MSC Industrial Direct Co Inc (MSM) 2015 Q2 法說會逐字稿

Good morning, and welcome to the MSC Industrial Supply second-quarter FY15 earnings call.

(Operator Instructions)

Please note: This event is being recorded.

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

Please go ahead.

Thank you, Andrew, and good morning, everyone.

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

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 plan, 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 and 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 is Jeff Kaczka, our Chief Financial Officer.

As I typically do on this call, I'll first cover the operating environment, which has changed significantly since our last call.

I'll then turn to our business developments, where we continue to see sales growth, but at lower levels as a result of the macro conditions; and then our progress on key initiatives, where I remain quite pleased with our execution.

Jeff will focus on our financial results, and provide our fiscal third-quarter guidance.

And I'll then conclude with an update of our expectations for FY15, and with a perspective on the current environment and the opportunities that it creates for our Business.

We'll then open the call for Q&A.

I'll now turn to the environment.

We've seen a significant and swift change in demand conditions since the start of the calendar year.

We heard this in a change in tone from many of our customers, and saw it in sentiment indicators like the ISM and MBI, both of which trended down through the quarter.

Root causes included the impact of the rapid drop in oil prices, and softening export demand.

As you know, our Business has very little direct exposure to the oil and gas sector.

There's little doubt, however, that the dislocation in this sector, and the resulting uncertainty, is currently impacting broader manufacturing activity, particularly in energy-producing states.

Softening export demand is also impacting manufacturing, and heavy manufacturing in particular, as exchange-rate headwinds have become more severe.

In addition, while weather was certainly a factor in the quarter, we believe the broader weakness that we're seeing is more than a temporary disruption.

With respect to the pricing environment, conditions remain quite soft, due primarily to the lack of commodities inflation.

A number of our suppliers did implement small price increases, and we were successful implementing a modest, mid-year price adjustment of our own at the beginning of January.

Turning to our results, the slowing demand environment resulted in lower-than-expected organic growth, which came in at 6.8% for the quarter.

As you can see from our monthly numbers, growth rates were solid in December, improved in January, before dropping significantly in February as the environment deteriorated.

Breaking out the total growth rate, our base business performed above the Company average, in the high-single digits for the quarter; but like the total business, it slowed significantly in February.

Large accounts, comprised of national accounts and government, continued to grow at a double-digit pace, well ahead of Company average, and indicative of share gains in these areas.

Our core customers, on the other hand, lagged the Company average for the quarter, and saw a more pronounced drop in growth rates in February as the environment worsened.

We've begun to see some large accounts pulling work in-house that had been subcontracted out.

As a result of all of this, customer mix remains a gross margin headwind.

As for CCSG, you may recall from our last call that growth was approaching mid-single digits at the end of the first quarter.

The combination of the slowing demand environment, weather-related disruptions, and the impact of foreign currency on the CCSG Canadian business resulted in the growth rate falling through the quarter, and coming in roughly flat with prior year.

Although these challenges are in line with overall industry results, they've slowed the recent momentum we were experiencing in the business.

We continue to execute on the three growth levers that we've outlined for you, including service improvements, sales force transformation, and cross selling.

Service improvements are going according to plan, and we're pleased with the resulting enhancements.

Sales force transformation efforts are largely behind us, as we move past the roughly 30% turn-over rates of the past year.

Turnover has now stabilized, and as a result we've turned our attention to sales force expansion, which should enhance growth in the quarters to come.

Cross selling remains on a slower ramp than our initial forecasts.

We're pleased, however, with the recent trending and the pick-up in average daily sales from this initiative despite the macro headwinds.

We continue to have strong conviction around this program, and more generally around the CCSG business.

Despite the overall slowing growth rate in the fiscal second quarter, we continue to see traction from our share-gain programs.

Both vending and eCommerce remain strong, as our customers continue to leverage our technology platforms.

eCommerce reached 55.4% of sales for the second quarter, as compared to 51.8% a year ago, and 54.5% last quarter.

Vending continued to add roughly 3 points to our growth rate.

And we also added approximately 30,000 SKUs to our web offering, and now have roughly 900,000 available online.

Continued growth in these areas bodes well for future share gains.

We added roughly 2% to our sales force headcount in the first half of the year, and we remain pleased with the performance of our new classes of sales associates.

This 2% reflects a flat sales headcount for the second quarter, which is a function of two factors; one is the timing of our hiring, and two is our decision to temper sales hiring just slightly.

As of now, our trajectory is to increase sales headcount by around 6%; a bit below the 8% to 10% range we previously provided.

And that could change further, either up or down, as we assess changes to the environment.

I'm also pleased with our execution on gross margin.

On the last call, we highlighted that we saw sequential stabilization on the horizon for our second and third quarters.

This was largely a function of sustainable countermeasures on both the buy side and the sales side of our Business.

Execution of these programs has been strong.

