MSC Industrial Direct Co Inc (MSM) 2012 Q2 法說會逐字稿

Good morning, and welcome to the MSC Industrial Direct second quarter 2012 conference call.

All participants will be in listen-only mode.

(Operator Instructions)

Please note this event is being recorded.

I would now like to turn the conference over to Alexandra Tramont.

Please go ahead.

Thank you, and good morning, everyone.

Welcome to the MSC Industrial Direct fiscal 2012 second quarter conference call.

An online archive of this broadcast will be available 1 hour after the conclusion of the call, and available for 1 month 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 contains forward-looking statements within the meaning of the US securities laws, including guidance about expected future results, statements regarding expected future revenue growth, and operating margin and earnings growth, 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 actual results to differ materially from those anticipated by these statements.

Information about these risks is noted in the earnings press release and the risk factors in the MD&A sections of the Company's latest annual report on Form 10-K filed with the SEC, as well as in the Company's other filings with the SEC.

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 Chief Executive Officer, David Sandler.

David, please go ahead.

Thanks, Alex, and good morning everyone.

Thanks for joining us today.

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

I'll be providing some perspective on our performance and results for Q2, as well as guidance for Q3.

Erik will continue to build upon our last call by describing our growth strategy in more detail.

He will provide color on our vending program progress, and will review the customer landscape.

Jeff will provide details on Q2 financial performance and Q3 guidance.

Let me start by saying that I'm thrilled with the progress we're making with our growth initiatives and the exciting outlook for the future.

With each passing quarter, it becomes increasingly clear to us that the industry consolidation that we foresaw coming almost four years ago is entering the next phase.

Customers are demanding greater levels of supply chain solutions, as they recognize that need in order for their business to flourish in today's fiercely competitive environment.

There is no doubt that the industrial marketplace is rewarding the narrowing field of distributors who are capable of consolidating customer spend across multiple plant locations, and who can provide the technology and technical expertise required to improve productivity, and reduce their total supply chain costs.

During the economic turmoil of '08, we outlined our plan to heavily invest, to take disproportionate market share, and that by capitalizing on the land grab opportunity, we would outperform the market by a significant margin.

That is exactly what is being seen in our results.

We will continue to position MSC to win, and to win big, in this highly fragmented market.

As Erik will describe in more detail, the drivers of our success will continue to be our organic growth programs in conjunction with the type of acquisitions you've seen from us over the past year or so.

We believe that is the most effective way to capitalize on the enormous opportunity at this unique point in time.

Consequently, we placed a priority on locking in share gains and penetration of customers, and while that has created some near-term gross margin headwinds, over the longer term, we expect these headwinds to abate as these initiatives' early successes become more mature.

The time is opportune for us to continue building on our strong momentum with these initiatives, as we increase our lead in metal working, and grow our business in adjacent product categories.

At this point, I'd like to provide some guidance for Q3.

Currently, we expect revenues to be between $610 million and $622 million, and fully diluted earnings per share to be between $1.08 and $1.12.

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

Thanks, David.

We're very pleased with the execution of our growth plan.

On the last earnings call, I outlined our longer-term strategy, starting with the big picture, our vision to be a $10 billion Company.

Today, I'll provide the next level of granularity to our growth story.

We view it as a journey, and there are several benchmarks or milestones that we surpass to reach our ultimate goal.

Today, I'll provide more information about the next milestone.

Our plan is to double the size of our business over the next 5 years, reaching approximately $4 billion in sales in fiscal 2016.

That implies a compound annual growth rate of approximately 15%.

It compares to historical CAGR during our life as a public Company of roughly 14%, and it also compares very favorably with industry growth that's roughly the rate of GDP over extended periods of time.

As David mentioned, we plan to disproportionately benefit from the continued trend towards industry consolidation.

Much of our historic growth has been organic, with acquisitions being a lesser, but important, part of the mix.

Roughly 12% of our 14% CAGR came organically.

Looking to our more recent past, the picture is very much the same.

Out of our 20% growth in fiscal year 2011, 18% came organically, and 2% through acquisition.

And looking most recently at Q2 of this year, about 3.5% of our 16.5% growth came through our recent acquisitions, and the balance was organic.

Over the next 5 years, we anticipate that once again the majority of our growth will come organically.

Acquisitions will be an important supplement, providing incremental growth in metal working, related product adjacencies, and potentially new geographies and end markets.

Our growth strategy starts with continuing to penetrate our core business, and that's the sale of metal working products into manufacturing customers.

At roughly 10% market share in a roughly $12 billion market, we see tremendous opportunity to exploit our leadership position further, and to continue growing.

We'll do this by executing on our organic initiatives.

Technology solutions such as vending, product expansion, including private brand buildout, eCommerce, technical sales force buildout, and more; and then supplementing these with fold-in acquisitions similar to the ones we've done recently.

At the same time, we'll increase our focus on another component to our growth plan.

As I described on the last call, the highest-percentage, lowest-risk adjacency move that we can make is further penetrating our MRO product lines into our existing manufacturing customers.

These are customers who already know and trust us, and these are product lines that are purchased by the same buyers who buy from us today, that we already carry in our catalog and that we already have success with.

Safety fasteners, hand and power tools, and material handling are all examples of product lines that we've had great success selling and will get our disproportionate focus in the years to come.

We'll take the repeatable formula that we've developed in metal working, including the organic and M&A initiatives I just described, and then apply it to these product lines.

We've mentioned our vending program a few times, so I'd like to highlight this initiative, as it's contributing significantly to our high growth rates.

Our vending program is unique in the marketplace.

We combine a customized supply chain technology with deep technical expertise on the production floor and our industry leading product and service offering.

