MSC Industrial Direct Co Inc (MSM) 2011 Q1 法說會逐字稿

Good afternoon.

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

At this time, I would like to welcome everyone to the MSC Industrial Direct first-quarter 2011 earnings conference call.

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

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

(Operator Instructions) Thank you.

I would now like to turn the call over to Mr.

Eric Boyriven of FD.

Sir, you may begin.

Good morning, everyone, and welcome to the MSC Industrial Direct fiscal first-quarter 2011 conference call.

An online archive of this broadcast will be available for one hour after the conclusion of the call, and available for two weeks on the homepage of the Company's website at www.mscdirect.com.

During today's presentation, Management will refer to financial and management data included under the section Operational Statistics, which you can find on the Investor Relations section of the Company's website.

Let me now take a minute to reference the Safe Harbor statement under the Private Securities Litigation and 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 statements.

Information about these risks is noted in the earnings press release and 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 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 thank you for joining us in our first quarterly call for fiscal year 2011.

With me are Erik Gershwind, EVP and Chief Operating Officer, Chuck Boehlke, EVP and Chief Financial Officer, and Shelley Boxer, VP Finance and Accounting.

I will begin today by talking about our investment strategy, Erik will describe the expected long-term benefits of those investments, and Chuck will provide details of our Q1 results and the second-quarter guidance.

For more than two years, we have talked about our plan to invest and to capitalize on what we saw as a unique opportunity in our highly fragmented market.

When the dislocation began, we recognized the effect this would have on the smaller, less well-capitalized competitors that control the bulk of the market, and we staked our claim that what would follow was to become the greatest land grab of our time.

We saw an opportunity to hire people with deep, long-standing customer relationships that we could not otherwise attract to invest in software and technology at reduced costs, and to use the time to accelerate our growth strategy.

As a result, we chose to step up our investment program and explain that while we could have converted our revenue growth into historical read-through levels, and greater earnings growth in the short term, we would get a better long-term result by moderating read-throughs and capitalizing on this once-in-a-lifetime opportunity by increasing our investment program.

The initial payoff from heading down that path has clearly been shown by our results over the past several quarters.

We are delivering what we expected when we first outlined our plan -- that being outsized revenue growth, significant market share gains, and the earnings leverage our model delivers when we produce high levels of revenue growth.

We view our progress to date as only the beginning in terms of the benefits we expect to receive from our investment program.

Many of these programs are being developed now for the longer-term benefits we expect they will yield, and it will take time for our results to reflect that future payoff.

The strategic value of these investments in web and data, our global sourcing program, and the continued build-out of our sales force, to name a few, will further enhance our customers' ability to save time and reduce their costs of acquiring and managing MRO products.

The power of these investments will be magnified when viewed in combination with the widening gap between MSC and our small and regional competitors, which should cue further share gains as customers move towards MSC to fulfill their growing needs.

Erik will describe these initiatives in greater detail in his presentation.

Our model already has a significant financial, technical, and logistical advantage over that of our small and regional traditional competitors.

Financially, these distributors are still laboring under the significant structure with little or no capital availability, during a time when their customers are demanding more in terms of credit and inventory availability.

They struggle to compete with MSC in those areas, although they continue to play the price card with a heavy hand.

Our competitive advantage and value gap is further extended by bringing the convenience of 600,000 SKUs, 99% fill rate, just-in-time delivery, an 8.00 PM Eastern cut-off time, in conjunction with a strong balance sheet to back up our value-added solutions that include enhanced vending solution, improved e-commerce capability, and technical support in the field.

We will continue to press our advantage, and believe we will not only keep this share as the economy improves, but over time, enhance the gross margins earned from these customers.

I would like to give some guidance for Q2.

Currently, we expect revenues to be between $466 million -- excuse me, and $478 million, including a $6 million contribution from Rutland, and fully diluted earnings per share to be between $0.66 and $0.70, including dilution of $0.03 per share from Rutland, primarily due to the integration and acquisition costs.

Thanks.

And I'll now turn the mike over to Erik.

Thanks, David.

I'll start with the customer landscape.

Macro indicators remain positive, and customer sentiment continues to gradually improve quarter-over-quarter.

However, there remains a cautious attitude about what the future holds, and that means that most customers are still unwilling to increase investment in inventory and in hiring.

Companies continue to operate as lean as possible, relying on MSC's next-day delivery and high service model to meet their needs.

We found that our core customers took fewer extended plant shut-downs this holiday season, due to increased demand and due to the fact that the holidays fell on a Friday this year.

