Applied Industrial Technologies Inc (AIT) 2011 Q1 法說會逐字稿

Welcome to the fiscal 2011 first quarter earnings call.

My name is Kim, and I will be your operator for today's call.

At this time, all participants are in a listen-only mode.

Later, we will conduct a question-and-answer session.

Please note that this conference is being recorded.

I will now turn the call over to Mr.

Rick Shaw.

Mr.

Shaw, you may begin.

Thank you, Kim, and good afternoon, everyone.

We appreciate the fact that you've joined us today at Applied Industrial Technologies for our fiscal 2011 first quarter investor conference call.

Our earnings release was issued this morning before the market opened, and if you've not received it, you can retrieve it at our website, applied.com.

A replay of today's broadcast will be available for the next two weeks as noted in the archive information that's contained in the press release.

Before we begin, I would like to remind everyone that we will discuss Applied's business outlook during this conference call and make statements that are considered forward-looking.

All forward-looking statements are based on current expectations regarding important risk factors, including trends in the industrial sector of the economy, the success of our various marketing strategies, and other risk factors identified in Applied's most recent periodic report, and also with other filings made with the SEC.

Accordingly, actual results may differ materially from those expressed in the forward-looking statements.

In compliance with SEC Regulation FD, this webcast is being made available to the media and the general public, as well as to analysts and investors.

Because the webcast is open to all constituents and prior notification has been widely and unselectively disseminated, all content of the call will be considered fully disclosed.

Our speakers today include David Pugh, Chairman and CEO of Applied, who will discuss our overall performance during the quarter.

You'll also hear from Ben Mondics, our President and Chief Operating Officer who will discuss operational activities, and Mark Eisele, Vice President and Chief Financial Officer, who will discuss our financial performance in detail.

Getting us started today is David Pugh.

Thanks, Rick.

It's good to be back with everyone, especially on the heels of a pretty good quarter.

Our first quarter was notable for several things.

The operating -- the sales and operating results were really strong in my eyes.

While the sales increase of 20.5% was a against a relatively weak comparable, it's still an indication of an ongoing economic recovery that we're seeing in the industrial markets.

To me, of even greater note is the net income improvement of 85.5%.

So feel like we're operating with good efficiency right now.

In the quarter, we completed the acquisitions of UZ Engineered Products and SCS Supply.

Both of these acquisitions have an excellent strategic fit with our growth plans.

And as the year progresses, we expect good, positive impact to our earnings as we complete the integration of these two acquisitions.

I think the question on everybody's mind right now centers on the sustainability of the industrial economic uptick.

There's still some rumbling about a double-dip recession and other negative factors that could impact manufacturing.

But, from what we're seeing, growth in the industrial sector has slowed somewhat on a year-over-year basis, but part of that is the comparables are getting tougher.

The good note is that we're continuing to see sequential growth on a month-over-month basis, [even though] the prognosis is still uneven by industrial segments.

Home construction for sure is still in the doldrums.

That impacts a number of other industries.

With our strength in that field, we probably won't see a really strong recovery until that structure gets realigned.

And that's projected to be two to three years out.

So, we're going to find places to park elsewhere.

We're still seeing steady performance in manufacturing and process industries.

We're going to keep an eye on the rate of inventory buildup, which is starting to creep up just a little bit.

We expect that we're going to continue to see moderate growth through our full fiscal year.

So operationally, I'm pleased with the performance during the quarter.

We continue to manage inventories well.

While we saw a net increase of inventories of about $10 million excluding acquisitions and price increases, that was a proactive decision that we made in response to supplier shortages and longer lead times on some of our orders.

This should only be a temporary increase as our suppliers assess the sustainability of current demand and add their own capacity.

Additionally, we take a look at the control on expenses.

That's something that's become a core competency for us.

We continue to do it well; I'm pleased with how that's going.

We're still on the upward swing, but we also have a ways to go before we can lay claim to a full recovery.

What we're looking at there is returning to peak sales and profitability.

But we are committed to getting there, and to exceed it.

So, with those positive notes, I'm going to turn it over to Ben to talk about the details of the operating performance for the quarter.

Thank you, Dave, and good afternoon, everyone.

While we continue to see good sales growth, the three economic indices that we follow suggest that the manufacturing economy has lost a little momentum.

In response, our rate of growth has slowed somewhat from the rapid increases we saw during the previous six months.

Industrial production declined by 0.2% in September, the first decline in over a year.

Factory output for the entire quarter increased at a 4.8% annual rate, a healthy gain but down from the 7% pace of the previous three quarters.

Manufacturing output rose at a 3.8% annual rate during the first quarter, down from the 9.1% gain and the 6.2% gain respectively posted in the previous two quarters.

