MSC Industrial Direct Co Inc (MSM) 2011 Q3 法說會逐字稿

Good day and welcome to the MSC Industrial Direct third-quarter 2011 conference call and webcast.

All participants will be in a listen-only mode.

(Operator Instructions).

After today's presentation, there will be an opportunity to ask questions.

Please note this event is being recorded.

I would now like to turn the conference over to Christine Mohrmann.

Ms.

Mohrmann, the floor is yours, ma'am.

Thank you and good morning, everyone and welcome to the MSC Industrial Direct fiscal third-quarter 2011 conference call.

An online archive of this broadcast will be available one hour after the conclusion of the call and available for four weeks on the homepage at 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 contains forward-looking statements within the meaning of the US securities laws, including guidance about expected future results, statements regarding expected revenue, gross and operating margin and earnings growth, expectations regarding the Company's ability to capture marketshare, 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 this statement.

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, Christine.

Good morning and thank you for joining us today.

With me are Erik Gershwind, Executive Vice President and Chief Operating Officer and Jeff Kaczka, Executive Vice President and Chief Financial Officer.

Shelley boxer was unable to be on today's call and will return for next quarter.

Today, I will give some perspective on our performance against our strategic plan.

Erik will provide an update on the landscape and economic environment, as well as the execution of our model.

And Jeff will provide details on our Q3 performance and the fourth-quarter guidance.

I am delighted with our performance in Q3, which was very strong and came in above expectations.

We continue to execute on our strategic plan, delivering strong growth in sales, gross margins and earnings against challenging comps.

Our Q3 operating margins reached a postrecession high and we delivered record EPS in the quarter.

Overall, our results reflect the benefits of our strategic investment initiatives and our continued marketshare gains.

These investments have enhanced our ability to provide customers with solutions and services that our smaller, less well-capitalized competitors often can't offer.

The value gap that this creates between MSC and these local competitors continues to widen as customers require more in the way of technology, just-in-time inventory availability and the ability to dramatically consolidate their spend from multiple suppliers.

The great landgrab opportunity that we recognized would occur from the onset of the downturn remains a vibrant one in the recovery.

While some of the stronger local and regional distributors have stabilized, the bulk of our traditional competitors remain capital-constrained and our challenge to meet the ever-increasing demands customers competing in today's global marketplace now require.

The weaker locals in particular struggle to maintain their service levels due to lack of inventory and are more often dropshipping directly from suppliers whose service model often requires multiple days to reach their customer, thus extending these leadtimes.

We continue to take advantage of this dynamic by taking marketshare and adding top industry talent to our team.

Before turning to our results, I thought I would use this opportunity to step back and summarize what we have accomplished over the past year.

To remind you, as we came out of the recession, we told you during fiscal year '10 that you could expect to see us do the following -- begin to see the payoff of our investments made through the downturn showing up in our results, accelerate share gains in excess of market growth, continue to invest in high levels to fuel growth and share gains going forward and finally, expand operating margins back towards our 18% prerecession high over time.

Our performance over the past year has exceeded even our own expectations.

If you look at our three quarters of actual results and include the fourth quarter at our guidance midpoint, we are on pace to achieve some exciting milestones in FY 2011, those being surpassing the $2 billion mark in revenues, a number well in excess of 2008 pre-recessionary levels, achieving approximately 46.6% gross margin, which is matching our single highest year in the Company's history and producing 17.1% operating margins, well on our way to catching and ultimately surpassing our 18% peak.

While we are tracking well to our plan, the most exciting part of the story is the future and the opportunity that we see in front of us.

I will now share a more strategic perspective on our growth story and what you can expect to see from us in the future.

As you have heard several times before, what we are doing now is honing our repeatable growth formula within the metalworking market.

That growth formula is made up of several investment opportunities that Erik has talked about on the last several calls, including salesforce expansion, further enhancing our technical capabilities, value-added solutions like our comprehensive vending suite, the build-out of our e-commerce capabilities, the expansion of our product offering and in particular our private brands and more.

Metalworking is so exciting to us because we have achieved a strong leadership position over many years and yet because of the fragmented nature of the industry, we estimate our share position to still only be in high single digits.

This gives us tremendous runway for continued growth right within our sweet spot.

Over time, you will see us extend our repeatable formula beyond metalworking.

A likely starting place will be adjacent productlines that are purchased and consumed on the manufacturing plant floor, productlines like safety, hands and power tools, fasteners and power transmission components, to name a few.

This opens up a new avenue of growth for us while leveraging our brand and relationships within manufacturing customers.

From there, you'll see us extend into new customer end markets.

Today, we play primarily within manufacturing and even within manufacturing, our core is a relatively narrow band of durable goods manufacturers.

