MSC Industrial Direct Co Inc (MSM) 2010 Q3 法說會逐字稿

Good morning.

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

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

(Operator Instructions).

Thank you.

Mr.

Eric Boyriven of FD, you may begin your conference.

Good morning everyone, and welcome to the MSC Industrial Direct fiscal third 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, can also be found in the earnings announcement, which is also posted in the Investor Relations section of our website.

In addition, during the presentation, management will refer to financial and management 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, and expectations regarding the Company's ability to capture market share, and expected benefits from the Company's investment and strategic plans.

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

Information about these risks is noted in the earnings press release, in the risk factors in the MD&A section 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 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 Erik Gershwind, EVP and Chief Operating Officer, Chuck Boehlke, EVP and Chief Financial Officer, and Shelley Boxer, VP, Finance.

Today I will cover our strategic view of the Company.

Erik will provide an update on the landscape and competitive environment, as well as the execution of our model, and Chuck will fill in some details on our Q3 performance, and Q4 guidance.

I am delighted with our performance in Q3.

Our team has worked hard since the beginning of the downturn to be proactive and focus on market share, while taking prudent measures to reduce costs and moderate risks.

One year ago, as the recovery was heading deeper into the worst recession in modern times, I said, that we believe that this is the time to increase our spending on growth and productivity initiatives, to strengthen our competitive advantage over small and regional distributors.

We expected to take significant share from them, by pressing our model's advantages, at the same time their businesses experienced significant service failures.

By carrying out our plan, we said that our model will deliver disproportionate growth in revenues and profitability during the cycle upturn.

Well, I'm happy to say today, that we are now beginning to see those investments validated in our results.

We executed on our time-tested plan to take share during a downturn.

Given our experience in past downturns, and our deep understanding of how these times impact local and regional competitors in our fragmented market, we believed in our plan, and the share gains that it would produce.

We just could not predict the timing.

As most of you know, we are one of the first in our industry to react to the turmoil in our markets.

However, we did so in a manner that was very different than most.

MSC has operated under a unique set of core values and principles for many years.

We have done so with an eye towards being one of the winners, in a long term industry consolidation.

These values and principles positioned us to be an organization that has prospered in all economic cycles, successfully transition leadership, and focused on market share growth.

We believe that we are built to last.

During the downturn, we took action to reduce costs,including some aspects of compensation, and discretionary spending as well.

However, we differentiate -- we differed from many others in how we treated our associates.

We did not reduce headcount through layoffs.

We maintained our associates, and continued to train and upgrade our team throughout the period.

As a result, unlike many of our competitors, we are not scrambling to fill gaps in service, to hire and train new people to support growth, and to not have the supply chain issue -- and do not have the supply chain issue, that many others have.

Although there remains a significant uncertainty relating to the economic environment and the current recovery, we are confident that our growth and market share will continue to accelerate.

As customer's businesses have begun to recover, their demands on MRO distributor's have grown quickly.

The supply chain has begun to stretch, and customers do not want to, or cannot afford to restock their inventories of supplies.

Increased production and backlogs, mean that customers can no longer wait several days for their orders.

This is now a just-in-time world.

Let me explain more specifically what is happening in our marketplace.

Industrial distribution is a relationship business.

In a normal environment, it's very difficult to break the bond between a strong local distributor and it's customers.

This downturn forced distributors to break these historical bonds, by laying off the field and telephone sales staff who had those relationships with the customers.

In addition, basic survival needs have driven many customers to take some steps, that they would have been reluctant to take in normal times.

They are switching business away from old relationships with suppliers who don't have the inventory, can't carry the receivables, or who have not been paying their suppliers.

Our market share gains, mean simply that we are winning, and capturing more business.

Once we get our foot in the door, we crash through it.

That's what you're witnessing, and that's why we believe that MSC will see continuing market share gains during it's recovery, and for a long time thereafter.

I'd like to give some guidance for Q4.

We expect sales to be between $446 million and $458 million, and fully diluted earnings per share to be between $0.61 and $0.65 per share.

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

Thanks, David.

I'll start with what we're seeing in our customer landscape.

The ISM remains at high levels, and is reflective of what is actually happening in our customer's business.

Sentiment continues to improve, as order levels increase.

And while there are some concerns about the economy, those concerns are outweighed by a building sense of optimism.

That optimism is reflected in backlogs that are starting to grow, and some renewed hiring.

Customer inventory levels on MRO products have increased over the last quarter, but they remained below historical levels.

We are seeing what we would describe, as cautious restocking among our customers.

There is still an overall desire to run lean and to preserve cash.

As we described before, this bodes very well for the MSC value prop, and for our ability to take market share.

Let me now turn to that market share story.

As David described, we are using this unprecedented time, or landgrab as he's called it, to take share from the local competition that makes up the majority of our market.