As a result, our second-quarter gross margin came in at the high end of our range, and we're projecting that stabilization to continue into the third quarter.

Looking now at sales: Since the second quarter ended, we have a full month of fiscal March, and two selling days of fiscal April, under our belts.

We posted ADS growth of 1.9% in our fiscal month of March, which includes a holiday impact that, based on our estimates, reduced March growth by roughly 150 basis points.

The environment in March was similar to February, with lower growth that was most pronounced in our core customers.

National accounts and government continue to grow at rates well above Company average, although we have seen some moderate declines in growth rates there, too.

Finally, CCSG trending was consistent with February at roughly flat.

All of this is reflected in our fiscal third-quarter guidance, and illustrates the change in market conditions as more than just a temporary, weather-related headwind.

Before I turn the call over to Jeff, let me update you on our executive searches for a new CFO and Chief Customer Officer.

Both are progressing nicely.

We remain committed to getting the right person in each seat, and to not rushing the process.

With that, I'll now turn it over to Jeff who will cover our financial results in greater detail.

Thanks, Erik, and good morning, everyone.

In our fiscal second quarter, we faced a rapid change in the environment and poor weather conditions that led to us coming in below the low end of our guidance on sales.

We were pleased, however, with the gross margin stabilization and operating expense management that resulted in adjusted earnings per share coming in within our guidance range.

So, let's get into the second-quarter results in more detail.

I'll continue to speak in terms of our reported results and our adjusted results, which reflect the exclusion of non-recurring costs associated with the CCSG integration, as well as executive transition costs, both of which were very small for the quarter.

Our sales growth for the quarter on an average daily sales basis was 6.8% compared with the same period last year.

This reflects the swift change in the demand environment that Erik described.

It also includes strong growth from our large-account customers, as well as continued benefit from customers within our vending program, which contributed roughly 3 points of growth.

With regards to gross margin, we posted 45.4% for the quarter, at the high end of our guidance.

We're pleased with this, as our countermeasures have begun to have a positive and sustained impact.

I should point out that net favorable adjustments of about 20 basis points, primarily driven by supplier rebates, also contributed to the gross margin outperformance in the second quarter.

Even so, we expect the gross margin stabilization to continue in our third quarter.

Our reported EPS for the quarter was $0.83, and adjusted EPS was $0.84, which was at the low end of our guidance of $0.84 to $0.88.

This reflects sales below our guidance range, offset with a pick-up in gross margin, as well as effective management of operating expenses.

In fact, our operating expenses came in roughly $4 million below our guidance, which is well below the variable expense reduction one would expect from lower sales.

Finally, the tax provision came in at 38.5%, slightly above our guidance of 38.4%.

Turning to the balance sheet, our DSOs were 48 days, up from last year's fiscal second quarter, reflecting continued high growth in our national accounts.

Inventory turns were down to 3.42 from the prior-quarter level of 3.53.

As mentioned on our previous call, over the longer term we expect inventory turns to improve; however, turns should continue declining slightly through the balance of FY15 before they begin improving again in FY16.

And 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.

With regards to our operating cash flow conversion ratio, or net cash from operating activities divided by net income, it was rather low for the fiscal first half.

The main driver of this was the inventory build I mentioned, but we fully expect our conversion ratio for the full year to normalize in the 90%-plus range.

In terms of other uses of cash, we paid out approximately $25 million in dividends, and repurchased over $20 million in stock.

Total capital expenditures and infrastructure investments were $12 million, in line with our plan.

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

As of the end of the second quarter, we had $542 million in debt, mostly comprised of $225 million on our term loan and a $288-million balance on our revolving credit facility.

We closed the quarter with $27 million in cash and cash equivalents.

This resulted in a leverage ratio of about 1.1 times, a level at which we are quite comfortable.

And since the end of the quarter -- the second quarter -- we've already repaid $46 million on our revolving credit facility.

Now let me turn to our guidance for the third quarter of FY15, and let me emphasize that visibility is very limited in this environment.

We expect revenues to be between $740 million and $752 million, which translates to ADS growth of about 3.6% at the midpoint.

The midpoint of our guidance range assumes that April and May continue with similar underlying sales growth rates seen in March, adjusting for the holiday impact.

The guidance assumes that our core customer growth rates will remain below the Company average.

It also assumes that CCSG will continue with flat growth rates, consistent with what we saw in March.

We expect national accounts and government to continue outperforming Company average, albeit at modestly lower absolute growth rates.

We expect gross margin to be in the range of 45.3%, plus or minus 20 basis points, which is stable sequentially, excluding the net favorable impact from adjustments in the second quarter.

This reflects the positive and sustainable impacts from our gross margin initiatives, like exclusive brands, as well as countermeasures such as smart buying and selling.

The sustained impact from these gross margin initiatives is helping offset the headwinds from the soft pricing environment and customer mix.