We see enormous runway to extend our model to new segments within manufacturing and ultimately into entirely new segments.

I would like to now give some guidance for Q4 and before I do, I should mention three considerations that will impact Q4 and that Erik and Jeff will speak to in more detail in their sections.

The first is the softness in the government sector.

The second is the atypical manufacturing ADS pattern we saw last year and the third is the normalization of rebate levels in our gross margin.

Currently, we expect revenues to be between $518 million and $530 million and fully diluted earnings per share to be between $0.83 and $0.87.

And I will now turn the mic over to Erik.

Thank you, David.

I will start by describing economic conditions.

In general, the environment remained cautiously positive in Q3, which is how we have characterized the entire recovery.

For the most part, our customers are growing, especially in the durable manufacturing sector.

There is though a bit more caution sprinkled into Q3 customer sentiment than we have heard over the past few quarters.

At this point, it is difficult to say whether the leveling in activity that we have seen is a short-term blip tied to the Japanese supply chain issues or something more sustained.

While the May ISM reading of 53.5 is indicative of more caution than there was in prior months, it continues to be a solid indicator of future growth.

And given the generally positive feedback we continue to receive from our customer base, we are hesitant to react to just one lower reading.

We have been asked several times over the past few weeks whether, as a country, we are still in the early stage recovery that has just taken a short-term hiatus or whether we are moving into the middle stages of the recovery.

Our answer is the same every time.

We simply don't know and we leave that to the economists.

However, what we do know is what we can control and that is our business model.

Under either scenario, here is what you can expect from MSC.

We will continue to grow our top line at rates in excess of market growth, reflecting the share gains we are making due to investment programs and to the power of our model.

We will continue to invest for future growth.

We will continue to expand operating margins, the degree to which is a function of two variables.

One is the trajectory of economic tailwind and hence revenue growth and two is the extent of inflation, which impacts our gross margin line.

Our fiscal year 2011 performance shows the power of what is possible when both of those factors are working in tandem.

Using the middle of our Q4 guidance, fiscal year 2011 would produce 19% revenue growth, 41% EPS growth and a 280 basis point expansion of our operating margin.

In a more moderate economic growth environment, those numbers would be tempered, but we still expect operating margin would expand.

Turning to our results for the quarter, you can see the impact of the healthy economic conditions and our share gain programs in the form of strong manufacturing growth rates.

Manufacturing grew 21.9% in Q3 and fared slightly better than we had expected when we set guidance.

On an average daily sales basis, manufacturing was up over 8% from our prior quarter.

We expect manufacturing average daily sales to remain strong in Q4.

However, we also expect growth rates to moderate due to the atypical pattern of very limited summer shutdowns that we saw last year.

The government sector continues to lag.

Our Q3 guidance had included government ADS that were roughly flat with Q2 and the quarter panned out pretty much that way.

While the federal budget was approved, the spending environment is still extremely tight.

Our contacts shared examples with us of how they are spending only on mission-critical supplies, which generally means items like replacement parts for military vehicles, but not MRO products.

Our Q4 guidance forecasts government average daily sales to tick up slightly from Q3, but still well below the accelerated levels that we saw during last year's Q4 due to heavy troop deployment activity.

Turning to gross margin, we had another good quarter.

Our higher than expected result of 47.3% was primarily a result of the high growth rates in our core, strong realization from the midyear price adjustment we took during the holidays and the benefit of rebates.

As you will hear from Jeff, we expect Q4 gross margin to tick down, reflecting our usual seasonal drop plus the additional impact from rebates as calendar 2011 rebates are normalizing to more typical levels.

Looking around the corner, we would expect to see an increase in gross margin in the first quarter of our fiscal year 2012, consistent with our typical pattern that will reflect the price increase in the new Big Book.

We are continuing to see the payoff from our investment program.

On a recent customer visit in the Midwest, I had the chance to see a few of our initiatives converge on one account.

This account is a manufacturer who supplies parts to the automotive and infrastructure industries.

It was a strong hold for a good local competitor in the area.

Fast forward a year and a half and the account is now a six-figure customer for MSC with the potential to more than double its spend with us over the next 12 months and there are a few things that are driving this result.

One, the plant we visited is a division of a larger corporation, one which we recently signed as a national account.

The local site got pushed from corporate purchasing to give MSC an opportunity in light of our national relationship, which is designed to consolidate their supply base.

Two, our new Web functionality is winning over contacts around the facility.

The storeroom and facility's manager is progressive and likes to order through the Web and encourages its people to do so as well.

He told me how he was blown away by the ease of use of our new search functionality.

And three, our VMI solution is gaining traction and we now have our system set up in three sections of the facility.

We have helped this customer take inventory out of its system.