And we're seeing the payoff in virtually every metric we use to gauge our share gains.

First, in our revenue trend.

Our growth momentum continued to build in the third quarter.

Average daily sales grew 31% in the month of May, and our Q4 guidance reflects our expectation for continued high sales growth, with growth in average daily sales of about 30% at the middle of our guidance range.

Second, we benchmark our growth by end market, against others in our industry and in our supplier community, and that also paints a very encouraging picture.

Third, we use as a supplier feedback regularly, as our manufacturers are able to compare performance across many distributors.

And I recently had the chance to attend a large industry trade show, and I was blown away by the supplier feedback regarding MSC.

We were repeatedly told that we're outpacing our manufacturer's other channels of distribution by a pretty wide margin.

The execution of our model remains at very high levels.

We proved capable of handling high sales growth rates, without missing a beat.

Our execution through the downturn, and now the upswing, has been one of our biggest share gain tactics.

While small and regional distributors struggle to put inventory on the shelves, their lead times extend, and their service slips.

And this is providing a better than ever chance for the MSC service model to shine.

Our huge product assortment, our high fill rates, same day shipping guarantee, and get-it-next-day delivery are more valuable now, than they've ever been.

We continue to invest in all the programs that we've mentioned so often on these calls.

Direct mail continues at reduced levels, producing an excellent return.

In fact, the direct mail productivity that we saw and highlighted in Q2, has continued in Q3, and we saw significant lift in all of our metrics.

We have increased our spending on electronic channel, and this will continue throughout Q4, as the results are excellent.

Our broader e-commerce initiative remains on track, and continues to hold great promise for future revenue growth, and earnings leverage in the future.

Our large account program continued it's robust growth, as we build upon our success in this sector.

And our investment in Asian sourcing, private branding, and our product management initiatives also continues.

We are using these programs to offset the near-term gross margin headwinds, and ultimately to expand our gross margins over time.

You'll notice that our sales force headcount came down slightly from the last quarter.

It's currently at 947 associates, versus last quarter's 949.

We remain very pleased with the hiring of top industry talent, just as we've described on prior calls.

We have seen an increase in attrition relative to the last year, although that still remains well below historical levels.

And we've also used this time to increase the quality of our sales team.

Our performance management process has resulted in the replacement of lower performing sales associates, with higher-level performers.

Our target for the end of our fiscal year remains at 965 to 975 associates, as we highlighted on the last call.

Thanks, and I would now like to turn the microphone over to Chuck.

Thank you, Eric.

MSC's financial performance in Q3 was excellent.

Sales exceeded the top of the guidance range, representing total growth of 28.5%, and growth in average daily sales of 26.5% versus last year's third quarter, when adjusting for the extra day.

There will be one less day in Q4 this year, versus the same quarter last year, and two fewer sales days in our recently completed Q3.

For projecting growth, in average daily sales at the middle of our guidance range to be 29.7% in Q4, versus the same quarter last year.

Gross margin in Q3 came in at the midpoint of our estimated range at 45.5%, and total spending was about as expected.

That resulted in an operating margin of 15.6% in Q3, demonstrating the leverage in our model.

Consequently, earnings per share increased 57% in Q3 of 2010, versus the same quarter last year.

We expect gross margins for Q4 to be in the range of 45.1%, plus or minus 20 basis points, reflecting normal seasonal trends.

With the introduction of our new Big Book catalog in September, we expect that Q1 2011 gross margins will be at, or above Q3 2010 levels.

Operating expenses will increase in Q4 versus Q3, by approximately $5 million at the midpoint of our sales guidance.

Benefit costs are increasing approximately $2.5 million, as we restore our 401(k) match, and continue to experience rising medical benefit costs.

Our recent favorable bad debt experience in Q3 is not expected to be repeated in Q4, accounting for approximately $1.5 million of the cost increase.

The remaining $1 million primarily reflects increasing investment spending.

Balance sheet metrics remain solid.

Inventory turns were 3.4 in Q3, receivable DSOs were solid at 42 days, and cash generation was excellent, as the Company produced $35 million in net cash provided by operating activities.

The growth in the business and in the cash balances, have given us the confidence to resume our policy of stock buybacks and regular dividend increases.

We repurchased 920,800 shares of MSC stock during May and June, at a total cost of about $46 million, and our Board recently increase our regular quarterly dividend by 10%, to $0.22 per share.

Thanks.

And I will turn it back over to David.

Thanks, Chuck.

And just to correct an earlier reference that I made, when I talked about what I said one year ago, I said, as the recovery was heading deeper into the recession, I obviously meant to say that as the economy was heading deeper into the worst recession of modern times.

So, just wanted to clarify.

All right, I'll continue.

Today's opportunity is the greatest I've ever seen in my 35 year career in industrial distribution.

