MSC Industrial Direct Co Inc (MSM) 2013 Q3 法說會逐字稿

Good morning, and welcome to the MSC Industrial Direct third quarter of fiscal year 2013 earnings 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 Mr. John Chironna, Vice President of Investor Relations and Treasurer.

Please go ahead, sir.

Thank you, Denise, and good morning to everyone.

I would like to welcome you to our fiscal 2013 third quarter conference call.

An online archive of this broadcast will be available one hour after the conclusion of the call, and available for one month on our home page at www.MSCdirect.com.

As many of you know, we filed our 8-K/A with the SEC this past Monday, July 8, which covers the completion of our acquisition of the Barnes Distribution North American business.

The filing includes historical financial statements for the BDNA business and pro formas to illustrate the combination with MSC on a historical basis.

Since today's call is to cover our earnings, if you have any technical questions regarding the 8-K/A filing, we would ask that you contact me after this call.

During today's call, we will refer to various financial and management data included under the section operational statistics, as well as presentation slides that accompany our comments, both of which can be found on the Investor Relations section of our website.

Let me reference our Safe Harbor statement under the Private Securities Litigation Reform Act of 1995.

Our comments on this call, as well as the supplemental information we are providing on the website contain forward-looking statements within the meaning of the US securities laws including guidance about expected future results, expectations regarding our ability to gain market share and expected benefits from our investment and strategic plans including the Barnes Distribution North American acquisition.

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 our latest quarterly report on Form 10-Q filed with the SEC, as well as in our other SEC filings.

These forward-looking statements are based on our 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.

In addition, during the course of this call, we will refer to certain adjusted financial results which are non-GAAP measures.

Please refer to the table attached to the press release, and the GAAP versus non-GAAP reconciliations in our presentation which contain the reconciliation of the adjusted financial measures to the most directly comparable GAAP measures.

I will now turn the call over to our Chief Executive Officer, Erik Gershwind.

Erik, please go ahead.

Thanks, John.

Good morning, everyone, and thanks for joining us today.

With me along with John is Jeff Kaczka, our Executive Vice President and CFO.

On this morning's call, I will discuss our current results and update you on the status of the BDNA acquisition.

I will then provide you with an updated strategic perspective on the Company's performance and our future.

Jeff will provide details regarding our financial performance for the quarter and our Q4 guidance.

And then I will wrap things up.

Our near term performance remains consistent with our expectations, and with the assessment that we have shared with you on recent calls.

We continue our share gain momentum through organic programs like vending, eCommerce, and other customer penetration initiatives.

At the same time, we continue to tightly manage the business through expense control.

That said, a combination of a weak demand environment, particularly in metalworking manufacturing, a soft pricing environment, and the timing of our significant infrastructure investments is producing a picture that has remained consistent over the past few quarters.

Basically, flat organic revenue growth, yielding a slight erosion in earnings.

I will briefly touch on each of these elements, and I will start with the demand environment.

Over the past several months, we had cited a disconnect between many macro indicators and the micro indicators that we consider when managing our business, like more specific metalworking indices, along with customer and supplier feedback.

When we all experienced ISM readings of 53 and 54, we shared with you at the time that we simply didn't see them as reflective of our business environment, particularly in the metalworking-related sectors such as primary metals, metal fabrication and machinery among others.

So we shared with you other metalworking indices that have continued contracting over the past nine months.

More recently, we have seen the macro catch up with what we have been describing.

For example, the last two months of ISM readings have averaged 50, and are more reflective of what we continue to see and hear from customers.

They have indicated that there has been no catalyst for increased demand.

And that in the meantime, while their business remains sluggish, they are tightly controlling metalworking and MRO spend.

On the supplier side, channel checks confirm the same and validate our share gains.

Regarding pricing, we have received questions from you about our decision not to implement a mid-year price increase.

Our pricing decisions are based on what we see from manufacturers and from our customers in the way of pricing behavior.

Neither of those supported a mid-year increase.

However, we will launch our catalog in August and will implement a normal-sized price increase.

Finally, regarding our investments.

We continue to forge ahead on key initiatives that are diluting our near-term margins through incremental operating expenses.

Those include infrastructure investments like Davidson, the Columbus Customer Fulfillment Center, and other growth-related investment priorities such as eCommerce, private brand, and vending.

While many of these are creating near-term pressure on margins particularly in a low growth and soft pricing environment, we are making these investments based on their significant future payback, and are confident that the strategy and timing behind them are sound.

Davidson remains on track and on budget for an August opening.

Roughly 120 or so of our Melville-based associates will be relocating in the weeks to come.

Our tight controls and ongoing training are helping to ensure a smooth transition.

Columbus also remains on track for a late 2014 opening.

With respect to our growth initiatives, our momentum continues on vending.

Signings remain strong, and Q3 growth contribution was around 3 points.

ECommerce is also moving along nicely with the roll-out of our new site, which is receiving favorable customer feedback, and that is reflected in our eCommerce growth.

Excluding BDNA as a percentage of sales, it was 43.5% for the first nine months of fiscal 2013, versus 40.5% for the same period a year ago.

I will now turn to an update on BDNA.

With it now a part of our business, we feel even better about the vision for this platform, especially after talking to customers, suppliers and associates since closing.

I am even more confident in the positive impact that BDNA will have on our growth rates and our profitability.

The rationale for the deal is squarely on point with our strategic plan.

We are adding a high margin product line adjacency to bring into MSC's manufacturing customers.

We are bringing the MSC product offering, next day delivery and web capabilities to the BDNA customers, including the transportation and natural resources sectors, among others.

We are gaining a platform into Canada that had previously been lacking from our portfolio.

And finally, we are gaining a foothold in a category with loyal and long-standing customers.