Government customers, on the other hand, are in an increasing crunch for budget money, as we all hear about in the news.

As a result, we are experiencing a drop in average daily sales from the government sector, which is affecting our growth -- the growth of our large accounts program.

Revenue trends were strong in Q1, with growth of 22.9% over last year.

We face tougher comps this quarter, and that is a trend that will continue through the fiscal year.

Our historical core business outperformed the rest of the Company, as a result of our share gain progress, as a resurgence in manufacturing.

And that is also a trend that we expect to continue in Q2.

As David mentioned, the continuing economic growth, combined with a lack of access to capital, has made it difficult for regional and small distributors to meet customer needs.

We continue to see a high level of service failures from these competitors, helping to fuel our share gain.

On the gross margin front, things have played out as we expected.

We saw our Q1 gross margin increase significantly over Q4, due primarily to our Big Book price increase.

As usual, our gross margin formula continues to be a combination of headwinds and tailwinds, netting a relatively stable result, despite lots of moving parts underneath the surface.

To highlight the main drivers, we have started to see commodities inflation creep into market pricing.

In response, we have taken an additional price adjustment to pass these increases along to our customers, which serves as a tailwind.

On the other hand, we continue to see aggressive pricing pressure from local competition, as David had mentioned, who are playing their final card to offset their service failures.

This has served as a headwind that will keep gross margin levels relatively in check, and Chuck will share more specifics shortly.

Let me now turn to our investment program.

As David mentioned, these have been areas of heightened spending during the downturn, and is a primary reason why read-throughs are not at historical highs.

The most exciting part of the story is that in most cases, we have either not seen the payoff at all from these investments, or we are in the very early stages of realizing results.

Today I'll take a deeper dive on four of them.

First, e-commerce.

Investment in e-commerce actually encompasses a number of initiatives that are underway.

They include an improved search experience, an overhaul of our transactional platform, and a heavy investment in our product information that sits behind the technology.

All three of these work together to produce a world-class web experience.

Customers will begin to see improvements gradually during the course of this fiscal year and next.

In fact, a new search is already in beta, and we are getting very positive user feedback today.

We anticipate these enhancements will drive improved performance across many of the metrics that we track carefully.

One metric is the percent of total business generated through the website.

MSC is already at high levels, and we expect to take the number higher as we execute our plan.

And this is going to impact our results positively in several ways.

First, our website is a sticky solution, and it helps with customer retention.

Second, an improved search experience leads to deeper customer penetration, as new categories from our extensive offering are more easily shopped.

And third, it brings down our variable cost of sale through cost avoidance in our call centers.

We have already seen this dynamic in our staffing models, and anticipate a more pronounced effect in the future as the improvements are rolled out.

And lastly, as customers migrate to the web, we will continue to reduce our costs associated with traditional paper catalog media.

The second investment I will highlight is our vending solutions.

These are inventory management systems for both the production tooling and the maintenance environments, with technology that is tailored for both large and small plants.

You've heard us talk about these before, and they include VMI, CMI, and CAP.

Rolling these solutions out across our target customers is a top priority for our sales force, for a few reasons.

First, we bring value to our customers by streamlining their inventory levels, improving accuracy, and avoiding out-of-stocks.

Second, each of these serves as an entry barrier, especially against small and regional barriers, who can't afford the required innovations.

And third, while there is an initial burst of effort and investment to get these solutions in place, over time we see economic efficiencies, such as a larger average order size and very high customer retention levels.

The third investment I will touch on is the one in our sales force, consisting of our telesales and outside sales teams.

Q1 ended at 986 associates, and we anticipate the sales force to grow to between 995 and 1,000 associates by the end of Q2.

And while you have been able to see the numbers growing, what you haven't been able to see is the changing nature of our sales force.

We have used the downturn to attract top industry talent, especially metalworking talent, and to upgrade the sales force by ratcheting up performance expectations.

In addition, we have continued to invest in additional training for our already talented existing team.

As a result, we have been moving towards a more technically savvy, value-added salesperson.

This is improving our positioning within our target accounts, which leads to improved retention rates and increased customer loyalty.

Fourth, private branding and global sourcing.

These are actually two initiatives that are tightly coupled.

Private branding is the front-end sales and marketing component, while global sourcing is the back-end purchasing one.

In both cases, the opportunity is to increase our mix of private branded and globally sourced products as a percent of total Company sales.

And doing so has two benefits.

First, there is a wide gap in gross margin between our private-label brands and the industry brands we carry.

Every dollar of private-label growth has positive implications on profitability.

And second, unlike many, private branding is not just a profitability play for us.