The economic snapback that we are currently experiencing is happening so fast, that the smaller competitor's already weakened balance sheets will be unable to keep up.

When you couple that with customers desires to maintaining inventory, and increasing demands being placed on their MRO suppliers, the MSC model is more compelling than ever, and should deliver significant share gains well into the future.

We firmly believe that we are only in the very early innings of this unique market opportunity.

We are confident that we have the right plan, the right investments, and the right team to continue to capitalize, and believe that we will continue to demonstrate that in our results moving forward.

In conclusion, I want to thank all of our associates for the hard work and dedication, that has produced such great results.

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

Operator, will you please open the lines for questions?

(Operator Instructions).

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

Thank you.

Good morning.

Good morning, John.

So the sequential guidance, I think implies a 14%, 142% OP margins.

First, I just wanted to verify that's what you're thinking, and I think, Chuck, you have said with $5 million sequential spending, that's roughly a percent or so on the midpoint of your revenue guidance.

I guess my question is, is the 14 right, and if so, why with 30% revenue growth, isn't there more leverage?

I get the fourth quarter dynamic, but why isn't -- why aren't the fourth quarter margins up a little bit more, given 30% top line?

Because it sort of speaks to, as revenues slow off tougher comps going forward, are you just not going to get much margin uplift, as you sort of think about the out years?

John, first of all, yes, you're right.

The implied midpoint in the guidance and about the operating margin range was about 14.2, so that's correct.

So let me reconcile for you, basically, Q3 to Q4.

There's roughly $0.06 and change there.

Based on the guidance we gave for margin, there is about a 40 basis point drop in gross margin in the fourth quarter versus Q3.

And that's seasonal and historically happens to us every year, as we get into the summer months.

As I did mention, once the Big Book comes out, and given where we are in the pricing environment, we'd expect to have the gross margin growth go right back up, if not exceed where we just achieved in Q3.

So you should have a margin boost coming first part of next year, relative to the guidance we've set in Q4.

So that's $0.6 in difference between Q3 and Q4, is roughly, $0.01 of it relates to the decline in gross margin.

The other $0.05 are in OpEx.

The benefit costs we talked a little bit about in the script, we are experiencing some increased medical costs.

As we've said many times on the calls this year, this is a transition year, where we have actually begun to add back previously reduced associate benefits, and incentive compensation, those types of things.

The last piece to go back into the equation, is actually in Q4 and was not in Q3, and that's our 401(k) match.

So between increased medical costs, our 401(k) match, you are looking at about $0.025, another $0.01, as I said, from the gross margin.

The other thing is, there's about a $0.015 relative to a very favorable bad debt expense kind of situation, that we had in Q3, that is kind of a one off, one time thing.

Our receivables quality improved.

We also recovered on a bankruptcy that we've previously written off.

There's been about a $0.015 of that change, from Q3 to Q4, based on returning to normal bad debt accruals in Q4 that were substantially in Q3.

And the last $0.01 in the OpEx piece is the investments and other things, that take about a $0.01 in Q4 versus Q3.

We think there is plenty of leverage left in the business.

Once we turn the corner, as I said with the new Big Book, and you see expanding gross margins, and a rising revenue environment, we think there's plenty of leverage left within the business.

And we think you'll see that as we turn into a more fertile pricing environment, coming out at the end of this year.

Chuck, can I just ask you, as you restore some of these benefits, and healthcare costs and so forth, you're absorbing some of them this year, and I assume some might spill into next year.

If you just based on the trend today, what is the annualized incremental cost headwind that hits you in fiscal 2011?

So not asking for fiscal 2011 guidance, I'm just asking based on the costs today --

John, the other thing I could tell you, the last piece in the fourth quarter is in now.

It's things like incentive compensation, again the 401(k) match, all that is back, and this is the very last place to go in.

So to try and tell you, in that time space, throughout the entire year versus this year, pieces of it happened early in the year, obviously some pieces here, happened at the end of the year.

All that will be baked in, so to speak, the run rate for Q4, is, maybe the best way to think about that, as having everything baked in.

So kind of worst case, your fourth quarter is like the run rate, basically?

That's right.

Well, what about the volume incentives then?

That perspectively, I know you guys had talked about 2011, when some of that begins to come back.

I'm assuming you didn't see any of that this quarter, based on again, 30% topline expectations, right?

You have got to be seeing at some point, some volume rebate benefits.

Does that happen in the first half of next year?

John, it is basically is in two months of -- there was nothing in the third quarter to speak of, but given our rapidly rising sales, and the need to now start to add back inventory to support that, yet, you are absolutely right.

You'll see some pretty sizable increases in volume incentives, as we move forward.

Basically, the accounting works, our entire purchases for 2010, you'll get the benefit of -- 10 months of that will happen next year.

We're getting it in July and August, the last two months of this year.

So there is some slight impact in the fourth quarter, but the big impact is throughout the entire fiscal year 2011.

