MSC Industrial Direct Co Inc (MSM) 2015 Q1 法說會逐字稿

Good morning and welcome to the MSC Industrial Supply Company first-quarter 2015 conference call.

(Operator Instructions)

Please note this event is being recorded.

Now, I would like to turn the conference over to John Chironna, Vice President of Investor Relations and Treasurer.

Mr. Chironna, please go ahead.

Thank you, Keith, and good morning, everyone.

I'd like to welcome you to our FY15 first-quarter conference call.

An online archive of this call will be available one hour after its conclusion for one month on our home page at MSCDirect.com.

During today's call we will refer to various financial and management data in the presentation slides that accompany our comments, as well as our operational statistics, 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 and expectations regarding future revenue and margin growth.

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 annual report on Form 10-K 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 tables 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'll now turn the call over to our Chief Executive Officer, Erik Gershwind.

Thanks, John.

Good morning and thank you for joining us today.

Also with us in the room is Jeff Kaczka, our Chief Financial Officer.

I'll follow our typical format on this call.

First I'll cover the current operating environment, which I would characterize as solid, stable, and showing some signs of increasing optimism about 2015; our business developments, where we continue to see sales growth momentum; and our progress on key initiatives, including CCSG, where we remain on track and very excited about the prospects for this business.

Jeff will focus on our financial results and provide our second-quarter guidance.

And I'll then conclude with an update of our expectations for FY15, which are in line with what I shared with you on our last call.

And then we'll open up the call for Q&A.

I'll now start with the environment.

Macro sentiment indicators, including the ISM and the Metalworking Business Index were for the most part stable through the quarter.

The December ISM reading did tick down from the high 50%s to the mid 50%s.

This is generally consistent with what we see and hear from our customers.

We continue to consider the demand environment as moderate.

That said, the tone from many of our customers about 2015 is more optimistic than we were hearing just a quarter ago.

There's been more talk of capital investments, which would lead to increased tooling consumption and demand across our customer base.

While the manufacturing recovery to date has been much stronger among larger businesses than smaller ones, should the increasing optimism translate in 2015, it would bode well for our business overall and for our core customer segments in particular.

With respect to the pricing environment, conditions remain soft with limited commodities inflation.

Several of our suppliers have announced price increases for calendar 2015, although in most cases the size of the increase is modest.

As a result, we're implementing a modest mid-year price increase this month.

Turning to our results.

The slightly improved environment along with our share gains resulted in organic growth of 7.8% for the quarter.

Excluding the impact of the drop ship accrual from last year's fiscal first quarter, underlying growth was 8.4% this year.

That 8.4% includes stronger growth in our base business, which approached double-digits, and low single-digit growth in CCSG.

Of note, we saw sequential improvement in our growth rate through the quarter for our base business and for CCSG, which grew in the mid single-digits in November.

Within our base business, we're encouraged that our core customers, with their relatively higher gross margins, continue to show sequential improvement as well.

While core growth is still lagging Company average, and hence remains a gross margin headwind, should this momentum continue it would bode well for both the top line and for gross margin stabilization as the year moves on.

Large accounts, which are comprised of national accounts and government, continued their strong momentum during the first quarter, by posting growth rates once again well into the double-digits.

National accounts are benefiting from large companies looking to leverage technology and leaner supply chains to consolidate their supply base.

We're seeing both penetration of existing customers and solid performance on new account signings.

Since the first quarter ended, we have a full month of fiscal December and just two selling days of January under our belts.

We posted ADS growth of roughly 8.2% in our fiscal month of December, which included a strong start to the month followed by a particularly soft holiday season.

We're further encouraged by the growth momentum that Jeff will describe shortly as part of our fiscal second-quarter guidance.

I'll now turn to the programs driving our share gain momentum.

Both vending and e-commerce remain strong as our customers continue to leverage our technology platforms.

E-commerce reached 54.5% of sales for the first quarter, as compared to 50.9% a year ago, and 53.7% last quarter.

Vending added a bit above 3 points to our growth rate.

And we also added approximately 30,000 SKUs to our web offering, and now have roughly 880,000 available online.

As I shared on our last call, we expect to grow sales force headcount by roughly 8% to 10% for the year, inclusive of CCSG.

In the first fiscal quarter, we grew sales force headcount by just over 7% from a year ago and we're on track with our plan for the year.

We remain pleased with the early performance of our new classes of sales associates.

CCSG continues to perform according to plan.

The sequential improvement in growth rate can be attributed to some momentum in cross-selling as well as the early effects of the service improvements and sales force retooling initiatives.

We're encouraged with these early signs of progress and more importantly, we continue to see a lot of runway in front of us from these various growth levers.

Now let me turn to other notable developments in the last quarter.

We're streamlining our structure to enhance our ability to serve our customers, partner with our suppliers, and grow our business.

We're organizing the operations of the Company into a front end and a back end that better aligns MSC with our strategy and our vision for the future.

The front end will include customer service, sales, CCSG, and our product management function.

A search is under way to fill a senior-level position that will lead these functions.

As previously announced and related to this realignment, Tom Cox, our former EVP of Sales, has left the Company.

The back end is now organized under the leadership of Doug Jones who was previously our Executive Vice President of Global Supply Chain Operations.