Let me now talk a bit more about how we view the economics of the deal.

When we evaluate acquisitions, we look at cash on cash returns.

In this case, by virtue of realizing more than $100 million in net present value cash tax benefits, and by executing on the cost synergies that are right in front of us, we rather quickly earn above our weighted average cost of capital.

In other words, the deal makes economic sense even without growth.

But this is ultimately a growth play for us.

The returns start getting incredibly attractive as the business grows.

We ultimately see the potential for this business to be at or even above MSC's operating margin levels.

At today's revenue rate of around $290 million annually, the business is doing around 9% in EBIT margins.

If we execute on our cost synergy range, between $15 million and $20 million, we will add between 500 and 600 basis points to EBIT margins, already bringing the business in the neighborhood of MSC levels.

And then because of the high gross margins, the incremental margins in the business are quite high, even when factoring reinvestment back into the business.

And finally, we see the opportunity to improve the current levels of BDNA sales force productivity by bringing the MSC offering to their customers, and by bringing MSC's sales management practices to the table.

Ray Rutledge and his team have gotten to know the BDNA organization quite well, and are excited by the excellent talent who make great additions to our team.

We are moving through our integration process, and have reached a few significant decisions that I would like to share.

First, regarding the distribution network, we will be folding five of the nine BDNA locations into MSC's over the next 18 months.

Customers will receive even better levels of service from our combined teams.

Three of the locations will consolidate sooner, while two will wait for our Columbus facility until it is up and running to absorb the incremental volume.

The four buildings that will remain include our three Canadian locations and the repackaging center, which brings added capabilities to our network and which we plan to leverage for improved purchasing.

Second, we have decided to close the BDNA corporate headquarters currently located in Cleveland, and merge it into our new Davidson location.

There are many in the Cleveland building who will make the move with us to Davidson, with a small number of associates remaining in a satellite Cleveland presence.

Third, we continue to work aggressively with our suppliers to improve our cost position.

Step one is rationalizing our deals across the two businesses.

And step two is working with those suppliers who see the incremental growth and share gain opportunities to invest incrementally in the combined businesses.

On this point, we have heard from a number of suppliers who view the combination of MSC and BDNA very positively.

As a result of our work to date, we have even greater confidence in the economics that we laid out previously, including the cost synergy run rate of $15 million to $20 million by FY '15.

As you can see on slide 4, we are reaffirming the other BDNA-related guidance that we had provided.

I would like to now pull back from the details, and provide you with an updated strategic perspective on the Company's performance.

We are in the midst of an important infrastructure build-out which happens to coincide with a slowdown in growth.

As you have seen, our investment spending has put pressure on our FY '13 earnings.

And I would expect some of that pressure to continue into FY '14, independent of the business environment.

As we typically do, we will provide greater detail regarding our FY '14 outlook on our next earnings call.

Looking beyond the near-term, we are building towards a picture that gets us very excited about the future.

Here is what I see.

We are laying the infrastructure to carry us through the next phase of growth.

For example, the new Columbus CFC will support our next $2 billion in growth, and we are not going to need another Davidson.

The anticipated payback from our productivity projects is significant.

That includes Davidson, which will generate cost savings over the coming years, and begins producing returns in FY '15.

It includes our vending improvement program which aims to improve productivity and service levels for our customers, and take vending program operating margins up to Company average over the next two to three years.

It also includes several other productivity initiatives that we have in the works throughout the Company.

We will benefit from the share gains that we are currently executing through vending, national accounts, sales force execution, eCommerce and more.

While today the results of those share gains are muted by soft customer activity levels, we would expect to grow disproportionately when the manufacturing economy rebounds.

And when it does rebound, we will also benefit from pricing and rebates.

Today, those two elements of our gross margin formula are headwinds, as we are in the late stages of an inflation cycle.

When we enter the next cycle, they will quickly turn to tailwinds.

We are going to also benefit from secular tailwinds of the manufacturing renaissance that we expect to follow in the years to come.

More and more, my discussions with supply chain executives at our key customers give me growing confidence that significant manufacturing growth is likely for North America over the next decade.

As the focus of supply chain moves from strictly a low-cost country sourcing mindset, to one centered on supply chain speed, flexibility and proximity to customers, the premium is high to keep a manufacturing supply base local to the North American market.

And finally, we will benefit from the consolidation story that we see building in the years to come within industrial distribution.

If all of this sounds familiar, and like a look back at our past, well, you are right.

Just the way our infrastructure build-out in the late '90s and early 2000s was followed by a decade of explosive growth and operating leverage, I see the same potential latent in the Company, as we move through our current build-out.

With that, I will turn things over to Jeff to discuss the financials in greater detail, and provide you with our Q4 guidance.

Thanks, Erik.

Good morning, everyone.

As Erik mentioned, this is our first call since we closed on the largest acquisition in Company history, and the integration is going quite well.

I will take you through the financials, both the reported and adjusted Q3 results.

Then I will go over the Q4 guidance before turning it back to Erik.

As John mentioned in the opening, we have provided slides on our website.

And given the complexity of the quarter, we hope that they will help clarify our comments.

And we look forward to your feedback on the slides, as we consider whether to continue their use in future calls.

So to start, I will go through the reported results.

Then I will share with you the adjusted results, which exclude the non-recurring relocation costs associated with our Davidson facility, as well as the non-recurring transaction and integration costs associated with the BDNA acquisition.

And that is exactly how we have been discussing the results with you in the past few quarters.

And to facilitate the comparison of our Q3 results to our Q3 guidance, we will also exclude the BDNA operating results, as we had not included them in our guidance provided last quarter.

We call these our comparable adjusted results.

You can see how we define these terms in the presentation on slide 3.

