Anixter International Inc (AXE) Q2 2021 Earnings Call Transcript

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Anixter International Inc (AXE)
Q2 2021 Earnings Call
Aug 5, 2021, 10:00 a.m. ET

Contents:

• Prepared Remarks
• Questions and Answers
• Call Participants

Prepared Remarks:

Operator

Good morning and welcome to the WESCO, Second Quarter 2021 Earnings Conference Call. [Operator Instructions]

I would now like to turn the conference over to Leslie Hunziker, the Senior Vice President of Investor Relations, please go ahead.

Leslie Hunziker -- Senior Vice President of Investor Relations

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

Today we'll use certain non-GAAP financial measures. Required information about these non-GAAP measures is available on our webcast slides and in our press release, both of which are posted on our website at WESCO.com. On the call this morning we have John Engel, our CEO, and Dave Schulz, WESCO's Chief Financial Officer. Now I'll turn the call over to John.

John Engel -- Chairman, President & CEO

Thank you Leslie, and good morning everyone. We had an exceptional quarter and delivered outstanding results across the board. In just one year after closing the transformational combination of WESCO and Anixter, the substantial value creation of the new WESCO is clear and powerful. We're capitalizing on our scale and industry-leading positions, we're generating significant integration synergies, at a pace exceeding our initial expectations, as a result, our margin performance in backlog, a record for the company and we're delevering our balance sheet at a rapid rate. Most importantly, we are only in the early stages of unlocking the power and performance of this new WESCO.

Moving to page 4, we are seeing accelerating sales and margin momentum across our entire business and delivered second quarter sales that are 4% above 2019 pre-pandemic levels and also delivered second quarter EBITDA margin, that is up 110 basis points versus 2019 pre-pandemic levels as well. Each of our three business units is making strong contributions to the growth of our company, our comprehensive product and value-added service offerings, our broad and deep supplier relationships and our technical expertise are proving to be critical differentiators for our customers. We're also ensuring continuity of supply to our customers, which is especially critical, as the economic recovery accelerates.

Now shifting the margin and operating leverage. We built a foundation for sustainable margin improvement through our increased global scale, value-based pricing program and the realization of cost synergies at a pace and scale that continues to exceed our expectations. Increased earnings power that we're generating has been a key catalyst to rapidly delevering our balance sheet since our June 2020 acquisition of Anixter, and just one year since closing the transaction we've improved our leverage ratio by 1.2 times, which is well ahead of schedule and highlights the power of our business model. As a result, we now expect to reach our targeted leverage range of 2.0 to 3.5 times by the second half of 2022, which is significantly ahead of our original outlook.

Year-to-date we've experienced upside to our forecast on all of our key operating metrics, and as such, we've raised our sales margin and profit guidance for the second time this year. In addition, we've raised our 3-year sales and cost synergy target on the continuing strength of our integration execution. Our employees have done an absolutely outstanding job on delivering on our commitments in the first year of the transformational combination of WESCO and Anixter. I would like to recognize and thank each and every one of them for the drive, dedication, resilience, and strong results.

Now moving to page 5, our dramatically increased scale and expanded portfolio positions us very well to capitalize on the secular growth trends that will sustain the current economic recovery and our foundational for the global economy in the years ahead. Our future growth opportunities amplified by the 6th secular growth trends outlined on this page. You'll recall that we previously had a wheel of 12 and we've collapsed into the 6th major secular trend category. I'd like to take a few moments to highlight two specific examples today. First, grid hardening, when it comes to power generation, transmission, and distribution, the overall infrastructure of that power change, so to speak, today's utility faced numerous calendar from new environmental regulations, evolving technologies, and aging infrastructure and increased storm activity, $60 million of US distribution lines that surpassed their 50-year life expectancy, and it's estimated that $1.5 to $2 trillion will need to be spent to modernize the grid, just to maintain reliability. As ongoing and significant infrastructure upgrades are required and we're supporting our customers with advanced products and more importantly with integrated supply chain management services, we are on-site with many of our utility customers helping with product selection, we're providing application and technical support, we're sourcing materials, and we're handling material staging and logistics. Through a single interface, our platforms are digitally integrated with our customer system for efficient project management. As the leader in utility distribution, we are well-positioned to continue to partner with all the major utilities, as they implement the critical work for grid modernization.

Second highlight area I wanted to highlight was rural broadband. Rural broadband network development is a huge growth opportunity for WESCO, today there are more than 30 million people in the US, who don't have access to broadband, 30 million homes that is, they don't have access to broadband. The pandemic put a spotlight on this challenge, as working from home and learning from home became necessary. The FCC has committed $20 billion to support the broadband build-out in the US, through the Rural Digital Opportunity Fund or better known as RDOF. There is another 65 billion within the proposed infrastructure bill. We're partnering with electric utilities co-option municipals, as well as telecom providers to help bring broadband to these rural markets. Specifically, we're supplying end-to-end fiber solutions for the build-out of broadband networks and last mile Internet access. Projections are that the build-out will take place over the next 10 plus years. We are in an absolutely outstanding position to leverage our broadband capability for customers, as a leader in both utility and broadband, supply chain management.

So in summary, our mission is to build connect power and protect the world. One year into this journey and we are confident that the results we are seeing are just the beginning of the value creation opportunity, that the new WESCO represents. The value creation potential of WESCO plus Anixter has started to emerge, but we have only just begun. With that, I'll turn it over to Dave to walk you through the details of the second quarter, as well as our updated guidance, Dave...

