MSC Industrial Direct Co Inc (MSM) 2009 Q3 法說會逐字稿

Good morning.

My name is Sylvia and I will be your conference operator today.

At this time, I would like to welcome everyone to the MSC Industrial third-quarter 2009 earnings conference call.

All lines have been placed on used to prevent any background noise.

After the speakers remarks, there will be a question-and-answer session.

(Operator Instructions)

Thank you.

I would now like to turn the call over to [Alex Tremont] of FD.

Miss Tremont, you may begin your conference.

Good morning everyone and welcome to the MSC Industrial Direct fiscal 2009 third-quarter conference call.

You should have received a copy of this morning's earnings announcement.

If you have not received a copy, please contact our office at 212-850-5600 and a copy will be sent to you.

An online archive of this broadcast will be available one hour after the conclusion of the call and available for two weeks at www.MSCDirect.com.

Certain information pertaining to non-GAAP financial measures may arise during this broadcast and can also be found in the earnings announcement which is posted on the same website in the investor relations section, which you can find under the tab, about MSC.

In addition, during the presentation, management will refer to financial and operating data included under the section operational statistics, which you can also find under the tab, about MSC, on the website.

Let me now take a minute to reference the Safe Harbor statement under the Private Securities Litigation Reform Act of 1995.

This call may contain certain forward-looking statements within the meaning of the US securities laws including guidance about expected results in the next quarter, expected benefits from the Company's recently launched new customer enhancements, expectations regarding conversion of net income into operating cash flow, expectations regarding the Company's ability to capture market share, the Company's growth plan and expectations about the Company's ability to manage costs.

These forward-looking statements involve risks and uncertainties that could cause the actual results to differ materially from those anticipated by these statements.

Information about these risks is noted in the earnings press release and in the risk factors in the MDNA section of the Company's latest annual report filed with the SEC as well as on the Company's other SEC filings.

These forward-looking statements are based on the Company's current expectations and the Company assumes no obligation to update these statements.

Investors are cautioned not to place undue reliance on these forward-looking statements.

I would now like to introduce MSC Industrial Direct's President and Chief Executive Officer, David Sandler.

David, please go ahead.

Thanks, Alex.

Good morning and thanks for joining us today.

With me are Chuck Boehlke, our Executive Vice President and CFO; and Shelley Boxer, our Vice President of Finance.

Last quarter, we spoke of our plans to deal with the effects of the deepest recession in the last 75 years.

Today, we will update you on what we are seeing in the landscape and the execution of our plans to date.

Chuck will then provide some details about the results.

I would like to begin by providing a high level theme to the way in which we view this operating environment.

We continue to take share from the smaller, less well-capitalized distributors.

Our team is successfully defending our gross margin in the face of significant price competition and maintaining solid control of our operating expenses while investing for the future.

We continue to strengthen our balance sheet, deliver excellent cash generation, and asset management.

We remain convinced that this period will be looked back upon as the greatest opportunity for MSC to gain share and to build a company for significant future growth and profitability.

There is no question that currently, our customers continue to generally convey that business conditions remain weak with no improvement from last quarter.

As you might imagine, there are many different opinions that we hear throughout our customer base as to when the economy will turn upwards.

However, we will maintain our disciplined approach of reporting to you what our customers are telling us about what's currently happening inside their business based on how they characterize their order flows, order backlogs, and future bookings rather than what might be hoped for in the future.

Our view is that it will be a difficult summer.

Industrial macro indicators continue to be negative, indicative of continued declines.

The ISM has remained well below 50, indicating a continued contraction in the industrial economy.

Customers continue to shed jobs and reduce work hours and from what we are hearing throughout our customer base, summer shutdowns are likely to be more prevalent and longer in duration than last year.

While some customers are indicating that inventory destocking may be approaching the bottom, many others continue to deplete their inventory and continue to find ways to reduce their spend or avoid new purchases whenever possible.

Our own sales force has reported that competitive pricing pressures have not abated as smaller distributors struggle to generate business and cash flow.

In the face of this increased price pressure, our gross margin remains strong; continuing to validate our model and reinforce the value that we deliver and the advantages that we gain through scale.

Our market share gains, gross margin and cash flow reinforce our confidence in the future.

This downturn is enabling us to make major improvements in a number of areas.

As a result of our continuing investment in our service model, electronic procurement systems, [huge] product base and high-value offering, we have widened the gap between our value proposition and those of smaller competitors who have been forced to retrench.

While they are suffering from low inventories, lack of working capital and significant service failure, the MSC team continues to deliver the highest levels of accuracy and availability.

Our fill rates remain at or above goal.

We make it very easy for our customers to rely on our inventory.

They can call and get a quick answer or go online and view our inventory.

They can order very late in the day with the knowledge that we will have it in their plant the next day.

Customers are under extreme pressure to reduce costs and generate cash by reducing working capital and that's exactly what our model accomplishes.