We expect adjusted operating expenses to increase at the midpoint of guidance by roughly $4 million versus the fiscal second quarter.

Not only does this include the variable expense we would expect to support the $40-million sequential increase in revenues, but the OpEx also includes healthy levels of growth investments.

So, you can see that we're more than offsetting the growth investments with increased productivity.

So, the midpoint of our guidance implies an adjusted operating margin of approximately 13.3%.

Finally, our adjusted EPS guidance is $0.95 to $0.99.

This assumes a tax rate of about 38.4%.

In summary, while we came in at the low end of our adjusted EPS guidance for the second quarter, I am encouraged by both the stabilization of our gross margin, and our ongoing expense management.

The environment is challenging, but I fully expect our growth initiatives will continue to fuel share gains as we move through the remainder of FY15 and beyond.

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

Thanks, Jeff.

Before I close the call, I want to do two things.

First, I'll reconfirm the FY15 operating margin framework.

And second, I'll pull back and look at the bigger picture.

With respect to our framework, we find ourselves, at best, in the lower-left quadrant in terms of environment, meaning moderate demand and soft pricing conditions.

There's no question that the price environment remains soft.

The demand environment is the trickier one to characterize.

We have seen a sudden and swift change.

At this point, without more visibility, it's difficult to say whether we've moved to a low-growth environment.

We'll have a better feel with a few more months under our belts, without weather-related disruptions in current results and in prior-year comparisons.

At this point, we see annual operating margins landing towards the lower end of the lower-left quadrant of our framework.

As you can see on the provided slides, the operating margin range for the soft pricing, moderate growth quadrant is 13.4%, plus or minus 50 basis points.

Regardless of the demand in pricing environments though, we will remain focused on what we can control: achieving share gains and, hence, growth rates, well above market; executing the gross margin countermeasures that are producing sequential stabilization; managing expenses carefully; and executing on our growth programs.

As I pull back from the near term, I remain as excited as ever about the growth story that's building at MSC.

We operate in a $140-billion, highly fragmented MRO marketplace, with clear signs that we've entered the early stages of a consolidation story.

We are well positioned in a US manufacturing sector that is strong, and will only benefit over the long run from lower energy prices, despite the near-term dislocation.

We are positioning the Company into value-add, high-retention businesses like inventory management, metal working, class C and more.

On top of all of this, history has proven that times of dislocation create even more opportunity for MSC to forge ahead in the years that follow.

If the recent softness continues, or even worsens, local and regional distributors will be hit disproportionately hard.

Cash flow, margins, talent, customer payment terms -- these things will all come under pressure if the demand in pricing environments persist.

That will mean even more opportunity for MSC to execute our growth plan.

We stand poised to capitalize on whatever environment is in front of us.

In the meantime, I'd like to thank our entire team of associates for their hard work and their dedication to executing our plan, and delighting customers.

With that, we'll now open the lines for questions.

(Operator Instructions)

The first question comes from David Manthey from Robert W. Baird.

Please go ahead.

Thank you.

Hi, guys, good morning.

Good morning, David.

First question on the top line, you're saying that you would expect stable daily sales growth rate underlying in April and May to hit the midpoint.

What gives you confidence in that outlook?

Did trends stabilize through March and into the first couple of selling days of April?

Or what gives you that confidence?

Yes, Dave.

One point I want to make sure that we connect is that the March growth rate that's posted on the website of 1.9%, you really need to back out our March because our fiscal calendar extends into April, includes the Good Friday impact that will reverse itself in April.

So on an effective basis, it was more like the mid-3 is consistent with our guidance.

And in terms of guidance, yes, Jeff gave the caveat that certainly visibility right now, things have changed in a hurry, so our visibility is lower than it normally is.

But with that said, we're giving you our best sense of what we anticipate happening which is, roughly stable growth rates with what we saw on an underlying basis in March.

Okay.

So you're saying that through March it was fairly stable at that growth rate?

Yes, that's right, when adjusting for Good Friday.

But again, what you'll see is that will reverse itself in April.

Because last year -- we'll have the benefit of a lower comp on that day which hurt us in March.

So, yes.

Okay.

And then second, could you discuss the sustainability of your current gross margins in terms of price mix and lower revenue growth rates and inflation?

It seems that it would be even harder going forward to sustain, given this situation.

Could you remind us how you approve for rebates?

Is there any possibility that when we get to the fourth quarter, say, there's an adjustment out there if sales don't accelerate the way you think they will?

Yes, so I'll give you our perspective on gross margin, Dave.

Overall we're pleased with our performance on gross margin.

If you think back, we had a few quarters back, seen a couple of quarters of sequential drops.

We implemented some countermeasures.

We felt we would see stabilization, certainly Q2, Q3.

We're executing as we thought.

And you're right, this is a difficult environment to sequentially hold gross margins in light of lack of price and, yes, a significant customer mix headwind.