It is also about market share capture.

Private-label product development opens up new price points to us that industry brands have trouble reaching.

And while we don't publicly break out our percent of private-label sales, it's fair to say that we are still in the early stages of this program.

We have developed a repeatable formula in a few of our core metalworking product lines that we are in the process of rolling out across our other product lines.

And in those core lines, we have seen significant gross margin expansion.

As importantly, we have seen private label create a win-win scenario.

Not only do we win, but the industry brands who partner with and invest in us win as well.

They see share gain benefits, as we increase the total value of our offering, and in addition, many have the opportunity to supply us with private-label products through their world-class global manufacturing facilities.

Key industry brands who offer differentiated value to our customers remain a vital part of our long-term product strategy.

This brief overview should give you a sense as to why we are so confident that diverting some of our incremental margin to accommodate increased investment is the right decision for the long-term earnings growth of this business.

In addition to executing on our organic investments, we also completed our first acquisition in quite some time with the closing of Rutland Supply on December 10.

Rutland supports our growth strategy by continuing our metalworking penetration.

The Company has had a strong presence in the West, where MSC has historically been underpenetrated, and brings many metalworking customers to us.

Our plan is to significantly improve Rutland's profitability by following a four-step approach.

First, we will fully integrate the business into MSC, including the brand name and most operations, over the course of the next two quarters.

Second and simultaneously, we will capitalize on extensive purchasing synergies.

Third, we are going to prune unprofitable accounts, which will bring the revenue number down in the near term but improve profitability.

And fourth, over time, we will upsell Rutland's accounts with MSC Big Book, which includes a more comprehensive metalworking category, as well as our MRO product offering, in order to drive growth.

I will now turn it over to Chuck, who will give our financial overview, and will also share the financial impact of Rutland.

Thank you, Erik.

Q1 results were solid, and better than originally participated.

Sales came in slightly above the midpoint of the guidance range, and EPS was at the top of the range.

Gross margin was in line with our guidance, and in conjunction with spending discipline resulted in higher earnings.

Incremental margin was 30% in Q1, and as a result, operating margin grew to 16.3% from 13.3% in Q1 of the previous year.

Based on our ongoing investment program, we continue to expect that our base business will deliver incremental margins in excess of 25% for the balance of the year.

In fact, Q2 guidance, excluding Rutland, implies an incremental margin of 32%, at the midpoint of the guidance range.

However, now that we have acquired Rutland, there will be an overall negative impact on consolidated incremental margin.

This results from 100% of Rutland sales being incremental, with no increase in operating income from these sales.

We expect that Rutland will be dilutive by $0.03 per share in Q2 on revenues of approximately $6 million, and then neutral to earnings for the balance of the year.

We anticipate the acquisition to be a few cents per share accretive in fiscal 2012.

Gross margin was 46% in Q1, and we expect it to be 46.1%, plus or minus 20 basis points, in Q2, inclusive of slight dilution from Rutland.

Operating expenses will increase in Q2, due to the acquisition of Rutland and increases in compensation and fringe benefit costs.

Balance sheet metrics were solid.

DSOs increased by 2 days to 44 days, reflecting normal seasonal patterns.

Inventory turns were steady at 3.6, and cash flow conversion turned to 88% of net income and to cash flow from operations.

We made our last payment on a term loan on December 31, and MSC is now debt-free with approximately $50 million in free cash reserve.

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

Thank you, Chuck.

December 15 marked our 15-year anniversary as a public Company.

At the time of our IPO, we were approximately $250 million in revenues, and had a future vision for MSC that we believed would deliver high growth rates and high returns for our shareholders.

Fast forward to today, as we are on the verge of breaking the $2 billion mark in revenues, and have delivered approximately 15% compounded annual return for shareholders over that period, resulting in a total return to date of over 700%.

Our vision for the future remains the same.

And our team has never been more energized about the path we are on, and committed to once again delivering at these high levels over the next 15 years.

Our read of the current landscape is even more conducive to MSC's success than at any point in the past.

Customers are demanding more and more from their distributors, to help them reduce their total cost of MRO supplies.

The pace of consolidation at our highly fragmented market is accelerating, as traditional distributors remain under increasing pressure.

The model that we have developed and have been honing for years is being executed at all-time high levels.

At the same time, we are investing, and we are confident in the returns that will be realized in our future results.

When you couple all of these factors with the excellent work being done by what we believe to be the best team in the business, we have never been more confident in how we are positioned to capitalize on the enormous opportunity we see for the future.

Thank you, and I'll now open the line for questions.

