MSC Industrial Direct Co Inc (MSM) 2011 Q2 法說會逐字稿

Good morning.

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

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

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

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

(Operator Instructions)

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

Eric Boyriven, of FD.

You may begin your conference.

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

An online archive of this broadcast will be available 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 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 and 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 this morning.

With me are Erik Gershwind, Executive Vice President and Chief Operating Officer; Chuck Boehlke, Executive Vice President and Chief Financial Officer; Jeff Kaczka, our soon to be Executive Vice President and Chief Financial Officer; and Shelley Boxer, Vice President Finance and Accounting.

Before getting into the quarter I want to take this opportunity and say a few words about Chuck and Jeff.

Chuck has decided to retire and pursue fulfilling his personal goals.

He has been a great partner and friend, and we will certainly miss him.

We want to thank Chuck for his many years of service and his many outstanding contributions to MSC.

During his 11-year tenure he has been a key contributor to our success and played an instrumental role in helping to shape our company to reach and exceed our growth and profitability goals.

We appreciate his dedication to MSC and wish him all the best in his retirement.

We are very fortunate to find someone with the outstanding credentials and skills that Jeff brings to our company.

He has extensive experience in distribution and manufacturing, an excellent reputation, and a proven track record as a manager who can meet and exceed strategic goals.

Beyond his excellent financial background and extensive public company experience, it's already clear that Jeff will be an excellent fit with our executive team and will be a leader of our culture.

I am confident that Jeff will help take MSC to the next level of growth and performance as we become a much larger company in the future.

Chuck will say a few words and Jeff will as well.

Jeff will not be answering any questions today, but will pick up in that role on the next quarter's call.

Chuck, please go ahead.

Thanks, David.

I feel both fortunate and proud to have been part of MSC for the past 11 years.

We have accomplished a lot together working as a team, always using our culture as our compass.

Moving forward, the runway of opportunity for continued MSC success is unlimited.

I would like to thank everyone I have had the pleasure of working with, both inside and outside of MSC, and welcome Jeff as our new CFO.

Thanks, Chuck, and thank you, David, for the kind words.

I am very excited to be joining MSC.

With Chuck leaving I know I have got big shoes to fill, but it feel very fortunate to be joining a company with a wonderful culture and a very strong team.

I look forward to being part of the continued success of MSC throughout the coming years.

I also look forward to meeting many of you who are on the call today.

Thanks, Chuck and Jeff.

Turning to the quarter, I am absolutely delighted with our execution and the strong financial results that our team delivered.

We continue to execute our strategic plan, delivering the excellent growth in sales, earnings, and operating margin percentage that we were confident would result from our model and investing into the greatest land grab of our time.

Since the beginning of the downturn, the smaller, less well-capitalized competitors that make up the bulk of the market have continued to suffer from service failures, lack of inventory, and the loss of key personnel.

The competitive advantage that MSC enjoys over the regional and small distributors has grown substantially over the past few years and we continue to widen the gap and gain market share.

Throughout the downturn and now in the recovery, we have hired many new and experienced salespeople from our competitors, people who would have been difficult to attract in the past.

These are associates with deep customer relationships and often bring strong technical capabilities to our sales team.

We have invested heavily in new technology, such as the Web, data, and sophisticated vending machine solutions.

We have dramatically improved our metal working technical capabilities at the customer level, added many new SKUs, and continue to build out our global sourcing initiative.

We could have easily allowed more of the margin dollars to read through to earnings during this period.

However, we strongly believe that our performance reinforces our position on market share growth and has proved out the accretion to earnings that follows well thought out investments in prior periods.

While some of the stronger regional and local players have stabilized, the bulk of the traditional competitors in this highly fragmented market continue to be capital constrained and experience delivery failures on a regular basis with their customers.

In essence, the land grab continues.

You might ask, why does it continue even though the market has rebounded?

The smaller competitor's inventories have generally been minimally restocked and as a result they are often forced to go in the direct or dropship route from suppliers to fulfill the order.

That method generally takes several days for products to reach the customers and does not deliver the timely service experience that customers require in today's just-in-time world.

It's further exacerbated by the pressures that the manufacturers are under given the increased demand.

These breaks in service are the windows of opportunity that open for the MSC model to capture share.

In addition, traditional distribution falls further behind as we continue to execute on our plan to deliver a continually expanding value basket.

They are not able to compete with a package that includes enhanced Web design, the ability to connect to modern electronic buying systems, BMI, CMI, smart vending machines, all coupled with our model.

We enable customers to order well into the evening from MSC's 600,000-plus product supermarket giving them confidence that their order will be delivered accurately and ready to be put to use in the machine spindle to run tomorrow's job.