It's important that we all remember that 75% or so of the market is serviced by small to mid-sized distributors.

Their balance sheets are under severe pressure and while they struggle to hold inventory or carry accounts receivable, we are outcompeting them with customers.

The longer this deep recession continues, the more we will take advantage of their service failures and the more sure that we will gain.

Another important reason for our optimism about the future is that historically we have kept their share gain when economic growth returned.

As I indicated earlier, we remain laser focused on our gross margin.

We are proactive in this effort by continuing our expensive private brand program supported by our Asian sourcing initiative with our preferred brand strategy.

As stated earlier, these initiatives when high levels of savings and value to customers while strengthening our competitive advantage over local distributors.

We are also prudently investing in the future.

As we expected, opportunities coming our way are increasing as the recession grinds on.

As a result, we believe that this is the right time to increase our spending and growth initiative.

The primary near-term opportunity is the share that we can gain by attracting the best salespeople in our industry.

They are becoming more concerned with their earnings, career potential and reputation as their employers struggle with weak cash flow and customer support.

Consequently, the opportunity to hire some outstanding new associates for our team continues to increase.

At the end of Q3, the salesforce has grown to 927 associates, and we anticipate that it will grow to approximately 940 by the end of the fourth quarter.

In the past, we had to actively recruit in order to drive our outside sales associates growth.

We can assure you that in this environment, our growth in associates is being driven due to the strength of our brand and our execution.

We have continued to invest in our West Coast expansion plan as we believe that it continues to provide a great opportunity for us.

We are also engaged in other growth and productivity projects that will help us to grow our top and bottom line for years to come.

These include investments in our ecomm and data management capabilities to fuel our competitive differentiation in this area and further heighten the customer service experience we offer.

This downturn has also provided the opportunity to focus on operating productivity.

We just finished the installation of a new outbound [picking] system in our Atlanta fulfillment center similar to the one we installed recently in the Harrisburg fulfillment center.

This system will provide cost savings, improved throughput, increase capacity and improve customer service.

Our goal today was to give you a sense of why we are so confident about our future prospects and how we are extremely well positioned to deliver robust growth in revenues and earnings when the cycle inevitably turns upwards in the future.

Given that visibility continues to be poor, Q4 guidance is based on current sales trends and incorporates an estimate of the effects of the extended customer shutdowns during the summer.

Also included in guidance is the increased spending on growth initiatives described above, slightly lower gross margins which Chuck will discuss in detail and items impacting operating expenses which Chuck will also discuss as well.

With the caveat that no one knows exactly what this summer will bring, we expect the sales for the fourth quarter of fiscal 2009 will be between $336 million and $348 million and diluted earnings per share will be between $0.33 per share and $0.37 per share.

And with that, I'll thank you and turn the mic ever to Chuck.

Thank you, David.

In Q3, sales came in at the top of our guidance range and earnings were $0.03 above the range.

Gross margin percentage was within guidance and operating expenses were below expectations as we realized the benefits from the cost savings measures that we implemented.

We have reduced our gross margin guidance to 45.4% plus or minus 20 basis points for Q4.

Approximately half of this change is due to customer and product mix with the remainder being driven by reduced volume rebates associated with our successful inventory management program.

It is important to note that the mix change is being exacerbated in this environment and as a result of this, deep declines being experienced in our higher-margin core customer base.

We are confident that its effect will reverse and be a catalyst for gross margin expansion once the economic cycle turns and growth resumes.

We expect operating expenses in Q4 to increase over Q3 levels as we accelerate investments in growth and productivity.

Our guidance implies an additional $3 million in growth and productivity spending ever Q3 levels.

Of this amount, approximately half will be embedded in our ongoing operations and half will be dropping out of our run rate once these initiatives are complete.

We are very pleased with our balance sheet management and cash generation continues to be outstanding.

In Q3, net cash provided by operating activities exceeded $91 million.

This is more than three times net income for the period and $14 million more than Q3 of fiscal 2008.

This was made possible by continued reductions in working capital.

At the same time, we have been able to maintain our inventory turns and our receivables DSO.

We believe that this is a notable accomplishment in the face of declining sales.

When the economy turns upward and we know that we will have to invest in working capital.

However, our goal will be to increase inventory turns so as to keep that investment to a minimum.

Our balance sheet is even stronger now than three months ago.

Inventory and receivables reserves continue at appropriately conservative levels and include provision for the anticipated effects of the deep recession.

Cash reserves have also increased substantially and as of June 30, cash on hand was greater than our outstanding debt.

We also have significant availability on our line of credit.

This gives us the freedom to take advantage of opportunities that may arise that other companies may not be able to because of tight or expensive credit.

Thank you and now I will turn it back over to David.

Thanks, Chuck.

In conclusion, we continue to take a carefully planned approach to balancing the needs of our stakeholders.