All three of these programs, national accounts, Web and VMI, are competitive advantages that are difficult for local distributors to replicate and are thereby translating into share gains.

We remain an employer of choice in the industry and continue to take advantage of our positioning to add more of the best and brightest into our ranks.

We grew our salesforce from 998 to 1015 associates in Q3 and we expect that number to grow to between 1025 and 1030 associates by the end of our fiscal year.

As we mentioned on the last call, Rutland's operations have been fully integrated into MSC and while we are no longer breaking out its performance, I will note that we are very pleased with the transaction and what it has done for our business on the West Coast.

Strategic M&A remains a key focus of our growth strategy and we will continue to evaluate and pursue opportunities that meet our strict criteria.

Thanks and I will now turn it over to Jeff who will give our financial overview.

Thanks, Erik.

We are very pleased with our financial performance for the third quarter.

Compared to the same period last year, sales grew 18.2%, gross margin is up 180 basis points and earnings per share grew 41%.

Our EPS was $0.97 for the quarter and this exceeded the top end of our guidance range.

The primary factors contributing to this higher than expected EPS were higher sales, improved gross margins and favorable operating expenses.

Let's talk briefly about these.

First, our sales came in above the midpoint of the guidance range thanks to even stronger-than-expected growth from our core customer base.

We are clearly seeing success from our growth initiatives.

These incremental sales above our midpoint contributed about $0.01 additional EPS.

Second, our gross margin of 47.3% was 50 basis points better than the midpoint of our guidance range driven by a favorable mix of core business, as well as the continued high levels of vendor rebates.

This contributed an incremental $0.025 to EPS.

And the remainder of the incremental EPS, about $0.01, came from improved operating expenses.

So we have plenty of good news.

We are also pleased with the 18.4% operating margin we achieved in Q3 and I should note that the incremental margin in Q3 was 33.8%.

Our tax rate for the quarter came in at 36.6%, somewhat lower than normal, but in line with our expectations as a result of expiring statutes of limitation.

Q3 balance sheet metrics remain strong.

DSOs were 44 days and inventory turns were 3.51.

Inventories increased about 5% from fiscal Q2 levels as we continued to take advantage of our liquidity and financial strength to ensure our ability to meet customer demand and enhance our service levels, as well as protecting our gross margins in this inflationary period.

Cash flow conversion was excellent.

We converted 105% of our net income into cash flow from operations in Q3 and we had approximately $137 million in cash and cash equivalents at quarter-end.

Our current cash position stands at approximately $164 million and we ended the quarter without any long-term debt.

I should mention that, in June, we entered into a new $200 million credit facility, which replaced our previous $150 million credit facility that expired.

The expansion of our credit facility will further enhance our ability to fund our growth strategy going forward.

As Erik mentioned, our Q4 guidance reflects the typical seasonal pattern that occurs in our business.

Sales are generally lower due to seasonal shutdowns in our manufacturing customer base and we experienced product mix changes.

Unlike last year, we expect to return to a more typical seasonal pattern of summer shutdowns.

Our anticipated sales growth at the midpoint is 13.5%.

Please note that we faced difficult comps from last year's Q4 as we saw an atypical pattern of accelerating ADS from the third to fourth quarter as a result of the improving economy, limited summer shutdown and a significant ramp from government sales.

We are expecting the pattern of a temporary decline in gross margin in Q4 to hold true again this year due to the typical seasonal summer factors, primarily driven by product mix.

In addition to this normal seasonal mix impact, and to a lesser extent, we also anticipate a negative impact to gross margin associated with lower rebate dollars.

The first three quarters of fiscal 2011 included the rebates earned related to the significant increase in purchases made in calendar year 2010.

In Q4, we expect to return to more normalized rebate levels.

As a result, we currently expect gross margins for Q4 to be in the range of 46.4% plus or minus 20 basis points.

And to be clear, with the introduction of our new Big Book catalog in September and the reversal of the seasonal mix impact, we expect to see an increase in gross margin in Q1 of FY '12, consistent with our typical seasonal patterns.

In Q4, we expect operating expenses will increase at the midpoint of our guidance by approximately $1.3 million over Q3, reflecting increased investment spending and expenditures necessary to support anticipated Q1 of FY '12 volumes.

Finally, the Q4 tax rate should be about 37.8%.

Again, we are very excited about our Q3 results and where we are headed for Q4 and beyond.

Thanks and now I will turn it back to David for the wrapup.

Thanks, Jeff.

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

We are executing on this model at all-time high levels.

We are on the verge of breaking the $2 billion mark on revenues and are well on our way to achieving pre-downturn operating margins.

Our team is pushing ahead with our growth plans and investments as we continue to gain marketshare and our results have proven that we have the right plan in place.

