MSC Industrial Direct Co Inc (MSM) 2016 Q1 法說會逐字稿

Good morning, and welcome to the MSC Industrial Supply Company first-quarter FY16 conference call.

(Operator Instructions)

Please note, today's event is being recorded.

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

Please go ahead, sir.

Thank you, Rocco, and good morning everyone.

I'd like to welcome you to our FY16 first-quarter conference call.

With me in the room is Erik Gershwind, our Chief Executive Officer; and Rustom Jilla, our Chief Financial Officer.

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.

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 our earnings press release and the Risk Factors and the MD&A sections of our latest annual report on form 10K filed with the SEC, as well as in 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 may refer to certain adjusted financial results, which are non-GAAP measures.

Please refer to the tables attached to the press release, 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 CEO, Erik Gershwind.

Thanks, John, and good morning, everybody.

Thank you for joining us today.

I'll start by wishing everyone a happy New Year, and also, thank you in advance for bearing with me as I muddle through a New Years head cold that I contracted.

So I'll now get into the remarks, and I'll begin by covering the macro environment, which remains extremely challenging.

I'll then turn to our recent performance, which I'm quite pleased with in the face of difficult conditions.

Rustom will then provide additional detail on our financial results and share our second-quarter FY16 guidance.

I'll then conclude with some additional comments on our expectations for the year and reinforce the opportunity that we see going forward.

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

So let me begin with market conditions and then our performance against a challenging backdrop.

The environment continued to deteriorate as expected.

The root causes for the slowdown remain the same.

The rapid and sustained drop in oil prices, the strong US dollar with its negative effect on export demand, and foreign exchange headwinds are all negatively impacting broader manufacturing activity.

Macro indicators continue to reflect a sharp and extended slowdown in manufacturing, with US factory activity extending the more than two-year low that I mentioned last quarter.

The ISM continued its decline in December and has now been below 50% for the past two months.

The MBI also continued falling and remained below 50% for eight months in a row.

The October and November MBI readings came in at 43.2%, indicating a significant contraction in the metalworking sector.

These readings are consistent with what we're hearing from our customers, which includes shrinking backlogs and order flows and very low visibility.

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

Supplier pricing activity, the primary driver of distributor pricing movement, continues to be minimal.

As such, we've not implemented a mid-year price adjustment and don't anticipate doing so absent the change in conditions.

Let me turn to our performance in the face of this challenging environment, and it's highlighted by three things.

First, continued share gains, as indicated by growth rates well ahead of the market.

Second, sustained gross margin stabilization from solid execution on both the buy side and the sell-side.

And third, continued strong expense controls and realization of the benefits from our productivity initiatives.

I'll start with revenues.

On an average daily sales basis, our net sales for the quarter were in line with our guidance and down 3.3% from last year.

The monthly trend deteriorated through November as anticipated.

Growth rates by customer class came down across the board.

Our large account business, comprised of government and national accounts, grew at a low-single-digit pace for the quarter.

Our core and CCSG customers lagged, the Company average reflecting extreme softness in both the metalworking and the mining end markets.

The combination of these factors meant that customer mix remained a gross margin headwind.

Despite negative growth rates in the quarter, the macro indices, industrial distributor surveys, and supplier feedback all confirm that our share gains have continued.

This is a function of strong execution of our growth initiatives, vending, SKU expansion, salesforce productivity, eCommerce, digital Marketing, and more, along with delivering excellent service in a difficult environment.

Availability of product is paramount to our customers, particularly now when they're reducing inventories on their own shelves.

Customers continued leveraging our vending and eCommerce technology platforms.

ECommerce reached 57% of sales for the first quarter, up from 56.7% last quarter and 54.5% a year ago.

Sales to vending customers contributed roughly 50 basis points of growth.

We also added approximately 70,000 SKUs, net of removals, to our web offering.

We now have nearly 1.1 million SKUs available online, and continued growth in these areas bodes well for future sustained share gains.

Regarding salesforce expansion, our net headcount for the quarter was basically flat.

I will note that beginning this fiscal year, we're including field sales and service associates in this calculation.

Given our increasing penetration of inventory management solutions, such as vending and VMI, this adjustment better reflects the way we go to market as both a sales and the service organization.

Field sales and service expansion remains an important growth lever, and we still anticipate increasing headcount in the low-single-digit range for the year, absent a change in conditions up or down.

We continue to execute well on our gross margin stabilization countermeasures, including purchasing and selling initiatives.

As a result, gross margin reached the high end of our guidance range for the quarter and continued the trend of sequential stabilization over the past few quarters in the face of current market conditions.

Finally, I want to note the continuing focus on expense control in the quarter.

Operating expenses are significantly below the prior year, and that reduction is beyond the volume-related declines, despite ongoing incremental spending on growth initiatives.

This reflects our Team's cost down mentality and strong execution in this difficult environment.

All of this resulted in earnings per share at the top end of our first-quarter guidance.

I'll now turn things over to Rustom.

Thanks, Erik.

Good morning, everyone.

As Erik noted, we executed nicely at both the gross margin and operating expense levels, so let me jump right into our fiscal first-quarter results in greater detail.

So sales have already been covered, but just to recap, the decline in average daily sales in our fiscal first quarter of 3.3% versus last year was within our minus 2% to minus 4% guidance.

