Good day, and welcome to the WESCO International second quarter 2018 earnings conference call and webcast. All participants will be in a listen-only mode. Should you need assistance, please signal a conference specialist by pressing the star key followed by zero. After today's presentation, there will be an opportunity to ask questions. To ask a question, you may press star followed by one on a touch-tone telephone. To withdraw your question, please press star, then two. Please note this event is being recorded. I would now like to turn the conference over to Will Ruthrauff. Please go ahead.
Thanks, Mia. Good morning, ladies and gentlemen. Thank you for joining us for WESCO International's conference call to review our second quarter financial results. 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. Therefore, actual results may differ materially from expectations. For additional information on WESCO International, please refer to the company's SEC filings, including the risk factors described therein. The following presentation includes a discussion of certain non-GAAP financial measures. Information required by Regulation G of the Exchange Act with respect to such non-GAAP financial measures can be obtained via WESCO's website at wesco.com. Means to access this conference call via webcast was disclosed in the press release and was posted on our corporate website.
Replays of this conference call will be archived and available for the next seven days. With that, I'll turn the call over to John Engel.
Thank you, Will, and welcome to WESCO. Good morning, everyone. Thank you for joining us today to discuss our second quarter results. I'll lead off with a few high-level remarks, then Dave will take you through the details of our second quarter. Q2 marked our fourth consecutive quarter of above-market sales growth and represented the highest quarterly revenue in our company's history. Our positive business momentum, which began in June of 2017, continued in the second quarter with organic sales up 9%. On a very positive note, the growth was again broad-based as all of our end markets and geographies delivered higher sales growth on both a year-over-year and sequential basis. Momentum was strong throughout the quarter as organic sales increased 11%, 10%, and 7% in April, May, and June, respectively. Sales in the U.S. and Canada each grew 8%, while international grew 30%.
Backlog increased sequentially and year-over-year as well and reached another record level for the company this quarter. On a two-year stack basis, Q2 monthly sales grew 9%, 10%, and 11% in April, May, and June, respectively, reflecting the continued positive momentum in our business. More importantly, for the second quarter in a row, operating profit and EPS both grew on a double-digit percentage basis versus prior year, reflecting the strong operating leverage of our business. The third quarter is also off to a strong start with preliminary sales growth in the mid-single-digits range in July or double digits on a two-year stack basis, and book-to-bill that has been tracking above 1.0 throughout the entire month.
Based on our second quarter results and our positive view of the end markets, we have increased our full-year sales outlook to reflect growth of 6%-9% and raised the low end of our diluted EPS outlook $0.10 to a range of $4.60-$5. We expect operating margin to be in the range of 4.2%-4.5% and strong free cash flow generation of more than 90% of net income. We're very pleased with our first-half results, and we remain laser-focused on executing our 2018 plan. It's a plan that includes continued above-market sales results, execution of our profitable growth initiatives, investments in our people and processes, and maintaining our consistent discipline on cash management or cost management and capital deployment. With that, I will now turn the call over to Dave to provide further details on our second quarter results and our updated outlook for 2018.
Dave?
Thank you, John, and good morning, everyone. Let's turn to our end markets beginning on page four. Industrial sales are up 6% organically, including 5% growth in the U.S. In local currency, sales are up 7% in Canada and 16% in our international markets. This represents our sixth consecutive quarter of year-over-year improvement. Momentum with industrial customers was again broad-based as several end markets posted double-digit growth, including technology, petrochemical, metals and mining, food and beverage, and aerospace. Our global accounts and integrated supply opportunity pipeline and our bidding activity levels remain healthy. WESCO is helping our industrial customers reduce costs, operate more efficiently, and better manage their projects through our extensive portfolio of supply chain solutions. During the quarter, we were awarded a multi-year contract to supply electrical MRO materials and support capital projects for a large food and beverage manufacturer in the U.S.
Turning to page five, we posted a fourth consecutive quarter of growth in construction with organic sales up 8%, including 8% growth in the U.S. and 9% in Canada in local currency. Sales growth was again broad-based across the U.S. and Canada with continued strong business momentum. Sales to both industrial and commercial contractors grew again this quarter. Backlog was up 10% year-over-year to a new record level and up 2% sequentially, providing a positive outlook for the second half of the year and 2019. With the current outlook for continued non-residential construction growth and demand for skilled trades, more of our customers are seeking productivity gains from their supply chain partners. WESCO is supporting customers with value-added services that provide job site efficiencies and help to deliver projects on time and under budget.
This quarter, we were awarded a contract to provide high voltage materials to a contractor for an upgrade to a wastewater treatment facility in the U.S. Moving to page six, our utility business had another very strong quarter as sales were up 19% over the prior year and 7% sequentially. Utility sales in the U.S. grew 22%, which was partially offset by a 2% decrease in Canada in local currency. Again, this quarter, we gained market share by expanding our relationships with investor-owned utility, public power, and utility contractor customers. Over the past six years, we have established a track record of success by expanding our scope of products and services while creating value for our utility customers. We are well positioned to benefit from secular trends in the utility sector, including continued construction market growth, higher industrial output, continued consolidation, and the increasing demand for renewable energy.