And you will absolutely will see it in our gross margin.

That's one of tailwinds we have behind us moving forward for margin next year.

Yes, just a last strategy question for David.

Firstly, you guys paid off a lot of debt this quarter.

I'm not entirely sure why you did that, but it does beg the question.

You're sitting on a fairly over capitalized balance sheet, with a lot of these spending headwinds kind of already now in the numbers.

It strikes me that if the market is not going to give you the kind of same optimistic outlook that you guys have, and have been reiterating, why don't you step up, and begin to repurchase stock on a more meaningful basis other than simply offsetting option creep?

In all, John, we think we got our debt off the shoulders this quarter with some buyback.

You can see that we've really started to get back to, I guess in a more normal pattern of dividend, dividend increases, what you see, with some share repurchase activity, which we haven't seen in quite some time.

We certainly recognize that we've got an under leveraged balance sheet.

But we've always been opportunistic, being able to use that balance sheet as a weapon.

We think we're doing it now.

The other component that you've not seen, although there is activity, is looking on the M&A side for great companies that would be additive to our plan.

We've not seen anything yet that reaches our hurdle levels, but we certainly are actively looking, and will continue to be opportunistic in that regard as well.

Okay.

So in other words, all else equal, we should probably expect more share repurchase on the (inaudible).

Is that a fair statement?

I'd rather not talk about the timing of that.

I think over time, given that we're getting back into what I'll call kind of a -- a more normal pattern of balancing dividend increases, stock repurchase activity, as well as continuing to look at M&A.

I think those are the primary uses of cash that you can look forward to over time.

Okay.

Thank you.

Thanks, John.

Next question comes from the line of Adam Uhlman of Cleveland Research.

Hi.

Good morning, guys.

Good morning, Adam.

First question here for Chuck.

Follow up on the gross margin.

It looked like the growth rates were much more balanced this quarter, between your high margins, small customers, and your maybe lower margin national account customers.

And I'm wondering why the gross margin rate didn't pick up from that.

It looks like the fourth quarter guidance is for even softer margins.

Could you walk through some of the other moving pieces of the gross margin picture?

You mentioned rebates.

How much did that pinch the gross margin this year, and what kind of a lift can we directionally think about for next year?

And what else is happening from the purchasing side?

Adam, it's Chuck.

I'll take the rebate piece, and I'll pass it over to Erik for some of your other thoughts and comments.

The rebate piece, without telling you obviously, we don't want to give away secrets here, but clearly, as you saw from our inventory reductions, throughout the down cycle, the buy-in rebates, substantially.

There's real money associated with rebates, and by and large, it's going to be back to historical highs, as we go forward next year from a very depressed level for this year.

So again only a small piece of that reached through to the fourth quarter.

The good news is that is all to come yet, in 2011 as one of the tailwinds is behind us, if you will, for gross margin.

Erik will touch on the other pieces you brought up.

Yes, Adam, as far as overall, sort of the gross margin formula, Chuck had called out in our prepared statements the seasonal effect, which didn't surprise us, because it happens most years.

Overall, just give you a sense of the formula, I'll start by saying that we absolutely are seeing, what we expected to see.

We're thrilled to see our core business come back, and that is having a positive contribution in our gross margin formula.

But as we always talk about the margin formula for us, it's a series of tailwinds, and a series of headwinds.

In terms of the tailwinds, you mentioned one of them.

So seeing our core business pick up and grow back is absolutely a tailwind.

Chuck had talked about what the others, which is pricing.

Which to date has certainly been very moderate, but as Chuck mentioned, and we talked about earlier with our Big Book coming out, you usually see from us when we launch our Big Book, which will be in a couple of months, typically that is associated with a price increase.

We don't expect this year to be any different.

The other tailwind that I highlighted on the script, is our investment programs that we have been really pleased with on the buy side.

On the headwind front, there is a couple.

There is still a little customer mix.

There is still a very real headwind.

We continued to see large order activity, as we've talked about before, which ties right into some of our sheer gain activity.

And the third one I highlighted is competitive activity.

And its interesting, Adam, because in this environment, we are actually seeing competitive activity on pricing and discounting from the locals and regionals to be as strong as ever.

And the reason we think that is the case is -- and we touched on it in a bit earlier on in the prepared statement -- the locals and regionals are under more pressure, as things turn around and pick up, than they were even in the downturn.

So their working capital is facing pressure, which puts pressure on their ability to extend credit, to put inventory on the shelves.

And we actually believe we're taking as much or more share as things pick back up, than they did when they went down.

So that obstacles a lot of pressure on the small locals when it comes to pricing.

Okay, got it.

Do you care to comment on how much of a price increase that we're looking at in the Big Book in September?

No, Adam, we typically do that the next quarter.

So we'll give you the update next quarter.