He's now assumed the position of Chief Supply Chain Officer and his expanded role encompasses a broader end-to-end view of improving our entire supply chain, including that of our customers and our suppliers.

Doug's responsibilities include distribution and fulfillment, transportation, purchasing and replenishment and operational excellence, including lean and process engineering.

Given the tight connection between supply chain and technology, Doug has also assumed oversight of IT.

Before I turn the call over to Jeff to discuss the financial results in greater detail, and provide our second-quarter guidance, I also want to address our recent announcement that he plans to retire as our CFO.

Jeff has played a tremendous role in strengthening our financial operations and building a solid team.

He's helped bring even greater discipline to our business, which has been particularly important during this phase of the Company's development.

I want to emphasize that Jeff will remain with MSC as our CFO during this transition period while we work to identify his successor.

Jeff and I have maintained a very tight partnership over the past three years and that continues to be as strong as ever until our new CFO is in the seat.

The search process is now under way and we'll keep you updated as we progress.

With that, I'll now turn things over to Jeff.

Thanks, Erik, and good morning, everyone.

It really has been an honor to be part of MSC and I'm proud of what the Company has achieved over the last several years.

We set a strong foundation and I believe MSC has an exciting growth path ahead.

As Erik mentioned, I'm committed to remaining CFO while a thorough search is undertaken and until my successor is in place.

In the meantime, I plan to remain very engaged and to accelerate through the finish line.

At the same time, I do look forward to my retirement and serving others through charitable and volunteer activities.

Now turning to our fiscal first quarter.

I'll continue to speak in terms of our reported results and our adjusted results, which reflect the exclusion of nonrecurring costs associated with executive separation and CCSG integration costs, the latter of which were minimal for the quarter.

Our sales growth on an average daily sales basis was 7.8% compared to the same period last year.

Note that growth was 8.4% excluding the one-time impact of the drop ship accrual in last year's first quarter.

Our growth rate reflects sequential improvement through the quarter for both our base business and CCSG.

We continue to benefit from customers within our vending program, which contributed a bit above 3 points of growth.

In regard to gross margin, we posted 45.2% for the quarter, 10 basis points under the midpoint of our guidance of 45.3%.

This continues to reflect the soft pricing environment as well as strong growth from our lower gross margin programs, including national accounts, government, and vending.

Our reported EPS for the quarter was $0.91, or $0.95 on an adjusted basis, which excludes roughly $0.03 for executive separation and about $0.01 for CCSG integration.

$0.95 was at the low end of our guidance range of $0.95 to $0.99, and reflects sales and gross margin slightly below the midpoint of our guidance range.

Operating expenses roughly in line with our expectations, and the impact of the special dividend under the two-class method of calculating EPS.

This relates to the treatment of unvested restricted stock awards and it reduced EPS by a penny in the quarter.

We expect virtually no impact from the two-class method on full-year EPS as net income accumulates throughout the year.

Finally, the tax provision came in at 38.4%, slightly above our guidance of 38.3%, due to apportionment and rate changes related to state taxes.

Our expectation for the full-year tax rate is slightly above 38%.

Turning to the balance sheet.

Our DSOs were 49 days, up slightly from last year's fiscal first quarter, reflecting continued high growth in our national accounts.

Inventory turns were down slightly to 3.53 from the previous quarter level of 3.55.

Over the longer term, we expect inventory turns to improve.

However, turns should continue declining slightly through the balance of FY15.

This reflects the inventory build related to expected future sales growth and stocking of the Columbus CFC working itself through the 13-point average turn calculation.

From a cash flow perspective, our operating cash flow for the quarter was $58 million.

In addition to increasing our quarterly cash dividend by 21% last quarter, we paid a special dividend of $3 per share.

In total, we paid out $3.40 per share, or approximately $209 million, to our shareholders during the first quarter.

In addition, and in line with our plan, we incurred capital expenditures of $13 million in the quarter.

Our expectation for CapEx for the year remains in the range of $75 million to $85 million.

As of the end of the first quarter, we had $496 million in debt, mostly comprised of $231 million on our term loan and a $235 million balance on our revolving credit facility.

We closed the quarter with $47 million in cash and cash equivalents.

Now let me turn to our guidance for the second quarter of FY15.

We expect revenues to be between $717 million and $729 million, which translates to ADS growth of about 9.3% at the midpoint.

Implied in this guidance is further sequential improvement in our core customer growth, continued strong double-digit growth in large accounts, and CCSG growth in the mid single-digits.

We expect gross margin in the second quarter to be in the range of 45.2%, plus or minus 20 basis points.

This sequential stabilization reflects a number of factors, including the modest mid-year price increase and other gross margin actions, offset by typical fiscal second-quarter seasonality and the headwinds resulting from growth programs like vending and national accounts.

We expect adjusted operating expenses to increase at the midpoint of guidance by roughly $6 million versus the fiscal first quarter.

The increase breaks out as follows.

About $2.5 million relates to medical costs and another $1.7 million to seasonally higher payroll taxes.

The remaining $1.8 million primarily relates to increased staffing to support expected future volume growth, continued growth investments, and the full depreciation run rate for Columbus, offset by productivity.

Typically, our fiscal second quarter is our lowest operating margin quarter for the year, and this year is expected to be no different.

As a result, the implied adjusted operating margin at the midpoint of our guidance is about 12.2%.

