MSC Industrial Direct Co Inc (MSM) 2009 Q4 法說會逐字稿

Good morning.

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

At this time, I would like to welcome everyone to the MSC Industrial Direct fourth quarter '09 earnings call.

All lines have been placed on mute 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 conference over to Mr.

Eric Boyriven of FD.

Sir, you may begin your conference.

Good morning everyone, and welcome to the MSC Industrial Direct fiscal 2009 fourth 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 U.S.

Securities laws, including guidance about expected results the next quarter, expected benefits from the Company's recently launched New Customer Enhancement, expectations regarding conversion of net income into operating cash flow, expectations regarding the Company's ability to capture market share, the Company's growth plans, and expectations about the Company's able 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 and MD&A section of the Company's latest annual report filed with the SEC, as well as in 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, Eric.

Good morning, everyone, and thanks for joining us today.

With me are Eric Gershwind, Executive Vice President and COO, Chuck Boehlke, Executive Vice President and CFO, and Shelley Boxer, VP, Finance.

Before I get into the quarter, I'd like to introduce Eric Gershwind, our new Chief Operating Officer.

In his new role, Eric will continue to report to me, and will take on increased responsibilities, including overall responsibility for the Company's sales and operations.

Eric is the grandson of our founder Sid Jacobson, and has had MSC in his blood his whole life.

He spent many summers working at MSC before joining the Company in 1996, after completing his academic career.

Eric's 13 years with MSC have prepared him well to tackle the challenges that lie ahead.

He has successfully led numerous projects and excelled in a succession of more challenging leadership roles.

These include business development, branch integration, sales management, e-commerce, marketing, and product management.

For the last four years, Eric has also led our Strategic Team, which has responsibility for formulating the Company's strategic plan and steering its direction.

Eric has a proven track record of success in all of these areas, and most importantly, has demonstrated that he is a cultural leader of the Company.

From the moment he joined us, he has demonstrated his commitment to the fulfillment of our mission statement of making MSC a vast industrial distributor as measured by all of our stakeholders.

I'll turn the Mike over to Eric for a few words.

Thank you, David, for the introduction, and thank you for the wonderful support that you've provided to me over the years.

I'd also like to thank our Board of Directors for entrusting me with these responsibilities.

And finally, I'd like to thank the many people whom I've worked so closely with over the years here at MSC.

My success has been the direct result of the team of people that I've been fortunate to be surrounded with.

I'm honored to accept the challenge that comes with this job, and I remain committed to fulfilling MSC's mission statement.

It's a great privilege for me to continue the legacy that was started by my grandfather Sid Jacobson so many years ago.

I look forward to ensuring continued success for all of our stakeholders.

Thank you, and now I'll turn the microphone back to David.

Thanks, Eric.

While not the case for this call, Eric will be available to take questions on future calls after he transitions into his new role.

Included in this call today will be an overview of the industrial landscape in which we operate, a review of the execution of our plans for the quarter, followed by guidance for the first quarter.

Chuck will follow with some details on the financial performance of our business.

Let me begin by providing an update on the competitive environment.

The small distributors that comprise the bulk of the market are struggling to meet the needs of their customers.

They have burned down their inventories to very, very low levels, significantly reduced their service levels, and dissatisfied many customers.

A number of them have closed branches, laid off staff and have begun to take orders at very low margins to contribute to their overhead.

This type of pricing environment has a negative impact on gross margins, but bodes well for our future.

As revenues snap back, the small distributors will face increasing pressure on their balance sheets, as they are called on to carry more receivables and inventories.

This will inevitably lead to ever increasing service failures.

We, in contrast, continue to gain share by executing our model, using our balance sheet as a weapon, having the inventory on hand, extending credit, and providing value through our e-commerce tools, inventory management programs, and our solutions suite.

Quite simply, we continue to further enhance our service, while the local distributors are eroding their business models.

While it's impossible to statistically measure, we remain convinced that we are gaining share in this market, and believe we are beginning to see some of that share gain in Q4 results.

We expect this to continue and to accelerate through any recovery, as customers' demands on their suppliers generally increase, as they order more items, demand faster delivery and larger credit lines, and move toward [just in] time management of their own inventories.

The small distributors often cannot meet those demands, as they do not have the capital or liquidity to do so.

Customers' order flows remain depressed, although some have begun to experience small improvements.

Overall, optimism continues to mount that the environment will soon improve.

This optimism was more pronounced towards the end of the fourth quarter and carried over in the first quarter.

We've seen the ISM improve with two consecutive readings above 50, which if continued and historical patterns repeat, indicate growth for our business in the months to come.

Customer inventories of MRO products continue at rock bottom levels, and customers are only ordering what they need to fill current orders.

There is no evidence of any restocking.

Customers are manufacturing to current orders, and are not build their finished goods inventories.

We look at the eventual recovery as a huge opportunity for our Company.

We view this as an extraordinary time to gain share, and we intend to take advantage of it.

We're taking a hands-on approach to how we manage our investments.

We have a track record of knowing how to adjust the dials and actively managing the right levels of investment spending to maintain what we think is the right balance between short-term profitability and long-term growth objectives.

In this environment, we think it's prudent to remain flexible and opportunistic in our approach, and we'll manage that mix based upon what we see happening with revenues and gross margin.

We'll dial it up or down, dependent upon our progress.

To give you some color, the middle of the guidance range contemplates approximately $125 million in OpEx.

This doesn't represent a significant increase of spending over Q4 levels, but does have increased levels of investment spending in it.

Overall, OpEx as a percentage of revenues would be lower in Q1 than Q4, in the middle of the guidance range, and we plan to provide that type of information quarterly.

This is an unusual time.

The economy appears to be at the beginning of a recovery from a deep recession, with an abundance of opportunity for our Company.

We'll take advantage of them; but in the context of protecting cash flow and earnings.

We also have a responsibility to restore compensation and benefits for our associates, which we will do in a measured way over time, as part of that mix.