As an example of the expanded scope of our service offerings, this quarter, we were awarded a multi-year contract to provide material management logistics services for an existing investor-owned utility customer in support of an infrastructure improvement project. Finally, turning to commercial, institutional, and government or CIG on page seven. We delivered 9% organic growth in the quarter, with Canada up 14% in local currency along with strong growth in international. Our technical expertise and supply chain solutions continue to drive growth with our technology customers who rely on WESCO for their data center, broadband, and cloud technology projects. We are continuing to add value to our customers through our LED lighting renovation and retrofit applications, fiber to the x deployments, broadband build-outs, and cyber and physical security infrastructure solutions.
As an example, this quarter, we were awarded a contract to provide outside plant materials in support of a fiber to the home network build-out for an electric cooperative. Moving to page eight, our outlook for the second quarter sales growth was between 7% and 10%. Actual reported sales for the quarter came in at the top end of our range. As with the prior quarter, and as John mentioned earlier, this growth was broad-based with all end markets and geographies posting year-over-year and sequential revenue increases. This included 8% organic growth in the U.S. and in Canada and 30% in international. Pricing again provided a favorable impact of 2%. Gross margin was 19.0% in the second quarter, down approximately 20 basis points versus the prior year and fewer than 10 basis points sequentially. The decline in gross margin from the prior year was due to two factors.
First, business mix reflecting an increase in the proportion of sales from traditionally lower gross margin international and utility businesses. Second, as mentioned last quarter, to align with the company's cost recognition policies, we reclassified labor costs associated with certain of our integrated supply services from operating expense to cost of sales. We will continue this classification in future quarters. On a combined basis, these factors reduced gross margin by approximately 30 basis points. Adjusting for these two factors, gross margin improved 10 basis points versus prior year. Margins have stabilized over the past five quarters as we continue to execute our margin improvement initiatives while pushing supplier price increases through to our customers. SG&A expenses represented 13.9% of sales, 10 basis points lower than the prior year.
The benefit of operating leverage from higher sales was partially offset by an increase of approximately $8 million for the planned restoration of variable compensation and an unanticipated bad debt charge of $2.5 million related to a long-term Canadian customer. We were informed in July that this customer was placed into receivership by their lender, resulting in the customer ceasing operations. Operating margin was 4.3% at the midpoint of our outlook range of 4.2%-4.5%. This result was in line with the prior year and 60 basis points higher than the first quarter. Excluding the just mentioned bad debt charge, operating margins would have been 4.5%, which is at the top end of our guidance range. Similar to Q1, our reported results reflect favorable operating leverage for the second quarter, which was reduced by the planned cost of restoring variable compensation compared to the prior year.
Adjusting the base period for this expense and the bad debt charge, we achieved a pull-through of incremental gross profit to EBIT of over 50%. The effective tax rate for the quarter was 21.5%, approximately 50 basis points higher than our outlook as we recorded a valuation allowance against certain deferred tax assets for one of our South American entities. The tax rate was 3.8 percentage points lower than the prior year due to the impact of the Tax Cuts and Jobs Act of 2017. Moving to the diluted EPS walk on page nine. We reported diluted earnings per share of $1.22, an increase of $0.20 or 20% versus the prior year. This increase reflects favorable operating results, a lower tax rate, the benefit of our share repurchase program, and a net favorable foreign exchange rate.
Turning to page 10, year-to-date free cash flow was $70 million, up 24% versus prior year or approximately 70% of net income. This is a bit below our target as higher sales drove increased accounts receivable. Year to date, net working capital increased under 4% in support of reported sales growth of 11%, reflecting the positive impact of asset management initiatives. Our debt leverage ratio is 3.3 times trailing 12 months EBITDA and is back within our target leverage range. Leveraged net of cash was 3.0 times EBITDA. As outlined in the appendix to the webcast deck, financial leverage includes the impact of adopting the recent accounting standard for net periodic benefit costs. This had a relatively minor impact over the trailing 12 months on leverage. We maintained strong liquidity, defined as available cash plus committed borrowing capacity of $772 million at the end of the quarter.
Interest and other expense was $18 million in the quarter, including the accelerated amortization of certain debt discount and issuance costs of approximately $800,000 associated with repayments of our term loan. Our weighted average borrowing rate was 4.5% for the quarter, consistent with historical averages. We believe our debt is appropriately balanced between fixed rate and variable rate instruments. 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 cash in organic growth initiatives and accretive acquisitions to strengthen and profitably grow our business. Second, we target a financial leverage ratio of between two and 3.5 times EBITDA. Third, we return cash to shareholders through share repurchase under our three-year, $300 million share buyback authorization.
We said previously that we intend to purchase stock under our buyback authorization to offset dilution from equity grants. We expect to do so later this year, the timing of which is subject to market conditions. We continue to evaluate options to repatriate cash held in foreign jurisdictions. We expect that our use of any repatriated cash will be consistent with our existing capital allocation priorities. Now let's turn to our outlook for the third quarter and full year 2018 on slide 11. For the third quarter, we are projecting sales growth to be in the range of 3%-6% and an operating margin of 4.5%-4.8%. As we have previously discussed, third quarter EBIT comparison will not be unfavorably impacted by lower variable compensation expense in the base period. We are expecting an effective tax rate of approximately 21% in the quarter.