Manufacturing capacity utilization was down slightly in September at 72.4%, but for the quarter it was up overall.

The ISM Purchasing Managers Index decreased in September to 54.4%, the fourth decline in the past five months, and its lowest mark since November of 2009.

Looking at our top 30 industries, we're seeing strong double-digit growth in more than half of them.

And our government sales continued to improve, although growth is somewhat inhibited by lower spending by federal, state and local governments.

Going forward, we will continue to focus on this important market, and we see it as having good, long-term growth potential.

For our first quarter, [SD&A] as a percent of sales was 20.5%, improved from 22.3% in the same quarter last year.

We attribute our strong SD&A improvement to leverage from stronger sales as well as our cost control efforts.

As we move forward in 2011, our goal continues to be keeping our SD&A growth rate at about half the rate of our sales growth.

At quarter end, our employee count was 4,652, which included 227 new employee associates from the acquisitions of UZ Engineered Products and SCS Supply.

Excluding acquisitions, our employee count is 4,425, down by 43 associates compared to June 30, 2010, and down by 210 associates compared to last year's first quarter.

Inventories were up $18.6 million in the first quarter compared to June 30, 2010.

Approximately $8.5 million of that increase came from acquisitions and price increases, so our net increase was right around $10 million on a comparable basis.

Most of that increase resulted from our efforts to safeguard against supply chain shortages.

We expect to see inventories at or below this level by our year end.

In early October, we announced that we had selected SAP to help us transform our technology platforms and enhance our business information and transaction systems.

Our growth through acquisitions has left us with multiple operating systems, and the need for a more modern, up-to-date platform has become self-evident.

We believe that we will see improved operational efficiency with the new system, as well as more modern functionality and greater capacity for future growth.

We are currently forming the Applied team that will help us redesign our business processes, using strong, knowledgeable associates from within our own ranks as well as from an outside integrator.

We are currently selecting the system integrator, and expect the project to be in full swing by January of 2011.

I will now turn the call over to Mark Eisele for a discussion of the quarter's financial results.

Thanks, Ben.

Good afternoon, everyone.

Let me provide some additional insight for our first quarter fiscal 2011 financial performance.

Our first quarter sales per day run rate of $8.2 million was consistent with our June quarter run rate.

We did experience our normal seasonality, though, with the July and August sales per day run rate being down slightly compared to June.

We then saw an improvement in September.

We also had 64 selling days in both the current quarter and the prior year first quarter.

Overall sales grew 20.5%, acquisitions during the quarter contributed 1.3% to our sales growth.

Our product mix during the quarter was 28.5% Fluid Power products, and 71.5% Industrial products.

In total, sales in our Service Center-Based Distribution segment increased $60.6 million, or 16.7%.

If you exclude the impact of our recent acquisitions, the sales increase for our Service Center-Based Distribution segment was 15.2%.

Quarterly sales from our Fluid Power businesses segment increased $29.1 million, or 39.1%, from the same period in the prior year, due to greater economic activity.

From a geographic perspective, same store sales in the first quarter from our US operations were up 20.3%.

Same store sales from our Canadian operations increased a total of $4.5 million, or 9.4%.

This same store increase is broken down as 2.5% from pricing, volume and mix, and 6.9% from foreign currency translation impact.

Our Mexican operations sales increased $2.9 million, or 26.1%.

Approximately 4.5% of this increase is attributable to foreign currency translation.

On an overall basis, positive foreign currency translation increased sales by 0.9% in the quarter.

Our North American operating facilities increased by nine due to our acquisitions completed in the quarter.

We also redefined how we classified some of our ongoing shop operations, which increased our reported number of operating facilities by 11.

After this adjustment, as of September 30 we now have 475 operating facilities.

Our gross profit percentage for the quarter was 27.1%, as compared to 26.4% in the prior year's quarter.

The current quarter's gross profit was positively impacted by 55 basis points, or $2.7 million, due to one-time LIFO benefits recorded in the quarter.

These LIFO benefits are the result of effective supplier price decreases in certain products, due to increased volume rebates realized on fiscal 2011 purchases versus 2010.

These flow through our LIFO calculation as a benefit, as the price paid for these products, net of volume rebates, is lower this year than last.

While there may be a modest similar benefit in the second quarter, we do not anticipate any further benefits in quarters three or four from this impact.

Our selling, distribution and administrative expenses as a percentage of sales for the quarter declined to 20.5%.

SD&A expenses increased from the prior year in absolute dollars by $10.4 million, or 10.7%, compared to a sales increase of 20.5%.

This absolute dollar increase is primarily due to expenses related to improved sales levels, the reinstatement of our 401-K match, and our traditional profit sharing payout levels, and increases in our other performance driven expenses.