So until we get back to what we consider normal, we're going to keep our hands tightly on the wheel and will provide quarterly guidance on projected spending levels.

There were just too many dynamics at play to provide any specifics beyond a quarterly time frame.

Hopefully this gives you a sense of our thinking on how we'll manage it, and I'm also comfortable telling you that nothing has changed in our model that in the longer term, once normalcy resumes, we are confident that earnings gross will outpace revenue growth.

There were 939 field sales associates at the end of Q4, and we expect this number to increase to between 945 and 950 in Q1.

Given that visibility remains poor, Q1 guidance is based on current sales trends and includes the costs of our investments in growth and productivity initiatives.

We expect that sales will be between $378 million and $398 million,(sic - see correction below) and fully diluted earnings per share to be between $0.46 and $0.50 per share.

Thanks, and I'll now turn the Mike over to Chuck.

Thanks, David.

Results for Q4 came in above the top of our guidance range in both sales and earnings.

We did experience summer shut-downs that were more widespread and longer than last year's fourth quarter, but not quite as bad as we had anticipated and had included in our guidance.

Sales trends improved during the summer, as year over year rates of decline in sales narrowed every month.

Additionally, average daily sales improved throughout the quarter, and total sales in Q4 exceeded Q3 levels.

September results and October to date have continued to trend in the same direction.

Gross margin in Q4 was below guidance, primarily as a result of disposal of excess inventory.

These adjustments reduced gross margin by 45 basis points in Q4, and are not expected to be repeated moving forward.

We expect gross margin in Q1 to be 45.6%, plus or minus 20 basis points.

Operating expenses were slightly under expectations, even at higher sales levels, reflecting our continuing efforts to improve our productivity and control spending.

We expect that expense levels will grow in Q1 from Q4 levels, reflecting higher sales volumes, increased investment spending, and some reversal of the cuts in associate compensation that we made last year.

As David mentioned we expect these reversals to occur in a slow and measured way.

The amount and timing is solely dependent on the strength and trajectory of the economic recovery.

Balance sheet management continued at high levels in Q4.

Inventory turns were basically unchanged, and DSOs decreased slightly from Q3.

Cash conversion remained high, and free cash flow, which we define as net cash flow provided by operating activities less capital expenditures, exceeded $260 million for all of fiscal '09.

When sales begin to trend upward, we expect absolute receivable and inventory balances to grow again.

Our goal is to increase inventory turns as we grow, so as not to add back as much as we took out during the recession.

Additionally, we anticipate a capital expenditure range of $30 million to $35 million for FY 2010, as we carry out our investment program.

We spent approximately $23 million on capital expenditures in FY '09.

Thanks, and now I'll turn it back over to David.

Thanks, Chuck.

And just to clarify, on the guidance for the revenue range, we expect sales to be between $378 million and $390 million.

So just wanted to double back on that folks.

And again, I'd like to welcome Eric to his new leadership position, and look forward to working closely with him and our leadership team in capitalizing on the unique opportunities presented to us by this unprecedented economy.

I'll close by offering my thanks and appreciation to all of our associates.

Our team executed at historically high levels during all of fiscal year '09, and made excellent progress in accomplishing our strategic objective, in spite of the challenging times that we face and the sacrifices made throughout our organization.

Thanks, and I'll now open the lines for questions.

(Operator Instructions) Your first question comes from Holden Lewis with BB&T Capital Markets.

Good morning, thank you.

Just wanted to sort of touch on some of the stuff in the supplemental information that you provide.

Specifically, discuss a little bit more the decline in the customer base.

You talked about gaining share, but then we see continued significant declines in the customer base.

I guess provide some color to that, and then secondly related to that, if you could just talk about what that means coming out.

One of your competitors has sort of grown new account growth through the downturn, and that would suggest they have more ammo once customers start ordering more.

You in contrast might have a situation where there's fewer customers ordering more.

Does that limit your growth possibilities at all?

Holden, it's David.

So let me talk a bit about what we've seen historically in our customer account; and I guess as a reminder, it really has been part of managing our growth investments.

And really, based upon how we manage them, it's been a proactive choice on our part.

Our team is constantly looking at where we can improve productivity with things like our direct marketing programs, and so we reduce it, or we adjust those dials based on how they're meeting ROI thresholds and all.

It's an area that we continue to dig into, by the way, currently.

So we've talked about our strategy to focusing on acquiring those large customers with multi ship-to locations, and specifically are treating those small one time buyers, and really that's how we focused our programs accordingly.

So the attrition that we've seen among these small customers has actually been the primary driver of the declines.

We've done more research that I'm able to share this quarter, as our team has continued to dig in, and it shows that about 97% of those customers that actually purchased in '08 that have since been lost or have not come back, have an average size of a $500 annual spend in revenues.

And the total loss from this entire pool of customers, overall actually, is what I'd consider to be not material.

So we also know that many of these customers are among businesses struggling to cope with a severe recession.

They're in the process of downsizing their inventories, conserving really every dollar that they can, and we've had a lot of research in this area.

It also shows that while, of course, some have gone out of business, although that's not what I would characterize as the primary driver, many are still out there, and when you speak to them, they still consider MSC to be one of their suppliers.

And we believe that coming out of this thing, which I guess is the second part of your question, Holden, is that they're going to resume back into their buying patterns when business picks up.

I guess the overall of it is that based on all of our research and the analytics underlying this issue is that we're very comfortable, that there is no material effect on our current business, and certainly only opportunity moving forward.

Okay.

So am I hearing that these guys are typically pretty small, $500 per year, and that they are struggling, so they're not spending, but they'll come back, and therefore your active customers will rise?

Or am I hearing that they're too expensive to serve, and therefore you've kind of made a strategic decision largely to not serve them in favor of bigger - - I guess I'm hearing both proactive and opportunity.

I'm not sure which one it is.

I think it's one that we have proactively have dialed down where we focus some of our investments in order to get that type of customer.

