MSC Industrial Direct Co Inc (MSM) 2010 Q1 法說會逐字稿

Good morning.

I will be your conference operator today.

At this time, I would like to welcome everyone to the MSC Industrial Direct first quarter 2010 earnings conference call.

(Operator Instructions).

I will now turn the call over to Mr.

Eric Boyriven with FD.

Sir, you may begin.

Good morning, everyone, and welcome to the MSC Industrial Direct fiscal 2010 first quarter conference call.

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 in the Investor Relations section which you can find under the tab About MSC.

Certain information pertaining to non-GAAP financial measures may arise during this broadcast and can also be found in the earnings announcement which also is posted in the Investor Relations section of our website.

In addition during the presentation, management will refer to financial and operating data included under the section Operational Statistics which you can also find in the Investor Relations section of our 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 future results, statements regarding expected revenue, margin, and earnings growth when economic conditions improve, statements about expectations regarding conversion of net income into operating cash flow, expectations regarding the Company's ability to capture market share, expected benefits from the Company's growth and strategic plans, 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 MD&A sections of the Company's latest annual report on Form 10-K 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 expectation, 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, and thanks for joining us today.

With me are Erik Gershwind, Executive Vice President and Chief Operating Officer, Chuck Boehlke, Executive Vice President and Chief Financial Officer, and Shelley Boxer, Vice President of Finance.

Today, I'll cover our strategic view of the landscape including the industrial and competitive environment.

Erik will provide an update on the execution of our model and of our investment projects, and Chuck will give some details on our first quarter financial performance and on our second quarter guidance.

I want to begin this call by providing our 30,000-foot view of fiscal years 2008 through 2011.

We think that it's an appropriate time to do so.

Visibility, while still murky, has begun to improve slightly.

We've begun to transition from living quarter to quarter and have the luxury of not being in crisis mode.

If we track back to the summer of 2008, you'll remember that we became cautious earlier than most.

We slowed spending and began to forecast more cautiously.

As we moved into the fall, we reacted very quickly, drastically cutting spending and purchasing early and implemented a new layer of controls in accounts receivable in front of what proved to be the most significant economic downturn of my 35-year career in industrial distribution.

While it was an extremely tough year by so many measures, it was also a time during which our team stepped up, learned some new things, and positioned our Company to be ahead of an economic recovery.

We believe that FY '10 and '11 will see what I call the greatest land grab in modern history in the industrial distribution business.

There have been unprecedented dislocations in the customer-distributor relationship across the country due to bankruptcies, branch closings, inventory reductions, accounts receivable tightening, layoffs, and movement among customers, buyers, and distributor salespeople.

Those tight connections between traditional local distributors and their customers have been severely stressed in ways that they have never before been put to the test.

Top line growth will further exacerbate this stress.

Weak balance sheets will crumble and service levels will further deteriorate as the weaker competitors struggle to do even more with less.

While we don't want to give anyone the impression that our performance was flawless or without extraordinary pain for our stakeholders, we think that we got it right in fiscal year '09.

We chartered our own course as we've done throughout the history of our Company, grounded in past lessons learned, and in our own unique culture, fully confident that this will give us an enormous edge just as it has in past recoveries.

While others were struggling, we ramped up our value proposition.

We extended our order cutoff times and next day reach to the entire country, maintained an enhanced sell rate, added to our outside sales team, retained all of our trained associates by reducing hours rather than headcount, creatively approached accounts receivable where we were able and aggressively signed new business.

We also remain steadfast in executing on those projects that further improve the scalability of our model which will enhance profitability on future volume levels.

When there is a snap back in revenues, our customers will be serviced by trained, seasoned, and motivated associates who have been here in their jobs for years and know their job one is to take this opportunity to win and win big for the benefit of all stakeholders.

Our balance sheet is rock solid and will not be stressed by working capital expansion.

We've just completed and rolled out to management a multi-year roadmap for growth around which our entire team is fully aligned and is now implementing.

Our foundation and our plans have never been more solid.

We do feel that we won in '09 and are very well positioned to win big in fiscal years '10 and '11 and we measure that by market share gains, balance sheet strength, human capital development, and strategic intent and plan.

We have a proven track record of turning those advantages into significant earnings growth over time and will continue to drive improvements for the benefit of our associates, customers, owners, and suppliers just as we've done throughout the almost 70 year history of our Company.

That is what has made MSC a Company that is truly built to last.

With that said, let's take the dive back into the quarter where you'll notice that the landscape remains challenged.

The business environment continues to be difficult.

Within our customer base, we've seen further layoffs, although at a diminishing pace, and also spotty pockets of companies adding back hours and workers.

There's almost no restocking to speak of, and customers continue to buy only what they need.

Consistent with the rising ISM, we have seen pockets of customers with modest increases in order flows, although still pretty small in general.

Optimism for the future continues to improve in the customer base, although that reflects sentiment not real improvement as yet in business conditions.

The recession continues to take its toll on its tradition -- on the traditional distributors who comprise the bulk of this market.

As a result, we continue to experience pressure on our gross margins, given their willingness to take very low margins on an order just to generate cash.

While this is a headwind in the current environment, we remain confident that it will lead to improved gross margins in the future as the economy recovers and these competitors cannot deliver the products to meet customers just-in-time requirements.

Average [day of] sales in Q1 were approximately 12% higher than in the previous quarter.

The focus of our investment program is beginning to show in our results as our large account business began to grow again in Q1 and that growth has continued to accelerate.

Overall sales momentum is building.

Sales growth in December was 10.3% and Q2 sales growth in the middle of the guidance range is projected to be approximately 11%.

We consider the increase in ADS and the growth in our large accounts to be strong evidence of share gains.

Visibility, while improving, remains poor, and our guidance is based in part upon current business trends.