We are executing our model at very high levels and taking share from the small distributors.

In these troubled times, we have taken the necessary steps to reduce our operating expenses and to also invest for the future in a measured and productive way with great confidence in the returns that will be generated.

We have concentrated on balance sheet management and cash generation that is building strength for the future as well as enhancing our ability to take advantage of current opportunities.

Historically, we have talked about the strength that our model would be capable of delivering through all phases of the economic cycle.

Our cash generation performance has demonstrated that strength through this recessionary cycle.

We have also historically talked about how our model delivered disproportionate growth in revenues and profitability during the cycle upturn and we remain as confident as ever that strength will once again become evident when the growth cycle begins.

In closing, I would like to extend my thanks to all of our MSC associates whose dedication and hard work make MSC successful and such a great place to build a career.

Thanks, and I will now open the lines for questions.

(Operator Instructions) David Manthey, Robert W.

Baird.

First off, I'm wondering if you could give us in broad strokes an outline of some of the SGA costs that you've been able to take out.

If you could just give us an idea of what the big chunks are and how permanent those are in a garden-variety moderate upturn.

Dave, it's Chuck.

Some of them like most organizations have been put in place that are temporary to the extent they will come back one day in the P&L, things like salary freeze that we've talked about previously, suspension of a 401(k) match.

Obviously an incentive accrual for this year's performance would be lower.

Those types of things eventually would come back in.

There's many other things that are out that would permanently be out.

David talked a little bit about turning Atlanta on to our warehouse optimization project.

That's a productivity gain and that productivity is in now and actually accelerated, the volumes start to pick back up in Atlanta.

There's things like contract negotiations that we would anticipate that we not only anticipate, but have realized favorable savings on that we would not anticipate even when the environment turns, that they would have to come back in.

So it's a mix of some temporary things as well with some permanent type productivity gains that are leading to the OpEx number you see right now.

David, the only thing I will add to that is the reduction in work hours that of course as volume builds back, those work hours will be -- will return back to normal.

Okay.

So it sounds like -- correct me if I'm wrong -- that a vast majority of the costs that have come out, it sounds like there's a lot of variable costs and then costs related to productivity as opposed to large fixed costs which would be expected with a distribution model, but is that the way the right way to think about it?

I think so, Dave.

You say variable costs, for example, I just want to elaborate on the productivity project David mentioned in Atlanta.

The pick, pack and ship cost obviously is a variable cost, but we permanently -- taken down, taken that variable cost to a lower level given the project has been completed now.

So even when the volume returns, the absolute cost may go up, but the variable component in aggregate would be down because of a project like that.

Okay.

And then just one more question, if I could.

In terms of the $3 million investment and your comment that you see this as a great opportunity to invest in the growth of the business, beyond the couple of things you mentioned about e-commerce and the new picking system and adding salespeople, that sort of thing, are there other opportunities that you've outlined that you can play offense here and maybe are there any acquisition opportunities that are starting to surface?

David, two things.

First of all, we -- I think you are right in characterizing it as playing offense.

Within some of our investment spending, we are absolutely really stepping down on things that we think are going to drive growth in the future, things that are going to improve productivity both in the OpEx line as well as the gross margin line.

So you've listed some and we've got other initiatives that frankly we are not talking about that are also embedded in our planning and in some of that spending.

There was a second part to your question and I just missed it.

Acquisitions.

Very good, thank you.

On the acquisition front, we are seeing some activity, albeit limited, although far more than when it was locked down several months ago.

It is an area that we continue to focus on.

But we are going to continue to maintain the kind of high standards that we have always had about looking at businesses that we think will really help us to outsize our results in future years.

So that is an area that we are actively looking at.

Thanks guys.

Have a great fourth.

John Inch, Merrill Lynch.

Thank you.

Good morning everyone.

Would you remind us of the mix or your mix between MRO versus OE roughly and sort of what's been the trend there?

We don't break out mix in business between our -- within our major product lines, metalworking and MRO, for example.

What we do break out, John, as you can see on our website is manufacturing and non-manufacturing business, and that's really a very significant split out of our business.

You can see where the economy has taken its toll on the manufacturing sector of course.

Right, I guess where I'm going with this is kind of the results that you are putting up is sort of down mid 20s on the top line.

I get the sense that MRO isn't nearly that bad.

So I'm not sure again what your split is specifically, but are you seeing the trend where your MRO businesses are down, sort of what the other players are doing, down 10 and kind of the non-MRO or OE businesses are down much, much more than that?

Is that -- is that where you get the snapback when the recovery happens (multiple speakers) mix?

John, yes.

I think one of the things to think about is that within our core customer base, our core historic base which is largely buried in manufacturing, that segment is way down and one of the product categories that that historic segment buys is it's certainly a concentration of metalworking supplies.

Not to say that they don't also buy MRO, but that's a higher margin segment for us.

It's a higher-margin overall line because of the number of years that we've been in the business.