And of course it's not a perfect science, but to the extent that we don't continue to attract that type of a customer that's going to be small and that's not going to grow up, that's one way that we kind of refocus our investment programs, and that something that we're constantly doing.

And then I guess the other part of that is just in really probing into that customer base, we find that largely what has attrited are those that are small, and that overall they don't contribute meaningfully to our revenues.

But because they consider themselves to still be customers that just, based on their pattern, have cut back trying to conserve their spending, we would expect, and we have heard from them that as they either hire or as business conditions improve, we would expect to see a lift from that specific segment as well.

You're not going to market to them?

You're kind of indifferent; but if they want to come back because you're a historic supplier, they're welcome to place order in a cost-effective way is sort of the mind-set?

Absolutely.

The only thing I would want to say, I would not want to make an absolute statement that we're not going to market them.

I think that we definitely adjust our marketing dollars away from that group, but to say that we categorically cut them off is not the way I would want to characterize it.

Okay.

By the same token, on the larger customers that have been sort of the focus, do you have any statistics or anything that would lend some support to the idea that maybe you have actually penetrated them more deeply in the downturn, so that when their ordering does come up, in fact there is more ammo there?

Yes.

The focus of our program really has got to do with both penetrating our existing base of large customers, as well as attracting both new ones and penetrating additional ship-to locations, which is another part of the metric that, because of the our bill-to, ship-to relationship, the bill-to that we measure, which is only one customer, where a ship-to may have many, many locations, is not the best metric to be able to have you kind of gauge what our progress is there.

But we know that we're penetrating solidly there, and of course, we measure the absolute size and growth of where we're putting our investments, and we feel very confident in the traction that we're gaining in that segment of our business.

All right.

Great.

Thanks.

Thanks, Holden.

Your next question comes from Adam Uhlman with Cleveland Research .

Hi, good morning.

Hi Adam.

Just a follow-up to that last question, what would the ship-to location trends be looking like right now?

Are you actually positive on that metric?

Adam it's not positive.

I will tell you that it's gone down much less than the active customer base, and that the ship-to universe is significantly larger.

It's something that we measure internally; it isn't something that we share externally.

Okay.

Got it.

And then, Chuck, a question on the guidance.

If I understand it correctly, it was at the midpoint of the range $125 million of SG&A expense, and a 45.6% gross margin.

If I do the math correctly, it would seem like earnings would come in at the high end of your guidance range, at the midpoint of the sales range.

So I'm wondering if there's anything unusual happening with the tax rate or share count?

No.

I'm not sure what element of that wouldn't hang for you and make total sense there.

The implied operating margin, we've basically given you all the pieces obviously, is 12.8%, and I think you would run that through with the tax rate that we should think about for planning purposes, using 37.8% and run it through.

We think you'd get pretty close to the midpoint of the range.

Okay.

And can you help me understand this sequential uptick in SG&A expense a little bit better?

I know you talked about it in the prepared remarks.

But it's about $8 million, and I'm wondering how much of that would be a resumption of the investment spending, and how much of that would be turning back on the temporary cost reductions.

Well, let's look at it sequentially over Q4, which is much better than going back to maybe a year ago.

There's roughly $7 million or $8 million of additional operating expenses.

You can see that the midpoint of our guidance for sales is a sound $30 million or so above where we were in Q4.

We have told you in the past that the margin, the variable to support something like that is in the neighborhood of 11%, so you have to factor that in.

And the remainder of it, as David said in the remarks, is a combination of investment spending and some element of the add-back for some of the things that were taken away last year.

That makes up the difference between the variable and the total of $8 million.

Okay.

Got it.

And then the last question for me, I'll get back in the queue, is could you talk about what you're seeing with your government accounts, and also in the quarter, sales came in a little bit better.

Some customers didn't have as long of productive shutdown days as you expected.

In what industries did you see that phenomenon occur?

You know, Adam we don't like to be real specific about how we characterize a further breakout, even our large customer segments of which, as you know, it really is comprised of two main pieces, the government segment of the business, and our large national accounts.

I can tell you that as you look across what's happening across the United States and you get a flavor of it in our regions, you see that durables continues to get pounded.

When you look at manufacturing versus non, of course the website stats show that manufacturing has improved slightly, but continues to experience severe declines.

And then when you get underneath manufacturing into durables, the declines are far steeper, and I think that's evidenced by, especially when you look at the regions and you look at the high concentration of the durables business, in particular in the midwest and in the northeast.

So would the improvement that you saw in the southeast be reflected in non-durable manufacturing picking up a bit?

You know, we see pockets of that across the country.

I wouldn't say that there was anything disproportionate there.

Remember that there are a lot of segments, which includes a large customer segment, that you'll see spread across the United States.

We really don't like to signal where we may be seeing some of those pockets in specific segments, obviously for competitive reasons.

But I will tell you that's part of how we manage our sales force, making sure that we're disproportionately spending time on those pockets that we think either are growing more quickly, or have the potential to grow more quickly.

Got it.

Thank you.

Thanks, Adam.

Your next question comes from John Inch with Merrill Lynch.

Thank you.

Good morning.

Good morning, John.

Good morning, guys.

A couple of things.

First I'm curious with respect to, as the year sort of unfolded here, did you guys experience sort of a lack of volume rebates that affected the mix in some manner; and if so, just because volumes are down, so you don't get the kind of customer rebates, when does that hit, and what proportionate impact would that have had on your financials?

John, it's Chuck.

Absolutely.

During the course of the year, you can actually tell pretty significantly from our inventory reductions, obviously the implication is there were a lot less purchases last year, as we were able to take a pretty heavy duty chunk of inventory out during the downturn.

Clearly, that affected our rebates and numbers, partly towards the end of last year, and some of that will continue into this year, fiscal year, based on how the accounting works for that.

That being said, we're going back to our suppliers, those that understand that we're taking share and willing to work with us, knowing that we're going to come out the other side here, we're aggressively working to kind of reset the bar, if you will, on rebates.

