WESCO International, inc (WCC) Q2 2021 Earnings Call Transcript

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WESCO International, inc (WCC -0.84%)
Q2 2021 Earnings Call
Aug 6, 2021, 2:30 p.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] Please note, this event is being recorded. 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 J. Engel -- Chairman, President & Chief Executive Officer

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 a 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 and backlog are records 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 four.

We are seeing accelerating sales and margin momentum across our entire business and delivered second quarter sales that are 4% above 2019 pre-pandemic level 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 to margin and operating leverage. We built a foundation for sustainable margin improvement through our increased global scale, value-based pricing programs 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. In just one year since closing the transaction, we've improved our leverage ratio by 1.2 turns, 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 three-year sales and cost synergy targets 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 their drive, dedication, resilience and strong results. Now moving to page five. 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 are foundational for the global economy in the years ahead. Our future growth opportunity is amplified by the six secular growth trends outlined on this page. You'll recall that we previously had a wheel of 12, and we've collapsed those into these six major secular trend categories. 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 chain, so to speak, today's utilities face numerous challenges from new environmental regulations, evolving technologies and aging infrastructure and increased storm activity. 60% of U.S. distribution lines have surpassed their 50-year life expectancy.

And it's estimated that $1.5 trillion to $2 trillion will need to be spent to modernize the grid just to maintain reliability. As ongoing and significant infrastructure upgrades are required, we're supporting our customers with advanced products and, more importantly, with integrated supply chain management services. We're on-site with many of our utility customers helping with product selection. We're providing application and technical support with sourcing materials, and we're handling material staging and logistics. Through a single interface, our platforms are digitally integrated with our customers' system for efficient project management. As a 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 monetization. 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 U.S. who don't have access to broadband -- or 30 million homes that 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 U.S. through the Rural Digital Opportunity Fund or better known as RDOF. There's another $65 billion within the proposed infrastructure bill. We're partnering with electric utilities, co-ops and 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, 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?

David S. Schulz -- Chief Financial Officer

Thanks, John. Good morning, everyone, and thank you for joining our call. Starting on slide seven. 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 three points to growth and pricing was approximately a 4-point benefit. During the quarter, we saw suppliers increase prices on average about 8%. As we have indicated in the past, pricing on 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 and 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 initiative 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 eight. 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 is sales processes and playbook, which captures the focus on value-based pricing, the emphasis on solution selling and the ongoing database coaching that our sales teams received. 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 continued margin expansion from this effort. Turning to page nine. You can see the drivers of nearly $100 million increase to 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 both 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 fitting activity levels that are driving an incremental increase to our backlog from its record level in the prior quarter, and we made further progress on our cross-sell initiatives that had capitalized on our ability to now offer a complete electrical package to our customers. We also continue 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-through. 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, data center and hyperscale 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 demand 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.

Utility demand was -- has remained consistently strong as our customers continued to invest in grid hardening and modernization, 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 and requirements to 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 one 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 assumes we would see some customer attrition as we merge WESCO and Anixter. To date, we have not seen any revenue dissynergies and have realized $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 have 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. Each of these examples reflects a multiyear 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 cumulative target by 20% and to $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 onetime costs to generate these synergies will be approximately $225 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 this slide, we have outlined 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 and a little 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 exceptionally strong sales growth we experienced across all of our strategic business units. We are gaining efficiencies and reduced 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 and are accelerating our plan to return to our target leverage range of two 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 and 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 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 macro 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 midpoint 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 expectation 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 million 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 to 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've 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 the 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 in this quarter than 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 profitability for the year. We increased our cost synergy target by $50 million to $300 million and 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

[Operator Instructions] Our first question comes from Deane Dray with RBC Capital Markets. Please go ahead.

Deane Dray -- RBC Capital Markets -- Analyst

Thank you and good morning everyone.

David S. Schulz -- Chief Financial Officer

Morning, Deane.

Deane Dray -- RBC Capital Markets -- Analyst

Hey, we can start with price cost. And as Dave was zipping through the prepared remarks, we heard four percentage point benefit to price, but then there was a reference to an 8% supplier input costs increase. Now we don't know the timing of these and how they came through. But we did hear 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 would be happy with the total company and start there, please.

David S. Schulz -- Chief Financial Officer

Yes, 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. 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, that provides at least some perspective. In terms of the 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. Just your degree of confidence on being able to keep -- these are extraordinary times right now on cost inflation, but just your degree of confidence that you're going to stay ahead of this during the course of the second half.

