Good day, and welcome to the West Coast Second Quarter 2019 Earnings Conference Call. All participants will be in a listen only mode. After today's presentation, there will be an opportunity to ask questions. Please note that this event is being recorded. I would now like to turn the conference over to Will Ruth Roth.
Please go ahead.
Thank you, Chuck. Good morning, ladies and gentlemen. Thank you for joining us. Joining me 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 was disclosed in the press release and was posted on our corporate website. Replays of this conference call will be archived and available for the next 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 Q2 results and our 2019 outlook before we open the call for questions. We achieved record sales in the Q2 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 May in the United States, our sales growth strengthened in June, but was impacted by slowing momentum and increased uncertainty in our end market. 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 $150,000,000 of our common stock, which was above our share repurchase forecast for the Q2. 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 Q2 results as well as our Q3 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 the U. S.
And a decrease of 8% in our international market. 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 non renewal 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 2nd quarter following a similar performance in the Q1. The lower overall sales growth relative to our expectations was primarily due to pockets of weakness that we are seeing in 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 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 and A expenses were 1% higher than the prior year on a consolidated basis. The increase in SG and A expense was primarily driven by the SLS acquisition, partially offset by the absence
of a
$2,500,000 bad debt charge incurred in the prior year period and lower variable compensation expenses. Operating profit in the Q1 was $97,900,000 or 4.6 percent 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 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 benefit of the SLS acquisition. Moving to our end market results beginning on Page 6.
Industrial sales were up 1% overall and up 2% 6% in the U. S. And Canada respectively. Industrial sales were up 2% sequentially from the Q1. 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 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 improvement. 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 $30,000,000 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 1st 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 in the balance of 2019. The skilled labor shortages that our customers are facing represent opportunities for Westfield 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 2nd 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 non renewal of a contract and 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 in the absence of this contract. We also expect to begin servicing the new utility alliance customer highlighted on our last call late in Q3. 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 continue 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 $400,000,000 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 5th 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 build outs 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 $38,000,000 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 have already seen a bounce back in our cash collections in July. Debt leverage net of cash was 3.2 times trailing 12 months EBITDA, up from the prior quarter driven by borrowing to support our share repurchase program. Leverage is within our target range of 2 to 3.5 times 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 $230,000,000 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 $587,000,000 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 $11,000,000 in the quarter, in line with the Q1 reflecting investments to digitize our business, including information technology tools, digital applications and facility. As we mentioned at our Investor Day, we entered into an accelerated share repurchase transaction in May for $150,000,000 When this program settles later this year, we will 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 acquisition, including large core electrical distributors that consolidate the market or transactions that provide a new strategic capability. 2nd, we seek to maintain a targeted financial leverage ratio of between 2x to 3.5x EBITDA. 3rd, we returned cash to shareholders through share repurchase under our 3 year $400,000,000 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 Slide 11. For the Q3, 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 3rd quarter, in line with the expectation for the full year. Preliminary July sales are up mid single digit, a 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 dollars 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 two quarters. With that, let's open the call to your questions.
We will now begin the question and answer session. The first question comes from Deane Dray with RBC Capital Markets. Please go ahead.
Thank you. Good morning, everyone.
Good morning, Dean.
Hey, 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 project push outs and delays. So John, you always give really good end market color and 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 Q3? And if you could take us
through that, I would appreciate it.
Yes. Thanks, Deane. Yes, the slowing momentum and you used the term short cycle, but also kind of daily activity, the MRO, We're seeing that in terms of directional pressure, and I'm using those words purposely. And then the projects for industrial and marketing customer applications, we're seeing some selected push out as well as a reluctance to kind of initiate or move those along versus what we had originally expected kind of going through Q2 and at the midpoint of 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 Q1, neither did Canada. And in the Q2, 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 a percentage point in Q2. In oil and gas, we're getting we're seeing low growth, but it is growth in Canada and U. S.
And the declines are in international, and again around this project activity. So clearly the markets have some slowing momentum and there's a pause 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 a half a day of sales from the low end.
So and July to your point, Dean, is in the 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's 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 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 that'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, healthy, but it really is around the confidence in 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 Q3 midpoint and see where that puts us in 4Q, it really does look like the implied guidance is well above consensus. So are you baking in this the trade resolution rebound or just it does look like it inflects stronger in the 4Q.