So we feel good about it.

We do anticipate gross margins being relatively stable.

I'll remind you that our Q4, we do typically see a seasonal drop, so I would anticipate this year being no different.

Although certainly if we continue to execute, a chance that the drop would be more modest.

As I look out and I think of where you're going is the bigger picture, if the current pricing conditions were to persist and if customer mix remained a headwind, what's our take on gross margin?

I'll give you the caveat certainly that it has so many moving parts to it on the headwinds and tailwinds side each, that there's a lot of variables.

But what I would tell you is I think, looking out, if conditions stayed as they were, certainly would be a challenge to expand gross margins.

But our aim would be to do what it is that we're doing now, and that's keep them relatively stable.

Your question regarding rebates is a good one, and it's one of the reasons why we point to all of these different moving parts and variables.

Rebate has been certainly a tailwind for us.

Jeff pointed to it in the second quarter.

You were correct that if the demand environment were to remain as we're seeing it right now, or even to worsen, yes, rebates could turn to a headwind later on in the calendar year as we move into FY16.

That certainly is possible.

And I'll remind you, Dave, that we usually see some seasonality in the gross margin in the fourth quarter due to the product mix.

In other words, some pressure on gross margin versus third quarter.

Got it, all right.

Thank you very much, guys.

The next question comes from John Inch from Deutsche Bank.

Please go ahead.

Good morning, everyone.

Hi, John.

Hi, John.

Good morning.

I don't remember if you've talked about this even at a broad level.

But what exactly is your mix, do you think of sales to the energy-driven or producing states?

Is there a way to come aside that?

Yes, John.

So on the last call we started to share, in light of the initial disruption that had happened in that sector.

It's a tricky one.

The direct exposure is very clear; the direct exposure is 3% or less to the oil and gas sector.

Where it gets trickier, and what we're now seeing, where the impact is much broader based, is all of the tiers of that supply chain and particularly in our core manufacturing base, that are actually influenced by oil and gas.

So we are seeing pretty pronounced changes in growth rates and in conditions in manufacturing.

And particularly when we go to manufacturing and look at our numbers and look at manufacturing activity in states that have an oil and gas influence, it's really pronounced.

So it's pretty clear to us that while the direct exposure is small, the indirect exposure is pretty broad based.

Yes, so the states, for instance, that have been the big job creators, North Dakota, Texas, Alaska, South Dakota, are you seeing then -- is what you're saying that where you have manufacturing in those states, you're actually seeing that?

Or are you talking about maybe, like Pennsylvania, for instance, is kind of a quasi-manufacturing state that has oil and gas fracking.

Is that what you're talking about?

Or is it a bit more --

John, exactly.

You rattled off a handful of the states where -- if you looked at our -- what we described in our total Company growth rates here, yes, you saw a pretty pronounced impact.

If you looked at the growth rates in those states, even just in our core customers in manufacturing, they would be considerably more pronounced than what's happening with the Company average.

Do you have, Erik, outsized exposures to any one of these states?

For instance, HC Supply, which I realize you don't really compete with, but they have a big proportionate exposure to Texas.

Is there any one of these energy-producing states that we should keep our eye on?

I don't think there is, but I'm just curious if there is.

No, you're correct.

There's no one that's disproportionately high.

But when you take the collective group of them, it's a meaningful influence.

What I'd also point to is, even beyond the oil and gas impact and the other thing we've seen outside of those states, we have seen a change in the manufacturing landscape.

And we think that's more than just oil and gas, the softening of the export environment being the other factor that's weighing things down right now.

You guys have been historically very good at drawing inferences and correlations with PMIs.

And the ISM has been -- this debate about its disconnect with what companies have been seeing over the past two years, they may have changed the methodology.

But one thing that does strike -- so considering the way you guys have been able to successfully do that, one thing that does strike somewhat unusually is the significant drop in the Chicago PMI now for two months, which seems to be beyond any sort of impact of a port strike.

Are you seeing in that regional Midwest area, are you seeing a trend that would correlate with that which dovetails with the comments you just made, Erik, possibly?

John, I would say in general, if you look at what's happened with the indices, the sentiment indices, they've been trending down.

So the drop you're referencing in Chicago, the ISM, in general what's happened with the MBI, I think it's indicative of what's happening on a broader base.

Less about one area like Chicago, more about what's happening across the board.

Look, in one quarter this thing moved pretty quickly.

You could tell our tone on this call is quite different from just a quarter ago.

We see that as pretty broad-based and not specific to a region.

Okay.

Then lastly, you guys have a very pristine balance sheet.

So in theory, I wanted to get your thoughts toward possibly raising some financial leverage down the road, given interest rates where they are.

Secondly, I don't remember, Jeff, what you said.

Why is cash flow so negative?

Normally when companies see softening sales, they're able to extract cash from the business.

But you guys had a fairly big use of working capital.