We expect sales in Q2 to be between $384 million and $396 million and fully diluted earnings per share to be between $0.43 per share and $0.47 per share.

Thanks, and I'll now turn the mic over to Erik.

Thanks, David.

We continue to execute at all-time highs and to deliver an outstanding service experience for our customers as measured by all of our metrics.

As David described, strong core execution is more important than ever in this environment.

I'll now turn to our investment programs.

We continue to adjust how we allocate dollars between our investments.

We're focusing on those that will provide the greatest returns and yield the strongest gains for the future.

We're partially funding these investments by reducing spending on those with smaller paybacks, and I'm going to touch upon several of our priorities now but will not provide greater detail for competitive reasons.

First, direct mail.

As you'll notice on our website stats, we're reducing our prospecting and our circulation levels as payback times have extended in this environment.

Productivity levels for this program will be significantly enhanced as a result as we remove mail from poorly performing segments, and we shift our prospecting and penetration efforts in this tier toward the more cost-effective electronic channels.

This allows us to reduce our direct mail count while our total number of quality customer touches remains very high.

Second, we continue to make improvements to our e-commerce experience and to our product information database.

Third, we continue to invest in our large account programs, including national accounts and government, and we're very encouraged by our progress.

Fourth, we remain focused on investments in the buy side of our business.

Those include expansion in Asian sourcing and in private brand management along with an improved product category management approach that has yielded profit improvement for the Company.

And just as importantly, share gains for the suppliers who partner with us.

Fifth, productivity improvements.

As David mentioned, we've made significant investments over the past few years improving the overall productivity of our model.

As a result of that focus, we've created significantly more scalability in our business than we had coming out of the last downturn and subsequent recovery.

Some of the large improvements include a greater percentage of our business now booked electronically.

Today, it's almost 30% versus the single digits back in 2002.

We've installed highly efficient warehouse management systems in two of our fulfillment centers with a third one currently underway.

Improvements made to our inventory management process have enabled to us maintain high fill rates while removing significant inventory through the downturn.

We expect these improvements to provide leverage on inventory turns as we add inventory back to support sales growth.

And sixth, salesforce investment.

We've used this time to acquire some of the best and brightest talent in the industry and plan to continue adding top talent to our team.

Market conditions have given us the opportunity to bring new associates to an already outstanding team, many of whom we could not have attracted in a more normal environment.

In Q1, our salesforce grew to 947 associates, and we would expect to be between 950 and 955 associates by the end of Q2.

I'm now going to turn things over to Chuck who will share some specifics of our financial performance.

Thank you, Erik.

Sales for Q1 came in at the midpoint of our guidance while EPS at $0.50 is at the high end of our range.

Gross margin was near the top of the range and operating expenses were about as expected.

The sales guidance provided for Q2 at the midpoint is approximately $5 million higher than Q1 sales.

The EPS at midpoint, however, is approximately $0.06 to $0.07 below what might be expected given the absolute level of sales.

I want to take a few minutes to explain the dynamics from Q1 to Q2.

Gross margin is expected to be 45.1% in Q2 plus or minus 20 basis points.

There was a large order in Q1 that added approximately 20 basis points to Q1's gross margin that is not expected to recur in Q2.

And approximately another 20 basis points of gross margin decline can be explained by the unusually large number and size of drop ship orders experienced thus far in Q2, primarily in our large account segment.

These orders generate a high operating margin but carry reduced gross margins.

We have projected this to continue throughout the quarter.

The remaining 20 basis points of gross margin decline is attributable to seasonal and other factors.

While visibility remains limited, we would expect gross margin for Q3 and Q4 to remain in the same range as Q2 plus or minus 30 basis points.

Decline in gross margin percentage in Q2 accounts for approximately $0.02 of the change in EPS from Q1.

Implied operating expenses at the midpoint of guidance are approximately $5 million above Q1 levels.

As was the case in Q1, higher sales volume, increased investment spending, and restoration of some associate compensation contributed to the increase.

These factors accounted for approximately $0.035 of EPS change from Q1.

One other factor that always occurs in Q2 is the restoration of payroll taxes coincidental with the beginning of a new payroll year.

These taxes appear in our fringe benefit line and accounted for another $0.01 in EPS versus Q1.

Balance sheet metrics remain solid.

DSOs increased slightly from August, reflecting seasonal trends and a changing customer mix.

Inventory turns increased slightly.

Cash generation remains excellent as cash flow from operating activities represent 149% of Q1 net income.

Thank you, and now back over to David.

Thanks, Chuck.

In summary, we hope that our enthusiasm for the future has been fully conveyed today as you listen to the script.

We are confident that our team's work through the downturn has set the stage for outsize growth in revenues and earnings over the long-term.

Our entire organization remains focused on executing on the activities we've described on this call which will create enormous value for all stakeholders in the future.

For that, I express my thanks and gratitude to their efforts and unwavering support as we successfully navigated through the economic storm.

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

Operator, will you please switch over to questions?

(Operator Instructions).

And your first question comes from the line of Sam Darkatsh with Raymond James.

Good morning, David, Chuck, Erik.

How are you?

Happy New Year to you.

Happy New Year, Sam.

Great.

I've got three quick questions.

First off, the change in the direct mail.

Can you quantify the savings?

And then, will there be continual incremental savings going forward as you continue to remove mail from paper to electronic?

That would be the first question.

The second question would be -- the $5 million operating expense increase sequentially from Q1 to Q2.

How much of that is going to be a permanent increase to OpEx?

And how much of that would be just in this one particular quarter?

The last question I would have would be with the December sales.

Were you finding a lot of budget flush from your customers?

Or was that a pretty pure number as you see it?

Thank you.

Sam, thanks.

I think we'll get started with the first.

Erik will take the direct mail question.