We are increasing our sales growth outlook in the midpoint of our diluted EPS guidance range. We now expect sales growth in the range of 6%-9% and diluted EPS in the range of $4.60-$5, excluding any share repurchase activity. We are adjusting the midpoint of our operating margin outlook five basis points to reflect the bad debt charge that I discussed a moment ago and now expect operating margin to be 4.2%-4.5%, and we continue to expect an effective tax rate of between 21% and 23%. Note that certain impacts resulting from the Tax Cuts and Jobs Act remain subject to further guidance from the IRS. Discrete items, including adjustments to the provisional estimates booked in 2017 to comply with the TCJA, could ultimately cause our effective tax rate to differ from this expectation.
We are also reaffirming our expectation of generating free cash flow of more than 90% of net income. John would like to make a few additional comments before we open the call to questions. John.
Thanks, Dave. I'd like to share with you two strong additions to our WESCO team. In June, we were pleased to welcome a new member to our senior management team. Chris Wolf joined WESCO as Senior Vice President and Chief Human Resources Officer. I've always said that people are the foundation of our success and our source of our competitive advantage. I'm confident that Chris will do an outstanding job overseeing our critical human resources and talent management functions for the company. In addition, we're pleased to announce that Esh Sundaram has been elected to the WESCO Board of Directors, effective August 15th. Esh has extensive experience in digital tools and applications, cybersecurity, and global supply chain management. He is currently Executive Vice President and Chief Digital and Technology Officer at JetBlue Airways and previously held senior leadership roles at Pall Corporation and McKesson as well.
We're delighted to welcome Esh to our board. With that, we will now open it up for questions.
We will now begin the question and answer session. To ask a question, you may press star then one on your touchtone phone. If you're using a speakerphone, please pick up your handset before pressing the keys. If any time your question has been addressed and you would like to withdraw your question, please press star then two.
In the interest of time, please limit yourself to one question. At this time, we will pause momentarily to assemble our roster. The first question is from Deane Dray with RBC Capital Markets. Please go ahead.
Thank you. Good morning, everyone.
Morning, Deane.
Hey, can we start with price costs? Since that is such a headwind for industrial companies and especially distributors, you all tend to like periods of inflation. 2% increase in price in the quarter, you called that out. Where do you stand so far year-to-date in expectations? Last quarter, you said you were raising prices dollar-for-dollar, that still gets you some margin pressure. An update there for starters would be helpful.
Yeah, Deane, maybe I'll start out. Great question. I'll start out with the context of the environment. When you look at the price increases that our supplier base attempted to push through to the market directly and through the channel in the second quarter, if I were to compare that to historical seasonality, Q2s in prior years and where, let's call it this phase of the cycle, they were greater. They were greater in number, and more in line with what we typically see in Q1, quite frankly. The pace and volume and kind of range of supplier price increases in Q2 are consistent with Q1, and normally Q1 is the busiest quarter of the year for price increases. That's the first point I'd make.
I think that as Dave outlined on a year-over-year basis and sequential basis, I think we're seeing the traction of our margin improvement initiatives. If we pass the price increases through one-for-one, just based on strict math, we'd actually have some margin compression. I actually feel really good about the progress we're making with our margin improvement initiatives. I think coming out of the first half, in retrospect, we faced a larger number and greater supplier price increases than we thought we would have. Margins remained stable. On a sequential basis, we didn't get any step-down in margins from Q1 to Q2. Now I think we're well-poised. We're first seeing the traction of our margin improvement initiatives, and I think we're well-poised to see margin improvement sequentially as we execute in the second half of the year.
That is our intent, which is explicitly built into our outlook for the Q3 and the full year.
Let's just stay with margins. The expectation has been that pull-through would show a meaningful uptick in the second half, and you've been moving in that direction. I think Dave was helpful in giving us that adjusted pull-through, which gets you to that 50%. Just frame for us the expectation second half on pull-through.
Yeah, the answer is absolutely yes. That's explicitly in our outlook. Look, I'll take you back to last year. We didn't return to growth until the month of June, and we didn't return to growth in a quarter until Q2. It was a two-speed year. We pulled a lot of cost levers in the first half. Variable compensation was a significant lever in actions that we took in the first half. Those got reset as we started to experience the return to growth in the second half, posting very strong organic growth numbers, we think outperforming the market measurably in Q3 and four.
When we gave our outlook for 2018, we clearly provided a profile of the year that said we'd have stronger top-line growth in the first half, but that we would have, on a reported basis, the pull-through would be a bit challenged because we're lapping the comparable period of the first half last year, where we didn't have the variable compensation. That's to the tune of $8 million per quarter or $16 million in the first half. We've now lapped that. By the way, on an adjusted basis, adjusting for that, we're at the 50%-plus pull-through in the first half. Our long-term growth algorithm and profit growth algorithm is intact in the first half. In the second half, we don't have that comparison, and that's explicitly built into our outlook, Deane. Thank you for that question.
Yep, that's real helpful. Thank you.
The next question is on the line with Ryan Merkel with William Blair. Please go ahead.
Hey, thanks. Good morning, everyone.