As a result, we're able to improve our customers' cash flow by better managing inventory, reducing waste and shrinkage, and by taking out hard costs on the plant floor.

The program is exploding, as our rate of implementations is growing rapidly.

Our vending program is currently adding roughly 4 points to our growth rate based on current customer volumes, and we see it as a continued growth tailwind well into the future.

As David mentioned, and you'll hear more from Jeff in just a minute, it's also serving as a modest gross margin headwind.

The reason is that the vending program brings us deeper into our customers' operations.

We're capturing more technically oriented, production business that comes in larger volumes, but lower gross margins.

Doing so locks us into our key accounts by tackling our customers' most important issues on the plant floor.

This affords us the opportunity to capture even more spot-buy, or unplanned business at higher gross margins, as we further penetrate with our broad Big Book and web offerings.

Over time, we would expect the gross margin headwind to abate, as pull-through business in conjunction with private brand, and other gross margin improvement programs gain traction.

I'll now turn to our quarter, and I'll begin with the current environment.

We're seeing solid momentum across the manufacturing sector.

While there's some concern about the potential impact of rising fuel costs and the European economy, plus the overhang of an election year, we nonetheless consistently see optimism in our core customer base.

It's coming from solid demand and order backlogs, and it's translating into some hiring and investment in capital projects.

The ISM trend has, for the most part, supported what we're seeing.

We believe we are now firmly in a moderate growth environment.

That environment, along with continued strong execution of our service model and our growth initiatives, is translating into very strong growth.

Q2 revenues came in at 16.5% growth, driven by continued strength in manufacturing, which grew at 19.4%.

Growth in the non-manufacturing segment was approximately 9.2%, impacted by softness in government, as we expected, due to the tight spending environment across both federal and state entities.

Q2 government average daily sales was about as expected, down from Q1, and slightly down relative to prior year.

Looking ahead to Q3, we see more evidence of a solid economy and accelerating share gains.

The midpoint of our guidance implies nearly 16% growth, inclusive of an estimated 4% from our two ATS acquisitions.

Our forecast assumes continued strength in manufacturing, and a slight pick up in government revenues, as we reach easier comps, and our average daily sales pick up in the back half of the year.

As a point of reference, year-to-date government business represents approximately 9% of our overall sales.

We continue to make progress with our M&A initiative.

During our second quarter, we closed on ATS Industrial Supply, a top distributor in the Rocky Mountain region.

No, we didn't make a typo, and yes, you heard us correctly.

This was our second acquisition of an ATS over the past year, and the names are purely coincidental.

American Tool, the first of the two, and the New England based distributor, was integrated into our systems at the end of our first quarter, and is proceeding according to plan.

We're proud of our entire New England team, who put so much effort into making the integration a success.

ATS, the Rocky Mountain distributor, is now part of the MSC family, and we're thrilled to have them.

They've been an excellent competitor for many years, and it's great to now have them on our side.

We're currently developing our integration plan, and we'll execute it in the months to come.

ATS is already slightly accretive on an operating basis, but as previously reported, will be dilutive by roughly $0.01 to $0.02 for the year, due to one-time integration and deal expenses.

As I mentioned on the last call, our current success and our aggressive growth plan requires us to eventually add a new customer fulfillment center, and that's in order to support our world class service model while we grow at high rates.

We're in the forecasting and planning stages now, and we'll report on our plan once it's fully developed.

As you know, program development of this type is a core competency for MSC.

Finally, we continue to invest in our industry-leading sales force.

Q2 came in at 1,081 associates, and we anticipate that at the end of Q3, we'll be at approximately 1,090 associates.

Thank you, and I'll turn things over to Jeff.

Thanks, Erik.

Our second quarter marked the continuation of solid financial performance for the Company.

Sales grew 16.5%, and earnings per share grew 22% over the same period last year.

I'm sure you can tell that we're very pleased with our sales results for the quarter.

Our sales came in above the top end of our guidance range.

A small amount of the growth, about 50 basis points, came from our Q2 acquisition of ATS Industrial Supply.

The real driver, though, is the success of our investment programs in this land grab environment.

Of the 16.5% quarterly sales growth year over year, nearly 4 points came from the success of our vending program, and about 3.5 points came from our recent acquisitions.

The remaining points came from volume and pricing.

Let me clarify that the 4 points of growth related to our vending program is measured by the total revenue growth in accounts with vending.

It is an important component of our investment strategy.

It's expected to continue to fuel growth in the future.

Now let me walk you through the puts and takes of gross margin in the quarter.

Our gross margin of 46.1% is down approximately 70 basis points in Q2 versus the same period in the prior year.

There are a series of headwinds and tailwinds affecting gross margin, but the 70 basis point decline from last year is due to approximately 50 points of dilution from the two ATS acquisitions, and about 20 points of dilution related to the vending program gross margin.

As you know, the acquisitions will both be accretive to EPS quickly, and both will see gross margin rise over time, as they have with other acquisitions in the past.

And in regard to vending, this program is fueling accelerated top line growth, although there is some gross margin dilution.

We expect these gross margins to expand over time, as customer relationships mature.

I should mention that purchase cost catch up remains a headwind to gross margin, but is being offset by pricing and other gross margin initiatives, such as private brand.

Our operating margin was 17.1% in Q2.

This included approximately 30 basis points of dilution from the recent ATS acquisition and the expenses incurred for a potential M&A transaction that was not completed.

Both of these were not in our original guidance for the quarter.

I'd also like to point out that our incremental margin in Q2 was 20%, including about 235 basis points in dilution from the recent ATS acquisition and the expenses incurred for M&A.

The tax provision for Q2 came in at 37.8%, slightly lower than expectations, as a result of a favorable state audit settlement.