Dave Schulz -- Senior Vice President & Chief Financial Officer

Thanks, John. Good morning everyone and thank you for joining our call. Starting on slide 7, this summary table compares our second quarter results to the pro forma results in the prior year. Compared with the prior year, sales were up 24%, currency added 3 points to growth and pricing was approximately a 4.0 benefit. During the quarter we saw suppliers increase prices on average about 8% as we have indicated in the past, pricing in our project-based bids are generally honored by our suppliers, and we don't see the full impact of supplier price increase notifications. Backlog reached another record level this quarter, up 36% from the prior year and up 17% from the prior record level in March. Notably, each business unit posted backlog increases of more than 15%. Gross margin was 21% in the quarter, up 140 basis points compared to the prior year. The strong gross margin performance included a 20 basis point negative impact from an $8 million write-down to inventory of personal protective equipment.

As we foreshadowed last quarter, we took additional inventory adjustments based on market prices and quantities in stock, relative to expected demand. Business unit mix was a 20 basis point benefit to gross margin versus the prior year. Supplier volume rebates increased gross margin by 30 basis points driven primarily by a year-to-date true-up in the quarter, given our strong performance. The balance of the gross margin improvement, approximately 110 basis points, was driven by the benefits of the ramp-up of our combined company margin improvement program and inflationary pricing. Sequentially versus the first quarter, gross margin increased by 90 basis points. Mix contributed 10 basis points and supplier volume rebates 30 basis points, with the balance, driven by the benefits of our margin improvement initiatives and positive price cost. Adjusted EBITDA, which excludes the merger-related costs, stock-based compensation, and other net adjustments, was $309 million, $99 million higher than the prior year. This represented 6.7% of sales, 100 basis points above the prior year, and 110 basis points above the 2019 second quarter, on a pro forma basis. Adjusted diluted EPS for the quarter was $2.64. Preliminary results for July are encouraging with sales up mid-teens versus the prior year.

Moving to slide 8, as I mentioned a moment ago, gross margin was 21% this quarter, this result was broad-based and a major driver was continued traction of the margin expansion program that we deployed across the entire organization. This slide lays out some of the aspects of the program, starting with capability building, which is the foundation of the program and includes the interactive training sessions that the entire sales organization undergoes to become familiar with the program. Second, the sales processes in playbook, which captures the focus on value-based pricing, the emphasis on solution selling, and the ongoing database coaching that our sales teams receive. Third, performance management captures the accountability aspect of the program and the alignment of our sales incentives to our margin expansion goals. Lastly, the systems and dashboards component of the program includes the access to dashboards that capture the most critical information our team needs and ultimately enables us to unlock the power of our big data. We are still in the early phases of the rollout and expansion of the program to the entire WESCO-Anixter organization and are confident we will see key margin expansion from this effort.

Turning to page 9, you can see the drivers of nearly $100 million increase of adjusted EBITDA, driven by higher sales, expanded gross margin, and the benefit of synergies from the integration. Partially offsetting the positive drivers were higher volume-related operating costs, including variable compensation. The higher variable compensation is a function of all sales commissions and an increase to incentive compensation, as we expect payouts for the year to exceed targets in the annual operating plan. Other headwinds to EBITDA in the quarter were higher benefit costs and the reversal of certain cost reduction actions we undertook in the prior year, in response to the COVID pandemic. In total, adjusted EBITDA was up 47% from the prior year, on sales growth of approximately 24%.

Now let me walk you through the results by business unit, beginning on slide 10. All the year-over-year comparisons, shown in the next three slides are based on the pro forma results in the prior year. Sales in our EES segment were up 34%, with double-digit growth in all operating groups. This growth reflects construction sales that are continuing to recover faster than we had anticipated, momentum on our cross-sell initiatives, and demand driven by secular growth trends. This quarter we continue to see a higher level of projects being released from backlog and shift relative to our expectations at the beginning of the year. We continue to experience robust bidding activity levels that are driving an incremental increase to our backlog from its record level in the prior quarter and we made further progress in our cross-sell initiatives that have capitalized on our ability to now offer a complete electrical package to our customers. We also beginning to see increasing momentum in our industrial and OEM businesses, in line with the broader industrial recovery. Adjusted EBITDA was up $85 million representing 8.7% of sales, 290 basis points higher than the prior-year level. This increase reflects the gross margin initiatives I discussed earlier, strong cost synergy realization, and effective price cost pass-throughs.

Turning to slide 11, sales in our CSS segment were up 22%, versus the prior year pro forma and up 17% sequentially. We saw strong growth in our security solutions, global accounts, datacenter, and hyper-scale projects, partially offset by decline in safety-related products. In addition to our cross-sell programs CSS benefited from several secular trends; the need for increased bandwidth, 24-7 connectivity, IP-based security solutions, and the demands related to remote work and school applications. Backlog increased almost 20% from March to a record level, profitability was also strong with adjusted EBITDA at 9% of sales, 30 basis points higher than the prior year, driven by operating leverage integration cost synergies and the execution of our margin improvement initiatives. Note that the majority of the $8 million inventory write-down was recorded in CSS, negatively impacting adjusted EBITDA margin by 40 basis points.

Turning to slide 12, sales in our UBS segment were up 13% versus the prior year and up 13% compared to the prior quarter. Still demand has remained consistently strong as our customers continue to invest in grid hardening and monetization and we won new business due to our leading value proposition. Our broadband business was up double digits versus the prior year, driven by strong demand for data and high-speed connectivity that has never been greater, due to the step-change expansion in requirements and work from home and school from home applications. Additionally, we are benefiting from sales activity, due to the federal government's Rural Digital Opportunity Fund, which John mentioned earlier, Phase 1 of that project began at the end of 2020. For UBS, adjusted EBITDA in the quarter was $101 million or 8.3% of sales, up 70 basis points, driven by synergy realization, gross margin expansion, and effective cost controls.