We will continue to keep our foot on the gas in order to extend the leadership position that we have fought for and won in the metalworking segment.

As we continue to drive share gains in metalworking, we are focused on improving the formula that we have developed over 30 years that vaulted us from a small metalworking distributor to the largest in that segment.

Our plan is to apply that formula more rapidly in other segments of the market.

We strongly believe that our game plan is repeatable and will lead to dramatic market share growth in the very categories that constitute the huge MRO market place that we sell into.

I would like to give some guidance for Q3.

Currently, we expect revenues to be between $524 million and $536 million and fully diluted earnings per share to be between $0.90 and $0.94.

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

Thanks, David.

I will start with the customer landscape.

Our customers are for the most part growing over last quarter as is their optimism about the future, especially in the manufacturing sector.

Customers still remain somewhat cautious, however.

Both hiring and inventories are growing, but remain well below where they were before the downturn.

As David described, this has enhanced our competitive advantage as customers prefer relying on suppliers with strong systems, technical support, and logistics models.

The trends in the ISM remains an encouraging indicator.

The latest index in a string of very strong results bodes particularly well for MSC as sales to the manufacturing sector make up over 70% of our business.

Turning to MSC's results, sales to manufacturing grew over 24% in Q2 as average daily sales grew sequentially over the first quarter by over 3% and also continued to build through the second quarter.

Growth in our core business continues to fuel our strong performance and, in fact, exceeded the expectations we had when we set Q2 guidance on our last call.

While this growth is, of course, aided by the manufacturing recovery, we are also capitalizing on significant share gains.

Our government business was also a little better than expected for the quarter, but still down from Q1.

In total, Q2 government sales were just slightly higher than Q2 of last fiscal year.

We have included in our Q3 guidance government sales being roughly flat with the second quarter.

And we have been told by many of our government customers that there is significant pent-up demand and that when the widespread budget problems are eventually resolved they will return to more normal buying levels.

Average order size grew just under 1% above the first quarter as continued strong performance in manufacturing offset a shrinking average order size within the government, as we had expected.

Turning to gross margin, we executed well in Q2.

Our higher-than-expected result of 46.8% is primarily a function of improved rebates, strong realization from the price adjustment that we made around the December holidays, and the benefit of customer mix as the core, our largest and highest gross margin segment, is the most rapidly growing.

As you will hear from Chuck, we expect gross margins to remain strong in Q3 and overall we are pleased with our progress to date.

I will now turn to the recent international events and how they impact MSC.

While these events are so unfortunate for the level of human tragedy that has occurred, they have had little effect on our business.

The war in Libya has had no effect on our customers except for concerns about the rising cost of petroleum.

The multiple disasters in Japan are horrific in their scope and magnitude.

Our prayers and best wishes go out to the people of Japan.

Our customers who buy from Japanese suppliers have moved to shore up their supply chains and we have heard of minimal impact to date.

Customers are also inquiring about our inventory levels.

We have a strong inventory position on most of these products that will bridge the gap and actually create a share gain opportunity for us.

Thanks to our good, better, best product offering we also stock substitutes for the Japanese products, so we can continue to meet customer demand with quality products should any longer-term outages develop.

The Rutland integration was completed successfully and ahead of schedule on March 18.

Results so far have been better than originally expected as Rutland delivered a breakeven result from operations, excluding integration costs of roughly $1.65 million in the quarter.

We are already hearing positive comments from Rutland customers about the improved service that they are getting due to the extensive MSC product offering, our high levels of customer service, and our strong metalworking capabilities.

Moving forward, Rutland will no longer be broken out as it has now been absorbed into MSC and I would like to take a moment to acknowledge the tremendous work of the integration team who has made this happen.

As David noted, we will continue our investment in a strategic growth programs that we have highlighted on the last several calls.

On a recent customer visit in the Midwest I had the chance to see several of our initiatives come to light at one account.

I spent the day with a long-time industry veteran who had recently joined MSC as a field sales associate.

We visited a machine fabricator, a relationship that this associate brought with him to MSC.

We also met up with one of our metalworking specialists whom we recently hired from a well-known industry supplier.

The purpose of our visit was to meet with the customer's management team, including its president, in order to discuss opportunities to reduce their costs and improve their production process.

During the course of the meeting our metalworking specialist shared that he had recently surveyed the operations at this account.

He identified a drilling process that was inefficient due to the use of a drill that was too small.

By making the change to a larger drill we were able to save this customer $30,000 in time and materials by the customers own calculation.

This example highlights how the investments we are making increase the value we bring to our customers and how we translate that value into share gains.

This account has now become a six-figure customer of MSC.