(Operator Instructions) Your first question will go to the line of Hamzah Mazari from Credit Suisse.

Good morning.

Hi, Hamzah, how are you?

Good, thank you.

Good, thanks.

Just a couple of questions.

The first question -- in terms of the mix impact on the gross margin line going forward, could you provide some more detail how we should be thinking about the mix impact?

It seems like the core metalworking business is coming back pretty fast, that has higher gross margins.

But it seems like the smaller customer has still not come back in any kind of big way yet.

The larger customer base seems to be probably slowing down in growth, given what's happened to the government side of your business.

Any color you can share as to how much of a negative or positive impact mix is going to be going forward?

Sure, Hamzah.

It's Erik.

How are you?

Good, thank you.

Regarding gross margin, I think you have characterized it right, you have heard us talk for a few quarters now about the gross margin formula really is a combination of some tailwinds and headwinds.

And for a while, we had characterized customer mix as a headwind, because we saw the large account segment so dramatically outpacing the core business.

And what we said was, as the core business and the manufacturing sector came back through share gains and -- through a resurgence in the economy, that that headwind would turn into a tailwind.

And that really has happened.

So we are seeing that.

What you see going on in gross margin right now is from a tailwinds standpoint.

Customer mix is certainly one, and you are right, we are seeing the core manufacturing business outpacing overall growth for the Company right now, which we are really encouraged about.

We mentioned in the script some additional pricing actions that we took, that would be another tailwind.

We have talked about rebates reversing.

All of those are the tailwinds that have really served to restore gross margins to sort of our normal -- if you track us back over a number of years, typical pattern for us, as compared to the last couple of years where you would have seen a drop-off in margin, Q1 to Q2.

Combating that, which is kind of keeping gross margin in check as we had referenced, are the headwinds.

And, pretty much the same story on the headwinds, and we described them earlier -- it's still a very competitive environment.

Particularly the pressure from the small local competitors, and also a mix of some of the large order activity that we have described as well.

And I guess the last one I would point out, for Q2 anyway, is some slight dilution from the addition of Rutland into our mix.

But tracking back, yes, we are seeing the benefit that we expected to see from customer mix, based on the accelerating growth in the quarter.

Great.

That's very helpful.

And just, last question, a question on your investment programs.

You mentioned the changing nature of -- of the sales force.

Has there been any change in the compensation metrics for the sales force?

You spoke of ratcheting up performance and expectations there.

And then, on the website sales, what could that number get to?

Do you have a long-term target there, and are you seeing any competition from others on that front, on the online front?

Thank you.

This is Erik again.

I will start with -- with sales force compensation, and certainly not something that we will -- we go into detail with.

Your question was, on a change.

And the answer is no.

Our compensation program continues to reward profitable growth, the way we have structured it.

Really, the focus has not been though on the compensation plan, it's been on the profile of the person who is out there calling on an account.

And as we said, that is a combination of using the downturn to bring in some really talented people who normally we couldn't have attracted, and it's also -- it's upgrading the current team through a combination of the performance management process.

But I think, more importantly, the training programs that we've put in place to make our salespeople that much more value-add.

So the focus has been on the quality of the salesperson, not so much on the compensation program.

David, do you want to jump in?

No.

Go right ahead, Erik.

On the website, the question is, are there targets to take it higher?

There's absolutely targets.

I mean, if -- if you sat in our strategy meeting, there are definitely some big targets that we talk about internally.

We are not going to publish any specific target.

But safe to say that, we definitely -- it's a metric that we intend to expand from where we are today.

And we are really confident that with the investments that I described earlier on that we are going to be able to do that.

Thank you.

Thanks, Hamzah.

Your next question will go to the line of Matt Duncan from Stephens Inc.

Hi guys.

Hey, Matt.

The first question I have is on the acquisition landscape.

Obviously, Rutland is the first thing you guys have done there in a while.

I'm curious what other opportunities you are seeing out there.

Obviously, no specifics on the targets, but are there a number of targets out there now?

And are you seeing multiples get a bit more reasonable in terms of what the targets are expecting?

Matt, it's David.

I hate that we are clearly seeing opportunities at one of the reasons we are seeing them is, we talked about -- call, we have structured a team to proactively be looking at acquisition opportunities so we do expect to be taking -- with the right companies with the right fit going forward that we feel are going to be added to our plan just as Rutland wants.

Okay.

And then, looking at your manufacturing customer base -- Erik, this is probably a question for you.

Are there any particular end markets with their manufacturing that stand out as being overly strong right now, or is it really just across the board you are seeing good strength?

Yes, good question, Matt.