So what's seasonal? And are there any macro assumptions there?
Yes, great question. I think what the way we look at it, first, I'll 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 that July start is a supportive and an encouraging start to and does support the guide. The implied 4Q guide has a wider range kind of by definition. So look, 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 outperform the market.
And again, I'm going to come back to this, because this is I think is the key issue. The 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 uncertainties resolve, that would represent a nice positive catalyst.
Appreciate all the color. Thank you.
Thanks, Dean.
The next question comes from David Manthey with Baird. Please go ahead.
Thanks. Good morning, everyone. Good morning. John, you just went through a lot of this stuff, but I'm still sensing a disconnect here. I'm thinking back to mid June when you said you were tracking the low end of the 3% to 6%, and then you came in at 2% after reporting what looks like a really strong June.
And now you're sort of guiding the Q3 and the full year lower on uncertainty and slowing momentum, but your growth just went from 1% to mid single digit. Can you help me justify those things?
Yes. I mean, again, I think it's the same commentary that I just shared with Dean in respect to overall first half, second half. The only thing I'll add to that because that was 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 on to this. If we look at utility, also our comparables there get measurably easier as we go through the second half due to the non renewal 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 wins. So we think we have really strong momentum, Dave, in utility versus underlying end markets. All three 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%. The Canada down over 20% is really due to that non renewal. So but that comparable gets measurably easier as we go through the second half of the year before.
If you go into CIG and this is really important and I don't think we made this point in our Q1 results, so which is why we wanted to amplify 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 common security in the first half. We're up very high single digits, close to a double digit rate, really nice results. And that 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, their execution. Then the final segment would be end market category would be construction. And we got our 2nd 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, the commercial construction piece of construction, the sales of the contractor 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 for commercial projects and construction. So if you kind of add that all up, it's the comments I made in response to Dean'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 Investor Day was we were trending towards below the 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 the prepared remarks, relative to what we thought, which was based on the 11th June at the time is the data that we had, we mis spiked 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 Q4 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 twenty eighteen, we did a plus 11. So the comparisons are getting easier. We've included that in how we think about our front half, back half split.
And from a 49, 51 split front half, back half revenue, that includes the SLS acquisition in the back half will 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 and contracts that we expect to continue and contracts that we have that will start generating revenue in the back half of the year.
Okay. Thanks for that. 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 in these 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's a little bit more downward pressure on gross margin than you previously expected?
So I Dave, you may want to add to this too. I would say that the mix piece, as you just outlined, which again Dave shared in his prepared comments, is clearly a factor. I think the other factor, let me expand on was and Haymont 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 2018, we shared that those increases in 2018 were more than the previous several years combined. So now 2019 first half is above 2018, which was you kind of at a very much elevated level.
The other thing we're hearing from our suppliers and 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 or the trigger in approximately 2 thirds 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' categories. So we're actually kind of caught in that same time lag, that we do experience, I think, maybe disproportionately at a higher level than others because of our percent of our business is global accounts, integrated supply, 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'd have contracting margins. 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 every 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 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 the 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.
All right. Thank you.
The next question comes from Sam Darkatsh with Raymond James. Please go ahead.
Good morning, John. Good morning, Dave. How are you?
Good
morning. 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 to start guiding in the call via a very question and answer, Sam. 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, tailwinds 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. 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 their 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 again, the spot market activity, we're factoring that in to how we're bidding effectively real time. But where we have the global account relationships as multiyear contracts or utility alliances, integrated supply contract, where we have construction projects that are already bid and there may be some dynamic there with what contract is trying 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 those of you that 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 will also be a function of what are all the headwinds, tailwinds in the pricing environment and where our 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 on all the efforts are focused on margin improvement initiatives and getting that sales top line, given 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, thank you, by the way, John. 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 $100,000,000 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 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. 2nd, 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 two factors, Sam, we would anticipate continued focus on managing our inventory level. And I would anticipate that our inventory levels would come down in the back half of the year because of those two 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 are 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 and new contracts that we won, ramp up of those new wins, but as well as kind of the walk in business. We're in real 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 they said, we had laid in some inventory originally to support 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'll be some downward trend there.