And speaking of our sales force, our feet-on-the-street headcount grew to 998 associates in the second quarter and we expect it to grow to approximately 1,010 associates by the end of Q3.

We have grown our sales force throughout the recession when just about everyone else was cutting back and we plan to continue doing so.

We launched our new search engine on MSCDirect.com in the second quarter and the early returns from customers have been very positive.

In addition to qualitative feedback, we have also started to see the improvements translate in the numbers that we track.

Improving our search experience and our overall web platform remains a top priority and we will introduce more improvements to our site iteratively in the coming quarters.

Customers continue to react favorably to our vending machine program and it's growing rapidly.

The program is a win-win, delivering cost savings to the customer and share gains in productivity to MSC.

Overall, we remain on track with our strategic growth initiative.

Thanks very much and I will now turn the microphone over to Chuck.

Thank you, Eric.

Results for fiscal Q2 were excellent and better than originally anticipated.

Sales grew 22.2% over the same quarter last year and were $5 million over the top of the guidance range driven by the growth in our historic core business.

EPS of $0.78 grew 63% versus last year's second quarter and included approximately $.015 of dilution from Rutland.

Gross margin was 46.8%, 50 basis points better than the high end of the guidance range, and reflected the year-end price adjustments, the growth in our most profitable core business, and an increase in expected rebates due to higher levels of activity.

We expect gross margin in Q3 to be about the same as Q2 at 46.8% plus or minus 20 basis points.

Gross margin should moderate somewhat in Q4 reflecting our normal seasonal decline and reduced rebate dollars.

Operating expenses in Q2 were approximately $3 million lower than originally anticipated, primarily reflecting lower fringe benefit costs and reduced Rutland integration expense.

In Q3 we expect operating expenses will increase at the midpoint of guidance by approximately $9 million, reflecting higher volume-related costs and increased investment spending.

Overall operating margin reached 16.7%, or 17.2% without Rutland in Q2, and is expected to be 17.6% in Q3 at the midpoint of guidance.

Incremental margin in Q2 was 34.9% or 39.6% excluding Rutland.

Our Q3 guidance implies sales growth of 17.6% at the midpoint.

This is lower than our March sales growth rate of 21.9%.

This difference is attributable to the change in the Easter holiday from March in 2010 to April of this year and the increasingly more difficult comps throughout the quarter.

Our overall guidance of $0.92 per share in earnings at the midpoint is $0.14 above the Q2's actual result.

This improvement comes from $0.12 per share in operating margin improvement from the higher sales and $0.02 per share improvement in our tax rate resulting from anticipated expiring statutes.

Q2 balance sheet metrics were good.

DSOs were 43 and inventory turns were 3.55.

Cash flow conversion is historically a bit weaker in Q2 due to two tax payments in the quarter.

We converted 77% of our net income into cash flow from operations in Q2, and we had approximately $75 million in cash and cash equivalents at quarter end.

Our current cash position stands at approximately $115 million.

We expect to convert more than 100% of our net income into operating cash flow for the remainder of the year.

Thanks and now I will turn it back over to David for the wrap up.

Thanks, Chuck.

Our results continue to demonstrate the inherent leverage and power of the MSC business model.

We are very encouraged by our progress, the performance of our investments, and the strong ISM trends, all of which bode well for the future.

Our team is focused on executing our plan and changing the face of the industrial landscape as we continue to gain market share.

We regard our team as the special sauce that makes MSC so unique and I want to thank every associate for all of their efforts in producing this quarter's outstanding results.

Thank you all and I will now open the line for questions.

(Operator Instructions) David Manthey, Robert W.

Baird.

Contribution margins this quarter were very strong, it looked like 30%-plus, and I am wondering was this a case where revenues just came in stronger than you expected during the quarter and you received higher rebates and better leverage on your cost structure.

And in terms of the 30%-plus it looks like that is the level of your guidance as well.

Could you talk about how sustainable that might be going forward?

Hi, David.

It's Chuck.

Yes, something, Dave, we have talked about in the past many times is the return to this kind of incremental operating margin at 30% in part was going to be a function of trajectory of the revenue recovery and a pricing environment that would be positive for us.

So you are right; we were actually closer to the 35% range in Q2 but, as we heard from the prepared remarks, our gross margin was significantly higher than we had planned for in our guidance.

So clearly that was a major factor in driving that up.

So accelerating revenue above the level that we had expected in conjunction with a pretty aggressive and strong gross margin performance were the two main drivers that take that up to higher levels than were originally anticipated.

The Q3 guidance is closer to 30% for the gross margin.

As I said, plus or minus to where we were in Q2, but still better than we were significantly at this point a year ago in Q3.