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

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

(Operator Instructions).

Matt Duncan, Stephens Inc.

Good morning, guys.

Congrats on a good quarter.

Thank you, Matt.

The first question I have got is with regard to the weather impact in May.

It was obviously pretty stormy across the South, a lot of flooding issues.

Do you guys feel like that had any kind of impact on your business as you wrapped up the quarter?

Matt, it's Erik.

No, not a significant impact on our business.

Okay.

And then, Erik, as you look at the economic outlook and sort of the customer tone conversation that you referred to, has there been a meaningful shift or is it really just more sort of a near-term cautious stance until maybe we get another month worth of data and sort of a little bit more outlook on where the economic data points are directing us?

Matt, as we described in the prepared remarks, in general, through the whole recovery, we have characterized it as a cautious recovery, a cautious sense of optimism and we'd still characterize it that way.

We did see a little more sprinkling in of caution than we had seen in prior quarters.

To your question as to whether this is kind of a short-term little hiatus or something more sustained, we just don't know.

So we are waiting and seeing like you, but, in general, we still feel like customer sentiment is strong and what we are seeing from the ISM really tracks to that.

Okay.

And then last thing from me and I will jump back in queue, on the acquisition landscape, are you guys hot on the trail of anything at this point, still expecting to be active with acquisitions?

Hey, Matt, David.

Yes, listen, we are actively looking at candidates and we have stepped up our activity in this area.

As you know, we have talked about the fact that we have structured a team who is now focused on M&A and we really do view the area as a good way to supplement our organic growth strategy.

But as we have always talked about, we remain selective.

But a couple things going on.

First of all, the success that we had with implementing or integrating Rutland continues to give us a lot of confidence in our ability to really successfully execute in this area and I think to give you, maybe give you a little bit more color, since this has been an area that we have been talking about, of the kind of candidates that are team looks at and it is really those acquisitions that we feel like can help fuel our growth strategy.

And some of the key elements that we have talked about of that certainly include penetrating our core metalworking market where we continue to hone our repeatable formula.

We have talked about taking that formula and applying it to adjacent productlines that are the ones principally consumed on the manufacturing plant floor.

And as we continue to pursue that path, we are also going to use it to expand our end-market verticals to bring us into entirely new segments, all of which as we continue to march towards capturing more and more share in this $140 billion MRO market.

So the way that we are viewing it is very focused, but as you have heard me describe, there really is a wide net and we are going to continue to remain opportunistic, continue to keep our foot on the gas in terms of what we look at, and ultimately we plan to use our strong balance sheet and the new credit facility that Jeff described to continue to capitalize and ultimately on the right acquisitions.

Okay, just one quick follow-up then, on the four-product segment that you pointed out in your prepared remarks -- safety, hand and power tools, fasteners and power transmission -- are there any of those four that are more interesting than the others or is that, as you refer to, sort of a broad net you are casting there?

I think that those four and others are very interesting.

We, of course, have our own kind of strategic prioritized list of how we view the order that we would rank them.

Of course, we wouldn't want to share whether it is those 4, or 8 or 10 what our prioritized order might be.

The only thing that we have talked about is that, among our priorities, metalworking penetrating our core continues to be among the highest.

Okay, thanks.

Sam Darkatsh, Raymond James.

Good morning, David, Erik, Jeff, how are you?

Doing great, Jeff, thank you.

Doing very well.

Thank you.

A couple questions here.

Your implied Q4 sales growth or at least implies a little bit of moderation versus what you saw in June.

Yet at least by my notes, it looks like July and August are similar year-on-year comparisons and I am also guessing that you are going to be getting some extra sales perhaps from WSCA.

So is that you just being conservative or is there something in your order rates that suggests that July and August will be a little softer because, again, the comparisons year-on-year are similar to June?

Hey, Sam, it's Erik.

I'd tell you that we follow the same process that we always use, which is to give you our best look at what we really expect for Q4 at the time.

So no different there.

Really two factors I would point to, one is we did see an atypical pattern last year.

So if you look at the Lipton average daily sales from Q3 to Q4, last year was particularly high.

So we do face tougher comps as we move through the quarter.

And the second thing I would point to is certainly the relative softness in government and I say relative because, as I said, baked into our guidance we are expecting average daily sales to pick up in the government sector from Q3.

But relative to last year, we saw a rapid acceleration primarily due to heavy troop deployment activity last year.

So those are the two factors I would point to.

Okay, second question, you are calling out the slightly lower rebates.

Are you seeing vendor lead times change meaningfully at all or even moderately on a sequential basis?

Sam, regarding vendor lead times, nothing material that I would point to.

Our product team -- I mean it is certainly something you would think given the environment, but our product team is really on top of it.