Chuck gave you some sense for the Q1 picture, that it will be at or above what you saw from us in Q3.

But we'll go one quarter at a time, and we'll give you more specific guidance, and we'll tell you about the price increase next quarter.

Okay, thanks.

I'll get back in queue.

Your next question comes from the line of Sam Darkatsh of Raymond James.

Good morning, David, Erik, Chuck.

How are you?

Hey, Sam.

A couple of questions here for you.

First off, Chuck, I think that you mentioned you repurchased almost a million shares.

Did that occur in June?

I didn't see it on the cash flow statement.

It was at the very, very end of the quarter.

It started at the end of the quarter, but primarily all of it is in June.

You'll see that obviously, in the next time report in the use of cash.

Okay, got you.

Restocking.

You talked about customers talking.

Do you have a sense of what proportion of your growth you're seeing now is due to that, versus what I would deem true demand this point?

Yes, Sam, it's Erik.

We characterize -- earlier on the characterize restocking as cautious restocking.

So again, relative to what we saw in Q3 relative to Q2, there was definitely some build in inventory, but still cautious and well below historical levels.

As we also talked about, we think certainly some of what we're seeing on the revenue line obviously is economic lift, and that would be a combination of some contribution from restocking, along with true increase in customer demand and order flow, combined with what we are seeing as a share gain.

Want to take a stab at a ballpark, what proportion of your growth is coming from the restocking?

No, no, that's not something that we're going to break out.

So I can't give you too much more detail there.

okay.

You're mentioning the share gains, and it appears as though it is coming from an existing customers, particularly, as they decide to use you more often than the smaller folks.

When do we -- when do you expect to see a stabilization of the overall customer count?

Sam, let me talk a little bit -- I will kind of take a step back and if you're referring to the terms of what you're seeing on the bill to decline.

That's something that's been several quarters now, and as we've said, something that will not surprise us to continue on the build to front.

The way we look at our customer base is, we segment it into tiers.

And the tiers are based on two things, based on actual revenues with us and based on potential for growth.

So what we've talked about in the past, and very much continues to hold true, where we're seeing the drop-off, is customers that have small actual dollar sales with us, and very limited potential for growth.

So let me put a little color on that with numbers.

Our average drop-off account does under $500 a year with us.

So when you're seeing the counts go down, it's in tiers, the very smallest of tiers with limited potential.

We're really pleased with where we are spending our time.

We look at retention by tier, and we look at all the metrics by tier and where we're spending our time focused in investment -- the customers who -- they range in dollar values.

Some are very large, and some are not so large.

But the common denominator we see, is a potential for growth and our metrics are pretty much at historic highs on those.

The other color I'll offer you, Sam ,which is not a metric, that we publish, but one that we did talk to, is the ship to number.

So we've mentioned before that through this decline, our ship to count had been much softer.

We did see a decline in ship to's, but was a much softer decline.

I think on the last call, we talked about it since a stabilization in the ship to number.

We actually this quarter saw a growth in the ship to number.

So we did see it tick back up.

So you are getting close to weaning off the customers that are less than optimal at this point then, because -- the ship to is stabilizing and increasing, that the bill to's also should?

In general, that -- they followed each other.

It's not a number that we forecast, in terms of the build to's, but in general, it would be logical that they follow each other.

But again, it wouldn't surprise us to see the bill to's, over the next few quarters, if the bill to's were still shrinking, that wouldn't surprise us.

Okay.

Last question, if I might, the fulfillment slipped a little bit.

Was there a P&L impact of that?

Or a little bit of color on that?

Yes, that has to do with our service level.

A couple of comments there, Sam.

I think what you're referencing is in the metrics we move from 99 to 98.

Yes.

Yes, sir.

Okay, yes, a few things.

Number one is, the number actually teetered, it was close to 98.5, but it was slightly below.

And that was a result of what I would describe as some very isolated pockets of service issues with supplier lead times.

And really that's the result of how fast the revenue trend has turned around.

And I'll tell you, our purchasing team has been all over this.

It was one that we saw coming, albeit not as quickly.

It was hard to predict this kind of revenue acceleration.

But our purchasing and product teams are over our suppliers on this.

And the other thing I would tell you is, isolated pockets, and when we go into the field, which we do regularly, and get a sense both from her salespeople, and from our customers about our service level, I would tell you if anything, or service gap, relative to the locals who we compete with, has widened.

So no concerns there.

Was there a P&L impact in the quarter due to that, where you might pick it up, again, in the fourth quarter?

I was just trying to get a sense of timing and impact.

Sam, David.

I would say no, the only P&L impact is a small amount of money that is probably related to the overtime in our CFCs, and in particular, in the receiving areas, working hard to get the goods in from suppliers in, and on the shelves.

But a small part of our OpEx.

Thank you.

Very helpful.

Thanks.

(Operator Instructions).