With regards to gross margin, we posted 45.1% for the quarter, at the high end of our guidance and virtually the same as in the first quarter last year.

Make no mistake, the headwinds from customer mix and a soft pricing environment remain significant, but the execution of our gross margin countermeasures, such as discount optimization, freight initiatives, and supply and cost reductions, has been strong.

And as I mentioned last quarter, supplier cost reductions should also have an increasing impact as we move through FY16, and we will certainly need them to offset those headwinds.

We continue to make steady progress on reducing overall operating expenses, and FY16 first-quarter OpEx was roughly $7.6 million lower than in the same period last year; however, as you may recall, last year's first quarter included $3.6 million of non-recurring costs, so the apples-to-apples improvement was approximately $4 million.

This came from headcount-related savings, various cost-reduction initiatives, and lower volume-related expenses.

These gains were partially offset by higher medical costs, making the savings from our cost-down efforts effectively even greater than the $4 million just mentioned.

The temporary spike in medical costs is partially due to MSC transitioning from our self-insured medical plan to a fully-insured private healthcare exchange, which will not only provide our associates with more choices, but will also help us better manage and reduce the volatility of healthcare costs over the long run.

Finally, the Q1 tax provision came in at 38.2%, slightly better than our guidance of 38.4%, and this was mostly due to the favorable closing of a State income tax audit.

Our EPS for the quarter was therefore $0.89, at the high end of our guidance range, due to continued expense reductions and gross margin stabilization.

The $0.89 compares to an adjusted $0.95 last year, as OpEx savings could not fully offset the negative impact of lower sales volumes.

Turning to the balance sheet.

Our DSO was 51 days, up from last years 49 days in the first quarter, reflecting continued growth in national accounts.

Our inventory turns were down to 3.11 from the prior quarter's level of 3.19, while inventories actually declined by roughly $14 million over the three months.

As I noted last quarter, these lower turns are a function of the 13-point average turn calculation we use and should begin improving in the second half of this fiscal year.

Our free cash flow, which is cash flow from operations net capital expenditures, was $107 million in the first quarter, so this compared to $44 million for the same quarter last year and reflects improvements in working capital.

Please note that while cash generation was quite strong in Q1, some of this, such as cash tax of state, is timing related, and free cash flow in our fiscal second quarter is expected to be just slightly positive.

Nevertheless, for FY16, we expect free cash flow to be in excess of last year's $198 million.

Capital expenditures were approximately $16 million for the quarter, versus $13 million in last year's Q1, and full-year 2016 CapEx expectations remain in the $60 million to $70 million range.

With regard to other uses of cash, we paid down $70 million of our revolver net of borrowings, paid out approximately $26 million in dividends, and bought back roughly 97,000 shares in the first quarter for about $6 million.

So we ended the first quarter with $38 million in cash and cash equivalents and $354 million in debt, mostly comprised of $206 million on our term loan and $118 million balance on our revolving credit facility, at a leverage ratio of just 0.71 times.

Now, to our guidance for the second quarter of FY16.

And please note that our visibility is very limited in the current environment.

Normally, this is our most difficult quarter to forecast in any case, coming so soon after the holidays, and it's been compounded this time by the challenging environment.

With that said, we expect second-quarter revenues to decline on an ABS basis by roughly 2% to 4% versus the prior-year period.

While December's sales decline was only 1.5%, this included the favorable impact of the holidays falling on Friday this year, as opposed to last year when they fell on a Thursday.

So excluding this favorable impact, we're projecting something similar for January and February.

In the second quarter, we expect a gross margin of 44.9% plus or minus 20 basis points, and that's flat to down to slightly down sequentially and down versus the same quarter a year ago.

Our gross margin will be impacted by headwinds and tail winds that will roughly neutralize each other.

The headwinds will be the impact of a soft pricing environment, including high competitive intensity, particularly from local distributors, customer mix, and lower supply rebates.

The tail winds will be the benefit from our gross margin stabilization initiatives, including buying and discounting improvements, along with longer-term strategic programs, such as growth in private brands.

We expect fiscal Q2 operating expenses at roughly the same level as our first quarter.

Our expense controls remain strong, and however, second quarter will include the seasonal increases in payroll-related expenses due to the calendar year reset, continued spending on growth initiatives, and the need to remain ready for a seasonal Q3 volume growth which we typically see.

As such, in the second quarter, we expect an operating margin of above 11.6%, at the mid point of guidance.

As many of you know, our fiscal second quarter is nearly always the one with the lowest operating margin, and we expect 2016 to be no different.

Clearly, our annual framework implies a second-half improvement in operating margins; however, this is not because we are assuming an improved environment.

Rather, it reflects the following.

First, sales comparisons get easier as we reach March and move through the back half of our fiscal year.

Second, absolute sales should increase sequentially from fiscal Q2 onward, simply due to the number of effective sales days providing increased leverage.

Third, we expect the execution of our various cost-down measures to only add to the leverage opportunity in the back half of the year.

We've also received a number of questions on the impact of the 53rd week on our FY16 operating margin framework, so let me clarify.

The framework in the accompanying presentation is based on a normal 52-week year, but we would also benefit from a 53rd week this year.