But clearly, they were down last year, and the trend would continue certainly into the first part of next year.

Did that disproportionately hit you in any given quarter, or was it steady throughout the year?

It's based on how the accounting works.

It was probably slightly more disproportional maybe in the fourth quarter; but it's significant in terms of it's important, but there are a million other things going on in gross margin, many of which had a much more significant impact than just the change in volume rebates from we were a year ago.

So, yes, it's going to have some impact moving forward, but that's been factored into our guidance that we gave you for Q1.

Okay, so let me shift to just your revenue guidance.

Your comparisons are about to become fairly easy.

Are you assuming that your growth rate, say, November, December, begins to turn positive, or what's your current thinking with respect to the timing, assuming that conditions continue to trend the way you're seeing?

John, back to me again, it's David.

We've shared what the trend is on our websites stats.

You can also see that October to date, so you've seen sequential improvement through the quarter.

October to date is a decline of about 12, and the decline at the midpoint of our guidance is a little bit more than 11%.

So based on everything that we're seeing, we're forecasting to that midpoint of the guidance that you'll continue to see throughout the quarter, and in fact, September and October, we've continued to see that improvement.

And I guess just the math in the guidance would say that we're expecting it to continue.

Frankly beyond that, I really wouldn't want to go beyond just the one quarter, given just a lack of visibility.

Fortunately though, to your point, as the year progresses, given what has happened last year, comps absolutely do get easier.

Comps get easier actually even in November.

Wouldn't that suggest if it's down today 12% in the quarter, if that's the midpoint of what you're assuming, you're being fairly conservative just based on the comparisons?

I tell you, I wouldn't want to characterize it as conservative, other than to the extent that we follow that same process that we always do, taking our very best look at the data and what we see, ADS trends, et cetera, et cetera, and doing our best to give you the guidance, low, medium, and high, what that midpoint is, so it's our best shot, John.

Okay, that's fair.

You say that your balance sheet, net negative cash, historically you've done things like one time dividends and so forth.

What is your current thinking as we kind of come out of this downturn here?

What is your currently thinking with respect to capital deployment?

How should we be thinking about the balance or mix between acquisitions, possibly from share repurchase dividends and the like?

And just as a follow up to that, what are you spending more CapEx on, you're going from 23 to it in the 30s?

What exactly are you spending that on?

Well, I guess two parts to the question.

In a minute, I'll have Chuck give you a little more color on CapEx, but I guess that in itself is indicative of certainly how we're going to use our war chest in the business.

I would say that we're going to be very opportunistic, John.

We have identified opportunities, for example, where we're going to be increasing our CapEx, which of course is a use of cash.

I'd say that all of the things that we've historically done are there and available to us.

I characterize our thinking as opportunistic, but also with a conservative bias to it.

We don't mind sitting on cash looking for the right opportunity.

Our dividend program continues.

Things like buy-back, we've got three million shares that continue to be authorized, so that's out there for us.

And the other is, we have been and continue to take a very hard look at acquisition opportunities, and to the extent certainly that we find something that meets what I characterize as a high hurdle rate and something that, longer term, would be additive to our strategy and our plan, we're absolutely not adverse to taking the plunge and moving down that path.

But we will be selective, and we continue to spend time focused on that area as well, looking for the right opportunity, or right opportunities, given the success that we have had with J and L.

And so let me give it to Chuck to give you a little bit more color on the CapEx.

John, one last comment on the cash.

Obviously, as we start to come out of this thing, and have accelerating revenue growth and so forth, there's certainly investment in working capital that's going to go back in.

As we said, we're going to work very hard to improve inventory turns and not add things back out at the rate which they came out, but no question about it, from an absolute point of view of receivables and inventory, hopefully we'll go up as we trend out of this thing.

So some of the cash is going to go to that.

We remain very high on our conversion rates of net income and operating cash flow, but it certainly won't be at the rates that happened in the past year when we were dropping in inventory and receivables, both coming down very quickly.

From a CapEx point of view this year, some of the increases, we've talked a little bit in the past about what we call our warehouse optimization projects.

We finished two facilities now, both Harrisburg and Atlanta, both with very desirable results, and we're going to move forward with that situation and that program, and a third facility, [Elkhart], this year.

So we anticipate a fairly significant outlay of cash to finance that project, which has a great return for us as we finish off our third facility.

Additionally, we have talked about ramping up investment spending.

I think it's important to think of that, both in terms of some additional OpEx, as well as some additional CapEx.

For example, one of the areas that we're absolutely going after is to improve the overall customer experience with our website.

That will have ramifications from an operating expense point of view, and we'll also have some consequences in terms of how much CapEx we're committing to the particular program.

So I think it's a combination of productivity and investment spending that's leaving the number a little bit higher than what you've traditionally seen from us in the past.

.

And just lastly, you're going to begin the investment working capital in this coming quarter, or when does that begin to kick in?

Well, yes, it looks like it's starting in the first quarter.

Again, the average daily sales, you can see the rate has certainly improved from the levels we were at last year.

So yes, there's a slight inventory build, probably in the first quarter, but, if you project it out for the year, we just want to be conservative and let you know that certainly we're not going to convert net income into operating cash flow at the rates when we were stripping out inventory on the way down.

We just have plans not to add it back as quickly on the way back up.

That's fair.

You still have too much cash sitting around, but a good problem to have.

Thank you.

You're welcome.

Your next question comes from Hamzah Mazari with Credit Suisse.

Thank you.

You guys talked about month over month sequential improvement in your sales as you sort of exited the quarter.

Could you maybe drill down a little bit and give us a sense of how the manufacturing business did, how the non-manufacturing business did, how MRO did, and whether you saw any bigger improvement in any one of those business lines versus the other?

Hamzah, I think the way I'd like to kind of characterize it is the same way as we break down into manufacturing and non-manufacturing.