And that's been significantly depressed.

Frankly what we've seen historically in recessions and we would expect this one to act the same way is that when that customer base snaps back, we will see significant growth in that segment and, in particular, we will also have margin expansion coming as a result of that growth.

That make sense.

What about auto specifically?

It's a huge chunk of the US industrial economy and clearly production is about to pick up very nicely as we roll into the fourth calendar quarter.

Are you guys going to see -- is that going to meaningfully impact your top line, maybe help us sort of bounce back a little bit here from this run rate?

We are hopeful that auto across the entire economy will be a general lift of course, when That finally does happen.

We are fortunate in what's gone on so far that the auto sector, we have no direct exposure to the big three and have very minimal exposure to the Tier 1 and Tier 2.

Of course, those plants and the areas that have been set down, of course, have impact.

You can see that in the heavy durables concentration in the Midwest.

So given its kind of broad impact on the economy and for those customers, it may have a small slice of auto embedded within them, of course it would be a good thing if it came back.

But overall, our auto exposure is really not significant to our overall business.

Okay, and then maybe just one last one for me.

Based on the input you provided sequentially, it looks like your operating margins are going to turn somewhere around the 10.5 to 11% range.

I guess based on the pricing dynamics that you called out as being very difficult, especially with the smaller, medium-sized players; do you guys think that margins can still hold as this recession sort of continues above the 10% range?

Or do you expect a little bit more softness there going forward?

Hi, John.

It's Chuck.

You are exactly right.

The implied margin from the midpoint of the guidance we gave is about 10.3, 10.4 for the fourth quarter and we've done some modeling.

We would probably need to go south of minus 25 for those margins to slip into the high single-digit land.

So presumably, if it doesn't get to that level, we should be able to stay above the 10% level and expansion in margins with -- obviously depending on how quick the recovery comes.

But it would take something probably south of 25 to drive the margins below 10.

Adam Uhlman, Cleveland Research.

Just a quick clarification.

What is MSC's exposure to the automotive sector?

Adam, it's not significant.

Remember we don't have business in the -- any direct business with the autos.

We have very little exposure to Tier 1 and Tier 2.

I think where we've got the exposure is in all those small shops and mid-size companies that have a slice of auto embedded within their customer base, almost impossible to measure that.

But as I go and visit customers, you know, you will often hear stories about shops that had high concentration in auto years ago, saw the handwriting on the wall, couldn't take the cyclicality of it and have moved far away from it and have diversified into other segments.

Having said that, they and others have some exposure to it and of course, that adds impact on the business.

Listen, what we've heard from some is given the trough that auto is in, we would hope that they be the recipient of when that automotive cycle finally does turn up, but overall, it's really not a meaningful part of our business today.

Okay, fine.

And Chuck, a question on the gross margin guidance, a pretty big stepdown from the third quarter level and I think you mentioned that half of that was due to product and customer mix.

Can you help me understand that a little bit better?

Because you are -- the manufacturing customers have been weak all this year, the metalworking mix has been a headwind all of this year.

So why is it that gross margin finally takes a step down in the fourth quarter?

Couple of things, Adam.

First of all, we will talk about customer mix [for a section].

We've talked about in the past a little bit and maybe you've been in the (inaudible) the larger accounts, the mix between that and the core business, the higher gross margin accounts are in our basic core business and that continues to deteriorate at a level that's continued to get a little bit worse versus where the larger accounts have kind of migrated to in the past couple of months here.

So it's a pure play on the customer mix.

That will be an opportunity for us coming back the other way when we would anticipate that core business which has the higher margins on the upswing, but come out hopefully a little bit stronger than the larger accounts.

But they continue to decline, so the more that mix is shifting away from our higher gross margin accounts, the pure mix of the customer sales alone starts to drive some of that out.

On the product mix side, June, one of the coolest Junes on record, less HVAC type stuff.

We have a little bit higher margins than that.

So there's some product mix issues in there.

And then the rebates was the other piece of that.

We've frankly done a little bit better than we thought on the inventory front and driving our inventory down and that obviously has ramifications from the amount of purchases that we have.

Now we're going back and challenging and looking to renegotiate thresholds, but the fact of the matter is given our successful inventory program, our purchasing plan is actually down further than we would have anticipated just a few months ago and that has ramifications from a rebate perspective.

So, the way the accounting works, that change starts to show up in our fourth quarter and would continue through the first part of next year.

So that's what makes up the 50 basis points or so decline from Q3 to Q4.

Okay, and then assuming that revenue levels would stay where they are at now, what -- how do you think about gross margin unfolding next year?

You said that gross margin would continue to get hit through the first part of the year, but would we still be in this 45.5% range or can you dimensionalize that a little better for us?

Adam, it's David.

I think we would rather not characterize it with a number.

You touched on some of it.

We've got, as you know and following us, there's a lot of moving parts.