Morning, Ryan.
I want to ask about organic growth. The slowdown in June and July is a little surprising to me. Is there anything, John, that you can call out, either in terms of end markets or geographies?
Thanks, Ryan. I don't see it as a slowdown. I think we've posted very strong results in Q3 of last year, Q4 of last year, Q1 of this year, and now Q2 of this year. Our view is now that's four quarters in a row, we think we've significantly outperformed the market. Our framework for the year, we've taken up our sales guide twice. We had an outlook that we gave in December. After Q1 earnings, we took up our full-year sales guide. After Q2, we've just taken it up again, and it's based upon two factors. One is the markets have strengthened a bit. We thought they'd be stronger, but they're a bit stronger. But more importantly, it's our outperformance. We had a construct of, in terms of market outperformance of 1%, 1%-2%.
Now we've taken it to 2%-3%, that's what supports our new full-year outlook on the top line. I don't see it as a slowing at all. In fact, I feel really good about coming out of the first half and entering the second. The markets we thought would improve, they have. Our strength of execution, we were highly confident in, given our return to growth in the second half last year, we built upon that in the first half. As I shift to the second half, our comparables become significantly more challenging. When you look at June on a two-year stack basis, it actually shows higher, greater sales growth than April or May. July, we have preliminary sales because we haven't fully closed the month yet.
On a year-over-year basis, it's mid-single digits growth. On a two-year stack basis, it's low double digits, it's stronger than June. We are building very nice momentum, I feel very strongly the way to look at this is on a two-year stack basis. Even these posted numbers, I think in an absolute sense, just on a year-over-year basis, are very strong. Look at the balance. We're growing across all end markets. We're growing across all product categories. I will make that comment. That's not included in the webcast. We're growing across all geographies. Furthermore, we have set a new all-time record in backlog, we have done that four quarters in a row now. We've set a new successive all-time record in backlog, that's a good indication of our project business, principally into the construction and contractor market.
Look, honestly, I couldn't be more pleased with how our team is performing and executing. We're taking advantage of a little improving market, but I feel very good about our execution of our top line and growth initiatives, and I think we're very well-positioned, as I mentioned to Deane earlier, to realize on a reported basis, the pull-through in the second half. On an adjusted basis, we've demonstrated that it's there in the first half.
I think I hear you. It's more the end markets are fine. You're not noting a slowdown. It's more just the comparisons are starting to get more difficult. The view is, look at the two-year stack. Things are still pretty firm.
Absolutely. My view of the end markets was positive entering the year. They turned out a little bit stronger than I thought, our execution is the real delta here. I think we've built a strong execution momentum, taking share second half last year. We've built on that into the first half, my view remains the same, Ryan. As I've spoken at EPG and various conferences in the year, I've shared this view. Now that the first half is behind us, my outlook for the second half is very positive in terms of the markets and our execution vector.
Okay. That's helpful. My second question, I know that guidance implies that EBIT margins are going to be a lot stronger in the second half, I wanted to ask about gross margins because, as you know, investors are focused on that for distribution companies. Is the message that we should expect stable gross margins in the second half, kind of at this 19% level that you reported this quarter?
You see what our Q3 outlook is, and obviously, you see where our full-year outlook is. It's math. Our operating margins are going to be stronger in the second half. That's clearly what we're saying. If you look at our typical front-half, back-half weighting, that's consistent with historical seasonality. That's the first point. The second point is I've got very good confidence that we're getting traction from our margin improvement initiatives. As I mentioned to Deane's question earlier, we got hit with many more price increases than we would have expected in Q2. The fact that we were successful in pushing those through, if we had not been, our margins would have degraded significantly Q1 to Q2 sequentially. I think we're on top of the wave right now.
We don't guide in terms of the recipe of gross margin versus operating costs. We do expect good operating cost leverage, and we expect to build off the traction of our margin improvement initiatives and begin to see an improvement in gross margins as we move forward.
That's helpful. Thank you.
Yep.
Next question is from the line of Sam Darkatsh with Raymond James. Please go ahead.
Good morning, John. Good morning, Dave. How are you?
Morning, Sam.
Sam.
Two questions, if I might. First off, inventories are a source of cash both in Q1 and Q2, which you normally wouldn't see, obviously, when you're growing like this. I'm trying to understand why that might be. Are vendor lead times extending, or did you load up on inventory at the end of last year to maximize on volume rebates or the pre-buy ahead of price increases? I'm just trying to understand why it's a source of cash.
The answer on both questions is no and no. What is driving it? It's a great question, insightful. We're getting traction on our operations and supply chain initiatives that are focused on both inventory, principally inventories. It's strong operating execution out of our business and operations teams on just improving our asset velocity. Quality of inventory is very strong. I think I've spoken about this over the years, that we're very focused on two major variables or metrics, let's call it, inventory availability and inventory accuracy or fill rates to our customers. Those metrics are in great shape. It's really the direct result of a focused set of initiatives
To improve the management of our inventory and our asset velocity. I think that we previously had identified, we've never talked about it externally, but I will tell you, we identified that we thought we had some cash opportunity that was held up in inventory. We have been focused on the other levers of the P&L, but this is an area that we did put into our operating plan, and I'm very pleased with the execution we're getting. The answer was no, and the short answer of the driver is self-help. It's our own initiative.