Let me start with an overview of the reported results.

Our reported sales growth on an average daily sales basis in the third quarter was 5.7%, compared to the same period last year.

This includes roughly five weeks of business for BDNA as we closed the transaction on April 22.

Additionally, our reported gross margin was 45.5%, and our reported EPS was $0.98 per share.

Our adjusted results eliminate roughly $0.06 for BDNA transaction and integration costs, and about $0.01 for Davidson relocation.

And this becomes an adjusted EPS of $1.05.

Perhaps most relevant measure when comparing to our guidance are the comparable adjusted Q3 results.

And these exclude the non-recurring Davidson and BDNA transaction and integration costs, and also exclude BDNA operating results which were not in our original guidance.

And because BDNA was $0.02 accretive, our comparable adjusted EPS was $1.03.

And the EPS walk for Q3 on slide 6 should help clarify this.

Okay, now let me drill down on the comparable adjusted Q3 results.

First, I need to mention there was one less sales day in our fiscal third quarter this year as compared to the same period last year, as the Memorial Day holiday fell into the fiscal third quarter this year.

Our sales growth on an organic and average daily sales basis came in flat.

Sales from our manufacturing customers were also flat, while sales from our non-manufacturing customers were up 1%.

Within non-manufacturing, our government sales overall in Q3 declined, showing the impact from the sequestration that started during Q2.

Our state business, however, grew significantly in the third quarter.

Nearly 3 points of organic growth came from customers within our vending program.

The offsetting decline is a direct result of the soft demand environment, particularly in the metalworking manufacturing sector that Erik mentioned earlier.

Our gross margin for Q3 was 45%.

And as you can see on slide 5, this was just above the midpoint of our guidance of 44.9%.

As compared to the same period last year, the margin was down by approximately 70 basis points, driven by 50 basis points of the dilution from our vending program, and the remainder primarily due to purchase cost increases without the benefit of a mid-year price increase.

As a reminder, while current supplier increases are few, the impact of last year's increase is still lingering due to our average costing inventory method.

Lastly, as I mentioned earlier, our comparable adjusted Q3 EPS was $1.03, which was well above our guidance of $0.95 to $0.99.

The primary reason we were able to exceed the top end of our EPS guidance was our tight management of operating expenses.

In fact, our operating expenses came in roughly $4 million better than we had guided.

And through the first three quarters of fiscal 2013, our comparable adjusted operating expenses as a percent of sales were 28.1%, versus 28.3% last year despite the lower growth environment.

Finally, the tax provision for Q3 came in at 37.1%, below what we had expected.

We did close our federal tax audits for 2009 and 2010 during the third quarter, which we had previously anticipated would come in the fourth quarter.

This resulted in approximately a $0.015 positive impact to earnings per share.

Turning to our balance sheet.

Our Q3 metrics were strong, DSOs were 46 days.

Inventory turns were 3.35, a slight improvement from Q2 levels.

And from a cash flow perspective, we converted 177% of our net income into cash flow from operations.

This compared to 101% for the same quarter last year.

The increase was the result of our successful working capital management, where particularly in view of the soft demand environment we worked hard to reduce our inventories and manage our receivables.

Now that we have debt on our balance sheet as a result of the BDNA acquisition, free cash flow is even more important as it allows us to pay down our debt and reduce our interest expense.

As you may recall, we incurred $370 million of debt, at a spread of 100 basis points over LIBOR when we closed the acquisition.

Not only did our strong free cash flow enable us to pay down our debt to $290 million by the end of the fiscal third quarter.

But as of today, we brought the revolver balance down to $0, leaving only the term loan of $250 million outstanding.

We had approximately $58 million in cash and cash equivalents at the end of Q3, and our current cash balance now stands at $50 million.

In regard to capital expenditures, our Q3 CapEx was approximately $22 million.

This included an increase in vending and approximately $8.5 million associated with the Davidson facility.

As we have mentioned on earlier calls, we expect CapEx in fiscal 2013 to be elevated due to infrastructure investments of nearly $40 million in Davidson and Columbus combined, in addition to increased investments related to our vending program.

We now believe fiscal 2013 CapEx will be in the $90 million to $100 million range, driven purely by the timing of certain capital expenditures moving into fiscal 2014.

Now let me turn to guidance for Q4.

This guidance will now include the impact from the BDNA operating results, but consistent with prior quarters exclude the non-recurring items like BDNA transaction and integration costs, as well as relocation costs associated with Davidson.

In addition, please note that our Q4 will have 4 less selling days, which becomes virtually a week given that the 4th of July holiday fell on a Thursday this year.

With all that said, we expect revenues to be between $661 million and $673 million.

On an organic basis, the expected ADS growth is flat, reflecting our assumption of a continued soft demand environment, particularly for the metalworking-related sectors.

This guidance is consistent with what we saw in June, the first month of Q4, excluding the holiday impact.

We expect gross margin for Q4 to be in the range of 45%, plus or minus 20 basis points.

The Q4 gross margin will be impacted by headwinds from the vending program, and the seasonally lower gross margin mix of products sold in the fourth quarter.

These headwinds are mostly mitigated by our strategic programs like private brand and discount management, as well as the BDNA higher gross margin products.

I would note that the BDNA gross margin includes a charge resulting from the typical inventory valuation step-up required by acquisition accounting.

The charge effectively reduces the BDNA gross margin from the high 50%s to the low 50%s through the end of the fiscal year.

The BDNA gross margin level will return to normal levels beginning in Q1 of fiscal 2014.

This, of course, temporarily suppresses operating margins in the fourth quarter.

In Q4, we expect adjusted operating expenses will increase at the midpoint of guidance by approximately $26 million versus Q3.