John J. Engel -- Chairman, President & Chief Executive Officer

Deane, this is John. Great confidence. If you look at what's occurred, and I'll keep my comments with respect to Q2 and Q1. So 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 customers to supplier price increases, that is, through a whole array of techniques, and they've 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. If you look at our end markets, across the board, demand is still outstripping overall -- this is a market question -- the supply chain rebuild. The rebuild is underway. But we're seeing -- the fact that we've added to our inventories 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 the -- what Dave broke out was the 8% is a published supplier price increases. 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 that's direct shipped and is 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 locked in between our suppliers and us. So again, that shows the difference -- that's the delta between the 8, Deane, and the four. Is that helpful?

Deane Dray -- RBC Capital Markets -- Analyst

It is really helpful. And I just -- in 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 love hearing that you're not seeing dissynergies 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 of 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 J. Engel -- Chairman, President & Chief Executive Officer

Yes. 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 Dave spoke to us on that one page. One is where we had the existing WESCO customer relationship, and we're able to pull in Anixter products and services, the new found capabilities as a result of the merger. The second was where there was 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 use some Anixter supply chain service capabilities to expand the business. So we wanted to show those three different types of examples. To the heart of your question, and we mentioned this before, we stood up a dedicated integration management office. We pulled some of our top talent across both respective organizations and staffed it.

That's full time, and we use the acronym IMO, that full-time integration management office is still in place and will be in place for the three -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 had 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 three percentage points of growth. 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 it's rigorous, again, is -- grew substantially as we moved through the second quarter. And 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 were going to take a very comprehensive look at our three-year plus integration synergies at the one-year close, it gives me great confidence, Deane, to take up the 1% to 3%.

Deane Dray -- RBC Capital Markets -- Analyst

Thank you and congrats 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. 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 for sequential pricing actions and sequential billing margin expansion within the guidance? And related to that, at what point does the PPE inventory write-down cease?

David S. Schulz -- Chief Financial Officer

Yes, Deane -- 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 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 would be immaterial. But again, that's something that we will continue to monitor and make sure we get the accounting correct as we report our results.

Sam Darkatsh -- Raymond James. -- Analyst

And your billing margin expectations in the second half versus the first half? Are you expecting continued improvement in billing margins?

David S. Schulz -- Chief Financial Officer

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 would be, I didn't note that year three free cash flow guidance had changed from the at least $600 million or so prior, despite the fact that you're obviously raising year three synergies. Now I know there's 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?

David S. Schulz -- Chief Financial Officer

Yes. We're confident that we can deliver the $600 million of free cash flow by year three. 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 three.

Sam Darkatsh -- Raymond James. -- Analyst

Thank you much.

David S. Schulz -- Chief Financial Officer

Thanks.

Operator

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

Nigel Coe -- Wolfe Research -- Analyst

Thanks, good morning everyone. So yes, look, the rebates disclosure is very helpful. I'm assuming that the bulk of that hit in the EES segment. 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 rebates that you're giving to your customers versus your supplier rebates, how sort of that announce here?

David S. Schulz -- Chief Financial Officer

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 were 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 volume 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. So I don't -- it would not be fair to say that the majority of that would be in 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 and 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 -- Analyst

Okay. That's great. And then on the comp headwind, the variable comp headwind, you mentioned that, 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 '22 from that reset?

David S. Schulz -- Chief Financial Officer

Yes. 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 -- Analyst

Thanks, Dave.

Operator

Our next question is from Steve Barger with KeyBanc Capital Markets. Please go ahead.

Steve Barger -- KeyBanc Capital Markets -- Analyst

Hi, good morning. 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 recovery and 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 J. Engel -- Chairman, President & Chief Executive Officer

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 I'll talk -- I'll address cycle, but then also the secular growth trends, Steve, because I think those two, you've got to look at in combination. Clearly, the economic cycle, the overall economic cycle recovery is underway. For EES, remember, exposed to industrial end markets. That's building. It includes OEM. That's building. So 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 -- so it's a kind of a double boost. Remember, we're not positioned to benefit directly from the resi cycle, but we benefit on a second derivative basis when it drives subsequent nonresi cycle. The nonresi cycle recovery has begun, but we're in the very early innings.