This should add roughly 15 to 20 basis points to our FY16 operating margin in each quadrant of the framework, with the full benefit coming in the fourth quarter, of course.

Finally, completing our fiscal second-quarter guidance, we expect EPS in the range of $0.76 to $0.80, and note that this assumes a tax rate of 38.4%.

I'll now turn back to Erik.

Thanks, Rustom.

Before we open up the line for your questions, I'll make some closing comments.

I'm pleased with our execution during the start of our FY16 in the face of an extremely challenging environment.

We started the year as expected and remain in line with our annual operating margin framework.

Looking beyond 2016, I remain confident about our business and its future.

Economic slowdowns are the times when MSC makes its greatest strides.

These are the times when the local and regional distributors that make up 70% of our market suffer disproportionately.

History tells us what will happen to local distributors if this downturn prolongs.

Reducing their inventory leaves customer service vulnerable.

Clamping down on receivables disrupts longstanding customer relationships.

Laying off people creates hiring opportunities to acquire industry talent not typically available.

We are just starting to see the very early signs of these things occur in the marketplace.

The pace will accelerate the longer these conditions hold.

We are pleased with our share gain performance to date and would anticipate it to continue or even accelerate the longer these conditions last, and that will lead to disproportionate top-line growth when the environment does improve.

We are also using this time to improve our cost structure through productivity initiatives and tight expense management, and that should create significant earnings leverage when revenue growth returns.

2016 marks an important milestone for us.

It represents MSC's 75-year anniversary.

I'd like to congratulate our MSC associates for this achievement and thank them for their hard work during our first quarter.

I have great confidence that they will do the same in the coming months and years.

We'll now open up the lines for questions.

Thank you, sir.

(Operator Instructions)

Our first question comes from Matt Duncan of Stephens Inc.

Good morning, guys.

Hey, Matt.

Good morning.

Nice job in a tough environment this quarter.

Thank you.

So the first question I've got is just on the sales trend.

Not surprised that things got worse as the quarter progressed given what we're seeing from the economic data points, just end markets are getting tougher.

Was a little surprised by how much things got better in terms of that decline in December versus November.

And Rustom, you pointed out there's a little bit of a holiday benefit there, but is there anything else going on, because it's 4.4 points better in terms of the sales decline in December versus November?

Given what Kennametal had to say and the extended holiday shutdown that a lot of manufactures were planning, I think that's a little bit of a surprisingly decent data point.

So is there something you guys did to help the sales there in December?

Is there anything you'd call out, Erik?

Matt, what I'd say is two -- I'd parse out two parts to the question.

Part one, what's happening in the environment.

Part two being our execution and what's happening with our growth rate.

With respect to environment, look, I think that it's difficult.

It's pretty much as described.

It's a very challenging environment, but now, both on the demand side and on the pricing side, and really no surprises.

I'd say visibility is quite low right now, so tough to identify a catalyst at this moment, although with low visibility, who knows?

So that's on the environment side.

With respect to our growth rates and performance, I think as we look at it, we don't make too much of the month-to-month movement.

We're looking over broader tranches of time quarter by quarter, and what we're seeing is, in a deteriorating, lousy environment, pretty stable performance that we feel quite good about.

I would note that December -- and Rustom mentioned the holiday impact, so just to give a little more color there and explain what was going on, the holidays this year, both Christmas and New Years -- and remember, New Years actually falls within our fiscal December, so both of those holidays fell on a Friday this year, last year on a Thursday, and the difference being, when the holidays fall on a Thursday, effectively, that Friday for us counts as a business day, but you can imagine a lot of businesses take long weekends.

So net-net, what we saw in December was similar level, I would say, of shutdown activity as prior years.

That, along with the benefit of the holidays being on Friday, counted for roughly 250 basis points or so if we had to peg it of benefit in December.

But net-net, I think for us, big picture in terms of our performance, we feel really good about it and really good about our share gain performance in a lousy environment.

Okay.

Very helpful.

And then last question for me, just Rustom, you've been there about six months now.

As you've looked at the business and have tried to identify cost savings opportunities, are you to a point where you can quantify how much more expense you think you can take out of the business to drive better profitability?

Matt, six months, you're right.

Look, it's an ongoing process.

We've been taking cost cuts across a whole range of areas, headcount, freight initiatives, minimization of discretionary expenses, stuff like that.

So that will continue.

We'll continue doing that, and it's being done bottoms up through the organization with everyone focusing on productivity.

So wouldn't quantify it, but certainly, we're using all that, and that's part the reason why we're guiding to be able to hold operating expenses flat in Q2.

Sure, okay.

Yes, Matt just to chime in for a second and give Rustom a little bit of props here because to Rustom's [quote], we did start some of these cost moves before he came on board the organization, but I will say that since he's joined, I think the pace has accelerated, and he and the Finance Team are bringing very strong leadership to the organization.

And this is going to be an iterative process that he's introduced of increasing discipline, increasing an intensity and focus on execution and taking cost out one cost center at a time at a very, as he said, grassroots level.

So I think the momentum will only increase over time.

Okay, thanks, Erik.

Appreciate the color, guys.

Our next question comes from Ryan Merkel of William Blair.

Thanks.

Good morning, everyone.

Hey, Ryan.

Nice job on gross margins and costs.

Thank you.