Acquisitions increased our selling, distribution and administrative expenses approximately $2.9 million, or 3%, as these organizations have a higher cost structure to support their operations when compared to our historical structure.

We expect SD&A expense as a percent of sales for the remaining three quarters of fiscal 2011 to increase slightly from the first quarter rate.

While we will experience improvements as we leverage incremental same store sales, we will continue to see some offsets by the reinstatement of merit increases, our 401-K match, a planned slight increase in head count to support anticipated growth and the return to full work weeks to our associate base, as well as the relatively higher levels of SD&A of companies acquired in the quarter.

Also contributing to our estimated SD&A increase, will be certain non-capitalizable expenses associated with our ERP implementation project.

Our effective tax rate for the quarter was 39.2%.

The increase above our previously communicated estimated rate of 37.5% is the result of recording deferred US tax expense for current year unrepatriated foreign earnings from Canada.

We expect the overall fiscal 2011 tax rate to now be in the 39% to 39.5% range, as we expect to continue the accrual of US taxes on current year, unrepatriated Canadian earnings throughout the remainder of our fiscal year.

Our consolidated balance sheet remains strong.

Shareholders equity is $569.1 million, up $14 million from June 30, 2010.

Excluding the impact of acquisitions and supplier price increases, inventories grew by $10 million in the quarter.

We expect inventories to remain stable or decrease slightly in the December quarter as well as for the remainder of the fiscal year.

Receivables increased during the quarter, commensurate with our sales increase.

Overall cash declined in the quarter, due to repayment of $50 million of outstanding debt, the payment of the fiscal 2010 year-end incentives, and the payments for our two acquisitions.

We expect overall cash levels to decline in the second quarter as well, as we retire the remaining $25 million of debt, along with the related $12 million cross-currency swap liability, and we fund capital expenditures related to our ERP project.

We expect fiscal 2011 CapEx related to ERP to be around $16 million, of which $10 million is included in the September quarter.

These amounts primarily relate to hardware and software fees.

This CapEx amount of $16 million should be added to the previous CapEx guidance of $8 million to $9.5 million provided during our last conference call.

We are finalizing our initial plans for ERP design, configuration and deployment over the next several months.

We plan on providing an overall cost perspective, both for capitalizable costs as well as items to be expensed immediately for the life of the project in the next two quarters.

Our estimate for the total project timeline is between three and four years until full implementation.

We provided updated annual earnings guidance for fiscal 2011 in this morning's press release, which included reaffirmed sales of between $2.05 billion to $2.25 billion, and with increased earnings per share of $1.80 to $2.05 per share, a $0.10 increase in both the top and bottom range.

Now, for some closing comments by Dave Pugh.

Thanks, Mark.

Again, solid quarter, nothing flashy.

Confident that our operating fundamentals are in balance with what the market is currently offering.

And we're capable of moving quickly if the times change.

At this point, Kim, we'll open it up for questions.

Thank you.

We will now begin the question-and-answer session.

(Operator Instructions).

At this time, we have a question from Matt Duncan from Stephens.

Please go ahead.

Good afternoon, guys.

Hi, Matt.

The first question I've got is, I'm wondering if we can get a little clarity on the gross margin issue, Mark.

I want to make sure I kind of understand how the flow should go here.

So if I back out the 55 basis point benefit this quarter, it would have been 26.5%, 26.6%.

But I guess if I heard you correctly, you're expecting a little bit of a benefit in the second quarter as well, is that right?

There's a possibility of a benefit for there, Matt.

We're really unsure as to what level, if any, may occur in the second quarter for that.

But we're pretty sure we won't see any in the third and fourth quarters.

Okay.

But if I understand you correctly, then it sounds like your gross margin should build off of what it would have been this quarter, excluding the benefit you had for the LIFO benefit.

Would that be fair?

I think that would be a fair perspective.

Okay.

And then on inventories, I know there was a little bit of a build associated with safety stock.

I think Ben said something about inventories maybe being flat or down the rest of the year, and you, Mark, said maybe they'd be up a little.

Maybe I [misheard] you guys.

What's the inventory plan for the rest of the year?

I said that I expect them to be down a little bit in December and then also down a little bit for the rest of the year from where they're at today.

I think our expectation is that they should be close to being equal to what they were at June of 2010.

Whether we're exactly equal or up just a little bit remains to be seen.

Okay.

And then did pricing have any impact on your revenues this quarter?

You said FX was a positive 0.9% benefit.

What about price?

I do not have a detailed calculation for that, but we do some rough cut looks at that, and we believe it was less than 1%.

Okay.

And then the last thing I've got, and I'll l hop back in the queue, is you guys are sitting on about a $70 million cash balance.