BDNA operating expenses account for roughly $21 million of this increase, and the remainder primarily relates to strategic investment projects.

We continue to manage tightly in this environment, but we will also continue investing in key growth initiatives.

And regarding our tax rate, we expect the fiscal Q4 tax rate to be about 37.5%.

Finally, our adjusted EPS guidance for Q4 is $0.87 to $0.91, reflecting the low growth market environment and our continued tight expense controls.

This, of course, includes BDNA operating results and excludes the transaction and integration costs associated with the BDNA acquisition, and the relocation costs associated with the Davidson facility, each approximately a $0.03 impact on EPS.

The BDNA business is expected to be roughly breakeven in Q4, and accretive thereafter.

So with flat organic ADS growth, our adjusted EPS at the midpoint of guidance is $0.89.

This is down from $1.09 last year, as you can see on slide 8. And almost all of this is due to two factors, the extra week in fiscal 2012, and the lack of a mid-year price increase.

In summary, the soft market conditions continued, but we were able to exceed our Q3 EPS guidance through effective management of expenses.

The BDNA integration is going well, and the results were slightly better than expected.

And the fourth quarter, after adjusting for the complexities, is expected to be similar to the previous couple quarters.

At this point, I will turn it back to Erik to wrap things up.

Thanks, Jeff.

While we face some near-term challenges due to the demand environment, I remain very excited about our future for three reasons.

First, we are strengthening our business through the infrastructure build-out that we have undertaken.

We are making moves now to support our next wave of growth, giving us leverage on the next $1 billion of revenue.

Second, we are investing in growth priorities such as eCommerce, private brand, sales force expansion and vending.

These are initiatives that will enhance our organic growth rates, particularly as the metalworking sector rebounds.

And third, BDNA adds a new growth platform to the road map that we have described for you.

These initiatives are energizing the Company.

History tells us that the macro demand and pricing environments will once again improve, and our growth initiatives will take hold, such that we will return to a much stronger growth trajectory.

One that not only gets us to our goal of $4 billion in sales by the end of 2016, but one that we can leverage into significant earnings growth.

I would like to thank our entire team for their continued hard work and dedication.

And I would also like to wish my best to our pioneers making the move to Davidson in the coming weeks.

I will now open up the lines for questions.

Thank you.

(Operator Instructions)

The first question will come from Ryan Merkel of William Blair.

Please go ahead.

Thanks.

Good morning, everyone.

How are you, Ryan?

Good.

I guess as John requested, I will save the 8-K technical questions for offline.

So let me just start then with the guidance.

I think you are calling for Barnes to be neutral to EPS in the fourth quarter, but I think it was $0.02 accretive in the third quarter.

So can you kind of walk us through that?

Yes.

We were pleasantly surprised that we were actually $0.02 accretive in that stub period, which included the results from April 22 on.

There is a little bit of an interesting phenomenon there which benefited us, Ryan.

And that is that, the sales at the tail end of the month in Barnes are traditionally very strong.

So we had the benefit of the higher sales week in the last week of April, without the proportionately higher expenses.

And so, that was the primary reason we were actually accretive in April.

We will have more of a normal quarter in the fourth quarter, with the exception that we have -- and this is associated with normal acquisition accounting -- a step-up in the inventory which suppresses the gross margins as I said in my prepared comment.

And that will run through our gross margin, through the end of the year.

We haven't spiked that out separately as a transaction or integration cost.

It runs through the operation.

So therefore, we expect to be roughly breakeven in Q4.

And then as we head into next year we don't have that impact, and we start realizing the benefits of the synergies.

Okay.

That makes sense.

And then I guess it was nice to see that you reiterated the accretion for next couple years on Barnes.

I guess as it relates to next year, the $0.15 to $0.20 of EPS accretion, how much of that is operational versus synergies kicking in?

Just trying to get a sense of how quickly those kick in?

Yes, Ryan, it's Erik.

I would say on the synergy front, as you heard in the prepared remarks, we feel very good about the range that we provided.

You can hear we wanted to give you, sort of the bread crumbs of how we are going to go about achieving those.

But what you could also imagine is that most of those take time to realize.

So from a synergy standpoint, most of that number will take some time before it kicks into the P&L.

Okay.

That is what I figured.

And then just last one real quick, you probably won't want to answer this question.

But you mentioned in prepared remarks, that spending on growth initiatives will continue into fiscal year '14.

Can you just give us a sense, is it stepping down?

Is it half?

Just give us a little bit of a sense there?

Because I think a lot of us were assuming that some that would start to fall off in '14, and then the margins would start to improve quite a bit.

Ryan, it's Erik.

So I know what you are grasping at there, which is kind of a framework for thinking about '14.

As I have said, we are in the middle of doing our work right now.

And we are going to come back to you with more of what we typically give you as a perspective for the year.

Let me say this.

I am going to start by stepping back to what we talked about at the start of fiscal year '13.

And we gave a framework.

And that framework basically outlined that we were entering a period of accelerated investment, and that was growth investment, and that was infrastructure investment.

And as a result of that, at any given level of revenue that you pick, incremental margins were going to be lower than historical.

So what we talked about was at the time, it was a little bit of a frothier environment, and we were looking at around 10% top line growth.

And what we said was at around10% growth, you could expect mid-teens incrementals from us.

And that it wouldn't be until what we called healthy double-digits, which to us was 12% or higher before you would see Op margin expansion.

And that then as revenue growth, if it were to step down from the 10%, incrementals would get proportionately lower until we reach a point somewhere in the low to mid single-digits, where we wouldn't be able to grow earnings due to the step-up in investments.

And then we overlaid that by saying, look, the wild card on top of all this is pricing.

So that was our outlook on '13.