The only exception I'd make to that general statement would be the Japan issue.

And we pointed to it, we mentioned on the last call that we bumped up our inventory levels for Japanese products.

We have seen supply chain disruption with respect to Japanese suppliers.

Other than that though, we stay really closely tied into our suppliers and nothing significant to speak of.

Last question and I will defer to others.

Share repurchase activity this year has been de minimis.

Any thoughts there going forward?

You have the new credit facility, you've got a lot of cash on the balance sheet generating a lot of cash.

What are your thoughts there on a go-forward basis?

Sam, David.

Basically, our strategy remains the same.

So you have seen us taking I would say a balanced approach to how we create shareholder value in that area.

And I think the way to think about our playbook is, if you take a look over longer stretches of time, you will see us repurchase shares just as you have mentioned.

You will see us pay a dividend and we consistently raise that dividend over time.

We also do a special dividend, which you have seen -- well, you have seen one recently, you saw one about five years earlier.

And then we also continue to use cash and deploy it when we find the right acquisition, the right M&A kind of activity.

And so those are all the things that you can expect to see going forward.

In terms of the timing of those ingredients, that is not something that we want to share further on this call.

But I think if you were to fast-forward over the next five years, what you would see is very likely several of what you have seen over the past five.

If I could just do a quick follow-up on that, is the lack of share repurchase activity this year tied to a price sensitivity on your behalf or perhaps trying to keep dry powder for acquisitions?

How should investors read that?

Well, I certainly would not want to characterize it as based on the price of the stock.

And I don't want to go too far as far as signaling some of the thinking behind it.

But I think part of the answer is -- you know what?

I am going to -- I don't want to second-guess myself.

I don't want to go too far because I see that, as I am thinking about this, Sam, other than talking about the prices of stock not being a deterrent for us, I think any other place that I go is going to signal activity that I would not want to signal.

All right, credit me for trying at least.

Thanks so much.

Sam, you had me double-thinking.

So good job.

Have a nice morning.

Thank you much.

Adam Uhlman, Cleveland Research.

Hi, guys, good morning.

I guess first question on the gross margin decline for the fourth quarter.

I was wondering if you could break out the rebate piece directionally, how big of that decline that would be because it looks like the decline is quite a bit bigger than we have seen historically.

Adam, we don't traditionally break out the components of gross margin, but if you look at the sequential decline to the midpoint of our guidance range in gross margin, it is 90 basis points.

If you look back at the last couple of years, you would see a decline in gross margin from Q3 to Q4 to varying degrees, but it was 55 basis points last year.

It was 105 basis points the year before and those declines were again driven by the seasonal factors, primarily the product mix.

As Erik said in his comments, the decline that we expect to see this year is primarily due to the seasonal factors and to a much smaller extent the rebate.

Okay, and then in the past, you have also, like in 2009, you had the inventory write-off.

Is there any other kind of one-time items that are coming through the number that you would expect?

Nothing that we expect.

Okay.

And then you guys are probably close to finalizing the catalog for next year, getting pretty close to that.

I was wondering if you could share any early thoughts on new SKUs, categories.

And then you had mentioned the gross margin should be going up in the first quarter like it always does.

Any thoughts on what the pricing might be in the new catalog?

Adam, it's Erik.

Next call is when we will traditionally share what the price increase is.

I mean you certainly could expect an increased time with the Big Book.

We will share numbers both on SKUs and pricing on the next call.

The one thing I will say on product expansion, it remains a key part of our growth strategy, as we highlighted in the prepared comments.

In particular private brand remains an important part of our growth and gross margin formula.

Okay, yes.

Just thought I would try.

And just a last quick one, the northeast growth rate slowed quite a bit relative to the prior quarter and it seems to be one of the softer areas of the country.

Can you just talk through what you are seeing there?

Adam, it is Erik again.

I think if you looked back over the past several quarters, in general, the northeast growth rates have been more moderate than other parts of the country.

The primary driver there is exposure to industry segments and in particular a relatively lower mix of the durable manufacturing, the core that we have been talking about that has been so strong for us nationally, a relatively lower mix of that in the northeast.

That is the primary driver.

Great.

Thank you.

David Manthey, Robert W.

Baird.

Hi, guys.

Good morning.

In terms of the government weakness, I was just wondering if you could characterize federal, state, local, if you are seeing any concentrations of weakness?

And then you have mentioned a couple of times this troop deployment thing.

Was there sort of a one-off hit last year that doesn't repeat this year?

Was it with a customer that you don't do business with any more or just help us understand how the weakness took place there?

Yes, David, so I will start with your first question.

We characterize the government weakness as general pretty broad-based weakness and I wouldn't call out any particular segment of the government, be that federal or state.