Why is cash negative in a slowing sales environment, again?

Thank you.

Yes, John, starting with the cash flow, during the fiscal first half we did have to build an inventory and that was associated with the stocking of the Columbus CFC and the anticipated sales growth.

So if you go to the cash flow statement you'll see almost all the difference versus the prior year is associated with that.

We anticipate the inventory levels to stabilize as we look at the back half of the year.

By the end of the year we expect to have a total-year cash flow conversion ratio consistent with our history, which is in the 90%-plus range.

Great, thank you.

The other one was on -- John, what was --

The balance sheet.

Your thoughts around raising financial leverage for some, perhaps, strategic use.

I know you've been talking up M&A a little bit, and maybe the environment presents more opportunity, just something like that.

Yes John, as you know, we made decisions in the past year or so to be slightly more aggressive, but still remain conservative and flexible in our capital allocation.

We've done a series of things, including larger than historical share repurchases, the special dividend not too long ago, an acquisition.

We've been investing organically.

We're operating now at about a 1:1 leverage.

We're very comfortable there.

We're willing to flex up and down depending on the opportunities out there.

Right.

Thanks, guys, appreciate it.

Thanks, John.

The next question comes from Flavio Campos from Credit Suisse.

Please go ahead.

Good morning, thank you for taking my questions.

I just wanted to see if you guys could give a little bit more detail on the slow-down on the manufacturing side.

A lot of your competitors have started unbundling their manufacturing exposure and giving a little bit more detail towards some markets like heavy machinery, which tends to be double hit by the oil and gas and the lower exports impact.

Can you guys give any more color on if any of these sub-markets are performing worse than others?

Yes, Flavio, it's Erik.

I think you hit on the key theme, which would be consistent here.

Look, manufacturing is a very broad umbrella.

We have seen over the past quarter -- so the slowdown has been broad-based on the factors we described.

If there's an area that we call out, it would be heavy manufacturing, heavy durables.

As you could imagine, given our strong metal working position, that's a significance percentage of our total company sales.

Heavy manufacturing has a big influence on our growth rates.

And you're right, there's been a double whammy in heavy manufacturing because of oil and gas, and then being particularly hit hard by the change in the export environments.

So within manufacturing, that's the one I'd call out, and certainly it's a relevant one for us.

Perfect, that's helpful.

And on the non-manufacturing exposure, I know you've talked about it slowing down slightly from the mid-teens, which seems a little high to begin with.

But it seems that once you consolidated CCSG on the operating statistics, you've got a little bit bigger non-manufacturing exposure.

And at the same time, that acceleration on the first two fiscal quarters, is there a correlation is there?

Is the non-manufacturing business of CCSG growing fast?

Or is this just two things that happened to happen at the same time?

Yes, it's more coincidence, Flavio.

So you are correct to point out that the reason on the op stats you saw there was one quarter, there was a quarter ago where you saw a relatively decent-sized jump up in non-manufacturing as a percentage of total.

You are correct, that was the influence of CCSG.

We've shared the most recent growth rate for CCSG being roughly flat, roughly two-thirds of their business is non-manufacturing.

So that's not the factor that was driving the non-manufacturing growth rates.

The bigger factor would be our government business, which certainly we've talked about the last couple of quarters being a strong performer for us.

And then a couple of other segments within non-manufacturing, where we happen to be doing well within our national accounts program.

Those are the bigger drivers.

Perfect, that's very helpful.

If I could just sneak in one real quick.

Your CapEx guidance seems to imply that it's firming acceleration in the second half.

Can you give some color on what are the main uses here?

Yes, it's probably a bit of a pick-up, not too much second half over the first half.

But CapEx includes a variety of things such as normal updated infrastructure investments, IT and vending spending.

Those are the three drivers.

Perfect, thank you so much.

The next question comes from Adam Uhlman from Cleveland Research.

Please go ahead.

Hi, guys, good morning.

Hey, Adam.

Hey, Erik, can I start with a clarification?

I think at the end of your prepared remarks you had mentioned that you thought that the EBIT margin would be the lower left quadrant for the year.

But then you might have said like the low end of that.

Are you saying the 13.4% or below the 13% for the year?

Yes, Adam, I'm glad you asked me to clarify.

I think you got it right.

Remember, so the lower left quadrant was the moderate demand soft pricing quadrant.

I'll start with environment and then move to what it means to our margins.

I would say the way we characterize the environment is it would be lower left quadrant at best, certainly soft pricing.

Demand environment, honestly we're not sure if we'd still call it moderate or low.

And I think we're going to want a couple of more months of experience before we make that call.

What we wanted to get across, though, was regardless, right now we see us for the year falling within that lower left quadrant, so we're in the range.

The range was 13.4%, plus or minus 50.

And you are correct, with what we see right now, it would be towards the lower end of that range.

So if you said plus or minus 50 basis points, minus 50 would bring you to 12.9%.