Turning to Slide 13, let me walk you through the updates to our integration and revised expectations for synergies. Starting with revenue, we originally estimated that we would generate sales synergies of approximately 1% of the pro forma sales of the combined company or a cumulative $170 million over three years based on 2019 pro forma sales, of approximately $17 billion. This assumed we would see some customer attrition, as we merged WESCO and Anixter. To date, we have not seen any revenue dis-synergies and have realized $70 to $77 million of cross-sell benefit. The success of the cross-sell program to date has exceeded our expectations and our pipeline of opportunities continues to build. Due to these factors, we are increasing our revenue synergies to the cumulative 500 million or roughly 3% of 2019 pro forma sales, to be achieved by the end of 2023. On this slide we provided examples of recent cross-sell wins for each business unit, in each case, we have been able to expand a legacy customer relationship of either WESCO or Anixter to sell additional products or capabilities. These are, these examples reflects a multi-year opportunity and combined represent future sales of more than $60 million in aggregate. You can see that they also cover a wide array of products and capabilities, including the wire and cable capabilities that Anixter is known for and the LED lighting capabilities of WESCO, as well as reflecting the secular trends of electrification, bandwidth driven fiber optic deployment, and the growing need for supply chain services.

Turning to slide 14, last quarter we mentioned we would be reevaluating the synergy plan, once we reach the one-year anniversary of the merger in June. Based on the results to date, the accelerated pace of integration, and the size of cost synergy opportunities, we are increasing the Cumulus target by 20% in the $300 million compared to the 2019 pro forma cost structure. This represents a 50% increase from our original cost synergy target of $200 million when the merger closed in June of last year. We expect one-time cost to generate the synergies, will be approximately $25 million, through the end of 2023. In total, we have generated approximately $117 million of cost synergies to date or roughly 40% of our target through 2023. On the right side of the slide, need outline the target by synergy type as well as an overlay of the synergies that have been realized to date. You can see as an example that most of the corporate overhead synergies have been generated, no more than half of the G&A synergies have been captured, primarily related to our organizational redesign, which is now essentially complete. The largest remaining synergies are those that take longer to execute, including the supply chain and field operations buckets.

Moving to Slide 15, we remain laser-focused on reducing our leverage. On this slide, you can see that this quarter, we reduced leverage by 0.4 times, trailing 12 month adjusted EBITDA, for the second quarter in a row and have reduced leverage by 1.2 times, since closing the Anixter acquisition 12 months ago. Net debt increased marginally in the quarter primarily, due to investment in working capital that we made to support the exceptional strong sales growth we experienced across all of our strategic business units. We are gaining efficiencies and reduce working capital by three days in the quarter. One of the hallmarks of our business model is our ability to generate strong cash flow throughout the economic cycle and we remain focused on reducing our leverage. We expect to continue the rapid pace of deleveraging in accelerating our plan, to return to our target leverage range of 2 to 3.5 times trailing 12 months adjusted EBITDA, in the second half of 2022, at least six months earlier than our prior expectation of mid-2023.

Turning to slide 16, in our outlook for 2021. We have increased our outlook for sales growth to a range of 10% to 13%, primarily due to the strong demand we have experienced in the first half of the year, execution of our cross-sell program, continued share gains, and the strong macroeconomic outlook for the remainder of the year. We now expect EES to be up at the high end of our range, driven by the faster than expected not recovery of our end markets. Note that we do not participate in the residential construction market in a meaningful way. We expect CSS to be at the middle of our sales range, due to its exposure to critical secular growth trends and its global footprint.

Next, we expect UBS to be at the low-to-mid-point of our sales range. The utility market has been very stable and we expect continued demand increases in the broadband market to contribute to growth as well. We have increased our outlook for adjusted EBITDA margin to a range of 6.1% to 6.4%, primarily driven by the strong profitability this quarter, the expectation for continued sales growth, and operating leverage in the second half of the year. Continuing down the income statement, we expect our effective tax rate to be approximately 23%. Due to the higher sales and profitability expectations, we are increasing our adjusted diluted EPS outlook to a range of $8.40 to $8.80. We are adjusting our expectations for free cash flow as a percentage of adjusted net income, to 90% to reflect the investment in working capital. to support the higher sales growth outlook. We still expect to deploy $100 to $120 million of cash for capital expenditures and investments in IT and digital. Note that many of our investments for IT will be cloud-based. Cloud-based and subscription services will be recorded as other assets and amortized over the term of its associated arrangement, rather than classified as a capital expenditure and depreciated over its useful life. Please note that we do not anticipate a change in the total depreciation and amortization related to this accounting.

Turning to page 17, before opening the call to questions, I'd like to walk you through a quick summary of the key takeaways, that we covered this morning. We've had an exceptionally strong first half of the year and the outlook calls for sequential growth in the back half. Results were again, strong across the board this quarter, with sales up double digits in each of our three businesses. We are outperforming the market, capitalizing on our leadership position, and executing well on a tremendous cross-selling opportunity of our combined business. We are well-positioned to continue benefiting from these trends in the years ahead. These businesses reported higher adjusted EBITDA margin this quarter in the prior year pro forma. In total, EBITDA was up nearly 50%, with 100 basis points of EBITDA margin expansion. We are driving increased operating leverage across the enterprise and realizing the benefits of our strong execution of cost synergies. Our rapid pace of deleveraging continues. We reduced our leverage by 0.4 turns, for the second consecutive quarter, and delivered a total leverage reduction of 1.2 turns, since closing the transaction, just 12 months ago. These strong results have enabled us to make several significant adjustments to our outlook for the business. We increased the expectations for sales growth and profit profitability for the year. We increased our cost synergy target by $50 million to $300 million, in our sales synergy outlook by approximately threefold, to be achieved by the end of 2023. And finally, we accelerated our anticipated deleveraging by at least six months to the back half of 2022. With that, I'd like to open the call to your questions.

Questions and Answers:

Operator

We will now begin the question-and-answer session [Operator Instructions]

Our first question comes from Deane Dray with RBC Capital Markets, please go ahead.

Deane Dray -- RBC Capital Markets -- Analyst

Thank you, good morning everyone.

Dave Schulz -- Senior Vice President & Chief Financial Officer

Good morning, Deane.