So, again, higher revenue growth with improved margins year over year would put that number closer to the 30% range for Q3.

Okay.

Then second, you have been growing your sales force that a 4% to 5% rate lately and I am wondering is that enough to drive your targeted growth or will you ultimately want to accelerate that.

And if you could just talk about your targeted growth.

Are you thinking mid-teens on a secular basis or slightly higher than that?

And could you talk about how the growth in the salesforce would tie into your targeted growth rates?

Sure, David, it is Eric.

Yes, overall I think just going back to what we've stated is our long-term goals are to continue to grow double-digit revenue growth.

And obviously that moves around; the specific target would depend upon economic environment.

And over time we've highlighted the fact that salesforce additions remain -- have been and remain one of the most important contributors.

So I would say a similar answer to the revenue in that you can expect us to continue to add to the salesforce.

And the specific amount, I mean certainly internally we have our formulas that we look at, but what I would say is we reserve the right to be flexible in terms of how big an increase we take based on what we see in market conditions, the opportunities that we've seen in the landscape.

So overall double-digit revenue growth and sales force remains a very important part of the formula.

Dave, it is David.

I guess I'll just add that in addition to the significance of our salesforce additions, something you've seen historically and that you'll continue to see from us, you can also see that part of our growth investment formula is including lots of other areas -- our investments in technology, Web, data, the building out and continued focus on our vending machine solutions, our technical capabilities.

So we're actually investing on a lot of different fronts and the formula, while very significantly focused on the buildout of our team and our salesforce, we've got many other pieces to it that we're also focused on and investing in.

I mean over time all of that is intended to continue to keep high revenue growth certainly double-digit over the long term and even faster on the earnings side.

All of that will track back to keeping our foot on the gas with a focus of expanding our operating margins where we are back to nipping on the 18%.

We will continue to focus on achieving 18% and expanding beyond that.

Great.

All right, thanks a lot, guys.

Thanks, David.

Hamzah Mazari, Credit Suisse.

Thank you, good morning.

The first question is just around your inventory levels.

Are you where you want to be given the demand environment?

It seems like you are building inventory sequentially over the last couple of quarters, but it also seems like maybe you want to build more inventory here given the revenue coming in and the smaller guys not being able to maintain inventory levels and production at OEMs being pretty tight.

So if you could just give some color there.

Hamzah, it's Erik.

I think you hit on the key in terms of our inventory build.

It has really been tied to -- this has been an amazing opportunity to take share from the smaller regional players, as David had described, with all the service failures that we see in the market.

One of our biggest differentiators is the ability to get lots of product to customers next day.

And so absolutely the primary driver that you have seen on the inventory build side has been to ensure the kind of outstanding service levels that we would expect.

We continue to monitor it very carefully.

What I would tell you is right now we are pretty comfortable that by building the inventory that is translating into world-class service levels and that is translating into the share gains that we are seeing.

This is Chuck.

I will just add to that that you don't have the benefit of seeing our December numbers because it's obviously inside the quarter, but our December 2010 inventory number was about $73 million higher than we finished December of 2009.

So we anticipated and put a big build in to make sure that we didn't miss service-level commitments as this thing took off.

So I think you will see that the inventory levels will incrementally build to support incrementally higher volume, but the big plug to get the inventory level to where we needed to have it in anticipation of the big run has already taken place.

All right, thank you.

And then just if you could give any color on -- are you seeing any particular regional strength geographically or is this pretty broad-based for you guys?

Hamzah, sure.

In general, I would describe it as broad-based.

If you looked at our regional report a couple of areas to highlight would be -- that are particularly strong would be the Midwest tied to the durable manufacturing recovery.

And the other area is the West Coast, which would also be tied into manufacturing in the core.

The one thing I would comment on with respect to the West is the numbers that we post on our website for the West which showed a roughly 25% growth was excluding Rutland.

If we were to include Rutland in that number the West number would actually be at around 35%.

So those are the two areas I would highlight with particular strength but, yes, I think you are right, broad-based recovery.

Okay, thank you.

Best of luck, Chuck.

Nice working with you.

Thank you.

I appreciate it.

Matt Duncan, Stephens Inc.

Good morning, guys.

Congrats on a good quarter.

The first question I have got is with regard to your gross margin.

You talked about this a little bit, but I am wondering if you can flesh out a bit more on what drove the big year-over-year jump in gross margin, maybe looking at volume versus price versus mix and some of the different gives and takes there.

Yes, Matt.

It's Erik; I will start.

And I think you hit on the big three that we talked about, the three biggest drivers in the expansion, and, quite frankly, expansion beyond what we had guided to and expected.

Pleasant surprise.