Somewhere between 12.9% and 13.4% would be where we'd see it right now.

Okay, got you, thank you.

And then, you guys had talked about the inventory investment that's happened, the inventory expansion.

I'm assuming that you're taking on some inventory to earn some extra rebates in addition to the Columbus distribution center.

I'm curious if you're nervous at all that you might be adding inventory at a time when you would expect that prices should be starting to fall from suppliers.

So you might be paying too much for some of this inventory build.

I'm wondering how you're thinking through that process and if you're having any success in getting any price concessions from suppliers.

So, Adam, let me start with inventory.

To answer the question there, no concerns.

A few things on the inventory.

Number one is that the build is in fast-moving inventory that we can turn quickly.

We've shown -- I have complete confidence in our team that it's being really changed.

We can bring inventory levels down quickly.

The other thing I'd say is, in times of -- if this becomes some sort of sustained softness, having inventory on the shelf, customers are not going to want to keep inventory.

Local distributors are going to be forced to bleed down inventory levels.

This becomes a really big advantage for us.

I talked in the prepared remarks about times like this, of dislocation, being an opportunity for us to accelerate share gains.

Having product in stock and getting it next day is absolutely critical, so I feel very good about our inventory investment.

And the other question that you asked was around the supply side.

Yes, I would say certainly it's been an area of focus for us.

It's been a healthy part of our gross margin countermeasures, given what's happened with commodities and currency, to reach back to our supplier community.

I think we've done it in a win-win way, where we're having success.

And it's been where we're having success, it's success for suppliers who are looking to invest in MSC.

And then, I think they would tell you that they're getting that back in terms of incremental investment from MSC in growing their brands.

So I would say, so far so good.

I anticipate this, though, being an ongoing initiative.

Great, thanks, Erik.

The next question comes from Scott Graham from Jefferies.

Please go ahead.

Hey, good morning, Erik, Jeff and John.

Hi, Scott.

I was wondering if we might look at this the other way for a moment.

We've been drowning in the negatives of the slower sales akin to the factors that you guys have talked about.

Considering that the consumer is still more than 60% of the pull on GDP, and that pull obviously ultimately impacts industrial markets, demand pull there as well.

With oil down, there is an effective tax cut that's taking place right now for the consumers.

So have you talked to your customers about the back half of the calendar year?

What could potentially take place for demand for volumes in the second half of the year as that tax cut makes its way through?

Yes, Scott, I think you're hitting on something that we tried to get across in the remarks that, longer term, whether it's the back half of 2015 or not, or it's 2016, we don't know.

But longer term, we think that what's happening with energy prices actually bodes quite well for manufacturing in the US.

Number one, it makes us more competitive.

And then number two, you're right that lower oil prices are going to put more dollars in consumers' pockets, and that's more money, more disposable income to spend.

So we feel really well positioned in manufacturing.

What's happened so far is the extreme drop has created a dislocation.

And right now, the way that's netting out is negative.

But over time we see this as something that will ultimately be a good thing.

It's tough for us to say when.

I would say in speaking to customers, I don't think they have a sense as to when either.

But I think they would agree, big picture, it's a good thing.

Sure.

What I was more trying to get at, Erik, was in fact if your customers were actually saying that to you.

That they're potentially expecting -- I wouldn't go anywhere near the words coiled spring -- but is it possible that we could see the demand destruction that we saw in your sales numbers and other distributor's sales numbers in the last quarter, really essentially flip around, let's say two quarters out.

Are your customers maybe thinking that?

Are they saying anything like that to you?

So, Scott, I would say the answer is right now, no, we are not hearing that.

I think we're hearing more caution than we are excitement for the near term.

That said, I give the caveat that if I went back a quarter, a quarter and a half ago, our customers also weren't talking about what was coming with oil and gas.

So certainly who knows; it's possible.

But right now we're not hearing a lot about a coiled spring for the back half of the calendar year.

Understood.

Last question.

Jeff, you indicated that you guys were expecting free cash conversion to be in the 90%-plus range for FY15, I believe I heard you say.

Would it require a fairly substantial sourcing of cash from working capital, to the tune of let's say $50 million?

Is my math right there?

Yes, Scott.

You will see, as we head into the second half of the year, with our earnings coupled with inventories remaining relatively stable, as well as our receivables, that if you do the calculation, you'll see that the cash flow conversion ratio for the second half of the year will be well over 100%.

And we've done the calculation and that should get us in it the 90% range, which is quite normal for the year.

Got you, thank you.

Thank you.

The next question comes from Sam Darkatsh from Raymond James.

Please go ahead.

Good morning, Erik, Jeff, John.

How are you?

Hey, Sam.

Most of my questions have been asked and answered.

A couple of follow-ups or piggybacks on prior questions.

Erik, do you have a sense of -- your manufacturing customers that do in fact export, any sense of what your specific mix, customer mix, is to that segment?