And it sounds like that may decline just a -- net cash balance.

That may decline just a little bit throughout the rest of the year but maybe not much.

You've got $150 million of borrowing capacity under your revolver.

I guess we're hearing there's a pretty active M&A marketplace out there right now.

You guys made two acquisitions during the quarter.

Update us on your thoughts on acquisitions here.

Is there anything of size that's out there?

Are you interested maybe in doing a larger acquisition?

Just update us on your thoughts on the acquisition world here.

Hi, Matt, this is Ben.

I guess first of all, on the acquisition side of the business, I believe today more than in the last year or two, we're probably closer on our valuations between buyer and seller.

We are active.

We have a number of things going on, and I know Mark will tell us from a financing standpoint we have the capability to do a lot of things.

And from a borrowing standpoint, we're in good shape.

So, we're not constrained right now.

There's good activity, and I think buyers and sellers are close on their expectations.

Okay.

Thanks, Ben.

Thank you.

Thank you.

Our next question comes from Adam Uhlman from Cleveland Research.

Please go ahead.

Hi, guys, good afternoon.

Hi, Adam.

Mark, could we talk about the change to the guidance for the year?

It was a $0.10 increase, and it looks like you're going to be getting a $0.06 headwind from tax,and there was the positive LIFO benefit in the first quarter, maybe second quarter.

Could you walk through the puts and the takes?

Well, I think we're looking at where the financial results are in the first quarter, and we're projecting out as to where we think things might end up for the rest of the year.

I mean, our first quarter results were better than what our initial plan was for the first quarter, and that enabled us to increase our view for the rest of the year as well.

So, I think based upon our comments in the conference call and our view of the overall macro economy, we're still cautiously optimistic on the prospects going forward..

I don't have any real specific things, Adam, to talk about on what the puts and takes would be on that.

Okay.

I guess relative to your plan, what was the biggest surprise?

Well, I don't think that there was a surprise.

I just think we executed quite well and we were able to do a good result and good perspective on things.

The only surprise would be the LIFO benefit that happened that was a one-time benefit that added about -- well, probably about $0.04 per share for this quarter.

Okay.

Got it.

And then Ben, could you talk about the government sales and what was happening there?

And then just to glue another question on, the inventory builds, where specifically in the supply chain are you guys seeing the tightness building?

I guess on the government piece, first of all, we continue to see the government segment as a great growth opportunity for us.

We are seeing some slowness with some of the budget cuts and maybe some of the activity with the Department of Defense.

But we expect that for the remainder of the year we should see some of those numbers improve, and hopefully as we get through the elections and some of the other issues with budgets, that we'll continue to see improvement in the government piece.

On the inventory side, from a supplier standpoint it's spotty.

I think our suppliers are hesitant to ramp up.

I think Dave made some comments about it in his opening statements about suppliers not really sure how sustainable the recovery is.

And we've had some spot shortages here and there, and I think our supply chain team has done a great job of managing through that and making sure that we keep our customers up and running.

Okay.

Got it.

I'll get back in queue.

Thanks.

Thank you.

Our next question comes from Jeff Hammond from Keybanc.

Please go ahead.

Hi, guys, can you hear me?

Hi, Jeff.

Ben, you mentioned some of the indicators losing momentum.

Are you seeing any signs of that in the business?

Or, is it outside the normal kind of seasonality that any areas of the business are decelerating or slowing?

I guess for the most part we lag the indicators by four to six months, and looking out four to six months from the industrial production number, we've seen four out of the last five months with the PMI down.

We're concerned that we might see a little bit of slowing, looking at the inventory build in some of the industry segments, that there might be some slowing in production.

But I think as Mark noted, we saw an increase in our daily sales in September, and October still looks pretty good.

So, we haven't seen it right now in our numbers, but we're watching it closely.

Okay.

Just back to the guidance.

It sounds like, Mark, the raise is generally reflecting a good first quarter.

Is that fair?

Or --

Yes, I would agree.

Okay.

Is it reflecting some additional LIFO benefit into the December quarter or would that be -- ?

Not really.

I would say that our view for the remainder of the year is relatively stable in Q3 and Q4 versus our original views.

And I think we're seeing Q2 a little potential benefit, not necessarily because of any additional LIFO benefits, per se, but just because of our view of the business outlook right now.

Okay.

And understanding you've made some acquisitions, but as we get into the March, June quarters and you're purchasing inventory at a higher level, are we kind of getting back to 2008, 2009 gross profit margin run rate, given the expectation that you'll start to get some rebate benefit through?

Or is that too optimistic?

I think that might be optimistic.