On your second question, yes, there was activity last year, particularly related to the military portion of our government business as the two troop deployment activities, that is what I was referencing.

If you think back to last year, there were troop deployments to both Haiti and Afghanistan.

We benefited from that within our military portion of our federal government business.

And there is just not the same degree of troop deployment activity this year.

Okay, thanks.

And in terms of the competitive landscape right now, I know you mentioned some of the capabilities you have that your smaller competitors don't, but I understand the competitive landscape out there is as tense as ever and I'm just wondering if you could help us with some of the other things that you are doing to help offset (inaudible).

Might be intense competitive pressure that might lead to gross margin pressure that you're obviously not seeing right now.

Yes, David, sure.

It is Erik again.

I go back to our usual characterization and particularly talking on the gross margin line, I believe you're right.

We are seeing intense competitive pressure.

David talked about it, the landgrab that we saw, beginning to take shape during the downturn has continued in the recovery.

It has put pressure on small distributors.

We are absolutely seeing them aggressive and it is what we characterize as one of the biggest headwinds with respect to gross margin.

It's a discount pressure.

The flipside is we are seeing a number of tailwinds that are net net pushing our gross margins up.

So certainly we have highlighted a couple, being price realization and we have talked about for a while, should inflation pan out, that would be a good thing for gross margins.

You are seeing that happen.

That is certainly one factor.

The second factor I would point to is our customer mix, as we have talked about historically.

The core being our highest gross margin segment.

That is helping us.

And the third one I would point to is our strategic programs and of those, private brand -- private brand coupled with global sourcing being a big contributor, along with our discount management (inaudible), trying to get smarter with our discount practices being the primary drivers of the strategic programs.

Okay, thanks.

Last question, were there 65 selling days in the third quarter and 63 in the fourth, is that right?

Yes, checking that now, Dave.

Yes, that's right.

We are looking right now.

That is correct.

Thanks very much, guys.

Hamzah Mazari, Credit Suisse.

Good morning, thank you.

The first question just on incremental margins going forward, you have talked about 33% this quarter and you talk about ramping up some of your sales associates.

How should we think about, given all the moving parts, where incremental margins go as we look out?

It is Erik.

I think you characterized it well with several moving parts and typically when we describe readthrough, we say there is a few variables that really drive the readthrough results.

And the three I would highlight, number one is revenue trajectory and related to that obviously being the economy.

Two is cost inflation, which ties directly to gross margin performance.

And three is the level of investment that we signed up for for the year.

What you saw and what we talked about is you are seeing when those three factors work together in our favor what is possible in our model and the proof is in the pudding with the 2011 results.

If you take the midpoint of our guidance and project it out, it would produce a readthrough for the year of roughly 32%.

So we are really pleased with that.

In terms of what to expect for FY '12, once again, it is going to be a function of those three variables.

We will comment more on our perspective on '12 on the next quarter.

All right, fair enough.

And second question, you have talked about getting into other productlines and end markets.

I am just curious if you could comment on the timing of that.

Is that something you are ready to do right now or is that something where you are going to concentrate on core acquisitions in metalworking first and then sort of whatever you get on the side or is this an initiative that you are ready to go full speed ahead at this moment?

It's David.

I want to be cautious about how much I share relative to our strategic plan and specifically about timing.

We have talked about, in a broad sense, where we will be heading as part of that plan over the coming year.

We have always got a lot of things in the MSC laboratory.

Where we are focused currently on our metalworking and our core initiatives, you have seen us constantly developing new kind of technology and adding to our value suite.

We also have lots of planning going on for next end-market verticals, productlines that we might both enhance, as well as extend into even beyond where we currently are today.

So in terms of -- so within our current sphere of activity right now, we are working on a lot of things and in terms of the next one or specifically where we would go in two months, three months, nine months or two years, I would rather not share that.

But as you know, we have got not only a strategic planning process that extends out five years, we also have an operating plan that gives us a very clear focused set of initiatives that we attack in a one-year period.

We are actually in that cycle right now.

It is a continuous cycle of closing out '11 and finalizing our plans for '12.

All right, that is great.

Thank you.

Scott Graham, Jefferies.

Hey, good morning, nice quarter.

The things that Erik went through on the gross margin build, operating leverage, price and rebates, is that also, Erik, in rank order?

Gross margin build -- Scott, no, I would say what I described is the fact that they are not in rank order, no, and we wouldn't rank them.

Obviously, we do internally, but not something we would share publicly.

Okay.

Was pricing better this quarter than it was last quarter or did the competitive pressures tamp that down a little bit?

With respect to pricing, the one thing I would say is we didn't -- we had our Big Book increase back in September.

We had the one midyear adjustment.

To date, we have not had any additional midyear adjustments and our realization has remained strong on pricing.