Just a clarification question, John. You mentioned that you're passing through greater than expected price pressures here in the second quarter, but the reported price was up 2%, which was the same as the first quarter off of the similar comparison year ago. Where would we see that externally? Would it show up in the third quarter pricing? How would that reflect itself on what you're going to report on a price basis?
My statement on price wasn't that measure. It's just in terms of the number of price increases and the size of those that we saw in Q2 versus Q1. Typically, Sam, this was not a normal second quarter. I'll expand upon this a bit. Part of it is I think that the tariffs, and it's not so much the tariffs are having a direct effect. They have a direct effect on certain commodities. Look, we understand that. Our suppliers do. Customers understand that, and we're working those through. It creates the opportunity also for suppliers as well as us to work additional price increases through the channel. Mine was more of a qualitative comment, Sam.
You think that pricing is going to be up more than 2% or so back half?
I'm not going to forecast pricing, but I wanted to give you a sense of kind of just what the momentum vector was like throughout the second quarter versus normal seasonality.
Got it. Thank you very much. Very helpful.
Yeah.
Next question is on the line of Christopher Glynn with Oppenheimer. Please go ahead.
Yeah, thanks. Good morning, guys.
Morning.
Just looking at what seems to be a little peculiar in the guidance. If we take the high end for revenue of the third quarter and the full year, the fourth quarter growth actually accelerates a bit from the third quarter versus tougher comps. Just curious what the thought is there.
Christopher, it's Dave Schulz. Again, as we take a look at the momentum that we're seeing across our end markets and with the execution of some of our initiatives to drive above-market performance on sales. Again, we're confident that we're going to continue to see broad-based growth across the back half of the year. Again, as you take a look at the midpoint for the guide that we put out for the third quarter, again, it's roughly in that 4.5% range. If you back into that, it would expect that we would see similar growth rates at the high end of our full year in the fourth quarter. Again, it's based on what we're seeing in our backlog and in the end markets that we serve.
Okay, a question on the international. You just put up 30% organic against a 27% comp last year. Just wanted to revisit what's going on there. How long in the making this unprecedented penetration trend? Does it suggest to you any different options about how you think about ROW strategically?
Yeah. Great question. First, let me level set by saying, you'll all recall that when we gave our original guidance/outlook for the year in December, in our December outlook call, that we had international at flat. We thought international actually was going to be flat in 2018 over 2017. Obviously, we had a very strong Q1 because it's in the record books, and a very strong Q2 that significantly outperformed our expectations. What happened was, as we went through the balance of December into the first quarter, we got very good traction on a number of our growth initiatives and a series of select global accounts and integrated supply customers. As well as some capital projects globally, stepped up significantly.
The backlog for international really grew substantially as we moved through the first quarter into the second, and in the middle of the second quarter, it reached a very all-time high versus history. We've begun to eat into that backlog through the balance of the second quarter entering the third. That's a little bit of the dynamic. In terms of where we're seeing it, global data center activity remains strong, and I think you may see that from others' reported results. Oil and gas downstream activity is increasing globally. Mining was now beginning to, we haven't really seen this kick in a major way yet coming off a market cycle bottom. There is increased quoting activity, significant increased quoting activity, and that's more of a 6-12 month cycle for new projects. That's a potential driver for 2019.
There's a bit of the dynamics. Strategically, we've constrained our growth outside of U.S., Canada, Mexico, we have a support our national account, global account customers, integrated supply customers globally, we'll follow that growth.
We make money internationally. We've always made money internationally, we do believe where we have the greatest scale and synergies is in U.S., Canada, Mexico as the three primary geographies. Any incremental growth there that we get, we're able to leverage our synergies, our infrastructure, and get better pull-through, quite frankly. That strategy has not changed. We just enjoyed some really strong results, good execution by the team, and it's driven by a number of global accounts, integrated supply customers, and capital projects. As we move to the second half, as Dave alluded to in his commentary, we don't see international growing at the same rate, as supportive of our new full-year guide, we have international on a full-year basis growing low single digits as a market. Hopefully that's helpful.
Yep. Thank you.
Next question is from the line of David Manthey with Baird. Please go ahead.
Hey, guys. Good morning.
Morning, Dave.
First off, Dave, I'm wondering, is there anything unusual about the fourth quarter a year ago or this year that would drive a higher level of incrementals? I guess as it relates to the fourth quarter of this year, should we anticipate anything unusual in terms of a spike up in gross margin or spike down in OpEx that's out of the ordinary?
There was nothing out of the ordinary. Again, if you go back to some of the comments we've been making since our outlook call, the big issue we've got in the front half is the variable compensation. That comparison goes away as we paid out the amounts in the second half of 2017. There's nothing unusual there. I think the one thing that I will highlight is that, again, we talked a little bit about some of our margin initiatives. As we take a look at our internal initiatives, the supplier price increases, we continue to see expansion of our billing margins across sequentially 60% of our businesses. About two-thirds of our business is still growing that billing margin sequentially. We made a comment about that during our first quarter earnings call.