Offhand, no, Sam, I would have to take a look and do some thinking.

But offhand, no.

Other than to say that, as we called out, we do think heavy manufacturing.

So durables are being hit particularly hard on exports.

That's the only color I'd offer.

Okay.

Second question, your Midwest geographic segment was up 5% in the quarter.

Which, it might be a little bit lower than Company average, but not dramatically, certainly not to the extent that a true major oil and gas derivative impact might have suggested.

Which implies that there are other aspects of the Midwestern exposure that are that are more than offsetting that negative hit.

Where are you seeing strengths, specifically vertical wise in the Midwest that might help to offset that oil and gas exposure?

Sam, so one thing I would say is when you're looking at our numbers, remember, you're looking at a quarterly average.

So you would probably see by month, you'd see, regionally you would see a more pronounced effect.

But, look, I think in general a couple of things I'd point out, there certainly are pockets of strength.

I don't think I'd be giving you any great revelations to say aerospace and automotive.

Automotive being more applicable to the Midwest, not so much aerospace, being strong pockets for us.

Despite the softness, we also feel like we are taking share.

And I think that's part of what you're seeing, and why the drop wasn't greater.

Last question, if I could.

Jeff, the cash flow percentage to net income in FY16, would you expect a performance better than 90%, based on some of the comparative math?

That's a little far to look in advance, and depending on a lot of factors.

But historically, we've been in that 90% plus range, and I don't see anything that would lead me to think it would be otherwise for 2016.

Okay, so the second half of FY15 should normalize the working capital to the extent that you should not expect outsized operating cash flow, all else equal next year?

That's a fair assumption.

Okay, thank you, gentlemen, I appreciate it.

Thanks, Sam.

The next question comes from Kwame Webb from Morningstar.

Please go ahead.

Good morning, gentlemen, thanks for taking my questions today.

Hey, Kwame, how are you?

I'm good.

I just want to follow up on a couple things that Erik said.

The first one for me was, there was some commentary about some accounts are pulling work in that they had previously subcontracted out.

Are you just referring to things that they're doing outside of their procurement efforts with you?

Or are you actually seeing them in-sourcing some of the procurement work that you might have handled for them?

Kwame, so to be clear, yes, that was more about their output, their work product.

And not atypical this would happen when things get a little bit soft, they're one of the first steps.

Larger companies, so if they have components of their finished product that they would outsource to other contract manufacturers, that's what they're pulling in, not the procurement.

Okay, great.

And then I just wanted to run a tactical hypothetical by you.

Clearly investors have been a little bit surprised by the margin compression related to the investment cycle you guys have been in.

Clearly what you've been doing, is you've been trying to build out the platform for future growth.

But I want to get an idea of what room you have to manage expenses.

So let's say we were to have like a 10% organic sales decline, what levers do you have to protect your margins, protect your returns, protect your free cash flow?

Or do you guys take the view that we don't really throttle back any resources because we're going to go after increased market share?

Help me think about how you guys would react to that sort of environment.

Yes, Kwame, it's a good question.

One thing I'll say, at this point from our standpoint, way premature to go there, if you're talking about minus 10% growth levels.

But as a hypothetical, what I would tell you is that, first of all what I'd say is I think you can see from the numbers, we've been doing a pretty good job despite the step-up in infrastructure and investments that we've been -- So what's happened here is a step-up in investment coincident with a soft demand environment and a soft pricing environment.

And that's produced the picture that you see.

But I think we've been managing expenses well.

Certainly there are other levers that we could pull in terms of managing expenses.

You've seen us historically through other periods, more severe dislocations than this, take other measures.

And so there are other measures we could take, but those measures would be proportional to the environment.

And certainly we're no where near that now.

The other thing I'd say is, depending upon how severe something got, we actually view times like that dislocation, as opportunities to put the foot on the accelerator, to really juice share gains coming out of it.

And you've seen us do this through periods.

So there's a chance that while we would certainly take cost down measures, that we could actually step up growth investment.

Now, let me be clear about that.

Our goal is to grow operating margins from where they are today, and to do it over time.

So if we were going to take that approach, the opportunity would have to be really compelling.

And it would have to be one where, like historical, where we would see the types of returns coming out of the downturn that made it such that it became a great investment.

That's how we look at it.

I think it's really going to depend upon the environment.

We certainly do have other levers on the cost side.

And then on the investment side, I would say the investments could go down or they could go up, depending upon what we saw in front of us.

So maybe just to paraphrase, it sounds like if things were to incrementally slow down, yes, expect you to definitely do your best with to defend margins.

And as you saw opportunities later on, maybe then expect you to reinvest in growth initiatives then?

Yes, I think that's reasonable.

And honestly, they could be happening at the same time.

Meaning if things got bad, we could pull some more levers on expense management certainly.