Then we'll go to Chuck.

Then we'll go to me.

So Erik?

Sure.

Hi, Sam.

Regarding direct mail, if you look back periodically over time, we will always make adjustments on our investment formula and how much we're investing in direct mail.

Certainly what you see this quarter is a more significant decline than what you would have seen in past quarters.

Really our focus has been to take down circulation on what is our lowest tier of customers.

So when we look at our customers by tiers, we're looking at what they do in volume with us, and what their potential for growth is.

The focus has been on the lowest tier.

To answer your question specifically, not something we're going to quantify in terms of what the savings are for this quarter.

And also, in terms of whether that will continue going forward.

Take a very similar approach to what we've done in the past, which is, we review it on a quarter-by-quarter basis.

It will depend upon what the returns look like which are a function of a number of factors.

Sam, on the OpEx -- this is Chuck -- a couple things.

The payroll taxes -- this happens every year.

We just -- we featured it to the extent we're trying to reconcile some earnings for you here.

That FICA starting over again the beginning of the year, it tends to mitigate a little bit throughout the year and drops off a little bit more toward the end of the year.

That's a very normal pattern and process for us, but I would not construe that as a permanent $0.01 increase, if you will, to EPS because of the payroll taxes.

The volume is up slightly in the quarter versus last time.

Maybe $0.5 million is variable expense to support that higher level of sales.

And obviously, as sales continue to grow and reach higher levels, we would have to have more variable expense to support it.

The biggest piece is that combination of associate benefit restoration in combination with increased investment spending.

And yes, that would be in our run rate, factored into our guidance, and you would expect that to continue throughout the rest of the year.

And, Sam, last question was about September -- excuse me, December.

Was that an anomaly?

I'll tell you just a little bit about characterizing the month.

Pretty typically, we see what we would hope to see in a normal environment or an improving environment.

Strength in the first half of the month, which we did see.

Far less strength around holiday times which is the last couple weeks of the month.

But given what we've seen coupled with what we're currently seeing, and the guidance that we're providing.

We're encouraged by the sales momentum, and we feel strongly that that momentum is building for us.

Thank you much.

Appreciate it.

Thanks, Sam.

Your next question comes from the line of John Baliotti with FTN Equity Capital.

Good morning.

Chuck, was wondering, maybe David, if you think about -- if you're talking about updating us on the longer term view.

And Chuck, you're talking about the investments you're making that will affect operating expenses for the balance of the year.

What's the -- what's your target like?

What are you trying to do with that in terms of efficiency?

Because it looks like the last cycle, as a percent of sales that dipped below 30%.

And I would think if your overall margins have been trending better than the last cycle that you'd be trying to get -- in terms of efficiency, you'd probably be aiming at least in the same direction as you were the last cycle.

Is that fair?

John, thanks.

I think probably the best thing to do is -- let me step back a bit, and I think it answers your question directly about the future and how we view today's point in time -- really is a transition.

You've seen volatility in our results.

Now as we begin to return to normalcy in our -- both our growth patterns and our operating characteristics.

So as this recovery continues to take hold, and our revenues gain momentum.

We'll eventually reach, really an inflection point, and when that happens -- let me lay out what you can expect to see from us.

And I'll do it in the order that you've alluded to.

So let me start with revenues.

Our core business in manufacturing will be experiencing strong growth.

We'd expect that from a strong ISM.

But I have to say that given our disproportionate share gains during this cycle, our expectations actually significantly surpass those that we saw during the last recession.

John, on the gross margin line.

Strong growth in our core naturally expands our gross margin.

So as capacity levels get back to normal, the pricing environment will firm as it always has, and higher sales levels will also drive larger rebates from our suppliers.

So all of these factors, in conjunction with the sourcing investments that we've been making, will fuel gross margin expansion.

And then just to jump to OpEx, operating expense, unquestionably, are poised to drop as a percentage of sales.

The steady stream of productivity investments and process improvements that we've been making no question will provide us with improved operating leverage really as volumes continue to grow.

And some of the great examples -- Erik touched on it -- our enhanced warehousing systems and our increasing electronic order flows, just to name a few.

And just to touch on the balance sheet, improvements that we have made to our asset management process will help reduce working capital needs as a percentage of sales moving forward at that point, and you'll see it in our strong operating cash flows.

So I guess what this all means after reaching what I'll call that inflection point is that there will be exceptional [read-throughs] and earnings growth that outpace revenue growth.

And I guess the current volatility in this, what I'll call transition year, has not changed our view a lick.

That operating margins can return to, and actually eventually exceed those previously achieved, as we continue to execute our plan.

So bottom line, which hopefully is why you understand we're so enthusiastic and excited about our progress, it's because of the enormous opportunities that we're capitalizing on in this market and what we see for our future.

Do you think that, obviously, customers were as you pointed out in the quarter you're seeing more buy based on what their immediate needs, and that's very consistent with some of the color around the ISM.

It's also consistent with how we looked at the durables most recently is that customers are buying for immediate need.

There's no planning.

Do you expect -- what would you expect when let's say the next couple of years?

Would the customer because of their experience with you stay with that model?

Or would you expect them to start having some safety stock on the shelves again?

Yes.

John, no question.

I don't think we've, in fact, I'm certain that we've never seen -- we've been through several recessions.

We've never seen the kind of inventory being taken out and being sustained as it is today, and I think actually there's a metric buried underneath that ISM number that illustrates that as well.

That customer inventory is low, very low, and, in fact, in particular in our core small to midsize -- our historic customer base, we see just about no evidence of restocking now.

Customers are really buying to fulfill their current demand.

I think that over time while I wouldn't expect restocking to be out of control because frankly, to remember just how tough this last year has been, but I think that they'll get to more normal levels.