We're seeing the same amount of momentum from those initiatives and from the supplier pass-through on prices. Again, as we think about the back half, we're taking a look at it overall on an EBIT margin expansion. There's nothing unique or out of the ordinary that occurred in the fourth quarter of 2017.
Okay. Thank you. John, when you've referred to backlog trends historically, you've mentioned that there's typical seasonal declines in the third and fourth quarters. Could you talk about what a normal sequential backlog trend would look like from fourth quarter to first quarter, and then from first into second?
Thank you, Dave, for that. We broke the normal pattern last year, and it's very striking. I've been at WESCO more than just a couple of years now. It was very striking in terms of how we moved through the second half. We normally eat in the backlog throughout the third quarter sequentially and significantly in the fourth quarter. Most notably, the backlog really comes down as we move through the second part of the fourth quarter and close out December. That's normal seasonality. We did not see that in Q3 and Q4 last year. We didn't see it in the second half. I've been calling that out and spiking that out because of how notable that really is versus just our normal seasonality. I would say it's a combination of the markets improving, it's also a reflection of our growth initiatives.
As our growth initiatives get traction, some of it turns into immediate sales, but it is also being reflected in the backlog growth. As we came into 2018, backlog continued to step up in January, February. Q1 kind of stepped up a bit, and now Q2 stepped up further. We normally do have some backlog build in a normal year throughout the first quarter and second quarter. We did not have a strong backlog build in 2015 or 2016 when we faced the industrial downturn. You would have to go back to 2014 where we had that more normal backlog build in the first half. As we go through the second half, a normal seasonality as we begin to eat into our backlog across Q3 and four, as I have outlined. I am not going to forecast backlog.
Now we do have, and we are not fully closed with the month, we do have one month under our belt with July, and we have book-to-bill rates above one throughout the entire month of July, which is an encouraging sign. It is one month of the third quarter. It is the first month of the third quarter. I think the vector is positive, Dave, we have been breaking historical patterns by and large in terms of how it has performed in the last four quarters in terms of direction and also magnitude.
All right. Thanks for the detail, John.
Yeah.
Next question is from the line of Nigel Coe with Wolfe Research. Please go ahead.
Thanks. Good morning, guys.
Good morning.
I'm going to probably retread a lot of the ground covered already here. Just going back to July, you've answered that question very well, I think, John. Thinking about the businesses, the business mix, I was a little bit surprised that industrial decelled down to roughly 5% in 2Q. I'm just wondering how that's tracking into July. Would you call out industrial as an area where you're seeing slowing trends as opposed to just tougher comps?
No. Absolutely no slowing trends in industrial. We're not seeing that. We're not seeing it. I'll expand on my comments earlier. Bid activity levels are very strong. There are discussions with customers are positive in terms of where their backlog of business is. They have very strong backlogs. Their outlook for growth is in the mid-single digit range. These are our customers in the second half. This is, again, for industrial. It's absolutely our comparables. On a two-year stack basis, you can see industrial is holding up very strongly. That's the real important point. Look, this is an important point. I think from my perspective, we're about six quarters in an industrial upcycle. I know not everyone shares that view. It's clearly reflected in WESCO's numbers. I think that's indicative of the market as well.
Our short cycle indicators are very strong and have remained strong throughout these last six quarters and through July. The long cycle and CapEx sentiment is very strong as well. I'll make this comment. One of the drivers now is labor supply has really become tight. I don't think that's a negative thing. It's for those companies that can provide productivity solutions for customers like WESCO, I think it's going to spur investment in productivity projects. There's clearly a need to address aged manufacturing assets, and as we move through time, IoT applications. I remain very bullish on industrial. If you double-click and go underneath industrial inside the second quarter, we have broad-based growth, again, as we've outlined. We're up double digits in a whole series of verticals.
Double digits in the quarter in a whole series of verticals, and Dave called out a number of those. No slowing at the market, and our execution, I feel very good about.
Great. That's very clear, John. Thanks for the color. Then I just want to kind of attack the price cost question from a slightly different angle. I should know this, but how much of the 2% pricing that you reported, both this quarter and last quarter, would you describe as copper pass-through pricing? Some of your competitors do have copper pass-through pricing. How much of that is copper pass-through? What I'm trying to get at here, John, is how much of that do you capture with lower copper prices as we go into the back half of the year? Then maybe just touch on as well the Section 301 tariffs and the degree to which WESCO is impacted by those proposed tariffs.
I'll make a comment. I know Dave may want to expand as well. I think many years ago, we had taken the investor community through our portfolio of end markets, product categories, and then for product categories, what our exposure is to various commodities like copper, steel, PVC, and such. Remember that we have very little direct exposure to residential. We have a second derivative driver for our utility business. Over the years, we've focused on diversifying our product categories. It's part of wire, cable, and conduit, but wire and cable and conduit includes aluminum wire, copper wire, all types of conduit, et cetera. We've said it's roughly 5% of the portfolio. It's a small percentage. It doesn't swing us, Nigel. It really doesn't. I think we have a smart way with how we manage that.