So I wanted to start with price, and it's a two-part question.

So first, how would you characterize the big book price realization?

And then secondly, what is your outlook for price realization for the year?

So Ryan, as you know, with respect to price, first of all, our big book price increase that we shared last quarter was quite low, at 1%.

So as you can imagine, realization off of 1% was going to be low.

I would say in general we feel good about how we're doing managing price discounting discipline in a very difficult environment.

And the evidence there is if you look at our growth decomposition on the offset, what you've seen now for a number of quarters is plus or minus price being essentially flat as a contributor to growth, which, again, I think in a what is effectively deflationary environment is a testament to execution and to the strength of the value proposition, so we feel good about that result.

Yes, and then price for the year?

Should we be assuming just flattish?

Is that a fair assumption?

Look, I think what I would do there, Ryan, is point you more to how we're looking at gross margin.

Price is one piece of the gross margin formula, and I think holding price plus or minus flat is what's allowing us to achieve the sequential stabilization.

So our Q2 guidance on the margin side more or less continued the trend of sequential stabilization.

If we were to look around the corner, we see something similar in Q3, and then as we move to Q4, we have seasonal factors that usually come into play that will take gross margin down in Q4.

But overall, I think we feel pretty good.

And all of that, by the way, is baked into the framework in each quadrant that we provided.

So in the current environment, more or less, more of the same, absent change in conditions.

Right, okay.

And then just maybe a bit of end-market color.

Manufacturing customers down about 5%, which I think is a pretty good in this environment.

I think it's evidence of share gains as you said.

Can you just list a couple of the end markets that are doing more poorly versus some that are doing a little bit better?

I think that would be helpful.

Yes, Ryan, I can add color.

It's probably going to be no great surprise relative to what you've heard and seen from others.

I think the overwhelming majority of segments are down, and down and have deteriorated over the past few months.

There's pockets like commercial, aerospace, that have been reasonably strong.

There's pockets of automotive that have been reasonably strong.

Again, probably no surprise to you.

The other color I would offer is as it relates to size of company.

You've heard us talk about large accounts even in a negative environment still growing, albeit in low-single-digit range.

So larger companies seem to be faring better than smaller companies.

Again, I think no great surprise there.

Right.

Okay, thank you very much.

Our next question comes from Sam Darkatsh of Raymond James.

Good morning, Erik, Rustom, John.

Happy New Year to you.

Happy New Year, Sam.

Couple questions.

First off, a follow-up on the pricing question.

And at the risk of -- I don't mean to imply that this is a zero-sum game, but clearly, your pricing over the last three quarters has been flat to up mildly, and Granger in the US has been showing pricing down 1% or 2%.

In the SKUs that you overlap Granger, are you seeing pricing down 1% or 2%, and then therefore, the difference might be the metalworking breadth and depth and the value prop that you give, or is it something else entirely?

Just trying to get a sense of why you're seeing different pricing than, let's say, Granger might?

Sam, so good question.

Tough for me to compare.

That's a tough one for me to answer.

Not sure as it relates to Granger.

To be honest, we are really focused on how we're executing in a tough market, and while we certainly pay attention to the competitive landscape, much more focus is given to how we're executing for customers.

What I would say -- I also -- I wouldn't make too much of pricing.

You're right; it's slightly positive.

I think net-net, as we look over the past several quarters, the trend has been flattish plus or minus, and we feel like that's a really good result.

I think there's two things going on.

I think one is execution and one is value proposition.

I think execution, we've been talking about countermeasures on the buying and the selling side, and certainly, on the selling side, that's been maintaining discipline.

It's very easy to, in a soft environment when customers are shopping, give price away, and we're being careful to maintain discipline in a tough environment.

So that's the execution side of things.

As it relates to value proposition, look, one of the things that we've been talking about is really paying attention and being mindful about our portfolio of business, that we want to be in businesses that have a lot of value add and where we think we bring a lot to the equation beyond price.

So metalworking, you bring up metalworking as a good example where our specialists are bringing cost savings on the plant floor outside of the price of the product.

So I would say those are the two reasons behind what I think has been good execution in a really tough pricing market.

Two more quick questions if I might.

The vending growth contribution, two or three quarters or so, it might have been 4 points.

It went to 2 points last quarter, and now it's 50 basis points.

That might suggest that the vending initiative is approaching or is that maturation.

Is that an unfair characterization?

Yes, Sam, it is.

I think that the bigger story there is it's the water level coming down on everything, so the 50 basis points is now relative to a minus 3. The 400 basis points was relative to like a plus 7, plus 8.

Effectively, what we're seeing is, because the slowdown is occurring virtually everywhere, remember, what that represents is sales to customers with vending machines.

Those businesses are being affected just like every other.

So from our standpoint, the fact that those businesses, that we're still showing growth in businesses that are coming way down is a good sign.

I don't think we've reached -- at all, that indicates reaching the end of the line on vending.

Last question, CCSG, what was the drag that CCSG provided on overall sales comparisons, and is that drag moderating, expanding, if you could help us with that?

Thank you.

Sure, Sam.

So CCSG, I would say we cite CCSG and metalworking both being below Company average, honestly, both in similar ranges.

Certainly, I'd like to see CCSG growing faster.