One of the things we talked about in prior conference calls that you alluded to in your question here, is that once we entered into fiscal 2011, the thought was that we could recapture the supplier incentive rebate levels that we were achieving in fiscal 2009 and before.

That is still a very hard thing for us to make happen, and we continue to negotiate with our suppliers regarding those levels.

But, we haven't declared victory on that yet, and it's still a battle.

Okay.

And then just a kind of a finer tuning question.

Can you just kind of talk about expectations for seasonality into the December quarter and how selling days may impact or not impact the sequential change?

For the December quarter, we have 61 selling days this year.

A year ago we had 62 selling days.

Our view is that our expectation as we move forward is that the December quarter in total will be a stronger quarter than the first quarter from a sales per day perspective as the economy continues to ramp up.

Okay.

Helpful.

Thanks, guys.

Thank you.

Our next question comes from Holden Lewis from BB&T Capital Markets.

Thanks.

Good afternoon.

Hi, Holden.

Hi.

Can you talk a little bit more at this point about SAP?

You kind of alluded to some costs coming in in the second half of the year.

Are you able to put some range of numbers to what that might be?

And then sort of carrying on with the cost question, you sort of alluded to more merit price increases, things like that.

When do you feel that your cost structure will be sort of normalized in the wake of the great recession?

When do you think that we're sort of back at normal cost structure that we could sort of just carry that forward as being where we want to be?

I think regarding the cost structure, we will ramp up throughout the year due to wage increases that we are permitting our associates to have now, starting in July.

By taking the wage freeze off, basically what that does in effect, is it enables people to get their raises throughout the year.

So on average, everybody should have their raise mid-year.

And so, theoretically we'll be seeing half that expense roll through for the whole year, but it will ramp up quarter-by-quarter as more and more people get their raises.

So, it really won't be until the fourth quarter that that's fully ramped up for that.

So, that's a slow ramp-up.

Our target for raises this year is 3%, 3% raises is the target.

So, to give you an idea for what that means.

Regarding SAP expenses in the current fiscal year, we don't have those all locked down.

Although we do have some -- we do have estimates in our numbers.

It's primarily we'll be hitting in the third and the fourth quarters.

And I would say it's in the $3.5 million or less range for that.

Per quarter, $3.5 million per quarter, or $3.5 million for the second half?

For the whole year, but primarily in the second half.

And it falls into SG&A.

Yes, those would, yes.

Okay.

And did you say that you had already spent a chunk of the $10 million in fiscal Q1 in CapEx?

Yes.

We have $10 million in our property increase in the September quarter.

We have not actually paid the bill yet, so, therefore, that's still offset in accounts payable for that.

So, when you look at the cash flow statement, you'll notice the property purchases is a lot lower than $10 million.

That's because we haven't paid the cash yet for this $10 million property purchase.

Got it.

It's in payables on the balance sheet?

Exactly.

Okay.

And then can you just talk to me about the 39.5% tax rate?

Just if you can -- I was writing when you were explaining it, but if you could just quickly give me again the reason why we're seeing that step up.

And then I guess generally, is that kind of what we'd expect to see in 2012, 2013 and beyond at this point?

Or, is this just kind of looks like a one-time deal?

This may be an ongoing thing, Holden.

One of the accounting requirements is that for US companies is that they must set up US taxes for unrepatriated foreign earnings, except if the Company deems those foreign earnings to be permanently reinvested in those countries.

Okay.

So, we believe all of our earnings in Canada, in prior years we have deemed them to be permanently reinvested.

But, for the current earnings and in the future, at least for this year, we are expecting that the earnings this year will not be "permanently" reinvested.

So, we need to make the accounting entry to set up those potential taxes on that.

But those decisions could potentially change quarter-by-quarter or year-by-year depending upon the financial situations.

Okay.

But in the past, you considered them to be permanently reinvested.

But just out of conservatism you're deciding now not to deem them that way?

Or, you just wanted the flexibility to bring it back.

It sounds like you're doing something a bit different here to explain or to generate this change.

Yes.

We need to be able to support the view of being able to permanently reinvest the money that's overseas.

And our view is all of the prior earnings, we can continue to support that at this point in time.

But then the question comes for the future earnings, it gets more of a challenge as cash builds up in Canada.

Got it.

All right.

Thank you.

Okay.

Thank you.

Our next question comes from Joe Mondillo from Sidoti & Company.

Please go ahead.

Hi, guys.

Hi, Joe.

I just wanted to follow up on the prior SAP implementation of SAP question before.

This platform should increase your operational efficiencies.

Could you talk about that, and whether or not you're eventually going to start to see any savings by investing in this?

Well, definitely, we've done a tremendous amount of research over the last 18 months and invested thousands of hours in looking at our current business systems and looking at the commercial enterprise packages.