And your next question comes from the line of David Manthey of Robert W.

Baird.

Good morning.

This is actually [Luke Yunk] on for David this morning.

If we look at contribution margin this quarter, on a year-over-year basis, it was real strong at 25%.

And I know as we finally roll in all of the things you've have taken out of SG&A in 2009, and some investments going forward for growth clearly, could you talk about where you think we are in the cycle, in terms of contribution margins going forward, and what point in time we get into more, more normal behavior?

Luke, it's David.

I guess I'll step back and kind of take the picture, talk about our goal first, which is, as you know, it's about growing revenues in double digits and earnings, at a faster rate than sales.

It naturally will mean, that as we execute upon that, operating margins are going to expand over time, and we think eventually exceeding our past high water mark of 18%.

But to answer specifically, on when we think that's going to occur, how quickly they're going to expand, and how quickly that contribution margin expands, is really going to continue to depend on three factors, which we've talked about -- revenue trajectory, the pricing environment, and our level of investment spending.

So as you point out, in Q3 and our Q4 guidance, we're in the neighborhood of 25% read throughs.

And that being achieved, in the context of rapidly rising revenues.

On the other side, also in what we consider to be very, very limited inflation, I think the other thing going on there, is, that's also happening while we're still feeling the effects of some of the addbacks that Chuck talked about.

So what the future holds for read throughs, and Op margins will continue to be a function of those same three things, revenue trajectory, pricing, and what's happening with our investment spending.

And we've talked about that as capacity begins to return to more normal levels, we'd expect pricing to firm, and for inflation to begin to return, and to creep in.

We -- that's historically what we have seen through every cycle.

And in that environment, we certainly expect to see gross margins expanding, and as a result, contribution margins would expand, as would operating margins.

So, we're confident, that as this recovery really gains traction, a combination of high growth and expanding gross margins, would produce absolutely powerful read through or contribution margin results.

But we just can't -- we can't predict the timing.

But ultimately laying out the factors is helpful.

No, that is helpful.

Thank you.

And then, as a follow-up, if you could maybe talk a little bit about how you are thinking about investment spending going forward, given that we have essentially restored everything was taken out during the 2009, and now any SG&A that's coming in, can go towards growing the business.

Do you have any preference versus increasing the sales force force, or sourcing initiatives productivity, could you talk a little bit about that?

So I guess I'll start, and then Eric can jump in on some of the specific programs.

I think you know that our goal is to incrementally invest every year, in order to drive long-term growth.

If you look at our history as a public Company, we really have a proven track record of translating those investments into rapid top line and bottom-line growth.

And we go through a strategic planning process every year that kind of redefines what those programs are going to be.

And I know Eric has been talking a lot about what we kind of have got working right now, and what we're going to continue to be working on.

So I'm going to have him give you just a little bit more color on the investments that we're currently making today.

Look, and from the last couple of calls, we highlight most of the big ones.

If I have to summarize, I will give you the quick summary here.

But I will tell you where you're going is one versus the other.

When we highlight these, all of these are an important part of the formula producing, both revenue growth and earnings growth.

And you hit on one very important one, which has been a growth driver for us for a while now, which is expanding our sales force.

And as we've said, this is really been a unique time for us, and we believe we've capitalized on it.

Building out our web business continues to be an area of heavy focus for us, and that's one that we see as, both a driver of from a growth on scalability and earnings leverage for us.

We have called out a large accounts program.

And that's what I was going to continue with.

Many of our buy side programs, that as I mentioned, are offsetting some of the gross margin headwinds, and ultimately are going to be driving the gross margin expansion.

We've talked some about our marketing programs, so beyond just direct mail, and some of the electric marketing programs that we've talked about before.

And the other one that I didn't touch on today, that is absolutely there, and showing good progress is our productivity initiatives.

So we've talked about our optimization efforts within our logistics network, and we fully expect those to continue.

And we're real pleased with the payoff.

So the answer is, we would expect to continue with a balanced portfolio of investments, focused both on revenue and share gain, along with earnings and leverage.

Okay.

Thanks, guys.

That was helpful.

Thanks, Luke.

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

Yes, good morning.

A number of questions if I could.

Sure, Brent.

First, on the mailings, continues to come off this year.

Just want to get a sense, is 20 million a year, kind of a new direct mailing number going into next year?

It's Erik.

This is one that we've talked about for a while.

That we sort of reserve the right -- we don't set an annual number like that, but it's a number that we adjust quarterly.

And that's a combination of based on what we're seeing in the environment, and the kind of returns that we get, and also trade-offs relative to other investments.

So certainly what you saw from us in the Q4 projection of the 4 million, is a, is a more dramatic decline.

And again, it's a combination of investment in other areas, along with, I'll tell you, spoke about on the call, we are really seeing great lift in productivity.

