WESCO International Leaves Investors Wondering

WESCO International, Inc. (WCC 1.29%) end markets have been improving this year, and the company has hiked its full-year 2018 sales and earnings guidance on two consecutive quarters. That said, its recent second-quarter results were something of an anticlimax. Once again, WESCO seems to be having a problem improving margins -- something that's usually built into investor expectations when it comes to distributors experiencing strong sales growth. Let's take a look at the earnings and what's going on.

Image source: Getty Images.

WESCO International second-quarter earnings: The raw numbers

Starting with the headline numbers from the quarter:

• Net sales increased 10.2% to $2.1 billion compared to guidance for an increase in the range of 7% to 10%.
• Gross margin declined to 19% from 19.2% in the same quarter last year.
• Operating margin was flat year on year at 4.3% and came inside the guidance range of 4.2% to 4.5%.
• Operating profit increased 10% to $91 million.

As you can see, it was a good quarter for sales -- more on that in a moment -- but margin performance was somewhat disappointing.

What happened with margins in the quarter

Margin movements matter for all businesses, but it's particularly important for industrial distributors because they tend to have slim operating margins -- an incremental change can make a big difference to profit growth. Moreover, margin expansion is expected when cyclical companies are on their upswing, and it's usually assumed when investors value such stocks.

Indeed, on the fourth-quarter 2017 earnings presentation in February, CEO John Engel said that 2018 would be about continuing growth while getting margin expansion. However, the first quarter saw gross and operating margin decline for WESCO. 

Discussing the gross margin decline on the earnings call, CFO David Schulz claimed it was down due to a combination of an increase in "traditionally lower gross margin international and utility businesses" and a change in the company's "cost recognition policies." That said, even when adjusting for these factors, gross margin would only have risen to 19.3% from 19.2% last year.

Turning to operating margin, Schulz was keen to point out that excluding a bad debt charge, operating margin would have been 4.5%. However, given the strong sales increase, it's reasonable to expect a bit more than this.

Sales growth remains strong

The disappointing margin performance somewhat overshadows a good improvement in sales growth. As you can see below, WESCO generated good growth in all its end markets in the first half, and as a consequence, full-year sales expectations have been internally raised for all of its end markets bar commercial, institutional, and government (CIG).

Data source: WESCO International presentations. Chart by author.

The stronger-than-expected sales growth is also reflected in the increase in full-year sales guidance. However, the failure to improve margin at WESCO has led to the improvement in sales barely falling through into a concomitant improvement in diluted EPS guidance.

Data source: WESCO International presentations.

Discussing the overall market outlook, Engel claimed the company has good momentum going into the second half and was currently growing in all of its end markets, product categories, and geographies. Moreover, WESCO's book-to-bill ratio was above 1 through the month of July -- a ratio above 1 indicates future growth, as the backlog will grow. In short, WESCO looks well set up for sales growth in the second half.

Looking ahead

WESCO's management was keen to stress the margin-improvement initiatives taken in the first half, and Engel claimed that a sequential improvement in margin is "explicitly built into our outlook for Q3 and the full year." It's clearly something that investors will be looking for in future quarters, particularly as it would dispel fears that WESCO's end markets are getting more competitive.