We've got several programs that we are making great progress on that serve to increase our margin on the [buy better] front, our preferred supplier program, our overseas sourcing initiatives that feed into our private branding initiative, and of course, you just mentioned a couple of the headwinds as well.

On the rebate front, Chuck touched upon the change in our customer mix as well as some of the promotional campaign activity that we've had and the ongoing discounting that we've seen out there.

So all of those pieces kind of fit together.

It's something that our team is managing; each component very, very closely and we're going to continue to drive gross margins and it will remain a very important focus for us and really executing there.

But we would rather not start giving kind of forecast for what might happen in 2010.

Hamzah Mazari, Credit Suisse.

Thank you.

Just a couple questions.

Could you talk a little bit about if your end markets take another leg down, how much additional room you have to run on the cost side?

You've done a pretty good job so far.

Could you talk a little bit about where the savings would come from, which buckets and how much of that would just be temporary versus permanent?

So just trying to get a sense of how much more room do you have to run on the cost side.

Sorry about cutting your off there.

I think, of course, we always have our contingency planning in our forefront in the event that there was another market turn and a leg down.

We would rather not share that.

Certainly the work that we're doing right now to continuously improve productivity and take costs out would help us there and I would tell you that if we needed to, if there was a significant market share, we would step back and of course, we would further adjust our plans in taking out more temporary costs and continuing to mind some of the more permanent costs.

But would rather not be real granular in exactly what we would do in that case.

But suffice to say that certainly we've got the thinking on our shelves in the event that there was another leg down to this thing.

Fair enough.

And then one other question.

Your average transaction size has been trending down.

Is that -- could you help us think about that?

Is that just pricing pressure mix?

Is that also a function of growth in national accounts with?

Could you touch on that?

Certainly can.

Actually it's not a function of our larger accounts.

What -- in [burrowing] in this quarter, what we see in our average order size is that the large customer segment was really flat and where the declines overall are coming from are within our core customer base; frankly, not unexpected to us given what's happening in this economy.

So it clearly tracks back to the effect of this recession.

Okay, thank you.

John Baliotti, FTN Equity Market.

David, what -- when the competitors are discounting, cutting price and they are able to sell the product, do you get the sense from the guys in the field of what they are doing next?

Are they trying -- are they even trying to put that product back on the shelves or are they not doing that?

You know, John, one of the things that the small distributor has, one of their primary weapons, of course relationship has always been there, but the other is the ability to be just really flexible on price.

The challenge though is that it's kind of a self-fulfilling prophecy that as the discounting is down and as their profit margins erode, that puts further pressure on their balance sheet, their ability to finance their accounts receivable and in particular, be able to replace inventory.

So the trend that we are seeing and frankly, we see more of it this quarter than we did before, and we would expect that to continue to exacerbate in quarters to come, which is really a great advantage for us, is that it chokes off their customer service level.

So inventories that customers had historically been able to rely upon them for -- on their shelves, all of a sudden now, they don't quite have because they are unable to replace it.

So that's kind of the trend that we are seeing.

And of course, that's the thing that really makes us confident in our share gains in this market.

Yes, because obviously the relationship gets you only so far.

If you don't have the product, then that's kind of irrelevant, right?

That's exactly right.

John, one of the reasons -- it's all part of the same theme is one of the reasons they are trying to discount is they might not have it in stock.

The last 40 times in a decent economy, the small distributor had it in stock.

He's trying to compete on price, he or she, but they don't even have it in stock.

They're waiting for the order from the customer before they go back to the supplier and try to help make some of that pain up, if you will to the customer, they will discount heavier than they might otherwise.

And that may work or it may not work, maybe an opportunity for us right out of the gate there because we will have it in stock.

Did you sense that any of your competition is actually buying from you just to keep that relationship going?

We actually note the fact that many do.

Just if you look at the macro data that has come out in the last couple of months, you get some conflicting numbers and I think people are looking for any glimmer of hope things are getting better.

But I think your view makes sense that the summer could be tough.

Is capacity utilization, is that consistent if you look at those levels with what you are seeing right now?

These are below the last 40 years.

We haven't seen numbers of this magnitude.

John, some of the numbers that we look at take our breath away.

Certainly capacity utilization is one.

We place a great amount of weight and priority on the ISM.

We are certainly pleased to see it moving from where it was in December.

And there were a few positive signs buried in yesterday's reading in terms of inventory and what's happening as that continues to be taken out and inventory levels come down.

A little bit of positive news on the new order front and on the production side as well.

So those are -- we look at all of them -- durables, etc.

But probably the biggest that we see, the biggest part of our radar beyond those that are publicly published is just really in the belly of our customer base.

And I've got to tell you, what we hear from so many customers is gee, we are really -- we think the fall might be promising.

When you burrow into that, gee, is it promising because you've got a new order that's coming or something promised from your customer?

And the answer is no.