And I think they'll do it cautiously, but I think the other piece of this that will come into play, unquestionably, is getting inventories back to where they need to be.

So you'll begin to see some restocking across the customer base.

When we look at our -- some of our inventory management programs, and customers have said to us that historically have always maintained, I'll say, prudent levels in their bins only right now saying no, you know what?

Don't replenish me right now.

I just want to go completely hand-to-mouth.

I think that what we'll see over time as this thing stabilizes, and as it really normalizes, that product will come back, for example, into those bins.

And it's not going to be fill them to the top, but any movement at all will actually be improved in our order flows.

So yes, I do think that over time over the next couple of years that's all going to be part of the equation of fueling this recovery and our sales momentum.

But on the flip side of that, the hand-to-mouth, actually, while you'd like to see your revenues go up.

In the near-term, the hand-to-mouth actually seems like it would keep that market share gain more permanent because the little guys just won't make it.

John, you're right on.

That's the beauty of our model -- is that because so much inventory from a distributor perspective has been taken out of the system, customers more and more rely on us to be a just-in-time provider.

And we're just seeing service failure after service failure where in customers where we've not previously had the opportunity, we're now going in with our fill rates and inventory and our service model is winning the business.

So -- and the stickiness of that, what we've historically seen is, once we get into a customer we now have got a new loyal customer.

Great.

Okay.

Thank you very much.

Thanks, John.

And your next question comes from the line of Adam Uhlman with Cleveland Research.

Hello.

Good morning.

Hey, Adam.

Sticking with this inventory theme.

You did a pretty good job holding inventories down pretty flattish versus last quarter, and I'm wondering longer term after we have these three of the distribution centers with the new management system under your belt.

Where do you think you can bring your turns to?

Adam, it's Chuck.

Unquestionably, we expect to get a lot better than where we are right now.

We're not going to sit here and tell you that we think by such and such a time we'll be at X or Y.

But the process improvements and the hard analysis and work we did on the down cycle.

You saw we actually maintained our turns through last year when sales were dropping like a rock.

I think that was a pretty significant achievement by our team.

The trick is when we turn is we're starting to see now that we don't add it all back in.

And given the process improvements we've made on how we manage inventory internally, working with our suppliers, we absolutely believe there's substantial room for turns improvement moving forward.

David mentioned that that's going to translate into working capital being a lower percentage of sales, and it has historically been when things return to normal.

Okay.

Then when you look at your plan for the second quarter, do you think you'll have to add inventory then?

For the second quarter, we'll probably be adding some right now through the first quarter when we expect again absolute levels of inventory and working capital will have to go up as we continue to grow, but I would tell you that would be probably in combination with some proved inventory turns.

So that's the metric we'll manage to.

Obviously, the first priority is taking care of the customer with service level.

Make sure that doesn't deteriorate.

We think we've demonstrated we can do that in almost any environment, but the absolute level of inventory is going to have to go up, albeit with improved inventory turns.

It won't go back up anywhere near the rate at which it came down.

Okay.

And then, over the last year you've amassed quite the pile of cash.

Could you talk about your plans for that here in the near-term?

And then the acquisition environment and your appetite to do acquisitions?

Again, Chuck.

On the cash, we have a position now that we're actually in a net position where our cash exceeds our outstanding debt in the $70 million, $75 million range.

What that's done for us is absolutely preserved the flexibility to do just about anything that we think is the right and prudent thing to do.

We've talked a little bit in the past about acquisitions, should the right thing be available.

Unlike many companies would have to go to the debt market to finance it, we might have the opportunity to use the cash that we have outstanding for that.

So the cash really on the balance sheet is providing the maximal level of flexibility for us and we like it that way and intend to keep it that way for now.

Okay.

And then just last, a clarification.

Could you break down the sales change for the quarter between price and large accounts in the quarter?

I'll grab it, Adam.

So let's see.

The change, year-over-year, in sales was about $48 million.

$61 million in decline came from core volume.

That was offset by $13 million from our large accounts program, and price was basically zero as the gains that we got from our big book pricing was basically offset by the cumulative effect of discounting, which is always how we calculate that metric.

Great, thanks.

Sure.

Your next question comes from the line of Hamzah Mazari with Credit Suisse.

Thank you.

I'm calling from overseas.

Can you hear me okay?

You made it.

Thanks.

If you could add a little more color, and you talk about the negative mixed impact you're seeing on margins from larger accounts which are, obviously, seeing a quicker demand recovery versus your traditional customer base.

And how to think about that going forward, one, and then (inaudible) again see that smaller, traditional customer base.

Make them a bigger part of your mix, or get back to a normalized historical level.

Hamzah, this is David.

I'm going to try and answer the question although I am going to apologize because I think we heard like every other line.

But based on what we heard, I think the question was around the implications of the negative mix, the pressure on gross margins, and how should we think about it going forward.

And I think the biggest factor there, and I think you touched on it, Hamzah, is that once our traditional -- our core customer base begins to grow again -- remember that is by far and away, our highest gross margin segment.

So as that begins to grow and comes back into the mix, as those ratios and our business come back, we are confident that that's actually going to be a significant influence on improving our gross margins.

And unfortunately, if that doesn't fully answer it, I don't think we heard the balance of the question.

That's okay.

I will connect with you when I'm back in the country.

I appreciate it.

Thank you.

Thanks for the call, Hamzah.

Thank you.

Bye bye.

Your next question comes from line of Holden Lewis with BB&T.

Morning, thank you.

Hey, Holden.

Just wanted to get a bit more, I guess the surprising part to me on the SG&A is this sheer dollars that increased.

Stripping out the D&A, SG&A in Q1 increased by roughly $8 million.

Could you give us perhaps a little bit more breakdown as to what that is?

How much of that eight million in the quarter was a function of things that are perhaps outside of your control like higher medical expenses and bonus accruals and things like that.