Our EPS was $0.95 for the quarter, and this came in above the midpoint of our guidance range.

The primary factor contributing to this higher end EPS was our higher sales.

I should note that if you were to exclude the impact of the Q2 acquisition and the expenses related to the acquisition opportunity that was not completed, our EPS would have come in at about $0.96, which was the top end of our guidance range.

Q2 balance sheet metrics were good.

DSOs were 44 days, improving from 46 days in Q1.

Inventory turns were 3.40, down very slightly from Q1 levels.

Inventories increased about 5% from fiscal Q1 levels, some of which came from the ATS acquisition.

But we have also been increasing inventories, as we continue to take advantage of our liquidity and financial strength to ensure our ability to meet customer demand.

We also have been taking advantage of select rebate and opportunity buys that produce strong ROIs.

Turning now to cash flow.

Cash flow conversion, historically, is weaker in Q2, due to the fact that we make two tax payments in the quarter.

In addition, as I just mentioned, we have invested in inventory.

We converted 46% of our net income into cash flow from operations in Q2, due to the tax payments and the inventory investments.

We ended the quarter with approximately $109 million in cash and cash equivalents.

Just as we've seen historically, we expect improved conversion for the balance of fiscal 2012.

Over the last couple of years, we've seen total year cash conversion well over 90%.

This year, I would expect conversion to remain strong, but a bit below those levels, due to the inventory strategy that we've been utilizing.

Our current cash position now is approximately $140 million.

In regard to capital expenditures, as we continue to grow, we will continue to invest in our very successful vending program.

This, and IT investments, are driving higher CapEx.

Through the first half, our CapEx was $17.3 million.

It's expected to accelerate even further in the second half, primarily driven by the investments in the vending program.

Turning to our guidance for Q3.

Our anticipated sales growth at the midpoint is approximately 16%, reflecting outstanding growth on top of an 18% growth quarter a year ago.

It's being fueled by the success of our investments, including our vending program.

We expect gross margins for Q3 to be in the range of 45.8%, plus or minus 20 basis points.

This takes into consideration all the factors, including the dilution from recent acquisitions, as well as sales and product mix, purchase cost catch up, and the impact from vending program growth.

This is about a 150 basis point drop from the previous year.

The estimated affect of the acquisitions and vending together account for about two-thirds of that.

In addition, Q3 of last year was our peak in terms of gross margin, and was also aided by a high level of rebates, making for tough comps.

Vending and M&A are temporarily impacting gross margin, but are very good for the business, and should continue to fuel strong results.

The purchase cost catch up is timing related, and our gross margin programs like private brand have a lot of runway.

All this continues to make us optimistic for the future.

In Q3, OpEx is projected to be 27.7% of sales, down 110 basis points from Q3 of last year.

On an absolute basis, we expect operating expenses will increase at the midpoint of guidance by approximately $8 million, reflecting higher volume-related costs, and a full quarter of the recent acquisition.

I'd like to spend a moment on incremental margin, or read-through, as we call it.

The big variables that influence read-through are sales growth trajectory, gross margin trends, and operating expense leverage.

The midpoint of our guidance for Q3 implies a 15% read-through.

Sales are growing strongly, and we're getting very good leverage on our OpEx spending, even though we're investing heavily in growth.

The lower read-through is being completely driven by the decline in gross margin.

While we would expect to see our typical seasonal gross margin declines in the back half of FY '12, the gross margin pressure should moderate as we get into FY '13, with the September Big Book price increase and easier comps.

The final data point I'd like to provide on guidance is that we expect the Q3 tax rate to be about 36.9%, based upon an anticipated total year effective tax rate of 37.4%.

So it's exciting times for our Company.

We're very pleased with our results, and where we're headed for the second half of fiscal 2012.

Thanks, and now I'll turn it back to David for wrap up.

Thanks, Jeff.

Our investments are clearly paying off, as we take share and outgrow the market by a significant margin.

There is growing optimism in our customer base, and we are well positioned to benefit from industry consolidation.

At the same time, we have never been more excited about our outlook than we are now.

I'd like to thank our associates whose hard work, enthusiasm, and boundless energy make these outstanding results possible.

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

(Operator Instructions)

Our first question comes from Hamzah Mazari at Credit Suisse.

Great, thank you.

This is Chris Parkinson on behalf of Hamzah.

You touched on this a little.

Can you just add some further details on how to think about the incremental margins in the next two quarters, particularly kind of parsing out the acquisition effect, and then also, how you expect these to go, relative to your normal levels, as you approach, you mentioned fiscal year '13?

Sure, Chris.

This is Jeff.

Let me step back for a moment.

Read-through, as you know, is a function of the three key variables, and that's the revenue trajectory, the operating expense management, and gross margin.

For this quarter and the foreseeable future, we'll be very successful in terms of revenue growth, to a great extent driven by the success of investment programs like the vending.

We're also doing very well in expense management, as you heard with some of the numbers there, investing at high levels, while achieving productivity, and our OpEx as a percent of sales is declining, and that's very good news.

The only near-term headwind to read-through is the gross margin, and this is something that we expect to abate over time.

As I mentioned, the gross margin is impacted by the acquisition dilution and the vending program margins.

I mentioned that two-thirds of the drop in Q3 year over year is related to that, but I should point out that both these initiatives are delivering solid growth, and it's profitable business, as it is today, very, very strong business.

The impact to the gross margin will abate over a longer period of time, as the customer, the vending customer relationships mature, as the acquisitions mature, and we've shown in the past that, that will improve.

I should also mention, though, that the gross margins have been impacted by the purchase cost catch up, which is part of the normal inflationary cycle.