Finally, our EPS guidance is $0.84 to $0.88, and this assumes a tax rate of about 38.4%.

In summary, while we came in at the low end of our EPS guidance for the first quarter, I am encouraged by our sales growth momentum and the stabilization of our gross margins.

Our various growth initiatives continued to fuel our growth rates and we continue to manage our operating expenses tightly.

Looking to the rest of the fiscal year, our second-half sales are typically significantly higher than the first half, and we expect to continue to benefit from our growth initiatives, even as our growth investments normalize.

We will also have our infrastructure investments fully in our run rate.

Our operating expenses will continue to grow sequentially, but this would be related primarily to volume and at a rate much lower than sequential sales growth.

This means that our operating expenses as a percent of sales will come down.

All of this is in line with our 2015 operating margin framework and specifically with the moderate growth and low price environment quadrant of the matrix.

It also means that we fully expect operating margins to be higher in the back half of the year.

Thanks, and I'll turn it back to Erik.

Thank you, Jeff.

Before I close the call, I want to confirm the FY15 framework that we shared with you on our last call.

At this point in time, we would continue to characterize the environment as one of moderate demand and soft pricing.

There are, however, a few encouraging signs that make it feasible that we move into a different quadrant of our FY15 op margin framework during the back half of the year, which would improve our operating margin outlook.

First, despite a somewhat uncertain environment, we are increasingly encouraged about the potential to move to a strong demand or high-growth environment.

We're hearing a more optimistic outlook and tone from many of our customers as it relates to 2015.

We are already seeing sequential improvement in our growth rates.

Second, while our gross margins are down considerably over prior year, we are seeing some sequential stabilization.

Second-quarter guidance on gross margin is roughly flat with our first quarter, and at this point in time we would anticipate something similar for our third quarter.

The stabilization is due to a combination of the small mid-year price adjustment, some gross margin counter measures that we're taking and the improving growth rates of our core customers and CCSG.

If the demand environment continues to improve, and we execute on CCSG as expected, the growth rates of both of these higher-margin businesses should increase as the year goes on.

Third, the operating expense headwind resulting from our infrastructure investments begins to abate as we move through the year.

While most of these expenses, particularly in Columbus, remain in our numbers, they get leveraged on a larger sales base as we grow.

Pulling back from the near term, I remain very confident in our direction.

We're executing on the infrastructure investments needed to support future growth.

We're seeing the returns of our growth investments in the form of strong share gains and improving growth rates.

We continue to move the portfolio of business to sticky, high retention and value-add businesses like metalworking, Class C, inventory management, and e-commerce.

We are aligning our organization, both in terms of structure and people, to support our plan.

All of these steps are positioning MSC for the earnings growth that this business is fully capable of delivering.

I'd like to thank our entire team for their hard work and their dedication to our plan.

And we'll now open the lines for questions.

Thank you.

We will now begin the question-and-answer session.

(Operator Instructions)

And the first question comes from Winnie Clark with UBS.

You highlighted you're taking some measures to counter gross margin headwinds at the end of your comments.

Erik, can you give us a little more color on what exactly you're doing there?

Hi, good morning, Winnie.

How are you?

Good.

So yes, in terms of gross margin, what we wanted to highlight was the fact that if you look year over year, certainly you're seeing declines in margin.

But we are seeing some stabilization and that's reflected in the guidance for Q2.

And then looking around the corner with what we see right now, something similar for Q3.

A couple of things going on there.

So you've got one would be, what we described as a modest price adjustment this month.

Number two is we do like the momentum that is starting to build with our core customer base and with CCSG.

And then the third point is what you mentioned, which is the gross margin counter measures.

I won't get too specific there for competitive reasons.

Suffice it to say that basically just taking some smart actions, both on the buy side and on the sell side, that we anticipate having some impact starting in Q2.

Okay, great.

Thank you.

And then on your guidance for 2Q, average daily sales are looking like they're set to accelerate over the next two months according to your guidance.

You do have a little bit more difficult comps.

I know you mentioned a little bit of weakness around the holiday.

But are you seeing something in the last few days that gives you some confidence that you should see that acceleration?

Winnie, good question.

So if you look at December as a whole, what you saw if you looked back at Q1, so we were on -- without the direct ship accrual, we were at about 8.4%.

We described seeing sequential improvement through the quarter.

We do like the momentum we're seeing.

That continued into December.

December was a bit of a funky month.

If you look through most of the month, the growth rate was quite strong.

The holiday effect, and in particular the last week holiday effect, was pronounced which brought the growth rate in at 8.2%.

As you mentioned, our guidance implies if we're at 9.3% for the quarter, that means that January and February are going to certainly be above that.

We only have two days under our belts here in January.

The color I could give you is yes, things returned back to normal where we would have expected to see them.

We chalk this up to just a soft holiday period.

Okay, great.

Thank you so much.

Thank you.

And the next question comes from Matt Duncan with Stephens Inc.

Good morning, guys.

Hey, Matt.

Good morning.

So Erik, you talked about some increased optimism that you're hearing from customers.

Are there any end markets in particular where that's most notable?

And then also I think it would probably be helpful for folks if you could talk a little about the energy exposure you guys may have.

Sure.

So first question is in regards to the increased optimism.

I would say, Matt, obviously with us you're going to get a perspective which is based upon our end market mix.