There's a bunch of puts and takes depending on the end market type or the type of project. But if 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 the 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 -- any normal historical seasonality or cyclicality. So we're 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 in -- 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 -- because you have this 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 hyperscale 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 unlike anything we've ever seen -- let's say, the Anixter team has ever seen in that business. And UBS is also sitting in 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 who benefit directly, UBS and CSS. EES, we're in the very early innings of the electrification secular trend. And that has legs for 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 in North America cut across our 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 the great confidence to increase our three-year targets on top line 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 J. Engel -- Chairman, President & Chief Executive Officer

So we -- I think the way I'd ask you to think about it and, Steve, you know us well, so I think with our three -year integration program, executing that and the targets that we've laid out for a three-year plus period through the end of 2023 post close, we've given you good insights in terms of how we think of the next two years because we're one year into this. 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 there 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 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 in not still seeing margin expansion, and we're delevering at a very rapid rate, and I would tell you, that's probably the most -- the strongest part of the story is deleveraging story. It's a major deleveraging story that's well underway. You put that all together, I think we've got just an outstanding value creation opportunity in terms of top line growth above market, significant EBITDA margin expansion, deleveraging and outstanding cash flow generation that can get redeployed to invest in the platform.

Steve Barger -- KeyBanc Capital Markets -- Analyst

Great detail. I appreciate it.

Operator

Our next question is from Christopher Glynn with Oppenheimer. Please go ahead.

Christopher Glynn -- Oppenheimer -- Analyst

Thanks, good morning and 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 J. Engel -- Chairman, President & Chief Executive Officer

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. That increased scale, and I just mentioned the complementary nature of the combination, and the -- overnight, the much stronger, broader, deeper relationships we have with our global supply chain partners, that's having benefits 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 demand in 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 a result of this transformational combination, and it's the benefit of scale of putting two leading companies together and what's still a fragmented value chain. So I see -- I honestly see these benefits carrying on into the future in the perpetuity.

Christopher Glynn -- Oppenheimer -- Analyst

Okay. And then the third and fourth quarter produced similar earnings results as the second quarter, puts you nicely above the range. So just curious, within the outlook, what part of the second quarter composition of the P&L might not repeat?

David S. Schulz -- Chief Financial Officer

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 -- but we did get that extra benefit in Q2 that really should have been spread out between Q1 and Q2, knowing what we know now. So we did get an outsized benefit here in the second quarter. There's 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 little bit more level in the second half of the year.

Christopher Glynn -- Oppenheimer -- Analyst

Okay, thank you.

Operator

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

David Manthey -- Baird -- Analyst

All right, thank you. Good morning. So inflation clearly had some positive effect on revenues, not pretty large in this quarter. But it sounds like you're telling us it's more like tens of basis points and a smaller impact than what you were able to achieve through organizational change. Is that the way to think about it?

John J. Engel -- Chairman, President & Chief Executive Officer

I would say, Dave, and this is really an important point, which is why we include a page we had not done previously of the structure, and I'll use the term our recipe of our margin improvement program within Dave's prepared remarks. Focus on value-based selling and getting those price pass-throughs is an explicit element among other elements in that comprehensive program. And as I mentioned earlier to Deane's question, I see us 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 that program that are positively impacting both billing and gross margins is impossible to do other than the explanation that because of the mix of our business, those are list prices that are published.

I'll come back to that. And in our project part of our business, we're quoting competitively every day, and we're securing SPAs, special pricing authorizations, in conjunction with our suppliers to secure those project bids. And that represents pricing that has not matched 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. 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 of business.

David Manthey -- Baird -- Analyst

That's understandable. If you're -- 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. Let's say. they're passing through something. I -- there is some confusion on what you're saying about the special pricing.

John J. Engel -- Chairman, President & Chief Executive Officer

No, no. Sure. Sure. And obviously, they pass that to us and we work -- they try to -- and I'm just talking about the dynamic of the value chain and what price is realized 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 premerger close. They had a rigorous set of training materials around a whole series of margin improvement levers, price pass-through, doing it quickly, but value-based selling. And it's just terrific set of materials. And it's those materials we refine and expanded and now 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 encouraged with what we're driving -- the set of initiatives we're driving as part of our comprehensive margin improvement program and the benefit that's having on both our billing and gross margins.

David Manthey -- Baird -- Analyst

Okay. Second, as it relates to the sequentials and the seasonal patterns here at new WESCO, there's always a glide path on pricing. So I would imagine you get a little more benefit net in the third quarter than the second quarter. And 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?