And how much of the $8 million is a function of the investment spend?

Holden, this is Chuck.

Sales expenses in the first quarter were pretty much in line with what we have set as guidance.

We talked last time about going from roughly $117 million at the end of the fourth quarter of fiscal '09 to the first quarter where we had about a $30 million increase in volume.

And a big piece of that certainly to support $30 million in higher volume was going to be $3 million or $4 million of it was going to be related to the variable expense to support that.

The other piece of it is, in fact, similar to what we've talked about in Q2, the restoration of the compensation as well as investment spending.

But since we were pretty close to what we had in the forecast or guided to for the first quarter, there is no unusual surprises in there from our perspective.

It wasn't off base by much, and we had factored that investment spending in combination with benefit restoration into our guidance that we gave you for Q1.

I guess what I wrestle with is -- the SG&A number -- the dollars in Q1, looks a lot like the dollars that you were spending in say the first three quarters of fiscal 2008.

Yet the revenues are a good $70-some million lower.

And I guess in 2008 you weren't restricting the raises, and you had bonus accruals in there and all that sort of thing.

So I guess I'm just surprised that the SG&A number is equivalent off $70 million less revenues?

And I'm curious how much of that is because you're front-end loading investment spending?

Or how that plays out?

I understand that it might be kind of where you said it was.

I'm just trying to understand -- not against your guidance, but against historical norms.

It just seems like a big number.

You hit on a piece of it.

There's been some fairly substantial investments if you look at the size of the salesforce and some of the other investments we made during the year in '08 which would be fully recognized in '09.

And then the incremental investments in '09, and what we talked about putting back into '10.

The most significant piece, by far, has been our investments over this last couple years.

Remember the investments we're talking about, Holden, both made last year and this year isn't the return to the levels that we saw back in '08.

Our plans are these investments should take us well beyond that.

And once we start riding the leverage curve, we think you're going to see that.

We absolutely could get back to '08 levels and stop there with the same salesforce we had in '08 and without making a ton of incremental investments.

These investments are on the table now are to drive us beyond that to a better position.

Okay.

And the increase in the SG&A dollars Q2 over Q1, again is that primarily because of incrementally greater investment spending?

So you're continuing to ramp that further, and that's just -- ?

That's correct, Holden.

Again just real quickly, of that $5 million if you chalk $0.5 million of it up to support the higher volume and $1 million of it for payroll taxes, it will mitigate throughout the year.

The other piece that's left -- the other $3 million is yes, it's the combination of the restoration of associate benefits and increased investment spending.

The piece that we gave you in the first quarter that relates to investment spending -- once that occurs that's embedded in the run rate.

This is incremental to that.

So as you can see, we think this is a great opportunity and a great time to invest and take share in this land grab.

And we're going to do it, and come out the other side with substantially improved results.

I guess the other way to look at the question, when do the lines cross?

In other words, so you might be ramping your investment spend right now for some future benefit in terms of where the model comes in, and you start to get the real incremental margin spinning off.

At what point does that occur?

Is Q2 one step in the path where we're just going to keep increasing the dollars we accrue to the investment spend, so it's going to take us a long time to cross those lines?

Or when would you expect the top line -- or maybe the level of investment spend to stabilize so the top line can catch up, surpass, and begin throwing off better incremental margins?

Holden, two things.

Number one, we'd certainly balance the investment spending with the long-term growth with the short-term profitability is always one of the parameters we use.

So if things look completely different than the world's expectations a couple quarters out, we have some dials we can change there, and we would react to that.

The other thing is, it's the trajectory of recovery.

It will eventually -- David talked about it a little bit in some of his other comments.

We'll hit the inflection point where this will start dropping significant dollars to the bottom line.

But the trajectory of the recovery, if that happens faster than we could spend the money, it would produce a very different result than if that's a very protracted, long, drawn-out process that gets us to that level.

We don't know exactly when, but we're extremely confident that it will happen.

And that we'll be in a better position with better results actually than we achieved coming out of the prior recession.

Holden?

Yes?

Sorry, it's David.

Just to add a little bit more to that.

On the investment side you'll also notice that we're not just incrementally investing.

While we are moderately increasing it, we're also mindful of that balance short-term and long-term profitability, and so we're turning the dials down and actually reducing spending on those investments that aren't performing as well as we'd like, given the environment.

So instead of just adding -- piling investments on top of the pile, we're trying to take logs from under the pile as well that we're setting aside and removing given the protracted payback period.

And I guess the other -- Chuck touched on the trajectory of the recovery, and that inflection point is going to be dependent upon where this economy goes, in particular, what that trajectory is going to be.

It's also going to be based on what I'll call market dynamics.

So you could easily see that once the growth starts to really resume, capacity starts getting back to more normal levels, and there's less focus on price and discount, and more focus on people running their businesses and getting supply and doing jobs, et cetera.

That should bode really well for our gross margin.

So between that, the scalability investments, and the money that we would see flowing from revenue growth, we think all of that would produce pretty extraordinary, both read-throughs and getting ourselves back to what we call normal, which is earnings growing faster than revenues.

Right.

And you -- no doubt -- you have your internal forecast which I doubt you'll necessarily share with us.

But, you are investing to those internal forecasts about revenues and growth.

And I guess we're trying to get sense of where do you see based on your internal forecasting that inflection occurring?

Is the inflection deep into 2011?

Is it some time in 2010?

When about approximately would you expect to see the inflection shift from revenues and earnings growing similarly to starting to leverage what you've invested?

Holden, I'd really not like to break pattern and start sharing what our forecasts -- longer term forecasts are over the next couple of years.

And the reason is, there's just -- the visibility and the potential to get it wrong is not something that I'd want to -- that I'd really be comfortable sharing.