And as you know, that's heavily weighted towards manufacturing, and in particular metalworking-related manufacturing.

I would not call out anything in particular.

I think if there was one thing to call out it's some potentially encouraging signs from the mid-sized customers who have been, as we've been describing, the recovery that we've seen over the past year has been more pronounced with the big customers.

You've seen that in our national accounts growth rates and the fact our core has lagged.

I think that's the only thing I'd call out which gives us good outlook on 2015 should that materialize, both in terms of the demand environment and then what that means for our gross margin as it relates to mix.

Okay.

On the -- sorry, go ahead on the energy exposure, yes.

On energy exposure, I can give you our direct exposure very clearly, which is about 3%.

That's direct into the market, which is quite small.

What's a little trickier, as you could imagine, is trying to quantify the indirect exposure from the trickle down and machine shops and such that are serving that industry.

That's one that's a tougher number for us to get our arms around.

Obviously, a lot swirling now with oil and gas.

There are different theories and there's certainly some potential negative consequences.

There's also some potential positive consequences.

That's the story on our exposure.

Okay, I appreciate it.

The last thing from me, and I'll hop back in the queue, on the mid-year price increase.

Can you comment on about how large that was?

And should we see the -- it looks like price was a little bit of a drag on revenues this quarter.

Would the expectation be that that price increase will get it to the point where price is helping a little bit?

Or just flatten it back out?

Yes, good question.

The price, the way we characterize the mid-year price is modest.

We don't break out our mid-year increases as we do for our big-book increases.

But just to give you a feel, if you look back over our number of years and you looked at our stated big-book increases, there's a range there.

Modest to us would mean at the low end of that range, if that helps.

It does.

And, yes, you're right to call out if you're talking about the growth composition.

For a first time in a while, what you're referring to is the fact that price was actually negative.

Not particularly surprising to us, given the soft pricing conditions, the fact that we took a small big-book increase for the quarter, and the fact that the mix headwinds of the large accounts also plays into that number.

So not particularly surprising to us.

Looking forward, tough to give you a direct answer on by how much that changes, because there are a bunch of factors that move that up and down, such as mix.

Certainly the pricing action we take, all else being equal, is going to help.

Great, thanks, Erik.

Thank you.

The next question comes from Scott Graham with Jefferies.

Good morning.

Thank you.

And Jeff, congratulations and good luck to you.

Thank you, Scott.

Wanted to ask two questions, essentially.

The e-commerce number on the operating stats that you guys provide had a real big jump this quarter.

I was wondering if you can get us underneath that number a little bit, Erik.

Sure, Scott.

So e-commerce, as we've described, is an umbrella that reflects all of our electronic channels.

And so to give you some examples there, MSCDirect.com is the biggest chunk there.

Vending, the business in the vending customers that are actually going through the machines, some of our EDI customers.

Not surprisingly, the big drivers there are the growth programs that we've highlighted, and those are e-commerce and vending.

From my perspective, what it's reflective of is this dynamic that we've been describing that as our industry begins to enter consolidation phase, as customers want to take advantage of technology, it's really playing right into our sweet spot.

Those are the two ones I'd call out.

Okay, although that was a very big jump.

I was hoping for a couple more things.

But that's fine.

My second question relates to a little bit more on the dynamics of your operating stats again.

You, for the second consecutive quarter, are showing an increase in customers of like 12%, 13%.

You do the calculation off of the average order size, the sales per customer in those same quarters has declined slightly.

Just to make sure I understand the dynamic here, you're adding customers off of the growth initiatives and growth spending, but those customers are coming in at a slightly lower average order size to start.

Scott, just to make sure you're clear, one of the things, if you saw a big jump, so over the past couple of years you are correct to point out we have seen customer count has been inching up.

We've said it's not a primary metric for us.

It has been inching up.

One thing I would note is, I believe it was last quarter we included the Class C business as we started to merge the businesses together.

We've merged some of those.

So the big jump that you're referring to is related to the Class C unique customers coming into the customer count.

I see, I see.

Does that help?

The 1Q 2015 number is a little bit different than the 1Q 2014 number?

You got it.

If you're looking year over year, just look sequentially back.

I think it was last quarter was the first time, you'll see a big jump.

Without that, we would be seeing a continued sequential trend along what you've seen for the last year, which is underlying base customer count growing but not by the amount you're describing.

That's a function of adding Class C.

Understood.

Okay, thank you.

Thank you.

The next question comes from John Baliotti with Janney Capital Markets.

Good morning, guys.

Hey, John.

Jeff, congratulations and good luck as well.

Thank you, John.

So Erik or Jeff, when we look at the gross margin assumptions for the next couple of quarters, are you assuming the mix dynamics that you've pointed out in terms of large customers and their profitability, you're assuming that aspect of it stays the same?

Yes, John.

When we described the stabilization, so as I said, a few factors.

But as it relates to mix, our assumptions are that not so much a dramatic -- we like a lot what we're seeing in the large accounts areas, both national accounts and government where we're seeing significant share gains.

We don't anticipate a change in those growth rates.

I think what is anticipated is that we continue to see momentum in the two higher gross margin segments.

So that's where the mix headwind begins to abate a little bit.

Those being Class C, where we started to see some sequential improvement in their growth rate to mid single-digits, and in our core customer base, which is relatively higher gross margin.