Going through all this analysis that led us to believe that ERP was the way to go, we believe that we'll obviously improve our business processes.

We'll get greater efficiency.

We'll have better information for better and faster decision-making.

It will improve our overall business controls and mitigate the number of business system risks as well as provide a good foundation for growth.

So many, many benefits.

And I guess generally what we're looking at is probably somewhere in the timeframe of two years into the project we'll start to see the benefits start to come in.

Is there any way you can estimate those savings, or is it just too hard to tell?

Very difficult.

We have a lot of debate about where we'll see the benefits, but we're confident that we'll see benefits in all areas of the P&L and the balance sheet.

We expect to get opportunities for revenue growth, margin improvement, both gross margin and operating margin, as well as operational efficiencies through SD&A and asset management.

I think I'll jump in here, Joe.

I think the expectation is that once this system is put into place and as we go down this path for the implementation path, we'll have more clarity as this marches on and we'll be able to provide more facts and figures to folks.

But our expectation is that once this thing's fully implemented and we're getting the benefits of that, that the benefits will exceed the costs.

Joe, let me just weigh in for a second, because I think one of the things we found out in talking with other people who have put ERPs in, is that you almost don't know what you don't know.

And there are going to be lots of capabilities of this system that as our people grow to understand them, our people will be creative in the way they use them.

And we will continue to become more efficient in little things that we're doing in side routines today.

So, there's a lot of opportunity out there.

We have high expectations for it and practically everyone with whom we discussed this, have said they have found more opportunity than they realized, that they had thought they would get at the beginning.

Okay.

Great.

In terms of rebates, how much of the sequential gross margin improvement excluding the LIFO benefit was due to an increase in the rebates?

I don't have that number here, Joe, so I don't want to hazard a guess.

Okay.

In terms of where we were at in 2009 in terms of a percent of sales regarding the rebates, where are we now?

Are we quite far away from that, where there's a lot of still potential improvement given rebates still come back or -- ?

Could you give a sense of where we are in terms of rebates as a percent of sales compared to in

Joe, I would not want to hazard a guess.

I don't have that information with me right now either.

So I do know --

Is there a lot of suppliers that you still can go to and negotiate rebates?

Negotiation of the rebates is an ongoing thing.

Even with suppliers when we have annual programs, it seems like we continually negotiate with them.

And a lot of the programs we have are a calendar year basis, so the negotiations are happening right now.

Others are fiscal year basis.

And we're still fighting the battle.

Are most of them calendar year?

I'd say that probably 40% of them are calendar year, 40% of them are our fiscal year, and then the other 20% are on a different year-end because maybe the suppliers have either a March or a September year-end.

Okay.

So we could potentially see some sort of improvement due to the rebates in the second half of this fiscal year?

Due to the calendar suppliers?

Well, I mean, there could be a change.

I mean, obviously our position would be to have that as an improvement.

But I wouldn't hazard a guess right now.

Okay.

Last question, I was wondering -- percent of sales, if and what state or municipal revenue is.

Total government sales are probably around 4% of our revenues.

But for the state and local portion of that, I don't have that right here.

So I don't know.

It's definitely lower than -- probably 1%, 1% or less of our total.

Okay.

All right.

Thanks a lot, guys.

Sure.

Thank you.

Our next question comes from Brent Rakers from Morgan Keegan.

Please go ahead.

Good afternoon.

I wanted to follow up maybe more if I could on the gross margin question first ,and then I think to the SAP.

On the gross margin, I think [of] 40 to 45 basis points sequentially.

And Mark, I know you said you couldn't comment specifically or didn't have the information on the rebates, but if you could maybe talk through some of the different factors that have improved the core sequentially, whether it be seasonality, whether the M&A has contributed positively, pricing, rebates.

If you could maybe go through some of the different lines and maybe single out the most important there.

Yes, I think I can talk about some of the other lines that impacted gross profit percent.

And one of the ones that comes to mind for us as well as others is our overall, what I call scrap expense.

And our scrap expense, or excess and obsolete reserve for inventory amounts, this year is better than what it was a year ago when we were in the middle of the downturn.

So, that has given us a slight help in our GP percent this quarter versus a year ago's quarter, and versus many of the quarters last year too.

So, we were seeing that.

And I think a second reason is our sales increase, as we talked in the script for the conference call, for our Fluid Power businesses was much higher than our service center businesses and that's -- so that helps drive us with some leverage for some of the work we do there.

Mark, care to prioritize those in terms of those 40 or 45 basis points sequentially, what might be the largest of those?

No.

I don't have that information with me.

Okay.

Fair enough.

And then just on to the SAP again.

You've talked about some of the year one, $16 million CapEx and $3.5 million of OpEx.