But suffice to say, of course, we do forecast.

We do watch it very closely, and we are getting more confident with the visibility.

And in particular, the fact that the revenue momentum that we're seeing -- we're starting to get confident that that momentum is building and that's going to be sustainable barring any extraordinary event that none of us would predict.

And we think that what's going to immediately follow that is starting to -- this whole pricing environment we think will start to firm up.

And we think the combination of that, coupled with more volume and having leverage producing earnings from that additional volume, is going to start to get us back to the place that I described as that inflection point.

But, I'd rather have you based on where you're going to pick your revenues, et cetera, put that on your model to come out with when you think that point's going to be.

Okay.

Alright.

Thanks.

Your next question comes from the line of John Inch with Merrill Lynch.

Thank you.

Good morning, everybody.

Morning, John.

Morning.

So if we were to extrapolate David's comments, and you look at December of '10, if the pattern holds through January, February, you do have six points of easier comps.

That would actually get your fiscal second quarter to up 14%, or a midpoint of sales over $400 million.

Yet your sales is forecast at the midpoint to be $390 million.

I'm just wondering what -- because of the comparison issue, what may I be missing?

John, I'm not sure.

We show the midpoint of our guidance at the -- about 11% or so.

Right.

I think what's possibly skewing it is December is a bit funny because ADS in December -- if you look at the first two weeks which have strength versus the last two weeks which are pretty anemic and that's historically consistent with holiday shutdowns.

I can only guess that maybe that's what's causing the slight difference, but we do see momentum building.

You saw our [11%].

You see what we're saying -- we're suggesting for January and February within our guidance, and that's consistent with momentum being built.

No, I understand, but the year over year in the other months should account for that.

Let's put it this way.

December was up 10.3%.

You're saying the quarter will be up 11%, yet the next two months have effectively six points of easier comp.

But you're still saying the growth rates for the whole quarter will be not that far off December.

So it almost implies a sequential -- you're either being very conservative, or there's something else going on in January and February which would be inconsistent with your prior comments that momentum is building.

I'm just trying to square the two.

You can be conservative.

That's fine.

We don't view it, John, as being conservative.

I can tell you because December, with the holidays in there, clearly the average daily sales that take place in January and February have to be above December's numbers to offset those weak -- those couple weak weeks, if you will, around the holidays as David mentioned.

But we're having trouble reconciling what you're saying here.

We believe that 11% is right now certainly our best estimate of where we think we're going to be.

But we've added, John, to your point, our guidance range -- that's the midpoint, but we do have a high end that I guess would take us to 13%.

And frankly when you look at it, we're rooting for what you're saying, and we hope to be at the high end of that guidance range.

And hopefully, we get some cooperation, and it goes even beyond.

Okay.

Well, I could take that part up later.

Let me ask you -- so let's just presume that these trends continue which is reasonable given everything else that we've been talking about, the momentum you're seeing.

Why would your gross margins actually be static in the third and fourth quarters?

Why wouldn't you get at least a little bit better operational leverage from now what is a clearly positive -- both year-over-year and sequential sales trend?

John, and it's David and listen, we very well may, which is why we gave a guidance range on margin to be 45.1% plus or minus 30 basis points.

So to the extent that we get the high side of that, you might be looking at a 45.4% or so.

The thing is that the unusually high direct ship orders-- very profitable orders, but have a drag on margin that we experienced really starting in December was unusual.

Those types of orders are part of our model, always have been, but we did get a disproportionately high share of them.

We projected in our guidance that that would continue through the quarter.

Frankly, whether or not that type of level would continue to persist, we don't know yet.

Okay.

That's fair.

That also strikes me as being very conservative because I would just presume that you're basically saying the drop ship mix will continue, which is a drag.

But then what about just the volume discounts associated with the higher revenues that are coming through?

So that doesn't factor that in as well, I'm assuming?

Well, just remember that the volume -- for example, supplier rebates, thing like that, that takes time to build.

So the fact that we're getting volumes increasing now don't -- that's not going to translate next quarter, for example, into higher rebates.

It absolutely will lead there over time, and we're planning for that.

But that isn't something that will drop.

There's more than just kind of the quarterly change in the business, but I think what you're hitting on is the same thing that we see which there is a building process that over -- assuming that things continue as they are -- this thing should build, and at some point in coming quarter we are going to hit that point where everything is coming together for us.

And you're going to see it in the profitability.

So if you were to look at fiscal 2010 based on your expectations versus 2009 and your plans, how much higher on an absolute dollar basis is compensation expense?

So that would include -- merit pay, some variable comp, and then just the extra dollar costs associated with hiring new sales associates as you've planned?

How much money are we talking?

John, we don't break it out.

The only thing I will tell you is the replacement of all of that comp and those comp levels -- called the blanket of add-backs is absolutely a material number.

It's material or immaterial?

Material.

It's a big number.

Again, David said it earlier, we have got to think of this year as a transition year.

Last year, for lack of a better way for whatever normal is -- last year comp expenses were artificially low because of some of the decisions we had to make given the environment we're in.

And when you add them back this year, they're different than they were last year and to try to compare the two is not -- it's significant as David pointed out, but it's tough to garner any insight to what that means.

Your investment discussion question is correct.

That's new additional spending, but again, we're making that to drive results that allowed us to do better than we did coming out of the last cycle.

Yes, no.

I understand.

Just lastly, I know what you said about share repo, but you are sitting on $250 million of cash.

And presumably, if these trends continue, you're not incrementally spending more in investments.

Why wouldn't you just do some share repo?

What are your thoughts toward that, or possibly another one-time dividend or something?

We'll consider any and all options, John, but we'll be opportunistic with the cash.

That's the point.

If we see something we really like from an acquisition point of view, we have the cash to do it.