So one being, as we have talked about for a long time, when our core business and when manufacturing grow quickly that is a really good thing for us as it relates not just to revenue but gross margin, because our core is our highest gross margin segment.

So certainly one thing that we saw during the quarter that drove the higher sales result was the core growing higher than we expected and that had a trickle-down effect to gross margin.

The second thing, also as we have talked about for a while, would be price inflation.

We have said that has historically been a very good formula.

Inflation in the market translates into gross margin expansion for MSC and you are absolutely seeing that play out.

We were pleased with the price realization that we saw, both from the September increase that we took and the December adjustment that we had talked about on the last one -- on the last call.

Then the third element I would highlight, and Chuck will put a little more color on, the rebates coming in stronger than we expected last quarter.

And I will let Chuck give a little bit of color on the rebates.

Sure.

Matt, you heard me just mention to Hamzah that our inventory levels at December 2010 were $73 million or so higher than the same period in 2009.

Our rebates are based on calendar year purchases.

So not only do we have higher levels of purchase to support an improving sales environment, we had a large inventory build in 2009.

And those rebates associated -- I am sorry in 2010.

The rebates associated with that higher inventory level and those higher purchases are finding their way through our P&L right now and will continue into the third quarter.

That is the third leg of what is driving the higher gross margin.

Okay.

Thanks, Chuck.

Erik, back on price realization for a minute, can you talk about how price is doing relative to your expectations?

And then what is the impact of price within your 3Q guide?

So regarding price realization, overall I would say meeting or exceeding expectation.

Matt, just to be clear, so we took -- in terms the pricing moves in September we had published roughly a 3% price increase.

We don't break out and share what the adjustments that we do in between catalog cycle, so the only other adjustment that we have made was the one that I referenced around the holiday.

So I can't quantify that for you publicly because we don't share what the number is.

But, overall, it's something we track carefully as the increase that we took relative to what we then see in gross margin improvement.

And we are really pleased with what we are seeing on price realization.

Matt, I guess -- David.

I will just jump in on the Q3 guide.

Given that we are guiding to sustain 46.8% plus or minus, price realization was an important factor in being able to -- we expect to deliver that kind of margin.

And that margin expansion was obviously important to our EPS guidance.

Okay, that is very helpful color.

Then two final things and I will get back in queue.

Chuck, you mentioned a change in the tax rate going forward; if you could give us some guidance on that.

And then the last thing is, with a potential federal government shutdown looming, can you remind us sort out how big within your sales federal government is and how you might be impacted if that were to occur?

Sure.

The tax rate for Q3, for planning purposes 36.7% would be a good number.

Then I think in the fourth quarter 37.5%, in that range, would be very helpful.

Those are both down from our first six months which is running about 38.3%.

Matt, regarding the federal government I will -- so let me start by answering your question on how big it is.

We don't -- it's not a number that we break out.

What you do see us publish publicly is manufacturing and the non-manufacturing as a percentage of business so you can certainly look at government as a portion of the non-manufacturing.

In terms of the color that we are seeing, not a lot of surprise actually.

We talked about it on the last call that what we were seeing in terms landscape was a really tight spending environment and that was driving the results that we had referenced on the last call and on this call.

What I tell you is that overall we are really confident in our share position and actually using the time right now to bolster our share position so that eventually budgets will be resolved, spending will resume.

And we think we are going to be really well-positioned when it does.

Matt, I am going to just add just one more, I guess, piece of color is that our Q3 guidance really does assume that the budget logjam continues.

So to the extent that that changes and we get any kind of positive surprise or cooperation in that regard then there is certainly the potential for upside.

But we are kind of factoring that that continues at this point.

Hopefully, it will be resolved and we will do better.

Okay.

Thanks, guys.

Erika Wolford, Cleveland Research.

Good morning.

I was wondering if we could talk a little bit more about the positive gross margin drivers.

Is there any way you can ballpark the impact on gross margin from the three things that you guys have referenced -- rebates, price, and then the improvement in the core business?

Kind of give us an idea of which was the largest driver to the gross margin increase.

Erika, this is Chuck.

We really can't break the pieces out for you.

I think, as Erik said, the core being the fastest growing piece of the business was a positive surprise from a mix point of view.

The pricing we baked in after we took the increase around the holidays and then the rebate is a result of better and higher activity levels (inaudible).

But for us to try to the split that out in little pieces for you it wouldn't make a lot of sense for us to do that.

Got it.

But is it fair to say that the core had the largest impact then, the pricing impact, and then the rebates third?

Is that how you would rank them when you look at them?

No, we wouldn't do it that way.

We would say the combination of the three pushed us 50 basis points over the top end of the guidance.