What we actually saw is sequential improvement in both of those segments throughout the quarter.

And I will tell you that in both of those segments, both in manufacturing and on non-manufacturing, we've seen that continue in September and through October to date as well as well.

Okay, and maybe one last question.

Could you frame for us your top line growth and cost structure, as you see it coming out of the downturn in sort of a full-blown economic recovery, assuming [UDB] grows a certain amount, what do you see your top line growing at two times [UDB], 2.5 times [UDB]?

How should we think about that?

And then looking at your cost structure, you've taken close to $175 million of cost total year on year, how much of that is permanent, and how much of that will come back, given volumes, come back; and using whatever assumptions on variable margins you want to use?

Hamzah, David again.

You know, very tough for us to give you any longer-term guidance, given, I think no one ever could have predicted what was going to happen in this in this unprecedented economy, and frankly, I think there's 20 very bright economists out there.

Ten will talk about the [V], and others will talk about a [W], or will talk about why this thing is going to kind of go back.

So we would rather just frankly stick to our knitting, really look at this thing quarter by quarter, and continue to keep our hands tightly on the wheel.

Suffice to say that we've got a long list of prioritized investment opportunities.

We have a desire certainly to restore all of our compensation and benefits for our associates, just as quickly as possible.

All of that is going to really be dependent upon the strength and trajectory of this economy, so we're not going to hazard a guess.

We're going to say very close to managing this business regardless of what's thrown at us.

And I think, on the cost structure side, as Chuck briefly spoke about, much of the cutbacks that we made are temporary in nature, things like reducing, as I said, cost and benefits, things like the work hours that were reduced for our associates.

As those continue to come back in, those were permanent in nature.

Excuse me.

Those were temporary in nature.

What's permanent in nature though, is remember that we have an ongoing productivity improvement program, just like what Chuck laid out in some of the CapEx investments that we've made.

Those have been historically, and will continue to be permanent in our cost structure, additive to our long-term productivity and profitability.

Is there a way to quantify the productivity that's permanent, or is that impossible to do?

Well, actually, for the programs that we invest into, we do significant ROI analysis, and then we monitor it very closely to make sure that the program, once executed, was as effective as what we had hoped.

For example, in our warehouse optimization projects.

That is something that we have carefully measured.

It's an internal metric that we watch closely, but it isn't something that we break out for the public to see.

Okay.

Fair enough.

Thank you very much.

Thank you.

Your next question comes from John Baliotti with FTN Equity Capital Markets.

Good morning.

David or Chuck, I'm not sure who would rather take this.

It seems like the revenues came in better than the range you had given us.

I understand you called out the fact that like you said in the last quarter, that you were expecting some extended shut-downs in the summer, you didn't see it as much as you thought.

But along with that the overall margins were better than I think many expected, given the EPS results, it seemed like the mix was a little bit more toward the operating expense versus the gross margin.

So can you kind of talk about those things, the conjunction of the revenue and maybe the gross margin that was there, how do those things interact this quarter ?

John, revenues absolutely came in better.

I think you mentioned it was really a function of we think that the summer, I don't want to give you the wrong impression, the summer was tough, extended shutdowns, a reduction of work hours of our customers, et cetera.

Based on what had been happening from what we could tell, from what we heard from customers, and just the environment on our last call, we had included what we thought would be a pretty significant effect of summer shutdowns in our guidance.

I will tell you that that effect was very significant, but not quite as much as we had included in our estimates for guidance.

We also think that, given what we are seeing, definitely starting to see some pockets of improvement, although it's probably more in terms of optimism and psychology, which we think will definitely bode well for this thing coming out, and hopefully the recovery gaining some legs and some traction.

And we think that although we're not able to point to a specific measurement, that the progress that our team has made over the last year, in really taking share, capitalizing on the weakness that we see from a broad traditional distribution base, is really starting to pay off.

We've got a process internally, John, that literally measures our wins in the hand to hand combat weekly, and it's a report that myself and others happen to see, and it's one that really shows that we are really winning out there, although the overall water levels of course are down.

So it's tough to show.

Gross margin, as we had touched up, I think was pretty close to what we had expected when we first gave guidance, with the exception of the excess inventory, and OpEx continued to be favorable, just because of our solid cost control.

We did executed and continue to execute on our investment programs, and we were able to begin to restore some of the add-backs into our P&L.

And I think hopefully that gives you a bit more of a field of color into it.

Yes, I was just wondering, you had mentioned earlier about gross margin, that there were a lot of other factors that went into it besides rebates, and I wasn't sure that you were referring to price as being part of that.

Yes, definitely.

I mean, if you think about gross margin, John, there's so many competing factors.

I mean, you have headwinds-like rebates that we talked about earlier in the call.

Certainly what we see in the marketplace for discounting to combat some of that and to add more value at a time like this.

You've got headwinds that we faced from our very effective promotional campaigns, and of course, the change in our customer mix, because our quarter had been so hard hit, that's historically been our highest segment part of the business as well.

So all of those are headwinds.

We fortunately have made a lot of progress where we've been investing and where we continue to focused, which really has a tendency to offset, and where we increase margins is through things like our buy-better programs, our overseas sourcing, and our private brand initiatives, as well as our Preferred Supplier programs.

So all of those things contribute to fighting the headwinds and give us the results that we've gotten, as well as for September, we also had a small increase in our big book pricing.

That also was factored into our gross margin guidance.

So as we think about the first quarter, I would expect that you were pretty cautious about summer shut-downs, and obviously as you go into the holidays, you have traditional holiday shut-downs.

I'm not sure if you're thinking maybe that those could be a little bit longer than traditional, but the gross margin, the range you're giving us would imply that year over year, you've got some more headwind in gross margin.

Are you thinking like you had this quarter, that price would help you to combat or maybe stimulate some of the buying when it might be a little more quiet seasonally because of the holidays?

Well, two things.

