the 2 companies together. We established strong aggressive targets on synergies. It allowed us to improve our core profitability. We've been over-delivering and beating and raising those, but we've been taking some of that overdrive and investing in our digital transformation.

We'll bring the 3-year integration program to a close at the end of 2023. But we've got another couple of years left on this digital transformation. And that is what I'm most excited about. It really is all about unlocking the power of our big data. Again, we're already seeing some tremendous examples of that. And we'll -- again, it's on our road map to bring that to life more for you going forward and establishing those KPIs and reporting against that. Excellent question. Thank you.

Today's last question comes from Chris Dankert with Loop Capital.

Just to kind of clarify on the guide, you said expect a fairly seasonal pattern to the year. I assume that, that kind of means any benefit from Infrastructure and Jobs Act or Inflation Reduction Act spending, kind of push into the market, that would be kind of incremental upside to what you're contemplating today.

Yes, short answer.

Perfect. Short and sweet.

I mean, yes, I think the secular trends are in place. We think they're enduring, they're long term. And we're seeing increased contribution from them. But honestly, it's our leading value proposition, taking advantage of those is what we're really seeing the effect, the result in our sales. But to your point, and we didn't talk much about it, Dave did allude to it though. That -- when you really look at that starting to unveil itself and deploy through the value chain, that could be substantial upside, absolutely.

Perfect, perfect. And just very quickly, again, just to fill up the last question, I guess. I know we're still waiting on the KPIs. When I think about maybe the earlier gross margin initiatives that started rolling years ago, the supplier segmentation, stratification kind of pushing cost visibility to the sales force, how do you feel about some of those initiatives that have a little bit more maturity to them at this point?

So I would say that we had -- we took all that, that was being done there, Chris, what you alluded to. But when we brought the 2 companies together, Anixter had an existing gross margin expansion program across their enterprise. And we put the 2 together and drove it enterprise-wide, but it's continuously being refined and improved.

If you look at what we've done for 2023, we're not using statically what was in place for 2022. We've introduced a whole series of additional improvements in terms of applications and visibility and leveraging our big data that's being brought to bear as the sales force is working individual order, kind of bidding opportunities and order opportunities. This is, again, the power of digital. When you get all our data into 1 world-class data lake and you can begin to leverage it, it's continuous. And so I mean, that's what I'm very excited about, and again, underpins our confidence around the legs that we have left in this gross margin expansion program.

Yes, really appreciate the color there, John. And then best of luck on 2023 here.

Thank you.

So thank you. We're a little bit past the top of the hour, but we had quite a few questions. I'll bring the call to a close. Thank you all for your support. It's very much appreciated. We've got a number of engagements planned here in the coming months -- a month or 2. We look forward to speaking to many of you. Later this quarter, we will be participating in the Raymond James Institutional Investors Conference, the Loop Capital Investors Conference, as well as the JPMorgan Industrials Conference next month. So with that, thank you very much. Have a great day.

The conference has now concluded. Thank you for your attendance. You may now disconnect.