It basically tracks to psychology just not being as bad as it was.

But when you really dig in, the data tells us that nothing has changed and unfortunately, our view for the summer is that what will change, if anything, is that the heat is going to drive less work hours and more layoffs.

I appreciate it.

Thank you.

Brent Rakers, Morgan Keegan.

Good morning.

You guys have done a good job kind of out outlining the automotive or I guess the lack of automotive exposure.

I was hoping maybe you could talk through some other kind of key metalworking customer sets in particular, Aerospace Defense and possibly oilfield as well?

Brent, I'd rather not talk about specific segments.

Of course we do watch all of the segments and where we see opportunity, that's really where we disproportionately focus our salesforce and where we target our investments.

I guess the additional color that I would tell you is that when you look at our manufacturing/non-manufacturing breakout, the -- you could obviously see the declines quarter over quarter.

One of the things that you won't see though in our numbers is I will characterize that the manufacturing segment, those declines were relatively stable throughout the quarter.

But when you look at the non-manufacturing segment, that actually declined sequentially throughout the quarter.

Okay.

That's actually a great lead-in to my next question.

I think when I look at the performance of your manufacturing segment, second quarter versus third quarter, in light of what's happening to I guess some suppliers and even some of your I guess distributor peers, it seems like your performance Q3 is significantly improved from where it was in Q2.

I guess first, do you see that as well?

And I guess second, maybe what some of the explanations might be of that?

Well, we could never get very excited about I think a minus 28 in that segment of the business.

But, Brent, we are heads down.

What you may be expressing is a result of us continuing to focus and execute on our game plan.

There's a tremendous amount of weakness out there.

We have seen the weakness within our small competitor base and there's no question in our minds that we are capitalizing on that weakness every single day and that's what gives us great confidence about when this thing turns.

Our process actually looks at the wins, albeit anecdotal, we understand where we are winning in this thing and I will tell you I see a report weekly that gets me very excited and really build my confidence in the future about how we are just grinding away, taking business that when things are robust, it would be very tough or impossible to get that business.

Great.

Just two quick final ones.

First, if you could maybe talk through the reason that the bad debt expense dropped off in Q3 and then maybe what the outlook should be going forward there?

And then lastly, on the headcount numbers, obviously you give some information on your salesforce numbers, but I think you started this is the year at about 4100 full-time employees.

I just wanted to get a sense for what that number might be right now.

Let me talk a little bit about the bad debt and give you some insight there, talk about macro first.

Our write-off percentage is clearly higher than they were a year ago.

However, when I tracked back and did some research back to where we were post 9/11, our write-off percentages are dramatically lower than they were in the last recession.

And I chalked that up to some solid work between our credit team and our sales team.

Remember, we're talking about post-9/11, a sales environment that was minus 9.

With our guidance we gave today, the implied full year is minus 17 and we are significantly less write-offs for the percent of saleswise than we were back then.

So we think we've done a decent job.

That being said, in the third quarter, no different than any other quarter.

We go through a very rigorous process on analyzing what our required reserve would be for bad debt.

That's taking all of the large accounts in every region and specifically looking at what the requirement might be and then taking the rest and putting it in an aging bucket and applying a formulaic approach to it.

Our overall requirement for the third quarter compared to what we had reserved on the books was actually down a little bit.

So there was a reduction in the necessary accrual if you will, Q3 versus Q2, to make the appropriate balance at the end of the quarter in terms of it relates to bad debt.

So we think we are in good shape.

We think we got the right number.

We were slightly overreserved and we pulled some of that back at the end of Q3, but it was only a couple hundred thousand dollars.

It wasn't a lot.

And I guess the other question that you asked was about headcount.

At the end of the fiscal year, we were at 4261.

And at the end of the quarter, our associate total was 4213.

Of course, be mindful, that's the absolute number.

Given that we've taken some work hours out, that wouldn't be reflected in that number.

But that's, of course, why we been able to control our expenses as we have.

Great.

Thanks a lot, guys.

(Operator Instructions) Gregory Macosko, Lord Abbett.

Thank you.

Could you talk a little bit about your CapEx?

It's up obviously this year and you are investing in the future, I believe the West Coast.

Just give us an update on how the buildouts are going.

First off, I just want to say that when you talk about the West Coast, most of the investment for sales expansion is in OpEx.

Obviously salaries, wages, (inaudible) branches, branch expense, so we need to separate that from CapEx.

The CapEx for this year based on where we are year-to-date and what we anticipate in the fourth quarter will be in the aggregated $26 million range, something like that.

The bulk of those dollars are actually projects that were approved in a very different business environment last year and the cash flow carried into this year.

So there wasn't a ton of new stuff approved necessarily this year where the cash is flowing.

It's primarily a reflection of what was done last year.

We will reassess here as we get near the end of the fiscal year and evaluate our plans moving forward and next quarter we will maybe give you an update on what we see for 2010.