At the same time, say we're going to choose to throttle up investment because if the opportunity were that compelling.

Okay, thanks so much.

I'll let somebody else get their questions in.

Thank you.

Thank you.

The next question comes from Eli Lustgarten from Longbow Securities.

Please go ahead.

Good morning, everyone.

Eli, good morning.

This is in the range of a followup.

Two pieces of data that you put out surprised me a little bit.

One was the slight decline in average transaction size.

And the one that surprised me more was the decline sequentially in e-commerce sales, which I probably haven't seen in quite a while.

Is that just the fluke of days or something or weather or something?

Do you have any explanation for what's going on for those things to happen?

Yes, Eli, I think both are supportive of what we've seen, which is the change in the demand environment.

So first of all, the second quarter it's not atypical for sales, I believe, to be down from first quarter.

But certainly sales were lower than we expected them to be because of the demand environment.

I think that's what you're seeing in the average transaction size, is reflective of the softness.

In terms of e-commerce, it's just the water level coming down because, actually, e-commerce as a percentage of sales --

Went up, yes.

-- is actually up sequentially from the first quarter.

And the other follow-up piece I'm looking at is one of the things I think is going on and I'm hearing is, we talk about demand slowing, is that there's probably an inventory liquidation cycle going on out there that may continue for another quarter or two.

The impact of the big decline in the oil side and you talked about the effects of oil on manufacturing.

The first thing anybody involved is going to do is take inventories down and probably take it down sharply, when you talk about at least 20% to 30% declines in upstream spending.

Can you characterize any of this demand decline as inventory liquidation more than just demand softening?

Have you looked into that at all?

Yes, Eli, it's something we're keeping our eye on.

Our VMI business and actually our CCSG business will give us a good pulse.

I would say it's a little early to tell.

It's hard for us to sort out, given all the noise in the past quarter.

There was so much noise.

In addition to these macro changes, there were weather-related disruptions and there were weather-related disruptions in the comps.

It was tough to tell, so I would say a little soon to call.

I think it's a reasonable hypothesis.

And I think in another quarter, we're going to have a better feel.

And particularly with the CCSG business, that will give us a sense.

You didn't see any of that in March also?

I understand through February and weather, but a lot of industries March had -- in construction March had a rebound.

Are we saying you couldn't pick up anything other than the change in demand in March and the holiday effect?

Yes, that's right, Eli.

I think the bigger story with March is the fact that growth rates did not bounce back, which I think is more supportive of the case that the Q2 factors were a lot deeper than just weather.

But beyond that, tough to read too much into it.

One final question.

You said you made a small pricing adjustment in January.

How big of an adjustment was that?

Was that in the 0.5% range?

We typically -- we'll break out and publish, or share publicly, our catalog increase, the August-September increase.

We generally don't on the mid-year.

The way I characterize it was small, think small.

Think at or below the lower end of what we would typically do in a catalog increase.

So if you looked at the range of catalog increases, at the bottom of that range.

All right, thank you very much.

And our last question comes from Charles Redding of BB&T.

Please go ahead.

Hi, good morning, gentlemen.

Hi, Charles.

I realize your Canadian exposure is relatively limited here.

Can you quantify the impact of currency on the quarter?

Typically foreign exchange is a minimal factor for us.

On our growth rate it amounted to about 30 basis points negative.

That's on the consolidated level.

On the consolidated level.

Obviously had a bigger impact on the CCSG, probably under 40 basis points or so.

Yes, I think that's a fair point.

So CCSG would have been slightly positive growth in the quarter but for the currency exchange.

Got it, okay.

And then I know you've talked a lot about the majority of MRO consumption being focused really among larger customers.

Can you perhaps speak to some of the added challenges here in terms of large customer integration?

And is there any reason to think that this dynamic change is given the current commodity in manufacturing headwinds that we're seeing?

Yes, I think what you're seeing, Charles, on the large accounts front, is the early stages of the industry consolidation playing out where the large well-capitalized national distributors, such as MSC are -- just huge opportunities there as these companies implement all kinds of buying technology and look to consolidate their supply base.

So I think what you're seeing is strong value proposition and early-stage consolidation driving the growth rates well above Company average.

I think if things soften, certainly we've seen it, the absolute growth rate comes down.

But I would say if anything, it actually should actually widen the share gain delta for MSC, for large distributors over local distributors, in the large accounts arena.

And the reason being, like every other business there will be more and more pressure for productivity.

And solutions like inventory management, vending, our class CVMI, our technical expertise, et cetera, et cetera, really play well when customers are starved for productivity.

That's great color.

Thank you much.

Thank you.

This includes our question-and-answer session.

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

So our next earning date is set for July 8, and we certainly look forward to speaking with you over the coming months.

I would like to thank everyone for joining us today and for your continued interest in MSC.

Have a great day.

The conference has now concluded.

Thank you for attending today's presentation.

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