David S. Schulz -- Chief Financial Officer

Yes, 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 passed through to our customers through our value-based pricing initiatives and our other margin improvement plans. But 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 -- Baird -- Analyst

Got it, thank you both thanks, Dave.

Operator

Our next question is from Chris Dankert with Loop Capital. Please go ahead.

Chris Dankert -- Loop Capital -- Analyst

Hey, good morning guys. Thanks for sneaking me in here. I guess, Dave, you walked through some of the key drivers of 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 the decision makers? And secondly, kind of utilization and adoption of those actual tools, I assume some of that rolled out in New Year, but just kind of where are we in terms of actually getting that to people on the ground?

John J. Engel -- Chairman, President & Chief Executive Officer

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 data sets, complete big data sets, I'll call it, and figuring 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, both 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 CDO, Chief Information Officer and Chief Digital Officer, Akash Khurana, who we hired six-plus months ago. Under his leadership and with that team, we've been developing our own digital applications to leverage that big data and unlock that -- the power of 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, using an agile development process, building our own digital app 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 built already that are part of this comprehensive margin program. And we're also using -- we've also built some 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.

Chris Dankert -- Loop Capital -- Analyst

No, no. Thank you for the response. Really helpful there. But glad you're moving fast. I guess the last follow-up from me. On the cross-selling, I appreciate the example. My curiosity -- have we seen any cross-selling on an international space kind of bringing legacy WESCO into other markets? Any color there would be great.

John J. Engel -- Chairman, President & Chief Executive Officer

Yes, we have. We've seen opportunities, a few opportunities, both in EES and CSS. Now CSS brought to us a very strong, extensive global footprint, global leadership capability and data communications and IP security. So we've been able to, in a few opportunities, already leverage the existing Anixter/CSS customers and pull in some of the WESCO 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 capability. So we've been able to sell more of a complete electrical "package" globally as well. So examples in both of those business units.

Chris Dankert -- Loop Capital -- Analyst

Yeah, I think. Thank you so much for the color.

John J. Engel -- Chairman, President & Chief Executive Officer

Much appreciated.

Operator

Our next question is from Patrick Baumann with JPMorgan. Please go ahead.

Patrick Baumann -- JPMorgan -- Analyst

Hi, good morning. Thanks for taking my question. Just going back to the pricing. I think you saw a 2% to 3% impact year-over-year in the first half of the year, but then you said something in response to a question about nothing incremental expected for the second half. Does that mean you have 0 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?

David S. Schulz -- Chief Financial Officer

Yes. So Patrick, it's Dave Schulz. So for pricing, very, very difficult for us to pull out what that pricing potential benefit or decrement would be to our overall revenue. And so we don't include that as we think about the back half guide. Same thing with foreign exchange. Right now, I mean 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 Baumann -- JPMorgan -- 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 investment. 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.

David S. Schulz -- 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 and digital. We are -- as John mentioned, we're still ramping up some of our digital initiatives in 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 Baumann -- JPMorgan -- Analyst

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

David S. Schulz -- Chief Financial Officer

Correct.

Patrick Baumann -- JPMorgan -- Analyst

Understood. And then last one for me. Why was mix a benefit to 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 a headwind.

David S. Schulz -- Chief Financial Officer

Yes. So when you think about the -- we made the comments specifically around the gross margin. We did get a mix benefit versus the prior year, and that was primarily driven by the strong gross margin in 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, like, our utility business grew, and our utility business does have a substantial portion of its businesses direct shift. So therefore, you do get a mix impact just based on the relative growth rates of the SBUs.

John J. Engel -- Chairman, President & Chief Executive 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

[Operator Closing Remarks]

Duration: 65 minutes

Call participants:

Leslie Hunziker -- Senior Vice President of Investor Relations.

John J. Engel -- Chairman, President & Chief Executive Officer

David S. Schulz -- Chief Financial Officer

Deane Dray -- RBC Capital Markets -- Analyst

Sam Darkatsh -- Raymond James. -- Analyst

Nigel Coe -- Wolfe Research -- Analyst

Steve Barger -- KeyBanc Capital Markets -- Analyst

Christopher Glynn -- Oppenheimer -- Analyst

David Manthey -- Baird -- Analyst

Chris Dankert -- Loop Capital -- Analyst

Patrick Baumann -- JPMorgan -- Analyst

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