Greg, I will give you a little bit of -- just a little color on the West, which is we are hiring out West.

We continue to take advantage of what we think is just a wonderful growth opportunity for the future and you will see us opening and announcing new branches in the quarters to come.

And should we expect those in what areas?

The West Coast basically is where most of them will come or --?

Yes.

As part of our West Coast buildout, we are continuing to focus on adding branches in that area.

How much have you -- how many have you closed year to date would you say?

Closed?

Yes.

Closed just around the country.

Have you closed any?

None.

We certainly as leases and as our space needs change, we may relocate a branch now and then.

But no, we have not closed any branches.

And then just going back to the CapEx, that means that the leadtime on your projects are kind of 12 months or so, right?

Is that what you are saying?

Yes.

Greg, for example, the optimization project that we did in Atlanta, we've been talking about -- that project was approved long ago because it's -- obviously, there's a lot of engineering work and some physical movement in the facility to prepare for that.

So yes, a lot of this stuff is -- has got longer leadtimes associated with it.

Some of it, if it's warehouse expansion, obviously, the project gets approved and the cash flows over a fairly extended period of time, some cases more than a year.

And so you basically -- well, did you -- were any of your projects at all delayed or postponed?

Yes, definitely.

We -- obviously, when the -- who knows if we're completely out, but when cash was king as it still is, but the crunch was going on, we took a look at our CapEx for the year and definitely scaled back.

You couldn't scale back what was in progress, but as I said, most of the $26 million we are spending this year is the result of approvals from last year projects.

So the opportunity to scale back is to curb your current appetite for CapEx and we did a lot of that during 2009 to basically minimize the CapEx at its 25, $26 million level which it will be for the year.

Okay.

Thanks very much.

Derek Jose, Longbow Research.

I was just wondering on the customer acquisition breakdown, you guys have historically over the past few calls talked about the focus on the larger customers, but it seems that most of the opportunity is in the smaller customer base.

I was wondering if you could maybe break out a little bit on the large customer segment, how that is going in the acquisition versus the small where it seems to be you are having all this opportunity.

Derek, it's David.

Yes, I'll talk a little bit about our customer base and our strategy has been to focus on that mid to large customer that has multi-plant locations.

So we've had significant investment there.

That's an area that we focus our salesforce.

You've seen that as the result of some of the changes -- the resulting changes in our customer count numbers, but make no mistake that our small to mid-size base is still one that is very attractive and it's very important to us.

We actually have a vibrant prospecting program and they're actually producing great results with it.

Of course, there's also the attrition that comes along with it.

And what we found and what you are seeing in our customer base largely is attrition of that small, one time, under $500 per year customer with little or no opportunity to grow up into what we call one of our core customers.

What we've also talked about, in fact we talked about it in the last call, was that we were starting to see some attrition that actually concerned us creeping into that next tier of customers, that 500 to $1000 a year customer.

We've actually done a lot of research, both anecdotal and in particular formal research, to understand what was going on with that base.

And what we found largely was it's really a function of the economy.

They've been hit very hard.

They've cut back on their purchases.

They've cut back because they laid off many employees.

So they have lots of supplies laying around.

And basically, what many of them told us is that -- listen, it's not a matter of that we no longer use MSC as a supplier.

We do think of you guys on these fronts.

But from a frequency standpoint, we just haven't had the need.

When our business picks up, we certainly will use you guys.

So that gives us a lot of encouragement and I guess there's some formal research that says that when this thing turns, even that segment of our customer base will be an expansion opportunity for us.

One point to add to that as well, don't forget that our customers are counted on a bill-to basis versus ship-to.

So you take the post office, which is in our customer count is one customer with lots and lots of ship-to locations, so need to be careful when you see customer metrics that -- understanding that you may be losing smaller accounts but acquiring one, two, or five bigger accounts could have a significant impact on the number because there's multiple ship-to's as David pointed out in these large accounts, but the account is only one customer in the customer count metric.

Okay.

I guess I also -- kind of an extension of that is the growth on the West Coast.

Is that aimed more at the larger customer segment or the larger -- sorry, the smaller customer segment at this point because you see a lot of small -- attrition of the smaller suppliers out there?

Yes, I would say that we are, our West Coast expansion is focused across the customer base that we believe is going to deliver value to us long-term, which, frankly, is the gamut of both small, long-term solid lifetime value customers as well as the very large.

And depending on the best way to penetrate that small or large customer really depends on what kind of channel or resources we put on it in order to produce the best return on our investment.

So we use all of our tools, whether it's the field sales force, our telesales area, much of our customer service area, our outside field reps and all, our e-commerce channel, many of our other tools, of course our Big Book.

So depending on what the opportunity is is where we will focus the most cost-effective resource to gain their business.

And actually, what I just described in the West is similar to what we do throughout the country.

But you can see the results of our investment in the West actually paying off in our regional statistics.