And I will tell you, I think what has played out in '13 is entirely consistent with that framework.

Of course, would we have liked to have seen a stronger demand environment which would have led to higher revenue growth?

Of course.

But I think what you have seen is consistent.

What I would tell you is for now, that framework still holds.

And you are seeing it in our Q4 guidance.

And I think not much changes in our perspective.

Of course, we still -- there is a lot of work going on right now on '14, and we will be back with more detail.

Well, great.

Thank you.

That was helpful.

Appreciate it.

The next question will come from John Inch of Deutsche Bank.

Please go ahead.

Thank you.

Good morning, everyone.

Hi, John.

Hi.

Want to ask you about the fourth quarter guide in the context of the sequential.

I appreciate the walk -- and by the way, I do think these slides are very helpful, so I would continue them.

I understand your year over year walk, and lacking the week.

But if I look at sort of the third quarter to the fourth quarter, each has 64 days.

And if you -- I think Jeff, you said that BDNA was neutral to EPS.

So you are kind of going from a walk of $1.03 down to $0.89 in a flat environment.

I am not quite sure why that is actually happening, if you have got the same number of days.

And if you look historically, right, your third quarter to fourth quarter walk, it doesn't go down that much.

So what -- is there anything else going on here?

It is just not clear.

It is sort of like down 12%.

It doesn't seem to jive with the flat environment, and the cost cutting that you have been successfully invoking.

In regard to the sequential walk, I think you will normally see, John, the decline, and primarily associated with the drop in the organic gross margin in the fourth quarter due to the lower margin mix of product we generally sell in our fiscal fourth quarter.

How much is that, Jeff?

What is the magnitude of the sequential --?

Well, the magnitude over the last several years, John, has been in the range of 50 to 125 basis points.

A lot will depend on whether or not there is fourth quarter actions in pricing.

As you will recall, last year we did accelerate some of our pricing actions, so in that range of gross margin decline, yes.

Okay.

So I am assuming that is probably coming in at the high end, just to be conservative.

Is there anything else on the sequential that you would call out, other than pricing and flat environment that is maybe tweaking some of this?

I see what your tax rate is.

Is there anything else?

You see the tax rate.

And then you see also the fact that sequentially, our operating expensing as I mentioned are going up $5 million, excluding the impact of BDNA.

And those are some strategic investments that we are choosing to make that will benefit us going forward.

Okay.

And then the -- Erik, you called out the price increase that you are expecting in the catalog.

I am curious, because obviously you traditionally put through a price increase.

Are you expecting that sort of the impact of this price increase to be the same order of magnitude as a year ago, or perhaps a little bit higher or lower?

Because obviously that will have in turn kind of a run rate, in terms of the impact of pricing as you get past this quarter into kind of future quarters.

Yes, John, we will come back.

I mean, our practice -- as you know, our practice is we wait until after we release the catalog.

So our next quarter, we will give you the specifics.

Not trying to be coy, but just for competitive reasons we are going to wait until after, to give you the increase.

Yes, I used the words normal.

And basically what I mean by that is if you go back, and you have tracked us for a while.

Yes.

If you took the low end of what we have done in catalog increases and the high end of what we have done, it is going to fall somewhere in the middle.

Right.

That makes sense.

And just lastly, I think you said you have got about $20 million left of integration transaction costs for BDNA, based on the amount that you have done thus far in the $25 million to $30 million guide.

Does that all conclude in '14, and how does that, Jeff, kind of delineate over the coming quarters?

Is it relatively linear?

Yes, John, what we said was the majority of that would be complete by the end of FY '14.

But it will continue to some extent into '15.

And linear is not a bad look at it, probably a little bit more heavier weighted in the first half of the year.

The first half.

Okay, great.

Thanks very much.

Appreciate it.

You're welcome.

The next question will come from Hamzah Mazari of Credit Suisse.

Please go ahead.

Good morning.

Thank you.

I was just wondering if you could maybe comment on how investors should think about execution risk and your ability to manage that, given the weak demand environment, given the largest acquisition you have done in your history, given the investment spend as well?

Maybe just walk us through how folks should think about that?

So Hamzah, it's Erik.

I think it is an excellent question.

And I will tell you that -- and I tried to hit this in the prepared remarks.

I feel very good about the plan that we are executing on right now.

We have a bunch of heavy lifting going on, but I will tell you we have a really strong management team here.

We have a deep team, and it is a team that has a lot of experience here working together.

So many of the initiatives, certainly Davidson is something that is new for us.

We have gotten a lot of help, and it has been very hands-on and actively managed.

When you look at things like acquisition, the opening of Columbus facility, these are things that we have done before, we have a playbook on.

We have a lot of the same people, the same leadership that was here for the last ones that are overseeing the projects.

So I feel very confident.

Great.

And just a follow-up.

Post the Barnes acquisition closing, how are you thinking about sales compensation metrics?

Is that going to change at all?

And then how much of your business, do you define as true MRO business?

So let me start with -- I will start with your first question.

So sales compensation -- are you referring specifically, Hamzah, to the BDNA business?

Yes.

Okay.

So let me say this, and hopefully, you got a sense of it in my opening.

With respect to BDNA, our approach to integration, think of it in two prongs.

On the back end of the business, support functions and the back end, we are moving aggressively and we are moving swiftly as you can see by some of the decisions that we have made and how that is fueling the synergies.

On the front ends of the business, there is some differences.

We knew this going in, and we found it to be true.

There is some differences in the value proposition, some differences in the sales model, some differences in sales force compensation.

And for that reason on the front end, we are moving very methodically, in terms of how we think about integrating these businesses on the front end.

So it is a much more measured approach.

I would tell you in the meantime, while we go through taking very measured steps, we do still see opportunities to capitalize on some near-term revenue synergies.