Deane Dray -- RBC Capital Markets -- Analyst

Hey, maybe we can start with price cost, and as Dave was zipping through the prepared remarks, we heard 4% point benefit the price, but then there was a reference to an 8% supplier input cost increase. Now, we don't know the timing of these and they came through, but we did hear a positive price-cost several times. Can you pull it together, what was price cost for the total company in the quarter, and if you can give it by segment that would be great, but we'd be happy with total company and start there, please.

Dave Schulz -- Senior Vice President & Chief Financial Officer

Yeah sure, Deane. Again, appreciate the question. As we mentioned, what we saw from our suppliers were supplier price increase notifications that on average, were 8% in the quarter and one of the things that we highlighted, was that we don't see all of that impacting our business because of the bids and our suppliers will honor the bids. One of the things that's very difficult for us to do is to call out the exact basis point benefit that we get from price cost at this point and that is one of the key elements of our margin improvement program, is making sure that we're pushing through price to our customers to the best of our ability. We do track that, but it's very difficult for us to break out the inflationary benefit that we're seeing in our gross margin, relative to what we're seeing from the balance of our margin improvement program. So I hope that provides at least some perspective in terms of the by strategic business unit. We're seeing more of the price increases coming through on the EES side, and then I would say it's UBS followed by CSS, just based on the different types of businesses and the impact that suppliers are pushing through on price increases.

Deane Dray -- RBC Capital Markets -- Analyst

That's great, but just to clarify, the WESCO that I know historically has always been quick to pass through input costs, I don't see where that changes and just your degree of confidence on being able to keep up, these are extraordinary times right now on cost inflation, which is your degree of confidence that you're going to stay ahead of this during the course of the second half?

John Engel -- Chairman, President & CEO

Deane. Yeah, good morning again. Yes, this is John. Great confidence, if you look at what's occurred, and I'll keep my comments with respect to Q2 and Q1, for the first half of this year, we're seeing, we're clearly in an inflationary cycle. So versus what the company has done historically, I will tell you that we are passing through the price increases quicker than we have historically. The lag that we typically experience in other inflationary cycles is much shorter. I'm very encouraged by that, It's really a function of two things, the comprehensive margin improvement program, the value based selling, and explicitly we're focused on moving that pricing through our business, in the customer's supplier price increases that is, through a whole array of techniques and Dave laid out the key elements of that comprehensive program. In addition, we doubled the size of the company, and that increased scale, and global supply chain capability. We're in a significantly better position to ensure continuity of supply. Do you look at our end markets, across the board, demand is still outstripping overall and this is a market question, the supply chain rebuild, the rebuild underway, but we're seeing the fact that we've added to our inventory consciously and using our new found and increased scale and very strong global supplier relationships, we're able to provide that continuity of supply as demand is ramping, which is also supportive of not only pricing and gross margins, but our sales growth, which is accelerating.

So, what they broke out was, the 8% is a published supplier price injuries, this is incredibly important and I think as you all know, that's not what's realized in the value chain. For the business that we provide, it's direct shipped in this project-based, those are competitively bid and we get special pricing authorizations in place from our suppliers, that represented a more competitive price to support that project activity and that gets lost in between our suppliers and us. So again that shows the difference, that's the delta between the age Deane and the floor. Is that helpful?

Deane Dray -- RBC Capital Markets -- Analyst

It is really helpful and reading the slides this morning before the call, there was no excuse, no complaining about price cost, which kind of was signaling that you had it handled and I appreciate the specifics you provided just here, so feel good about that. And just as my follow-up on the cross-selling target increase, I mean that's a big bump and I loved hearing that you're not seeing dis-synergies because that's kind of the one area we were holding our breath on in terms of the merger. So that's good news. Just talk about the rigor and how you're tracking these actual cross-selling wins, I mean you gave good examples in the slide, but just, is this a bucket that we can have a high degree of confidence that, yes, that's a cross-selling that would not have existed prior to the integration.

John Engel -- Chairman, President & CEO

Yeah, what we tried to do Deane, was spotlight three different types of examples to give a sense of the categories. One was where we had, and they spoke to this on page 1, is where we had an existing WESCO customer relationship and we were able to pull in Anixter products and services. I quote, "the new found capabilities as a result of merger." The second was where there is an existing Anixter customer relationship and we did the reciprocal, we pulled in WESCO product service capabilities and capabilities. And the third was an existing WESCO customer, where we did two things, where we pulled in Anixter products, but we also expanded the scope of supply and used some Anixter supply chain service capabilities to expand the business. So we wanted to show you those three different types of examples to the heart of your question, and we mentioned it before, we stood up a dedicated Integration Management Office, we pulled some of our top talent across those respective organizations and staffed that full time, and we use the acronym IMO, that's full-time integration management office is still in place and will be in place for the 3-year integration period.

We're still working with our external consulting partner across that integration period and the integration execution, which includes detailed program management processes and tracking mechanisms and scorecards, is incredibly rigorous. Unlike anything either company has ever had in place prior to the merger, so great confidence, very high degree of confidence that we're going to go from the 1% cumulative incremental growth via cross-sell to 3 % point to grow and it's really, we're in the very early innings of this, that's my final point. The opportunity pipeline that we're tracking and its rigorous, again grew substantially, as we move through the second quarter and it's that coupled with the recent wins we spotlighted three and we're beginning to see the cross-selling results in our sales results. You put that all together and we told you that we are going to take a very comprehensive look at our 3-year plus integration synergies that the one-year close, it gives me great confidence, Deane, to take up the 1% to 3%.

Deane Dray -- RBC Capital Markets -- Analyst

That's all good to hear. Thank you and congrats.

John Engel -- Chairman, President & CEO

Thanks, Dave.

Operator

The next question is from Sam Darkatsh with Raymond James, please go ahead.