Okay.

So it's based on what you've already seen.

You're not just assuming that something gets better.

You're already starting to see some trends there.

Yes, it would be based on continuing the trend that we're starting to see.

I think should things pick up radically from there, it could be upside.

Okay.

And then to finish on the margin side, Jeff, you mentioned that the back half of the year should be a better margin than the first half of the year.

Can you give us a contribution?

Is it the salespeople that you hired last year that you're getting some benefits from?

Is there more of that?

Or is it an even mix between that and some of the investments that are now fully annualized that are contributing?

John, I think it's all that.

As I described, the operating expense leverage that we begin to see in the back half of the year for which we have a lot of confidence.

We generally have higher sales in the back half of the year.

The infrastructure investments have already been embedded into our run rate.

We'll see the benefits of those growth investments.

Although we'll see sequential growth in operating expenses, it will be really related to the variable costs associated with the increased volume.

So we'll see operating expense leverage defined as operating expense to sales.

That in and of itself, coupled with stabilization of margins, will improve our operating margin.

Okay, great.

Thank you.

Thank you.

And the next question comes from Sam Darkatsh with Raymond James.

This is Josh filling in for Sam.

Thanks for taking my questions and congratulations again, Jeff.

Thank you.

Hey, Josh.

Regarding the price increase you're going to take later this month, the pricing environment's still soft and it sounds like you're not seeing a lot of movement out of your vendors.

Could you talk about what gives you confidence that it will stick?

Yes, Josh, it's a good question because certainly, as everybody's aware, the pricing environment is still soft.

What I would say is the primary trigger, realize, it's a modest increase, number one.

Number two is it's triggered off of manufacturer increases that are pretty generally well accepted.

As I've said, those increases are not huge, which is why the increase is modest.

Those are generally, as I've said, well accepted.

The other thing I'd say is if you take a look at our whole body of work here on pricing, both -- the big-book increase was quite small relative to average combined with a modest mid-year.

From our standpoint, our perspective, the pricing actions are very consistent with the soft pricing environment, which does give us confidence in the realization.

So you do have some cover fire, for lack of a better word, from vendor increases?

Yes, we do have some.

Okay.

I'm guessing your gross margin in November came in below where you're guiding the second quarter.

Could you talk about whether that's accurate?

If I'm looking at it the right way, that there's some sequential improvement immediately and what's driving that.

Josh, you know what, we'd have to get back to you.

Don't know offhand on November.

The one thing I'd caution you, is there's so much seasonality and variance month to month, that it's tough to make too much of one month.

Basically, the picture you're getting is if you look back the last two quarters, I think the big picture here is we have seen sequential drops two quarters in a row, pretty sizable sequential drops two quarters in a row, that were related to two factors.

The soft pricing environment, which meant a small big-book increase, along with the headwinds in our business and the mix headwinds that were particularly pronounced.

The picture we want to give here is that has stabilized.

That's based on the factors that we're describing.

It's the three things.

It's the modest pricing this month, it's some of the other countermeasures that I talked about and it's the early signs of the improvement in the higher-margin businesses.

Thanks.

Good luck with the next quarter.

Thanks, Josh.

Thank you.

And the next question comes from Ryan Merkel with William Blair.

Good morning, everyone.

Hey, Ryan.

Hey, Ryan.

I want to start with a big-picture question.

Erik, is it fair to say that industry consolidation is happening faster today than in any time in the past 10 years?

Ryan, I think that's a fair statement.

And we've been describing that for a while that we're seeing the consolidation story that was slow-going years ago, to be picking up.

So I think that's a fair statement.

And then a follow-up there.

What inning do you think we are in there?

Well, what's so exciting, and you're really hitting on what's so exciting about this growth story, is to answer that question, the punch line is very early.

Just look at the data.

The market size of North America of roughly $140 billion, and with everything that's happened to date, the top 50 players in the space still having 30% share.

As we speak, consolidation increasing, yes.

But there is so far to go from the point we are today to the point at which the consolidation story plays out, that I would describe it as very early innings, which is part of what gets us so excited.

What do you think the tipping point has been more recently?

You mentioned technology.

I'm hearing from a lot of the distributors that they're seeing big chunks of business today that they hadn't seen in the past.

A lot of it is due to being able to provide a lot more visibility into the spend.

Can you talk through that?

Is that what you're seeing as well?

Big chunks of spend and big customers coming to the table and finally realizing that they can save a lot of money by consolidating their MRO?

Ryan, I think there's two inflection points that we see over the last few years that have become, as you describe them, tipping points that have sped the consolidation.

One is the one you mentioned, which is technology.

For the larger customers, and you're seeing that evidenced in our national accounts growth rates, our government growth rates, that years back never had the ability to gain visibility into where their spend was going across plants around the US.

So it was much tougher to consolidate spend.

Fast forward to today, and most of our customers, most large companies out there, are now taking advantage of those, as we discussed, those tools regularly.

And that's helping them gain visibility, which is helping drive supplier consolidation.

The other one that I would point out is the global recession of 2008, 2009.

We see it as a sea change for industry, for manufacturing.

There's been a renewed focus on supply chain and the need to get to market, for our customers to get their products to market faster.