But we are going to be methodical about it.

Great.

And then just on how much of your business is true MRO?

How would you define that?

Yes.

I mean, when you say true MRO, I mean, by some measures, all of it is MRO.

If where you are going is, what is not metalworking, what we have described as metalworking is roughly 50% of our business, so the other 50% would be MRO.

Oh, fair enough.

Thank you.

The next question will come from Matt Duncan of Stephens, Inc.

Please go ahead.

Good morning.

Good morning, Matt.

I have got a couple of quick numbers questions, and then take a step back and look at the bigger picture.

Jeff, on the gross margin going forward, can you size for us the impact of a normal price increase?

And when you get into a more normal pricing environment, remind us what that means for gross margin expansion?

And then also, BDNA returning to a normal gross margin level, sounds like it is somewhere in the order of 600 to 800 basis points that you will see moving from 4Q into 1Q.

How does that flow through?

Yes.

Let me take the second piece of that.

That is correct, Matt.

We have this normal inventory valuation adjustment which will run through our P&L associated with BDNA, and that effectively reduces the gross margins.

On an apples-to-apples basis, we would expect the gross margins for BDNA to return to the upper 50%s.

And that is how it would essentially flow through our P&L.

As Erik mentioned before, we are talking about $290 million in annual sales.

So you can break that down for the quarter, and see what the relative impact would be on our overall Company gross margins.

In regard to the second question there, Erik please?

Yes, Matt, on the price increase, so what I would say is we are going to hold off from giving you any numbers, only because obviously the impact is going to be a function of the size of the increase.

And we are going to share that next quarter.

What I would tell you is that we would expect realization on the price increase to be strong.

It has been strong in recent years.

That has been an area of focus for us, in some programs we have put in place to improve it.

So we would expect to it be typical realization, with what you have seen over the past few years.

But of course, on an absolute level, it is going to be a function of the size of the increase.

Okay.

So then taking that a step further, obviously you ought to have a pretty nice sequential gross margin improvement from 4Q to 1Q.

Because Barnes is over 10% of the revenue flowing through, probably going to help you 70 to maybe 90 basis points, plus you get the benefit of the price increase.

So is it unreasonable to expect a pretty good jump then, from 4Q to 1Q?

Not unreasonable at all.

That's right, Matt.

Okay.

And then the last numbers question before I move on.

On SG&A costs, you have obviously done a very good job controlling the operating expenses.

Jeff, you commented that there is an assumption of $5 million of gross spending sequentially.

Could we also expect there might be some offset to that though, from cost control actions that obviously did help in the third quarter?

Yes, those costs control actions have helped each quarter this year.

We will keep those in place, Matt, but the net impact of the two is the $5 million.

Okay.

And then last thing from me, just bigger picture, maybe Erik if you could share thoughts sort of what you are seeing in the trenches, do you have any reason to be more pessimistic or optimistic at this point on the outlook for the general macro?

Obviously, you have been in a pretty flat environment for a while now.

Sort of what are do you see unfolding there over the coming year?

Matt, I think the message that I would share with you right now, is more of the same.

What we are hearing from customers, what we are seeing in terms of confidence levels, and then just activity levels like incoming orders, order flows, activity levels, very consistent with what we have described the last couple of quarters, which is in our core.

So in the metalworking, manufacturing sector in particular, it is sluggish.

So it is not like activity levels have dropped off a cliff.

This isn't '08, '09, but very sluggish.

And what is happening is, with sluggish activity levels, customers are clamping down on spend.

So spend is down.

In terms of the outlook, our view is always fairly limited and relatively short time horizon.

I would tell you that with what we see and hear today, we don't see anything changing.

I think the ISM and kind of historical correlation would support that.

But I would also give you the caveat that our line of sight is not all that far into the future.

Sure.

Thanks for the insight.

Appreciate it.

Our next question will come from Sam Darkatsh of Raymond James.

Please go ahead.

This is Josh, filling in for Sam.

Thanks for taking my questions.

Just on the big book price increase, I know historically at least the big book prices have been easier for you to pass along.

Could you talk about whether the pricing environment in general has changed much over the recent months?

Josh, good question.

In general, my answer is no.

I think what you are seeing, is you are absolutely right.

It is an easier bar for us, in terms of passing an increase along with our new catalog.

In general, what I would tell you is that raw materials have stayed relatively flat, at depressed levels from where they had been.

I would point out that in the last quarter we have seen in pockets, tungsten being one example which is a big ingredient that goes into carbide, a little more volatility than we had seen earlier on in the year.

And I think it is way too early to say anything.

I think should that volatility continue, that could lead to more pricing opportunities.

So too early to say.

For now I would say, consistent with maybe a little bit of spark of hope, should the volatility continue.

Thank you very much.

Our next question will come from John Baliotti of Janney Capital Markets.

Please go ahead.

Thank you.

Erik, I think last quarter we talked about, you had illustrated the fact that the average transaction size had grown a little slower in last quarter versus the quarter before.

And I think that was obviously reflective of the core growth.

But you made a comment about that within that, that there was a higher lines picked.

And I was just curious to see if you saw that similar trend in this fiscal third quarter?

Yes, John, good memory.

You re right.

The answer is we did not.

Lines picked were -- have flattened down a smidge.

When I say a smidge, I mean a smidge, virtually flat with the prior -- sequentially with the prior quarter, so we did not.

I would say on the average order size, it really tracks back to what we are seeing in the macro with our customers.

I would point out two other things.

So if you looked on our history there, at the last couple of years, you have seen sequentially in the back half of the year is a slight tick-up in average order size.

In addition to economy, two other factors I would point out.