Sam Darkatsh -- Raymond James -- Analyst

Good morning, John. Good morning, Dave. How are you? Terrific performance, obviously, two questions, and one of them I guess would be a piggyback on what Deane's prior query was, as it relates to your implied second-half guidance for this year, what specifically are you baking in first, sequential pricing actions, and sequential billing margin expansion, but within the guidance and related to that. At what point does that PPE inventory write-down cease?

John Engel -- Chairman, President & CEO

Yeah, Deane. All right. I'm sorry. Sam, let me address first on the pricing impact for the second half. Very, very difficult to forecast the impact of pricing on our revenue. So therefore we don't include that, we know what we experienced in the first half, that's assumed in our full-year forecast, but we don't assume any incremental pricing benefit as we enter the second half of the year. Related to the PPE write-downs, as we mentioned back in our first-quarter call, that was a very fluid situation and we had indicated at that point, back in May, that we would continue, continue to look at our inventory write-down requirements related to that safety equipment. We still do have some inventory. We think that any potential write-down will be immaterial, but again that's something that we will continue to monitor and make sure that we get the accounting correct as we report our results.

Sam Darkatsh -- Raymond James -- Analyst

And you're billing margin expectations in the second half versus the first half, are you expecting continued improvement in billing margins?

John Engel -- Chairman, President & CEO

You know, we generally don't disclose any of the drivers or the forecast for our gross margin. So I don't want to get into too much detail on that, obviously one of the things that we're focused on is making sure that we continue to address the inflation. We continue to make sure that we're getting the value-based pricing through to our customers. So again, I'm not going to comment specifically on the billing margin or the gross margin going forward, but as you can see from our implied second half, we are assuming adjusted EBITDA margin expansion in the second half.

Sam Darkatsh -- Raymond James -- Analyst

And then my last question, thank you. My last question would be, I didn't know that year 3, free cash flow guidance had changed from the, at least $600 million or so prior, despite the fact that you're obviously racing year 3 synergies. Now, I know there is going to be some incremental working capital needs, but theoretically, would it be more than $600 million at this point, based on current trends and synergy expectations?

John Engel -- Chairman, President & CEO

Yeah, we're confident that we can deliver the $600 million of free cash flow by year 3. We continue to recognize that one of the drivers to our ability to generate that free cash flow, is continuing to become more effective on net working capital, and as we expect more sales synergies, that's going to require more net working capital. With that combination, we're very confident that we can deliver the $600 million by year 3.

Sam Darkatsh -- Raymond James -- Analyst

Thank you much.

John Engel -- Chairman, President & CEO

Thanks, Sam.

Operator

The next question is from Nigel Coe with Wolfe Research, please go ahead.

Nigel Coe -- Wolfe Research, LLC -- Analyst

Thanks, good morning everyone. So yeah, look, the rebates disclosure, very helpful. I'm assuming that the bulk of our heads in the segments, maybe just confirm that, and then, I'm actually more curious on the customer rebates that you're giving to your customers, the 4% price, would that be net of rebates and I'm just wondering how the dynamic on the rebate you're giving to your customers versus your prior rebates, how that [Indecipherable] yeah.

John Engel -- Chairman, President & CEO

Certainly, Nigel. So let me address first on the supplier volume rebates, we did do a true-up in the second quarter, again we generally looking at our expectations for the full year and of that 30 basis point improvement that we saw at the gross margin related to supplier by rebates, the majority of that was just a true-up to get the front half where we thought it needed to be, based on our performance and our expectations for the balance of the year. The supplier volume rebates are actually recognized in each of our businesses and so I don't, it would not be fair to say that the majority of that would be an EES, it is split out between the three businesses, based on the agreements that we have with our suppliers, and on your comment about the customer rebates in the pricing impact, the customer rebates are netted. So generally it's the agreements that we have with customers on rebates, is based on primarily, what their spend pools are and how much they purchase from us. So that would be a net against the inflationary impact on our revenue.

Nigel Coe -- Wolfe Research, LLC -- Analyst

Okay, that's great. And then on the comp headwind, the variable comp headwinds, that you mentioned that stepped up in the bridge, just curious where we sit on that, on a dollar basis here. And then as we think beyond this year and sort of a more normalized plan, what kind of tailwind can we expect into 2022 from that research?

John Engel -- Chairman, President & CEO

Yeah. So at this point, we've accrued what we believe is the appropriate amount of incentive compensation for the front half of the year, based on the performance of the company we are above our targeted annual operating plan. So we will be expecting to pay out incentives at a higher level, if you think about what we outlined earlier in the year, relative to the headwinds, that we had for both incentive compensation plus COVID, we recognize that and we've increased the accruals for the dollars that we expect to pay out for 2021, similar to what we had occurred for the current year. If we accrue at a higher level versus target, we would reset our plans for 2022 back to target, so there would be a potential tailwind in 2022 related to the incentive compensation.

Nigel Coe -- Wolfe Research, LLC -- Analyst

Okay. Will follow up offline on the actual quantification of that. Thanks, Dave.

Operator

The next question is from Steve Barger with KeyBanc Capital Markets, please go ahead.

Steve Barger -- KeyBanc Capital Markets -- Analyst

Hi, good morning. Well for a lot of companies, this quarter, we've seen really solid increases to revenue and EPS, like you just put up, due to cycle recovering inflation, I think some investors are just thinking about how the demand cycle plays out here. So I'm curious to the extent you can talk about it, what is your view on cycle duration, and is there any reason to think that you can drive further solid earnings upside as long as you're seeing revenue growth?

John Engel -- Chairman, President & CEO

I think we're in the early innings, to answer your question directly on cycle early innings, you look at each of the three big business units and our profit [Indecipherable] cycle, but then also the secular growth trend, Steve, because I think those two, you got to look at, in combination. Clearly the economic cycle, the overall economic cycle recoveries underway. For EES, remember, exposed to industrial end markets that building, it includes OEM that building for both of those are in recovery, and we're seeing real nice sequential growth.