There's been no change in that over the years. We're very focused on maintaining appropriate margin levels. I won't go into detail. I've taken investors through this in the past, suffice to say, certain of our competitors will play that commodity game, and they'll chase sales dollars at much lower margin rates. For WESCO, and this is what we've ingrained in our sales force, that spot market business, we don't want it. We don't want it. We think of that where we're selling wire and cable, and we're adding value-added services, it's part of a broader customer relationship. That's something we've worked on for over a decade, quite frankly. We could always unleash greater sales growth if we change the strategy or philosophy for how we manage true commodity wire products. We've never done that. It's not our strategy.
We're not going to do that. In terms of tariffs, I won't comment specifically on any tariffs except to say that as they hit our suppliers directly, we're having those discussions. We work in conjunction with them to try to pass them through to customers. I will make a comment. I don't know if it is your question, I'll use it to make a comment. I know there's been a few that have asked the question, is it going to have any impact on our Canadian business? You can see from our Canadian results and the strong backlog growth as well, we've seen zero impact in terms of, I'll say, cross-border flows or impact in terms of our Canadian business. We feel Again, this is another very strong quarter that we posted in Canada. Remember, Canada returned to growth ahead of the U.S.
We returned to growth a couple of quarters ahead of the U.S. back in early 2017.
Dave, I'll just address, provide a bit more color on your question about the commodity. Wire cable conduit for us, roughly 15% of our sales. We have a process where we're constantly getting feedback on the commodity costs, then we're passing that through to our customers. Obviously, we do have some near-term contracts for which we are not able to fully pass through the commodity impact, generally, we have a good success record of passing through that wire cable commodity markup. Yeah, that's how we approach it, and we've been successful thus far. Thanks.
Next question is from the line of Hamza Mazari with Macquarie. Please go ahead.
Hi, this is Kavon Rabar. I'm filling in for Hamza Mazari. Can you comment on your M&A pipeline, specifically which segments or regions are seeing a more robust deal pipeline and where your focus is?
So-
Robust
We're very robust pipeline. We continue to manage our M&A process. It's a phase-gated process, so we've got a number of very attractive opportunities in our pipeline that we're working. Our M&A strategy is unchanged in terms of priorities. I'll reiterate that we did take a bit of a pause in Canada over the last couple of years, because we wanted to digest and integrate and leverage the acquisitions we did. I'll remind all of you that we never did our first acquisition in Canada till December of 2010, when we acquired TVC. Then we acquired five other companies since then. We feel terrific about our Canadian market position, the strength of that business, and the execution. So our focus shifted to the U.S. We're not looking at acquiring anything outside of North America principally for that purpose.
Sometimes when we acquire a competitor, they may have operations in addition to the U.S. and Canada or outside of North America. If we get that benefit, we do, and that's fine, like we did with EECOL. I would say the focus is still strengthening core electrical and adding selective product categories that we can take to our market, to our customers, through our business models, global accounts, integrated supply, and the like, and supplement them by wrapping our broad array of supply chain solutions around them.
Thanks for that. It's helpful. One follow-up and one kind of sort of related is, could you comment on the utility business in Canada? It was down 2% in local currency. Based on some of the comments you made earlier about Canada, could you maybe-
Yeah
put some color on that?
Yeah. First of all, in terms of our overall utility business and value proposition, we think we have an industry-leading value proposition. We've grown our utility business six years in a row. It's very strong growth. I would say this quarter is another quarter of, I would call it, significant outsized growth overall, principally driven by the U.S., growing over 20%. Again, just really strong growth numbers. Canada was down a couple of points. No concern by us there. We've got solid backlog. It was really just some year-over-year timing issues. Zero concern. Again, we think we've got an industry-leading value prop.
The next question is from the line of Steve Barger with KeyBanc Capital Markets.
Good morning, guys. This is Ryan on for Steve.
Hey, Ryan.
Just going back to the sales guidance. I didn't see an update on expectations for drivers of that. I was wondering if you could provide both by segment, total market growth, market outperformance, and FX impacts expectations.
Look, I'll remind everyone, after our outlook call for 2018 that we did in December, we've taken our guidance or outlook up twice. Actually three times, technically. When we announced our fourth quarter results, we adjusted our EPS range up, and that was to reflect the tax reform. When we announced our Q1 results, we took up both sales and EPS. Here's the second quarter in a row where we've taken up sales again in Q2 and EPS again. We've actually taken up the EPS outlook range three times since our December call, one time to reflect tax reform, two times to reflect strong operational performance, as well as top-line growth that is significantly exceeding the market, we think. Our framework for the market growth, we updated last quarter when we took the guide up.
Remember, our original sales growth guide for the year was 3%-6%. At the end of Q1, we took it to 5%-8%. I'll give you the pieces. U.S., we originally framed it low single-digits to mid-single-digit growth. We took it to mid-single-digit growth. Canada was flat to low single-digit growth. We took it to low single-digit to mid-single-digit growth. International, we had originally assumed flat back in our outlook call. We took it to low single-digit growth. Those remain unchanged now for Q2, for us raising the full year from 5% to 6%-9%. I'll come back to what the delta is. By end market, we originally thought industrial would be low single-digits to mid-single-digits. Last quarter, when we took up our full-year outlook, it's now mid-single-digits.