I'd like to see metalworking growing fast, and I'd like see the business growing faster.

I think the overwhelming headline there is they are being impacted by the macro like everybody else.

Execution at CCSG remains focused on the three levers that we've talked about, which are service improvements -- core customer service improvements, which are going quite well; cross-selling, which is really picking up traction; and then salesforce retooling and transformation, which I would say remains a work in process, have a lot of confidence in the Team and the plan there.

Thank you, gentlemen.

Thank you, Sam.

And our next question comes from Adam Uhlman of Cleveland Research.

Hi, guys.

Good morning.

Happy New Year, and congrats on the numbers in a tough environment.

Thank you.

I wanted to dig more into the market share capture because that's still a point that I agree with you on, but the average order sizes were flattish, and the customer count was flat or down a little bit from last quarter.

We've talked about this a little bit, but maybe could you flush out some other metrics that you use to track your penetration with customers?

Could you talk about maybe like your -- are you seeing growth in the ship-to locations versus maybe just overall customer count, or maybe you could talk about the productivity with the new SKUs that you've added to the book?

Maybe just to help us put some more flesh around that aspect.

Yes, sure, Adam.

So let me start.

When we look at share gains, we begin with the bottom line, so we'll look top down to evaluate overall Company performance, and then in a very granular way, we look bottom up at a ton of different metrics.

The bottom line for us when we look top down is, how does the Company's growth rate compare to industry?

And as you know, we triangulate -- and by the way, your work is an excellent piece of work, along with some others on the distributor surveys.

We triangulate data, including your surveys, including supplier feedback, including macro indices, peer comparisons, to get at what we believe market is growing at and assess our growth relative to market.

At the end of the day, that is the bottom line, and that's what we can't out run.

Our assessment is that our share gain performance remains quite strong as measured along that dimension.

I think what you're then getting at is, hey, where is it coming from?

The where is it coming from, there's two things I'm going to cite.

One is program execution, and that program execution is both directed at share of wallet penetration and new account acquisition.

And the other is going back to the strength of the value proposition and the customer service.

Particularly what we find in times like this, when times are tough and customers really need to lean out their operation, they need to rely more heavily on supplier partners, whether that's helping them in the plant, whether that's them getting product quickly, so we see the MSC advantage really being widened when times get difficult

So I think that's part of the story.

The other part of the story is program execution, again, directed at share of wallet penetration and account acquisition.

I'll touch on one other thing you mentioned, piggybacking on the account acquisition piece, and that's customer count.

Not surprising to us here, it's a metric that we've said for awhile is not top of mind for us.

It's really been a left over.

It's more of a direct marketing metric.

Not surprising to us that it would flatten out.

If you look back at other periods of economic difficulty, that number tends to ebb and flow with the economy.

In fact, in the last downturn, it was down significantly.

It's now flat, so not a particularly surprising result to us.

Okay, got you.

And then Rustom, you had mentioned when you were going through the margin drivers for the quarter, the discount management, the freight supplier cost reductions.

I was wondering if you could maybe quantify the savings that you're getting from each one of those buckets, or rank them out, or help us better understand the drivers there.

Thanks.

No, I couldn't, and for probably competitive reasons and the fact that we work with our suppliers, and just for competitive reasons, I couldn't.

But those are the main drivers, and they are just the levers, Adam, that we keep working on.

Okay, great.

Thank you.

Our next question comes from Robert McCarthy of Stifel.

Good morning, everyone.

Congratulations on some nice execution in the quarter.

Thanks, Robert.

A couple of questions.

One, not to drill down on December again, but I understand the comparison, and you highlighted the 250 basis points, but could you comment on what you're seeing maybe with respect to your energy-facing or derivative markets in association with energy, whether you saw any signs from a comparison standpoint or any stabilization there vis-a-vis December or recent trends that may explain some of this -- I don't want to say stabilization, but this better performance in the month?

Yes, Rob, so let me start with two things there.

I'll start with energy and then get to the December number.

But on the energy front, really no change.

And just a reminder, our direct exposure to energy is really low, really low meaning well under 5%.

The indirect exposure is I think what's taken everybody by surprise, not only at MSC, but in the broader economy, and it's ugly.

There's no other way to say it.

And I think in the past, we've shared that when we look at our manufacturing end markets, that they're what would be traditionally thought of as metalworking markets in areas that are energy exposed, i.e., Texas, Oklahoma, et cetera.

The results are really, really poor, and not surprisingly.

So no sign of life there.

I would not read anything into that.

With respect to December, as I've said, the holiday impact, call it roughly 250 basis points, when we look month to month, there can be noise in the growth rates.

What we're really focused on is what's happening on an average daily sales level in absolute dollars.

And what we're seeing there, over the past couple of quarters, going into our Q2 guide, is effectively average daily sales stabilization.

And I think that's really where we're focused because the growth rate is strictly a function of how it lines up to comparisons prior year, and again, I think we feel pretty good.

What we've seen is average daily sales stabilization in the face of a deteriorating environment.

Well no, clearly, you look at the Kennametal pre announcement coupled with the whole investor tenor around shutdowns for year end in December, expectations are zero there, so it's a pretty surprising result, and obviously, I think you've guided to something a little more conservative.

We wouldn't want to extrapolate from that data point.