We're also outperforming that because we believe we're outperforming that and taking share. but we feel it's a kind of a double boost, remember we're not positioned to benefit directly from the resi cycle, but we benefit the second derivative basis when it drives subsequent non-resi cycle. The non-resi cycle recoveries has begun, but we're in the very early innings, there's a bunch of puts and takes, depending on the end market type of the type of project, but you look at non-resi, it's our view that as we kick into 2022 and 2023, that cycle recovery is well underway. We're not really seeing a tailwind from the cycle yet, but as evidenced by our improving sales growth momentum, sequentially, particularly, as noted in EES, plus the record backlog and the degree to which backlog grew, I'm going to put a very fine point on this, normally based on historical seasonality, we would eat into the backlog sequentially in the second quarter. We grew our backlog sequentially by a large margin, this is counter, normal cyclical, any normal historical seasonality or cyclicality. So you're more in the early innings of the recovery. I think we're significantly outperforming in construction. So that's what's driving EES, relative to UBS we're benefiting just from a leading leadership position in the industry, leading value prop, and there are strong secular growth trends, that are driving across the utility power chain and that's why I cited that example in my opening comments about grid modernization, as well as broadband. And then CSS is really benefiting from a global leadership position, it's tech-driven selling technical driven selling, and very strong secular growth trends, I think we're in the very early innings. Could you have the cycle question, we're in the very early innings of a large capital deployment cycle across 5G. Plus FTTx Fiber-to-the-X, including fiber to the home and hyper-scale data centers. The backlog for CSS is also at a record level by an extraordinarily large margin, when you look at how much backlog grew in CSS in Q1 and Q2, it's is unlike anything we've ever seen, so let's say the Anixter team has ever seen in that business, and UBS is also sitting at a record backlog.

So the cycle question is a great question. I'm glad you asked me. I think we're getting some benefits, but we're effectively in the early innings. I'll come back to the secular growth trends, you look at what we laid out there, I've touched upon those benefit directly, UBS and CSS, we're in the very early innings of the electrification secular trend and that has legs of the next decade and beyond, and green energy, we're in the very early stages that has legs for the next decade and beyond and obviously digitalization and supply chain reshoring the North America cut across the entire enterprise. So I feel really good about where we are and I feel really good about our outperformance versus the current markets. You couple that with where we are in the cycle, that's what gave us a great confidence to increase our three-year targets, on topline and cost and bottom line effectively.

Steve Barger -- KeyBanc Capital Markets -- Analyst

That is really great color and now that we're a year or so into this, and you're getting a better sense of the cost structure, obviously, you're increasing those targets for sales and cost synergies and you think about those secular trends and opportunities and what the mix impact of that is, how are you thinking about sustainable, incremental operating contribution margin in an upcycle, for however long that lasts?

John Engel -- Chairman, President & CEO

So we, I think the way I'd ask you to think about, and Steve, you know us well, so I think with our 3-year integration programs, executing that and the targets that we've laid out for 3-year plus period, through the end of 2023 post-close. We've given a good insight in terms of how we think of the next two years, [Indecipherable] one year, end of us, I will tell you that this transformational combination is exceeding our expectations. I told you that the two businesses were more complementary than we thought when you looked at end-markets, customers, and categories products and services. Also, the cultural integration is exceeding our expectations.

So those two elements together, bear on the higher confidence we have, relative to the sustainable value creation. I do want to make the point we're above the 2019 pre-pandemic levels on sales, gross margin, EBITDA dollars, and EBITDA margin. So, and that's without all the tailwinds of the cycle. So I'm not going to give you the longer-term construct right now, but we believe we're exceptionally well-positioned to outperform the market on the top line obviously, leveraging the combined increased scale and the cross-selling. The cost synergies, we've only delivered 117 million to date, is in our P&L, of the 300 million right, that we've outlined through the end of 2023. Gross margins at a record level and we're in the early innings of our margin expansion program. On the WESCO side, Anixter's three years and still seeing margin expansion and we're delevering at a very rapid rate.

I would tell you that's probably the most, the strongest part of the story is, deleveraging story, it's a major deleveraging story as well underway, you put that all together, I think we've got just outstanding value creation opportunity in terms of top-line growth, above market, a significant EBITDA margin expansion, deleveraging and outstanding cash flow generation that get redeployed to invest in the platform.

Steve Barger -- KeyBanc Capital Markets -- Analyst

Great detail. I appreciate it.

Operator

The next question is from Christopher Glynn with Oppenheimer, please go ahead.

Christopher Glynn -- Oppenheimer Holdings -- Analyst

Thanks, good morning, and congrats. Congratulations on all the success to date, curious if you're seeing your volumes right now, kind of augmented by overall supply chain disruptions globally and the influence that might have on customer buying patterns.

John Engel -- Chairman, President & CEO

So that's a contributor Chris, we doubled the company in one move. So it's the inherent benefits of putting two strong leading companies together, we increased scale and I just mentioned, the complementary nature of the combination and overnight, the much stronger, broader, deeper relationship that we have with our global supply chain partners. That's having benefit across the entire operation, the entire company, and part of that is, as the demand is pulling on the supply chain that is rebuilding. We are able, we're in a position to provide high integrity, supply chain management, and continuity of supply. Look we consciously increased our inventories because we're seeing very strong sales growth and we're focused on inventory availability and fill rates for what we're seeing in demand and what our customers are giving us insight into and we're able to, in conjunction with our supplier partners, provide a continuity of supply that we think is differentiated. I don't think that is temporal I mean, I think this is the result of this transformational combination and it's the benefits of scale of putting two leading companies together, in what is still a fragmented value chain. So I honestly see these benefits carrying on in the future, in the perpetuity.