I would say that, really, the closer we get to our core, which is really durable manufacturing, the stronger the growth is and the stronger the activity.

So, that is probably the best characterization I can give you, is that within manufacturing, really within the durable manufacturing sector, which really ties in closely to our metalworking core business, we are seeing a lot of strength.

Okay.

And then last thing is on market share gains.

Obviously, you guys are probably seeing market share gains as good as you've ever seen right now.

Is there any way to quantify the impact that that is having on sales growth?

And as kind of a tack onto that, most of your smaller competitors survived the downturn by getting aggressive with inventories and pricing.

Are you -- are you seeing any of them fall by the wayside at this point, or are they getting more desperate on what they are willing to sell for?

So, what are you seeing from some of the smaller competition in the market?

Matt, I will start with your second question first on local -- I -- local competition.

And I think you have it right.

More than companies going out of business, what we are seeing is service failures, just because of what you described -- inability to stock product.

And, interestingly, as we've talked about, and the trend has continued, it has almost been more pronounced now that we are on the upswing than it was during the downturn.

Because these companies cut during a downturn because they had to, and as things are coming back now, they are under a real credit crunch and a cash crunch, so they are not able to put inventory back on the shelves.

They are not able to extend payment terms and keep receivables out there.

So the service failures have continued as strong as ever, and that's -- predominately that's where we are seeing the share gains.

So theoretically then, Erik, your share gains ought to accelerate and not decelerate going forward, if that's happening with the small guys, correct?

Yes, I would say, Matt, that's what we have been seeing.

To get to your other question about quantifying share gains, it's a great question.

And it's not an easy process in a market so big and so fragmented.

We do it in a number of ways, and we sort of triangulate the different measurements to get our own gauge as to how much share and try to quantify it.

But certainly, one way we will do it, is we will look at our performance by segment against public comps.

Right.

But so, to the extent that we see public comps report by segment, we can compare our performance, that's one.

Two is, we look at many of the macro indices that we would all track, such as ISN, change in capacity, and so forth, and compare our relative growth rate by segment against changes in those numbers.

And the third point that I would say we used that really is helpful is our supplier network, because our suppliers are getting point-of-sale information on us and against a lot of our competition, and particularly the small guys who otherwise we'd have no feel for how they are doing.

They are seeing point-of-sale, and when you go to trade shows, or we go to visit suppliers, or suppliers come into our office, we will ask them, talk to us about how our point-of-sale compares to competition, give us -- if you had to quantify a gap, how would you quantify it?

We piece those things together, and we think we get a pretty good picture as to how much share we are taking.

And is there any way to maybe share what you think that -- that percentage contribution to your revenue growth is right now?

Not -- not something we share publicly, Matt.

Just for competitive purposes, not something we share.

Okay.

Thanks, Erik.

Okay.

And your next question will go to the line of Adam Uhlman from Cleveland Research.

Hi, guys.

Good morning.

Hi, Adam.

Hey, I was wondering if we could dig into the -- the slowing government demand that you guys alluded to earlier.

And I'm wondering if you could talk -- talk through the moving parts of that, between some of the federal government spend or state and local spend, kind of where your mix is today?

And if you could also talk directionally about the pace of growth that you are seeing, is it flowing or is it actually declining now?

And for the full year, is that a business you think you can actually grow, or is that going to be a headwind to the growth number going forward?

Adam, it's Erik.

Just a little color on the government picture.

I would say to your question about federal or state, the answer is both.

And really, the story is not much deeper than what most of us are reading about in the paper.

So, the states, we all know many states -- California, New York, you name it, are facing severe deficits and are really ratcheting down or clamping down on spending.

We are absolutely feeling the effects of that, and the same goes for the federal picture.

Most government agencies now are operating without an approved budget, and what that means is, same thing, clamp down on spending.

So, we are feeling good about our share gain -- our share position, nothing has changed there.

But a real clamp down on spending, I characterize it as what we are seeing is declining rates of ADS growth.

And in terms of a headwind to our overall growth rate, the answer would be yes, as of now, that is what we see.

How much of the business today is government?

Not a number -- not a number we break out, Adam.

Adam, just one other thing, by the way, I point to, is certainly, relative to prior years, prior quarters, is lower activity from the military.

We have been helped by troop deployment activity, also something you read about in the papers, and that is less.

So on top of the budget crunch situation, we are seeing less activity from troop deployment.

So that would be another factor I would add in.

But again, we don't see any change in our share position.

We feel good about that.

But we would characterize, right now, government as a headwind, and that's baked into our guidance and our forecasts.