Competitive pressures do remain a headwind.

They were a significant headwind last quarter and they remain one this quarter.

Right.

But with pricing now reaching more of distribution, I assume that the realizations this quarter are a little higher than last quarter just based on the math.

No?

Scott, you know what?

There are so many moving parts in gross margin that I don't think -- you can't attribute the lift in margin to any one of those.

We have got several factors.

So I wouldn't say that.

I would characterize the realization on the price realization as strong in both quarters.

Fair enough.

Two other questions.

Why would government sales improve next quarter?

You mean what we have described -- what we forecasted for average daily sales?

That's right.

Typically, when we look over the course of a year, there is somewhat of a seasonality to the government business.

And seasonality would dictate that we would expect average -- on an average daily sales basis sales to be higher.

So that is right.

There is a seasonal pattern to the government is what I am saying.

Got it.

Last question is, on the manufacturing side, could you talk about the three, four, five specific end markets or product categories, however you want to answer it, that were the strongest?

Sure, Scott, and I will answer it a little more broadly than the three, four, five specifics.

What we pointed to in the prepared comments and what I would say in general, we are seeing strength in durable manufacturing.

So that is how I'd characterize it.

I am not going to get too detailed on within durable what pockets are stronger than others.

But, in general, we see strength in durables.

All right, well then if I can ask this question then.

Was the strength in product sales additive or did it detract from mix?

One more time.

When you say mix, do you mean from gross margin?

Sales mix impact on the margin, yes.

Yes, Scott, I would say, in general, not just this quarter, but during the course of the recovery, as the core goes, so goes our metalworking product sales.

So our growth -- our strong growth in metalworking product sales certainly would be a contributor to gross margin, yes.

Got it.

Thanks a lot.

Ryan Merkel, William Blair.

Thanks, good morning, everyone.

So the first question is on the plant shutdowns.

It sounds like you are expecting that this year.

Are you hearing or seeing anything that suggested that will happen or could that be a source of upside?

Yes, what we characterized in Jeff's remarks and my remarks is what we are hearing.

It's a reflection of what we are hearing from our customers.

And the way I would describe it is a return to a more typical pattern.

So if we go back over the last couple of -- we had two atypical years.

'09 summer shutdowns were certainly more extensive than we had seen in recent memory.

In 2010, there were virtually no summer shutdowns or I'd call very limited.

This year we would see it more as a return to a normal pattern.

Okay, that makes sense.

And then my other question was on active accounts.

It looks like it is starting to climb again.

Is that a function of core customers returning or is there something else going on?

Yes, Ryan, it is pretty much the same story.

You're looking to our bill to customer account.

It is pretty much the same story there, which is the combination of, on the one hand, we are continuing our pattern of attriting accounts that we don't think have potential to be good profitable customers.

The tailwind there is a combination of a couple of things, primarily economy.

The other factor I would point to is we did get a slight benefit from Rutland this quarter as we have described as Rutland customers started placing orders on the MSC system.

That is when we picked them up in our bill to account and you are seeing a bit of that, but not a dramatic change in the customer account story.

Great.

Thank you very much.

Brent Rakers, Morgan Keegan.

Good morning.

A couple questions.

I think, first, you referred a lot to supply chain issues with some of maybe the Japanese customers, maybe some derivatives of those.

Any sense within maybe categories, certain metalworking steel auto categories, if there was any detrimental impact to your revenues in Q3 from that?

Brent, it's Erik.

Yes, I mean we mentioned it because we did certainly hear and we are hearing in customer sentiment that the Japan supply chain issues are a factor.

Don't yet know how prolonged that is going to be, but certainly it is a factor and what I would point to is any customer that has certainly exposure to auto would be more affected than others, but we are hearing it.

Have you taken any pen to paper and tried to estimate what that dollar number might have been in the third quarter?

The one thing I will say is we included it, so it is baked into our fourth-quarter guidance.

Okay, great.

Tough to pinpoint those specifically for Q3 what impact it had.

Okay.

And then just to clarify from I think several earlier questions on the government business, you said sequentially up, but presumably that means significantly down year-over-year.

Would that be correct?

That is exactly right.

Oh, double-digit declines?

Not going to comment.

Given that we don't break government out, I am not going to go there, Brent, on giving you more color, but fair to say that it's significantly down in Q4 from prior year.

And Erik, I guess the last thing before I leave this topic, that is a function of the comp more than anything here.

So as you get into Q1, the troop deployment business that boosted last year's fourth quarter did not necessarily boost Q1 2011, correct?

That's correct.

Okay, great.

And then just last question, just to kind of -- I hate to harp more on this gross margin issue -- but there is kind of this new normal in terms of sequential pattern in what was the normal gross margins.