Christopher Glynn -- Oppenheimer Holdings -- Analyst

Okay, and then you have, 3rd and 4th quarter produced similar earnings results of the second quarter pretty nicely above the range, so just curious within the outlook, what part of the second quarter composition of the P&L might not repeat?

Dave Schulz -- Senior Vice President & Chief Financial Officer

Yeah. Hey Chris, it's Dave Schulz. So a couple of things to look at, that may not repeat in the second half, obviously, the gross margin true-up, the SVR true-up, that we got benefit from, we're at the right level in our forecast for supplier volume rebates and what we did get that extra benefit in Q2 that really should have been spread out between Q1 in Q2, knowing what we know now. So we did get an outsized benefit here and in the second quarter. There is also the incentive compensation true-up, again going back to the discussion we had earlier around, based on the progress that we've made relative to our annual operating plan. We do expect to pay higher incentives. There was a portion of a true-up that was included in Q2. So again, that would be a bit more level in the second half of the year.

Christopher Glynn -- Oppenheimer Holdings -- Analyst

Okay, thanks Dave.

Operator

The next question is from David Manthey with Baird, please go ahead.

David Manthey -- Robert W. Baird & Co. -- Analyst

Hey, thank you. Good morning.

John Engel -- Chairman, President & CEO

Good morning, Dave.

David Manthey -- Robert W. Baird & Co. -- Analyst

Yeah, hi, John. So, inflation clearly had some positive effect on revenues and operating margin this quarter, but it sounds like you're telling us it's more like 10s of basis points in a smaller impact than what you were able to achieve through organizational changes, is that the way to think about it?

John Engel -- Chairman, President & CEO

I would say Dave, and it's really an important point, which is why we include a page, we have not done it previously, of the structure and I'll use the term our recipe, of our margin improvement program. We can bare prepared remarks, focused on value-based selling and getting those price pass-throughs is in an explicit element, among other elements in that comprehensive program and as I mentioned earlier to Deane, Deane's question, I see of passing through those more quickly than we have historically, as a result of this enterprisewide margin execution program, parsing out just that inflation benefit versus all the other initiatives that's embodied in the program that are positively impacting both billing and gross margins, is impossible to do, other than the explanation that the, because of the mix of our business, there are list prices that are published. I'll come back to that, and in our project part of our business, we're quoting competitively ever debt every day and we're securing SPA, special pricing authorizations, in conjunction with our suppliers to secure those project bids and that represents pricing that does not match the list pricing that you're seeing, that are published. And because we have a sizable portion of our business is direct ship, that dynamic, the pricing dynamic, is different there, we're getting special pricing authorizations that support winning those jobs, in conjunction with our suppliers. And then consequently we have a different SG&A structure too, to execute that direction business.

David Manthey -- Robert W. Baird & Co. -- Analyst

That's understandable if the suppliers, though, are experiencing price increases across the board. It's not a net zero game, they're not going to sell it to you at lower than their cost. Their passing through something we have some confusion, what you're saying about the special pricing.

John Engel -- Chairman, President & CEO

Oh sure, no, no. Sure, sure, and obviously they pass that to us that we work they try to and I'm just, I'm just talking about the dynamic of the value chain and what price is real because what's in our margin is the price we're realizing. That was my main point and we're obviously working in conjunction with our supplier partners to push that through. And I think what I'm most encouraged about, is again, Anixter had this two years running pre-merger close, they had a rigorous set of training materials around a whole series of margin improvement levers, pipe pre-pass through, doing it quickly, but value-based selling and it just terrific set of material and it's those materials, we would find and expanded and now we are driving enterprisewide, effective really with the start of this year, across the legacy WESCO portion of the combination that we're seeing the benefits on so super with, you know what we're driving, the set of initiatives we're driving, in so far as our comprehensive margin improvement program and the benefit that's having on both billing and growth margins.

David Manthey -- Robert W. Baird & Co. -- Analyst

Okay, thank you for that. John. Second, as it relates to the sequentials, in the seasonal pattern here at New WESCO, there's always a glide path on pricing. So I'd imagine you get a little more benefit that in third quarter than second quarter, you talked about the backlog build. The question is, should we just assume that the quarter-to-quarter growth from 2Q to 3Q, should be at least as good as normal, maybe a little bit better than that?

John Engel -- Chairman, President & CEO

Yeah, Dave, obviously you can do the math on our total back half versus where we are, year to date, with our outlook as we think about the sequentials, we do anticipate that we will see continued back half, I mean at the midpoint of our guide we're 7% growth on sales front half to back half and obviously as we see increases in supplier price increase notifications, we're going to work really hard to get those pass through to our customers, through our value-based pricing initiatives in our other margin improvement plans, but what we are expecting, EBITDA margin improvement, front half to back half. As you can see from our outlook, we're not going to break out the specifics between the gross margin line.

David Manthey -- Robert W. Baird & Co. -- Analyst

Got it, thank you both.

Operator

The next question is from Chris Dankert with Loop Capital, please go ahead.

Christopher Dankert -- Loop Capital Markets -- Analyst

Hey, morning guys. Thanks for sneaking me in here. I guess, Dave, you walked us through some of the key drivers in that margin improvement program, and John, you highlighted pricing for value specifically, but I guess more on the systems and data side, what inning are we into when it comes to, first the availability of that data to decision-makers, and secondly some kind of utilization and adoption of those actual tools. I assume some of that rolled out in the new year, but where are we in terms of actually getting that to the people on the ground.