And then the other question I have is can you break out the dilution impact on gross margin from the Rutland acquisition?

Well, the whole thing was in the quarter about $0.015 worth of dilution, plus or minus.

I can tell you Rutland, from an operating point of view, was close to breakeven and then we had roughly $0.015 worth of integration charges.

That is how we net out to $0.015 of dilution.

Okay.

Well, great.

Well, thank you.

Scott Graham, Jefferies.

Good afternoon, good morning; very nice quarter.

Couple questions.

Could you in manufacturing kind of delineate which end-markets you saw which were particularly strong?

Yes, sure, Scott.

It's Erik.

So I will start by saying that manufacturing sort of grew 24% overall and pretty broad-broad based strength is how I would describe it.

But I had referenced early on when talking about the Midwest that durables, metalworking and durables manufacturing really lead the way.

That is the one area that I would point to, but overall strong across the board.

So you would include within that auto?

Yes, that is part of durables, sure.

Yes, okay.

The other question I had was on the continuing rise of commodities prices.

Are there any expected price increases upcoming?

Yes, so I will talk a little bit -- I mean overall, Scott, the dynamic is playing out as we had expected.

On the last couple of calls we have been talking about seeing the inflationary pressures creeping in to the market.

It's fully here on the sell price side, so as I mentioned we have taken -- we took the September increase, we took a midyear or a December adjustment.

As of now -- so there is no other increases that we have on sale price increases on the table.

But I would say that certainly if you look back at our past track record, depending upon the environment, it wouldn't be out of the question that there would be another before we release our catalog, but nothing planned.

On the cost side, we are seeing some pressure from suppliers and I would tell you that we are working -- our product management team works very carefully to understand of the suppliers that are talking about increases how that plays out in their P&L.

And we actually see it as an opportunity with many of our suppliers.

This is the time where they are able to hold the line and thereby giving MSC a preferential position without having to take their costs down.

We typically will reward those suppliers with accelerated share gains.

So that is kind of the landscape on the sale price side and the cost side.

That is helpful, very helpful, actually.

Thank you.

Last question is we have seen in the last couple of quarters a convergence, something of a convergence, between the Internet sales and the total company organic sales.

The spending that you are doing on the technology side, should we expect maybe a reacceleration in the Internet business or is that -- those expenditures required to just kind of keep growing double digit?

Scott, good question.

So I think what you are referencing is if you are looking at our Web sales as a percent of total sales, you are correct that you are seeing that rise.

That has been a trend for a while.

In terms of the investments that we are making now, those are absolutely over time to grow that number.

So internally we have our own targets over time.

But to answer your question, the investments we are making are not just to hold the line on the percentage but over time that is a number that we would like to see grow.

Okay, but my question actually was more specifically that the growth in the Internet sales versus the total company organic sales the last several quarters have come closer and closer together with the Web sales still outperforming.

What I am asking, I think, more specifically is not just for growth but will we potentially see an accelerated growth?

Can we keep the number, let's say, for example, at 20% growth in the Web sales or is the investing just going to kind of get us to 10% to 20%?

Okay.

So I think the answer I gave you is -- again the metric we really track is over time how do Web sales compare to the Company total.

So to some degree the web sales are a function of what is happening in the overall business.

To the extent that revenue growth really accelerates, obviously the Web will with it.

But what we measure is the delta between the Web sales growth and the Company sales growth to see that grow, because what that translates into for us is leverage and leverage that means productivity gains which improves margins.

Am I answering your question?

Yes, I think we are now saying the same thing.

So you want to keep a positive gap in the growth of web sales versus the growth of total company sales?

That is right.

Our goal over time is to grow Web sales as a percentage of company total.

And to do that what that means is that the Web business -- the growth in the Web business has to outpace the Company average.

That is really -- when it comes to the Web that is the metric we are tracking, because to some degree as the Company does better the Web by itself will do better.

We want to see it grow at a disproportionate rate so that the percentage of total business grows.

Sure.

Very good, thank you.

Sam Darkatsh, Raymond James.

Good morning.

This is actually Josh filling in for Sam.

Sam passes along his apologies for not being able to be on the call and also his congratulations to you, Chuck.

It has been a pleasure for both he and I to work with you and we wish you nothing but the best in your future endeavors.

Thank you, I appreciate it.

Thanks very much.

A couple questions.

First about the tax rate.

You have said that it was looking like maybe 37.5% for the fourth quarter.

Would that also be the run rate going beyond that?

No, I would go back to something closer to 38% -- to 38.3% for 2012 planning forward.

The second half of the year, when it becomes obvious that there won't be audits and tax positions that we have taken are no longer needed, that is when we generally have some change in our tax rate.