So as we scale back, we are seeing by every productivity metric we get, we're really pleased with the performance.

So not one that we would then -- I wouldn't take that, and blow it out 12 months.

It's really going to depend on the environment, and the kind of metrics we're seeing.

Thanks.

Great.

And then, you talk a lot about the outside sales force numbers coming down this quarter, then coming back up next quarter.

But I can't remember seeing a quarter, when the outside sales numbers didn't come up, in the total headcount number went up as much as it did this quarter.

Just want to get a sense of what those 62 full-time employee hirings might be focused in.

Was it volume based hirings coming back?

How many more of those people have to come back, or are these other, kind of growth initiatives spending?

Brad, it does Brett, it's David.

Are you referring to the total associate population headcount?

Yes, I am.

Okay.

So those would be spread throughout functional areas across the Company, whether there to support operational volume increases, or whether it's to support some of our investment areas.

Remember, we've got a lot going on.

The sales force is an important part of it, but it' spread beyond.

And by the way, when we invest in some of our sales head count, that would also be in our associate population number.

But if it's not in one of the classified folks that goes into that sales force headcount number, you'd see it in associates, you wouldn't see it in number of outside sales people for example.

So, the long and the short of it is, there isn't one area in particular.

It would be spread functionally throughout the Company.

And David, just for clarification, on a go forward basis, given that you -- MSC actually held the headcount intact during the downturn, I guess I think it was available capacity of people to manage these volumes gains.

Is that not a correct assumption?

Or do we have to continue to escalate the headcount numbers up through next year?

This is Chuck.

I will focus on one specific area where we made the most productivity investments.

That's in our -- are CFCs.

But I think your assumption is correct.

The amount of labor that we have to add back, at these rapidly rising revenue levels, is nowhere near we would've had to add back three years ago.

So we've retained the -- team that we had in the CFCs, and our investment in productivity to drive productivity in the fulfillment centers is now actually being leveraged at these higher volumes, much more significant way that was in the investments, and we're in a much better spot than we've never have been.

So I think your assumption is correct.

That we would -- relative to where we were in the last up cycle, we don't have to proportionally add back as much labor as we have before.

And two, maybe, clarification questions.

First, on the bad debt expense.

I know obviously, last quarter you had a reversal, but prior to that, the last four quarter numbers have been running about $600,000 a quarter, and it looks like your jumping up to a $1.2 million quarterly run rate for this fourth quarter.

Any sense if that -- is that the new run rate kind of going forward?

We accrued -- we basically (inaudible) for a longtime as a percentage of sales, Brent.

But obviously as the revenues rise, you put that same percentage into bad debt expense.

What happened in the quarter, clearly, the receivables position for us, in our bad debt management overall, improved significantly, which afforded us the opportunity to have less reserve on the books.

We also were very successful in recovering a previously completely written off bankruptcy claim.

So those two combinations are what drove the third quarter behavior.

What you are seeing in the fourth quarter, is plus or minus a more normal, as we see it, at these revenue levels moving forward.

And final question just to clarify.

The $2.5 million benefits cost you refer to, the 401(k) match restoration, but I think you also tied medical costs in there, which I would assume would not necessarily be benefits coming back on line, but more of maybe some of the medical cost efficient and other items like that.

If you could kind of distinguish those two points?

Brent, your 100% right.

We are self-insured, and unfortunately it goes as the usage of the medical services goes.

So it seems to run in trends.

We have had quarters where we're very favorable, and quarters where we've been unfavorable.

And the trend now has moved back a little the other direction.

And that's why you're seeing an up crease in medical.

But I would not look at that as structure if you will, like the 401(k) match, that fluctuates quarter to quarter depending on the usage of the services.

Chuck, did that start in Q -- did that up lift in Q3 as well, or is that just kind of planned for Q4?

Partially in Q3, with that trend in all three months of Q4, until we see something that tell us it is going to reverse.

It's more pronounced in Q4 that in Q3.

Great.

Thank you very much.

Thanks, Brent.

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

Thank you.

Good morning.

Good morning.

In some of the initial details that you're giving out now, in terms of the contribution in revenue growth and price, large accounts, core, et cetera.

You do have a bigger component from price in fiscal Q3, about 3% of the gross, where as I think in the prior quarter you hadn't had any.

So given that the Big Book hasn't gone out at this point, and that sort of thing, did we put in some sort of interest cycle price increases, or what is the source of that?

Holden, it's Erik.

We talked about on the last call, at the very end of Q2 we had implemented a, what we refer to as a pretty moderate price increase that was factored into our Q3 guidance.

As you know, we don't break out, so we don't quantify the size of the midyear increase.

We do that for the Big Book, as we've said, we will do that next quarter.

But I think we talked about on the last call, there was a pretty moderate midyear increase that happened at the very end of Q2, and end of Q3 numbers.