We're not ruling out that we will or won't do anything with the cash in the future related to what you described.

We just don't telegraph that in advance.

Okay.

That's not off the table.

You're just saying you're not making a commitment.

Yes.

Absolutely not.

No options are off the table.

Thank you.

Thank you.

Thanks, John.

Thanks, John.

Your next question comes from the line of David Manthey with Robert W.

Baird.

Good morning, everyone.

How you doing?

Good, good.

Chuck, in your guidance, it looks like we're implying 10% to 20% contribution margins, and that's on a very moderate revenue growth and slightly lower gross profit.

As we look to the rest of the year, and we're thinking near-term -- fiscal '10, is that the level we have should be thinking about.

And then it sounds like you're saying due to the investments and the things you're putting in place today -- once we lap this, we get to higher volumes.

We're able to get leverage on these costs, that it could be a much more normal or a much higher contribution margin.

Could you give us an idea -- short-term, long-term -- how you're thinking about contribution or read-through margins?

Sure.

Dave, I think again because of the transition that we have talked about -- looking at incremental read-through like we historically have, is not particularly relevant.

You're absolutely right.

Once we lap this year, and again, we're comparing this year to last year where things were being pulled out and now they are getting added back in.

Once we get a baseline established this year, we think again there will be some merit to looking at the read-through margin, if you will, moving forward in 2011, rather than 2010.

That's probably the best way to think about it.

We've given you some gross margin guidance.

Obviously, we'll update each quarter for OpEx and revs as we go along here.

But I think, thinking of this year in term of incremental read-through, it's not a metric that we're focused on because of the transition.

But we believe we'd reimplement and reinstate that next year and start paying a lot more attention to what that really tells us and doesn't tell us about the business.

Okay.

And thinking about the first quarter that you just reported, was there benefit restoration and investment spending that was incremental to the fourth quarter in the first quarter?

And if so, how much was that?

The answer is yes, and for the most part, everything that wasn't related to the variable expense to support the higher sales volume from Q4 to Q1 was related to the combination of increased investment spending and associate benefit restoration -- or compensation restoration.

Right.

So you see there was a large jump in incremental sales from $30 million or so.

So we've told you at the short end of the margin curve roughly 11% is variable.

So you could say -- and I think we said this actually in the Q&A last call that roughly $3 million or so was related to the variable expense -- freight and whatnot to support the higher activity levels.

And the bulk of the other piece of expense was the combination of the incremental investment spending and the restoration of the compensation.

Got it, okay.

Thanks a lot, Chuck.

Yes.

Your next question come from the line of Jeff Germanotta with William Blair.

Happy New Year, gentlemen.

Thank you.

Same to you.

Thanks.

I've got a few questions.

The first one is, as you see demand sequentially building, any sense of how much of that is stimulus-derived versus real private demand being created?

Jeff, we have probed this stimulus thing, and we see very little of it impacting our business.

And then the second question is, back to gross margins, probably coming at a prior question a different way.

When do you see the mix shifting back?

I understand the large customers.

I understand the large order.

I understand drop shipping.

But at what point do you see competitive dynamics, then the mix shifting back to smaller accounts such that we can get back to a 46% gross margin?

Is that a 2011-type of phenomenon at best?

Jeff, it's David, and I unfortunately can't answer that because I can't predict what's going to happen with this recovery or, in particular, the trajectory of what's going on.

So it's really going to be dependent upon that, and specifically, when our core gets back to what I'll call normalcy.

And as soon as that happens, and as soon as we see this core starting to grow robustly again, given that it's the highest margin piece of our business.

That will begin to fuel our gross margin expansion.

Jeff, just to add to that.

It's just not the mix itself because with the mix comes other things like abatement of some of the discounting that's been going on and the firming of the pricing environment.

It's not only the flat-out mix of the sales when the core returns.

You get some other things that generally come along and accompany that which will all provide fuel for expanding margin.

Okay.

And then my last question really gets to the SG&A.

Obviously, there's some restoration of benefits and compensation to employees.

There's elevated investment spending.

But at what point do we get to a steady state and start to lap that such that it's not incremental anymore?

Is that later this year, or is it early next fiscal year?

Jeff, from the benefit and compensation point of view, it really occurs throughout the entire year and to a much lesser extent maybe into the first quarter of next year, given that a lot of this stuff was restored on a calendar year basis versus our fiscal year basis.

So that's one factor to consider.

The investment spending will be managed and looked at, as I said earlier, we can tweak the dial on that to some extent as we see how the environment unfolds.

So I don't think it's fair or right to say when do we lap that.

That's something we'll look at -- how much appetite we have for investment spending given the environment we're in and where we want to go on a quarter by quarter basis.

But the benefit piece will actually run through the full calendar year, which as you know, will start to lap into at least to some extent part of next year as well.

Thanks very much.

Thanks, Jeff.

Your next question comes from the line of Duffy Fischer with ClearBridge Advisors.

(Operator Instructions).

Yes, two questions.

The first is, you have made several references to tough pricing and pricing issues.

Could you talk about specifically where you're seeing the most pricing issue?

And is that your custom -- or your suppliers cutting their price, and then you having to pass that through?

Or is that actually you having to cut your price for your service, so to speak?

And then the second question would be the one that everybody seems to be trying to get at.

I'm not asking you to give me a projection of timing when you hit that inflection point, but is there an absolute sales dollar number we could think of, i.e., if you get back to a $1.6 billion run rate of sales.

Then we can put our projections on where we think the macro will drive you.

So starting with the tough pricing, and that really is because of what I'll call the tough pricing environment.

As I've said, two things going on.

One is, that we're seeing traditional competitors use one of the few weapons that they have and to try and really just generate cash they are taking orders at low margins.

We've been -- we certainly sell on value, but we also are absolutely in there doing hand-to-hand combat.