I think if you look historically back in the second half of the year it has been that way.

We just don't count on that until that time gets here, so we generally revert back in the first part of the year to something a little bit higher.

Sure, okay.

I believe your prior commentary on Rutland was that it was going to be sort of neutral to EPS in the second half.

So, since it's already at breakeven, would you say it's going to be accretive sooner than you expected?

Josh, it's Erik.

You are right, we are ahead of schedule on Rutland so we would expect, moving forward, it to be accretive.

And as we talked about on the call, we are not going to report on it separately given that it's now absorbed into MSC, but to answer your question, yes.

Okay.

And then one other quick question.

With all the debt essentially off of the balance sheet and it looked like the share repurchase activity was not -- it looked like maybe a little bit less even than the prior quarter, could you give us maybe an update on your thoughts for the cash that you are doing so well at generating and balance sheet leverage going forward?

Sure.

Josh, it's David.

Essentially our strategy remains the same; we continue to take a balanced approach in how we create value for shareholders.

Really I guess my best suggestion is to take a look at the playbook that we have used over several years, because I think that gives a lot of insight into how we have used our cash historically and how we will continue to use it moving forward.

You have seen us pay a regular dividend, one that increases over time.

You have seen us, from time to time, deliver a special dividend.

You have seen us consistently buying back stock.

And I guess the other is that you have seen us also use cash to do small and significant acquisitions.

So really the playbook and kind of our formula in the past in one that you can expect to repeat moving forward.

Okay.

Well, thank you very much for your answers.

Again, best of luck to you in your future, Chuck, and, Jeff, we look forward to working with you.

Ryan Merkel, William Blair.

So my first question is on investment spending.

Would you say that we are still running at above-average investment spending and that might normalize over the next couple of quarters, or how should I think about that?

Ryan, I would say overall we are continuing on the investment program that we have highlighted so, to answer the first part of your question, yes.

The second part of your question in terms of moving forward, what we had talked about is now that we have moved into a more stable economic environment that we would talk about that on an annual basis.

So I think for the next couple of quarters, meaning 2011, fair to say yes and then beyond that we will come back as it gets closer to 2012 to give you a view into investment spending for 2012.

But, overall, high levels of investment consistent with what we have talked about.

As you can tell from the prepared remarks, we are really pleased with the results we are seeing.

Ryan, the only add I would make, we certainly will come back as we are ready to start sharing more in 2012.

But in general you can expect to see us incrementally investing every year because we are constantly focused not only on our current results, but what we internally call the fifth quarter and our longer-term plan, which is making sure that we are staying ahead of this thing and delivering the growth in many quarters from now.

Okay.

And then, as the benefits from past investments kick in, are you able to sustain mid to high 20%s incremental margins over the next four to six quarters?

Is that the right way to think about it?

Ryan, again, I think you would have to wait until we give guidance.

We talked earlier about the accelerating revenue growth being a very important factor in those margins as well as expanding gross margins.

David just touched on a third piece and Erik did as well in our investment spending.

Those are the three components of determining what the incremental read-through would be as we move forward.

So when we get closer to 2012 we will frame a little bit of that for you as we get a little bit closer in.

Fair enough.

Then last question is on ship-to.

You gave us the bill-to again, but I am wondering what the ship-to number was.

Was it up year-to-year?

Can you quantify it for us to help frame the market share gains?

Ryan, it's Erik.

The answer is the ship-tos, the trend on the ship-tos or the location level is consistent with what we have seen.

It is growing.

Not yet ready to share it publicly; still doing some work internally, but certainly directionally it gives us a good picture and consistent with what we have talked about in the last few quarters.

Great.

Thank you very much.

(Operator Instructions) Brent Rakers, Morgan Keegan.

Good morning.

Just I think two questions left for me.

I think the first one, if you could address possibly in the January/February months if there was any detrimental impact from weather, both related to your DCs or possibly some of your customers.

Brent, it's Erik.

We have quantified the impact on the revenue line on weather to be roughly $3 million to $4 million in the quarter for Q2.

Erik, do you believe any of that shifted into that March month?

Brent, so hard to tell, so hard to tell.

Okay.

And then just last question.

You have talked a lot about gross margins and I guess how you have gotten to the point you are at now.

If I look back I believe this second-quarter gross margin percentage was the highest post the J&L transaction.

I guess in light of that you have come full circle and made full recovery.

If you could maybe address additional levers to be pulled, additional goals that you might have in the future, or maybe what components of that gross margin still have recovery left over the next several years.

Brent, it's Erik again.

Look, I think over time it's our goal to continue to be able to expand gross margins over time.

Your question around what are the components that still have juice in them, I think that is where you were going.