Definitely, what's in our 45, 46 plus or minus guidance includes the effects, the favorable effects of the big-book pricing, and just to give you more color on the holidays, our team has actually done pretty extensive research at this point.

Of course, as it gets closer, it will be that much more meaningful, but we have not gotten any negative feedback, at least right now, on what might happen for the holiday shut-downs.

Probably, the answer might been different in people's thoughts back in June.

I would tell you our latest view is that we're not seeing that we're going to have any dramatic change to what might happen moving forward, but that is something that we'll continue to watch.

And as we learn more and give you future guidance, we'll certainly give you a better peek into that.

Thanks very much.

Your next question comes from Sam Darkatsh with Raymond James.

Good morning, David, Chuck.

How are you?

Good morning.

Hey, Sam, how are you doing?

I'm doing excellent, thank you.

Many of my questions have been asked and answered, but just two quick ones.

Hopefully, this puts the customer count line of questioning to bed.

I know that when you report that, it's on a trailing 12-month basis.

At what point do you anticipate the customer count on a year on year when you report in your supplemental information to stabilize or to flatten out on a year on year?

You know, Sam, I'd rather not give you any specific guidance.

That it isn't something we do, [with] our customer count, we really do take it quarter by quarter.

Part of that is because it would mean forecasting our attrition rates, and part of that is it would mean forecasting what we think is going to happen with our investment programs, how much we're going to be focused on circulation, how much we're going to be focused on prospecting, and frankly, that's an area that we like to remain flexible, and frankly turning the dials to the extent that we see more areas within that program that have a quicker payback and better returns on our investment, we'll ramp it up.

Frankly, to the extent that those are push out, as we have been seeing them, we may have the tendency to pull back even further, as we manage our investments and redirect those dollars into what we consider to be more profitable places to go in the near term.

Okay.

The price increase that you just noted in September on the big-book items, broadly speaking, what was the percentage change in pricing?

It was about 1%; and just as a reminder that compares to last year's 3.5% to 4% increase.

And my last question, when I look at your average transaction count and the transaction count per customer, it doesn't look like it's declining as much as sales, and maybe I'm over-analyzing this, but it would appear to me that there might be a possibility that some of the more discretionary type of transactions might be coming in a little bit more, or declining a little bit less, which might be a bit of a leading indicator for things that are stabilizing or improving.

Do you folks look at transaction count in that fashion, and is that a leading indicator in your experience?

Well, do you mean average order size and the line count associated with each order, Sam?

Yes.

As I think about it, more of the MRO type, or daily transactions would be the ones most easily discretionary and postponable.

So, therefore, by definition, if your transaction count is doing better than your overall sales, I would think that that would serve as a leading indicator on the way back up, much like it might have been on the way back down, as I was looking at your history.

Yes.

I think that's reasonable.

I think that this is the first quarter; I think in the last three or four, that we've actually seen a slight tick-up in our average order size.

That was actually good to see, and that might be indicative of certainly, at a minimum, stabilization, and I think we would absolutely see it the same way.

Just as a point to point out on that, when you look at our average order size and you break down on what's underneath, what actually drove that average order size, basically what we see is stability within our core, meaning it was about the same, quarter over quarter.

The fact that it hasn't gone down we think is a good thing, and we did seen an uptick in the size of our large customer segment orders, and that's what drove that overall average increase to average order size.

Thanks much.

Very helpful.

Thanks, Sam.

Your next question comes from David Manthey with Robert W.

Baird.

Hi, guys.

Good morning.

Hi David.

Chuck, could you discuss the impact on gross margin from lower rebates, and is it or is it not included in that that 45 basis points that you called inventory disposal earlier?

No, it's definitely not in that 45 basis points, a whole separate thing, Dave.

As you said, the rebates have been coming down in relation to, as you can see from our inventory reductions.

So as I said earlier, it's factored into our guidance, it's definitely not related to the 45 points.

It's one of the headwinds on gross margin.

There's stuff going both ways in margin, rebates, and smaller rebates are a piece that's kind of the headwind right now.

Okay.

Can you quantify it or no?

No, we haven't publicly quantified it, no.

Okay.

And then finally, could you discuss your key growth drivers next fiscal year, and how they'll roll out?

Hopefully you're expecting some sort of volume recovery, along with a little bit of bit of pricing.

Could you talk about growth in sales people, skus, mailings, etc., that are going to be offensive moves, rather than just waiting for the economy to come at you?

David, yes, I'm happy to talk about it, and I think playing offense is a good way to describe it of course in the context of being mindful of that balance between short-term profitability and how we invest in longer-term growth.

So in terms of how they're going to roll out, it really does come back to the strength and trajectory of the economy, and we're going to dial it up or dial it down, depending on what we see happening there.

So I guess with that as the backdrop, we'll continue to invest in our sales force.

You'll continue to see us, part of that, of course, includes a focus on building out our West Coast.

Chuck had talked about our web experience, and continuing to invest in that area, enhancing the quality, the speed, the shopping experience of our sight, and part of that is going to include investing in data management, because that's an important part of what makes for a great customer experience.

We're also going to continue to invest in technology to help improve productivity, specifically the productivity of our sales force is one area that we'll be investing.

Chuck had also talked about investing in productivity like our warehouse optimization program, things like that.

I had also mentioned earlier that part of our investment focus will be continuing on global sourcing and our private brand initiatives .

We'll continue to build out our product offering, continuing to add selectively to key brands that have strong brand equity out there, as well as our own generics, and in particular, our private label program.

So hopefully that gives you kind of a sense.

We have a large appetite and a long list of wonderful areas that we can consider to invest for growth.

We've put that list together, and we are going to continue to seed all of the areas that I just described.

The more that we get in the way of revenues or gross margin improvement, the more that we'll be able to feed components of

Okay.

Thanks, David.

But as you're looking at the budget right now, and as you see the world out there, should we expect the sales force growth, the number of salespeople to increase by 13%, 15% again, or is it something less than that?