And so the whole purpose and raison d'etre for procurement, for supply chain, has moved a bit from just saying, hey, I exist to get the lowest price on a part, to I exist to help my company get product to market faster.

And in a world like that, MRO becomes much more strategic and important.

I think that's driving a spotlight on it and that's leading to these big opportunities that are playing into the consolidation story.

That's very exciting.

Okay, then, last thing is could you speak to your vending profit improvement program?

What type of progress have you made?

I think last quarter you said vending was not a drag to Company average EBIT margin.

We're basically there, Ryan, to the point where vending -- so the vending program and the way we describe the profitability, just to be clear, is a fully-loaded contribution margin.

So it's basically every cost associated with the initiative, the selling expense, et cetera, just not a corporate overhead allocation.

Where we're at is that measure which had been a drag on op margins is no longer a drag.

The program as a whole, it's in the range, we're right at Company average margin.

What is still a bit of a drag is the gross margin.

We've been very pleased with the improvements we've seen in our VIP on productivity at an OpEx standpoint.

That's really driven most of the improvement, more so than gross margin.

It is still a bit of a gross margin headwind, just not on the op margin line.

Thank you.

Thank you.

The next question comes from David Manthey with Robert W. Baird.

Thank you.

Good morning and Happy New Year, guys.

You too, David.

First of all, Jeff, when you were talking about the operating cost, if we said variable costs on the side, and just think about your SG&A run rate, is it safe to say that as we look into the second quarter all of the growth in infrastructure investments are pretty much in there at that point?

That's correct, David.

Okay.

If we were to look from the second quarter of this fiscal year to the third quarter, as we get the seasonal uptick there, would you expect to see more normal contribution margins or incrementals from second quarter to third quarter, representative of incremental revenue and profitability there and that should carry forward?

Of course, the year-over-year, you're still under the pressure of those incremental costs.

But when you look 2Q to 3Q, should that get more normal for MSC?

Yes, I think that's very fair, David.

We'll continue to have the variable costs associated with the volume growth and we'll continue to make growth investments, but that will be at a more normalized level.

Okay.

And in terms of the growth rate, as you look to the coming, let's say 12 or 18 months, would you be disappointed if you weren't able to get to double-digit growth?

The reason I ask is that if the market is currently growing at a low single-digit rate, you've got e-commerce adding 3, 4 percentage points to that, you get a little bit of price, you're already getting close to mid to high single-digit growth rates there.

When you start adding in sales force and productivity and things like that, I would think you should be able to get to low double-digits in this type of environment.

Could you give us your thoughts on that?

Am I thinking about that correctly?

That as those things ramp up, potentially you should get there and you might be disappointed if you're not at double-digit growth rate?

David, I think it's a reasonable assessment.

When I tell you it's obviously the wild card is what happens in the market and the world.

Assuming the momentum that we're seeing now continues, realize that within our Q2 guidance essentially the base business, because we've described CCSG a as still below Company average.

You have a base business already into double-digits.

We have more growth investments that are kicking in, such as sales force expansion.

We anticipate seeing the CCSG growth rates improving and we started to see that.

We're encouraged by the prospect there.

When you put that together, I think it's a reasonable assessment.

Okay.

And then finally, could you remind me, as you've added CCSG to that e-commerce calculation and the operating statistics, could you describe the major customer interfaces, as you're looking across that whole range of EDI and portals and the number of the different things that you define as e-commerce?

Could you talk about where CCSG has strength across those different interfaces?

Yes, David, it's vendor managed.

Its their inventory management program, their VMI program.

That's why that --

-- which is electronic.

That's it.

Got it, yes.

Okay, thanks, guys.

Thanks.

Thank you.

And the next question comes from Robert McCarthy with Stifel.

Good morning, everyone.

Hey, Rob.

Congratulations on best wishes, Jeff.

Thanks, Rob.

The first question is, Erik, as you're looking for a new CFO, perhaps you could talk about the qualitative factors you're looking for in that CFO in terms of experience, focus, aside from the obvious which is a good capital allocator, a good warranter of the business, a good understanding of the processes of rolling up and porting the businesses.

What you're looking for specifically, as you put a signature hire in place.

That's a great question, Rob.

What I'd tell you, the nice things about the Company here is that there's such a strong sense of legacy.

Jeff has done a lot of good things here.

First of all, I think you described many of the attributes, which is somebody who's a good capital allocator, somebody who is going to be a good business leader, work very well internally here.

What I'd call out is that probably the single biggest thing is going to be somebody who -- we have a very strong culture.

And so all of those things, ethics and integrity, capital allocation, business leadership, are going to be the left brain, very tangible attributes.

What's going to be really important is somebody who can work really well with our management team.

I feel great about the team that's being formed here.

We have a nice healthy balance of folks who have been with the Company for quite a while and are getting great opportunities to step up and really know the history.

We're sprinkling in a mixture of people who bring fresh perspectives.

I think the single biggest thing I'd call out is all of those business attributes are a must, and then somebody who can work really well within our culture.

As a follow-up to that, do you expect further management turnover in the top 20 ranks?

Or do you think the team's going to be on the field once we get the CFO in place?

How do you think about that?

Maybe some narrative around the last six months in terms of any management changes.

I would say I feel very good about our team.

Look, we have some very exciting aspirations, Rob.

One of the things, one of the most important things in business, is having a very clear vision, a clear plan on how you get there, which we feel we do.