And, it's anyone's guess as to when that changes, and should it change, it would mean upside to our numbers.

Okay.

And then, two quick clarifications.

Number one, how much is the gross margin dilution from Rutland, that's baked into the guidance?

Adam, it's Chuck.

The numbers are down just slightly.

It's -- it's in the neighborhood of ten basis points.

It would have been a little bit higher without Rutland baked in for Q2.

Okay.

And then, the -- can you size the price increase that was just put through?

It sounds like the beginning of the year, when exactly did you push through a price increase?

Adam, it was pushed through -- it's Erik -- it was -- we did it right around the holiday season.

We don't -- we don't -- for competitive reasons, we don't publish what the -- we don't quantify publicly the mid-year increase.

We do it for our Big Book increase in September, not for ones in-between cycle.

But in terms of timing, right around the holiday period.

And again, tying into what we were seeing, we had talked about, for the last couple of quarters, that we were beginning to see signs of commodities inflation.

It had not really factored its way into market pricing, and that was a dynamic that we actually have started to see play out.

Hence, the move.

Okay, thanks.

Thanks, Adam.

Your next question will go to the line of David Manthey from Robert W.

Baird.

Hi, guys.

Good morning.

Hey, David.

Let's see.

Just a couple things to wrap up here on the government.

Of the quarter of your business that is non-manufacturing, would you say government is one of your larger segments within that category?

Yes.

It would be fair to say that.

Okay.

And then, Erik, I think you have mentioned this, but I just want to be clear.

You're saying that -- as of right now, you're not seeing negative year-on-year growth?

You're just seeing a deceleration, but for the full year, you might expect to see that go negative, is that what you said?

Tough -- Dave, we really -- tough for us to project out full year.

We don't know.

We really don't know how things are going to play out with the government, whether a budget gets approved with this continuing resolution or not.

So, we certainly don't have the visibility to go out beyond the quarter.

But Dave, the only thing I will add -- it's David -- is that we have seen a continued deceleration from Q1.

And we are projecting, given what we have seen in December, and what we continue to project through the balance of Q2, that's why you are seeing our revenue guidance as it is.

It definitely is playing [effect], having what we'd consider to be a significant factor in that -- in the revenue guidance.

Okay.

And the majority of what you are selling to these customers, of course, is maintenance and repair-type products.

So, if you have an adjustment at some point, you may see it catch up in the future?

Dave, I don't know if that -- yes, of course that is what we are selling, but we talked a little bit about troop deployment, those types of things, so -- there's lots of moving pieces in the government business, and we just don't know what is going to happen after the first part of the year, after Q2.

Okay.

All right.

And then, the second question, could you talk about the number of salespeople, and if there's any unique products that came with the Rutland acquisition?

In terms of unique products, for the most part, Dave, I characterize it as heavy overlap with MSC.

Really, right in our sweet spot, metalworking company, and I think the real -- the value here, and the play for us, in terms of growth, is going to be to be able to upsell the Rutland customers with the broader MSC offering.

So, it's really about bringing -- and that's both our MRO products -- it's also, even within the metalworking category, we typically will go deeper and wider than Rutland did.

So we see that as upside, future upside, and that's part of the integration plan that I described.

In terms of salespeople, not meaningful, it's really -- is a direct marketing business.

So, heavily concentrated, and certainly customer concentration in the Southern California area, which for us fills an area out that was underpenetrated.

But not meaningful in salespeople as a direct marketing business.

Okay.

Thanks very much, guys.

Thanks, Dave.

Your next question will go to the line of Sam Darkatsh from Raymond James.

Good morning, and this is actually Josh filling in for Sam.

Hi, Josh.

Hey, Josh.

Wanted to drill down a little bit more on some of the pricing pressure you were talking about.

Could you talk about whether it's concentrated in particular end markets or customer segments, or is there any sort of pattern you're seeing to it?

The pattern -- hey, Josh, what I would describe is that it's primarily coming from the small and local distributors.

And this is a dynamic, really, that we have been describing the last few quarters, that -- I talked about earlier -- when the downturn began and now on the upswing, many of these competitors are really in desperate times, because they've had to cut back salespeople, they've had to cut back inventory, their service offering, and they are doing -- these are small businesses who are in survival mode.

And as I described, most of our share gain is not coming from these guys actually going out of business, but not being able to service customers.

So, their last resort is price.

That's where most of the pressure is coming from, from the small locals.

And just to remind you, when we -- when we react to pricing pressure, we are doing it -- it's not an across the board, sweeping cut of prices.