But countering that, we also have a lot of runway on the gross margin initiatives that we've got underway, such as private brand and global sourcing, and this, also, will mitigate gross margin pressure as they grow.

So putting it all together, shorter term, I expect some pressure to the gross margin, and for it to be consistent with the seasonal patterns of the lower margin in Q4, and then tick up following the big book price increase.

Longer term, as the acquisitions and the vending relationships mature, and as we move through the inflationary cycle, and we have success in our gross margin initiatives like private brand, I expect to see the gross margin pressure abate over time.

But again, in the short-term, even though there is some gross margin pressure associated with the acquisitions and the vending, it's solid profitable business, and it's driving growth.

And as far as the read-throughs go, with the revenue rising, effective OpEx management, and then as the gross margin pressure mitigates, we would expect to see strong read-throughs, and long term, nothing's really changed in terms of our plans to incrementally expand operating margin over time.

That's great color, thank you.

And just a quick follow-up.

Can you just kind of briefly update us on your thoughts on the acquisition front, and how you're viewing your core metal working competency, versus broadening out into complimentary businesses?

Yes, Chris, it's Erik.

Excuse me here, struggling with a little cold.

The rest of us in the Northeast are.

So Jeff gave you, I think, a good perspective on how we view incremental margins.

I just want to touch on one thing, and I know you asked about M&A, but it really ties into the overall growth story here, and hopefully you heard that come through loud and clear in the prepared remarks.

We really see ourselves at a unique point in time, and as much as we're pleased with the current growth rates that we're seeing, and certainly M&A is one of the growth initiatives, you also heard us feature vending as another one.

We really think we're in the very early stages here of the growth story, and the reason is, David talked about the industry consolidation that we see just starting to heat up.

This is something that, quite frankly, he called four years ago and used the term land grab, and it's really playing out just as we thought.

We see it as a unique point in time, because there's a couple inflection points that we see occurring right now in the market.

One is technology, and we touched on it today with vending, we've touched on it before with our e-com initiative, but it's really raising the bar as a distributor on the level of investment that's required, and quite frankly, not just investment, but the innovation that's needed to really gain a leadership position.

The other inflection point that I want to hit on is the large accounts program, and you've heard us talk about it over the years.

But it's reaching an inflection point-type stage, because the local distributors, some of whom have been recent acquisitions and some of whom are competitors, are facing a tough time.

Historically, they're able to develop great relationships locally with a plant in a given MSA, and what's happening is, more and more of the larger businesses, purchasing is becoming, procurement is becoming more centralized, and driving greater compliance in national contracts, which is making, all of a sudden, giving us the opportunity to dislodge relationships that have been in place, and very tough to crack, quite frankly, for years and years.

So I put all of that in the backdrop, because we really do see it as a unique point in time, and what that means is we have our foot on our accelerator in our growth programs, and we highlighted two of them, vending and M&A.

There's others that we've talked about, and we highlighted them because they're producing exceptional results.

They're resulting in some near-term gross margin headwind, and that, as Jeff said, is the factor, near-term, in our incremental contribution margins.

We do expect that to abate over time, but I think most importantly, we're thrilled with growth, and we're really excited by what we see as the beginning of the story here.

Perfect, great.

Thank you, and feel better.

Thanks.

The next question comes from Ryan Merkel at William Blair.

Hi, Ryan.

Good morning everyone, how are you?

Hi, Ryan.

Thanks for all of the extra color here.

It's really great and very helpful.

Let me start with the goal to double the size of the Company by 2016.

It seems reasonable, given all of the growth drivers you talked about.

Can you just speak to how that may translate into bottom line, or talk about how much more investment is required to reach these targets, or I guess, said another way, is some of this growth pre-funded, given the high rate of investment we've seen these last couple years?

Ryan it's a great question.

So first of all, what I'll tell you is, you heard us talk about, let me talk about the top line for a second.

So on the last call, we gave kind of the really big rallying cry, we're a growth oriented Company that gets excited by a big vision, but we move in increments.

So what you heard today was a pretty aggressive goal for the next five years.

The balance of that is going to be achieved through organic growth, and we talked about the programs, and then supplemented with M&A.

In terms of bottom line, what I'd tell you is, nothing's changed in our perspective, and our position has remained, and will be that over increments of time, we would expect to incrementally expand our operating margins, which means that, over time, read-throughs would be in excess of current operating margins, and really, nothing's changed there, so we didn't provide a five year specific goal, because it's a ways out.

There's a lot of factors at play, but what I would tell you is, nothing's changed in our perspective, and that over increments of time, we would expect to expand operating margin.

Great, and then second question is on vending, clearly a nice driver on the top line.

Can you just discuss some of your competitive advantages in vending?

I saw in the press release, you used the language -- highly customized vending program.

Maybe just expand upon that a bit?

Sure, Ryan, yes.

I'll start by saying, so we did, you picked up on, and I'm glad you appreciated it.

We want to provide more color and some more tangible data for you to get your arms around on just how explosive the program has been for us.

It's building in momentum, and part of the reason that it's building in momentum is because we have a solution that's really unique in the marketplace and that's really resonating with customers, and there's 2 things I'd point to in terms of what makes it unique.

One is that it is, as we mentioned in the language, it's a highly customized solution, that the technology is very much geared towards a manufacturing production environment.

So without getting and boring you with a lot of detail, and you can certainly go on our website and take a look at the machine in a lot more detail, it really is geared for customers in a manufacturing production environment, and it's customized to that environment.

The second thing I'd talk about is it's a program, and we call it a program because it's more than just technology.

It's not just about a machine.

It's about all we bring to bear around the machine, and there's two things I'd point to.