David, I'd really rather just say with quarterly guidance, given the number of moving parts, I wouldn't want to give you an absolute number there, in part because I can't be certain what our investment program dollars might end up to be, just based on what I described before, or that as we're evaluating this, should we find an opportunity that is even more compelling, when they redirect some of our investment dollars there, which might mean that the number that I give you on the sales force wouldn't have been quite as large.

Of course, it could go the other way as well.

And I didn't mention before direct mail, that's another one that, as we continue to mine and look for opportunity there, our team is constantly digging in and evaluating the return on investment there, and what we see for pay-back versus others, both in the short and the long term, it's possible that we would look at that program, theoretically dial that down and reallocate some of those dollars, for example, to our sales force.

And of course, it could go the other way as well.

So it really does depend on what we continue to see as our best opportunities going forward, and the context of how big the investment pool might be.

Okay.

Thanks, David.

Thank you.

Your next question comes from Brent Rakers with Morgan Keegan.

Good morning.

Going on good afternoon.

A couple of housekeeping questions first.

Do you have the numbers for the head count at the end of the year; and then, second, I think you usually break down three components of revenue into price, large customers, and core.

Would you mind providing that, please?

Yes, Brent, David.

We're flipping the pages, and looks like I'm the winner here.

We ended FY '09 with a head count on 4,193.

Just a reminder, I guess, we began the year at 4,261.

And your second question was the decomposition of growth.

So let me give it to you maybe in two ways.

It's a bit more difficult to talk about it when it's in decline mode.

So in the quarter, sales declined year over year around $94 million.

Of that decline, $91 million of it, Brent, came from basically our core from overall volume.

$6.6 million of it came from our large account base, and $1.7 million of it came from exchange rates, primarily related to the UK.

And then the final positive offset came from pricing, which offset some of the decline by $4.8 million.

So I guess, if you want, I could also give it to you broken down, of the minus 21%, I guess I'll give it to you that way as well, 20% was attributable to our core, to overall volume, 0.5% came from exchange rate, 1.5% came from our larger customer base, and offsetting as a positive, about 1% came from pricing.

Great.

That's helpful.

I guess my follow-up to this, in light of only getting I guess what amounts to about a percentage point of positive price in to the quarter after having announced a 3.5% to 4% price increase in the catalog last year, as you go into the months of September and October, does that imply year over year declines on the price contribution?

Listen, I wouldn't want to start breaking it out monthly.

The one thing that needs to be factored in is that you would absolutely see declines during the normal course of the business, if there weren't so many other programs that were frankly in place do fight those declines, so I'd rather stay within our guidance, let you know what we're doing quarterly, and continue to talk about the fact that we have many programs that are margin enhancing programs, frankly to offset some of the headwinds that we face within our gross margin line.

Okay.

Fair enough.

Back to the SG&A, I seem to recall, I guess, three or four months ago, you talk about $3 million for a sequential target, an increase in SG&A tied to investment spending, and I guess in light of the higher revenues coupled with that, you probably came in $3 million or $4 million below that.

First, did you actually incur that $3 million investment spending, and were there any year end true-ups to speak of within the SG&A line?

No, year end true-ups, normal process that we would always go through at year end, which for us, because of how we accrue and so forth, there's no major adjustments that pop up in Q4 that would give you any reason that's different than in other quarters.

Most of the investment spending sequentially from prior periods was around the head count for the OSAs.

David has elaborated a little bit more this morning on some other programs besides that that we'll be considering investing in moving forward.

But by and large, given how we performed to the guidance we gave on the OSAs, it's relatively close to what we expected.

Obviously lots of offsets and lots of moving pieces, but specifically the investment piece is pretty close to what we had talked about doing, and that was last year, more focused on the OSAs, whereas next year it will be a combination of some other things we already talked a little bit about.

Great, then just a couple more.

On the comments on the gross margin about disposal of excess inventory, I know you gave a number on that, and that's great, but I was hoping you could elaborate on what that really means, and did that have revenue ramifications for the quarter.

No, no revenue ramifications.

Let me put a little more color on it for you.

We always have a process that identifies excess inventories and reserves, and we reserve adequately in every quarter.

Basically in Q4, with the slowdown in the economy, particularly in the midwest, we had items that were multiple years of supply on hand, and frankly the economics of disposing that inventory and freeing up the space and so on and so forth made more sense to go ahead and frankly, write it off as opposed to trying to sell it through our normal access channels, which could have taken a significant period of time, and still occupied a lot of space and so forth.

So the economics from a tax perspective, from a space perspective, and everything else, it made sense to go ahead and do that, and the bulk of it was inventory associated where the markets have been hit the most, primarily in the midwest.

And just the last question.

I think you're now the fifth industrial distributor to report, and honestly, it looks like to me that your revenues look quite a bit better kind of on a sequential quarter basis than all of your peers, and I'm just wondering if you can cast any more specific light, whether any specific end markets, major competitors closing shop, major customer wins, auto sector exposure, anything that might help explain that differential?

I think it's, we probably, unfortunately, went down farther than most early on in the cycle, given our exposure to manufacturing and durable goods.

We have a couple months here of ISM readings above 50.

We're obviously doing a lot of things on the productivity front with our sales team, and are actively involved in many projects that drive sales growth.

But just like on the downside, it was a tough time down.

Maybe we're getting the benefit of some recovery on the manufacturing side on the way up.

Our sales mix, as you know, is very different than it was with some of our other competitors.

The only thing I'd add is that our focus in this market is against what is still the bulk of what we see, which is that roughly 70% of the market is still comprised of the small to mid-size traditional industrial distributor.

Our model is designed to help our customers, especially in an environment like this, that as we've spent the last year really continuing to enhance our value proposition and what we're able to do, help our customers get them through these difficult times with their inventories, and really being able to rely on us.

Fortunately, in that respect, we've been very successful, we believe, and again, we talk about the wins that we see, literally captured on a constant basis.