But turning to the compares, and I think you cited that compares get significantly better in the March time frame.

Do you have some sense whether you could return to positive growth in the back half of the year, or is that plausible given how the compares lay out?

How do you think about how the back half could play out from a top-line perspective?

Well Robert, if you just continue to assume that we have sales per day running per day at more or less the same level as we're running today, and we don't have the visibility to be able to tell you any different to that, right?

Yes.

If you project at that, the back half of the year would be close to breakeven, very slightly negative, call it, you can do the math yourself, but close to breakeven.

Right.

I prefer you to do the math Rustom, (laughter) but no, I appreciate that.

And the final point, or question I guess, is just looking -- is there an opportunity here to maybe do more larger cost take out or restructuring across metalworking or CCSG or whatever the case may be just given the prevailing environment?

Is there a potential plan B here to just say, you know what, this may be a real opportunity to take a lot of cost take out or really rethink the cost structure of the business?

How do you think about wrestling with that?

Well first of all, we also -- we prefer the approach of working through very bottoms up, very collectively with the Team and trying to see how we can improve productivity and doing it without trying to take cost out, purely reactively to market conditions, right?

That's one of the reasons why MSC bounced back so strongly from 2008 and 2009 as well.

So right now, we're not really seeing an environment where we need to do that.

If things get much worse, then obviously, we'll respond accordingly, accelerate cost actions that we've taken and do stuff.

But as of now, no, I think we continue to innovate discipline with focus and execute and let the Team run away with it.

Anything to add there, Erik, or not?

No, Rob, I think Rustom is really leading us through the approach to expense management and productivity in a very effective way, and it's not going to be about a big bang and a massive transformation.

The transformation is happening one cost center at a time with just doing things smarter, one productivity initiative at a time, and I think it's working.

I will tell you, I think there's still a lot of runway.

That's the exciting part.

It just is not going to be in a big bang.

The only other thing I would add to Rustom's first comment and your question on the back half of the year, look, we are squarely -- one thing I want to reiterate -- we are squarely in that lower left quadrant, so that demand quadrant that we call slightly negative and we said was 0 to minus 4, right now, with everything we see, and granted, our visibility is extremely low, but we would characterize it as right smack in that quadrant.

Thanks for your time guys.

Our next question comes from David Manthey of Robert W. Baird.

Thank you.

Happy New Year, guys.

You too, David.

First off, I have to ask the requisite December question.

Would you characterize the impact of the mild weather across the entire US as either a positive or a negative?

And then second, a lot of the questions have referenced the year-end shutdowns or the holiday shutdowns.

What do you see from your customer base specifically as it relates to those shutdowns?

Yes, Dave, good questions.

Nothing major to report on weather that would have been a factor either way.

We didn't see anything big there.

With respect to shutdown activity, we would characterize the shutdown activity as relatively similar to last year.

So if you take a similar level of shutdown activity combined with the benefit of the Thursday versus the Friday holiday effect, we think that's what helped us in those last couple of weeks.

And I'll admit it's hard to parse out the shutdown activity from the Thursday-Friday phenomenon because again, just going back to the analogy, when the holidays fall on a Thursday, it's unlikely that a business is going to come back for that Friday, so you're effectively losing a selling day twice, one for Christmas, one for New Year.

So hard to parse those out, but I'd call it similar to last year.

Okay.

And clearly, some of your customers carry some amount of safety stock in the products as you sell them.

Do you have any comments, either anecdotal or statistical, that will help you and us understand where we are in the inventory destocking cycle?

Yes, boy, I wish I had something [quantitive].

It's a tough one to get precise on, Dave.

What I would tell you is, certainly, like what MSC is doing, which you see inventory levels have come down, our customers are doing the same thing.

However, I would say I want to draw your attention to what we see as the bigger headline, which is the results we saw and others have seen in terms of the macro for the back half of the year and the last few months.

The primary driver there is a reduction in incoming orders, in demand, in backlogs, not in destocking, and I think that's the bigger headline.

Okay.

And then somewhat related to that and final question.

Your sales historically have somewhat tracked the ISM PMI with maybe a two- or three-month lag, and do you look at that relationship differently today, or -- the reason I ask is that it seems that the ISM has fallen since mid year last year and your average daily sales growth and your guidance is basically the same in the second quarter as what you saw in the first at the mid point, so I'm just wondering if you could square those two things, or are you thinking about that relationship differently?

Dave, I think the honest answer is we're thinking about the relationship -- if you go back, and you probably have seen the same thing with other distributors, but historically, the correlation with PMI was quite tight, and over the past couple of years, not just for us but for peers, it's not been nearly as tight.

So we certainly look at it, but we look at a bunch of other factors as well in forming judgments.

We introduced for awhile now the MVI, which seems to have a tighter correlation.

So again, we'll look at PMI, but not with the same degree.

I don't think it has the same degree of predictive correlation as it did years ago.

All right.

Thanks a lot, Erik.

Our next question comes from Ryan Cieslak of KeyBanc Capital Markets.

Hey, guys.

Good morning, and happy New Year.

Hey, Ryan.

Happy New Year to you.

A lot of my questions have been answered, but I just wanted to ask the share gain question one more time in a different way.

And Erik, is there a way of thinking about maybe where you're seeing the greatest share gains right now from the segment of your business, whether it's your core metalworking business or vending or CCSG?