One is our service, our world class service, that we consider to be industry leading, and that makes it unique, and the second is the technical expertise that we bring to bear.

So in addition to the machine, we're bringing in folks who are helping our customers actually take cost out on the plant floor, and that's another differentiator for us that's really resonating with customers.

Great.

Thanks for the color.

I'll jump back in line.

The next question comes from Matt Duncan at Stephens Inc.

Good morning guys.

Good morning, Matt.

First question I've got is, Erik, on the non-manufacturing customers, it looks like the growth rate accelerated a little bit there from what you've seen the two quarters before this one.

Is there anything at play there?

Is there any customer group that might explain that?

It looks like government is still down, so it's got to be something else.

Just curious what it is.

Matt you're right.

Non-manufacturing did tick up a little bit, and as you said, the numbers you're seeing there, the 9.2%, are weighed down by the slight declines in government.

No specific color to give you, other than that, obviously, we did share today, government represents 9% of the business, so the rest of the business, with that piece being slightly down, is substantially outperforming the 9.2%.

And Erik, as government starts to flatten out and maybe turn positive, can that growth rate in non-manufacturing customers catch up to what you're seeing in manufacturing, or is that going to probably stay a little bit lower, since government will probably, even if it starts to grow, might be weighing that down some still?

Well, we sure hope it will tick up, Matt.

So we gave you a little color on government, and we would be hopeful that if we continue to execute on the market, the environment cooperates, we would hope that we could accelerate it.

Okay, and then last thing I've got is on the growth plan.

You've talked a lot about adding some new product categories, and I'm curious how you think that's going to change the number of SKUs you guys are offering over time.

Do you have to make any changes to your distribution footprint to be able to handle the extra product, because it's obvious you're going to have to carry enough safety stock in all those new product lines, and with the one distribution center you're thinking about adding, is that enough to get you to that 2016 $4 billion revenue goal, or would you might need to add another one along the way?

Matt, so a couple of good questions embedded in there.

The first one regarding the growth plan, so you've got a sense for our, what are pretty ambitious growth goals, and what we said was that there's really going to be a couple of elements, which is, number one, continuing to exploit what is a pretty strong leadership position in the metal working market, and yet, with still a big growth runway, and then we're going to supplement that by adding a new leg to the plan, a new leg of growth to the plan.

But one of the things I want to make sure that came across in the prepared remarks is that the categories, and it's why we've called this such a low-risk, high-percentage adjacency move, is that these are product lines that we already carried.

So what we're talking about here, and the repeatable formula, is deeper penetration into a product line, many of the types of programs that we've described we've applied to metal working, applying it to those lines.

So we're dealing with customers who are already buying from us, and we're dealing with product lines that we already carry in the catalog.

We've had years of experience with our suppliers, and have gotten to know those businesses fairly well, so it's actually a pretty short putt in that regard.

So certainly, one of your questions was around SKU expansion.

Yes, and I did mention, that continues to be, and has been a growth driver for us.

So what you could expect to see is that we'll certainly add products across the board.

We'll put some focus on those product lines, but by large measure, the core product offering is already in place.

Okay, that's helpful.

Your other question was related to our CFC, our fifth CFC.

What I would tell you there is, first thing I want to say is, really nothing new, in that network planning has been and always is a part of our strategic planning process.

With everything we see right now, this next one certainly supports the next leg of growth, and we don't see a need to go beyond that, and if anything were to change well off into the future, of course, we would give you plenty of notice, as we're doing this one.

But from everything we've seen right now, no.

Thanks for the color guys.

The next question comes from [Luke Young] at Robert W.

Baird.

Good morning guys.

Good morning, Luke.

First question on the pricing and some of the catch ups that you cited here.

Would you just be able to give some color whether those are things that maybe caught you off guard a little bit, or is this something that is just a natural derivative of the timing of your price increases to your customers, versus when you get the price increases from your suppliers that will just naturally take care of itself with the new big book in September?

Luke, really it's the latter of the two, and what I mean by that is no, this did not catch us off guard.

In fact, if you go back over the past few quarters, we've been talking about the purchase cost catch up coming.

And this is really, if you go back over periods of inflationary time throughout the Company, this is a fairly typical pattern here, that early on, we take pricing and we realize pricing in an inflationary environment very quickly, and through a combination of good negotiating, and just the fact that it takes a while for purchase cost to work its way through our P&L, that this is a timing element that we fully expected and that we've seen in the past.

Okay, that's helpful.

And second, maybe more of a big picture question in vending for you guys, but obviously you've had -- a, thanks for sharing the information that you did today, that really helps to size up the contribution that you guys are seeing.

As we look at some of your competitors also with vending solutions out in the market, do you guys feel like multiple competitors bringing this to the market helps you, in that it raises awareness, and that you're able to go in and sell a customized solution, versus what some other competitors may be offering, and that may be seen by some as more cookie cutter if you will?

Yes, Luke.

I mean I'll start by saying, obviously you could get a feel for just how excited we are about vending.

To be honest, we are pretty, our culture is quite customer focused, so we don't pay a whole lot of attention to competitors or various vending solutions.

What we do is we go in, and we really want to understand our customers' needs.

And what gets us so excited is that the solution that we've built, which is highly customized, we think is really meeting a need, and an unmet need, and that's evidenced by the kind of growth contribution we're seeing.

Okay, thanks guys.

The next question comes from Sam Darkatsh at Raymond James.

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

Hi, Sam.

How are you doing?

Doing well.

Three questions if I might.

First off, don't want to play too big of a role in this, because I know these deals are fairly small, but it does seem as though acquisitions is an increasing focus for you guys.

So it looks like, based on your cash flow statement, you paid roughly 1 times sales for the most recent ATS acquisition, and if my memory holds, American Tool Supply and Rutland were all about 30% to 40% of sales, was the multiple that you paid.