And remember that as this thing has dragged on and continues to drag on, the pain on that traditional distributor being able to maintain their business model, we think, has been weakened.

We think it's been weakened substantially and continues as it drags on, to make it more difficult to finance the receivables, to continue to provide inventory that they have on hand, and to take care of it for their customers.

That in itself has created lot of opportunities for us to come in where in a normal environment would be much, much difficult for us to get in and take that business.

And we think that no question that's also having an impact in the total mix of our performance.

Great, great.

Dave, thanks for taking the time to answer the questions.

Absolutely.

Your next question is a follow-up from Adam Uhlman with Cleveland Research.

Hi, guys.

Just a big picture question on the gross margin.

We started the year at just above 47%, and ended the year just below 45%, and if I remember correctly, the before the J & L deal, MSC had gross margins of just over 47%.

I'm just wondering, in the future, with no time frame attached to it, there's a lot of pluses and minuses that have unfolded over the last couple of years.

.

Do you think this is a Company that can move back to the high watermark eventually, or are we never returning to those levels

Adam, David, I appreciate the way that you asked the question, not trying to put it in a box and what quarter, et cetera.

I guess frankly, I would answer it the same way that I would answer the operating margin question, which is we think that there's opportunity for us to improve it over time.

We think that that's true on the operating margin line.

Of course, moving towards, in a methodical way we hope, towards the kinds of margins that we had before.

But we've got some ambitious plans on the gross margin line as well, which over time, is why you've seen us investing and even stepping up our investments in those programs that we think are going to add enormous value for our customers, really increase our competitive differentiator, and advantage in the marketplace, and while adding all of that value, we think also will help us over time to increase our gross margin line as well.

So to answer that question over the long term, no, we don't think we're done there, and we do see opportunity to incrementally expand it.

Great.

Thanks very much.

Thanks, Adam.

And your final question comes from Holden Lewis with BB&T Capital Markets.

In the past, when there were incremental margins to discuss, you were always pretty good about talking about what those were.

Looking at this quarter, I think you out performed at the top line and the operating margin line.

When you think about how much you out performed at the top line, you dropped about half of that down, sort of a 50% incremental margin on incremental revenues of out performance.

When you get to the point where revenues are growing again, in recognizing that it's nothing that unusual for you to do a 35% to 50% type of incremental margins early in a cycle, I mean, can we expect that again, or are the type of investments that you're looking for for personnel and such, greater than perhaps what you've done in past cycles, and therefore maybe we're not looking at 35% to 50% type of incremental margins early in the recovery?

Holden, it's Chuck.

From where we are right now, we don't think the read-through is a particularly valid metric, given the comps, given the crazy environment we've been in in the last two years.

We're not even looking at the incremental read-throughs, [a lot of] the metrics that we track real closely not.

The only way we could really answer the question, Holden, is we believe the longer term when we return to normal, clearly our earnings growth should out pace our top line revenue growth.

You mentioned some of the variables that would affect the read-through, the gross margin change quarter to quarter would have an impact, how much we choose to invest moving forward would have an impact.

Again, I'm talking about return to normal levels here, when the read through metric might become more relevant again.

But I think the only thing we're comfortable with saying right now for sure is we feel confident in saying that our earnings growth in any kind of scenario, when we return to normal, tour earnings growth would exceed our revenue growth, and that's about all we can say right now.

But relative to past cycles, is sort of your emergence out of this one looking a lot like the emergence out of past ones, in that at one point in the past cycles, you may have cut back on the staff adds and then early on, you started ramping it back up.

I guess I'm trying to get a sense of your exit from this cycle, does it look in any way, shape or form different from exits from past cycles for you?

Holden, it's David.

I think what's different, which is why Chuck said and what we have talked about, which is really returning to normalcy.

Very important to really think about it that way.

What's different in this cycle, given the depth, and given the unprecedented economy, remember, is that we took certain actions, which included compensation, benefits, things that we cut back from our associate population, which was a big sacrifice, but done in order to take actions across and preserve our entire community.

In any event, I think that it's important that, it's probably going to be, I don't know how you'd characterize it in the cycle, but that's very different than anything that we've ever experienced in the past.

When Chuck talks about returning to normalcy, it really means that we think we've got a more predictable revenue growth stream, as we've historically had, other than in this very unusual time, that all of our compensation and benefits have restored to what I'll call normal levels across our associate population.

I think, once the business gets back into what I'll call that normal rhythm, I think we can go back to a read-through metric, that I think will be very meaningful, and I think you could expect that we then begin to characterize what those numbers should be looking like when we look at earnings, leverage in the business, and the investment mix in the business.

Thank you for that.

And then, finally, talk about, obviously, you haven't cut pricing, but was there any activity.

You made an elusion to sort of marketing materials and initiatives, things like that.

Price stayed stable, but was there any greater discounting or anything of that sort, which might explain some of the stronger revenues, or was discipline held as well on the discounting activities and the marketing activity?

No.

Actually, the team has done just a tremendous job in this environment of frankly preserving, maintaining our gross margins.

No, we've got our e-mail and fax campaigns, our promotional activities, that we've consistently used throughout this downturn.

We think it's been a really effective tool for us.

Nothing changed in the quarter that would have explained I guess the kind of thing that you're digging for in revenues.

We think likely, it's more of a cumulative effect of our efforts throughout the year, and that, coupled with what we're seeing in the environment in general.

Okay.

And last thing, the hundred basis points of price in the big book, is that net of cost, or is the cost that you're seeing somewhere in that ballpark as well?

That's what we would expect as the net incremental improvement increase from the - -

[pure] revenue.

Okay.

Thank you.

Thanks Holden.

There are no further questions at this time.

I'd like to turn the call back over to management for any closing remarks.

Well, thank you all for joining us today.

We appreciate all of your interest, and we look forward to speaking to you again in future quarters.

Goodbye now.

Thank you.

This concludes today's conference.

You may now disconnect.