We do it very surgically, we do it in strategic accounts, and we're doing it with an eye towards capturing important accounts where we see the ability to generate pull-through beyond the existing base of business.

So there's a -- there's a broader strategic context around how we go about getting aggressive on pricing when we need to.

And, I guess what I was trying to ask, is it mostly in manufacturing, or non-manufacturing, large or small accounts, or any sort of regional pattern to it that could maybe help us get a better feel for the puts and takes on it?

I would say no regional feel.

If anything, probably more closely tied to our manufacturing accounts, because it's really coming from the small locals who we compete with, especially heavily in the manufacturing area.

Okay.

And then, you mentioned a little while back about looking at a variety of different metrics, like salesperson productivity and share of wallet and things like that.

Could you talk a little bit more about how well those are coming in, and any way we could maybe track or get a better sense of how those things are coming in?

Good question.

In terms of what we publicly share, I don't have anything to point to -- public.

I would tell you, internally, we have a bunch of metrics, particularly on share of wallet, within our target accounts.

And there's a very tight process we go through with our sales force, by account.

We have specific targets, by region, by account.

We are really pleased with what we are seeing there, and I can give you that color without pointing to anything publicly.

Under the covers, it's a very, very detailed process by market, by region, by branch, by account.

And we're really pleased -- I mean, the growth is -- I would say, exceeding our expectations.

Okay, thank you.

Thanks, Josh.

Your next question will go to the line of Scott Graham from Jefferies.

Hey, good morning.

Morning, Scott.

I have a question regarding some comments that were previously made about the incremental margins and gross margins.

I'm trying to tally the headwinds and tailwinds here, and what I am coming up with is that Rutland does not look like it's much of either.

So we can kind of dismiss that.

But certainly, the -- some of the pricing pressures that you are seeing on the manufacturing side seem like they are going to maybe offset the manufacturing mix.

And maybe I am oversimplifying this or exaggerating, I am not sure, but from what I understand, the manufacturing side is your best business, your highest margin business.

And with price pressures there, why would we expect incrementals to return to normal after now?

I understand that the government business weakening is also a benefit to the margin, because I think that's a lower margin business for you.

But maybe help me connect these dots, if you wouldn't mind.

Scott, it's Erik.

I think there's actually two pieces to your question -- the gross margin picture and then the incremental margin contribution margin picture.

And I think there's two answers, so I will take gross margin and I'll pass it to Chuck on the read-through incremental margin.

On gross margin, I think you got it right.

I think that is exactly right, that we have been describing the tailwind/headwind phenomenon.

And you're right -- we are seeing -- there's absolutely a tailwind in the mix of our business, moving more towards manufacturing as it grows.

And you are also right, that one of the headwinds we face is pricing pressure, which certainly isn't limited to manufacturing.

I've described it primarily as coming from the small local guys, which therefore makes it primarily in manufacturing, but I think that is exactly right.

Scott, it's Chuck.

Yes, the incremental margin here, if you ex Rutland for a minute, is pretty similar to what we said last time, that the numbers would be above 25% from the core, or base, if you will, MSC business.

The fact that we have told you that Rutland is dilutive in the second quarter, and actually a push for the back half of the year, given that all those sales, obviously, are incremental to the numbers that we had last year, without any corresponding operating income coming along with them, would dilute that margin down a little bit from what we would see from the core MSC business.

Scott, it's David.

I guess the only other add that I'll make is that what you are also seeing in our incremental margins that we are anticipating for the balance of this year, remember, also reflect our investment strategy.

So, the number of investments that we are making, let's say, compared to some of the read-throughs that you have seen from us, if you call those, quote, unquote, normal kind of read-throughs, we are -- our plan is specifically to invest some of those read-throughs into our growth programs and the investments for the future that we have talked a lot about today.

And those are obviously impacting -- serving to actually reduce the size of those incremental margins in our -- in our forecast.

That -- that's fair.

And I think my understanding was to clarify with you guys that Rutland looks like a push to gross margin, but it is a little bit diluted to the operating margin.

Fair enough, right?

Yes on both fronts.

Yes.

Okay.

So then, if that's the case, and obviously, any time you make an acquisition, you become a lot smarter on that acquisition, what have is that the reason why we kind of went from thinking that this could be created by the end of this year to maybe pushing that out to 2012?

I think, we actually have a forecast now that we are under the covers and looking at Rutland and so forth.

And you have a lot of acquisition costs, acquisition integration, reorganization costs, if you will, that's in the Q2 guidance, that are more of a one-time nature.