We've been aggressive in our promotional campaign to take share which is something that customers really appreciate in this environment.

And I guess the other factor is that, certainly you see, that our large customer segment which is a segment that does come with lower gross margins as part of the mix is also contributing to what we're seeing on the pricing front.

I think that the extraordinary environment that we've seen over the last year, unquestionably from a competitive standpoint, has contributed.

But I also think just the absolute level of demand has contributed and when that begins to stabilize and I think customers get busier focusing on orders in hand rather than focusing on how to just save money.

I think that's what we would consider and that's seen historically getting back to normal.

And that, too, should bode well on the gross margin line.

You want to take part two?

Your question about sales level, and again the reason we can't give you an absolute level of sales it is, again, a function of the trajectory or the recovery.

It's a very different result if we return to pre-recession levels in the next six months versus it takes 15 months to get there.

You'd have a very different bottom line read-through and a different operating income percent of sales depending on the pace of this recovery.

So it's virtually impossible to give you an absolute sales dollar.

It's more of a case of how quickly does it happen, and when does it happen that would drive that inflection point.

Your next question comes from the line of Brent Rakers with Morgan Keegan.

Good afternoon.

Three questions.

First is pretty straightforward.

If you can give me the headcount numbers at quarter-end, that would be helpful.

The second question -- I was hoping you could maybe revisit for us the magnitude of the permanent cost take-out if any, or if material over the last let's say year, year and one half?

And then the third question, was hoping maybe to follow along a little bit with Holden's question earlier -- to give us the sense because I believe the headcount numbers are fairly flattish even though you have added salespeople between now and let's say about two years ago.

Was hoping you can give a sense -- will the payroll numbers in 2010 essentially be roughly the same as they were back in 2008?

Will they be more than that?

Or will they be less than that?

And if you could help maybe quantify that a little bit more?

Well, Brent, I'll kick off with the absolute headcount number.

Ending Q1 is -- hold on.

I need to put my specs on here.

4,164 associates, which you can see versus where we ended last year.

That is down a bit.

Remember in your calculation that while that is down a bit, we have [attrited] in our volume-sensitive areas in particular.

But remember, we're also restoring hours to our associates as well as we have been as volume builds.

Chuck is going to talk about some of the permanent take-up.

A couple of the other things you had mentioned.

The permanent cost reduction.

There's been a pretty fair amount of that.

Again, we wouldn't sit here and quantify it for you.

But to give you an example -- and we talked about it a little bit earlier.

Some of the investments we have made in our warehouse systems which drives efficiency and serves to effectively lower that variable cost.

We have been talking for a while about 11% at the margin.

All four of our DCs are up and running on this system.

When that happens, it's already happening in the places where it's implemented.

We're effectively taking the variable costs down.

So we're not having to add back to support the sales growth that's coming which will factor into the leverage equation here as the volumes continue to grow and pick up.

So why that's not in our numbers apparently right now, simply because we weren't in a growth environment for a long period of time.

As we start to grow here, you'll see some pretty significant improvements based in large part on that efficiency improvement in the DC.

We took a lot of time to renegotiate contracts on the expense side that we don't believe are temporary at all.

Certainly, there will be some inflation down the road, but they'll be coming off a much lower base than they were back in 2008.

We've gone to more cost-effective cars for our sales team which is a permanent change.

There's thing like that that have been in the aggregate that are pretty significant in term of cost take-outs.

And some of them are more variable, and they'll manifest themselves more as the growth takes hold.

And others are in our run rate right now and will be there for the foreseeable future.

And then, Chuck, just the last question, actually, on the payroll, maybe 2010 versus 2008?

Right, right.

Leaving aside the payroll associated which is volume, which is primarily the labor, of course, in our DC.

The payroll, absolutely, would be higher because the investment spending and the hires we've made through the cycle here not only what we've invested in '08, but '09.

And what we have on the table for 2010.

Coming out the other side, yes, all things being equal.

The payroll would be higher because of the investments.

Chuck, maybe one last question related to that.

Obviously, a lot of the hiring is focused on outside salespeople.

And presumably, a lot of these outside salespeople are coming from some of the mom and pop distributors or existing salespeople with books of business already.

First of all, I guess is that right?

And if that's so, wouldn't the turn on the economics of those be pretty quick if they're already producers?

Brent, the answer is absolutely they would be quicker.

The time to break even because the point you made of bringing the book in business of those folks that were solid producers at smaller companies that are afraid that their company is not going to make payroll.

Or they're discouraged from what they've seen from the service level their current company provides.

Absolutely, those types of hires bring business -- turn a little bit quicker.

But we've got 900 or so other associates that obviously, in the downturn -- productivity is down compared to what it will be obviously when we start to grow again.

So for the ones we bring in that are from those types of situations -- 100% correct.

I'm sorry, Chuck, just one more.

So just to clarify your payroll comment.

So on a per employee basis, the per employee comp in 2010 you think will be higher than it was in 2008 despite significantly lower revenues?

You said per employee comp.

That's different than total comp.

Yes.

I'd say kind of on a same employee basis, so that kind of throws out some of the new employee adds.

Well, since the volume is lower, certainly in our associates in the warehouse, there would be less hours associated than there would be with the payroll to support that level of activity from '08.

And since the sales hires and other professional hires, if you will, have added to the headcount to some extent from '08 -- yes, that's -- doing the math on that that would be true.

But I think once the volume recovers, and you start to put payroll in to some extent from the warehouse point of view, that dynamic would change once again.

Okay.

Thank you very much.

Thanks, Brent.

There are no further questions.

I will now turn the call back over to management.

Okay.

Well, we appreciate all of your interest today, and we look forward to speaking to you again on our next quarter's call.

Thank you for participating in today's conference call.

You may now disconnect.