I believe that Ben mentioned earlier, three to four years until full implementation.

Just wanted to understand the acceleration of CapEx and OpEx into fiscal 2012, if I could.

We don't have those numbers right now.

We're still in the process of pulling them together as we finalize our selection of an integrator and finalize the team that's working on this.

I think over the next two quarters, we will be able to give a better snapshot of the total, three to four year cost for these things to give you guys a better idea.

But at this point in time, we really can't do that.

If I could tag on to that, it's the system integrator as well as the deployment model.

There are many different approaches to how the integration and how it's deployed over that three to four year time frame, so we have some choices to make in the next few months.

And that's where I think we'll l have better visibility come January and then April.

And then guys, two questions on the headcount.

And I apologize.

I missed the total headcount, including the acquisitions.

If you could repeat that number for me, that would be great.

Let's see if I can find it first.

And then while you're looking for that, I guess the related question.

You talked, I think Mark did in his earlier commentary, about employee additions during the year, needing to build back up some of that employee base.

Just wanted to get a sense, are we talking 25 people a quarter?

Are we talking 75 people?

100 people?

Just want to get a sense for how many additions need to be made.

First of all, the total headcount at quarter end, including the acquisitions was 4,652.

And excluding the acquisitions, we were down 43 compared to June 30.

I believe that we will have -- as compared to June 30, we will be up from that number.

How high above there, boy, it's tough to say.

I just had the -- I was surprised to see that the number was down that much from June 30.

I kind of had the feeling like we were building headcount, and to see that number was a little bit of a surprise to me.

We're making investments in some areas where the business is strong.

If you look at overall, we're up 20%.

We have some areas that are up much higher than that, and we're adding head count and we're still making adjustments obviously in some areas.

So, difficult to say at year-end but won't be significant.

I think some of the adjustments we made were permanent adjustments.

Ben, would 4% or 5% increase in headcount kind of apples-to-apples, would that surprise you at the end of the year?

I think that would be high.

Okay.

Great.

All right.

Thanks a lot, guys.

Thank you.

(Operator Instructions).

At this time, we have a question from Holden Lewis from BB&T Capital Markets.

Thanks.

I just wanted to again I guess test your confidence in the statement that you'll keep -- be able to keep the SG&A rising at about half the level of revenues.

And the reason I ask is, you've laid out here a scenario where headcount's going to go up.

You're going to put back in place full work weeks.

Merit increases are coming in.

You're going to have SAP costs coming in.

At the same time, you could have -- just comps alone causes the increases in revenues to begin to moderate.

I mean, this just kind of sounds like what happens to every Company that once you get to a certain part of the cycle, you have to invest to support the growth.

And it seems like the model that you've kept well to so far, which is that half the growth of revenues, it just seems like that would be very difficult, and may not even be desirable once we get into the second half of this year and beyond as the cycle tends to mature.

When you talk about that goal, is that -- I mean, is that extending throughout the year?

Is that just kind of Q2?

How should we look at that?

When we do our budgeting process, Holden, we do it on a location-by-location basis, and our model shows a slight increase in headcount, and our model has all of the benefits that we suspended back in the plan.

And I think just as an indication in the first quarter, to be up 19%, 20% in sales and headcount to be down, I think is really I think a good sign that I feel strongly that we can do it throughout the remainder of the year.

Okay.

Holden, remember one thing too.

I think it's a point we made in prior quarters, is we had to maintain critical mass when the market went down the level it went down.

So, we had what we would consider some excess capacity in the field to absorb the first wave of sales increases.

So, I don't think -- you shouldn't be looking at this on a linear basis.

We [had] some capacity to absorb to begin with.

Okay.

Now [we need to look at] the question of when you sort of run out of that capacity.

I guess what you're saying is, you still feel like you have excess capacity and you think you will through the year?

Yes.

Holden, your theoretical discussion is correct as in yes, at some point in time these things will happen and to meet our goals it gets progressively harder from the first quarter to the second quarter, and then in our third and fourth quarters, definitely.

I think we will definitely see a slowdown in trying to accomplish that goal.

It will make it harder and maybe we won't hit the goal actually in those last couple of quarters, as we get back to equilibrium.

Okay.

On the gross margin, if I adjust out the LIFO gain from Q1 last year and I adjust out the $2.7 million Q1 this year, I think I'm getting about a 60 basis point increase apples-to-apples.

I think this may have been asked with respect to rebates.

But I guess 'm asking more broadly, that 60 basis point increase year-over-year, if it's not rebates, what are the other pieces that are driving that?

Are those internal initiatives?

Is it just general pricing going through?

How should we look at that?