Okay.

And this is the final one.

I'm looking at your balance sheet here.

You have a very large cash position and you have I think it's -- if you look at your leverage ratio, you could probably raise up to $400 million.

Is there a thought although there's weakness in the smaller distributor segment, that you can make a serious acquisition on the terms of not just maybe a mid-level supplier who has a similar model to yours that would be complementary?

Obviously David talked before about playing offense.

One of the things we can do with the cash we have on the balance sheet, as we mentioned earlier, the ability to borrow even more under the existing line of credit, that's not completely tapped out.

And any future leverages, it gives us the flexibility to do and make the decisions that we want to make depending on the opportunity.

So we have the flexibility to do lots of things given our leverageability to borrow and the cash that we have.

So the right opportunity with the right return, we have got the balance sheet to do it.

I think that was your question.

We could do it if that's what we chose to do.

And, Derek, we are absolutely aggressively but selectively pursuing opportunities in this market.

It's really a very exciting time for us given the number of opportunities that I would say have actually increased in coming our way through this downturn.

So we are pretty bullish on what we're seeing out there relative to our opportunities.

Certainly not to what we are seeing in the macro.

Thank you very much, guys.

I appreciate it.

Adam Uhlman, Cleveland Research.

I was wondering if you could break out the sales decline this quarter between the volume price and large customer account buckets.

Sure will.

We're getting that as we speak.

Give us one second here.

So the decomposition -- one second away here.

Let's see who gets it first.

Page 14.

Thank you.

Sorry about that.

So if you take a look at the total sales decline of $107 million, $88 million came from decline in the core.

$27 million came from decline in our large customer segment and $8 million to the positive came from pricing contribution.

Great, thanks.

And then just one last quick one.

Here in the next month or so, the next year's Big Book is going to be coming out.

I was wondering if you guys could talk about first of all, any embedded pricing changes in the book, any new product categories that are being added.

And then, could you also remind me what's happening with the J&L metalworking book?

Is there going to be a separate book there?

Thanks.

Let me hit them one at a time.

On the Big Book front, our team is getting excited to launch at the end of August as we do -- as is our tradition annually.

There will be exciting new things in our Big Book, expanding our offering.

You will see that the results of our Asian outsourcing initiative and in particular our private branding will be some of the products that we are prominently featuring and adding to our offering.

Basically, we will be adding about 21,000 or so new items and you will see roughly 23,000 non-performing items being removed from the book.

I would rather not talk about what the Big Book pricing might reflect until we are actually launched and into the quarter next quarter, Adam.

And you will also see an MSC metalworking separate catalog launched in September as well.

Thanks.

Thank you, Adam.

Yvonne Varano, Jefferies.

Thanks.

Chuck, I just wanted to go back to your comment on the OpEx going up $3 million quarter over quarter.

I know the half is going to stay, but of the half that drops out of that run rate, what are those items and when does that come out again?

Some of these projects are going to run through fourth quarter and go into next year.

Some of them are soliciting some help that would further enhance our growth and productivity initiatives, and once they are executed upon, the benefit will be in our numbers and the expense will drop off.

But it will probably bridge over, bleed over from Q4 this year into the early part of next year.

And it's a matter of getting some help to turbocharge for not only when the thing turns around, but hopefully the long-term our growth rates and productivity efforts.

And then, I know that we put the new picking system in the second facility now.

Are there plans to roll that into the other two facilities and when might that occur?

The answer is definitely yes.

The timing of that in part will be baked into our capital planning for next year and subsequent periods.

So when we give you an update on CapEx, we will let you know if that's in our plans or not moving forward.

But sometimes for sure in the future, we envision all four facilities being turned on to that new system.

And are there any actual numbers that you can tie to the cost savings that that generates?

I would just tell you that the returns is far above the corporate cost of capital.

We don't want to specifically talk about dollars and cents and EPS, but it's accretive.

And certainly is a project that we wouldn't undertake unless it significantly exceeded the corporate cost of capital which it does on the return.

And then just lastly, it seems like you are looking a little bit at acquisitions again.

Is there anything you can tell us about what type of acquisition you would be looking for, whether it's geographic, product?

We would rather not talk specifically about some of what we look at.

But certainly overall, I will tell you that what -- we want to make sure that any company that we would acquire is going to in fact enhance the things that we've got on the table over the next five years in terms of advancing our strategy, and we think that there's lots of opportunities whether it's in the product value add customer segment, multiple ways to look at this, but all of them would need to further our advancement in our -- to our strategic plan much as J&L did years ago.

Sure.

Thanks very much.

Ladies and gentlemen, we have reached the allotted time for questions and answers.

I will now turn the call back over to management for any closing remarks.

Okay.

Thank you operator.

Thank you all for joining us today and we look forward to speaking to you again next quarter.

Ladies and gentlemen, this does conclude today's conference call.

You may now disconnect.