It remains unchanged as a supporting for this raise. Construction was flat to mid-single-digit growth. Now it's mid-single-digit growth. Same thing. Utility was flat to low single-digit growth. Now it's low single-digit growth to mid-single-digit growth. CIG was unchanged throughout. With all forecast pricing. I'll comment on FX last. Where we've seen the meaningful change is our market outperformance. We're now saying that what's built into our 6%-9% is 2-3 points of market outperformance as opposed to approximately 1 or 1-2. That's a significant change. That's the only change that we're making in support of this full-year raise as a result of Q2 results. In terms of exchange rate, we had a slight tailwind in the first half.
You know we don't forecast exchange rate, but we do provide our assumption of what it is as we move quarter-to-quarter. We actually see that turning to a slight headwind in the second half. We probably didn't amplify this point enough. We're going from a slight tailwind in the first half to a slight headwind in the second half. Even with that, we still raised our full-year sales guide and our EPS guide. Hopefully that's helpful.
Yep. Going to free cash flow. Year-to-date, it's about 70% of net income. John, it sounds like the momentum bets are still strong. I'm thinking that might lead to some more working capital investments. On the other hand, with improved inventory management system, sounds like you might be able to bleed inventories out a little bit for a source of cash. Just hoping maybe you could give the puts and takes on achieving 90% net income for free cash.
Look, if you look at where we are through the first half and compare it to the first half of last year, we grew our free cash flow 24%, right? In terms of converting net income to free cash, we're in very good shape. Last year, what did we face? We faced a second half where we went from flat sales to double-digit organic roughly, rounding, for the second half. We still delivered our strong cash flow. We've got great confidence in that. I would say that's a bedrock. That's a bedrock of our business model. Really, the full growth year-over-year is AR, as Dave mentioned. That's a high-quality asset, right? Our customer AR. Great confidence in that number.
Thanks for the time, guys.
Yep.
In the interest of time, we take one more question from Steven Winoker with UBS. Please go ahead.
Thanks very much for fitting me in. Good morning. Just on the 9% growth in the quarter, any way you could break that out between the half of the business that's sort of capital project oriented and the half that is MRO OE, if you just cut across all the verticals?
I don't want to wing that. I think that's something we would need to go back and do the analytic on that. It's not how we've been casting it. We'll take that under advisement and be thoughtful of that going forward. Very good question, though.
Fair enough. Can you give us an idea of visibility into pricing in the backlog? Given the book-to-bill that you've been talking about.
Yeah, I will make this comment. Our margins in our backlog have stepped up.
And-
The momentum vector on those. I'll make this comment. As we've been growing the backlog through the first half, the margin rate of our backlog at this point, coming out of June, is at a higher rate than it was entering the year.
Okay. That's helpful. One more. Just on all the initiatives around integrated supply solution offerings, value-added services. John, as you sort of think about not just exiting the year and what kind of help you're getting from those, I know it's probably hard to exactly parse them out on margin. In terms of what it takes to break 5% in the future, how do you see the success of those initiatives helping you get there, and I should use the word how quickly?
I think it's a great question. That's probably the type of question that's best developed in an investor day for us to really lay out how that works. We have a wide array of business models. That's true across WESCO. It's also true in terms of our integrated supply implementations. Where we're really delivering strong value and we've wrapped services around it, that's highly EBIT accretive and EBIT margin accretive. I'll just leave it at that. For our most sophisticated relationships where we're really adding value and we've got a high service component in the relationship. I see it as being very supportive. As we grow with the multi-location customers and implement our global accounts integrated supply business models, that's supportive of our margin expansion goals, and it supports our long-term investment thesis on the pull-through.
All right, great. Look forward to more detail later. Thank you.
Yep. Thank you, everyone. I'll make two comments. There's one specific comment I have prepared, two comments that didn't come out in the call, so I'd like to get that out there. Speaking to two categories, on communications and security, we didn't get a lot of questions. We did have some good questions on utility, and I shared how strong our results were. We also had a very strong set of results for communications and security as a category. We grew double digits, and that included growth with broadband data comm, broadband communications, data communications, as well as security. Really solid. I said all product categories grew. Secondly, lighting. I'm surprised I didn't get any questions about lighting, we actually had a very strong quarter. We grew high single digits in lighting. Again, we're seeing the benefit of our retrofit and renovation solutions.
Now, to the extent construction continues to kick in and projects, that'll just be kind of a double driver of growth. We feel very good about our lighting solutions and again, up high single digits, so you can calibrate that versus others. We think we're taking share there. Let me shift to my final comment, and one is noteworthy. I do thank you for your time this morning. Before we conclude, I wanted to highlight that we're going to discontinue the practice of hosting a full outlook call in December for our next fiscal year. For this fall and into next year, here's our plan. We're going to provide you with an outlook for our end markets during our third quarter earnings call in November. Then we will provide our full year 2019 outlook when we report our fourth quarter and 2018 earnings next January.
Thank you for your time this morning. Brian Begg, our Treasurer and IR leader, and Will, who was introduced at the beginning of this call, will be available to take your questions. Thank you for your time today. We appreciate your support, and we look forward to seeing you at one of our investor marketing events that we have upcoming in the third quarter, including the RBC Global Industrials Conference in September. Have a great day.
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