One is the lack of the mid-year pricing, and we keep going back to this.

But certainly you could imagine that has an impact on average order size.

The other thing is, Jeff mentioned the impact in terms of federal government spending, the sequestration.

Generally in the back half of our year, we see average daily sales build in the government as they move towards their fiscal year-end spend.

That has been slow, and that drives up average order size.

Those tend to be larger orders.

That build is slower than it has been in prior years due to sequestration.

And I think you are also seeing that play out in average order size.

Okay.

That makes sense.

And just where do you think -- Erik, where do you think you are with respect to integration of the product lines of Barnes and the traditional MSC product lines, with customers?

Is that -- where do you think you are in terms of getting that all rolled together?

Yes, John.

I would go back to the framework that I laid out earlier.

I think it was for Hamzah on, think of our integration as following two tracks, on the back end, we are moving quickly.

On the front end -- and that one by the way, I would categorize as part of the front end, we are moving in a measured and methodical way.

So I would say, the answer is, we are very early.

Okay, good.

So I mean, even though you are getting, even though you have had some positive feedback from customers and suppliers and Barnes employees, you still have a long runway ahead of you?

Yes, we -- John, our approach is -- we bought this business and our vision is to achieve a leadership position that is going to last and sustain.

We want to get it right.

We want to build the foundation right and not just rush.

I think at the same time, we are going to find some quick hit ways to capture revenue synergies, in a way that still allows us to move along in a measured way, getting the foundation right.

But, yes, very early in terms of runway.

Good.

Okay.

Thanks, Erik.

Our next question will come from Brent Rakers of Wunderlich Securities.

Please go ahead.

Yes.

Good morning.

I guess I want to start with just a clarification again on the Barnes gross margins.

Are you saying that the valuation issues were kind of equally present in Q3 and the Q4 numbers?

So the gross margin will be relatively the same there?

Yes, that is correct, Brent.

But remember, for the period of time in Q3, it was five weeks that we owned the company.

So we have a full quarter's worth of that, of sales and similar gross margins for BDNA.

And I guess the second question related to the same topic.

You keep referencing moves to the high 50% kind of level, but the pro forma suggests 55% numbers.

So can you explain maybe what the disconnect would be there?

I am aware of it being in the high 50%s.

I don't -- I'm not familiar with the 55%.

Brent, I would say let's get together after the call, and go over that calculation.

But when you re-class the freight, and account for it the way we account for it --(Multiple Speakers) -- you should get into the high 50%s.

Okay.

Great.

And then on the core gross margins, I am looking back at kind of couple year numbers, looks like you are down give or take a 200 basis points from about two years ago.

I was hoping maybe you could dissect that kind of on a generic basis, between the drag from the acquisitions that were lower margins, the drag from vending, and the drag from pricing, how big have the influence of those three items been?

Hi, Brent, it's Erik.

Yes, I would say the biggest of the three would be the pricing differential.

That if you look to two years ago, we talked about as over time the margin has moved within a relatively narrow band, but in any given period it could move up or down.

Certainly, you pointed out a couple of the growth programs that are going to be drags, and those are the vending and the branch-based acquisitions, absolutely were headwinds to margin.

We have strategic programs, private branding and discount management that are serving to mitigate those drags.

And then the biggest change in the factor is two years back, we had early stage inflation.

And what that means is aggressive sell price moves without the purchase cost realizing, kind of bleeding through the P&L.

And we are now at the tail end of that, and it has flip-flopped, where it is modest price increase was the high purchase cost bleeding through the P&L.

Okay.

And then -- that's perfect.

And then just I guess the last question on, some of the Barnes-related synergies, it sounds like you are talking in terms of later rather than sooner.

I guess I wanted to get a clarification on the headcount.

The headcount I think was up, under 1,300 sequentially, but at Barnes initially was acquired with about 1,400 employees.

I was wondering maybe, if you could give me a bit of a reconciliation on why the headcount wasn't up more sequentially?

You have got two things going on, Brent.

The primary one is headcount is down.

And I know we didn't break this out -- but headcount on the base business, the organic business is down quarter to quarter.

So you saw the field sales number which is roughly flat quarter to quarter.

Our support headcount is down.

So that is one factor.

And then there has been some attrition, particularly in non-customer-facing support functions at BDNA.

And part of that is by plan, given that those are some of the duplicate functions.

Okay.

Great.

Thank you very much.

The next question will come from David Manthey of Robert W. Baird.

Please go ahead.

Thank you.

First off, in terms of the guidance, you are saying that the midpoint of the range is based on flat daily sales in the core business.

I am wondering if you could talk about your revenue expectation for BDNA?

Yes.

BDNA, we expect to be in the low- to mid-$70 millions.

Low- to mid-$70 millions.

And what does that represent year over year?

Actually, and that actually contributes about -- is at11% -- 11% to 12% of our reported top line growth.

Okay.

And then just if you did a look-back, what year over year would that be?

Is that business growing today?

Is it flat like the core business?

For our core business, it's roughly flat.

For the Barnes business, as best we can tell, it is down slightly from their previous year.

Okay.

And then finally, not to get in the weeds on this, but I am -- in looking at the supplemental data and the pro formas, could you just talk about the D&A related to the Barnes acquisition?

And maybe just as simple as quantifying Barnes' EBITDA margins?

I think we were assuming they are sort of in the low teens.

I just wanted to clarify that.

I mean, the EBITDA, David, is -- we came out to roughly around [$37 million] on a $300 million business, so --

Adjusted.

So that is basically the EBIT you will see.

Add back the corporate allocations, and you add back the D&A of $7 million or so.

So rough ballpark, that is what you get.

That's great.

Okay.

Thanks very much.

You're welcome.