It's also (inaudible) you saw growth in the quarter.

The way we calculate the effect of price, is that price increases net of discounts, discounts being built into some of our customer base, for instance, the large accounts.

So with the growth in the customer core, then you saw a little bit of a revolution or devolution away from the higher discount customers, as a percentage of the business.

So because the core grew so much, it shows up effectively in this deconstruction of sales, as a price increase.

And there you see the contribution to the gross margin.

Thanks.

So there's a mixed piece of that as well, in effect.

That's right.

So the price was not 3%, it's up less, and there some mix in there.

Right, got it.

And then, looking at the SG&A, can you give a sense, when you think about the components that are in there, was kind of the -- as you look forward, what's kind of the annual just general increase, whether it be in wages, health care costs?

I mean if you're talking about the fourth quarter being kind of the base if you will, before any incremental investment spending, what level of annual increases, do you assume that those costs seem to go up?

What would be a decently way to look at that?

Holden, this is Chuck.

The best I can do for you is tell you that the fourth quarter run rate has all the one-time stuff that was out, baked back in.

We've got productivity measures going forward which could lead to cost reductions.

We obviously will have, plan on having incremental salary increases now year-over-year again.

So it's a combination of all those things.

I can't give you a percentage, to say take the fourth quarter and take it up by X.

We have a lot going on, and we obviously have productivity plans to mitigate some of the investment spending and any other structurally increases that we would incur.

You also mentioned international investment spending.

And as I said before, certainly our goal, based on the programs and the opportunities that we see, is to incrementally -- invest at levels above where we are built into current run rate.

Got it.

Okay.

Thank you.

Sure.

Your final question comes in the line of Adam Uhlman of Cleveland Research.

Hi, guys, I snuck back in.

Just a couple of clarifications.

The sales pace in the Northeast, why was that so much slower than the rest of the country?

This is Erik.

Your referring to the 17%, that we fell in the third quarter.

And what I'd tell you is, that if you look, if you tracked back over the last three quarters, the Northeast has lagged behind the other regions.

This is not the first quarter that's been the case.

So that's an ongoing trend.

I think our sense is that, it ties into the Northeast being tied to manufacturing, being tied into our core business, which has been the last to come around.

But no, we did see it come around this quarter, and for us, it's a very encouraging sign, if anything.

Okay.

I guess I'm just wondering because your customer growth was 30% in the quarter.

Is there some specific industry that you are more heavily tied to in the Northeast, that is lagging?

Adam, David.

Each one of the regions has kind of it's own portfolio with it's own asset allocation, in terms of customer segments.

And there's no question that beyond the economy, and underlying comps, you'll also see the effects of that customer portfolio distribution, so to speak.

And the Northeast, for example, that allocation of customers looks pretty different than let's say, the South, for example.

So that is a driver.

Okay.

And then the last thing, kind of bigger picture.

A while back, you guys rolled out the free next day delivery across the entire country, and it helped you to better address customers in the middle portion of the country.

I was wondering if you could just talk through any success that you're seeing, in signing up new customers in that area.

Is it helping drive, better average order sizes with those customers, just in the middle part of the country?

Can you just talk through the costs that are associated with that, and then the benefits?

Sure.

Adam, it's Erik.

We won't break out specifically on costs and benefits, and give numbers, but let me paint the picture for you.

So I think this is a combination of some good planning and some good fortune in that, we implemented this program, if you think back, it was at the start of the fiscal year of 2009, so it was September 2008.

And obviously there is some costs associated with the program, and we layered that in right at the start of the peak of the downturn.

And when I reference good fortune, in hindsight, the timing couldn't have been better, because this has really served to enhance our value proposition.

As you mentioned, in pockets that weren't were reaching, either we weren't reaching next day, or where the cutoff time was extended considerably, our value proposition really was bolstered.

And what's happened is, it's become particularly valuable in the downturn.

So as customers were cutting their inventory back, they needed to lean more heavily on suppliers.

And that phenomenon has continued on the upswing.

So customers -- as I talked before about this restocking going on, but it's cautious restocking.

We have seen a change in mindset, among our customers.

And that means that they want to preserve cash, they want to keep inventories leaner than they used to run them.

That combined with their alternatives, locals, their alternatives to get product, meaning the local competitors, can't keep inventory on the shelves.

So this next day delivery, combined with the same day shipping, has made us that much better of a choice for the customers that want to run lean.

They've got to lean on a supplier, MSC becomes a great choice.

So I would tell you is, absolutely, this has been a great enhancement to the value prop, and timing-wise, it couldn't have been a better time for that to go into place.

Great, thanks.

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

Okay, thank you.

I want to thank everyone today for their time and attention.

We'll talk to you next quarter, and we would like to wish all of you a very happy and healthy Fourth of July.

Thanks.

This concludes today's conference call.

You may now disconnect.