And then aligning the organization.

Really, the thing I'd highlight as much as anything, is about through the structure and how the business is organized, as much as some of the changes that you've seen come in and out.

And some of those changes, like in Jeff's case, it was Jeff's choice; others it was the Company's decision.

But I would tell you, I feel great about the team that's forming and great about how the structure now aligns with the plan.

Last question, just drilling in, no pun intended, on the implied energy or exposure and association with this retrenchment in oil.

Clearly, you've ring fenced the direct exposure.

Clearly you can think about the headwinds potentially to pricing in an environment where there's going to be potentially global deflation in commodity prices and component costs in association with this energy.

Maybe you could talk about some of the negative obvious factors, but then also if there's any potential positives in association with it.

Whether it's relief in a certain end market that's especially prone to energy costs where they get better margins.

Or anything along those lines that maybe we're not thinking about where you could spin something positive with this oil retrenchment.

Yes, Rob, sure thing.

As you said, our direct exposure is very low.

Very difficult, your term was ring fence, very difficult for us to ring fence indirect exposure.

I'll give you the caveat, that we definitely do not profess to be economists.

Tough to say exactly how this shakes out.

The negative effects are fairly obvious, as you said.

A couple of the positive ones that I'd call out, number one is over the long run, one of the cases for US manufacturing growth and strength over the next decade was lower energy prices.

And so that, certainly to us, is one thing that I'd call out.

The other one is the fact that for durable goods companies, the implications of lower oil and gas prices on consumers having more money in their pocket books to spend, I think also is a potential upside.

How all that shakes out, the pluses versus the minuses, tough for us to say.

But I do think there are arguments in both directions.

Thanks for your time.

Thank you, Rob.

Thank you.

The next question comes from Eli Lustgarten with Longbow Securities.

Good morning, everyone.

And my best wishes to Jeff also.

Hi, Eli.

I have a couple of wrap-up questions around, but one of them's when we talk about the outlook getting better in January, February, have we looked at the weather effect versus last year?

Remember we had that awful first quarter winter environment.

The comparisons probably aren't as difficult.

Have you looked at or adjusted for last year's environment as you're looking out?

Or is that still a potential add-on if we have more normal weather the next couple of months.

Yes, Eli, we looked at it.

It's tough to give you an exact number of last year's weather impact.

Probably the best proxy when we look at it, the best proxy we could give you is if you took a look back last year, which is what we did at our guidance for this quarter last year, and then looked at where we came in for the quarter on sales it was about a $4 million, I think roughly $4 million, $4.5 million difference.

That was primarily weather related.

That would give you some proxy.

What I would tell you is right now we have -- the guidance is everything we see as of today factored into that guidance.

Okay.

And can we talk a little bit about currency effect in two aspects, or several aspects?

We've got major changes in the US dollar versus the rest of the world.

That impacts, one, your sourcing of material or your sourcing of product.

I can think of the difference between a can of metal and a sand rick, for example.

Whether there's some changes in what you would source that might give you some better pricing or type of product sold as you look out.

And the impact of currency effect on your own operations, particularly with the craziness in Canada that goes on.

Eli, on the buy side, the dollar strength, certainly I talked about we are active in global sourcing as you know.

I talked about some of the countermeasures being smart activities in the buy and the sell side.

Those are the types of things that we'd be looking at for sure.

And then in terms of currency impact on our business here, very small.

You point out the one area where it would impact us, which is Canada.

But in total, not meaningful.

And I assume when you talked about your energy exposure you factored in the bigger exposure in Canada to the natural resource business.

Yes, we did.

One final question.

We've looked across some industrial markets, and if you look at the state sales across the United States, we've had some companies indicate that they've had a lot of strength in energy-related states more so than non-energy-related states over the last year and there's a potential change here.

Have you seen any distribution as you look across the country, as to whether you benefited from the strength in the energy states and that's something to be concerned about?

Or have things been pretty balanced across the marketplace?

If you looked back over our -- we actually break out our growth rate by region for us.

I think the biggest thing to point out there is the regional -- there is relative regional strength in the south and the West.

It tends to be tied to where our growth is coming from.

We've been highlighting significant growth in national accounts and government.

You could expect those to be strong overlays on top of those states.

In terms of energy, again, the direct exposure for us is small.

Thank you very much.

Thank you.

And the next question comes from Flavio Campos with Credit Suisse.

Good morning, guys.

Thank you for taking my questions.

I just wanted to drill in a little bit on CCSG and the recovery.

Wanted to get some color on the drivers there.

How do you see the run rate on growth for the business being?

And what's the status of the CCSG sales force selling the legacy MSM products?

Okay, Flavio, I'll take you back just to give you the full perspective here.

When we bought the business, it was a low to mid single-digit decliner.

Those growth rates had gradually improved through some heavy lifting on integration.

We still saw a bit of improvement to where the business had been steady-state low single-digit grower.

Last month of the first quarter, which was November, we saw the business pick up to mid single-digits.

Implied, as Jeff said, implied in our guidance for Q2 is mid single-digits.

So we are starting to see a little bit of momentum there.

There are three factors that I would point to.

Number one, it's the three levers that we've been hitting on.

Number one is service improvements, just basic blocking and tackling in the business, which we know are absolutely critical.

They certainly take time.