Is there one area that you think you're maybe garnering greater share gains than the other, or is it pretty much across the board?

Yes.

Ryan, I think what we try to do is highlight for you, and there's three dimensions by which we look at the business, by customer type, by product type, and by channel, to highlight for you what we think is driving -- and look, I think we're doing well in a lot of areas, but certainly, what we'll do during the prepared remarks is highlight where we think we're doing particularly well.

So by customer type, we've been calling out the large accounts as an area that's done particularly well, and that's not just national accounts, but we think that it's an area where technology is allowing for supplier consolidation to happen at our customers at an accelerated pace, and we think we're benefiting quite nicely from that.

Along the product dimension, look, we've talked about metalworking as a key area of focus, as an area of leadership where we feel like we're doing quite well.

We've talked about the Class C area as an area of focus.

And then along the channel dimension, there's two that we've highlighted that we think are doing quite well, vending and eCommerce So those are the ones that we call most attention to.

Okay, fair enough.

And then just on the -- you've been talking about the gross margin countermeasures, particularly some benefit you guys are getting with your suppliers in terms of how you're buying right now.

Just if you could maybe give more granularity on the cadence of that benefit as we go into the other quarters, is it something you see or you expect to really pick up in the back half, or do you see a gradual incremental benefit quarter by quarter?

I'll take that.

We do see that gradually beginning to accelerate as we go on, and that's -- we've been working with our suppliers, and the suppliers who see us as a value add driver of growth, the brand building platform, they're investing in us, and obviously, we're focusing more on them.

And we kicked off a lot of work on this back in November with a second round pretty much rolling out now, and so we've seen some of these benefits come in as we go into the back half of the year, and then some of them will actually flow into FY17.

Okay.

And then Rustom, is there a percentage or way of thinking about -- are you working with or targeting a certain percentage of your supplier base, or is this a broader initiative with all of your suppliers you're really looking to target?

Broader.

We started with our key strategic suppliers, clearly, and focused on that, but definitely broader.

It's working across the whole base.

Ryan, the one comment I'll add-on the supplier front is this has been ongoing.

It's not a one and done.

It's ongoing discussions.

It's ongoing actions.

And look, to some degree, it has to be a win-win situation, so it's not just a matter of us going back and beating the supplier over the head saying give us more money.

That's not going to be sustainable and long term not good for both sides.

So it's been about dialogue, certainly, with strategic suppliers, as Rustom said, going broader, but also about not just what the supplier is going to do for us, but what can we do for them to make it worth their investment in us.

Okay, great.

And then just a housekeeping question.

Rustom, if I heard you right, you said that there was higher medical costs in the quarter, and I think you said part of them were temporary.

I just wanted to make sure that was the case, and is there a one-time in nature headwind that was in the quarter that rolls off going forward, or how should we be thinking about medical costs going forward?

Sure, absolutely.

Well, we've been self-insured through the end of calendar 2015, and so we've always had variability in our quarterly medical costs, right?

And this year's Q1, which for us ends at the end of November, remember, so it's been compounded by the introduction.

The Q1 peak that we [haven't seen] was compounded by the introduction of our private health exchange.

And then probably see, based on what we've seen anyway so far, some reasonably high medical costs so far coming through December, right?

But going into Q3 and Q4, then you'll start to see the benefits of a steadier run rate of medical costs and certainly a lower run rate than what we've had in Q1.

Is there a way of quantifying what type of headwind that was in the quarter?

In this particular quarter, medical costs were almost $4 million higher sequentially compared to the quarter before.

But like I said, you don't really take away too much from that because they do vary quite a bit.

They bounce around quite a bit.

Got you.

Okay, fair enough.

Good quarter, guys.

Thank you, Ryan.

Our next question comes from Charles Redding of BB&T.

Hi.

Good morning, gentlemen.

Thanks for taking my question.

Hi, Charles.

Just wondering if we could drill down a little bit on government and national accounts.

You mentioned the low-single-digit growth expectations here, and certainly the benefits from technology, but where else do you see strength here, and maybe how do you prioritize large accounts here over the coming quarters?

Charles, it's been an area of focus; it remains an area of focus.

And it's been -- I think what you're seeing as slight positive is -- it's again, going back to the two drivers of performance right now in terms of execution and the strength of the value proposition, and I think both are at play with respect to national accounts and with respect to government.

So both of those segments have been pretty soft, so we feel good about a positive result as being indicative of strong share gains, and that's been an ongoing area of focus, and it will remain an ongoing area of focus.

Okay, great.

Thanks.

Maybe how do we think about the opportunity for M&A in the current environment?

We're coming up on three years here post Barnes.

Can you give us any color on changes in the market and maybe how you think about current consolidation in the industry just given the ongoing headline pressures?

Yes, sure, Charles.

I would say despite the significant changes in environment, not a significant change in our approach here and what we're seeing or in how we're thinking about M&A, which is we certainly keep our ears and eyes wide open.

Have not seen a radical change in activity levels, and certainly, M&A part of the equation.

And as I've said for the last couple of quarters and I'd reiterate is, at the moment, certainly, we're open to, it but the bar is a bit higher than it normally is just given everything going on inside the Company and outside of the Company, and quite honestly, the nice traction that I think we're seeing on the top line, on gross margin, and on expense controls.