I think I'll just sort of repeat some of the benefits that we saw from lower scrap expense, inventory reserves as well as some gross profit benefits in our Fluid Power businesses due to some of the leveraging of their increase in their activities.

As you know, our Fluid Power businesses, besides just selling components, they also are putting components together to build systems and doing some fabrication work like that.

And so, with the increases we were able to see some nice leveraging that improved the margins from that.

Okay.

And then lastly, if I could, I'm sorry if this is a repeat but I didn't quite get it when you said it.

Explain again, this LIFO adjustment you made this quarter is different from what you were doing last year.

Can you give a quick synopsis again of what these benefits are and why they're temporary?

They're one-time benefits, non-repeatable.

Basically when you think of the LIFO concept, you think of LIFO expense that you record LIFO expense at a time of rising prices.

Well, in the situation we have, is we have a situation with some decreasing prices for a certain amount of our goods because of volume rebates kicking back up to higher levels.

So, therefore, that translates into a LIFO income or LIFO benefit as that reverses out.

And I think the way I look at it is like if I'm buying a product for $100 in fiscal 2010 and I get a 1% rebate, really I'm paying $99 for that product.

Then in fiscal 2011, my purchases starting in July, I'm getting let's say a 3% rebate so in essence that $ 100 product is really costing me $97.

So, the moving from $99 to $97 really is this decrease in prices that we're experiencing because of the volume rebates for certain of our product lines kicking back in.

And that flows through the LIFO calculations right now, and it just flows through this quarter because it went down from $99 to $97 this quarter, and it will be $97 next quarter, but I've already had that negative impact of the decrease.

That's why it won't really continue much more additional benefits for the rest of the year.

Not going to go away.

But it's not going to reverse but it's -- that's just what it was for the year.

Okay.

All right.

Great.

Hope that helps a little.

Yes, it does.

Thank you.

Okay.

Thank you.

Our final question comes from Joe Mondillo from Sidoti & Company.

Please go ahead.

Hi, guys.

I was wondering, and I don't know if you know the answer to this but if you know any strengths and weaknesses in terms of sales in any of the regions around the country that you're seeing.

Yes, I'll jump in.

This is Ben.

It really depends on the comparables from prior year.

If you take, for example, our Midwest, kind of the central part of the US was probably down the most last year.

It's up the most this year.

And some of our other areas geographically that were not down as much are not up as much this year.

So, it really is important to look at what was happening a year ago.

And so, in the -- I guess in the central part of the US we're seeing some good growth in the central part.

Okay.

And then just a sort of stem off of that, where would you like to target expanding in terms of regions?

I guess from a North American standpoint, we're always looking to grow in all areas of North America.

We have some areas where we're stronger than others, and we're constantly looking at those areas where we have a lower market share than our overall, and we have plans and strategies, whether it's via acquisition or organically to grow in those markets, whether it's product-wise, focus on an industry.

We have a great team of folks here that focus on all the above to try to gain market share.

Are there any markets or actual geographic regions that you specifically would like to expand into?

Or at least you would want to mention?

Joe, it's really -- it's a lot of variables that go in.

Again, there are some very desirable market segments that we would like to be into that sometimes manifest themselves into certain geographic areas.

There are certain acquisitions that kind of rule a particular market that we would love to have.

There are certain places that certain acquisitions that would give us some product lines we'd like to have.

So, we don't look at it as purely a regional focus.

We have a combination focus out there where we put all the strategic pieces together to make a selection.

So, I wouldn't say that we're sitting here today coveting one geographical area of the country that drives us.

I think our two latest acquisitions were great examples.

SCS Supply in Ontario is our first entree into the province of Ontario, something we've looked at for a long time and wanted to be there.

And then UZ, as somewhat of a government play as well as a product expansion play.

Both fit very well into our strategies.

Okay.

Great.

And then just very lastly, I was just wondering if you could give us an idea of how the sales progressed throughout the quarter, and then I guess what you're seeing here in October.

I think in my remarks I talked about us seeing a small down tick in the month of July and August, which is our traditional seasonality.

And then it did tick back up in September, and we have seen a continued strength into October.

Okay.

Great.

Thanks a lot.

Thank you.

This concludes our question-and-answer session.

I'll now turn the conference over to Dave Pugh for any closing remarks.

Great.

Thanks.

Thanks for joining us today, and sorry to give you a few of those items that have caused your models to challenge you a little bit.

But I think they will be mitigated as we get into the next quarter.

Again, it was a solid quarter, nothing flashy.

Fair stability in the demand, and we feel like we're operating with good, efficient fundamentals.

So, stick with us.

We'll see you in a quarter.

Thanks.

Thank you, ladies and gentlemen.

This concludes today's conference.

Thank you for participating.

You may now disconnect.