There's a lag time between when the improvement is made and when we see the growth rate improve.

But we feel good about progress there.

The second one is what you called out, which was really a repositioning, a retooling of the sales force.

We've undergone some hefty sales force turnover as we've integrated the business and brought some of the MSC management practices to bear.

We're now at a point where much of that heavy lifting is done.

We are beginning to expand the CCSG sales force, which is factored into our sales force expansion numbers.

So that's the second initiative.

The third one, and I think you mentioned, is cross-selling.

The CCSG sales folks taking the MSC product offering through the catalog, the website, et cetera, into their customer base.

We began that program in July.

It was, we shared on the last call, a little slow out of the gate.

Not surprising a new program.

We are seeing some momentum there.

It is part of the story as to how the business, the growth rate is progressing.

Great.

That's very good color, thank you.

As you consolidated CCSG into your breakdown of manufacturing, non-manufacturing, I think that tipped the scale to increasing your non-manufacturing exposure.

Can you give us some color on how is that non-manufacturing exposure within CCSG, if it's also large accounts and government oriented, if it brings new suite of customers?

You are right, the CCSG is now in that breakout, which is what moved it to 70/30.

CCSG was roughly about a third manufacturing, a third processing-related industries.

Other areas that are big are transportation and natural resources.

I would point out natural resources are not primarily oil and gas.

But those would be the end markets that are outside of manufacturing that are big for the CCSG business.

And very little government.

Perfect, very helpful.

If I could sneak in a last one, you mentioned that you're seeing supplier price increases out there.

Do you have any detail on the magnitude of those price increases?

Or if you can give any color there.

The word I'd use is modest.

What we're seeing is, there are several very visible important suppliers who have come to the table with increases.

And I said that was the trigger for us.

What I'd point out, though, is just like with us, if you look back, modest means it's on the low side of the range of what it's been historically.

I would say the same thing for the manufacturer increases, smaller than what we would see in a more normalized environment.

But the fact that they went up was helpful nonetheless.

Perfect.

That's very helpful.

Thank you and best of luck to you, Jeff.

Thank you, Flavio.

Thank you.

And the next question comes from Charles Redding with BB&T Capital Markets.

Thanks, gentlemen.

Just a quick follow-up on pricing, if I might.

Is the recent increase applied to all SKUs across the board?

Or do you selectively target those items with stronger demand or recent OEM increases?

Charles, get the sensitive one, for competitive reasons I'm going to -- I apologize -- but deflect that one and just leave it a as modest.

There's a lot of intelligence that goes in.

I'll just put it that way, a lot of intelligence that goes into how we price.

Of course.

And then in terms of current supply chain capacity, post Columbus, are there other areas where you feel like expansion could be warranted?

Or are you comfortable with capacity, given the current demand environment?

Yes, Charles, that's a really good question.

I'll touch on two.

Columbus, the big driver with Columbus in our supply chain, there's really two factors to think about.

The first one is throughput capacity, meaning how fast can we get orders and totes through the system.

That was the driver behind Columbus.

Columbus really gave us now a lot of capacity that gets us to -- what we described was, certainly we don't see another CFC coming, assuming the next billion or so looks like the first three.

We don't see another one (technical difficulty) at least through 4 billion.

The second driver of CFC, of expansions, would be space, just storage space.

It is possible, and this has been, over the years, part of our base CapEx has been periodic expansions of facilities.

You could see us, and knock on wood, I hope that you're going to see us have an expansion in one of the existing buildings, which is going to mean that we're growing quickly and that we need storage space.

But what you wouldn't expect to see is another building.

That's excellent color.

Thank you.

Thank you.

And the next question comes from Adam Uhlman with Cleveland Research.

Hi, guys.

Thanks for squeezing me in.

Best of luck, Jeff.

Thanks, Adam.

I might have missed it, but the lower pricing that you reported for the quarter, the $6 million, did you break that down between discounting and customer product mix by chance?

Or could you?

We don't because there's so many moving parts under the cover there, Adam.

So much of what you see as price contribution is a function of the mix.

For instance, when we sell into a large account, we could be selling the same SKU at a different discount level given the account.

So we don't for that reason.

Okay, got you.

And then could you talk about the productivity of the recent SKU additions that you've had over the last year and how that's compared to what we had been doing previously?

The basis of the question is to really understand where we're at in terms of the contribution from the inventory build and the new products that you've added to the distribution centers.

Yes, sure.

The SKU expansion has been a nice part of the growth story.

I would say the last -- most of these are being added as we've described, not necessarily to the catalog, but to the web.

We're using a lot of science and data and customer behavior to help us predict what SKUs are going to sell best.

And so we've seen that in the performance.

I would tell you that program is pretty much at full run rate.

I think one of the nice things you're seeing now is we have a growth in a number of areas.

The growth of the Company has gone up.

Some of the core programs are doing what they should be doing, but then on top of that we're getting growth outside of those.

I would say steady as she goes on the SKU program and it's pretty much at full run rate.

Great, thank you.

Thank you.

This does conclude the question-and-answer session, so at this time I'd like to turn the call back over to Mr. Chironna for any closing remarks.

Thanks again, everyone, for joining us today.

Our next earnings date will be April 8 and we look forward to speaking with you in between.

Take care.

Thank you.

The conference is now concluded.

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