Absolutely, Erik.

Certainly one that I would put on the table is price and really that is a function of what continues to happen with commodities prices and with inflation.

But should we see sustained inflation, we still believe that price will be a tailwind for us.

The other one that is our big internal program are the tight coupling of global sourcing with our private brand initiative that we are beginning to see pay off.

We track it carefully internally.

It's one of the Company's top priorities.

But certainly in terms of runway that is one that I would still describe as in the very early stages or early innings of the story.

So that is the one that I would point to that as well within our control that gives us a lever moving forward.

And near-term, again depending upon environment, certainly price is an option as well.

Erik, if I might, can I follow-up on maybe two other areas related to that?

Can you maybe give a general comment, maybe speaking towards what the competitive landscape is?

Because I know for a period of time the competitive pressures have still been fairly intense and maybe comment on that with regards to gross margin.

Then also maybe comment in terms of customer mix, maybe large customers, small customers, if you are getting those kind of core small metalworking shops really have come back full to the table yet.

Yes.

Brent, I will address them in order.

Two good questions actually.

Competitive landscape, so I had laid out some of the tailwinds on -- as we look at our margin picture going forward, there certainly are some headwinds and one of them is the competitive landscape.

We actually -- I would describe the competitive environment as -- despite our margin gain, the competitive environment is as strong as ever in terms of -- particularly the local and regional players where we see -- David has described it well.

They are under severe pressure.

They are playing the price card, so I would describe the competitive pressure as strong as ever and certainly does represent the headwind.

Again, even now, despite the good results, it's still a balance of tailwinds and headwinds, and that absolutely is a headwind.

With respect to customer mix that is one that tends to move back and forth.

It was a headwind for a long time and we had talked about that it would move to the tailwind column as the economy recovered and as we saw growth at our core in manufacturing.

To answer your question, yes, we are seeing the small to mid-sized businesses recover.

That is part of the story that is driving the strength in core.

Over time, as the large accounts, particularly as the government -- David described if we were to get a positive surprise with respect to government spending, depending upon the budget environment, increased government spending would represent a headwind in terms of gross margin.

So right now I would characterize customer mix as the tailwind.

In the future, depending upon what happens with the core and what happens with government, that could move to the headwind column.

Great, Erik.

Thanks a lot for the detail.

Dave McGonigle, Copeland Capital Management.

Just quick question on customer count.

First time in a long while that we didn't see a decline.

Just wanted to get a sense of whether you think that trend is complete or moderating, and, if so, any color you could give on average order size and/or margin impact as far as the degree to which that was helping margins by getting rid of some of the lower margin clients and the potential for that lever to be either finished or like I said moderating.

Any thoughts on those subjects?

Yes, Dave.

Sure, I will start with customer count.

You are right, the published metric is 317,000.

You are right that this was the first time in awhile it moderated.

I would tell you not much different in terms of color I would provide on the bill-to customer count.

It's really, as we have described, not that meaningfully metric for us over the long haul.

Our strategy continues to be focusing on high potential, under-penetrated accounts.

We are continuing our strategy tightly coupled with that of trading out small, low potential and unprofitable accounts.

You see that reflected in some of the direct mail numbers.

If you look back over the past couple of years, those numbers are down.

I think what you are seeing with the flattening is a balancing of that attrition strategy offset by the improvements in the economy that are having an upward effect on the count.

So I think what is really important to us, the metric internally that we track most carefully is what retention rates look at within our targeted bands of customers.

And the color I will give you there is those are extremely strong.

We are very pleased with what we are seeing and where we are putting the investment dollars.

Great, that is helpful.

Any chance -- this is a long shot, but any chance we are ever going to get either the retention number or the bill-to count?

Not today, but I mean just as a thought for you.

You have this great supplement; just thinking about something else that would be helpful to have in there.

Yes, Dave, the bill-to count is actually what we do publish.

What you may be referring to is the location count, which is kind of lying underneath the bill-tos or the ship-to or location count.

I got it.

Okay.

So eventually it is something that we could publish at some point; we want to get really comfortable with the numbers.

We are comfortable directionally with the picture it tells us but before we would put anything publicly we would want to get more comfortable.

Erik, you are referring to getting comfortable with the process to make sure that what we put out there is something that is a solid number and the process is repeatable in our reporting of it?

That is right.

The picture which we have been giving you quarter over quarter is very accurate directionally.

Okay, makes a lot of sense.

Thanks, guys.

There are no more questions at this time.

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

Okay.

Well, thank you all for all of your interest today.

We enjoyed talking to you and look forward to speaking to you again next quarter.

Thank you.

And this concludes today's conference call.

You may now disconnect.