John Engel -- Chairman, President & CEO

Yeah, great question, Chris. So one of the major activities that we've been working on literally started post-merger close, was getting both companies' respective datasets, complete big datasets I'll call it, and figuring out how to knit those together. So we've been working with one. We have one new data lake that we've established as part of our foundational element of our digital transformation program and we've been hydrating and porting that data, those legacy Anixter data, and legacy WESCO data, into that new enterprisewide data lake. As we've been doing that, we've also been through our digital initiatives under the leadership of our new CIO and CTO, Chief Information Officer, Chief Digital Officer, Akash Khurana, we hired six plus months ago. Under his leadership and with our team, we've been developing our own digital applications, the leverage that big data to unlock that the power that big data. There are several applications that we've stood up, Chris, specifically that are supporting that margin improvement program. With all that said, this is the new WESCO, I mean we're in a multiyear digital transformation journey and increasingly we will be standing up, building, moving, an agile development process, building our own digital apps to leverage our big data. Super excited about the long-term impact of this, I'm not going to go through the specific apps we've built, but I will tell you a few have been build already, that are part of this comprehensive margin program and we're also using both built-in apps that are helping other parts of the front-end sales management and order management and execution process. So we are in the very early innings of applying digital and unlocking the power of our big data, but thanks for that question.

Christopher Dankert -- Loop Capital Markets -- Analyst

No, no, and thank you for the response, really helpful there, but glad to hear you're moving fast. I guess the last follow-up from me, on the cross-selling, appreciate the examples, out of curiosity, and we've seen any cross-selling on an international space kind of bringing legacy WESCO into other markets, any caller there would be great.

John Engel -- Chairman, President & CEO

Yes, we have, we've seen a few opportunities, both in EES and CSS. The CSS brought to us very strong, extensive global footprint. Yeah, global leadership capability and data communications and IP security. So we've been able to, in a few opportunities already, leveraged existing Anixter/CSS customers then pull in some of the rest of the portfolio, but in addition Anixter, over the years, on the foundation of the leading position in wire and cable in North America, they also have been expanding globally, that capable. So we've been able to sell more of the complete electrical package, quote on quote, "globally as well." So yeah examples in both of those business units.

Christopher Dankert -- Loop Capital Markets -- Analyst

Yeah, thank you so much for the call, much appreciated.

Operator

The next question is from Patrick Baumann with JP Morgan, please go ahead.

Patrick M. Baumann -- JP Morgan Securities, LLC -- Analyst

Hi, good morning, thanks for our taking my question. Just going back to the pricing, I think you saw 2%-3% impact year-over-year, in the first half of the year, but then you said something in response to your question about nothing incremental expected for the second half. Does that mean you've zero for price year-over-year in the second half or does it mean that you have nothing incremental versus the first half, but still up year-over-year? And then also, what is the assumption for foreign exchange in the guide if there is any.

John Engel -- Chairman, President & CEO

So, Patrick [Indecipherable] also for pricing, very, very difficult for us to pull out what that pricing potential benefit or detriment would be to our overall revenue. So we don't include that as we think about the back half guide, the same thing with foreign exchange, right now we do look, obviously at expected foreign exchange rate forwards, but we don't include any significant incremental delta for foreign exchange in the back half of the year.

Patrick M. Baumann -- JP Morgan Securities, LLC -- Analyst

Okay, understood, and then on free cash flow, you mentioned your capital spend target is unchanged, but so far this year, you've only spent about 20 million. And then you also mentioned something about cloud investments. So just wondering if you could flesh this out a bit. Why the significant back half weighting on capital spend and then maybe some examples of things you'll be investing the CapEx in from a digital perspective?

Dave Schulz -- Senior Vice President & Chief Financial Officer

Certainly. So, if you include some of the other expenditures from a cash flow perspective related to our IT and digital, we spent approximately $40 million year to date, a combination of capital expenditure, plus other cash spend on IT digital. We are, as John mentioned, we are still ramping up some of our digital initiatives and some of our platforms as we move forward. So we do expect to see an incremental spend in the second half of the year related to those IT and digital expenditures.

Patrick M. Baumann -- JP Morgan Securities, LLC -- Analyst

And then the other 20 in operating cash flow that we don't see?

Dave Schulz -- Senior Vice President & Chief Financial Officer

Correct.

Patrick M. Baumann -- JP Morgan Securities, LLC -- Analyst

Understood, and then last one from me, why was mix a benefits margins like what drove that? I just would have thought with EES growing faster than the rest of the company that mix would have been headwind?

Dave Schulz -- Senior Vice President & Chief Financial Officer

Yeah. So when you think about the, we made the comment specifically around the gross margin and we did get a mix benefit versus the prior year and that was primarily driven by the strong gross margin and the EES business. So if you take a look at some of the historical pro forma numbers, our EES business tends to have an above average gross margin relative to the company. And when you take a look at that growth rate relative to where our utility business grew, in our utility business does have a substantial portion of its business is direct ship, so therefore, though, you do get a mixed impact just based on the relative growth rates of the SBUs.

Patrick M. Baumann -- JP Morgan Securities, LLC -- Analyst

Okay, thanks a lot, appreciate the time. Good luck.

Dave Schulz -- Senior Vice President & Chief Financial Officer

So I think we're at the top of the hour. So I'll bring the call to a wrap. Thank you all for your support, much appreciated. We look forward to speaking with many of you in the coming days and throughout the quarter, as well as our upcoming investor events including the RBC Global Industrial Conference, next month. Have a great day, everyone.

Operator

The conference is now concluded. [Operator Closing Remarks]

Duration: 65 minutes

Call participants:

Leslie Hunziker -- Senior Vice President of Investor Relations

John Engel -- Chairman, President & CEO

Dave Schulz -- Senior Vice President & Chief Financial Officer

Deane Dray -- RBC Capital Markets -- Analyst

Sam Darkatsh -- Raymond James -- Analyst

Nigel Coe -- Wolfe Research, LLC -- Analyst

Steve Barger -- KeyBanc Capital Markets -- Analyst

Christopher Glynn -- Oppenheimer Holdings -- Analyst

David Manthey -- Robert W. Baird & Co. -- Analyst

Christopher Dankert -- Loop Capital Markets -- Analyst

Patrick M. Baumann -- JP Morgan Securities, LLC -- Analyst

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