I feel like the Company is executing well, and so to divert attention to an acquisition, we would do it for the right acquisition, but the bar is just a bit higher.

We certainly have the capacity to make acquisitions as well because remember that under our debt covenants, we can go up to 3X, if you would, and we're at 0.71.

Excellent.

Thanks again.

Thank you, Charles.

Our last question for today is John Inch of Deutsche Bank.

Thank you.

Good morning, everyone.

Hi, John.

So just hypothetically, if we were to lose two days, Christmas and New Years, right, on that 23-day month, that's about 8% to 9% benefit, right, if you don't lose them.

Is the reason it's only 2.5% because they were just slower days of the month anyway, or you still get some business so you cut it in half, or just trying to understand the 2.5% Is that when you have an extra day or something, is it always 1.25%?

Is that the way to think about it?

John, you got it.

It's just that it's a partial day.

It's not that it's -- there's business coming in, but it's not a full day, so that's it [that set us apart].

It's not -- those days are not the equivalent of a full day.

Okay.

So then to get to down to 3% for the quarter, I think you have to go from your down 1.5%, you have to go down 4% for the next two months, so that almost implies, right, that if you we to add the 2.5% to the 1.5%, that's 4%.

Are you assuming then, Erik, that January and February are also down 4% to get to the down 3%?

Is that -- in other words, it's simply a continuation of the run rate of the apples-to-apples down 4%.

Does that make sense?

Yes, it does.

And I think that's how I look at it.

I couch it by saying, as Rustom said, our visibility right now is extremely low.

This is always a tough quarter for us, John, because we come off of the holidays and really don't have any peek into how things bounce back.

It's compounded, the low visibility this year, by the environment.

But yes, essentially, you're right.

If you do the math, you're right.

It averages about 4% down January, February, and our assumption is more or less a continuation of what we're seeing in the environment.

Okay.

Federal Government was -- well, at least generally, Government was source of strength, right?

Now, Government fiscal year ended in September in your quarter.

Did you see any kind of an anomaly around that time, Erik and Rustom, that you would call out, maybe some a buy in advance or buy after the September period, because you did call out that the growth rate had decelerated, which I guess is natural because it had been so strong.

I'm just wondering if there was any other anomaly associated with the year-end fiscal that might have accounted for some of that?

John, good catch on Government.

Not so much an anomaly.

Generally, there's a seasonal pattern with the Government.

You're right, their fiscal year ends in September, so as you can imagine, there's a lot of spending leading up through September and then a big drop off as people spend their final budget dollars.

That happens every year, so no big surprise there.

We've been really pleased with the performance in Government.

That has been a very strong grower for us.

You are right to note the growth slowed down.

The big factor there, and it wasn't so much ADS, it was more a function of the ongoing lack of budget resolution within the Federal Government that did not get resolved until late December that most certainly had an impact on spending environment in Government.

We did see a change there.

We're hopeful with resolution -- hopefully, that bodes well for the back half of the year, but like everything else, visibility is low and to be seen, but that was the big driver.

That makes sense.

Just lastly, so you called out, Erik, you added 70,000 SKUs to the online catalog, so you're at 1.1 million.

I've got a two-part question.

Did that materially impact growth in the quarter, the 70,000 on the 1 million before that you saw?

Like is there an initial fill or something like that?

And then the second part is, like, where do you think the 1.1 million can go to?

Because in theory, right, that could be a good buffer or stabilizer to a tough market if you can just keep adding these SKUs to broaden your product line and then maybe take a little bit of market share.

John, let me take your questions in reverse order.

Look, I do think there is still some runway there left, and yes, we've been adding them at 100,000, 150,000 clip for the last few years.

We still do see some runway there.

And look, I do think it's been a piece of the market share story has been capture of new products.

No question.

To answer your question, the 70,000 would not have a material impact on the results to date.

Think of these in waves that hit the beach, so the impact actually happens cumulatively over a couple of years, but the 70,000 would not yet have a material impact on the current results.

So in other words, potentially a benefit in FY17.

Let's say you add another 50% SKUs.

At some point, do you have to add another warehouse because there's just no free lunch.

You just can't keep adding SKUs without having to stock them because your advantage is actually being able to stock product when mom and pop can't in a downturn?

Do you know what I mean?

At some point, I hope so because it means we've grown so much that we do.

We've talked about on the warehouse side is that what we see right now, Columbus should take us to $4 billion, assuming the next billion looks like the first $3 billion, and that's factoring in what we're doing on the SKU front.

The other thing I'll call out we've talked about is we are trying to be smart about these, that they get added to the web.

They don't immediately get added to stock until we see them trip certain thresholds, so we're trying to be inventory and capital wise about how we do it.

Got it.

Thanks much.

Appreciate it.

Thank you, John.

This concludes our question-and-answer session.

I'd like to turn the conference back over to Mr. Chironna for any final remarks.

Okay, thank you, everyone, for joining us today.

Our next earnings date is going to be April 6, and we certainly look forward to speaking with you over the coming months.

Take care.

Thank you, sir.

Today's conference has now concluded.

We thank you all for attending today's presentation.

You may now disconnect your lines, and have a wonderful day.