Is that more reflective of the multiples creeping higher in the pipeline that you're looking at, or is that the different level, or quality of business of the ATS in the margin characteristics?

Can you help put a little color on that?

Yes, Sam, I think, let me start by saying, let me just go back to the top.

What we tried to get across, and want to make sure is coming across, is certainly M&A is a part of the formula, but not much has changed if you look at the breakout over any period of time you go by.

That organic is still the priority, with M&A as a very important supplement.

So the second thing I'd comment on is that the funnel, the M&A funnel is full and it's robust.

The third thing is, I wouldn't draw too much from looking at a ratio of purchase price times sales.

There's lots of factors that go into the purchase price of a business, including the quality of the business, the earnings, and so forth.

So it's really a function of, not necessarily the top line, as much as it is the bottom line.

Okay, so on an EBITDA basis, reading between the lines, you are not seeing much of a change in terms of the multiples you're looking at?

Yes, so Sam, on multiples, overall what I would say is, as the market has strengthened, we've seen a slight tick up in multiples, so it would be fair to say that, but I wouldn't say it's as dramatic as what you're describing, based on the ratios of purchase price to sales.

Understood.

Second question, Erik.

Your long term view of the 15% top line CAGR, would you be going to what your macro assumptions are for that level of growth over the next five years?

Yes, that's a good question, Sam.

And again, I'll just go back to, we did, I just want to reinforce, because you mentioned M&A again, of the 15, we see the majority being organic, and I think what we would assume, is a moderate, what we refer to as a moderate growth environment, which if you look over, and we've done a lot of analysis of when we've referenced our CAGR as a public Company, and when you smooth out, that period of time includes some real downturns, it includes some strong rebounds, and when you smooth it out, we think a moderate growth economy is a reasonable assumption.

So similar to today, in an ISM PMI type of environment?

Yes, I think that's fair.

Okay, last question, as it relates to vending.

Could you help us understand, generally speaking, what percentage of your customers today have a vending solution through you, and what the opportunity might be?

Yes, sure, Sam.

So we track internally a ton of metrics, including how many signings we have, what the total runway is.

Today we gave you what we felt were a couple of important pieces of information.

We are not going to share, for competitive purposes, we don't think it's in anyone's best interest to share a lot of details.

The punch line that I want to get across, though, is the runway is big.

So we have a nice number of signings.

It's obviously producing a great contribution to growth, but relative to the size of the runway analysis that we've done, it's still very low.

So we anticipate, the punch line is, we anticipate vending to be a growth tailwind for the quarters in the years to come.

Because 4% of your growth, of your total sales growth for the quarter, would suggest that this is not an embryonic initiative, that you already have a fair amount of vending machines in place that are creating out-sized growth.

That's why I was trying to get a sense of how material what you already have in place is.

Yes, Sam.

So the way you've characterized it, it's kind of like how we think of and talked about the overall growth story.

So we like what we've done to date.

You're right, it's beyond embryonic.

But at the same time, relative to the runway, it's still the early innings.

Okay, thank you much.

The next question comes from John Inch at Bank of America.

Thanks, good morning everyone.

Hi, John.

Good morning guys.

Jeff, I want to go back to the gross margin issue just for a second.

I heard the points, right, but you came in, still, 40 BPs below the midpoint of what was the guide, and the guide at the time would have included the original ATS, and then the latest ATS came at the end of the quarter, so what, ultimately, is going on in terms of the quarter result?

Was it, for instance larger, I think Erik, you mentioned more national accounts.

Is that what's driving some of the miss, or what?

John, first of all, as you know, we're thrilled with the growth rates that we had seen for the quarter which were above the high end of our guidance range.

Obviously, a good deal of that was delivered by higher-than-anticipated vending growth, and a smaller amount of that by the recent ATS acquisition, both of which, again, weren't assumed that at those levels, in terms of the time in which we provided the guidance.

And again, this is all a very pleasant surprise, all very good, all very profitable business that will even become more profitable over time.

Okay, so are you assuming vending kind of sustains the trajectory?

That's obviously what's -- help me a little bit.

Why was vending so strong in the quarter?

Was there a customer group initiative that all of a sudden you delivered a bunch of machines to, or is there some aspect of your manufacturing profile that's just doing that much better, which is a big vending user, or what was the, it was clearly a surprise right?

Because you had that gross margin versus your expectation, so what was it within the context of vending that was the surprise?

It sounds like a good opportunity.

I'm just trying to understand.

Yes, John.

It's Erik, and look, on the gross margin story, Jack touched on it.

The punch line is that, first of all, we have a range in there for a reason, that you can't predict it exactly on gross margin, but you're right.

It was down slightly.

A piece of that, and really it ties back to our two growth initiatives that we highlighted on the call.

One was ATS West, which was a little piece of it, and the other is vending.

And yes, you're right.

It's exceeding expectations, and the evidence of that is the Q3 sales guidance that we're providing, and vending being a big part of that.

I'll tell you, the answer to your question on why on vending, is that it's simply building momentum.

It's exploding as a program.

And it's not one customer, it's customers are really receptive to it, and we think we've got a solution here, between the technology and our technical expertise, that's really fitting a need.

Erik, were there aspects of your vertical industry exposures in manufacturing that got better?

So I'm not asking for what's your auto-exposure, but as you look at manufacturing, which is so large, could you identify any sort of subgroup, whether it's metal working or anything else, that actually seemed to get better as the quarter progressed, to help to drive kind of the top line beef that you saw?

John, to be honest, it was pretty much, the characterization I'd give you is durables, and it was pretty strong across durables.