I mean it used to be, '04 to '08, the Q3 to Q4 gross margins were largely flat.

Now you have had some pattern disruptions here in the last couple years that is leading to the guidance again here.

Maybe you can compare what has changed from the last cyclical upturn to now where you are seeing this sharp change in gross margin.

What do you view now as the normal Q3 to Q4 and then Q4 to Q1?

What I would say there, because we actually did a similar exercise to what you did, of course, which is look back over time.

What you are seeing now -- so it would now be, given the guidance for this fourth quarter plus the past two years, that's three years of history of a seasonal Q4 drop, that is reflective of what we see in the business.

As we went back in time, each year, there was sort of a way of explaining what happened.

So one year, it was J&L.

There are some other factors on pricing actions that were taken at the time, but what you're seeing now is reflective of the true seasonal pattern in our business.

Okay, and then just to clarify, on the Q4 to Q1 patterns for normalcy, if I looked back the last two or three years and looked at that, that is how you are trying to interpret what the new normal is, correct?

Correct.

Okay, great.

Thank you very much.

(Operator Instructions).

Holden Lewis, BB&T Capital Markets.

Good morning.

Thank you.

To continue to harp on the gross margin question, I guess could you explain a little bit about how the rebates work because my understanding about rebates is the more you buy the better the rebate you typically get and you try to sort of make an accommodation for those at the beginning of the year and then you'll sort of true them up or true them down as the year goes on based on your actual purchases.

I guess I just would have thought that given the strength you have seen in your end markets as the year has gone on that we wouldn't see a pattern where you had strong rebate contribution in Q3 and then weaker rebate contribution in Q4.

So can you comment a little bit about that and then is this sort of a true-up activity or what am I missing there?

Holden, this is Jeff.

Let me try and explain it.

It is a bit complicated, but here is how it works.

Even though we report on a different fiscal year basis, we earn our rebates on our calendar year purchases.

And the rebates are generally based on growth over the previous year.

So the accounting rules though require us to record the rebates in the P&L when the inventory is sold, not when it is actually purchased.

So in calendar year 2010, we grew our purchases significantly over 2009 and we maximized the rebates in that year of purchases and these rebates have been realized with our sales in fiscal year '11 through May.

After May and in our fiscal Q4, we begin realizing rebates for our estimated calendar year 2011 purchases and these rebates are expected to be a bit lower or more normalized because the growth in purchases in 2011 over 2010 is not expected to be as high as the growth in purchases of 2010 over 2009.

Does that help?

Yes, but then it kind of seems like, if you are seeing a 90-point sort of [nick] to your gross margins, I mean you are basically being punished even though you're going to be ultimately buying more volumes of stuff.

I mean it just seems kind of -- I guess it seems a bit counterintuitive that you would be buying more stuff in terms of the absolute volume and yet your gross margin is going to get beat up just because the rate of growth moderates a little bit.

Yes, and the rebates work on growth over the previous year.

By the way, the 90 basis point decline that we are seeing in Q4 based on our guidance, the bulk of that is not associated with the rebate, let me be clear on that.

The bulk of that is associated with the seasonality factor and to a much smaller extent the rebate factor.

Okay, but -- so the rebates then, whatever that rebate piece is, 20, 30 bps, whatever, that represents kind of a hole that persists and then you are saying that you are going to get that back through pricing in the Big Book as you get into Q1 or the blue book.

Well, that will certainly be an offset and that's part of our normal seasonal pattern from Q4 to Q1, yes, correct.

Okay.

I was also curious, back to the question of active clients, it sounds like basically active clients is kind of stable if you adjust for all the pieces, but it has really been declining for some period of time and to the extent that that is culling, it should benefit the gross margin.

Now that you see those active clients kind of stabilizing at these levels, would you expect that that would sort of take away a gross margin tailwind now that you are not culling as many of the lower margin accounts?

It's Erik.

I wouldn't draw that correlation and the biggest reason I wouldn't draw the correlation is the culling is of customers with very low sales dollars and very low potential.

So in terms of impact to total, it is not a big impact.

Okay.

And then just lastly a quick little item, are you able to give a sense -- I know you talked a little bit about how much revenue you acquired from Rutland.

Are you able to sort of give us what the incremental revenue was in the quarter?

No, we don't break out -- Holden, what we have done is we are going to bake it into our numbers now and going forward and not break it out separately.

All right, thank you.

It appears that we have no further questions at this time.

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

Okay, well, thank you all for joining us today.

We appreciate your time and attention and we look forward to speaking to you again next quarter.

Thank you.

Gentlemen, we thank you also for your time.

The conference is now concluded.

We thank you all for attending today's presentation.

At this time, you may disconnect your lines.

Thank you.