The next question will come from Adam Uhlman of Cleveland Research Company.

Please go ahead.

Good morning.

Hi, Adam.

How are you doing?

Good.

And to chime in on the slides, they are very helpful, so please continue.

I guess my first question, Erik -- last quarter we were talking about adding to the sales force a bit on the core MSC business.

And with a lot of the work that is happening right now with Barnes and integrating the sales forces, the work there, is there still an expectation that we are going to ramp up hiring on the outside sales?

Yes, Adam, good memory.

And you are right, we came in flat.

That is more of a timing difference than anything else.

I think you can expect -- I think what I said on the last call was 2% to 3% increase in sales force in the back half of the year.

It is more of just a timing issue on the recruiting front.

And you can expect the sales force headcount to be up slightly in Q4.

So yes, that continues.

And the reason it continues is, it's a really proven growth driver for us.

A salesperson adds growth.

It adds customer retention, and customer value and satisfaction.

So we think it is a growth -- an important growth driver.

And the way we are running the business, given that it is still separate from BDNA in terms of how it is being run, we are able to from a bandwidth standpoint, add to our MSC sales force while we integrate BDNA.

Okay.

Got it.

And then it is somewhat related, but over the last year the Company has been cautious with pushing through price increases, and there's a certain customer set that would like that.

And I am just wondering within the active account base if MSC has picked up any large account wins?

That as the manufacturing economy starts to come back, that might see some of those new wins pour through at an accelerated pace, or if that just really hasn't played out at all?

Adam, yes, the answer is yes.

And I talked about it in the prepared remarks.

And I used examples like certainly vending, national accounts program, some of our other customer penetration initiatives.

What we see happening is, we have -- I mean for competitive reasons, we don't like to call those out publicly.

But a lot of wins that get me -- either new account wins or share of wallet wins that get me really excited.

What is happening right now is because -- so customer activity levels are really sluggish.

They are clamping down on spend.

So their spend on indirect, on MRO and metalworking is down.

So as a result, the share gains, the activity levels are being muted by the customer sluggishness.

That is what I was referencing.

I do see a built-in -- when metalworking rebounds, I see a built-in gain there that is going to occur by virtue of the share gains that we are experiencing.

So the answer is yes.

If the market remains flat, how big do you think that could help your revenues?

I hope a bunch.

But you can imagine internally, we -- it is not something we are going to share publicly, but internally you could imagine we do track it carefully.

Thank you very much.

Ladies and gentlemen, our final question this morning will come from Holden Lewis of BB&T.

Please go ahead with your question.

Thank you.

Good afternoon.

Hi, Holden.

Yes.

And just -- I know you are not giving guidance on fiscal '14.

I am not asking you to.

I am trying to just get a little bit of a framework about the size of the increase that you might expect to see in gross margin?

I think earlier, it kind of got discussed what the mixing up effect of Barnes would be.

And then you should have the pricing from the big book.

Can you, without giving us what you plan on doing in '14 -- if you didn't cover it already, what is sort of the historical bump that you have typically gotten from the big book?

Can we sort of think about it by framing it in historical terms?

Yes, Holden, let me step in for a second.

So we are in the middle of doing the work.

As I have said, we will come back and give you more color on '14.

I -- net-net for now, if you are trying to look at right now for the foreseeable future how will the business perform, I would take you back to the framework that we laid out at the beginning of '13, that incremental margins still lower than historical at any given point of revenue.

And what you are pointing out is, yes, we are seeing nice tailwinds that we didn't have in '13.

We also see a couple other headwinds that we didn't have in '13.

Jeff talked about one of them being a rebate headwind, due to the fact that purchases are down, due to the sluggish environment.

So net-net for now, I think use the framework that we have already laid out for you.

And we will come back with more detail as we complete our planning.

Okay.

And the other thing I wanted to ask about, you have been breaking out the expenses related to Davidson.

You haven't been doing so for Columbus.

Have those expenses just been relatively immaterial to this point?

And then I guess the sort of second part of that is, I guess Davidson's going to be about a $0.05 drain this year.

What do you expect the overall sort of impact in going forward from Columbus to be, relative to that $0.05 from Davidson?

Yes, we haven't spiked those out separately.

Thus far it has been immaterial, Holden.

And we will evaluate how we talk about those expenses going forward.

Okay?

We barely just broke ground on Columbus a few -- a month or so ago, I think, so --

Okay.

But do you expect, for your modeling purposes, are you expecting the costs related to Columbus to be similar to Davidson?

I would think that they would be greater in '14.

No.

Well, the things, Holden, that we have been spiking out separately for Davidson were the relocation costs.

And we said that would be in the $7 million to $10 million range, when that was ultimately complete.

We don't see the -- that type of expenditure associated with Columbus.

We will move some associates there, but not a significant amount.

Okay.

So it is mostly capital?

It is not much OpEx?

It will be capital and some start-up operating expenses.

Okay.

And Holden, there is -- there will be some OpEx build in '14 related to Columbus.

And yes, we talked about headwinds, that is one of them.

And we will come back with more detail on a future call.

Okay.

Great.

Thank you.

Thank you.

Thanks, Holden.

Ladies and gentlemen, that will conclude our question and answer session.

I would like to turn the call back over to John Chironna for any closing remarks.

Thank you, Denise.

Well, we would like to thank everyone for your continued interest in MSC.

If anyone has any additional questions, of course, you can reach me in my office here in Melville the rest of the day and tomorrow.

And I would alert everyone to our next earnings date which is set for October 30.

And we will certainly look forward to speaking to you then or over the coming months.

Thanks, again, and have a good day.

Operator.

Ladies and gentlemen, the conference has now concluded.

We thank you for attending today's presentation.

You may now disconnect your lines.