I wouldn't go any deeper in terms of any specific pockets.

We saw general strengthen durables.

That makes sense.

One last question, Erik, I think you actually made the point that you've got your foot on the accelerator of these growth initiatives.

Clearly, there's a lot of things that are gaining traction right now from vendor, et cetera.

Government's shrinking, which has been a drag in proportion to the total.

Let me ask you, why over the next five years do you think your growth is only going to be 15%, if the past five years its been 14%?

Why couldn't it be better than that?

You still have very, very low penetration of the overall market.

Some reason it couldn't be closer to 20%?

John, that's a great question, and it's one that I ask of my internal team all the time.

And seriously, I think you're right.

It's certainly possible, and I'll tell you, look, we're an aggressive Company, and you can imagine that we're a performance-driven Company that would set internal stretch targets for ourselves beyond what we would share with you, so if we perform over the next five years, I would hope we could do better.

Good answer.

Thanks, Erik.

Appreciate it.

The next question comes from Robert Barry at UBS.

Hi guys, good morning.

Hi, Rob.

Apologies if somebody asked this already, but I wanted to see what your thoughts were about what looks like a decelerating average daily sales growth rate from February to March.

So Rob, if you look, and I think what you're referencing, just for clarification, is if you look on the West side, what we're showing is, it's really in the growth rate.

It's not in average daily sales.

It's in the growth rate for March at 14.3%.

A couple things going on.

One is that, really two things going on with March.

One is that you had, we're coming off of a prior year of very high comp, a very high average daily sales spike in March.

The second thing is, we did see in the back half of the month a little bit of softening.

Primarily, we're attributing it to the timing of vacations and schedules and so forth.

From everything we see in the environment, we're pretty confident in what we shared with you, as evidenced by the guidance that we gave for the quarter.

I mean, best I can back into it, I think the midpoint of your revenue guidance implies some modest decline in volume growth, if I kind of strip out the M&A, and assume the pricing stays about flat, but not as much as we saw it decline from February to March, so it does suggest that you're assuming that 14.3% improves in the next couple of months.

Is that a fair interpretation?

That's a very fair interpretation, if you do the math.

So Jeff shared it was 15.7% as the midpoint of guidance, so you can do the math, on the last two months, we would expect a growth rate, given the conditions we see today, we would expect growth to be in excess of 14.3%.

Rob, if you look at the same chart, look at April and May in 2011, you can see the difference, and it's really reflective of the change in the ISM trend a couple of months earlier.

So we'll have a little bit weaker comps there, but that will drive higher percentage growth from where we stand now.

And can you update us, too, on the pricing?

I think, just based on your disclosure, it looks like it added 4 points in 1Q, and 3 points in 2Q.

What's the assumption in 3Q?

So Rob, specifically on sale pricing, you mean?

I'm sorry?

You're referring to sale price increases?

Yes.

Yes, so what we shared is that, during our second quarter, around holiday time, we took a mid-cycle price adjustment.

To date, there's not been any further adjustments.

It's not baked in to any forecast assumptions, but as always, we remain opportunistic, and that's something if we see an opportunity on sale pricing, we wouldn't be bashful about it.

Certainly, the later on in the year we go, and the closer we get to the launch of our big book, the less likely we would be to do one, but it's possible but not assumed.

Okay, and then I think you said that the gross margin in the second quarter saw the pricing offset product cost catch up, or pricing and private label offset product cost catch up.

Do you think that dynamic is going to remain the same for the next couple of quarters, or become less favorable?

I think what I shared in regard to the expectations for the third quarter was that about two-thirds of the 150 basis point decline year over year would be driven by the acquisitions and the vending growth.

The remaining 50 basis points would still be negative over prior-year comps.

A piece of that is driven by the higher level of rebates from last year, which would imply that the product cost increase is also a bit of a negative drag, net-net.

Just finally on the tax rate, I wasn't clear on why -- I think you had guided to 38% last quarter, and now for next quarter it's going to be 36%.

How should we model that?

I guess we should model 36% for 3Q, but how about for 4Q and kind of go forward in our models, and what's driving that down so much?

Well, and actually, it's expiring statutes that happen to be occurring in Q3 of this year, and the same similar thing happened in Q3 of last year, as a matter of fact.

I think if you compare the tax rates for Q3 in terms of our forecasted tax rate with the prior year, it's actually slightly up.

We also provided, within my script, the total year tax rate of 37.4%, so I think you could determine the fourth quarter based on that.

And then, on a go-forward basis, for working assumption, just so we're all on the same page, is like 37.5% or 38% a good number?

Going forward in the years out, is that what you're getting at?

Yes.

Yes, okay.

I think the best thing to look at is where we've been historically over the last several years, and that's the best indication of the future.

Okay, thank you.

The next question comes from Adam Uhlman at Cleveland Research.

Hi, good morning guys.

Hi, Adam.

Thanks again for all the added disclosure.

I think it's very helpful.

Just a follow-up question on the vending initiative, it obviously sounds pretty attractive.

A lot of the discussion has been around the gross margin pressure.

I might have missed it, but can you talk about the overall margin profile that you're seeing with mature vending customers?

Are they at your average EBIT level, or better, or lower?

Yes, Adam, and I think this is really the exciting part of the story.

So what I would tell you is that we're seeing near term lower gross margins for the reason we described, but the opportunity to grow them over time, we're seeing near term very solid return on investment numbers that we generate in the form of incremental sales and incremental profits.

And the beauty of the program is the leverage that we get, because early on, so with a slightly lower gross margin, as we grow gross margin, we also see extremely high retention rates in these accounts, because we're locking ourselves in.