And the rest of the business, on a standalone basis, with plus or minus, a push, it'll take us through the rest of the year to sort out revenue, cost synergies, and everything else, we believe it will be accretive next year to the tune of a few cents per share.

I got you.

Here's my last question.

And it's on the recent commodities inflation, which, truthfully, is probably not so recent.

But nevertheless, in past cycles, as distributor, you increased prices, not in lockstep, but pretty close to lockstep as -- as inflation hits you.

You pass that right on to the customers, and typically, you get your pricing and you are off on your merry way.

This cycle seems -- feels a little bit different than others.

I think 2010 was a very good year for a lot of companies, because 2009 was such a dreadful year.

And so, what I am wondering here is, do you guys see anything different this cycle with the ability to get pricing as commodities inflation takes hold, and presumably will increasingly take hold?

Do you see anything different this cycle with the ability to realize pricing?

Scott, it's Erik.

Very good question, actually, and the short answer would be no, we really don't see much difference.

Obviously, we track pricing realization very carefully.

And what I would tell you is that you are right, while customers are extremely cost-conscious, what we've found is that our value -- our value basket, our value profit is really playing out right now, because customers have leaned out so much on their inventories that the next-day delivery, the availability of the inventory, is really valuable now.

And it becomes incredibly important, and therefore, what we've found so far, is no change.

That is helpful.

(Inaudible) is the one we took around the holidays, for that exact reason.

And it seems to -- seems to be sticking.

Very good.

Thanks a lot.

Thanks, Scott.

And your final question will go to the line of Brent Rakers from Morgan Keegan.

Good morning.

Just a number of questions.

I hate to beat on this government thing too badly.

But, maybe hoping you could talk a little bit through just how lumpy that government business is, and how much of the pressure that you have been seeing and maybe are guiding to see and then the February quarter, really comes from maybe the anniversary of some of the troop deployments and such.

Brent, it's Erik.

I think what's going on in government is actually both.

There is some of the anniversarying, if you will, of troop deployment, but really, the bigger -- the bigger theme is the tightening of spending because of budget constraints.

And I am not so sure I'd characterize it as lumpy.

What we would describe it as, is we have seen a steady erosion in average daily sales.

And Erik, exactly -- if you can maybe pinpoint exactly when that deterioration really started for you?

I would say it was through the quarter -- through the first quarter.

And then, obviously, extending even more into the December month, is that the correct read?

Yes.

Yes.

And we forecasted it to continue through Q2.

And Brent -- it's David.

I think it's fair to say that not only, as Erik pointed out through the quarter, but I think it is fair to say that accelerating through December and anticipating that that acceleration is captured within our Q2 guidance.

And then, I know you guys don't or haven't in the past commented on the monthly manufacturing and non-manufacturing trends after the end of the quarter, but in light of the divergence going on, should we expect then that the trend you are seeing between manufacturing and non-manufacturing has actually continued to widen as you get into the December month, and you're projecting it to widen significantly in the February quarter?

I -- I think that's fair to say, Brent.

Yes.

Okay, great.

And then, last question.

Maybe just to tie up some of the other comments you guys have made about price and all that.

If you go back to your disclosures, I think for the fourth quarter, pricing was roughly 0% year-over-year, and then for the first quarter, it was 1.3% up, but in between that time you had 3% catalog, roughly a 3% catalog price increase.

If you could maybe walk through a little bit of what that 1.7% discrepancy might be, and if you think over the coming quarters that actually will be rectified.

Yes, Brent, what is actually going on, I think what you are referring to is the chart that breaks out the growth and has price as a factor.

Am I right?

That's right.

Yes.

So, that -- that category, the price realization category, really has a few things going on.

It's a bucket that includes changes in catalog price, it's a bucket that would include change in discounting activity, and would also include changes in customer mix that we have.

So it's the netting of those three things.

So -- and that's really the reason why you couldn't correlate the 3% to seeing a 3% change in the price realization bucket in the growth decomposition.

Erik, and just -- if I might, though -- involving that, the catalog price obviously gives you the 3%.

The customer mix, in theory, should be a positive to that right now, right?

Because your smaller customers are performing better.

So the only remaining missing point, then, is the discounting point, right?

It's discounting, it's also -- it's not necessarily smaller customers performing better, but it's --

Product mix, too.

As well.

Okay, great.

Okay.

Thanks a lot, guys.

Thanks, Brent.

And there are no further questions in the queue at this time.

Management, do you have any closing remarks?

Okay.

Well, thank you all for joining us today.

We appreciate your interest, and look forward to talking to you again next quarter.

Thank you.

This does conclude today's conference call.

You may now disconnect.