Thank you, both.
Thank you, Fin.
The next question comes from Robert Barry with Buckingham Research. Please go ahead. Hey, guys. Good morning.
Good morning.
I was curious to understand better what was going on with SG and A. Could you give or could you give a kind of same store basis SG and A number or performance? I guess you have some SLS SG and A in there.
Rob, that's correct. So our SG and A versus the prior year was up 1%. So when you take a look at it on a consolidated basis, we're up roughly $3,000,000 Couple of factors that drove that. The first is in the base period, we had that bad debt charge, but we didn't have that same level of bad debt expense in the current year. Obviously, SLS has a much higher SG and 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've reduced the accruals for our variable compensation.
Got it. Yes, that 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 and 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 one time events in the back half of last year, including a property sale that reduced our SG and 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 and 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 MYC, I mean big picture directionally given it sounds like you're expecting a lot of the growth improvement in back half in addition to comp come from utility and construction. Does this mix headwind probably get worse in the back half?
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?
Sure. So you've seen the numbers that we reported for the Q2. I would say that we're still executing against our $150,000,000 share repurchase. I think for Q3, you should expect about 43,000,000 shares outstanding on a diluted basis.
Okay. And for the year, maybe 40 $2,000,000
or
$43,000,000 Right now, I would anticipate the 4th quarter be similar to the Q3. So you're probably in that $43,500,000 to $44,000,000 diluted share count for the full year share count.
All right, great. Thanks a lot.
The next question comes from Steve Barger with KeyBanc Capital Markets. Please go ahead.
Good morning, guys. This is Ryan Mills on for Steve. Hey, Ryan.
Good morning.
Yes, I just want to focus in on the guide. Back half is implying more top line growth in 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 one time 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 as we had $28,000,000 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 twenty eighteen versus back half of twenty nineteen, 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. Thank you for that. 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 rates. But we're still comfortable that we are growing share. I mean, we obviously are looking at that very closely. We 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 that where what has occurred, the end market growth rates we're expecting, I mean, that they're materially lower in the second half. I mean, there is some that's the pressure that has kind of rippled through our outlook, etcetera. Now our performance versus them, I don't see that degrading. I see that kind of maintainingimprovement. 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 of how I think we're performing and what some of the headwinds were.
So and the wildcard is going to be, I think, again, as I answered in response to Dean's question and Dave Mancey's question, what did the end how did the end markets develop as we move through Q3 and Q4, principally around industrial and CapEx spending.
Thank you. 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're 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. Please go ahead.
Thanks guys. Good morning.
Good morning, Nigel.
Hey, Dave. Just wanted to sorry, John. It's been a long day, Long day already. Just wanted to go back
to the Okay, Nigel. No problem.
Can call me David if you want to as well.
So I wanted to go back
to the industrial momentum and you called out metals, called out petrochem and these are obviously CapEx focused projects. But then you referred to some of the projects getting sort of 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 the source of strength that we're 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 1? And then the second part would be, do you call that OEM weakness?
And so 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 it. And when Dave's comments are when he talked about what pieces of industrial were 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, directly with that global account end user customer, it would show up in those sales.
If we're selling through a big contractor or it's a large construction project through an EPC, it will 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 and 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 2 verticals that we had headwinds in, in Global Account. And one was OEM. And so you'll remember that we bought a business back in 2,005, Carlton, Bates and then we made a few other acquisitions along the way, RS Electronics, AA Electric. So we've got a terrific OEM business model and platform. And so that's selling value added assemblies, kitted parts and value added assemblies that get incorporated into our customers' product 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 Gains 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 center. And we did call out as a comparable challenging comparable in Q2 of last year, we had significant growth with those tech companies supporting 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's our overall backlog level. We're the 2nd 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 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 headwinds for capital spending or if some of the uncertainties are kind of resolved, does business spending become 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. Thanks, John. It really does. And I do have a quick follow on this time 4 days 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 DSO to get back to where they were year end 2018 by year end? And then on the inventory, you talked about some work down 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'd expect to see?
That's correct. So again, our key driver in 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.
Okay. Thank you very much.
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'll be participating in during the Q3. Thanks again.
Have a great day.
The conference has now concluded.