So what you get is this picture of incremental growth driving nice contribution margins and very high retention rates, so there's very little churn that, as we model out the future years on the return on investment, which is really what you're getting at, beyond just gross margin, we like the picture a lot.

Okay, and then as I understand it, most of the product that is going through your vending initiative now is metal working, which I thought was an above average gross margin product line for you, so is the issue that the growth that you're seeing now is from larger customers, and so that's what's pressuring the gross margin?

Adam, that's a piece of it.

The bigger piece is, what I was trying to convey on the call, was we're going in and penetrating production business at our key accounts.

So that can often times be cutting tools in metal working, but it's really the volume that's related to the production process.

Because it's higher volume and planned out, that will typically come at a lower gross margin profile, but what it does for us is we're really getting at the heart of the customer's operation.

We're locking ourselves in, and getting access, then, to the higher pull-through that's less planned, that comes typically with higher margins.

Okay, got it, and then just a clarification on your $4 billion revenue goal.

Right now, you're growing your headcount 7% to 8% year over year.

Do you think that's enough headcount growth on the sales force to support that goal, or will we see an acceleration of sales force growth?

Adam, really, I'd take you back to the comment I made earlier.

Nothing has changed in our outlook, and I think if you looked back over the life of our public life, as we talked about, the 14%, we've been able to achieve those rates with a very healthy level of sales force investment, but certainly at rates less than our revenue growth.

And again, nothing's really changed in our outlook going forward, and how that translates into investment, and hence into op margins that we would expect over time to incrementally be able to take up.

Okay, got it.

And then just a quick one, Jeff.

I don't remember the Company ever calling out a M&A opportunity that was missed, and was an expense item in the quarter, so it implies that this potential acquisition was somewhat sizeable.

I know you are not going to give any specifics, but I'm wondering if you could dimension how big of a revenue type Company that slipped through your fingers.

Was this was one of your normal ones that you've been doing of less than $50 million, or $100 million, or $500 million in revenue?

Maybe a little bit more color on that would be helpful, thanks.

Adam, it's Erik.

Obviously, we can't share any information.

We always sign non-disclosure agreements, and we can't give you any specifics there in terms of the type of company.

What I'd tell you is that this is a fairly typical process for us, that we'll take a deep look at a company, and for all different types of reasons choose not to pursue it.

The only reason we called it out this quarter was because of the materiality on the results at roughly $800,000, it moved the needle a bit on the EPS, and that's why we shared it this quarter.

Okay, great.

Thanks very much.

Our next question comes from Holden Lewis at BB&T.

Thank you.

Good afternoon.

Hi, Holden.

Wanted to ask you, so the vending initiative in particular, a lot of people tend to focus on the gross contribution, rather than sort of the net contribution, and by the same vending, it seems like in order to put these things in, there's a selling process, there's an installation process, it's really a hands-on kind of effort by your sales force.

Do you feel like getting growth out of vending comes at the expense of growth somewhere, and again going back to the earlier question about how your targeted revenue CAGR isn't all that much more than what you've done, and the weaker monthly number in March.

Do you feel like as much as you're getting stuff on the front end, you have to get some up the back end to take advantage of the resources?

Yes, so Holden, it's a great question from somebody who clearly understands vending, and our sales team would empathize with you, in terms of the up front work.

But really, what that points to, Holden, because there is an up front burst of work in effort and cost, what gets us so excited about that is thinking about the future, the leverage on this program, because there is an initial burst.

So not only is it an initial gross margin headwind but yes, you're right.

To get one in place takes time and effort.

The beauty is the growth that we see and the retention rates that we see in these accounts, it's all leverage over time.

So baked in to the results that you're seeing from us now, because we're in this land grab mode, and because the program's exploding, you're seeing some dilution from up front investment in time that, as this thing matures, we're going to get more leverage on it.

Okay, and then also right now, there's a bit of a land grab, and it's tons of runway, so obviously, you go to a lot of customers and they really haven't done this, so they're doing it anew.

What happens when you start bumping into a Grainger machine, or a Fastenal machine, or an Airgas machine?

Do you have a vision where all of these national accounts and such are just going to have rows of machines of different vendors, like they do catalogs today, or at some point, are you going to have to beat a Fastenal machine out, are they going to have to beat your machine out?

How do you see that sort of maturing?

Is this the first area where you guys are really going to hit head-to-head the hardest?

Holden, it's a good question.

What I'd tell you is, what you're talking about feels so far into the future that it's tough to envision, because the market is just so fragmented that, again, when I ride with our reps, and we talk about who we target, what accounts we're targeting and who we're running up against, it's really not the names that you mentioned.

So I mean, even in a case of a vending, it's typically not a local distributor, and we're winning, because it's not just about the machine.

It's the whole program that we bring to bear, with the product and service offering that we have, with the technical expertise that really is unmatched.

So I think the answer is vending in that regard is not that much different from what we've been talking about for years, which is there's so much runway because the market is just so fragmented.

Thank you.

Oh, and before I go, did you give the revenues from the acquisition this quarter?

I think we indicated 50 basis points was due to the most recent acquisition, and then in the previous call, we indicated the percent growth from that.

Okay, so this quarter 50 basis points of your growth was due to M&A?

Due to the most recent acquisitions.

Okay.

I think what we shared, the language from the script said, and I want to make sure we get it right, was in Q2, we gave you the last two.

We gave you ATS East and ATS West, and what I had said was, of the 16.5% growth, 3.5% came from our recent acquisitions.

Got it.

Perfect, thank you.

At this time we show no further questions.

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

Okay, well thank you for all of the energy and interest today.

We appreciate it.

We'll talk to you again on the next call.

Thank you.

This conference is now concluded.

Thank you for attending today's event.

You may now disconnect.